NPAs and the need for healthy markets for credit risk instruments

Why are banks not lending to Priority sectors?

According to the study released by Assocham and Resurgent India on Indian Banking Industry: Sustaining Growth with Equity (2013), one of the key reasons explaining bank’s hesitation to lend to priority sectors is lack of detailed financial information and appropriate performance analysis of small firms. Also, banks incur higher costs associated with PSL, higher lending risks due to lack of transparency of financial conditions and subsequent rise in non-performing assets (NPA), constraints to availability of funds, lowering of credit ratings, resulting in reduced profitability of the banking sector. It has been vindicated by a recent RBI Report on Operations and Performance of Commercial Banks (2013), which estimates a gross NPA ratio at the aggregate level stood at 3.6% at end-March 2013, a rise from previous year’s 3.1%.

Securing transparency of financial conditions of the borrowers influences decisions for financing loans.  But the sustainable growth of the Indian economy depends on how we leverage our financial sector to make it a broad based phenomenon. In the absence of lending to all types of economic activities and stakeholders taking into account the risk they pose to the principal in a more appropriate manner, growth is likely to be narrower.  Hence, it is necessary to augment the risk taking ability of banks by introducing an efficient market for credit risk transfer (CRT) instruments which have gained significance in the recent past. Banks would stand to benefit from credit derivative instruments (CRT) due to two reasons – efficient utilization of capital and flexibility in developing/ managing a target risk portfolio. Currently, Indian Banks face two broad sets of issues with respect to their credit asset portfolio especially at a time when the entire business cycle is at a low due to prevailing economic conditions that leads to blockage of capital and loss of revenue earning opportunities.

Globally, credit derivatives have become important CRT instruments and are integral to the risk management functions of several firms, driven by established standards of documentation, standardization and diversified participation.  With the shift of these instruments to transparent clearing platforms, the so called risks of CDOs that led to the Lehmann collapse can be mitigated through appropriate control measures before such lending or trading activity takes systemic proportions.  This has been proposed by the G20 led Financial Stability Board, implemented by the Dodd-Frank Bill of the US and the forthcoming regulations of European Securities Markets Authority.

Evolving Regulatory Framework – A Global Perspective:

CDS are bilateral over-the-counter derivative contracts which have had minimal regulatory oversight in the US and Europe since the inception of trading. In the US, bilateral transactions like CDS between counterparties have been excluded till recently from regulation under Commodities and Futures Modernisation Act of 2000. However, post 2009 financial crises, the US government had introduced a broad range of regulatory regime for OTC derivatives including CRT instruments which are largely traded in the OTC markets to move the OTC traded CRT instruments into a transparent reporting and clearing regime. The EU authorities are also reported to be working on similar initiatives to move OTC derivatives including CRT instruments to mandatory reporting and clearing regime. Additionally, in line with the G20 recommendations, the EU regulators have also proposed that standardized OTC derivative contracts be developed for trading on electronic trading platforms (or exchanges) and cleared through central counterparties.

Market for CRT Instruments – Developmental Initiatives in India:

Policy makers in India took fairly cautious steps while introducing CDS to defer it twice (in 2003 and 2007) before finally introducing single-name OTC CDS for corporate bonds as announced in the Monetary Policy Review of Q2FY10. After the submission of report on introduction of credit derivatives in India by working group, draft guidelines for the functioning of CRT instruments were introduced in March 26, 2003. This was further revisited in 2007 with an indication that credit derivatives would be introduced in a calibrated manner as a part of the broader process of financial sector liberalization in India. The final version of CDS for corporate bonds were required to report to a centralized trade reporting platform, with an aim of bringing them on to a central clearing platform i.e. the Clearing Corporation of India Limited. According to the RBI report on introduction of credit default swaps for corporate bonds (2011) that followed the announcement made in the Q2FY10 review, “the objective of the measure is to provide credit risk transfer tool to the Indian market participants and enable them to manage credit risk in an effective manner through redistribution of risk.” RBI further expanded the scope of the credit default swaps (CDS) market by allowing CDS for unlisted corporate bonds in January 2013. Additionally, CDS were permitted to be introduced on securities with original maturity up to one year like Commercial Papers, Certificates of Deposit and Non-Convertible Debentures with original maturity less than one year as reference/deliverable obligations. In an effort to broad base participation and to enable stakeholder risk management, SEBI had also permitted mutual funds to participate in CDS market.