Institutions Covered

1. These guidelines will apply to all commercial banks.

Extant RBI Instructions on Guarantees

2. In terms of extant RBI instructions banks are precluded from issuing direct financial guarantees favouring other banks / financial institutions for loans extended except in case of infrastructure projects, provided the bank issuing guarantee takes a funded share in the project at least to the extent of 5% of the project cost and undertakes normal credit appraisal, monitoring and follow up of the project. These instructions relating to bank guarantees will not be applicable to transactions pertaining to use of credit derivatives as derivatives are normally concluded under standardized master agreements, are structurally different from plain bank guarantees, and subject to ongoing risk controlling, risk management and valuation procedures.

Type of Activities

3. Banks will be initially permitted to use credit derivatives only for the purpose of managing their credit risk, which includes

   • Buying protection on loans and investments for reduction of credit risk,

   • Selling protection for the purpose of diversifying their credit risk and reducing credit concentrations and taking exposure in high quality assets,

   • Market making activities by banks in credit derivatives are not envisaged for the present.

4. For the present banks will not be permitted to take long or short credit derivative positions with a trading intent. It means that banks may hold the derivatives in their banking books and not in the trading books except in case of Credit Linked Notes, which can be held as investments in the trading book if the bank so desires.

Types of Derivative Products

5. The credit derivatives range from plain vanilla products to complex structures. The valuation standards, accounting norms, capital adequacy issues, methodologies for identifying risk components and concentrations of risks, especially in case of complex credit derivative structures are in the evolutionary stage. Therefore, currently RBI proposes to restrict banks to use simple credit derivative structures like credit default swaps and credit linked notes described in paragraph 2.2 (a) (i), (ii) and (iii) only, involving single reference entities, in the initial phase. The credit default options will be treated as credit default swaps for regulatory purposes.

Parties to the Transactions

6. RBI has been allowing transactions between the banks and their financial services subsidiaries on the principle of arms' length relationship i.e., the transactions should be on the basis of market related rates and based on free availability of information to both the parties. As the derivatives market will take time to develop, it would be difficult to have objective price discovery mechanism in the beginning and determine whether an arms' length relationship exits or not. Therefore, RBI proposes not to allow credit derivatives transactions between related parties till the players gain experience and maturity. Except for the above there will be no restrictions on the parties to the transactions.

Exchange Control Issues

7. It is the intention of RBI to develop the credit derivatives as a domestic product for the domestic loan and investments market, initially. As under the present exchange control regulations, there are certain restrictions on non-residents to acquire, hold and dispose of immovable property in India, non-resident entities cannot be parties to credit derivative transactions in the domestic market for the present.

8. The underlying assets on which credit derivatives can be written could be either the rupee denominated assets or foreign currency denominated assets originated by domestic entities and having resident entities as the obligors. In case of foreign currency assets, the premiums and the credit event payments can be denominated in foreign currency. In such cases, the participants in the transactions can only be such banks and financial institutions who are authorized to deal in foreign exchange.

Bank fulfills the following criteria of recognition of protection of credit risk:

1. Existence of Adequate Risk Management Policies, Procedures, and Systems and Controls (Paragraph: 4.1.1)

   The credit derivatives activity to be undertaken by bank should be under the adequate oversight of its Board of Directors and senior management. Written policies and procedures should be established to cover credit derivatives business. Banks using credit derivatives should have adequate policies and procedures in place to manage associated risks. There should be adequate separation between the function of transacting credit derivatives business and those monitoring, reporting and risk control. The participants should verify that the types of transactions entered into by them are not inappropriate to their needs and needs of the counterparty. Further, all staff engaged in the business should be fully conversant with the relevant policies and procedures. Any changes to the policy or engagement in new types of credit derivatives business should be approved by the Board.

   1. Policies

      The policy duly approved by the Board of Directors should cover at the minimum;

      1. The bank's strategy, appetite and limits for different types of credit derivatives business,

      2. Authorization levels for engaging in such business and identification of those responsible for managing it,

      3. Procedure for measuring, monitoring, reviewing, reporting and managing the associated risks like credit risk, market risk, liquidity risk and specific risks,

      4. Fair and cautious valuation and risk assessment of a portfolio's position,

      5. Calculation of derivative value adjustments independent of the business, size and reasons for adjustments to be transparent to the business management,

      6. Pursuing the underlying borrower when a credit event payment has been triggered,

      7. Determination of contractual characteristics of the products,

      8. Use of best market practices.

   2. Procedures

      The bank should have adequate procedures for:

      1. Measuring, monitoring, reviewing, reporting and managing the associated risks,

      2. Full analysis of all credit risks to which the banks will be exposed, the minimization and management of such risks,

      3. Ensuring that the credit risk of a reference asset is captured in the bank's normal credit approval and monitoring regime,

      4. Management of market risk associated with credit derivatives held by banks in their trading books by measuring portfolio exposures at least daily using robust market accepted methodology,

      5. Management of the potential legal risk arising from unenforceable contracts and uncertain payment procedures,

      6. Valuation procedures and mechanism to determine adequate liquidity, especially, where the reference asset is a loan or the derivative has multiple obligors. Sometimes, banks may face liquidity risk when counterparties are able to terminate transactions prematurely under the contract. This should be indicated in the bank's liquidity management policy,

      7. Determination of an appropriate liquidity reserve to be held against uncertainty in valuation. This is important especially where the reference asset is illiquid like a loan,

      8. Valuation adjustments to decrease the asset or increases the liability arising from the initial valuation of a credit derivative transaction by bank's approved mathematical model. The purpose of the valuation adjustments are to report in the bank's statements of accounts the "fair" economic value that the bank expects to realise from its credit derivative portfolios based upon current market prices and taking into account credit and market risk characteristics arising from those portfolio position.

   3. Systems and Controls

      The senior management should establish an independent framework for reporting, monitoring and controlling all aspects of risks, assessing performance, valuing exposures, monitoring and enforcing position and other limits. The systems and controls should:

      1. Ensure that the types of transactions entered into by the counterparty are not inappropriate for their needs,

      2. Ensure that the senior most levels of management at the counterparty are involved in transactions by methods like obtaining from the counterparty a copy of a resolution passed by their Board of Directors, authorising the counterparty to transact in credit derivatives,

      3. Ensure that counterparties do not enter into transactions that violate other rules and regulations,

      4. Ensure adequate Management Information Systems to make senior management aware of the risks being undertaken, which should provide information on the types of transactions carried out and their corresponding risks, the trading income/losses, realized/unrealized from various types of risks/exposures taken by the bank, contribution of derivatives to the total business and the risk portfolio, and value of derivative positions,

      5. Assess and account for the possibility of default correlation between reference asset and the protection provider,

      6. Ensure that trading activities, if undertaken (in case of credit linked notes for the present) are properly supervised and are subject to an effective framework of internal controls and audits so that transactions are in compliance with regulations and internal policy of execution, recording, processing and settlement,

      7. Ensure that the bank has the ability to pursue the underlying borrower when a credit event payment has been triggered.

2. Satisfaction of Minimum Criteria (Paragraph: 4.1.2)

   The credit derivative should conform to the following minimum criteria i.e., it should be direct, explicit, irrevocable and unconditional. These criteria are explained below:

   1. Direct
      The credit protection must represent a direct claim on the protection provider.

   2. Explicit
      The credit protection must be linked to specific exposures, so that the extent of the cover is clearly defined and incontrovertible.

   3. Irrevocable
      Other than a protection purchaser's non-payment of money due in respect of the credit protection contract, there must be no clause in the contract that would allow the protection provider unilaterally to cancel the credit cover.

   4. Unconditional
      There should be no clause in the protection contract that could prevent the protection provider from being obliged to pay out in a timely manner in the event that the original obligor fails to make the payment(s) due.

3. Satisfaction of Minimum Operational requirements (Paragraph: 4.1.3)

   In order for protection from a credit derivative to be recognised, the following conditions must be satisfied:

   1. The credit events specified by the contracting parties must, at a minimum, include:

      • failure to pay the amounts due according to reference asset specified in the contract;

      • a reduction in the rate or amount of interest payable or the amount of scheduled interest accruals;

      • a reduction in the amount of principal or premium payable at maturity or at scheduled redemption dates;

      • a change in the ranking in the priority of payment of any obligation, causing the subordination of such obligation.

   2. Contracts allowing for cash settlement are recognised for capital purposes insofar as a robust valuation process is in place to estimate loss reliably. There must also be a clearly specified period for obtaining post-credit-event valuations of the reference asset, typically no more than 30 days;

   3. The credit protection must be legally enforceable in all relevant jurisdictions;

   4. Default events must be triggered by any material event, e.g. failure to make payment over a certain period or filing for bankruptcy or protection from creditors;

   5. The grace period in the credit derivative contract must not be longer than the grace period agreed upon under the loan agreement;

   6. The protection purchaser must have the right/ability to transfer the underlying exposure to protection provider, if required for settlement;

   7. The identity of the parties responsible for determining whether a credit event has occurred must be clearly defined. This determination must not be the sole responsibility of the protection seller. The protection buyer must have the right/ability to inform the protection provider of the occurrence of a credit event;

   8. Where there is an asset mismatch between the exposure and the reference asset then:

   9. the reference and underlying assets must be issued by the same obligor (i.e. the same legal entity); and

   10. the reference asset must rank pari passu or more junior than the underlying asset, and legally effective cross-reference clauses (e.g. cross-default or cross-acceleration clauses) must apply.

1. The credit event payment or settlement amount will determine the amount of credit protection bought /sold in case of CDS. This could be payment of par or other specified value in exchange for physical delivery of the Reference Asset (or a variety of assets of the Reference Entity as allowed under some contracts (Physical Delivery Settlement), or payment of par less recovery value (Cash Settlement) or payment of fixed amount as per the CDS agreement (Fixed Amount Settlement). In case of CLN the amount of protection bought will be equal to the funds raised from issue of the CLNs and the amount of protection sold will be equal to the book value of the CLN.

2. Some credit derivative contracts may contain a materiality threshold specified for determining the loss that must be reached before a credit event is triggered. Therefore, the materiality threshold may affect the amount of credit protection that may be recognized.