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Derivatives to cut credit risk of banks

Mumbai, March 27: Making a beginning in the use of credit derivatives by banks, the Reserve Bank of India today said they would be allowed to use such instruments to manage risks relating to lending, including buying protection on loans and investments, to reduce risk.

The central bank, in a notification, said effective management of credit risk is a critical factor in comprehensive risk management and is essential for the long-term financial health of business organisations, especially banks.

Credit risk management, it added, encompasses identification, measurement, monitoring and control of credit risk exposures.

To enable banks and financial institutions to manage their credit risks effectively it was being felt appropriate to permit them to use credit risk hedging techniques like credit derivatives.

Credit derivatives are financial contracts and they are usually defined as ‘off-balance sheet’ financial instruments that permit one party to transfer credit risk of a reference asset, which it owns, to another party without actually selling the asset.

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, RBI added.

Banks would be barred from using these derivatives for trading and only domestic entities would be allowed to enter in credit risk contracts, Reserve Bank said in its draft guidelines while seeking comments from the banks.

Banks, it said, could use two types of contracts — credit default swap (CDS) and credit linked note (CLN). CDS is a bilateral contract on one or more reference assets.

Under credit linked note 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 credit linked note’s directly, they would need to take prior approval of the apex bank, it said.

Initially, banks will not be permitted to take long or short credit derivative positions. However, CLN can be held as investments in the trading book if the bank so desires, RBI said.

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