The Hindu Business Line : Credit default swaps may push up borrowing costs

In the event of a loan default, the counter party or the CDS writer would have to purchase the asset, compensating the lender for the remaining interest on the credit as well as the principal.

Bangalore April 25 For aspiring borrowers, this may not be right time to say cheers. Introduction of credit default swaps (CDS) in the domestic financial markets is actually likely to push up borrowing costs.

The Reserve Bank of India (RBI) in its credit policy gave the green signal for introduction of CDS, a credit derivative instrument. CDS is essentially an insurance against credit risk for bankers. It is a specific agreement that allowed transfer of third party credit risk from one party to another.

The counter party, in a typical CDS transaction, agrees to insure the credit risk in exchange for regular periodic payments (or premium). In the event of a loan default, the counter party or the CDS writer would have to purchase the asset, compensating the lender for the remaining interest on the credit as well as the principal.

Pass through items

Bankers said that such premium payments would be treated as pass through items. This implied that the hedging costs would be passed on to the customer, as is normally done throughout the world. As a result of the pass through, "loan pricing is not likely to come down," a banker explained.

Risk weighting of assets hedged under the CDS was likely to come down, the bankers said. This is, however, a grey area, and would in turn depend on the RBI's guidelines for migration to the BASEL II regime beginning next financial year. But assets covered by the credit risk insurance products of Deposit Insurance and Credit Guarantee Corporation, New India Assurance Company of India Ltd and Export Credit Guarantee Corporation of India Ltd are zero risk weighted.

Escalation costs

Besides, bankers said, what could also cause borrowing costs to escalate was the CDS pricing. Globally, CDS pricing was closely linked to the yield curve. This implied that in a regime, where yields were on the ascent, the CDS premiums would also rise in tandem. With the yields on government securities already faced with an upward momentum, the bankers said, the premia was unlikely to be low.

However, some public sector bankers said that the pass through would apply to only certain categories of advances - retail, corporate and big-ticket loans. For loans coming with in the purview of the priority sector credits, the bankers said, the PSBs themselves were in a position to absorb them or work out a cross subsidy mechanism. This was to contain the high borrowing costs for certain vulnerable classes of borrowers.

Moreover, the bankers said, that PSBs were unlikely to take recourse to such derivative products in view of their limited retail lending exposures, barely 20 per cent of their gross advances. Globally CDS is used as a hedge against delinquencies in credit card receivables, home loans, auto loans and other personal loan products. PSBs, the bankers said, would prefer to tap the existing institutional mechanisms for such contingencies, the bankers said.

The CDS mechanism would mostly be patronised by new generation private sector and foreign banks operating in the country in view of their large retail lending exposures.

Foreign banks such as Citi already have the mechanism for transacting credit derivative products like CDS, the bankers added.

More Stories on : Credit Policy | Derivatives Markets | Credit Market

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