A V Rajwade: Counterparty credit risk

WORLD MONEY

The Bear Stearns case has underscored the issue of such risk in the credit derivatives market as well.

Two ongoing events in the derivatives market evidence the importance, for banks, of counterparty credit exposures. In the US, one has serious doubts whether the Federal Reserve would have participated in, let alone committed as much as $30 bn of public money for the rescue of an investment bank: it did so only because Bear Stearns was counterparty to a very large number of outstanding derivatives with an aggregate notional in trillions of dollars, and its insolvency would have posed a systemic risk for the banking system. The issue of counterparty credit risk has also great importance for the Indian banking system; in at least some of the cases of currency derivatives making news, the negative mark-to-market value of the outstanding transactions seems to have amounted to a significant percentage of the corporate's net worth. (In one case, incredibly, it seems to be as high as 150 per cent of the net worth!) What is market risk for the corporate client becomes credit risk for the bank. Its effective management would mean the capability to value the transactions constantly, having proper limits on negative values "" and the right to unwind the transaction if the limits are reached unless proper collateral is provided.

What surprises me is how such basic precautions seem to have been overlooked in many cases. After all, banks are intermediaries between savers on the one hand and borrowers on the other: clearly, assessing and managing credit risk is at the heart of the business of banking. From one's own experience, it seems doubtful whether a bank's credit department would have permitted such exposures, that too on a clean, that is, unsecured, basis. Or is it that, in so far as derivatives are concerned, it is the treasury which has the bigger say, rather than the credit department, and does not follow very rigorous standards? This is also evidenced in the amount of mark-to-market losses being declared through exposure to credit derivatives of the investment variety, by banks in the so-called mature financial markets. Earlier, analysts were talking of losses of the order of $400 bn,: the IMF has last week estimated the number at very close to a trillion dollars! (Incidentally, what is the tangible net worth, net of goodwill, of the entire global financial services industry?) The near default of Bear Stearns has brought into sharp focus the issue of counterparty credit risk in the rapidly expanding credit derivatives market as well. The notional principal of credit default swaps (which protect the buyer against default by a corporate under its bond or loan obligations) has grown from less than a trillion dollars at the end of 2001, to $45 trillion by the end of June last year. The rapid growth of the market in terms of both the number of transactions and the outstanding notional has led to backlogs in the back office processes of deal confirmation, etc. There are therefore question marks whether banks are monitoring the credit exposures in an effective fashion. A major default in the CDS market would make the recent sub-prime crisis look as a minor event: the latter itself was recently described by George Soros as the most "serious financial crisis of our life time ..., the end of an era". He also described Basel-II as misconceived, and has expressed the need for Basel-III "" even while banks are struggling with Basel-II.

Recently, the Reserve Bank has come out with the model of an Internal Capital Adequacy Assessment Process (ICAAP) as part of the guidelines for introduction of the Basel-II capital adequacy norms for the Indian banking system. As the RBI circular states, "The ultimate responsibility for designing and implementation of the ICAAP lies with the bank's board of directors." While this is, of course, true, the question is whether the boards of nationalised banks have the professional knowledge and expertise, and the time, to fulfill their responsibilities in a proper fashion. Apart from at least some of them being political appointees, one also hears that quite often the agenda runs to a couple of thousand pages. It would obviously be very difficult for anybody to do justice to such lengthy agendas. Clearly, something needs to be done to limit the size of the agenda papers to more manageable numbers if the board members are expected to read, study and comment on them.

But to come back to the derivatives market in India, the outstanding notional of rupee derivatives has been reported to be as high as Rs 128 trillion, a huge number by any yardstick, and with all the attendant issues of counterparty exposures and management of the credit risk. Like the credit default swaps market globally, the transaction volumes in the domestic interest rate swap market, particularly MIBOR OIS, have grown rapidly in recent years. It is high time that a proper clearing and settlement system is introduced. Perhaps CCIL is the best agency for undertaking the function, but I should confess a personal bias "" I sit on its board.

avrajwade@gmail.com