Asset Securitisation and Credit Derivatives – An Overview

Introduction

Credit derivatives are among the most recent innovations in the financial markets and these instruments have the advantage of combining the attributes of securitisation and derivatives. Securitisation, is the process of converting illiquid or non-marketable assets into smaller, marketable assets by selling the expected cash flow generated from these assets through the capital market. Though the end-result of securitisation is financing, but it is not ‘financing’ as such, since the entity securitising its assets is not borrowing money, but selling a stream of cash flows that was otherwise to accrue to it. Credit derivatives are only a logical extension of the concept of securitisation. A credit derivative is a non-fund based contract, when one person agrees to undertake, for a fee, the risk inherent in a credit without actually taking over the credit. The risk could be undertaken either by guaranteeing against a default, or by guaranteeing the total expected return from the credit transaction. While the former could be just another form of traditional guarantees, the latter is the true concept of credit derivatives. The development of credit derivatives has not reduced the role for securitisation: It has only increased the potential for securitisation. The market for credit derivatives is essentially over-the-counter (OTC) and not subject to serious regulation. The credit derivatives market functions on the concept that the credit risk alone can be sold to a willing risk buyer by paying a premium without transferring the titles of the underlying asset. As reported in The Times on 15 September 2008, the "Worldwide credit derivatives market is valued at $62 trillion". Although the credit derivatives market is a global one, London has a market share of about 40%, with the rest of Europe having about 10%.

Credit default swaps are a form of bilateral contracts, meaning they are private contracts between two parties. The CDS has become the cornerstone of the credit derivatives market. This product represents over 30% of the credit derivatives market. CDSs are subject only to the collateral and margin agreed to by contract. Swaps originated as a way for financial institutions to hedge against the risk of sudden price movements or interest rate fluctuations. They are traded over-the-counter, usually by telephone and are subject to re-sale to another party willing to enter into another contract. Credit default swaps are not standardised instruments. In fact, they technically do not qualify as true securities, in that they are not transparent, are not traded on any exchange, are not subject to present securities laws and are not regulated. Most frighteningly, credit default swaps are subject to counterparty risk. But, these instruments, primarily used to hedge exposures in certain asset categories have become tradable instruments in the market place as proxies for transactions in their underlying assets. The market size for Credit Default Swaps began to grow rapidly from 2003; by the end of 2007, the CDS market had a notional value of $45 trillion. But notional amount began to fall during 2008 as a result of dealer "portfolio compression" efforts, and by the end of 2008 notional amount outstanding had fallen 38 percent to $38.6 trillion. Risk speculators who wanted exposure to certain asset classes, various bonds and loans, or security pools such as residential and commercial mortgage-backed securities but didn’t actually own the underlying credits, now had a means by which to speculate on them. Illiquid Sources of Cash Flow may include Home or Commercial Loans (Mortgages), Credit Card Accounts, Car Loans, Consumer Loans, Corporate Bank Loans, Illiquid Bonds, Aircraft Leases, and many more asset and receivable types.

A schematic diagram illustrates this:

Source : http://en.wikipedia.org/wiki/credit-derivative

Origins and Trends 

The earliest securitised transactions date back to the early 1970s in United States of America (USA), wherein the pooled mortgage loans were sold by the government-sponsored enterprises-Government National Mortgage Association (Ginnie Mae). The Federal Home Loan Mortgage Corporation (Freddie Mac) and Federal National Mortgage Association (Fannie Mae) followed suit with similar transactions. The genesis of establishing these government-sponsored agencies was to facilitate home ownership by providing a reliable supply of home mortgage finance. The credit derivatives market has grown to one of the dominant means of global financing particularly in USA, Canada, Europe, Latin America and South-East Asia. USA continues to dominate the world securitisation market both in terms of depth as well as width. In terms of depth, it draws participants from both institutional as well as individual investors. While in terms of width, it has more applications of securitisation than any other market. 

General Pros and Cons of Securitisation :

Pros

Securitisation provides several advantages to the financial system as a whole. It increases the number of debt instruments in the market and provides additional liquidity in the market. It also facilitates unbundling, better allocation and management of project risks. It could widen the market by attracting new players on account of the availability of superior quality assets. In particular, advantages accruing to originators are

·         The receivables are moved ‘off balance sheet’ and replaced by cash equivalent, thereby improving the originator’s liquidity and balance sheet.

·         Securitised structures may enjoy a rating significantly higher than the originator’s own. This helps in reducing cost of borrowing, by transferring legal ownership of the assets and the credit enhancement in the structure. This can even help the originator widen the investor base.

·         Most regulators/ accounting bodies recognize securitisation transactions as sale transactions and allow capital to be released on these assets. This proves to be a major benefit to the originator, as they can increase their leverage while still remaining within the regulatory norms.

·         Other risks such as interest rate burden and duration mismatch risks can be partly or completely transferred through the securitisation process.

·         Better assets-liability management by reducing market risks resulting from interest rates mismatches.

Advantages accruing to investors are as follows :

·         Securitisation creates new classes of securities that appeal to investors with different appetite for risk.

·         It reduces investor’s transaction costs and improves portfolio efficiency by enabling them to take only those components of a particular asset’s cash flow that accords to their preferences.

·         Adds value to investor’s portfolio by facilitating the acquisition of specialized investment information. By structuring an assets-backed transaction into tranches with varying degrees of informational complexity, it allows investors with relatively low levels of expertise to take positions in the more superior securities offered by SPV, thereby adding value to their portfolio. 

Cons 

There are several limitations of this market as it operates now. Chief among them are:

·         The market is entirely unregulated and there are no public records showing whether sellers have the assets to pay out if a bond defaults. CDS contracts are not cleared on a centralized exchange nor are they government regulated. That means that no one really knows whether issuers of CDS can pay off potential claims or not.

·         Unless derivatives contracts are collateralized or guaranteed, their ultimate value depends on the creditworthiness of the counterparties.

·         Sellers of protection aren’t required by law to set aside reserves in the CDS market. While banks ask protection sellers to put some money when making the trade, there are no industry standards.

·         CDS often leads to excessive speculation as there is no requirement to actually hold any asset or suffer a loss. 

Link to Global Crisis

While credit derivatives help in releasing funds to originators and help diversifying       portfolio of assets of the investor community, as is well-known by now, the sub-prime crisis owed its origin to the unbridled explosion of the credit-derivatives markets. According to Alan Greenspan, it is securitisation of home loans that is to be blamed rather than the poor credit quality of these loans. However, now every one accepts that it is a case of both market failure and regualtory failure. The problem being that the rating agencies did not rate the securitised assets appropriately and then when things started worsening, were very slow to react. The crisis precipitated when highly overrated credit default swaps written on subprime mortgage securities bought by banks, investment banks, insurance companies and hedge funds ended up falling precipitously in value as foreclosures mounted on the underlying mortgages in the pools. Speculators sold and bought trillions of dollars of insurance that these pools would, or would not default. CDS, which were originally created to reduce potential losses from defaulting bonds, has turned into a cash cow for the big banks, generating mega-profits on, what amounts to, nothing but legalized gambling.

Before the current crisis, the US accounted for the lion’s share of the credit derivatives market at 80% while Europe contributed 9%. Owing to significant depth in these markets, there were larger number of participants, including banks, securities firms and insurance companies. Issuers from US, Australia and certain Asian markets also tap the European markets. Over 50% of Australian volumes were issued in Europe. Within Asia, Japan and South Korea were players, India’s participation in the international derivatives market was however not large, but securitisation on bank assets was picking up. Recent developments and legislations have seen Taiwan, Hong Kong and Singapore also foraying into the securitsation market.

Global credit markets experienced a large-scale sell-off during 2007-08, as broad-based deleveraging combined with uncertainty about the size and valuation of credit exposures. The chain of events started with what appeared to be at first, a relatively contained problem in the US subprime mortgage sector, but quickly spread to other markets. In an environment of rather accomodative financial conditions and elevated risk appetite, use of credit derivatives and securitisation had aided the build-up of substantial leverage in the financial system as a whole. When this leverage started to be unwound in the face of subprime losses, price deterioration led to margin calls and further deleveraging. With liquidity evaporating, valuations came under greater downward pressure and became increasingly uncertain. The resulting retrenchment of positions across markets triggered a sharp and disorderly repricing of risky assets that continued through much of the period. The total losses due to such toxic assets are still to be estimated precisely, but the current assessment is about $ 4 trillion.

Need for strengthening Financial Regulation

The ongoing crisis has thrown up issues as regards the need for strengthening financial regulation at the national and international levels, since failure of regulation has been attributed as one of the main causes of the current financial crisis. Though the sub-prime market in the US was the proximate cause, post-crisis, weaknesses in the overall regulation of financial system, in particular financial markets, have come to light. Therefore, serious deliberations are under way led by the US and the UK through the G-20 Group, which has prepared an action plan on which all members of the G-20 have committed to work in a coordinated manner. From the point of view of improving the regulatory architecture the efforts are on, so as to bring hitherto unregulated institutions, markets and instruments under the regulatory framework. The regulatory framework itself needs to be redesigned to address the emerging needs at both the national and international levels. In this context, some recommendations put forward by Dr. Rakesh Mohan (Deputy Governor, RBI) in a paper prepared for the Bank of France are worth noting, which also benefited from the Report of the Working Group I of the G-20 on ‘Enhancing Sound Regulation and Strengthening Transparency’. The Working group I comprised of again, Dr.Rakesh Mohan (Deputy Governor of the Reserve Bank of India) and Tiff Macklem  (Associate Deputy Minister, Canadian Ministry of Finance). Also, notable are the views of  Jonathan Adair Turner, Chairman of Financial Services Authority (FSA) United Kingdom (UK) which also provided inputs.

Recommendations of the paper prepared by Dr.Rakesh Mohan

Some of the most important issues dealt with in the paper are :

1)      Macro prudential orientation : Prudential regimes should encourage behaviour that supports systemic stability; discourages regulatory arbitrage; and adopts the concept of ‘systemic risk’, factoring in the effects of leverage and funding. Within this, the three broad areas that require strengthening are :

                                i.            Capital adequacy framework:  There is a clear need for higher quantity and  quality capital resulting in minimum regulatory requirements significantly above existing Basel rules. The emphasis should be on Tier I capital. The transition to future rules should be carefully phased given the importance of maintaining bank lending in the current macroeconomic climate. Capital required against trading book activities should be increased significantly. Published accounts could also include buffers which anticipate potential future losses, through for instance, the creation of an ‘Economic Cycle Reserve’.

                              ii.            Liquidity risk management :  An effective liquidity framework for managing liquidity in large, cross-border financial institutions should include internationally agreed levels of liquidity buffers and should encourage an increase in the quality of their composition. Areas that could be considered include :

a)      Improved funding risk management by strengthening risk management &   governance and control.

b)      Introduction of minimum quantitative funding liquidity buffers of high –quality liquidity assets.

c)      Introduction of regulatory charge for institutions that present a higher-than average liquidity risk and pricing of access to central bank liquidity in order to encourage institutions holding better-quality collateral.

                            iii.            Infrastructure for OTC derivatives : In the light of problems involving some large players in the CDS markets, attention has been focused on the systemic risks posed by CDS. There is a global consensus on the need for a central counter party (CCP) for all OTC derivatives. The development of a CCP facilitates greater market transparency, including the reporting of prices for CDS, trading volumes and aggregate open interest. The availability of pricing information can improve the fairness, efficiency and competitiveness of markets- all of which enhance investor protection and facilitate capital formation. The degree of transparency, however, depends on the extent of participation in the CCP.

2)      Regulatory regime: With the emergence of the shadow banking system and other leveraged financial institutions, the scope of regulation and oversight needs to be expanded to include all systemically important institutions, markets and instruments. Financial authorities will need enhanced information on all material financial institutions and markets, including private pools of capital. Consideration would also need to be given to put in regulatory disincentives for institutions to not become too big to fail.

3)      Procyclicality: Once conditions in the financial system have recovered, international standards for capital and liquidity buffers will have to be enhanced. The build-up of capital buffers and provisions in good times should be encouraged so that capital can absorb losses and be drawn down in difficult times such as the current period.

The G-20 group shoulders the responsibility of monitoring the implementation of actions already identified and make further recommendations to strengthen international standards in the areas of accounting and disclosure, prudential oversight and risk management. It will also develop policy recommendations to dampen cyclical forces in the financial system and to address issues around the scope and consistency of regulatory regimes.

Recommendations of the Turner Report

Jonathan Adair Turner, Chairman of Financial Services Authority (FSA) UK, has identified 3 causes that led to the sub-prime crisis. The causes identified are; macroeconomic imbalances, financial innovation of little social value and deficiencies in key bank capital and liquidity requirements. Also, remedies suggested by him include stronger guidance about business models and products, counter-cyclical capital requirements so money is hoarded in good times for a downturn and a greater emphasis on the importance of risk management. This forms part of the FSA report which was to be tabled at the G-20 Nation’s Summit in April 2009, London. The FSA report is UK-centric in that it has forced banks in UK to curb trading activity that helped cause the global financial crisis. Also, banks will be required to put aside more capital against potential losses on their trades. The FSA plans to present proposals for capital and other regulatory changes in the second half of the year for further debate.  The recommendation’s of the report can be enlisted as under:

• Quality and quantity of overall capital in the global banking system should be increased with a minimum imposed in 2010.

• Capital required against trading book activities should be increased several times.
• ‘Through the cycle’ rather than ‘point in time’ measures of probabilities of default should be used with immediate effect.

• A counter –cyclical capital adequacy regime should be introduced.
•  Published accounts should include buffers which anticipate potential future losses
• A maximum gross leverage ratio should be introduced.
• More intense supervision of banks’ liquidity should be introduced with the use of stress tests and the introduction of a ‘core funding ration’ to ensure sustainable funding of balance sheet growth.

Further, Turner’s recommendations also encompass the role of credit rating agencies, credit default swaps, firm risk management & governance, utility banking Vs investment banking and cross-border co-operation amongst others. 

IOSCO recommends regulations of securitisation and credit derivatives

The International Organisation for Securities Commissions’ (IOSCO) Technical Committee published a report on ‘Unregulated Financial Markets and Products - Consultation Report prepared by its task force.

In a period when lot of commentators are spitting venom at securitisation as being the source of the present crisis, the Report recognizes the significance of securitisation. “The absence of a well-functioning securitisation market will impact consumers, banks, issuers and investors. The price of credit is likely to be higher for the consumer and the availability scarcer. Banks will no longer have a tool to reduce risk and diversify their financing sources”, says the Report.  Credit default swaps, too, can serve as an excellent instrument for risk hedging and price discovery, but also have a potential to proliferate as a tool of speculative trading in credit.

Thus, the interim recommendations are aimed towards restoring transparency and investors’ confidence, promoting fairness and bringing about stability in the international financial markets. The interim recommendations on securitisation include:

• The originators or the sponsors to have longer term economic interest in the securitisation transaction

• Disclosures and the transparency norms to be made stringent to ensure that appropriate checks and assessments are done and the originator, issuer and underwriters have duly performed their duties.

• Improving disclosure norms for the issuers on initial and continuing basis, giving out data on the underlying asset pool’s performance and so on.

• Independence of experts used by issuers

In the CDS market, the task force recommended the formation of central counterparties to handle clearing of CDS contracts and for market participants to support the clearing process by developing a standardised CDS contract. The report is open for comments till the 15^th June 2009.

The Indian Scenario

Asset securitisation in India, is at a nascent stage. It is in existence since early 1990s, though essentially as a device of bilateral acquisitions of portfolios of finance companies. Being amongst the pioneers in Asia in leveraging securitisation, India’s first securitsation deal was struck in 1991, when Citibank securitized part of its auto loans portfolio.

 Issuance trends in the Indian Structured Finance Market

The volumes comprising ABS, MBS and CDO/LSO accounted for Rs.282 billion at the end of FY2005. Issuance volume in the Indian structured finance (SF) comprising these three categories since then has increased to Rs. 520 billion for the year-ending March 2009. However, in FY2009, the volume showed a decline of 18% over the previous year’s level of Rs.637 billion. Refer table below:

Single corporate loan securitisations [also known as Single Loan Collateralised Loan Obligations (CLOs) or Loan Sell-Offs (LSOs)] accounted for around 68% of the total volume; Asset Backed Securitisation (ABS), traditionally the dominant product class, for around 26%; and Residential Mortgage Backed Securitisation (RMBS) for the balance 6% or so, with its relatively long tenure continuing to hinder investor appetite. Securitisation of retail assets (both ABS and RMBS) cumulatively reported a 47% drop in volume during FY2009 over the previous fiscal. However, issuance of ABS was about 57% lower over the FY2008 levels. Tight liquidity conditions and the rise in interest rates-especially in the second half of the fiscal-together with the rise in delinquency levels in many asset classes caused most of the retail loan originators to scale down volumes significantly.  

Fiscal year 2009 saw an increase in the issuance volumes of residential mortgage-backed securitisation and securitisation of individual corporate loans, although the pace of growth of the latter was slower over the previous fiscal. According to ICRA’s estimates, 6 RMBS transactions worth Rs.32.9 billion were executed as against four deals aggregating Rs.6 billion during FY2008. This translates into a whopping 448% rise in issuance volumes. In FY2009, LSOs amounted to Rs.351 billion, an increase of 10% over FY2008. Despite the slower growth rate, LSOs were the largest securitisation product in the period under review. Its share in the total securitisation activity rose to around 68% from the 50% share it held in the previous period. It may be noted that around 92% of the LSO issuances were made in the first half of FY2009. While the second half was characterised by drying up of the issuances on the back of credit concerns relating to certain key borrorwers segments coupled with a systemic liquidity crunch.

The ABS market continues to be driven by a handful of issuers. During FY2009, the top 5 originators accounted for about 80% of the issuance volume. The volumes were led by Tata Motors Group, Shriram Transport Finance Company and Cholamandalam DBS Finance Ltd. CICI Bank, hitherto one of the largest issuers of ABS paper and the originator of the country’s largest ABS deal, was absent from the securitisation market in FY2009.

New asset classes emerge

FY2009 saw 2 new asset classes emerge viz; securitisation of loans against gold and microfinance loan receivables. Microfinance loans are given to economically backward borrowers, typically through a joint liability mechanism. Such loans are characterised by small ticket sizes (average size being around Rs.10,000) and short tenures (less than a year). Gold loans are also small ticket loans, average being around Rs.20,000 and these are secured by pledging gold ornaments. While the contracted terms could be upto 12 months, gold loan portfolios tupically witness very high payments.      

India’s securitisation market is an asset backed market, securitisng auto loans, commercial vehicles, equipments and other assets. The rest of the market is constituted by mortgage and securitisation of credit products. The market in India is characterisd by low appetite for risk and hence highly rated instruments (mostly AAA), a small investor base consisting mostly of private banks, mutual funds and housing finance companies. Public sector banks have not participated in any significant way as the need for expansion and hence funds are not seen as an immediate problem by the banks. The credit derivatives market in India is yet to take off in a significant manner.

The main bottlenecks for the operation of credit derivatives market in India are :

1)      Lack of secondary market for the protection seller to short his position and lack of liquidity in the market.

2)      The delay in implementation of proper regulations in dealing with the structure and working of credit derivatives has led to a lack of standard credit derivative products.  

3)      Legal issues pertaining to true sale complicating structuring of transactions.

4)      High stamp duty structures and registration charges in states.

5)      Absence of accounting standards (though ICAI has come out with Guidance Note).

6)      The RBI guidelines on securitisation do not permit immediate profit recognition and re-computation of credit enhancements. It is mandated that losses from the sale of securitized standard assets must be borne upfront, while profits are to be amortised over the tenure of the transaction. This approach has prevented the use of securitisation for the management of immediate profits by banks. 

Draft Guidelines by RBI

The credit derivatives market is yet to take off in India. To ensure a regulated credit derivative market in India, the Reserve Bank of India (Amendment) Bill, 2006 has been enacted. The Act empowers the RBI to lay down policy directions to any agency dealing in various kinds of contracts in respect of G-securities, money-market instruments and derivatives and inspect such agencies. RBI is also empowered to deal in derivatives and to lend or borrow securities.

In 2002, RBI formed a Working Group on Introduction of Credit Derivatives to study the conditions and scope for introducing the tools in India. The Working Group recommended that, to begin with, banks, financial institutions, NBFCs, mutual funds, insurance companies and corporates may be allowed to introduce credit derivative The Reserve Bank of India (RBI) had issued the ‘Draft Guidelines for Introduction of Credit Derivatives in India’, on 26 March 2003, inviting comments from banks and other stake holders. However, taking into account the status of the risk management practices then prevailing in the banking system, the issuance of final guidelines had been deferred. Subsequently, in the Annual Policy Statement for 2007-08, an announcement was made as regards the introduction of credit derivatives in a calibrated manner. Modified draft guidelines on Credit Default Swaps were, therefore, issued on 16 May 2007. Based on the feedback received on draft guidelines, these were revised and a second draft of the guidelines was issued, on 24 October 2007, for another round of consultation with provisions inter alia relating to Risk Management Systems, documentation,  policy requirements, procedures, systems and control, prudential norms, accounting etc. The details are provided in the Annex to this note.

However, in view of certain adverse developments witnessed in different international financial markets, particularly the credit markets, resulting in considerable volatility in the recent past, such as mounting losses suffered by banks on account of sub-prime crisis, need for the central banks of those countries to inject liquidity into the system, as also the level of risk management systems and possible non-adherence to the regulatory guidelines on complex products such as credit derivatives, it was considered that the time is not opportune to introduce the credit derivatives in India, for the present. Therefore, in June 2008, the RBI withheld from issuing the final guidelines mainly by way of exercising extreme caution at the present stage of crisis stricken environment globally. Apparently, the decision was taken so as to be able to draw upon the experience of the financial sector of some of the developed countries, particularly in the current circumstances, in which the entire dimensions of the recent credit market crisis have not yet been gauged.

The Way Forward  

Despite the setback in the evolution of credit derivatives in India, it should be noted that India has considerable scope for sell-off market which can make use of the benefits of credit derivatives. Even though banks in the developed countries have been using the tool for well over a decade and a half, credit derivatives are still to enter the Indian market. However, two sectors in India most likely to benefit from securitisation are banking and the infrastructure sector.

In the context of banking, securitisation will help banks to provide credit for retail expansion. As rate of growth of credit surpasses rate of growth of deposits, the banks find it difficult to raise resources to fund the aggressive expansion. An attempt to attract more deposits by offering higher interest rates would lead to lower margins and lower earnings. This leaves banks with the option of securitising its existing portfolios, thus freeing their balance sheets and use proceeds from it to disburse more loans.   

India’s infrastructure investment needs are huge (estimated at USD 215 bn over 2001-2005 by the India Infrastructure Report) but, financing the same raises several issues such as huge initial outlays, multiple project risks, unconventional assets (bridges, roads etc.), long gestation period etc. Moreover, many state-owned units like State Electricity Boards are saddled with huge NPAs, thus limiting their ability to invest from internal accruals.

Given this situation, securitisation makes available financing from a larger pool of investors, enables players specialised in various aspects of the project to participate and redistribute risks amongst others. The introduction of credit derivatives in India may have to be revisited at the earliest opportunity.

Annex 

RBI’s Modified Guidelines on Credit Default Swaps (circulated on October 24, 2007, but shelved in June 2008)

Mojor Provisions

(i) Risk Management Systems

1)   Banks’ credit derivative activities shall be governed by the risk management, corporate governance and suitability and appropriateness requirements stipulated in our ‘Comprehensive Guidelines on Derivatives’ issued vide our circular DBOD.No.BP.BC. 86/21.04.157/2006-07 dated 20 April 2007.

2)   Banks should consider carefully all related risks and rewards before entering the credit derivatives market. They should not enter into such transaction unless their management has the ability to understand and manage properly the credit and other risks associated with these instruments. They should establish sound risk management policy and procedures integrated into their overall risk management.

3)   Credit risk assumed in connection with a credit derivative should undergo the bank’s usual credit approval procedure as per board approved policy and henceforth be subject to established review, monitoring and information requirement.

4)      Banks which are protection buyers should periodically assess the ability of the protection sellers to make the credit event payment as and when they may fall due. The results of such assessments should be used to review the counterparty limits. 

5)      Banks which are active in the credit derivative market shall have in place internal limits on the gross amount of protection sold by them on a single entity as well as the aggregate of such individual gross positions. These limits shall be set in relation to the bank’s capital funds. Banks shall also periodically assess the likely stress that these gross positions of protection sold, may pose on their liquidity position and their options / ability to raise funds, at short notice.

6)      Banks should be aware of the potential legal risk arising from an unenforceable contract, e.g. due to inadequate documentation, lack of authority for a counterparty to enter into the contract (or to transfer the asset upon occurrence of a credit event), uncertain payment procedure associated with bankruptcy proceedings or inability to determine market value when required. They should consult their legal advisers on these and related legal aspects before engaging in credit derivative transactions.

7)      Banks should address conflicts of interest that may arise within the institution in respect of privileged information if there is no widely traded asset of the reference entity.

8)      The credit derivatives activity to be undertaken by bank should be under the adequate oversight of its Board of Directors and senior management. Written policies and procedures should be established to cover use of credit derivatives. Banks using credit derivatives should have adequate policies and procedures in place to manage associated risks. There should be adequate separation between the function of transacting credit derivatives business and those of monitoring, reporting and risk control. The participants should verify that the types of transactions entered into by them are appropriate to their needs and needs of the counterparty. Further, all staff engaged in the business should be fully conversant with the relevant policies and procedures. Any changes to the policy or engagement in new types ocredit derivatives business should be approved by the Board. 

(ii) Documentation:

The transactions in credit derivatives may be covered by the 1992 or 2002 ISDA Master Agreement and the 2003 ISDA Credit Derivatives Definitions and subsequent supplements to definitions, as amended or modified from time to time. However, banks should consult their legal advisers about adequate documentation and other legal requirements and issues concerning credit derivative contracts before engaging in any transactions. Banks should document the establishment of the legal enforceability of these contracts in all relevant jurisdictions before theyundertake CDS transactions.

(iii) Policy requirements:

The policy duly approved by the Board of Directors should cover at the minimum;

• The bank’s strategy – i.e., whether for hedging or for trading, risk appetite and limits for credit derivatives business,

• Authorisation levels for engaging in such business and identification of those responsible for managing it,

• Procedure for measuring, monitoring, reviewing, reporting and managing the associated risks like credit risk, market risk, liquidity risk and specific risks,

• Appropriate accounting and valuation principles for the credit derivatives,

• Pursuing with the underlying borrower when a credit event payment has been triggered,

• Determination of contractual characteristics of the products,

• Use of best market practices.

(iv) Procedures

The banks should have adequate procedures for: 

• Measuring, monitoring, reviewing, reporting and managing the associated risks,

• Full analysis of all credit risks to which the banks will be exposed, the minimisation and management of such risks,

• Ensuring that the credit risk of a reference asset is captured in the bank’s normal credit approval and monitoring regime. This function in no case should be entrusted to the desk dealing with credit derivatives.

• Management of market risk associated with credit derivatives held by banks in their trading books by measuring portfolio exposures at least daily using robust market accepted methodology,

• Management of the potential legal risk arising from unenforceable contracts and uncertain payment procedures,

• Determination of an appropriate liquidity reserve to be held against uncertainty in valuation. This is important especially where the reference asset is illiquid like a loan,

• Valuation adjustments to decrease the asset or increase the liability arising from the initial valuation of a credit derivative transaction by bank’s approved model. The purpose of the valuation adjustments are to report in the bank’s statements of accounts the “fair” economic value that the bank expects to realise from its credit derivative portfolios based upon current market prices and taking into account credit and market risk characteristics arising from those portfolio position.

(v) Systems and Controls

The senior management should establish an independent framework for reporting, monitoring and controlling all aspects of risks, assessing performance, valuing exposures, monitoring and enforcing position and other limits. The systems and controls should:

• Ensure that the types of transactions entered into by the counterparty are appropriate for their needs,

• Ensure that the senior most levels of management at the counterparty are involved in transactions by methods like obtaining from the counterparty a copy of a resolution passed by their Board of Directors, authorising the counterparty to transact in credit derivatives,

• Ensure that counterparties do not enter into transactions that violate other rules and regulations,

• Ensure that (a) the credit derivative contract confirmations are received promptly and verified for accuracy; (b) appropriate systems to track the delays in confirmations and to escalate the delays in such confirmations to the appropriate levels within the bank; and (c) the systems provide for an appropriate authority (preferably the Chief Executive Officer) to decide on cessation of dealing with the counterparties where the confirmations are in arrears beyond a reasonable number of business days.

• Ensure adequate Management Information Systems to make senior management aware of the risks being undertaken, which should provide information on the types of transactions carried out and their corresponding risks, the trading income/losses, realized/unrealized from various types of risks/exposures taken by the bank, contribution of derivatives to the total business and the risk portfolio, and value of derivative positions,

• Assess and account for the possibility of default correlation between reference asset and the protection provider,

• Ensure that trading activities, if undertaken, are properly supervised and are subject to an effective framework of internal controls and audits so that transactions are in compliance with regulations and internal policy of execution, recording, processing and settlement,

• Ensure that the bank has the ability to pursue the underlying borrower when a credit event payment has been triggered.

(vi) Prudential Norms:

Eligible counterparties

As the credit derivative market in India will take some time to develop, it would be difficult to have an objective and transparent price discovery mechanism at this stage and, therefore, difficult to determine whether an arms' length relationship exits or not. Therefore, banks are not permitted to enter into credit derivative transactions where their ‘related parties’ are the counterparties or where the related parties are reference entities. Related parties for the purpose of these guidelines will be as defined in ‘Accounting Standard 18 – Related Party Disclosures’. In the case of foreign banks operating in India, the term related parties shall include an entity which is a related party of the foreign bank, its parent, or group entity. 

Applicability of guarantee norms

A CDS contract will not be deemed to be a guarantee and will consequently not be governed by the regulations applicable to bank guarantees. This is because CDS contracts are normally concluded under standardised master agreements, they are structurally different from bank guarantees, they may have a secondary market and they are regulated under these special regulations.

Amount of protection under CDS

(a)   Amount of credit protection: The credit event payment or settlement amount will determine the amount of credit protection bought /sold in case of CDS. The amount of credit protection shall be the amount that the protection specified in seller has undertaken to pay in the event of occurrence of a credit eventthe CDS contract without netting the value of the reference asset.

(b)   Amount of risk assumed when protection is sold: When a bank has sold credit protection using a credit derivative, it should be assumed that the protection seller has assumed credit risk on 100 per cent of the amount of protection (as defined in paragraph 4.4.1) irrespective of the credit events specified or mismatches if any between the underlying asset/ obligation and thereference / deliverable asset / obligation with regard to asset or maturity.

Capital Adequacy for Protection Seller

(a)  Where a Protection Seller has sold protection through a CDS it acquires exposure to the credit risk of the deliverable asset/ reference asset to the extent of the amount of protection computed as per paragraph 4.4. This exposure should be risk-weighted according to the risk weight of the reference entity or reference asset, whichever is higher. Sold CDS will be an off balancesheet item with a CCF of 100%.

(b)  The protection seller will also have an exposure on the protection buyer as a long position in a series of zero coupon bonds issued by the protectionbuyer (representing the periodic payment of premium).

(c) Banks are not permitted to have a position as protection buyer in their banking book except as a hedge against a credit risk exposure. In such case the capital adequacy treatment will be as detailed in paragraph 5.6 below.

 Capital adequacy for Credit Derivatives in the Trading Book

Recognition of positions: The general norms for recognising positions bythe participants dealing in CDS are as under: 

1. A credit default swap does not normally create a position for general market risk.

2. A CDS creates a notional long or short position for specific risk in the reference asset/ obligation. The notional amount of the CDS must be used and the maturity of the CDS contract will be used instead of the maturity of the reference asset/ obligation.

3. The premium payable / receivable create notional positions in government securities of relevant maturity with the appropriate fixed or floating rate. These positions will attract appropriate capital charge for general market risk.

4. A CDS contract creates a counterparty exposure on the protection seller account of the credit event payment and on the protection buyer on account of the amount of premium payable under the contract.

Banks may fully offset the specific risk capital charges when the values of two legs (i.e., long and short) always move in the opposite direction and broadly to the same extent. This would be the case when the two legs consist of completely identical instruments - including the identity of the reference entity, maturity, and coupon; - there is an exact match between the maturity of both the reference obligation and the credit derivative, and the currency of the underlying exposure; the credit events are identical (including their definitions and settlement mechanisms). In these cases, no specific risk capital requirement applies to both sides of the position.

Banks may offset 80% of the specific risk capital charges when the value of two legs (i.e. long and short) always moves in the opposite direction but not broadly to the same extent. This would be the case when a long cash position is hedged by a credit default swap (or vice versa) and there is an exact match in terms of the reference obligation, and the maturity of both the reference obligation and the credit derivative. In addition, key features of the credit derivative contract (e.g. credit event definitions, settlement mechanisms) should not cause the price movement of the credit derivative to materially deviate from the price movements of the cash position. To the extent that the transaction transfers risk, an 80% specific risk offset will be applied to the side of the transaction with the higher capital charge, while the specific risk requirement on the other side will be zero.

Banks may offset partially the specific risk capital charges when the value of the two legs (i.e. long and short) usually moves in the opposite direction.

Exposure Norms  

Protection buyer: While computing its credit exposure to a reference entity, the protection buyer (a) may set off the exposure to the reference entity; and (b) shall reckon this exposure (which is non-fund based) on the protection seller to the extent of credit protection purchased through a CDS contract where there is no maturity mismatch. Where there is a maturity mismatch, and the time to expiry of CDS is three months or less , credit derivatives do not reduce the credit exposure to the underlying asset/ reference entity and, therefore, the protection buyer shall start reckoning exposure on the underlying asset/ obligor when residual period left is less than three months.

Protection seller:  Conversely, while computing its credit exposure to a reference entity, the protection seller shall add to the existing exposure (if any) on the reference entity, the extent of credit protection sold through a CDS contract, as a non-fund based exposure on the reference entity. In addition, the protection seller shall reckon an off-balance sheet credit exposure on the protection buyer to the extent of the premia receivable periodically over the term of the credit derivative contract.

Once the aggregate credit exposure on the reference entity or the protection seller or the protection buyer, including credit derivative contracts, is computed, banks will have to ensure that they are compliant with the prudential credit exposure limits (the lower of regulatory and internal limits) applicable to the reference entities/ protection sellers. In case the reference entity is a commercial bank or a co-operative bank, compliance with the internal limits set for each of those counterparties should be complied with. For the purpose of these guidelines :

1.   The participants who are not subjected to a regulatory limit on their counterparty credit risk exposures similar to commercial banks but are subject to regulatory capital adequacy requirement, shall observe a counterparty exposure limit of 15 per cent of their capital funds or the counterparty exposure limits as stipulated by their regulator, whichever is less;

2.   Exposure will include both fund based and non-fund based exposures;

3.   Exposure shall be reckoned as limits or outstanding whichever is higher;

4.   Participants which do not have a capital adequacy requirement similar to commercial banks shall compute their counterparty exposure limits as 15% of their net worth. These entities will compute net worth as “paid up capital + reserves – revaluation reserves – accumulated losses – intangible assets – goodwill (if any)”

 Provisioning Requirements

(i) Protection Buyer: The underlying asset in respect of which the protection buyer has bought credit risk protection will continue to be on the protection buyer’s balance sheet. Consequently, the protection buyer shall hold adequate “provision for standard assets” until the occurrence of a credit event.

(ii) Protection Seller: The protection seller is not assuming a fund based credit exposure on the reference entity/ underlying asset and hence, it may not hold “provisions for standard assets” until the occurrence of the credit event and the deliverable obligation.

Prudential treatment post credit event 

(i)     Protection buyer: From the date of credit event and until receipt of credit event payment in accordance with the CDS contract, the protection buyer shall ignore the credit protection of the CDS and reckon the credit exposure on the underlying asset/ reference entity and maintain appropriate level of capital and provisions as warranted for the exposure. On receipt of the credit event payment, (a) the underlying asset shall be removed from the books if it has been delivered to the protection seller or (b) the book value of the underlying asset shall be reduced to the extent of credit event payment if the credit event payment does not fully cover the book value of the underlying asset and appropriate provisions shall be maintained for the reduced value.  

(ii) Protection seller: From the date of credit event and until making of the credit event payment in accordance with the CDS contract, the protection seller shall debit the profit and loss account and recognise a liability to pay to the protection buyer, for an amount equal to the amount of credit protection sold. After the credit event payment, the protection seller shall recognise the assets received, if any, from the protection buyer at the assessed realisable value and reverse the provisions made earlier, up to that amount. Thereafter, the protection seller shall subject these assets to the appropriate prudential treatment as applicable to loans and advances or investments, as the case may be.

(vii) Use of credit default swapsas a credit risk mitigant

The credit derivative should conform to the following general criteria to be recognised as credit risk mitigants :

·               A CDS contract must represent a direct claim on the protection seller and must be explicitly referenced to specific exposures of the protection buyer, so that the extent of the cover is clearly defined and incontrovertible. The contract must be irrevocable; there must be no clause in the contract that would allow the protection seller unilaterally to cancel the cover or that would increase the effective cost of cover as a result of deteriorating credit quality in the underlying asset / obligation.

·               The CDS contract shall not have any clause that could prevent the protection seller from making the credit event payment in a timely manner after occurrence of the credit event and completion of necessary formalities in terms of the contract.

·               The protection seller shall have no recourse to the protection buyer for losses.

·               The credit events specified in the CDS contract shall contain as wide a range of triggers as possible with a view to adequately cover the credit risk in the underlying / reference asset and, at a minimum, cover the following. (If the set of credit events is restrictive, it is possible that the credit derivative will transfer insufficient risk.)

·                     failure to pay the amounts due under terms of the underlying obligation that are in effect at the time of such failure (with a grace period that is closely in line with the grace period in the underlying obligation); 

·                     bankruptcy, insolvency or inability of the obligor to pay its debts, or its failure or admission in writing of its inability generally to pay its debts as they become due, and analogous events;

·                     restructuring of the underlying obligation involving forgiveness or postponement of principal, interest or fees that results in a credit loss event (i.e. charge-off, specific provision or other similar debit to the profit and loss account); and

·               CDS contracts must have a clearly specified period for obtaining post-creditevent valuations of the reference asset, generally no more than 30 days;

·               The credit protection must be legally enforceable in all relevant jurisdictions;

·               The reference / obligation shall have equal seniority with, or greater seniority than, the underlying asset/ obligation, and legally effective crossreference clauses (e.g. cross-default or cross-acceleration clauses) should be there between reference asset and the underlying assets.

·               The protection buyer must have the right/ability to transfer the reference/deliverable asset/ obligation to the protection seller, if required for settlement;

·               The credit risk transfer should not contravene any terms and conditions relating to the reference / deliverable / underlying asset/ obligation and where necessary all consents should have been obtained.

·               If the reference obligation in a credit derivative does not include the underlying obligation, sub-paragraph (xiii) below governs whether the asset mismatch is permissible.

·               The credit derivative shall not terminate prior to expiration of any grace period required for a default on the underlying obligation to occur as a result of a failure to pay. If it does, it will be considered as maturity mismatch and treated as detailed below.

·               The identity of the parties responsible for determining whether a credit event has occurred must be clearly defined. This determination must not be the sole responsibility of the protection seller. The protection buyer must have the right/ability to inform the protection seller of the occurrence of a credit event;

·               Where there is an asset mismatch between the underlying asset/ obligation and the reference asset/ obligation then:

·                     The reference and underlying assets/ obligations must be issued by the same obligor (i.e. the same legal entity);

·                     the reference asset must rank pari passu or senior to the underlying asset/ obligation;

(viii) Accounting:

·         The normal accounting entries for credit derivative transactions should be fairly straightforward depending on cash flows that take place at various points in time during the tenor of the transaction, e.g., for a credit default swap, there will be periodic payment of fees by the protection buyer to the protection seller. If there is a credit event, then settlement will be appropriately accounted depending on whether cash settled or settled via physical exchange versus par payment.

·         The accounting norms applicable to credit derivative contracts shall be on the lines indicated in the ‘Accounting Standard (AS) 30 – Financial Instruments : Recognition and Measurement’, approved by the Institute of Chartered Accountants of India.

·         Banks may adopt appropriate norms for accounting of Credit Default Swaps which are in compliance with the guidelines issued by the Reserve Bank from time to time, with the approval of their respective boards.

(ix) Mark to market

The CDS contracts allowing for cash settlement arerecognised for capital purposes insofar as a robust valuation process is in placeo estimate loss reliably. Banks need to put in place appropriate and robustmethodologies for marking to market the CDS contracts as also to assess the hedge effectiveness, where applicable. These methodologies should also besubject to appropriate internal control and audit.

(x) Supervisory Reporting

·         Banks shall report the details as per the proforma in paragraph 7 below, to the Department of Banking Supervision along with their periodical DSB returns. The supervisory reporting shall be made on a monthly basis. 

·         All banks shall report the details of their CDS transactions on a fortnightly basis within a week after the end of the fortnight as per the proforma furnished in the Appendix, to the Department of Banking Supervision.

·         On the basis of the stage of development of the credit derivative market in India, the supervisory reporting requirements will be reviewed and may be revised to capture greater details.

*  This note has been prepared by Deepa S Vaidya

Wheat procurement undertaken by the central agencies, as on June 5, has crossed 24 million tonnes displaying an increase of 11% as against 21.7 million tonnes procured during the same period a year ago. Rice procurement so far in the current marketing season, is reported to be around 30 million tonnes, higher by 18% as compared to 25.2 million tonnes procured during the same period a year earlier. Procurement of rice so far during this year has crossed total rice procurement level of the last procurement season by 5.3%.

The Cotton Association of India has reiterated that delay in sowing and excess rain in major producing areas have damaged cotton crops, thereby lowering the estimates as made earlier. It has been projected that production of cotton would be around 291 lakh bales (of 170 kg) in the year ending September as compared with 293 lakh bales estimated earlier. Farmers have so far sold 285 lakh bales during this season and stockpiles by the end of September is expected to increase to 6.88 million bales, as against 4.3 million bales a year earlier. Exports are expected to be around 40 lakh bales and imports would total to 10 lakh bales.

Total acreage under cotton in the three states Haryana, Punjab and Rajasthan have risen by about 7% to 1.3 million hectares as compared to about 1.22 million hectares sown last year. The area covered under cotton so far is 14% of last year’s total production. Sowings of cotton has not yet started in the key producing states (Gujarat and Maharashtra). Coverage under cotton in Haryana has risen by about 15% as compared to that of last year. Sowings of cotton is about to complete in Punjab and Haryana, while 70% of area has been covered in Rajasthan.

Tea exports from India have registered a decline of 20% to 50.3 million kilograms in the four months from January to April as against 62.8 million kilograms shipped during the corresponding period of the last year. This reduction is attributed to low arrival of crop in the market due to dry weather that damaged the crop. Production of tea has tumbled to 144.5 kilograms from 169.97 million kilograms produced during the corresponding period a year earlier. Exports of tea fetched an average Rs 127.4 a kilogram as compared with Rs 97.9 a year earlier.

 Spices Board, has projected that exports of spices in 2009-10 would worth to Rs 45, 00 crore from the record performance of Rs 5,300.25 crore in 2008-09. It has been reported that volume of exports has declined by 20% to 25% in all countries. Exports during 2008-09 were

4,70,520 tonnes valued at Rs 5,300.25 crore ($1.168 billion) against 4, 44,250 tonnes valued at Rs 4,435.50 crore ($1.102 billion) in 2007-08. Exports to Europe have been the worst hit and rupee value realisation has dropped by 7% in April. Mint products contributed 40% of the export earnings, Chilli's stood at 20%, followed by cumin with 10%, pepper with 8% and turmeric with 5%. Major items such as spice oils and oleoresins and curry powder and blends have shown substantial increase both in quantity and value compared to last year. The US continues to be the single largest exporter from India accounting 21%, Malaysia (7%), UAE (6%) and UK (5%), respectively.

Spices Board would be launching pepper re-plantation scheme under which old as well as disease affected pepper vine would be re-planted with disease free high yielding varieties. It aims to enhance the total production of pepper in Idukki district to 100,000 tonnes a year. Farmers would be eligible for a subsidy of Rs 28 per vine, provided there should be ten pepper vines. The productivity would be enhanced to 840 kg per hectare form the current 314 kg.

Industry

Infrastructure

Inflation

Capital Markets

Primary Market

Secondary Market

Derivatives

Primary Market

Secondary Market

Insurance regulator IRDA has insisted to the insurance companies to have policy documents in vernacular languages, which will be helpful in increasing the penetration of insurance products, as more than two-third of the country’s population is in rural area.

Banking

External Sector

Information Technology

Telecom 

Tata Teleservices Ltd and Japan’s NTT DoCoMo are launching GSM handsets for less than Rs 1,000 in the rural markets. The new handset would be the cheapest GSM device bundled with talk-time in the market. The move will mark the company’s entry later into the GSM segment, for which an investment of $2 billion has been earmarked.

The board of Etisalat DB said that Swan Telecom, a joint venture between Etisalat and DB Realty, has been renamed as Etisalat DB Telecom India.

Mobile banking will be used by more customers than the internet banking in future. Although at present most of the transactions for mobile banking are SMS based and GPRs-enabled cell phones do only 1% transactions, telecom operators are gearing up to launch voice-based transaction platform. Cell phone operators are working on introduction of automatic speech recognition, which will lift the mobile banking