RBI PITCHES FOR CREDIT DEFAULT SWAPS

RBI issued its guidelines on CDS whereby RBI- regulated lenders, mutual funds and listed companies can buy credit protection on the bonds they hold. The protection can be sold by banks and finance companies with a net worth of over 500 crore and non-performing assets of less than 3%. Banks that intend to sell protection need to have a capital adequacy of at least 12% while non-banks it would be 15%. In a way, credit default swaps work like an insurance cover. The premium of the cost of cover is determined by the CDS spread. Credit default swaps had got a bad name following the global financial crisis as it emerged that AIG had sold protection against subprime loans most of which turned bad.

There are a number of ways in which CDS in India will be different from those that brought down AIG.

• The protection can be sold against risks of a single issue. In the case of AIG the protection was provided for a mortgage backed security representing thousands of unknown home loans.
• The protection can be bought by only those who actually hold the bonds. The crisis was accentuated by the fact that many investors not holding any bonds bought protection betting on the default of a particular corporate.
• RBI has severely restricted the number of parties that can issue of protection.

The biggest gainers will be large corporates, particularly infrastructure companies. A bank which
risks hitting its exposure limits in respect of a particular loan can safely continue lending without hitting its exposure limit by purchasing protection through CDS. Once the CDS is purchased the banks exposure will be to the entity that is providing protection.