India is paving the way for the introduction of credit derivatives—instruments that allow banks to hedge against loan defaults—in a move that could reduce the level of overall risk in the country’s financial system at a time when lending is soaring.
The prospect marks the latest step in India’s gradual process of market liberalization as its economy becomes more global and foreign companies and investors flock here. The Reserve Bank of India (RBI) is expected as soon as today to issue new guidelines that will set the regulatory framework for credit derivatives’ issuance. The next step is for the banking industry to settle on terms for trading the instruments, a process that could take several months.
A spokeswoman for the central bank declined to elaborate beyond the central bank’s previous statement that it would issue guidance by 15 May.
One of the simplest forms of credit derivative is the credit default swap. It effectively allows banks to insure against bad loans or debt by paying another party, typically an investor, to assume some or all of the risk of default.
The potential upside for India: The transfer of credit risk to investors could help make debt markets more liquid while helping Indian banks manage and spread the risk they carry on their books. That could be useful as banks continue to issue loans at eyebrow-raising speed. India’s economy has grown at more than 8% for the past three years. In the 12 months to 27 April, loans outstanding by banks rose 27%. In addition, India is eyeing loans from private institutions to fund massive and much-needed infrastructure projects.
“There’s been a lot of interest in this product because it does take Indian financial markets to the next stage of evolution,” said Pavan Sukhdev, Deutsche Bank’s head of global markets in India. “It’s important to have these instruments to provide transparency, depth, liquidity and to avoid concentration of risk.”
For the past several years, credit derivatives have been among the world’s fastest-growing financial instruments. As of June 2006, the notional amount of credit-default swaps outstanding worldwide was $20.4 trillion, double the amount outstanding just a year earlier, according to the Bank for International Settlements in Basel, Switzerland, which acts as a central bank for central banks. The notional amount reflects the value of the underlying loan or debt the derivative is written on. Credit derivatives are in their infancy through much of Asia, but issuance is growing in more developed markets such as Hong Kong, Taiwan and Singapore, according to a December report by Fitch Ratings.
Credit derivatives can bring risks of their own. India’s push will likely be closely monitored by domestic and global financial regulators because of the risks that even mature markets such as the US and Europe have struggled with. One of the most difficult issues for banks and regulators is being able to understand what happens in the event of mass defaults and if investors rush for the exits. In recent months, regulators in the US and UK have worked together to press for stronger risk-management policies such as stress-testing what happens during multiple and sharp market moves.
RBI said last month in its annual policy report that it had reached an “adequate comfort level for the introduction of such products”. The central bank also noted that Indian banks have improved their risk management and are in the process of complying with new international standards on the capital they have to set aside to cover their risks. The bank has been considering the issue of credit derivatives since 2003.
Key to how the market develops here will be the kind of credit derivatives the central bank permits and the kind of underlying instruments it allows derivatives to be based on. Bankers would like to see credit default swaps available on corporate bonds, bank loans to Indian companies and also Indian companies’ overseas borrowing.
It’s possible that the central bank at first will insist that credit default swaps be secured against an asset, said Prakash Subramanian, regional head of capital markets for India and South Asia at Standard Chartered bank.
Later on, he said, the central bank may allow a market for credit default swaps detached from the asset underpinning them, allowing them to be traded more freely.
Whether offshore institutions, such as hedge funds, will be able to trade such instruments is also up in the air. Many bankers in India expect the market to be restricted to domestic banks and locally registered international banks, at least at first.
Before 1999, Indian companies were only permitted to use derivatives to hedge their foreign currency exposure. In 1999, RBI issued guidelines on derivatives covering Indian rupees, which essentially permitted Indian banks and companies to manage their interest rate risk through the use of interest rate derivatives.
(Eric Bellman in Mumbai contributed to this story.)