The Hindu Business Line : Monetary Policy — Deriving new ways to finance infrastructure

To help banks fund infrastructure, the RBI's latest Monetary Policy has allowed them to transact in `single entity credit default swaps'. However, financial innovation can increase the complexity of risk management. The focus of the policy should, thus, be on improving the quality of shock absorbers in the system, says PADMALATHA SURESH.

The next big thing on the Indian credit market after securitisation is `credit derivatives', introduced in the Reserve Bank of India's recent Monetary Policy. Banks would, henceforth, be allowed to transact in ``single entity credit default swaps (CDS)''. Simply, CDS is a `derivative instrument' used to transfer the risk of a borrower's default, or `credit risk'.

Why does the Indian credit market need a new instrument to manage risk, when the NPA (non-performing asset) levels are ostensibly on the decline? An analysis of the RBI statistics shows that the NPA percentage in non-priority advances is higher for all bank groups than that for priority sector advances. Not surprising, considering that credit guarantee schemes are available for small industries and insurance from Export Credit Guarantee Corporation of India (ECGC) for export credit.

Securitisation, intended at banks taking large, non-priority borrowers off their balance-sheets, has not been as popular as expected due to various reasons — legal, tax and regulatory — and the potentially higher transaction costs. When a bank securitises its assets, the legal title is transferred (usually to a special purpose vehicle or SPV), which could mar relationships with some customers. Further, bankers may be unwilling to take certain borrowers off their balance-sheet.

Where does CDS score?

The RBI-constituted ``Working group on introduction of credit derivatives'' states that weighed against existing alternatives, credit derivatives are more liquid, need no intermediation, and importantly, can ensure efficient credit market functioning by maximising "the number of participants in the market to encompass banks, financial institutions, non-banking finance companies (NBFCs), mutual funds, insurance companies and corporates."

Globally, CDS are the most prevalently used form of credit derivatives. The notional amount of credit derivatives outstanding has doubled each year for the past five years, totalling $20 trillion at end-June 2006 (Bank for International Settlements). Of these, `single entity CDS' constitutes 70 per cent. Single entity CDS, the most liquid, is considered the building block for more complex structures. Regardless of the type, CDS represents a financial contract between two parties, enabling the `buyer' of protection to isolate and reduce its credit risk in respect of, say, a specific borrower, called the `reference entity'. The protection `seller', providing `insurance' against credit risk, gains `synthetic' exposure to the same entity. Unlike securitisation, there would be no cash outlay to gain the exposure. Typically, the buyer compensates the seller through a premium paid over the predetermined life of the transaction. On occurrence of certain specified `credit events' (typically bankruptcy, failure to pay or restructuring), the seller pays the buyer the agreed compensation, irrespective of the buyer experiencing losses. This is unlike a credit guarantee, where compensation depends both on the credit event happening and the protection buying bank suffering losses.

CDS for infrastructure

Though the RBI's stated objectives are silent in this aspect, credit derivatives would help banks in financing infrastructure.

Analysts question the achievability of the $320 billion infrastructure investment target in India's Eleventh Plan. As though confirming these fears, the monetary policy document reveals near stagnation in the share of bank credit to infrastructure sectors.

Indian banks, like their international counterparts, have a key role to play in financing infrastructure. The primary deterrents to project lenders are the potential illiquidity of long-term infrastructure assets, and the attendant credit risks. Both these issues can be addressed to a large extent by financial innovations involving credit derivatives.

The high liquidity levels in the CDS market can lead to `synthetic' securitisations such as collateralised synthetic obligation (CSO), where the assets remain on the bank's balance-sheet, while the credit risk does not. Removal of the credit exposure risk would mean less regulatory capital. This technique is popular among European banks. German Landesbanks, for example, use CSOs to transfer large illiquid credit risk pools such as aircraft loans or real estate exposures.

Project finance lenders can structure collateralised debt obligations (CDOs) to mitigate credit risks. CDOs are similar to mutual funds, bundling together bonds, loans or swaps. But, unlike mutual funds, they have different tranches giving investors different rights over this portfolio.

For example, as borrowers pay interest on underlying loans, the cash flows will first be allocated to the `senior' tranches. In case of default, junior tranches take the first hit.

Past default or restructuring large infrastructure loans, such as those of the Dabhol Power or Noida toll Bridge projects, created a rumble in the n financial system. If credit risk is assessed, transferred and held by investors in diversified pools, each investor loses only a fraction of its portfolio even under a loss scenario. This advantage makes the banking system more secure.

CDS pricing trends could serve as their reference entities' credit quality indicators. Credit rating agencies have found that pricing of credit derivatives can act as barometers of improving or deteriorating credit climate.

Safeguards for effective CDS

New instruments, however, cannot change fundamental risks in credit markets — they only reallocate risks. For effective reallocation, regulators should ensure against new risks emerging.

Some aspects deserving the immediate attention of regulators to make CDS an effective way of financing infrastructure are:

The CDS counter-parties themselves could be risky and necessitate additional capital maintenance by banks. Clear guidelines should be in place for counter-party selection and monitoring.

Banks generally rely on collateral to mitigate counter-party credit risk. In non-recourse infrastructure loans, banks look primarily to project cash flows for debt-service. Where huge, specialised infrastructure assets holding uncertain liquidation value form the collateral, the regulator should ensure adequate safeguards to protect banks against a stress scenario.

Synthetic deals freeing up regulatory capital need intensive rating processes, which should be cost-effective to make the process worthwhile.

Creating active bond markets and liquid secondary markets are requisites for successful credit markets.

Adequate market infrastructure is imperative for clearing and settling the trades without time lag.

The ISDA definition of `credit events' applied to project finance loans could cause confusion. For instance, many Indian infrastructure projects have been `restructured'. Which type of `restructuring' could trigger a credit event should be carefully defined.

`Bankruptcy' is another ISDA specified credit event. Antiquated Indian bankruptcy laws may pose a problem in deciding and enforcing the trigger. A bankruptcy code delivering efficient ex-post outcomes, specially designed for large projects, is urgently needed.

Confidentiality clauses in project documentation may prevent full due-diligence on an underlying borrower or loan whose credit risk is being transferred. Transparency and disclosure norms should, therefore, be clearly spelt out.

Other challenges could emerge:

With interest rates rising, CDS prices could turn volatile;

Credit quantity might score over credit quality if the bank need not bear the entire credit risk;

Credit monitoring, a critical advantage of bank financing for large projects, may be diluted, since credit risk is shared;

Banks may lend to more risky projects, leading to investors recovering less value;

The additional liquidity created by credit derivatives may inflate asset prices;

Though innovation in financial instruments and techniques is essential for the country's infrastructure development, it may also increase the complexity in risk management. The focus of the policy should, therefore, lie not in delaying innovation but in improving the quality of shock absorbers in the financial system.

(The author is a finance consultant and visiting professor at IIMs. Feedback can be sent to padmalathasuresh@yahoo.com)

More Stories on : Credit Policy | Insight | RBI & Other Central Banks

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Banks red-carded

A viable alternative to Clause 49

Distil `the company's value algorithm' into `an elevator speech'

Who will be kingmaker in UP?

Monetary Policy — Deriving new ways to finance infrastructure

Do accounting standards apply to NPOs?

Brain drain