The Basel committee may eliminate restructuring as a definition of a credit event for the purposes of regulatory capital relief, a move that could have profound consequences for the credit derivatives industry. Norah Barger, chairman of the credit risk mitigation subgroup of the Basel committee in Washington, told DW, "This is still open for debate," adding, that the committee is willing to listen to industry comment.
At present financial institutions wishing to get regulatory capital relief against loans will be required under the proposed Basel Capital Adequacy Accord to arrange protection against losses resulting from failure to pay, bankruptcy and restructuring. Of the three definitions, restructuring is the most problematic because of its ambiguity and has resulted in a schism between the U.S. and European credit derivatives markets, according to dealers.
Anjan Malik, co-head of credit derivatives trading at Lehman Brothers in London, said eliminating restructuring "would be huge."
Louise Marshall, policy director at the International Swaps and Derivatives Association in New York, said a logical conclusion of Basel not requiring restructuring would be to drop the definition from standard derivatives contracts. ISDA has asked its members to comment on whether restructuring should be required for regulatory capital relief by Friday. Marshall, said, "A broad section of our members want to drop restructuring as a requirement."
A third consultative paper is due in the spring with comments due 90 days later. However, Barger said in order for credit risk to have been mitigated the holder of the debt should not suffer a loss in the event of a restructuring. Bankers argue that any serious deterioration in credit quality will result in a failure to pay or bankruptcy and the holder of protection will be compensated. But the regulator argues that through maturity mismatches protection may expire before the situation becomes critical enough to trigger the other events.
One of the most significant consequences of dropping restructuring would be a boost to the synthetic collateralized debt obligation market, according to Lehman's Malik. This would increase the opportunity for ratings arbitrage and therefore the attractiveness of CDOs. Trading default swaps without restructuring would lead to a purer form of credit risk and would therefore increase liquidity as it could bring in new users, he added.
