Banks can use the tool only for risk management; market-making activities not envisaged for now
A working group of the Reserve Bank of India (RBI) has recommended that scheduled commercial banks may initially be permitted to use credit derivatives only for managing their credit risks.
Market-making activities in credit derivatives, however, are not envisaged for the present.
Credit risk hedging techniques such as credit derivatives help banks manage the risk arising from adverse movements in the credit quality of their loans and advances, and their investments.
Managing credit risk by banks includes (1) buying protection on loans and investments for reduction of credit risk and (2) selling protection for the purpose of diversifying their credit risk and reducing credit concentrations and taking exposure in high quality assets,
Extant RBI instructions relating to bank guarantees will not be applicable to transactions pertaining to use of credit derivatives as derivatives are normally concluded under standardised master agreements, are structurally different from plain bank guarantees, and subject to ongoing risk controlling, risk management and valuation procedures.
For the present, banks will not be permitted to take long or short credit derivative positions with a trading intent. It means that banks may hold the derivatives in their banking books and not in the trading books except in case of credit-linked notes, which can be held as investments in the trading book if the bank so desires.
Currently, RBI proposes to restrict banks to use simple credit derivative structures such as credit default swaps and credit linked notes involving single reference entities, in the initial phase.
Banks can derive many benefits from credit derivatives such as : (1) transfer credit risk and, hence, free up capital, which can be used in other opportunities; (2) diversify credit risk; (3) maintain client relationships, and (4) construct and manage a credit risk portfolio as per their risk preference and appetite unconstrained by funds, distribution and sales effort.
The RBI proposes not to allow credit derivatives transactions between related parties till the players gain experience and maturity. It is the intention of RBI to develop the credit derivatives as a domestic product for the domestic loan and investments market, initially.
The underlying assets on which credit derivatives can be written could be either the rupee denominated assets or foreign currency denominated assets originated by domestic entities and having resident entities as the obligors.
In case of foreign currency assets, the premiums and the credit event payments can be denominated in foreign currency. In such cases, the participants in the transactions can only be such banks and financial institutions who are authorised to deal in foreign exchange.
The credit derivatives activity to be undertaken by bank should be under the adequate oversight of its board and senior management.
The policy on credit derivatives should, among others, cover at the minimum : the bank
