Complexity and hidden risk caused the crash, says BIS

The Bank for International Settlements (BIS) blames the credit crisis on a failure to understand the risks involved in complex credit risk transfer structures set up earlier this decade, in a report published this month.

The decision by some banks to take off-balance-sheet structures back on to their balance sheets, even without a prior commitment to do so, "may reflect reputation concerns," the BIS said: "a business decision to assume a previously transferred risk may raise a question about the true extent of the original risk transfer". Such moves often put additional strain on the parent banks' balance sheets, the bank added.

Growing demand for equity and mezzanine tranches of securitised products left the structuring banks, "perhaps unwittingly", warehousing large amounts of super-senior exposure, which they were not competent to manage, the BIS said. In particular, complex structured products and correlation risks were poorly handled, and dealers were unable to keep their counterparty risk measurements up to date.

Weak market discipline, rooted in overconfidence and overreliance on credit ratings, "set the stage for the market turmoil of 2007", the BIS reported.

As for the future of the credit risk transfer market, the BIS said the markets for complex products such as collateralised debt obligations (CDOs) of asset-backed securities were likely to "shrink dramatically or disappear", but simpler corporate CDOs and collateralised loan obligations would survive in the new, weaker market. The bank exhorts regulators and overseers to try harder to compel transparency and operational issues in the credit markets.

See also: Fund managers bought products they didn't understand, survey finds
BIS survey brings mixed message
  Regulatory burden set to increase 
Basel Committee to tighten up rules after crisis
Bank practices undermined liquidity, says BIS