Credit Derivatives Explained

Credit derivatives are a new market segment in the area of financial derivatives. They are financial products which transfer either specific or all the inherent risks of a credit position from one partner in the transaction viz., the risk seller, to another viz., the risk buyer, against payment of a premium. They are a new management tool, which facilitates evaluation and transfer of credit risk. Credit derivatives thus serve to evaluate and separate risks and to make them fungible. The areas of application are the traditional credit and bond business as well as risk and portfolio management. Credit derivatives deal with credit risk or risk of debtor default as pure debtor risk and not general market risk. The hedge refers directly to a particular debtor. The credit risk is typically debtor specific. The focus is placed on individual solutions designed to fulfil customer-specific wishes with an eye on their balance sheets. The products are hardly standardised, and there is practically no secondary market trade, even in the USA. Internationally, capital treatment has yet to be clarified and standardised documentation is not available for most of the products¹

RBI has recently published a proposal to permit SCBs to trade in specific types of credit derivative, viz. Credit Default Swap (CDS), and Credit Linked Note (CLN), thus heralding formally the initiation of credit-derivative trading in India. RBI also has formulated detailed guidelines for conducting operations in credit-derivative trading. Salient features of the Guidelines by RBI are covered in the subsequent pages. It is relevant in this context to understand the basic information about this financial product and how its introduction will benefit Indian commercial banks and financial institutions.

Banks/financial Institutions are major players in the credit market and are, therefore, exposed to credit risk. Credit market is considered to be an inefficient market. On the one hand, market players like banks and financial institutions mostly have loans and little of bonds in their portfolios. They have competitive advantage in pricing and back office capabilities and therefore, earn comparatively high returns on loans. On the other hand, the mutual funds, insurance companies, pension funds and hedge funds have mostly bonds in their portfolios, with little access to loans because of lack of back office capabilities required for processing, monitoring and supervising loans. Thus, they are deprived of high returns of loans portfolios.

Credit risk is defined as the possibility of losses associated with diminution in the credit quality of borrowers or counterparties. In a bank's portfolio, losses stem from outright default due to inability or unwillingness of a customer or counterparty to meet commitments in relation to lending, trading, settlement and other financial transactions. Alternatively, losses result from reduction in portfolio value arising from actual or perceived deterioration in credit quality. Credit risk emanates from a bank's dealings with an individual, corporate, bank, financial institution or a sovereign. Credit risk may take the following forms

• in the case of direct lending: principal/and or interest amount may not be repaid;

• in the case of guarantees or letters of credit: funds may not be forthcoming from the constituents upon crystallization of the liability;

• in the case of treasury operation: the payment or series of payments due from the counter parties under the respective contracts may not be forthcoming or ceases;

• in the case of securities trading businesses: funds/ securities settlement may not be effected;

• in the case of cross-border exposure: the availability and free transfer of foreign currency funds may either cease or restrictions may be imposed by the sovereign.²

The market in the past did not provide the necessary credit risk protection to banks and financial institutions. Neither did it provide any mechanism to the mutual funds, insurance companies, pension funds and hedge funds to have an access to loan market to diversify their risks and earn better return. Even within the groups of banks and financial institutions, some of them had concentrated portfolios because of location or client specific business commitments. As a result, credit was sub-optimally held across financial institutions and investors. Paradoxically while riosk-awareness was keenly felt, systematic risk analysis was rarely conducted.

In this backdrop, it is imperative that banks have a robust credit risk management system which is sensitive and responsive to these factors. The effective management of credit risk is a critical component of comprehensive risk management and is essential for the long term success of any banking organisation. Credit risk management encompasses identification, measurement, monitoring and control of the credit risk exposures.²

The unbridled virus of NPA, its emergence and the challenge it poses to Indian Commercial banks and financial institutions are elaborately analysed and discussed earlier. This brought Risk-assessment and Risk-management into focus. Concerned over the alarming developments, the regulatory authorities at the international level(comprising G7 Countries) brought the Basel committee Accord 1988, as an effective solution for providing risk-resistence and protecting banks. The Accord 1988 exclusively focuses on credit-risk

The Second Basel Accord now under finalisation stresses more importance on structuring of internal supervision and accurate evaluation of credit risks for building capital adequacy. The subject risk analysis and risk management thus have come into the fore-front. In India RBI recently issued detailed guidelines on Credit Risk Management. These guidelines are discussed on this website under ten articles. Following the heels on the perception of risk analysis and the importance given on risk-management, the search at the international level for hedging tools to minimise impact of adverse effects of credit-failures on the credit institutions came to be started. How the process led to the launching of the first credit derivative in 1991 is explained later.

A number of traditional methods (such as operational limits on credit lines, loan provisioning, portfolio diversification and collateralisation) and innovative methods (such as loan securitisation and separately capitalised derivatives) are already available internationally to manage credit risk. These are considered to be significantly less flexible on their own than the techniques available in the area of market risk. Capital adequacy guidelines have also encouraged financial institutions to put greater emphasis on the risk and return characteristics of their assets and liabilities. Credit derivatives, make it possible to evaluate and trade credit risk without liquidating the original product. They enhance flexibility and reduce costs. They allow banks to hedge the credit risk of a loan without having to assign the loan and with no risk to deteriorate the relationship. Credit derivatives, therefore, offer banks the advantage of improving the flexibility of their credit structures without imposing constraints on their client relations. This enhances efficient balance sheet management and adds to traditional hedging instruments. ³

Credit derivatives were developed to provide a solution to the inefficiencies in the credit market. Internationally, banks are able to protect themselves from the credit risk through the mechanism of credit derivatives for more than a decade now. However, credit derivative has not yet been used by banks and financial institutions in India in a formal way.

In the middle of the year 2002 RBI appointed a Working Group on introduction of Credit Derivatives in India, comprising officers from the Reserve Bank of India and industry. Ther working group was to study the need and scope for allowing banks and financial institutions to use credit derivatives, the regulatory issues involved and to make suitable recommendations in this regard. The Group has submitted its report and is available at the website of RBI.

Reserve Bank of India based on the findings of the working group came out recently with draft guidelines to allow banks to use credit derivatives to manage risks relating to lending, including buying protection on loans and investments. Banks would be barred from using these derivatives for trading and only domestic entities would be allowed to enter in credit risk contracts.

Banks could use two types of contracts -- Credit Default Swap and Credit Linked Note. CDS is a bilateral contract on one or more reference assets, while under the CLN structure, the price of the note is linked to the performance of a reference asset, offering lenders a hedge against credit risk. CLNs are generally issued by floating special purpose vehicle. But, when banks plan to issue CLN's directly, they would need to take prior approval of apex bank as per the draft guidelines.

Credit derivatives are thus set to come into the Indian Banking System. In view of the size, the composition of market players and the turnover of credit dispensation in the country it is sure to become a widely used tool within a few years after introduction, as Interest Rate Swaps introduced in the Nineties to hedge market risks have now become.