Indian banking industry would soon be ushering into credit derivatives regime, if the recent draft guidelines by the Reserve Bank of India, issued on March 26, 2003, are any indication. In a move towards improving and fine-tuning the existing risk management practices in banks, the apex bank has decided to allow banks to deal in credit derivatives. As per the guidelines, the banks would be allowed to use credit derivatives to manage risks such as those relating to lending, including buying protection on loans and investments. For the uninitiated, credit derivatives are over-the-counter financial contracts, usually `off-balance sheet', that permit one party to transfer credit risk of a reference asset, which it owns, to another party without actually selling the asset.
For
long, banks in India needed a risk management tool to
mitigate risks arising from adverse movements in the
credit quality of their loans and advances, and their
investments. Credit derivatives would help banks and
financial institutions not only in reducing their credit
risks but also in diversifying their asset portfolios.
To begin with, banks will be permitted to use credit
derivatives for managing their credit risk. According
to the recommendations of the working group on Credit
Derivatives, constituted by the RBI, banks may use credit
derivatives for buying protection on loans and investments
for reduction of credit risk, selling protection for
the purpose of diversifying their credit risk and reducing
credit concentrations for exposure in high quality assets.
The
new regime presents banks with opportunities to not
only transfer their risks but also free their capital;
it also poses significant challenges for them. Foremost,
the banks would need to beef-up their in-house research
to deal in such highly complicated products. With the
corporate disclosure standards and financial reporting
leaving much to be desired, it would pose significant
challenge to banks to assess the true credit quality
of its debtors.
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