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said to exist in a country™s currency. The central idea here is that certain
countries in the world have economic and/or political ties to a “major” eco-
nomic and/or political power, and thus enjoy particular amenities when/if
any stress emerges. Such an economic/political relationship might be explicit,
as between the west coast of Africa and France, where the exchange rate
between the CFA (Communaut© Financière Africaine) and the French franc
is fixed and as such symbolizes the strong ties between western Africa and
France, or less implicit though nonetheless real, as when the United States
demonstrated its support when Mexico experienced economic and currency
problems in 1994“1995.
These embedded calls have a price, and someone is paying for them.
Arguably some part of the “price” may be paid by the weaker currency coun-
try (as when domestic priorities and policy ambitions may be subjugated to
the priorities and policy ambitions of the stronger currency country), and some
of the price may be paid by the stronger currency country (as when financial
assistance is provided during both challenging times and other times).
This is all relevant because the worst-case scenario with any credit risk
is the situation where a default occurs and there is zero recovery value poten-
tial. Note that the nature of the intervention provided to avoid or otherwise
ease the effects of (potential) default does not necessarily have to be mone-
tary. Support could come in many shapes, including a relaxing of regulatory
constraints or tax breaks. Further, while the initial extramarket assistance
might come relatively quickly, actually seeing the assistance take hold and
with the desired effects might take much longer.
The previous paragraph cited regulatory and tax policy in the same sen-
tence. Market regulation may be defined as any attempt to somehow influence
or otherwise direct or guide someone™s actions. By this definition, even a tar-
geted tax policy could be viewed as a regulation of sorts, particularly if the tax
policy provides some kind of break or incentive (or just the opposite) to a unique
industry or type of business. Regulations do not necessarily have to be dictated


by governmental decree. They might be imposed (or become effective merely
by the power of suggestion) in a variety of different ways, as with special indus-
try groups seeking to provide self-regulatory guidelines, or with rating agencies
that may put forward their view on the desirable best practices of an industry
or market sector. Regulations can be well defined or ad hoc, and may come with
stiff fines and penalties or simple words of encouragement or warning. In short,
a regulation can be anything that by intent seeks to promote or encourage a
particular kind of desired behavior or outcome. Regulations may be intended
to protect, to promote, or to deter certain behaviors. For our purposes here reg-
ulations can and do cause market participants to act in ways they may not oth-
erwise; as such, regulations generally interfere with market efficiency, if
“efficiency” is defined in the strictest sense of being the complete absence of any
market frictions. Such an environment does not actually exist anywhere today,
nor is it desirable.
It is presumed that in the absence of a particular regulation, the behav-
ior of the targeted entity would otherwise be different. Whether this inter-
ference is seen as a good thing or a bad thing may well depend on which
side of the regulation one is: the side being regulated or the side doing busi-
ness with the regulated entity. Perhaps in some instances both sides see them-
selves as winners, while in other instances one side may be perceived to be
a beneficiary while the other is somehow being held back. Table 6.6 pre-
sents examples of all possibilities.
In the United States (and in most other markets as well), two industry
types that are heavily regulated are banking and insurance. This regulation
extends to a variety of operations, including how they manage their capital
and how they invest.


The previous section discussed how regulations can greatly impact issuers.
This section addresses how investors may be subject to a variety of con-
straints, both self-imposed and imposed by others. For example, many fund
managers voluntarily restrict their funds from being invested in certain types
of derivatives, or they may face limits on how much they can leverage their

Market Environment

TABLE 6.6 Regulations by Point of View
Regulated Entity The Other Side

Positive view May view regulation as a form May view regulation as
of protection against such protection against being sold
things as other firms trying to an inferior good or service
enter into the industry
Negative view May see regulation as an May see regulation as
impediment to entering other preventing the ability to have
desirable business lines access to a desired good or

portfolio. Among industry types in the United States that are subject to more
formal restrictions on the way they can invest, banking and insurance are
most certainly at the top of the list. With banks, restrictions exist with invest-
ing in any type of equity product, as well as having to designate if the invest-
ments they have made are held for portfolio (a long-term investment) or
available for sale (a short-term investment).
Another restriction on bank investments relates to credit considerations.
In particular, banks often are required by the government where they oper-
ate to follow strict formulas for how much capital must be set aside relative
to the types of securities they have purchased. Many times guidelines are taken
directly from the Bank of International Settlements (BIS). For example, in
1988 the BIS released a document covering credit risk. The document out-
lines how different asset classes can be weighted in a capital-at-risk accord-
ing to a security™s riskiness. There are five risk weightings: 0 percent, 10
percent, 20 percent, 50 percent, and 100 percent. OECD (Organization for
Economic Cooperation and Development) government debt or cash, for
example, has a zero or low weight, loans on banks get 20 percent, while loans
fully secured by mortgages on residential property are weighted at 50 per-
cent. All claims on the private sector or on banks incorporated outside the
OECD with a residual maturity of over one year are weighted at 100 percent.
To allow for a more dynamic approach to risk-based capital guidelines,
the BIS has issued a new framework for credit risk. The new framework is
designed to improve the way regulatory capital reflects underlying risk, and
it consists of three pillars:

1. Minimum capital requirements
2. Supervisory review of capital adequacy
3. Market discipline


The area of minimum capital requirements develops and expands on the
standardized 1988 rules. The risk-weighting system described above is
replaced by a system that uses external credit ratings. Accordingly, the debt
of an OECD country rated single-A will have a risk weighting of 20 percent
while that of a triple-A will still enjoy a zero weighting. Corporate debt also
will benefit from graduated weightings so that a double-A rated corporate
bond will be risk-weighted at 20 percent while a single-A will be weighted
at 100 percent. The committee also introduced a higher-than-100-percent
risk weight for certain low-quality securities. A new scheme to address asset
securitization was proposed whereby securitized assets would receive lower
weightings relative to like-rated unsecuritized bonds. Further, the BIS indi-
cated that more banks with more sophisticated risk management procedures
in place could use their own internal ratings-based approach to form the
basis for setting capital charges, subject to supervisory approval and adher-
ence to quantitative and qualitative guidelines.
The supervisory review of capital adequacy attempts to ensure that a
bank™s risk position is consistent with its overall risk profile and strategy and,
as such, will encourage early supervisory intervention. Supervisors want the
ability to require banks that show a greater degree of risk to hold capital in
excess of an 8 percent minimum capital charge.
Market discipline is hoped to encourage high disclosure standards and
enhance the role of market participants in encouraging banks to carry ade-
quate capital against their securities holdings. In sum, the BIS wants to spec-
ify explicit capital charges for credit and market risks and even seeks to
enforce a charge for operational-type risks. Under the 1988 requirements,
the BIS already made use of credit conversion factors and weightings accord-
ing to the nature of counterparty risk.
The credit risk of derivatives is assessed by calculating the derivative™s
current replacement cost, plus an “add-on” to account for potential expo-
sure. The “add-on” is based on the notional principal of each contract and
varies depending on the volatility of the underlying asset and residual matu-
rity of the contract. Foreign exchange contracts have higher weights than
those of interest rates, and transactions with a residual maturity of more than
one year bear higher weights than those under one year. The higher weights
of the foreign exchange contracts are consistent with the relatively higher
price volatility of currencies relative to interest rates. In further assessing the
credit risk on derivatives, the BIS distinguishes between exchange-traded and
over-the-counter products. Since the outstanding credit risk at exchanges is
addressed with daily margin calls, exchange-traded contracts are exempt
from credit risk capital.
In 1993 the Basle Committee proposed formulas for measuring market
risk arising from foreign exchange positions and trading in debt and equity

Market Environment

securities. The proposals were subsequently amended due to shortcomings
in the way that the market risk of different instruments was to be treated,
especially for derivatives. Key to the amendments was that the BIS Basle
agreed to let banks use their own internal models to calculate capital charges
for market risk. This is significant if only because it represents the first time
that banking regulators moved from simple formulaic-type requirements to
more sophisticated in-house models to determine regulatory capital. Banks
that do not meet the criteria set down by the Basle Committee are not
allowed to use their own internal models.
Another way that capital allocation decisions can be made, and especially
at the product-type level, is with volatility measures. Again, simply put, the
more price volatile one product type is relative to another, the less initial cap-
ital it might receive until it can show that its profitability makes it deserving
of an even larger capital allocation. Various consulting firms derive their sole
source of revenue from advising banking institutions on how they might best
manage their operations in the context of regulatory requirements.
Value at Risk (VAR) refers to a process whereby fundamental statisti-
cal analysis is applied to historical market trends and volatilities so as to gen-
erate estimates of the likelihood that a given security™s or portfolio™s losses
might exceed a certain amount. VAR is a popular risk-management vehicle
for firms, where maximum loss amounts are set internally and are not per-
mitted to be exceeded unless express permission is granted for doing so.
As stated, insurance companies are also subject to a variety of stringent
rules of operation. Among the restrictions faced by insurance companies is a
prohibition against investing in non-dollar-denominated securities, as well as
having to evaluate potential purchases of mortgage-backed securities (MBSs).
Regarding insurance regulations pertaining to investment policy, this
matter is generally handled on a state-by-state basis. To assist states with
the drafting of appropriate law, the National Association of Insurance
Commissioners (NAIC) has prepared so-called model laws. These propos-
als contain suggested limits or guidelines on various types of investments
inclusive of mortgage products, securities denominated in currencies other
than the dollar, securities lending, derivatives, and other matters.
Meantime, the Federal Financial Institutions Examination Council
(FFIEC) has mandated three standard tests that CMOs must pass before a
bank, savings and loan, or credit union can purchase a CMO security. The
tests help to determine the level of interest rate risk and volatility of a CMO
when subjected to interest rate changes. The three tests determine whether
a CMO is high-risk, and thus ineligible to be purchased by these financial
Since some CMOs are structured to pay out a steadier level of cash flows
over time, these would likely be more stable and predictable and tend to
qualify for purchase under FFIEC tests. The FFIEC tests involve:


1. An average life test. The expected average life of the CMO must be less
than or equal to 10 years.
2. An average life sensitivity test. The average life of the eligible CMO can-
not extend by more than four years or shorten by more than six years
with an immediate shift in the curve of plus or minus 300 basis points.
3. Price sensitivity test. The price of the eligible CMO cannot change by
more than 17 percent for an immediate shift in the Treasury curve of
plus or minus 300 basis points.

Certain employee pension funds are also subject to restrictions on the
types of MBS and ABS that can be purchased. In 1974 the Employee
Retirement Income Security Act (ERISA) was enacted giving the U.S.
Department of Labor (DOL) the authority to define eligible ABS and MBS
investments for employee benefit plans. The exemptions have been modi-
fied a few times since 1974, and generally permit employee benefit plan assets
to be invested in pass-through certificates issued by grantor trusts, REMICs
or FASITs holding fixed pools of certain types of secured debt obligations.
These include single-family, commercial, or multifamily mortgage loans and
loans secured by manufactured housing, motor vehicles, equipment and cer-
tain other limited types of property. Certificates backed by credit card receiv-
ables or any other types of unsecured obligation are not eligible for purchase.
In 2000 some rather substantive changes were made to ease restrictions on
purchases, and these are summarized in Table 6.7.
Figure 6.1 presents a brief summary of how financial products relate to
investor classifications in the context of regulatory guidelines on investment


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