Credit Derivatives Regulation

• The presentation concerns the regulation of credit derivatives, as presented by Faeezah Peerbhai from the Department of Finance and Tax in 2025.

Learning Objectives

• To understand why regulation in credit derivatives is necessary
• Regulation addresses systemic risk, moral hazard, and excessive risk-taking behavior
• To identify regulations governing credit derivatives
• Includes Dodd-Frank Act and Basel III framework
• Understand prudential and conduct regulations in South Africa's regulatory framework for credit derivatives.
• Identify the regulations for credit derivatives in South Africa.
• The regulations include the Financial Markets Act, and the Financial Sector Regulation Act.

The Need for Regulation

• Systemic Risk
• Moral Hazard
• Excessive Risk-Taking

Systemic Risk

• Systemic risk is the risk of disruption or failure in a system spreading to other systems or markets
• It can cause widespread damage or instability to the economy or financial system

Systemic Risk Continued

• Credit risk transfer increases systemic risk instead of reducing it
• Risks are not shifted outside the banking sector; most remain within it
• The probability of a single bank defaulting decreases, but the joint probability of multiple banks defaulting increases
• Simultaneous defaults can be costly for the economy
• Banks may deliberately increase systemic risk by becoming "too interconnected to fail" via credit derivatives
• Risk is not always shifted to parties best able to bear it, but to those with laxer regulatory constraints

Moral Hazard

• A loan implies a commitment to monitor the borrower
• Commitment breaks down if credit risk is easily transferable via Credit Default Swaps (CDS)
• Credit risk is passed between institutions, creating a lack of monitoring incentives
• Credit risk transfer leads to a moral hazard in loan origination
• Banks may knowingly grant loans where the present value of expected cash flows is less than the loan amount if the credit risk can be transferred

Excessive Risk Taking

• Credit derivatives are susceptible to excessive risk-taking due to their return structure
• They provide a small positive return with a high probability but entail huge losses with a low probability
• The unlikely event of huge losses is not considered because losses can be shifted to creditors, deposit insurance, or taxpayers

Derivative Regulation Before Global Financial Crisis (GFC)

• There was "light touch regulation"
• The Gramm-Bleach Bliley Act allowed commercial banks to engage in investment banking activities, securitizing debts
• Disclosure rules for Collateralized Debt Obligations (CDOs) and Credit Default Swaps (CDSs) were weak
• CDOs and CDSs operated in the shadow banking system through Special Purpose Vehicles (SPVs)

The Basel Framework

• International guidelines regulate the capital banks must hold to withstand financial shocks
• Developed by the Basel Committee on Banking Supervision, comprised of central banks and financial regulators worldwide
• The Basel Framework has evolved since its inception in 1988 with three main versions: Basel I, II, and III
• The latest iteration, Basel III, improves the quality and quantity of capital banks hold and strengthens risk management

Basel I

• It was the first iteration of the Basel framework, introduced in 1988
• It was focused on setting minimum capital requirements for banks based on credit risk exposure
• Banks are required to maintain a minimum Capital Adequacy Ratio (CAR) of 8%, calculated as a percentage of their risk-weighted assets
• Basel I was criticized for being simplistic and not adequately reflecting banks' risk leading to the development of Basel II

Basel II

• Second iteration of the Basel framework, introduced in 2004
• It aimed to improve the risk sensitivity and accuracy of regulatory capital framework
• Introduced a more sophisticated approach to credit risk management
• It allows banks to use internal models to calculate the risk of their assets
• Internal Ratings-Based (IRB) approach is a method used by banks to assess the credit risk of their borrowers
• The model considers financial strength, payment history, and industry sector
• Banks assign borrowers a rating reflecting credit risk level: higher default risk means higher rating, requiring more capital to cover potential losses
• Basel II was criticized for allowing banks too much discretion in their risk calculations, as internal models varied, and banks had an incentive to underestimate risk

Basel III

• It is a major overhaul of bank regulations published by the Basel Committee in December 2010
• Basel III increased minimum capital requirements for banks to provide a buffer to absorb losses during times of stress
• Focuses on Higher capital requirements for securitized assets
• Introduced new liquidity requirements mandate banks to hold liquid assets easily sold or converted to cash during stress
• Introduced stringent risk management, encouraging banks to improve risk measurement and management practices, including stress testing, reporting, and governance
• It introduced enhanced disclosure requirements, mandating banks to provide transparent information about their capital, risk, and positions
• Encouraged central clearing of derivatives

The Dodd-Frank Act

• Signed into law in July 2010
• It aims to prevent future bailouts of financial institutions and protect the consumer
• The Act established the Financial Stability Oversight Council (FSOC) and the Office of Financial Research (OFR)
• It monitors systemic risk and researches the economy's state
• The amount of deposits insured by the FDIC increased permanently to $250,000
• Introduced regulations requiring large hedge funds and similar financial intermediaries to register with the SEC and report their activities
• Increased investor protection and improvements to securities regulation
• Created the Consumer Financial Protection Bureau within the Federal Reserve
• The bureau ensures consumers receive clear information when shopping for mortgages and credit cards
• Mortgage lenders have to make a reasonable “good faith determination” based on verified information that the borrower can repay
• Large firms now required to have board committees including at least one expert with risk management experience

The Dodd-Frank Act Continued

• Rating agencies must make their assumptions and methodologies more transparent
• The potentional forrating agencies liability increased
• Introduced Swap Execution Facilities for electronic trading of CDS
• The Act also required central trading for standardized OTC contracts
• All derivative transactions must be reported to a registered Swap Data Repository (SDR)
• Introduced margin and capital requirements for derivatives not centrally cleared

Volcker Rule

• Restricted banks from engaging in proprietary trading, including using derivatives for speculation
• Limited bank investments in hedge funds and private equity, including some securitized products.

Risk Retention Rule

• Requires securitizers to retain at least 5% of the credit risk in asset-backed securities (ABS)

Regulation in South Africa

• South Africa has a regulatory framework for credit derivatives, including prudential and conduct regulations
• Prudential regulation in South Africa is primarily overseen by the South African Reserve Bank (SARB)
• Banks in South Africa must maintain a minimum capital level to support credit derivative activities, ensuring they can absorb potential losses
• Banks must have robust risk management and internal control frameworks to identify, measure, monitor, and control risks associated with credit derivatives
• Banks must provide disclosures on their credit derivative use to regulators and the public, including exposure size and nature, counterparties, and risk management practices.
• FSCA conducts regulation
• It is responsible for ensuring that financial institutions treat customers fairly and conduct business transparently and ethically

Regulation in South Africa Cont.

• FSCA has regulations to prevent market abuse, including insider trading and market manipulation in the credit derivatives market
• FSCA has regulations protecting investors from misleading or fraudulent advertising and sales practices related to credit derivatives
• Financial institutions are required to maintain accurate records of their credit derivative transactions and report these transactions to regulators regularly

The Financial Markets Act (FMA) of 2012

• It regulates the trading of financial instruments, including credit derivatives
• It provides a framework for regulating credit derivatives
• Derivatives must be traded on regulated exchanges or alternative trading platforms
• Market participants must meet certain standards of conduct
• The Act included new provisions relating to increased regulation and reporting requirements in respect of OTC derivatives
• It further empowered the Financial Sector Conduct Authority (FSCA) to supervise market participants, take enforcement action, investigate suspected misconduct, and impose fines

Financial Sector Regulation Act (FSRA) of 2017

• It promotes financial stability, protects consumers, and enhances the financial system's efficiency and competitiveness
• Established the Prudential Authority, responsible for regulating the prudential aspects of the financial sector
• This includes supervising banks and other financial institutions using credit derivatives
• The Prudential Authority can set and enforce prudential standards for financial institutions
• Standards include requirements for capital, liquidity, risk management practices, and corporate governance related to using credit derivatives
• FSRA also establishes a regulatory framework for market conduct to protect consumers and promote fair and transparent financial markets
• This includes rules for trading financial instruments and reporting trades to regulatory authorities

Credit Rating Agencies

• Before the Global Financial Crisis (GFC), the US recognized certain CRAs as Nationally Recognized Statistical Rating Organizations (NRSRO)
• Pension funds demanded a rating Deomm NRSRO before investing
• Pre-GFC NRSRO ratings were deemed opinions and thus entitled to protection under the first amendment i.e. Free speech
• If filing a lawsuit against CRA, the plaintiff has to prove malice

Credit Rating Agencies Post GFC:

• Ratings methodology must be disclosed
• Rating agencies reporting, examination and disclosure requirements increased
• Ratings analysts must pass qualifying exams and undergo continuing education
• The CFO or Chief Compliance Officer (CCO) must give annual report to SEC
• SEC has authority to deregister an NRSRO: an independent regulatory committee that oversees and protects shareholder interest
• At least half or more of the board needs to be independent of the entity

Credit Rating Findings

• The SEC also found failures to address conflicts of interest, poor disclosure, internal control issues, insufficient record retention, and misuse of material, nonpublic information.
• SEC found “some problems still percolate within the industry”