As stated in Paragraphs 3.(ii) and (iii) above banks will be initially permitted to use credit derivatives only for the purpose of managing their credit risk and not for taking 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.

Where an asset is protected by a credit default swap (CDS), the Protection Buyer may replace the risk weight of the underlying asset with that of the Protection Seller to the extent of amount of protection as determined as per paragraph 4.2 above. Where an asset is protected by a credit derivative funded by cash (CLN), the Protection Buyer may reduce the amount of its exposure to the underlying asset by the amount of funding received. For the unprotected portions the risk weight of the underlying asset will apply. The treatment of capital requirement will be modified if there are mismatches in the structures as discussed below.

In many credit derivative transactions, it is difficult to achieve an effective hedge due to the existence of mismatches and therefore, suitable adjustments will be made to the extent of credit protection recognizable on account of presence of such mismatches as outlined below:

1. Asset Mismatches: Asset mismatch will arise if the underlying asset is different from the reference obligation (in case of cash settlement) or deliverable obligation (in case of physical settlement). The recognition of availability of protection will be made in terms of provisions of paragraph 4.1.3(f) above.

2. Maturity Mismatches: If the maturity of the credit derivative contract is less than the maturity of the underlying asset, then it would construe as a maturity mismatch though the protection buyer would be completely hedged if the contract maturity were to be higher than the maturity of the underlying asset. In case maturity mismatches the capital adequacy will be determined in the following manner.

   1. If the residual maturity of the derivative product is less than one year no protection will be recognized and the risk weight of the underlying asset will apply.

   2. If the residual maturity of the credit derivative is one year or more protection will be recognized and the risk weight will be weighted average of risk weight of the Protection Seller and risk weight of the reference entity (weighted by proportions of period for which protection is available and the period for which protection is not available, counted from the date of contract till maturity of the derivative. Thereafter, the risk weight of the reference will apply.

3. Currency Mismatches:A currency mismatch is caused if the credit derivative contract is denominated in a currency different to the underlying asset. In such an event, the credit protection obtained should be marked to market to the prevailing exchange rate and if the value of credit protection (valued in terms of the currency of the underlying asset) is less than the value of the underlying asset, the residual risk must be risk-weighted on the basis of the underlying

Where a Protection Seller has sold protection through a CDS it acquires credit exposure to the Reference Asset. This exposure is to be risk-weighted according to the risk weight of the Reference Asset. In a funded credit derivative (CLN), the Protection Seller acquires on balance-sheet exposure to both the Reference Asset and the Protection Buyer. The CLN can be held in the banking book or trading book as decided by the bank. If held in the banking book, the amount of exposure will be equal to the book value of the note and will be risk weighted by the higher of the risk weight of the reference entity or the Protection Buyer. Where the credit derivative is referenced to more than one obligor, the amount of credit protection provided would depend on the structure of the contract.

As stated in paragraph 3.(v) above banks will hold investments in CLNs issued by Protection Sellers in their banking book or trading book. The assets in the trading book are held primarily for generating profit on short-term differences in prices/yields as against assets in the banking book which are contracted basically on account of relationship or for steady income and statutory obligations and are generally held till maturity. A CLN held in the trading book will represent a position to the note itself, with an embedded credit default product. A credit-linked note has a notional position to the specific risk of the Reference Asset. There is also specific risk to the Protection Buyer and general market risk according to the coupon or interest rate of the note. The risk weight for such positions would be the risk weight for 'All other Investments' i.e. 102.50% as per present guidelines.

4.5.1 Sufficient provisioning (based on what would be the provisioning applicable if the reference asset were on the seller's books) would have to be made by the credit protection seller if it is offering credit protection on a non performing asset.

4.5.2 The protection buyer should not make any provision for a reference asset that has turned NPA and on which it has bought protection which is valid on date.

Exposure ceilings for all fund based and non-fund based exposures will be computed in relation to total capital as defined under capital adequacy standards. As per present policy, from April 1, 2003 exposure calculation will be computed on the basis of 100% of non-fund based exposures in addition to fund-based exposures.

While determining the overall sectoral / borrower group / individual company exposure, suitable reduction will be allowed in the level of exposure with respect to the credit protection bought by means of credit derivatives. Conversely, the protection seller's exposure would increase as the protection seller acquires what is equivalent to a credit exposure on the reference asset. For the credit protection seller, the method of measuring exposure that would be applicable would be similar to the manner in which non-fund based credit limits such as guarantees are reckoned. Once the exposure is computed to individual/group entities, banks will have to ensure that they are within the overall ceiling as laid out in the relevant RBI guidelines.

It is recommended that transactions in credit derivatives may be covered by the 1992 ISDA Master Agreement and the 1999 ISDA Credit Derivatives Definitions and subsequent supplements to definitions with suitable modifications to suit conditions in India. Credit Linked Notes that are typically issued as bonds will be subject to additional documentation requirements of bonds. However, banks should consult their legal advisors about adequate documentation and other legal requirements and issues of credit derivative contracts before engaging in any transactions.

7.1 Normal accounting entries for credit derivative transactions are fairly straightforward depending on cash flows that take place at various points in time during the tenor of the transaction. e.g. for a credit default swap, there will be periodic payment of fees by the protection buyer to the protection seller. If there is a credit event, then settlement will be appropriately accounted depending on whether cash settled or settled via physical exchange versus par payment.

Prudent accounting principles require that derivatives create assets and liabilities which should be captured on the balance sheet at fair economic value based on current market prices taking into account credit and market risk characteristics arising from these positions. All future cash flows arising from the contracts should be brought to present value using appropriate discount rates from mid-market data. The determination of future cash flows may require use of appropriate valuation models ranging from simple deterministic derivations to exotic pricing models.

Banks may adopt suitable norms for accounting of Credit Default Swaps and Credit Linked Notes with the approval of their respective boards. All derivatives should be fair valued at least on a quarterly basis. The changes in fair value must be reported in current earnings.

Normally CLNs will be issued by SPVs set up by banks for specific purpose. However, it is possible that some banks may consider issuing CLNs themselves, in which case they have to maintain CRR and SLR as required. However, before issuing CLNs, banks will be required to take prior approval of RBI.

The banks will be required to disclose the following in the Notes on Accounts of their annual accounts in respect of the credit derivative transactions:

• The types of transactions carried out and their corresponding risks,

• The gains/losses, realized/unrealized from various types credit derivative transactions undertaken by the banks,

• Contribution of derivatives to the total business and the risk portfolio,

• Fair Value of derivative positions.