5  See the Annex for brief explanations. BIS Review 44/2007  3  hold tranches of other CDOs, which hold LBO debt of all types as well as asset-backed securities bundling together household loans. (The diagram may, or may not, help!) What is going on here? One possible explanation is that capital might be being allocated to wherever its cost is cheapest for a particular desired risk profile. That optimisation involves comparing the capital charges applied by regulators to regulated institutions; and by rating agencies to various types of vehicle (SIVs, CPDCs, CDOs, monolines etc). The “smart money” seems to be assembling its own portfolio of vehicles, so that it can choose from a menu of where to book transactions. One of the drivers is commonly referred to by practitioners as “ratings arbitrage”. Another was of course Basel I, which triggered the securitisation of high-quality credits, and for quite a few years fuelled a ballooning of vehicles whose existence depended on commercial banks providing zero-capital-weighted “liquidity” lines. Basel II will change all of that. Indeed, if central banks are to understand how the global financial system fits together, we will need to fathom the reconfiguration that Basel II prompts, including the potential for risk transfers between banks adopting different steps on the ladder of Standard, Foundation, Advanced approaches that it makes available.
A distinction is typically drawn – including in the Bank’s Financial Stability Reports 2 – between a “fast fuse” risk, in which credit is abruptly repriced; and a “slow fuse” risk, in which cheap credit leads over time to overleveraged borrowers and so to vulnerability to a deterioration in the global economy. As time passes, attention has perhaps been shifting to the longer-fuse risk, given signs of a pick up in aggregate corporate sector leverage and gradual dilution of covenants in loan terms and conditions, most obviously recently in so-called “covenant-lite” transactions in the leveraged loan market. 3 But, in contrast to global imbalances, no one can say with complete conviction that a lower risk premia environment is definitely unsustainable, which may contribute to explaining why few market participants seem prepared to bet on the time or scale of any correction. In terms of the second dimension – the probability that any adjustment would be disorderly –market practitioners at least seem to regard “low risk premia” more seriously than “global imbalances”. Resolution of the problem of global imbalances could come in various ways, not all of which need involve an abrupt correction in asset prices or further movements in nominal exchange rates. For example, the US might obtain greater competitiveness through a depreciation in the dollar’s real value if inflation in China and elsewhere were to be relatively high for a period.