European Union Case Study

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STUDY

Policy Department Economic and Scientific Policy

Financial Supervision and Crisis Management in the EU

(IP/A/ECON/IC/2007-069)

JANUARY 2004

IP/A/ECON/ST/2007-26

PE 400.992

This study was requested by the European Parliament's Committee on Economic and Monetary Affairs Only published in English. Authors: Prof. Kern Alexander Prof. John Eatwell Prof. Avinash Persaud Mr. Robert Reoch Reoch Credit Partners LLP. Queens’ College, Cambridge, CB3 9ET UK

Administrator Responsible:

Josina Kamerling Policy Department Economy and Science DG Internal Policies European Parliament Rue Wiertz 60 - ATR 00L0xx B-1047 Brussels Tel: +32-2-28 32 337 Fax: +32-2-28 46 929 E-mail: josina.kamerling@europarl.europa.eu

Manuscript completed in December 2007

The opinions expressed in this document do not necessarily represent the official position of the European Parliament. Reproduction and translation for non-commercial purposes are authorised provided the source is acknowledged and the publisher is given prior notice and receives a copy. E-mail: poldep-esc@europarl.europa.eu.

IP/A/ECON/ST/2007-26

Page i

PE400.992

TABLE OF CONTENTS
EXECUTIVE SUMMARY .....................................................................................................................v INTRODUCTION....................................................................................................................................1 1.2 Externalities and the macroeconomics of systemic risk .............................................................3 1.3 The analytical framework .............................................................................................................3 1.31 Homogeneity.............................................................................................................................3 1.32 Regulation and homogeneity...................................................................................................5 1.33 Strategic behaviour..................................................................................................................7 2. THE NATURE OF MODERN CREDIT MARKETS AND THE ORIGINATE, RATE AND RELOCATE MODEL OF MODERN BANKING .....................................................................8 2.1 Bank motivation .............................................................................................................................8 2.2 Fixed income investors ..................................................................................................................9 3. FINANCIAL INNOVATION: AN ANATOMY OF CREDIT DERIVATIVES, SIVs AND CDOs .............................................................................................................................................10 3.1 Credit derivatives.........................................................................................................................10 3.2 Structured investment vehicles (SIVs) .......................................................................................10 3.21 Commercial paper .................................................................................................................11 3.22 Managing SIV risks ...............................................................................................................11 3.3 Collateralised debt obligations (CDOs.......................................................................................12 3.31 The Structure and Characteristics of CDOs .......................................................................12 3.4 Market Participants.....................................................................................................................13 3.5 Arranger Rationale for the creation of CDOs...........................................................................14 3.52 Regulatory Capital Management...
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