NPAs and the need for healthy markets for credit risk instruments

Issues pertaining to development of CDS markets in India:

Globally, while credit default swaps are valuable tools for managing risk, it has been debated that untamed trading in CDS instruments on opaque OTC markets could lead to significant systemic risks. CDS contracts are only traded in the OTC markets and not on transparent exchange traded platforms, raising concerns over counterparty risks as it happened during the last financial crisis and Lehmann collapse. The failure of one important participant in the CDS market can destabilize the financial system by inflicting significant losses on many trading partners simultaneously. In India though CDS was introduced in Dec 2011 after series of deliberations only on Corporate Bonds, with stringent regulations, however the market did not pick up further due to inherent constraints in development of CDS markets.

According to the IOSCO report on The Credit Default Swap Market ( June 2012), globally the growth of the CDS market has been fostered by the development of a self-regulatory environment, promoted by the initiatives of the ISDA, which resulted in contract standardization, aimed at facilitating back office and contract management operations, and in reduction of legal disputes.  The major issue has been that the CDS markets are still quite opaque and not well regulated.  Making transparent the CDS markets would help regulators benefit from better access to information on trade data both from the perspective of financial stability, assessing clearing/systemic risks emerging out of the CDS markets and potential market abuse by the players.

Though CDS market has not picked up in India, if it could be activated, it could help the banks augment lending to the economically weaker sections through cost effective credit risk management on market based CRT instruments.  Available research suggests that CDS play an important role in reducing funding costs for entities of lower credit quality and introduction and development of CDS markets have always contributed to reduction of funding costs in the underlying debt markets.  Lack of default statistics and empirical data on the past about any particular category of priority sector would make it difficult for the participants to price the risk if at all CDS against bank lending to PSL category is introduced.  However, a Brickwork Ratings and City of London Report (2011) indicates that the standardization of industry practice with respect to the loan assessment and disbursement is still lacking and unless this happens it will be difficult to allow CDS on loans. The onus is on the industry to move to standardized loans, which would enable the introduction of CDS with loans as underlying.  Also information asymmetry caused by the existence of strong ‘Chinese walls’ between different departments within a lending bank and a buyer and the seller is expected to be a constraint to the development of CDS markets in India.   Additionally, standardization of the underlying market would also make it all the more difficult to launch a standard CDS instrument and multiple CDS instruments would lead to fragmentation of liquidity leading to development of illiquid markets. Critics also indicate that lack of strong bankruptcy regulations would also further prevent development of CDS markets.  Prevention of naked selling will remain a constraint to development of liquid market in credit default instruments.  Further, implementation of a standardized margining policy and central counterparty settlement could go a long way in settling issues associated with problems in collateral availability and its management in the most efficient way and to catalyze liquidity development in the CDS markets.

The way forward:

According to a study: Sustaining Growth with Equity (2013), as high as 75% of India’s Micro, Small and Medium Enterprises (MSMEs) are deprived of access to banks or institutional financing channels, highlighting the fact that financing gap has widened given the significant demand-supply constraints. This signifies the need for creating a sustainable pathway for accessing mainstream financing at affordable rates for the economically weaker sections of the population and micro, small and medium enterprises.  Introduction of CRTs would help the banks, especially the private banks to manage the credit exposure against PSL targets to earn principal protection than resorting to alternative means of meeting the PSL targets mandated on them.  Existence of liquid markets for CRT instruments against standardized PSL lending exposures may in fact, enthuse the existing private banks and the yet to be licensed private banks to augment their balance sheets and also manage capital in a Basel compliant manner.  In the current liberalized scenario, where even the scheduled commercial banks are also expected to be left to the market forces, existence of such a market for credit risk hedging instruments would augment access to finance even for the economically weaker sections representing priority sector lending.  However, if the world were to innovate in standardizing a CDS instrument to be traded on the exchange platforms that has the potential to be the benchmark for the entire markets for CRT instruments, it would herald a new era in improvement of efficiency of the markets for CRT instruments and to make it a common practice among the lenders to manage risks in a more efficient way and deliver value to the economic stakeholders besides paving way for achieving the policy objective of equitable growth.

References:

1. Reserve Bank of India (RBI)-  “Evolution of Banking in India”; September 2008; pp 74-141
2. RBI – “Banking Structure in India – The Way Forward”; August 2013, pp 1-88
3. Assocham and Resurgent India – “Indian Banking Industry: Sustaining Growth with Equity”; September 2013, pp 1- 35
4. RBI –“Operations and Performance of Commercial Banks” ; November 2013; pp 1 – 38
5. RBI –“Introduction of Credit Default Swaps for Corporate Bonds”; January 2011, pp 1-86
6. V.K. Sharma – “The Financial Innovations that Never Were”; November 2012, pp 1-13
7. International Organization of Securities Commissions (IOSCO) – “Credit default Swap Market”; June 2012, pp 1- 47
8. Brickwork and The City of London – “Credit Default Swaps & Interest Rate Futures”; March 2011, pp 3-52