A fine-balancing act

On Wall Street, a new name was coined for the insurance conglomerate AIG - American Innocence and Greed - after the US Government bailed out the company from going the Lehman way. AIG got into a mighty lot of trouble due to credit-default swaps (CDS) which can be described as a financial instrument that acts as an insurance against the risk of defaults on corporate bonds.

AIG indulged in excesses of CDS and rewrote risk management policies by indulging in only selling CDS, and not taking the basic precaution of covering its exposure by either reinsuring or buying other CDS. The world of finance involves multiple exposures which could lead to troubled debts and basic risk management norms necessitate taking protection.

RBI initiatives

The Reserve Bank of India (RBI) has been contemplating issuing guidelines for CDS in India and has recently finalised draft guidelines on CDS. The RBI appears to have got the cue from the Government on giving a thrust to the foreign institutional investments (FIIs) and focusing on the infrastructure sector. FIIs can now buy credit protection to hedge their credit risk. CDS will be allowed only on listed corporate bonds. However, keeping in mind the need for infrastructure financing, CDS can also be written on unlisted but rated bonds of infrastructure companies. CDS cannot be written on interest receivables and on securities with original maturity up to one year.

In terms of risk management, market participants are required to take the various risks associated with CDS into account and build robust risk management architectures. Taking a cue from global developments, the RBI has prevented FIIs from playing the role of market- makers — those permitted to quote both buy and/or sell CDS spreads.

The RBI has been very choosy in deciding who the market makers are — banks and finance companies with a net worth of over Rs 500 crore and bad loans of less than 3 per cent. Banks that intend to sell these swaps will need to have a capital adequacy ratio of at least 12 per cent while for non-banks, the bar has been set higher at 15 per cent. Market makers and users would have to report CDS trades on the reporting platform of the CDS trade repository within 30 minutes of the deal.

Insurance companies and mutual funds would be permitted as market-makers subject to their having strong financials and risk management capabilities as prescribed by their respective regulators (Insurance Regulatory and Development Authority and Securities and Exchange Board of India) and as and when permitted by the regulatory authorities. As a precautionary measure, the RBI states that all CDS trades shall have an RBI-regulated entity at least on one side of the transaction.

Accounting for CDS

The accounting norms applicable to CDS contracts shall be on the lines indicated in the ‘Accounting Standard AS-30 – Financial Instruments: Recognition and Measurement', ‘AS- 31, Financial Instruments: Presentation' and ‘AS-32 on Disclosures' as approved by the Institute of derivatives are still evolving; market participants, with the approval of their respective boards, shall adopt appropriate norms for accounting of CDS transactions which are in compliance with the Indian accounting standards and approved by the regulators from time to time. With AS 30, 31 and 32 deferred for non-Ind-AS entities and date of implementation not finalised for Ind-AS entities, there could be a disconnect between accounting standards and accounting practices in financial institutions in accounting for CDS if the norms are announced prior to the three standards on financial instruments being mandated.

Risk Management

The intention of the RBI to permit trading in a product that cannot be avoided but with built-in controls to prevent over-exposure and a crisis is obvious in its instructions on risk management. Proper assessment and management of various risks such as sudden increases in credit spreads resulting in mark-to-market losses, high incidence of credit events, Jump-to-Default Risk, basis risk, counterparty risks, etc., are essential. The RBI warns that CDS are not used to build up excessive leveraged exposures to credit risk. The market participants need to take various risks associated with CDS into account and build robust risk management architecture to manage the risks.

The RBI appears to have achieved a fine balance between the dynamism of the new-age financial instruments and the conservatism traditionally associated with our culture.

(The author is a Bangalore-based chartered accountant.)