Rather it is in the use of credit derivatives that leave the underlying asset on the balance sheet but transfer some or all of the credit risk. The market in credit default swaps on individual investment-grade corporate and country issuers is becoming more liquid, in some cases, we have been told, more liquid than the underlying bond market. And investment banks pricing new bond issues can increasingly look to credit default swap premia as well as to the spread over the relevant benchmark on any existing debt. Increasingly, also, banks use derivatives to transfer some portion of the credit risk on a loan portfolio rather than selling the portfolio outright, creating so-called 'synthetic' collateralised debt obligations. Data on the size of the market are difficult to come by. But a survey by the British Bankers' Association last year found that outstanding notional principal of all credit derivatives had increased more than three times since 1997 to around $ billion. Some contacts suggest the market may now be even larger than this. But I think it safe to conclude that it is already large and has been growing quickly. In a wider sense, the development of these markets for the transfer of credit risk is highly desirable. The institution best placed to originate a loan is not necessarily best placed to bear the risk. Markets in credit risk allow financial institutions to diversify their exposures across different sectors and geographic regions while maintaining customer relationships.
Indirectly, in the same way that the change in banks' behaviour in response to the original Basel Accord had a profound effect in shaping developments in securities markets in the last decade. Directly to the extent that EU investment firms, under the Capital Adequacy Directive, are subject to the same capital requirements as banks. One of the principal goals of the new Basel framework is, of course, greater risk sensitivity. The lack of sensitivity of the existing Accord has been one of the drivers of increased capital market activity: both through disintermediation, as companies have accessed the capital markets for funding directly instead of relatively more expensive bank loans, and through securitisation, as banks themselves have sought to continue originating credit but not incur the capital costs of holding it on their balance sheet. The new Basel proposals to the extent they succeed in aligning capital more closely with the underlying risk, will we hope significantly reduce incentives for pure regulatory arbitrage. While the original Accord created an incentive to securitise or, by other means, move exposures off balance sheet, it is too simplistic to assume that adoption of the new proposals will result in a swing back to more traditional bank lending. The wider use of internal ratings, coupled with greater transparency regarding their compilation and some assurance of quality control by the regulators, may in fact contribute to further 'commoditisation' of bank loans. It is conceivable that this development could reduce the cost of due diligence on loan portfolios by rating agencies and buyers.