CONTENTS

INTRODUCTION..................................................................................................................1
EXECUTIVE SUMMARY......................................................................................................2
CREDIT RISK: DEFINITION AND MEANING......................................................................4
EXPECTED AND UNEXPECTED LOSS...................................................................4
CREDIT RISK OF PORTFOLIO................................................................................5
THE RELATIONSHIP BETWEEN CREDIT AND OTHER RISKS.............................6
THE BASEL COMMITTEE’S PRINCIPLES OF CREDIT RISK MANAGEMENT................7
CLASSIFYING IMPAIRED LOANS......................................................................................8
LOAN WORKOUTS AND GOING TO COURT FOR RECOVERY....................................10
CREDIT RISK MODELS.....................................................................................................11
CREDIT RISK TRANSFERS –LOAN AND CREDIT DERIVATIVES.................................13
CREDIT DERIVATIVES......................................................................................................19
EVOLUTION OF CREDIT DERIVATIVES...............................................................20
WHY DO BANKS USE CREDIT DERVATIVES......................................................21
CREDIT DERIVATIVES STRUCTURES............................................................................22
LOAN PORTFOLIO SWAP......................................................................................22
TOTAL RETURN SWAP .........................................................................................22
CREDIT DEFAULT SWAP.......................................................................................24
CREDIT RISK OPTIONS.........................................................................................25
CREDIT INTERMEDIATION SWAP........................................................................25
DYNAMIC CREDIT SWAP.......................................................................................26
CREDIT SPREAD DERIVATIVES...........................................................................26
CREDIT LINKED NOTES .......................................................................................27
REPACKAGED NOTES..........................................................................................29.
BASKET DEFAULT SWAP......................................................................................30
OPERATIONAL REQUIREMENTS FOR CREDIT DERIVATIVES........................31
INDIAN SCENARIO............................................................................................................33
IMPORTANT EXPOSURE NORMS...................................................................................34
PRUDENTIAL NORMS FOR ASSET CLASSIFICATION,INCOME RECOGNITION AND
PROVISIONING..................................................................................................................36
NON PERFORMING ASSETS..........................................................................36
INCOME RECOGNITION...................................................................................................37
ASSET CLASSIFICATION................................................................................................38

i
TREATMENT UNDER ASSET CLASSIFICATION NORMS.............................................39
PROVISIONING NORMS...................................................................................................40
DOUBTFUL ASSET..............................................................................................40
SUBSTANDARD STANDARD..............................................................................42
STANDARD..........................................................................................................43
FLOATING PROVISIONS.....................................................................................43
PROVISIONING WHERE ECGC/CGTSI GURANTEE IS
AVAILABLE..........................................................................................................43
WRITING OFF NPAs............................................................................................44
PROVISIONS UNDER SPECIAL CIRCUMSTANCES-RBI GUIDELINES........................45
TREATMENT OF CREDIT RISK IN INDIA........................................................................47
SECURITIASATION ...........................................................................................47
CREDIT DERIVATIVES.......................................................................................48
TYPE OF DERIVATIVE PRODUCTS.................................................................48.
CONCLUSION....................................................................................................................51
SUGGESTIONS..................................................................................................................52
LIMITATION.......................................................................................................................53
BIBLOIGRAPHY................................................................................................................54

ii
 INTRODUCTION

Banks grant credit to produce profits. In the process, they also assume and accept risks. In
evaluating risks, banks should assess the likely downside scenarios and their possible
impact on the borrowers and their debt serving capacity.

Two types of losses are possible in respect of any borrower or borrower class -expected
and unexpected losses. Expected losses can be budgeted for and provisions held to offset
their adverse effects on the banks balance sheet. Expected losses could arise from the
risk in the industry in which the borrower operates. The business risks associated with the
borrower firm, track record of payments and future potential to generate cash flows.
Unexpected losses, being unpredictable, have to be cushioned by holding adequate
capital. Here we will concentrate on the process by which banks identify and provide for
expected losses.

Banks can utilize the structure of the borrower’s transactions, collaterals and guarantees to
mitigate, identified and inherent risks but none of these can substitute for comprehensive
assessment of borrower’s repayment capacity or compensate for inadequate information.
Any action of credit enforcement (recalling the advances made or instituting foreclosure
proceedings, including legal proceedings)may only serve to erode the already thin profit
margins on the transactions.

EXECUTIVE SUMMARY
1
Two types of losses are possible in respect of any borrower or borrower class-
expected or unexpected losses. Expected losses can be budgeted for and provisions
held to offset their adverse effects on the banks’ balance sheet. Unexpected losses
being unpredictable , have to be cushioned by holding adequate capital. Credit risk is
simply defined as the probability that a bank borrower or counterparty will fail to meet
its obligations in accordance with agreed terms. A bank needs to manage (a) the risk
in individual credits or transactions (b) the credit risk inherent in the entire portfolio
and (c) the relationship between credit risks and other risks. Although specific credit
risk management practices may differ among banks depending upon the nature and
complexity of their credit activities, a comprehensive credit risk management
program will address these four areas. 1) Establishing an appropriate credit risk
environment .2) Maintaining an appropriate credit administration, measurement and
monitoring process.3) Operating under a sound credit granting process.4) Ensuring
adequate controls over credit risk. These practices should also be applied in
conjunction with sound practices related to the assessment of asset quality, the
adequacy of provisions and reserves and disclosure of credit risk. International
accounting practices set forth standards for estimating impairment of a loan for
general financial reporting purposes. Regulators are expected to follow these
standards to the letter for determining the provisions and allowances for loan losses.
According to these standards, a loan is impaired when based on current information
and events, it is probable that the creditor will be unable to collect all amounts due in
line with the terms of the loan agreements. Such assets are also called “criticized” or
“non performing assets”. Loan sales provide liquidity to the selling banks , and also
represent a valuable portfolio management tool , which minimizes risk through
diversification. Some prominent forms of loan sales include a)syndication b) novation
c)participation and d)securitization. A credit derivative is a security with a pay off
linked to a credit related event ,such as borrower default, credit rating downgrades,
or a structural change in a security containing credit risk. In credit derivatives, there
is a party(or a bank) trying to transfer credit risk, called a protection buyer , there is a
counter party (or another bank) trying to acquire credit risk, called a protection seller.
Credit derivatives are typically unfunded. The protection buyer generally pays a
periodic premium. However the credit derivative may be funded in some cases.

Some popular form of credit derivatives include a) loan default swaps b) total return
swap c) credit default swap d) credit risk option e) credit intermediation swap
f)dynamic credit swap g) credit spread derivatives h) credit linked notes i) credit
linked deposits j) repackaged notes and k) basket default swap. For Indian banks the
RBI has provided detailed guidelines for exposures norms to avoid credit
concentration and for asset classification. Income recognition and provisioning for
credit risk. Assets are classified into a) standard b) substandard c) doubtful and d)
loss, and provisions are made accordingly. The existing draft RBI guidelines permit
banks to initially use credit derivatives only for the purpose of managing their credit
2
risk, which includes a) buying protection for the purpose of diversifying their credit
risk and reducing credit concentration and taking exposure in high quality assets.

3
EXPECTED VS UNEXPECTED LOSS

Although credit losses are typically dependent on time and economic conditions, it is
theoretically possible to arrive at a statistically measured long run average loss level.
Assume for example, that based on historical performance a bank expects around 1% of
its loans to default every year, with an average recovery rate of 50%, in that case, the
banks' expected loss (EL) for a credit portfolio of Rs 1000 crores is Rs 5 crore that is (1000
crore*1%*50%) EL is, therefore, seen to be based on three parameters.

• The likelihood that default will take place over a specified time horizon(probability of
default or PD)

• The amount owned by the counterparty at the moment of default(exposure at

default or EAD)

• The fraction of the exposure net of any recovery which will be lost following a
default event(loss given default or LGD)

Since PD is normally specified on a one year basis, the product of these three factors is
the one year EL.

EL=PD*EAD*LGD

EL can be aggregated at the level of individual loans or the entire credit portfolio. It is also
both customer and facility specific, since two different loans to the same customer can
have very different ELs due to differences in EAD and /or LGD.

It is important to note that EL (and credit quality does not by itself constitute risk if losses
turned out as expected, they represent the anticipated “cost “of being in business in any
case, their impact is being factored into loan pricing and provisions. Credit risk, in fact,
emerges from adverse variations in the actual loss levels, which give rise to the so called
unexpected loss (UL) as described in a later chapter; the need for bank capital arises from
the need to cushion against unexpected losses or loss volatility.

4
DEFINING CREDIT RISK
Credit risk is most simply defined as the probability that a bank borrower or counter party
will fail to meet its obligations in accordance with agreed terms.

The effective management of credit risk is a critical component of a comprehensive

approach to risk management and essential to the long term success of any banking
organization. The goal of credit risk management should be maximizing a banks risk
adjusted rate of return by maintaining credit risk exposure within acceptable parameters.

It follows that banks need to manage the following:

• The risk in individual credits or transactions

• The credit risk inherent in the entire portfolio

• The relationships between credit risk and other risk

CREDIT RISK OF THE PORTFOLIO

From our earlier discussions it would be evident that managing the credit portfolio of a
bank involves a higher level of risk-reward decisions than managing a portfolio of market
investments. This is due to the fact that there is limited upside risk and unlimited risk in
bank lending (in contrast to market investments, which hold limited downside risk but
unlimited upside risk).

For example, when a bank makes a ‘good loan’ that is repaid in full on the due date, what
the bank has received are only the interest payments and principal repayments due to it.
The bank cannot demand a share of the substantial cash flows that the business has
managed to generate with the help of bank funds. On the other hand, if the business fails,
the banks’ earnings take a direct hit-the banks suffer along with the borrower. The bank
could price’ risky ‘borrowers’ higher to compensate for the risk of failure. But market
dynamics would limit the extent of the risk premium that the bank can charge.

Often, a bank develops expertise in financing a particular activity or industry, and

increases its credit exposure to this sector, to leverage its capabilities. If this sector
collapses, for some force major reason, it drags the banks’ fortune down with it.

Thus, it is evident that a bank could be vulnerable to two factors-one, it may not be able to
price its loan to compensate fully for the risk; and two, its concentration in a specific
industry or economic activity could render the bank susceptible to risks inherent in that
industry.

It follows that the loan policy of a bank should be able to structure policies and procedures
that ensure that credit exposures to various sectors and regions are adequately diversified
to maximize the return on the loan portfolio of the bank. Such a task is too daunting for
5
individual banks’ portfolio managers, and requires the intervention of the central banks of
the countries. In most countries, central banks propose optimal ‘exposure norms’ for
various industries and activities from time to time. Such exposure norms not only pre-empt
banks intending to invest excessively in similar firms but also try to balance the risk-reward
relationship for banks in the country.

THE RELATIONSHIP BETWEEN CREDIT AND OHER RISKS

While loans are the largest source of credit risk and exposure to credit risk continues to be
a leading source of problems, there are other sources of credit risk throughtout the
activities of a bank, in the banking and trading books, and on and off its balance sheet. For
example, a bank could face credit (or counterparty default) risk in various financial
instruments other than loans, such as in

a. Acceptances,

b. Inter-bank transactions

c. Trade financing,

d. Foreign exchange transactions,

e. Financial futures, swaps, bonds, equities, options, and

f. In the extension of commitments and guarantees, and the settlement of

transactions.

6
THE BASEL COMMITTEE’S PRINCIPLES OF
CREDIT RISK MANAGEMENT

Annexure 1 presents the sound practices set out by the Basel committee to specifically
address the following areas:

1. Establishing an appropriate credit risk environment;

2. Operating under a sound credit granting process;

3. Maintaining an appropriate credit administration, measurement and monitoring

process; and

4. Ensuring adequate controls over credit risk

.Although specific credit risk management practices may differ among banks depending
upon the nature and complexity of their credit activities, a comprehensive credit risk
management program should address these four areas. These practices should also be
applied in conjunction with sound practices related to the assessment of asset quality, the
adequacy of provisions and reserves, and the disclosure of credit risk.

7
 CLASSIFYING ‘IMPAIRED’ LOANS

International accounting practices set fourth standards for estimating the impairment of a
loan for general financial reporting purposes. Regulators are expected to follow these
standards ‘to the letters’ for determining the provisions and allowances for loan losses.
According to these standards, a loan is ‘impaired’ when, based on current information and
events, it is probable that the creditor will be unable to collect all amounts (interest and
principal) due in line with the terms of the loan agreement. Such assets are also called
‘criticised’ assets.

Typically, the impaired assets are categorized as follows.

Special mentioned loans: these loans are assessed as ‘inherently weak.’ The credit risks
may be minor, but may involve ‘unwarranted risk.’ Such credit contain weaknesses such
as an inadequate loan agreement, or poor condition of or control over collateral, or
deficient loan documentation or evidence of imprudent lending practices. Adverse market
conditions in future may unfavourably impact the operations or the financials of the
borrower firm, but may not endanger liquidation of assets held as security. The special
mentioned loans carry more than normal risks, which, had they been present when the
credit was appraised, would have led to rejection of the credit request.

Sub-standard assets: These assets are seen to have well defined weaknesses that may
jeopardizes liquidation of the debt, since they are not fully protected by the borrower’s
financial condition or the collateral given as security. The bank is likely to sustain a loss if
the defects are not corrected.

Doubtful assets: These assets contain all the weaknesses of sub-standard assets, and
additionally, recovery of the debt in full is quite remote. Auditors may insist on a write down
of the assets through a charge to loan loss reserves, or a write off of a portion of the asset,
or they may call for additional capital allocation. Any portion of the balance outstanding in
the loan, which is uncovered by the market value of the collateral, may be identified as
uncollectible and written off.

8
Loss assets: All identified losses have to be charged off. Uncollectible loans with such
little value that their continuance as bankable assets is not warranted are generally
charged off. Losses are expensed in the same period in which they are written off.Partially
charged off loans: Though credit exposures contain weaknesses that render them
uncollectible in full, some portion of the outstanding loan could be collected if the collateral
is marketable and in good condition. Hence, the secured portion is not written off, while the
unsecured portion of the loan is charged off.

Income accrual on impaired loans is discontinued from the time they are classified.

9
 LOAN WORKOUTS AND GOING TO COURT FOR
RECOVERY

In the case of a restructured loan, the ability of the borrower to repay the loan on modified
terms is focused upon. The loan will be classified under the ‘impaired’ category if even
after restructuring; there arise weaknesses that tend to jeopardize repayment on the
modified terms.

In some developed countries like the US, regulatory rules do not require that banks
restructuring a loan grant excessive concessions to the borrower during the period of
restructuring.

If all other forms of renegotiation between the bank and the borrower fail, the bank
approaches the court to enforce recovery of dues. In some cases, ‘Debtor – in –
Possession’ (DIP) fencing is also done while the suit against the borrower is pending at the
court. DIP financing is considered attractive by banks where such provision exists, since it
is done only under the order of the court, which is empowered to give a priority position on
the bankruptcy estate to the lender. Some alternatives for DIP financing include receivable
backed credit, factory and loans against equipment and inventory.

The DIP loan is repayed from the following sources

a. Cash flow from operations

b. Liquidation of the collateral

c. The firm turns viable and the new lender refinances the DIP loan and

d. The DIP loan is taken over by a new DIP lender.

10
 CREDIT RISK MODELS

Ever since Markowitz developed his pioneering portfolio analysis model in 1950,
quantitative model of portfolio management have been widely used in financial analysis,
especially in analysis of equity portfolios. Over the last few decades, equity analysts have
been successfully using portfolio management models to quantify default risks in a
portfolio of assets. The objective of these methods is to maximize the port folio’s returns
while reining the risk within acceptable levels. Risk maximization involves balancing of
risks and return within a portfolio, asset by asset, group of assets by group of assets.

However, similar models are not widely used for debt portfolios because of the greater
analytical and empirical difficulties involved.

• Debt defaults can happen all of a sudden, and once they happen , the risk can
increase very quickly

• We have seen the risk premium associated with the borrower or borrower class is
inbuilt into the loan pricing. Is the borrower risk has been misjudged; the loan would not be
priced appropriately, implying further erosion in the banks already thin margins on lending.

• It is also pertinent to remember here that the lenders- the banks- themselves are
highly leveraged entities. History is replete with instances where lenders have been
destroyed by the combination of financial and default risks.

The truth is that “risks can not be wished away, insures away, hedged away of structured
away. Risk can merely be allocated or transferred, but ultimately the risk has to be borne
by somebody. Hence, lenders try to diversify their credit risks, for they know that they
cannot do business if the eliminate risks altogether. How can lenders diversify their risk?
By avoiding “concentration” of credit.

The basal committee has identified “credit concentrations” as the single most important
cause of major credit problems. Credit concentrations are viewed as any exposure where
11
potential losses are large relative to the banks’ capital, its total assets or, where adequate
measures exist, the banks overall risk level. Concentrations of credit and hence, risk can
occur when the banks portfolio contains a high level of direct or indirect credit to (a) a
single borrowed;

(a) A group of associated borrowers;

(b) A specific industry of economic activity;

(c) Geographic reason;

(d) A specific country or a group of inter- related countries,

(e) A type of credit facility, or

(f) Specific type of security. Some times concentrations can also arise from credits with
similar maturities, or from inter- linkages within the portfolio.

Relatively large losses may reflect not only large exposures, but also the potential for
unusually high percentage losses given default. Credit concentrations can further be
grouped into two broad categories:

• Conventional credit concentrations would include concentrations of credit to single

borrowers or counter parties, a group of connected counter parties, and sectors or
industries, such as commercial real estate, and oil and gas.

• Concentrations based on common or correlated risk factors reflect subtler or more

situations – specific factors, and often can only be uncovered through analysis – such as
correlations between market and credit risks, and their correlation with liquidity risk. Such
interplay of risks can produce substantial losses.

Why do banks permit concentrations in their credit port folios? The basal committee cites
the following reasons. ‘first, in developing their business strategy , most banks face an
inherent trade – off between choosing to specialize in a few key areas with the goal of
achieving a market leadership position in diversifying their income streams, especially
when they are engaged in some volatile market segments. This trade-off has been
exacerbated by intensified competition among banks and non-banks alike for traditional
banking activities, such as providing credit to investment grade corporations.
Concentrations appear most frequently to arise because banks identify ‘hot’ and rapidly
growing industries and use overly optimistic assumptions about an industry’s future
prospects, especially asset appreciation and the potential to earn above-average fees

12
and/or spreads. Banks seem most susceptible to overlooking the dangers in such
situations when they are focused on asset growth or market share.

Until recently, such ‘concentrations’ could be measured only after the credit exposures had
been created. Of late, finance literature has produced a variety of models that attempt to
measure default risk.

While most of the methodologies are seen to work adequately in practice, research
indicates that the following issues are still not tackled by the models in respect of Bank
lending-predicting macro-economic cycles and industry shocks (systematic or exogenous
default risk) and hedging strategies.

CREDIT RISK TRANSFERS—LOAN AND CREDIT

DERIVATIVES

Hedging reduces portfolio risk by offsetting one risk against another. Diversification
reduces risk because risks are uncorrelated. How portfolio hedges are structured will vary
according to the bank’s goals on hedging credit risk.

Till even about a decade ago, banks had to expand their loan portfolios for growing their
business, and keep these assets in their books till they were completely liquidated. In the
present scenario, banks still grow their business by expanding loan assets, but these
assets are sold off to other agencies or offloaded in the secondary loan market. In this
manner, banks get risky loans off their books. Such loan sales provide liquidity to the
selling banks, and also represent a valuable portfolio management tool, which minimizes
risk through diversification.

Some prominent forms of loan sales include the following.

Syndication: The manner in which syndication is conducted spreads the credit risk in the
transaction among the banks in the syndicate. Let us assume a borrower wants a loan of
Rs 10,000 crore for a large project. If bank X is nominated as the lead bank for
syndication, X will negotiate the documents with the borrower and solicit a group of bank to
share the credit exposure.X will generally hold the maximum exposure, though this is not
mandatory. Bank X claims a fee for its efforts in syndication.

Novation: In the above example, Bank X assigns its rights to one or more buyer Banks.
These buyer Banks then become original signatories to the loan agreement .Thus, the
borrower would have contracted with Bank X for Rs 10,000 crore loans. Post Novation
bank X would hold, say Rs 2,000 crore of credit exposure to the borrower, and the three
buyer banks say a, b, c would hold the remaining Rs 8,000 crore shares among

13
themselves in a mutually agreed proportion. Unlike syndication, A, B, C would enter into
separate loan agreements with the borrower.

Participation: In this case, Bank X transfers to other participating Banks A, B, C the right
to receive pro-rata payments from the borrower. Typically the seller of the participation –
Bank X –will have to consult A, B, and C before agreeing to changes in the terms of the
loan (Principal, interest, repayment terms, gurantees, collaterals, interest rate, fees and
other covenants).

Securitisation: This is one of the most popular and prominent forms of loan sale. The
critical factor is finding a homogenous pool of loan assets that generate a predictable
stream of future cash flows.

Simply stated, securitization involves the c transfer of assets and other credit exposure
from the “originator” (the bank) through pooling and repackaging by a special purpose
vehicle (SPV) into securities that can be sold to investors. It involves legally isolating the
underlying exposures from the originating bank A ‘true sale’ or ‘Traditional securitisation’
happens when the assets are actually transferred from the originator’s Balance Sheet to
the issuer of the securities. For instance, a bank makes auto loans and sells these loans to
a special purpose entity (SPE or SPV) that structures these assets into a homogenous
asset pool. The SPE retains the loan as collateral, sells the pool to investors, and pays the
banks for the loans brought from it with the proceeds from the sale of securities.

At the end of the tenure of securitization, the residual assets are passed on to the
investors. If the asset quality deteriorates the investors have to bear the loss. The
investors who are ready to take the first loss get the maximum spread. The originator, in
this fashion, has passed on the risk associated with the assets to the investor.

Securitisation can be seen as the method of turning untradeable, illiquid assets into
various types of securities ,which can be sold to different investors with different risk
appetites .these different types of securities with different inherent risks are known as
‘tranches’. Technically, securitization is defined as a transaction involving one or more
underlying credit exposures from which tranches that reflect different degrees of credit
risks are created .Credit exposures may include loans .commitments and receivables .It
may take the form of a d credit derivative .The payments to investors depend upon the
performance of specified underlying credit exposures.

The securities sold to investors are called asset backed securities’ (ABS), since they are
backed by the homogenous pool of underlying assets. Originators of ABS usually want to
sell loans ‘without recourse’. Hence, investors usually safeguard their interests through
three mechanisms-
14
 a. Overcollateralisation

b. Senior/Subordinated structures, and

c. Credit Enhancement.

Cash
flow to
originato
Originato r
Obligors
r

Passes cash to Proceeds of sale

SPV less fees. of securities

Reinvestm SPV
ent
Reinvestme
contract nt/ liquidity
buffer Cost of the
Coupon and final securities
payment

Senior
investors
Tranches
Junior
investors

Figure depicts a typical securitization process.

15
 ‘Overcollateralization‘ as the nomenclature implies involves structuring a collateral pool
to ensure cash flow in excess of the amount required to pay the principal and the interest
on the securities.

In the ‘Senior/Subordinated structure’ the issuer of securities sells two categories of

certificates-Senior and junior-both secured by the same collateral pool. The Senior
Certificates are usually taken by investors, while the originator itself may purchase the
junior certificates. The cash flows from the collateral are first allocated to make payments
to senior holders and the residual cash flows are allocated to junior holders. In other words
,the actual losses should not exceed the promised payments to subordinated certificate
therefore, the larger the component of junior holders the greater the protection for senior
investors.

‘Credit enhancements’ such as letters of credit are used to cover losses in the collateral.
A bank other than the originating bank issues the letter of credit\,generally covering a
certain proportion on of the loss on the pool(comparable to historical losses plus a
margin)for a fee.

Thus, securitization is seen to benefit banks’ by providing liquidity to banks’ loan portfolios
and mitigating credit risk by removing assets from banks’ books. Other spinoffs include a
possible lowering of interest rate risk and profitability enhancement through better asst
turnover and fee based income.

The following provides an overview of collateralized debt obligations (CDOs)and

compares them with securitization.

These are the fastest growing segments of the securitization market .Banks resort to
securitization with the following predominant motives-

Sourcing cheaper funds,attaining higher regulatory capital. Better asset liability

management and reduced non performing and underperforming assets.

Where the originating bank transfers a pool of loans, the bonds that emerge are called
collateralized loan obligations (CLOs).where the bank transfer a portfolio of bonds and
securities the same, the resulting securitized are termed as collateralized bonds
obligation(CBOs).A generic name given to both these is collateralized debt

16
obligations(CDOs).Some banks even securitise their equity investments-calling them
collateralized investment obligations(CIOs).

Difference between securitization and CDO structures.

Though the essential nature of the structures are similar, securitization in its generic forms
and issuing collateralized bond obligations(CBO)/ collateralized loan obligations(CLO) at
the instance of banks, differ in respect of the following.

• For securitizations, the primary objective is liquidity, while in the case of

CBO/CLOs, the objectives could be capital relief, risk transfer, arbitraging profits, or
balance sheet optimization.

• While securitisations of say mortgaged portfolios or auto loan portfolios could

have thousands of obligors, CDO pools typically have only 100-200 loans.

• The loans/bonds are mostly heterogeneous in CDOs , whereas the

securitized assets are typically homogeneous pools. The originator of CDOs might
try to bunch together uncorrelated loans ,to provide the benefits of a diversified
portfolio .

• Most CDO structure use a tranched ,multi-layered structure with a substantial

amount a residual interest retained by originator .

• Generally, CDO issue will use a reinvestment period and amortization

period .Some tranches might have a ‘soft bullet’ repayment (a bullet repayment that
is not guaranteed by any third party)

• Arbitraging is common practice in the CDO market ,where larger banks by

out loans from smaller ones and securitized them, earning arbitrage revenue in the
process. The is a class of CDOs called arbitrage CDOs where the originating bank
buys loans /bonds from the market and securitizes the same for gaining an
advantage on the rate . Since the motive of such securitization is arbitraging such
CDOs are called arbitrage CLOs/CBOs. To distinguish these from the ones were a
banks’ securitized its own recievables, the later are sometimes referred to a
balance sheet CLOs /CBOs,

Yet another upcoming variety of CLOs is synthetic CLOs .Here the originating bank merely
securitise credit risk and retain the loans of its balance sheet. Synthetic CLOs repackage

17
the underlying loans into cash flows that suit the needs of the investors and are not
dependent on the repayment structure of the underlying loans..

To summarise ,CDOs could fall into two basic categories balance sheet ,CDOs and
arbitrage CDOs. In the case of balance sheet, CDOs loans are actually transferred from
the balance sheet of the originator and therefore impact the originating bank’s balance
sheet..In the case of arbitrage CDOs ,the originator merely buys’ loan of bonds or assets-
backed securities from the market ,pools and securitises them as a repackaged entity. The
prime objective of balance sheet CDOs is to reduce risk and regulatory capital, while the
purpose of arbitrage CDOs is to make profit from arbitrage.

Balance sheet CDOs could be further classified into cash flow CDOs and synthetic CDOs
based on the nature of their assets.

In the case of cash flow CDOs ,the assets are acquired for cash. The originating bank
transfers a portfolio of loans into an SPV.’ Master Trust ‘structures are commonly
employed in CDOs to enable the bank to keep transferring the loans into pool on the
regular basis without having to do complex documentation for every transfer. In view of
varied repayment structure of commercial loans, Cash flow CDO typically repays through
bullet repayments, and hence have a reinvestment period, during which the cash flow
from repayment are reinvested.

However a synthetic CDO primarily acquires ‘synthetic’ assets by selling ‘a protection’

rather than buying assets for cash. Hence, the funding requirement for a synthetic CDO is
much lower than for a cash flow CDO.The amount of cash raised is limited only to extent
of expected and unexpected losses in the portfolio of synthetic assets, such that the
highest of the cash liabilities can get an investment grade rating. Once the senior most
cash liability obtains investment grade rating ,the synthetic CDO does not raise more cash-
it merely raises a synthetic liability by buying protection from a super-senior swap provider.
A typical structure in a synthetic CDO is illustrated below. Clearly the three different
tranches have different risk characteristics.

Summation of alternatives in respect of a bank.

• It can continue to hold the loans, assess the expected loss periodically, take
preventive or remedial measures to reduce the risk of loss, or make a provision on the
expected loss, and allocate capital for unexpected losses.

• It can diversify its loan portfolio with several loans to different counterparties, so that
a few expected defaults may not lead to earnings volatility.

• It can negotiate a loan sale for the whole or part of the loan amount, and incur the
costs associated with the loan sale.
18
In resorting to the first alternatives:

(a) The bank runs the risk of earnings erosion if the provisions are substantial in value.
It is not always easy to diversify the portfolio as in alternative.

(b) Since the banks operation, driven by its own internal skills and external competition,
may not be able to balance the portfolio as optimally as it would like to. Further a highly
diversified portfolio is no complete hedge against borrower defaults, and could lead to high
transaction costs. Beyond diversification, bank look to sell off or securitise the loans as in
the alternatives.

(c) This approach is seen to work well for standardised payment schedules and
homogenous credit risk characteristics.

CREDIT DERIVATIVES

Due to the difficulties experienced by bankers with alternative methods of dealing with
credit risk, another alternative has emerged: ‘credit derivatives’-a more specialised way to
insure against credit related losses.

Credit derivatives are an effective means of protecting against credit risk. They came in
many shapes and sizes, but all serve the same purpose. Simply stated, a credit derivative
is a security with a pay-off linked to a credit related event, such as borrowers default, credit
rating downgrades, or a structural change in a security containing credit risk.

In credit derivatives, there is a party(or bank) trying to transfer credit risk, called protection
buyer, and there is a counterparty (another bank) trying to acquire credit risk, called
protection seller. Over time, credit derivatives market has become a trading market.
Trades in credit derivatives are taken to be proxies for trades in actual loans or bonds of
the reference entity, the borrower. For example, a bank willing to acquire exposure in a
particular borrower would sell protection with reference to the borrower; while a bank
wanting to hedge the risk of lending to the same borrower will buy protection.

Credit derivatives are typically unfunded-the protection seller is not required to put in any
money upfront. The protection seller is not required to put in any money upfront. The
protection buyer generally pays a periodic premium. However, the credit derivatives does
not require either of the parties – the protection seller or protection buyer- to actually hold
the reference asset(the credit that is being hedged). Thus, a bank buy protection for an
exposure it has taken ,or has not taken, irrespective of the amount or term of the actual
exposure. It, therefore, follows that the amount of compensation claimed under a credit
derivative may not be related to actual losses suffered by the protection buyer.

19
When a credit event(as specified in the contract between the protection buyer and seller)
takes place, there are two ways of settlement-cash and physical. In a cash settlement, the
reference asset will be valued, and the difference between its part and fair value will be
paid by the protection seller. In the case of physical settlement, the protection seller would
acquire the defaulted asset, for its full par.

EVOLUTION OF CREDIT DERIVATIVES

In March 1993, Global finance carried a feature on J.P.Morgan, Merrill Lynch, and Banker
trust, which were already then marketing some form of credit derivatives.

In November 1993,Investment Dealers Digest carried an article ‘ Derivatives Pros

Snubbed on Latest Exotic Product which claimed that a number of private credit derivative
deals had been seen in the market but it was doubted if they were completed. The article
also said that standard and poor’s had refused to rate credit derivative products and this
refusal may put a permanent damper on the fledgling market. One commentor quoted in
the article said:’(credit derivatives ) is like Russian roulette. It doesn’t make a difference if
there’s only one bullet:if you get it you die.’

Almost 3 years later, euromoney reported (March 1996’credit derivatives get cracking’)
that a lot of credit derivatives deals are already happening. This article was optimistic:’ the
potential of credit derivative is immense. There are hundreds of possible applications for
commercial banks which want to change the risk profile of their loan books; for investment
banks managing huge bond and derivatives portfolio; for manufacturing companies over
exposed to a single customer; for equity investors in projectfinane deals with unacceptable
sovereign risk; for institutional investors that have unusual risk appetites; even for
employees worried about the safety of their deffered remuneration. The potential uses are
so widespread that some market participant argues that credit derivatives could eventually
outstrip all other derivative products in size and importance.’

Some significant milestones in the development of credit derivatives have been as

follows:

20
 • 1992: Credit derivatives emerge. ISDA first uses the term ‘credit derivatives’ to
describe a new, exotic type of over-the-counter contract.

• 1993: KMY introduces the first version of its Portfolio Manager model, the first credit
portfolio model.

• 1994: Credit derivatives market begins to evolve. There are doubts expressed by
some.

• September 1996: The first CLO of UK’s National Westminister Bank.

• April 1997: J.P.Morgan launches credit Metrics.

• October 1997: Credit Suisse launches CreditRisk.

• December 1997: The first synthetic securitisation, JP Morgan’s BISTRO deal.

• July 1999: Credit derivative definition issued by ISDA.

WHY DO BANKS USE CREDIT DERIVATIVES?

• They are an easy and cost effective means to hedge portfolio risk.

• They permit substantial flexibility and hence increase the portfolio efficiency. For instance,
the bank may have made a loan with 5 year maturity,but may be concerned with the risk
over the next 2 year period only. The credit derivatives permit the bank to allocate this risk
to another party. The bank also effectively creates a 2 year security with many of the
pricing characteristics of the 5 year loan. There are thus endless possibilities to create and
structure flexible credit derivatives.

• They can be used to hedge against interest rate risks.

• Credit derivatives are often more efficient than loan sales since some investors who are
unwilling to participate in the loan sales market are more willing to acquire credit
derivatives.

• The bank transferring its credit risk may not want its actions to be visible to its borrowers
and competitors, and hence may want to use credit derivatives.

21
• Loan sales call for substantial information sharing among participants, and the bank is
likely to incur higher administrative costs and more obligations.

CREDIT DERIVATIVES STRUCTURES

1. Loan Portfolio Swap:
Banks swap loan portfolios to diversify their credit exposures to a particular industry or
activity. For instance, if bank X has more real estate loans in its portfolio, and Bank Y has
more loans to technology firms, X and Y can agree to swap payments received on a
basket of each bank’s loan exposures.

2. Total Return Swap:

This is one of the most popular credit derivatives instruments. The steps involved in the
swap are as follows:

• Bank A has made 5 year loan to firm XYZ. The bank would like to hedge its credit
risk on the loan. Bank A is called the ‘beneficiary’ or the ‘protection buyer’.
22
• In terms of swap agreement, Bank A agrees to pay Bank B,who is called the
‘guarantor’ or ‘protection seller,’ the total return’ on the ‘reference asset’, in this case ,the
loan to XYZ. The ‘total return’ comprises of all contractual payments on the loan, plus any
appreciation in the market value of the reference asset.

• The swap arrangement is completed when Bank B agrees to pay a particular

rate(which would include a ‘spread’ and an allowance for loan value depreciation) to Bank
A. This rate is generally fixed based on a reference rate such as the LIBOR. Now, in effect,
Bank B has a ‘synthetic’ ownership of the reference asset, since it has agreed to bear the
risks and rewards of such ownership over the swap period. Bank B,therefore,assumes the
credit risk, and receives a ‘risk premium’ for doing so. The greater the credit risk, the
higher the risk premium.

• On the date of a specified payment, or when the derivatives mature, or on the

happenings of a specified event, such as default, the contract terminates. Any depreciation
or appreciation in the amortised value of the reference asset(the loan to XYZ),is arrived at
as the difference between the notional principal amount of the reference asset, and the
dealer price.

• If the dealer price is less than the notional principal amount on the date of contract
termination, Bank B must pay the difference to Bank A, absorbing any loss due to the
decline in credit quality of the reference asset

TOTAL RETURN OF
TR PAYER TR RECEIVER

LIBOR+Y BP
p.a.

To sum up, the protection buyer makes payments based on the total returns fro the
reference assets-the loan to XYZ.

The total returns include contractual payments on the loan plus appreciation of the loan
value. In return, the protection seller makes regular payments, fixed or floating, which
include a spread over funding costs plus the depreciation value(the ‘protection’). Both
parties make payment based on the same notional amount. The protection seller gets the

23
advantage of returns without holding the asset on its balance sheet. The protection buyer
can negotiate credit protection without having to liquidate the underlying asset. In floating
rate contracts, not only is interest rate risk hedged, but also the risk of deterioration of
credit quality.

Some advantages of the TR Swap are as follows:

• Since the asset is never transferred, the bank seeking protection can diversify its
credit risk without the need to divulge confidential information on the borrower.

• The feature of this of credit protection are seen to have lower administration costs,
as compared to loan liquidation.

• Banks with high funding levels can take advantage of other banks’ lower cost
balance sheets through such TR swaps. This facilitates diversification of the user’s asset
portfolio as well.

• The maturity of a TR Swap does not have to match the maturity of the underlying
asset. Therefore, the protection seller in a swap with maturity less than that of the
underlying asset may benefit from the ‘positive carry’ associated with being able to roll
forward short term synthetic financing of a longer-term investment. The protection
buyer(TR payer) may benefit from being able to purchase protection for a limited period
without having to liquidate the asset permanently. At the maturity of a TR Swap whose
term is less than that of the reference asset, the protection seller has the option to reinvest
in that asset (by continuing to own it) or to sell it at the market price.

• Other applications of TR Swaps include making new asset classes accessible to

investors for whom administrative complexity or lending group restrictions imposed by
borrowers have traditionally presented barriers to entry. Recently insurance companies
and levered fund managers have made use of TR Swaps to access bank loan markets.

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3. Credit Default Swap(CDS):
The credit default swap provides protection against specific credit related events,and
hence bear more resemblance to a financial bank guarantee or a standby letter of credit,
than to a ‘swap’. Under this agreement, the protection buyer (Bank A) pays the protection
seller(Bank B) only a fixed periodic amount over the life of the agreement.

X BP PROTECTIO
PROTECTION p.a. N SELLER
BUYER

Contingent

Figure illustrates the mechanism of a CDS

The steps in which CDS proceeds are as follows:

• Bank A agrees to pay a fee to Bank B for being guarantor or protection seller. The
fee amounts to a specified number of basis points on the value of the reference asset(the
loan made by Bank A).
Bank B agrees to pay a pre-determined, market value based amount(usually a percentage
of the value of the reference asset) in the event of credit default. The ‘event of default’ is
rigorously defined in the contract-it could take the form of verifiable events such as
bankruptcy, payment default, or can amount to a specific amount of loss sustained by the
protection seeker due to the credit(‘materiality threshold’). Bank B is not required to make
any payment unless there is a default within the period of the swap.

• The amount to be paid by Bank B,post-default, will be defined in the contract. This
amount usually represents the difference between the reference asset’s initial principal
and the actual market value of the defaulted reference asset. The amount is settled
through the ‘cash settlement’ mechanism.

25
 To lower the cost of protection in the credit swap, contingent credit swaps are employed.
Contingent credit swaps are hybrid credit derivatives which, in addition to the occurrence
of a credit event, require an additional trigger. Such a trigger could typically be tied to the
occurrence of a credit event with respect to another reference asset or a material
movement in equity prices, commodity prices, or interest rates. The credit protection
provided by a contingent credit swap, being weaker, is cheaper than that provided under a
regular credit swap.

4. Credit risk options:

These options provide the protection buyer a valuable hedge against interest rate risk,
primarily arising out of a downgrade in a borrower’s credit rating. Example, when Bank A
entered into a loan agreement with firm XYZ ,the firm had an investment grade rating ,and
the loan price was fixed accordingly on floating terms. However, in a year’s time, firm XYZ
witnessed a slide in its credit rating, due to various factors. This implies that Bank A will
have to raise the risk premium and the run the risk of default by XYZ , or retain the
contracted rate and take on higher risk. The third option available to Bank A is to enter into
a contract with Bank B,the protection seller. Bank B writes a simple European option with a
fixed maturity, agreeing to compensate Bank A or the decline in credit quality due to the
lower credit rating of XYZ.
Credit options can also be put or call options on the price of either a floating rate
note bond, or loan. In this case, the credit put (or call) option grants the option buyer the
right, but not the obligation, to sell to (or buy from) the option seller a specified floating rate
reference asset at a pre-specified price(the ‘strike price’). Settlement may be on a cash or
physical basis.

5. Credit Intermediation swap:

In a credit intermediation swap, one creditworthy bank serves as an intermediary between
two smaller banks, to alleviate credit concerns in the swap transaction. For example, let us
assume two small regional banks are keen in entering into a swap contract with each
other. Both of them do not have much presence or credibility, and are not convinced of
each other’s capability of honouring the respective commitments under the swap. The two
small banks, therefore, invite a large prime bank with national/international presence to
guarantee the swap. The two smaller banks can either pay to the large bank at floating
rate and receive fixed rate in return or pay at fixed rate and receive floating rate. The

26
 difference between the rates received and paid forms the income for the large bank for
accepting the credit risk of the two smaller banks.

6. Dynamic credit swap:

An important innovation in credit derivatives is the dynamic credit swap. The protection
buyer pays a fixed fee, either up front or periodically, which once set does not vary with the
size of protection provided. The protection buyer will only incur default losses if the swap
counterparty and protection seller fail. The dual credit effect means that the credit quality
of the protection buyer’s position is at a level better than the quality of either of its
individual counterparties. Also assuming uncorrelated counterparties, the probability of a
joint default is small.

Foreign currency denominated exposure may also be hedged using a dynamic credit swap
where a creditor is owed an amount denominated in a foreign currency, this is analogous
to credit exposure in a cross- currency swap.

7. Credit Spread Derivatives:

Credit spread is the difference between the interest rates of risk free Government
securities and risky debt in the market. It is assumed that interest rates moves consistently
with the market. That is, one per cent change in government securities rate leads to a
similar change in the debt market. If this is so, any difference between the two rates could
be attributed to credit risk for the risky debt. Derivatives written on this spread are credit
spread options/forwards/swaps.

For example, a ‘credit spread call’ is a call option on credit spreads. If spread increases,
the value of the call increases and pays off if the credit spread at maturity exceeds the
strike price of the call option.

The ‘asset swap package’ consists of credit risky instruments (with any payment
characteristics) and a corresponding derivative contract. The contract exchanges the cash
flows of the credit risky instrument for a floating rate cash flow stream. Credit option may
be American, European, or multi-european.Their structure may transfer default risk or
credit spread risk, or both.

Credit options have found favour with investors and banks for the following
reasons:

27
• Institutional investors see credit options as a means of increasing yields, especially
when credit spreads are thin and they find themselves underinvested. These investors
prefer to bear the risk of owning(in a put option) or losing(in a call option) an asset at a
predetermined price in future, and collects income commensurate with the risk taken.

• Banks, with their highly leveraged balance sheets, prefer credit options since they
are off balance sheet. Further, the credit options and credit swaps are structured to trigger
payments upon the happening of a specific event, which help in mitigating credit exposure
risk.

• Such options are also attractive for portfolios that are forced to sell deterioting
assets. Options are structured to reduce the risk of forced sales at distressed prices and
consequently enable the portfolio manager to own assets of marginal credit quality at
lower risk. Where the cost of such protection is less than the benefit in terms of increased
yield from weaker credits, a distinct improvement in portfolio risk-adjusted returns can be
achieved.

• Borrowers also find options useful for looking in future borrowing costs, without
impacting their balance sheets. Prior to advent of credit derivatives, borrowers had to issue
debt immediately even if they had no requirement for the entire amount of debt all at once.
The unutilised debt could be invested in other liquid assets, till the requirement for funds
came up. This had the adverse effect of inflating the current balance sheet and exposing
the issuer to reinvestment risk and,often,negative carry. Today, issuers can enter into
credit options on their own name and lock in future borrowing costs with certainty.

8. Credit Linked Notes(CLN):

This is a funded credit derivative, where the protection buyer requires the protection seller
to make upfront payments. In return, the protection buyer issues the note, called ‘credit
linked note’. The CLN is largely similar to any other bond or note. The simplest form of
credit linked note(CLN) is represented by a standard note with an embedded credit default
swap. These are typically issued by a trust or a special purpose entity (SPE). The steps in
issuing CLN are as follows:

• The bank seeing to issue CLNs9Bank A) sets up an SPE, called a ‘trust’. The CLNs
are intented to protect Bank A in the event the borrower firm XYZ is unable to repay its
debt to the bank.

• Investors or other banks(say, Bank B) buy into these trusts and receive a credit
linked note for a fixed period, say, 3 years.

• The trust offers a steady stream of fixed payments to Bank B over the 3 year period.
These payments constitute interest plus a risk premium. The total return on the notes is
linked to the market value of the underlying pool of debt securities.

28
• Bank A invests the fund received from Bank B in relatively risk free securities,
including highly rated corporate bonds.

• If, during the 3 year period of the CLN, firm XYZ keeps up regular payments to
Bank A,it returns the investment made by Bank B.

• If firmXYZ defaults in payment, bank a compensates its possible loss by liquidating

the risk free security investments. Bank B receives firm XYZ’s debt which could have
turned unsecured or worthless.

Issuers find CLNs attractive, because the ‘risk’ attached to a particular borrowers is
hedged and therefore the immediate need for more regulatory capital is avoided.the
investing banks find CLNs attractive, because they are able to find a pool of leveraged
securities,which could give them good income.

RISK

CREDIT DEFAULT
SWAP
Protectio
n
payment
MGT SPV INVESTOR
29
 Contingent
payment
REFERENCE Par minus net losses
CREDIT
Ana securities

Figure illustrate structure of a CLN

30
9. Credit linked deposits/credit linked certificates of deposit:
Credit linked deposits (CLDs) are structured deposits with embedded default swaps.
Conceptually they can be thought of as deposits along with a default swap that the
investors sell to the deposit taker. The default contingency can be based on a variety of
underlying assets, including a specific corporate loan or security, a portfolio of loans or
securities or sovereign debt instruments, or even a portfolio of contracts which give rise to
credit exposures. If necessary, the structure can include an interest rate or foreign
exchange swap to create cash flows required investors. In effect, the depositor is selling
protection on the reference obligation and earning a premium in the form of a yield spread
over plain deposits. If a credit event occurs during the tenure of the CLD,the deposit is
paid and the investor would get the deliverable obligation instead of the deposit amount.

Deposit
amount

INVESTOR DEPOSIT
TAKER
CLD coupon and principal subject
to default not taking place,
deliverable obligation if default
takes place(or cash settlement)
IR/FX
SWAP (IF

BANK
REFERENC
E
OBLIGATIO

Figure illustrates the structure of a simple CLD.

10. Repackaged Notes:

Repackaging involves placing securities and derivatives in a special purpose vehicle
(SPV) which then issues customised notes that are backed by the instruments placed. The
difference between repackaged notes and CLDs(credit linked deposits) is that while CLDs
are default swaps embedded in deposits/notes, repackaged notes are issued against
collateral-which typically would include cash collateral (bonds/loans/cash) and derivative
contracts. Another feature of repackaged notes is that any issue by the SPV has recourse
only to the collateral of that issue.

31
 REPACKAGED
NOTES

Market

Buys floating rate credits

Issues notes backed by credit with fixed

coupon

SPV INVESTOR
Funding for notes S

Swaps floating for

fixed rate with Bank

BANK

Figure depicts the transaction under a repackaged notes.

11.Basket default swap:

A credit derivative may be with reference to a single reference asset, or a portfolio of
reference asset. Accordingly it is termed a single credit derivative,or a portfolio credit
derivative. In a portfolio derivative, the protection seller is exposed to the risk one or more
components of the portfolio (to the extent of the notional value of the transaction).
A variant of a portfolio trade is a basket default swap. In this type of swap, there would
be a bunch of asset, usually homogeneous. Let us assume that the swap is for the first to
default in the basket. The protection seller sells protection on the whole basket, but once
there is one default in the basket, the transaction is settled and closed. If the asset in the
basket are uncorrelated, this allows the protection seller to leverage himself-his losses are
limited to only one default but he actually takes exposure on all the names in the basket.
And for the protection buyer,assuming the probability of the second default in a basket is
quite low, he actually buys protection for the entire basket but paying a price which is
much lower than the sum of individual prices in the basket. Likewise, there might be a
second-to-default or nth to default basket swaps.

OPERATIONAL REQUIREMENTS FOR CREDIT DERVATIVES

32
In order for protection from a credit derivative to be recognised the following conditions
must be satisfied:

• The credit events specified by the contracting parties must at a minimum include:
-a failure to pay the amounts due according to reference asset specified in the
contract.
-a reduction in the rate or amount of interest payable or the amount of scheduled
interest accruals;

-a reduction in the amount of principal or premium payable at maturity or at scheduled

redemption rates; and

-a change in the ranking in the priority of payments of any obligation, causing the
subordination of such obligation.

• Contracts allowing for cash settlement are recognised for capital purposes provided
a robust valuation process is in place in order to estimate loss reliably. Further, there
must be a clearly specified period for obtaining post-credit valuation of the reference
asset, typically no more than 30 days.

• The credit protection must be legally enforceable in all relevant jurisdictions.

• Default events must be triggered by any material events e.g., failure to make
payment over a certain period or filing for bankruptcy or protection from creditors.

• The grace period in the credit derivative contract must not be longer than the grace
period agreed upon under the loan agreement.

• The protection purchaser must have the right/ability to transfer the underlying
exposure to protection provider, if required for settlement.

• The identities 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 provider of the occurrence of a credit event.

• When there is an asset mismatch between the exposure and the reference asset
then.
-the reference and underlying assets must be issued by the same obligor(i.e. the same
legal entity);and
-the reference asset must rank more junior than the underlying asset and legally
effective cross-reference clauses(e.g. cross default or cross-acceleration clauses)
must apply.

• When a bank buying credit protection through a total return swap records the net
payments received on the swap as net income, but does not record offsetting

33
deterioration in the value of the asset that is protected (either through reductions in fair
value or by an addition to reserves) the credit protection will not be recognised.

34
• Credit linked notes issued by the bank will be treated as cash collateralised
transactions.

• Credit protection given by the following will be recognised.

-Sovereign entities,PSEs and banks with a lower risk weight than the obliger;
-corporates(including insurance companies) including parental guarantees rated A or
better.

35
 INDIAN SCENARIO

ICICI Bank Ltd.,Reliance Industries Ltd, Tata Motors Ltd. and State Bank of India are
among the users of Rupee denominated Credit default swaps contracts in Asia, excluding
Japan, according to a dealer survey company index in Frankfurt. Indian Banks have an
incentive to use credit –default to offset the risk in their portfolios. The Central bank’s
guidelines make Indian credit –default swaps simple and easy to document, which are
easily floated in the market.

36
 SOME IMPORTANT EXPOSURE NORMS

Exposure is defined as including credit exposure [funded and non-funded credit limits] and
investments exposure [including underwriting and similar commitments] as well as and
investments in companies. Exposure is taken to be the higher of sanctioned limits or
outstanding advances. Further , in line with international best practices, effective 1april
2003,non-fund based exposures are included at100 percent of the higher of the limit or
outstanding advances. Further, banks should also include forward contracts in foreign
exchange and other derivative products like currency swaps, and options at their
replacement cost value in determining individual / group borrower exposure.

Credit exposure comprises the following:

• All types of funded and non-funded credit limits.

• Facilities extended by way of equipment leasing, hire purchase finance and

factoring services.

• Advances against shares, debentures, bonds, units of mutual funds, and to stock
brokers, market makers
37
 • Bank loan for financing promoter’s contributions.

• Bridge loans against equity flows/issues

• Financing initial public offerings (ipos)/employee stock options (esops)

• Investment exposure comprises of the following

• Investments in shares and debentures of companies acquired through direct

subscription , devolvement arising out of underwriting obligations or purchased from
secondary markets or on conversion of debt into equity.

• Investment in Psu bonds through direct subscription, devolvement arising out of

underwriting obligations or purchase made in the secondary market.

• Investments in commercial papers (CPs)issued by corporate bodies / public sector

units

• The securitisation and reconstruction of financial assets and enforcement of

security interest act 2002,provides, among others, sale of financial assets by banks/ fls
investments in debentures / bonds / security receipts / pass-through certificates (ptcs)
issued by a SC / RC as compensation consequent upon sale of financial assets will
constitute exposure on the SC/RC (as only a few SC/RC are being set up now,
banks/Fls exposure on SC/RC through their investments in debentures / bonds /
security receipts /(PTCs)issued by the SC/RC may go beyond their prudential
exposure ceiling). In the view of the extraordinary nature of event ,banks /fls will be
allowed , in the initial years , to exceed prudential exposure ceiling on a case –to-case
basis.

The concept of group and the identification of borrowers belonging to a specific group re to
be used on the perception of the bank . The guiding principles should however be
commonality of management and effective control .

The salient features of the exposure norms proposed by the RBI are given below :

38
• The exposure ceiling limits applicable from 1 April 2002, computed based on the
capital funds in India would be 15 percent of capital funds in case of single borrower
and 40 percent in the case of a borrower group.

• Credit exposure to a borrower group can exceed the exposure norm of 40 percent
of the banks capital funds by an additional 10 percent(upto 50 percent), if the
additional credit exposure is to infrastructure projects. Similarly, exposure to a single
borrower may exceed the norm of15 percent by 5 percent (upto 20 percent ) if the
additinal credit exposure is to the infrastructure sector.

• In addition to the above exposures, banks may enhance exposure to a borrower up

to a further 5 percent of capital funds in exceptional circumstances , with the approval
of their board of directors.

• The exposures should be disclosed in the banks financial statements under notes
on accounts

• Exemption to the above exposure norms can be made in the case of

(a)rehabilitation of sick/weak industrial units :(b) food credit (allocated directly by the
RBI) :(c) advances fully guaranteed by the government of India :and(d) loans and
advances granted against the security of the banks own term deposits, on which the
banks hold specific lien.

• Exposure norms for specific sectors have also been outlined by the RBI.

39
 PR U D E N T I A L NORMS FOR ASSET CLASSIFICATION , INCOME

RECOGNITION AND PROVISIONING

- To correspond with the classification of loans discussed in section I . RBI instructs

all banks in India to classify assets under the following categories ,non-performing assets
are the broad equivalent of impaired assets discussed in section I ,the RBI has provided
detailed guidelines for asset classification , the salient features of which are presented
below.

Non – performing assets

An assets, including a leased asset, becomes non-performing when it ceases to generate
income for the bank. A non-performing asset (NPA) is a loan or an advances when one of
the following is applicable.

• Interest and / or instalment of principal remain overdue for a period of more than 90
days in respect of term loan.

• The accounts remain out of order in respect of an overdraft / cash credit (OD/CC) .

• The bill remains over due for a period of more than 90 days in the case of bills
purchased and discounted .

• A loan granted for short duration crops will be treated as NPA, if the installment of
principal or interest thereon remains overdue for one crop season

40
 I NCOME RECOGNITION

The policy for recognition has to be objective and based on the record of recovery . In line
with international best practices , income from NPAS is not to be recognised on accrual
basis but is booked as income only when it is actually received . Therefore, the banks
should not charge and take to income account interest on any NPA.

REVERSAL OF INCOME: if any advance, including bills purchased and discounted,

becomes an NPA as at close of any year, the unrealised interest accrued and credited to
income account in the previous year, should be reversed or provided for . This will apply to
government guaranteed accounts also. Similarly, uncollected fees, commission and other
income that have accrued in the NPAS during past periods should be reversed or provided
for .

LEASED ASSETS: the unrealised finance charge component of finance income on the
leased asset, accrued and credited to income account before the asset became non-
performing , should be reversed or provided for in the current accounting period .

APPROPRIATION OF RECOVERY IN NPAS: interest realised on NPAS may be taken to

income account provided the credits in the accounts towards interest are not out of fresh/
additional credit facilities sanctioned to the borrower.

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 A S SE T C L A S S I F I C A T I O N
CATEGORIES OF NPAs

Banks in India are required to classify NPAs into the following three categories based on
(a) the period for which the asset has been non performing and (b) the realisability of the
dues.

(i) Sub-standard assets,

(ii) Doubtful assets,

(iii) Loss assets

SUB-STANDARD ASSETS

With effect from 31 March 2005, a sub-standard asset would be one ,which has remained
NPA for a period less than or equal to 12 months. The following features are exhibited by
sub-standard assets: the current net worth the borrower /guarantor or the current value of
security charged is not enough to ensure recovery of the dues to the banks in full; and the
asset has well defined credit weakness that jeopardise the liquidation of the debt and are
characterised by the distinct possibility that the bank will sustain some loss, if deficiencies
are not corrected.

DOUBTFUL ASSETS

With effect from 31 March 2005,an asset would be classified as doubtful if it has remained
in the sub-standard category for the period of 12 months .

A loan classified as doubtful has all the weakness’ inherent in assets that were classified
as sub-standard , with the added characteristic that the weakness make collection or
liquidation in full-on the basic of currently known facts, conditions and values –highly
questionable and improbable.

LOSS ASSETS

A Loss assets is one which is considered uncollectible and of such little value that is
continuance as a bankable asset is not warranted –although there may be some salvage
or recovery value. Also, these assets would have been identified as ‘loss assets ‘by the
bank of internal or external auditors or the RBI inspection but the amount would not have
been written off wholly.

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 TREATMENT UNDER ASSET CLASSIFICATION
Accounts with temporary deficiencies.
Some assets display operational deficiencies such as inadequate drawing power non-
submission of stock statements, non-renewal of limits on due date or excess drawing over
the limit .When should banks classify accounts exhibiting these characteristics as NPAs.

• When the outstanding in the account in the account in based on stock

statements more than 3 months old.
• If such irregular drawing are permitted in the account for 90 days continuously,
even though the firm is functioning or the borrower’s financial health is satisfactory.
• When an account enjoying regular or ad c credit limits has not been
reviewed/renewed within 180 days from the due date/date of ad hoc sanction.
• In such cases, if arrears of interest and principal are paid by the borrower
subsequently, the account may be upgraded to standard* category.

Accounts regularized near about the balance date.

Where a solitary or a few credits are recovered just before the balance sheet date in a
borrowal account, and the account exhibits inherent credit weakness based on the current
available date, it should be classified an NPA.

Asset classification to be borrower –wise and not facility wise

Even if one credit facility among many such credit facilities granted to a borrower will have
to be treated an NPA the entire borrowing accounts has to be classified an NPA.

Advances under consortium arrangements.

Asset classification of accounts under consortium should be based on the record of

recovery of the individual member banks and other aspects having a bearing on the
recoverability of the advances.

Accounts where there is erosion in the value of security/frauds committed by

borrowers.

In such cases of serious credit impairment it will not be prudent to put these accounts
through various stages of assets classified and the asset should be straightaway classified
as a doubtful or loss asset as appropriate.

• Erosion in the value of security can be reckoned as significant when the realizable
value of the security in less than 50 per cent of the value assessed by the bank or
accepted by the RBI at the time of last inspection .Such NPAs may be straight away
classified under doubtful category and provisioning should be made as applicable to
doubtful assets.

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 • If the realizable value of the security as assessed by the banking/the RBI is less
than 10 per cent of the outstanding in the borrowal account, the existence of security
should be ignored and the asset should be straightaway classified as a loss it may be
either written off or fully provided for by the bank.

Advances against term deposits, NSCs ,KVP/IVP

Advances against term deposits, NSCs eligible for surrender, IVPs, KVPs and life policies
need not to be treated as NPAs. However, advances against gold ornaments securities
and all other securities are not covered by this exemption.

Loans with moratorium for payment of interest

• In cases where the loan agreement incorporates a moratorium for payment of

interest become due only after completion of the moratorium or gestation period
.Therefore ,such interest does not become overdue and hence is not termed as NPA
during the moratorium period .However the advance become overdue if interest
remains uncollected offer the specified due date.
• In the case of housing loan or similar advances granted to staff member where
interest is payable after recovery of principal interest need not be considered as
overdue from the first quarter onwards .such loans /advances should be classified as
an NPA only when there is a default in repayment of principal installment or payment
of interest on the specified due dates.

Agriculture advances (some salient features)

• A loan granted for short duration crops (with crop season less than 1 year) will
be treated as an NPA, if the installment of principal or interest thereon remains
overdue for two crop season.
• A loan granted for long duration (those with crop season longer than 1 year) will
be treated as an NPA,if the installment of principal or interest thereon remains overdue
for the crop season (period up to harvesting of the crop).
• Where natural calamities impair the repaying capacity of agriculture borrowers
,bank may decide on appropriate relief measures- conversion of the short –term
production loan a term loan or rescheduling repayment ,or sanctioning a fresh short –
term loan ,(subject to RBI directives).
• In such cases of conversion or re schedulement, the term loan as well as fresh
short –term loan may be treated as current dues and need not be classified as NPA.

Government guaranteed advances.

Overdue credit facilities backed by central government guarantee may be treated as an

NPA only if the government repudiated its guarantee when invoked .However respect of
state government guaranteed advances and investments in state government guaranteed
securities would attract asset classified and provisioning norms if interest and/or principal
or any other amount due to the bank remains overdue for more than 90 days.

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 PROVISIONING NORMS

Adequate provisions have to be made for impaired loans or ‘non-performing assets’

classified as given in the foreign paragraphs. Taking into accounts the time lag between an
account becoming doubtful for recovery, its recognition as an impaired loan, the realization
of the security charged to the bank and the likely erosion over time in the value of this
security, banks should classify impaired loans into ‘sub-standard’, ’doubtful’, and ‘loss’
assets, and make provisions against these.

Loss assets should be written off or 100 percent provided for.

DOUBTFUL ASSETS
• Provision of 100 percent to the extent is advance is not covered by the realizable
value of the security (to which bank has a valid course).
• That portion of advances covered by realizable value of the security will be provided
for on the following basis:

Period for which the advances has Provision requirement

Remained in ‘doubtful’ category (%)( for the secured portion)

Up to 1 year 20

1 to 3 year 30

More than 3 years

(i) Outstanding stock of NPAs as on 31 60 per cent with effect from 31 March 2005.

March 2004. 75 per cent with effect from 31 March 2006.

100 per cent with effect from 31March 2007.

(ii) Advances classified as ‘doubtful’ 100 per cent with effect from 31March 2005.

3 years’ on or 1 April 2004

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ILLUSTRATION

Existing Stock of advances classified as doubtful more than 3 years ‘as on 31 March
2004.

The outstanding amount as on 31 March 2004 Rs 25,000

Realizable value of security: Rs 20,000

Period for which the advance has remained in ‘doubtful’ category as on 31 March 2004; 4
years (i.e.; doubtful more than 3 years)

Provisioning requirement:

As on Provisions on secured portion Provisions on unsecured portion Total (Rs)

% Amount % Amount

31March 2004 50 10,000 100 5,000 15,000

31 March 2005 60 12,000 100 5,000 17,000

31 March 2006 75 15,.000 100 5,000 20,000

31 March 2007 100 20,000 100 5,000 25,000

SUB-STANDARD ASSETS
A general provision of 10 percent on total outstanding should be made (without making
any allowance for ECGC guarantee cover and securities available). The ‘unsecured
exposures‘ identified as ‘sub-standard’ would attract additional provision of 10 percent thus
constituting 20 percent on the outstanding balance.

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STANDARD ASSETS
Under the existing norms, banks should make a general provision of a minimum of 0.40
percent on standard assets on global loan portfolio basis. However, these provisions need
not to be included included for arriving at net NPAs, and will be presented as ‘Contingent
Provisions against Standard Assets’ under ‘Other Liabilities and Provisions-Others’in
schedule 5 of the balance sheet.

FLOATING PROVISIONS
Where banks make a ‘floating provision’ over and above the specific provisions made in
required to be made as recommended in the provisioning guidelines of RBI.

PROVISIONING WHERE ECGC/ CGTSI GUARANTEE IS AVAILABLE-

SOME ILLUSTRATIONS

In the advance covered by CGTSI guarantee becomes non- performing , no provision

needs be made towards the guaranteed portion. Only the amount outstanding in excess of
the guaranteed portion should be provided for.

In the case of advances classified as doubtful and guaranteed by the ECGC provision
should be made only for the amount guaranteed by the corporation .Further while arriving
at the provision required to be made for doubtful asset, realizable value of securities
should be deducted from the outstanding balance in respect of the amount guaranteed by
the corporation before provisioning.

EXAMPLE:-

Outstanding Balance Rs 4 Lakh

ECGC cover 50 percent

Period for which the amount has remained doubtful More than 3 years remained

Doubtful(as on 31/4/2004)

Value of security held (excludes worth of Rs) Rs 1.50 Lakh

Provision required to be made

Outstanding Balance Rs 4.00 Lakh

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Less; Value of security held Rs 1.50 Lakh

Unrealised Balance Rs 2.50 Lakh

Less; ECGC Cover (50% of unrealizable balance) Rs 1.25 Lakh

Net unsecured balance Rs 1.25 Lakh

Provision for unsecured portion of advance Rs 1.25 Lakh

(@100% of unsecure portion)

Provision for secured portion of advance Rs 0.90 Lakh

(@60% of the secured portion)

Total provision to be made Rs 2.15 Lakh

(as on 31/3/200)

WRITING OFF NPAS

Provisions made for NPAs are not eligible for tax deductions. However, tax benefits can be
claimed for writing off advances.

Illustration below demonstrates the impact of provisioning and write-off on banks’ profits.

Profit before provisions for Bank Y Rs 500 crore. If the tax rate is 30% , what will be the
impact of the following actions on Bank Y’s (a) profits and (b) capital base?

• Make a provision of Rs 250 crore for NPAs

• Provide Rs 200 crore for NPAs and write-off the remaining Rs 50 crore.
Option I:Provide Rs 250 crore for NPAs

Profit before provision Rs 500 crore

Less provision for NPAs Rs 250 crore

Profit before tax Rs 250 crore

Less tax at 30% Rs 150 crore (since

mmmmmmmmmmmmmmmmmmmmmmmmmmmmmmmmmprovision for NPA not tax
mmmmmmmmmmmmmmmmmmmmmmmmmmmmmmmmmdeductible tax calculated at
mmmmmmmmmmmmmmmmmmmmmmmmmmmmmmmmm30 % of Rs 500 crore).

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PROVISIONS UNDER SPECIAL CIRCUMSTANCES
–RBI GUIDELINES
Provisions on leased assets
- Sub-standard assets-10% of the net investment in the leased and unrealized
portion of finance income net of finance charges .Unsecured lease exposures
identified as substandard would require additional provision of 10% (aggregating to
20%).
- Doubtful assets – after realistically estimating the value of the leased asset. 100%
provision on the unsecured portion is required. On the secured portion , rates of
provisioning are as specified earlier.
- Loss assets- the entire asset should be written-off, or the asset is allowed to remain
in books,100% of the sum of the net investment in the lease and the unrealized portion
of finance income net of finance charge component should be provided for.
Advances under rehabilitation packages.

Provision will continue to be made in accordance with the borrower’s asset classification
as sub standard or doubtful in respect of existing outstanding advances. For the additional
credit facilities sanctioned as part of the rehabilitation package, no provisions need to be
made for a year after disbursement.

Advances against bank term deposits.NSCs eligible for surrender ,Indra Vikas Patras
(IVPs),Kisan Vikas Patras (KVPs ) and life policies ,as well as advances against gold
ornaments government and all other securities require provisioning according to their
asset classification status.

Any amount held in interest suspense accounts should be deducted from the outstanding
advance and provisions are to be applied only on the balance amount.

Take out finance-Pending take over the by the institution taking over the advance the
lending institution should make adequate provision .These provisions can be set off when
the take over is complete.

Reserve for exchange rate fluctuations account (RERFA)- When exchange rate
movements of Indian rupee turn adverse ,provisioning is necessitated since the
outstanding amount of foreign currency denominated loans (Where disbursement had
been made in INR) turns overdue. In case such assets have to be revalued the loss on
revaluation is booked in the bank’s income statement .In case there is a revaluation gain
the entire amount of gain should be taken as provision.

Provision for country risk (w.e.f31 march 2003) –To be made where the bank’s net funded
exposure is more than 1% of total assets. This is a provision additional to the one made
through asset classification .In any case the provision cannot exceed 100% of the
outstanding advance.
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The provision will be required for exposure of Indian banks’ foreign branches to the host
country Foreign banks will have to hold appropriate provisions for the country exposures of
their Indian branches (excluding exposure to India).

Risk category ECGC classification Provisioning

requirement(%)

Insignificant A1 0.25

Low A2 0.25

Moderate B1 5

High B2 20

Very high C1 25

Restricted C2 100

Off-credit D 100

Provisioning for sale of financial assets to securitization company(SC)/ reconstruction

company (RC)-

I. If the sale of financial asset is at price below the net book value (NBV) , the shortfall
is booked as a loss in the statement of the bank.
II. If he sale is for a value higher than the NBV the excess provision will be set off
against losses in sale if other assets.

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 TREATEMENT OF CREDIT RISK IN INDIA –
SECURITIZATION AND CREDIT DERIVATIVES

SECURITIZATION

With effect from 23 April 2003,’ The securitization companies and Reconstruction
Companies (Reserve Bank) Guidelines and directions,2003’ are operational in India.
These guidelines and directions apply to securitization companies or reconstruction
companies (SC/RC) registered with the Reserve Bank of India under Section 3 of the
Securitization and reconstruction of Financial Assets and Enforcement of Security Interest
Act, 2002.

The salient features of the Securitization Act are listed below:

• Incorporations of special purpose vehicles namely securitization company and

reconstruction company.
• Securitization of financial assets.
• Funding of securitization.
• Asset reconstruction.
• Enforcing security interest, i.e., taking over the asset given as the security for the
loan.
• Offences and penalties.
• Boiler-plate provisions.
• Dilution of provisions of the SICA.
• Establishment of a central registry for regulating and registering securitization
transactions: One objective of the Securitization Act is to provide for the enforcement of
security interest i.e., taking possession of the assets given as security for the loan. Section
13 of the Securitization Act contains elaborate provisions for a lender (referred to as
‘secured creditor’) to take possession of the security given by the borrower.

Banks can sell the following financial assets it the securitization company.

• An NPA, including a non-performing bond/debenture.

• A ‘Standard Asset’ where
 The asset is under consortium/multiple banking arrangements.
 At least 75% by value of the asset is classified as non-performing asset in the
books of other banks/FIs; and
 At least 75% (by value) of the banks/FIs who are under the consortium/multiple
banking arrangements agree to the sale of the asset to SC/RC.
The securitization and Reconstruction of Financial Assets and Enforcement of Security
Interest Act,2002 (SRFAESI Act) allows acquisition of financial assets by SC/RC from any
bank/FI on mutually agreed terms and conditions.

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CREDIT DERIVATIVES
In terms of the existing RBI draft guidelines, banks will be initially permitted to use credit
derivatives only for the purpose of managing their credit risk,which include the following.

• Buying protection on loans and investments for reduction of credit risk.

• Selling for the purpose of diversifying their credit risk and reducing credit
concentrations and taking exposure in high quality assets.

Market making activities by banks in credit derivatives are not envisaged for the present.
Also , banks will not be permitted to take long or short credit derivative positions with a
trading intent. This implies the banks may hold the derivatives in their banking books and
in the trading book (if the bank so desires)

TYPES OF DERIVATIVE PRODUCTS

The credit derivatives range from plain vanilla products to complex structures. The
valuation standards, accounting norms, capital adequacy issues, methodologies for
identifying risk components and concentrations of risks; especially in case of complex
credit derivative to use simple credit structures like credit default swaps and credit linked
notes only, involving single default swaps for regulatory purposes.

Other salient features of the draft guidelines are as follows:

• Credit derivative transactions between related parties are not permitted, for
instance, between a bank and its financial services subsidiary.
• At present ,non-resident entities cannot be parties to credit derivative transactions
in the domestic market . However the underlying assets could be either rupee
denominated or foreign currency denominated (the latter in case of banks authorized
to deal in foreign exchange).
• Existence of adequate risk management policies , procedures and systems and
controls-
The credit derivatives activity to be undertaken by bank should be under the adequate
oversight of its Board of directors and senior management. Banks using credit
derivatives should have adequate policies procedures in place to manage associated
risks. There should be adequate separation between the function of transacting credit
derivatives business and those monitoring, reporting and risk control.

• The credit derivative should be (a) direct (representing a direct claim on the
protection seller ); (b) explicit (linked to specific exposures; (c) irrevocable (no clause
in the contract permitting the protection seller to unilaterally cancel protection); and (d)
unconditional (no clause in the contract preventing the protection provider to pay on
time in case of default).
• The credit protection must be legally enforceable in all relevant jurisdictions.

52
• Default events must be triggered by any material event, such as, failure to make
payment over a certain period or bankruptcy.
• The grace in the credit derivative contract must not be longer than the grace period
under the loan agreement.
• The credit event payment or settlement under default swaps (CDS) may be through
physical delivery, cash or could be a fixed amount settlement.
• In the case of credit linked notes (CLN),the amount of protection bought will be
through physical delivery, cash or could be a fixed amount settlement.
• Banks will hold the derivatives in their banking books, since trading in credit
derivatives is not permitted. However CLNs, for the purpose of determining capital
adequacy.
• In the case of CLN, where the asset is protected by a credit derivative funded by
cash , the protection buyer will be apply the appropriate risk weight only to the
unprotected portion of the underlying asset, for determining capital adequacy.
• The risk weight of the underlying asset will be replaced by that of the protection
seller to the extent of protection under CDS, for the purpose of determining capital
adequacy.
• In the case of ‘maturity mismatches’ (the maturity of the credit derivative contract is
less than the maturity of the underlying asset), if the residual maturity of the derivative
is one year or more, the risk weight applied will be the weighted average of the risk –
weight of the protection seller and the risk weight of the reference asset (weighted by
proportions of period for which protections available/not available.
• In the case of currency of a ‘currency mismatch’ (where the credit derivative
contract is denominated in a currency different from that of the underlying asset), the
credit protection should be marked to market at the prevailing exchange rate. If such
valuation of the value of the underlying asset, the residual risk is to be risk-weighted
on the basis of the underlying asset.
• In a CDS, the protection seller has acquired credit exposure to the reference asset,
and therefore the exposure would be risk weighted in terms of the risk weight of the
reference asset. In a funded derivative such as the CLN, the protection seller acquires
on balance sheet exposure to both the reference asset and the protection buyer. If the
bank decides to hold the CLN, in the banking book, the exposure will be risk-weighted
by the higher of the reference asset or the protection buyer. If held in the trading book,
the risk –weight would be the risk weight applicable to all other investments.
• The protection seller will have to create provision as the reference assets were on
the seller’s books. The protection buyer need not make any provision for a reference
asset which is an NPA but for which protections available.

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• Normally CLNs will be issued by SPVs set up by banks for specific purpose.
However, if a bank desires to issue CLNs (after prior approval from the RBI), adequate
CRR and SLR would have to be maintained.
• The following disclosures will have to be made in the banks’ ‘Notes on Accounts’ of
their annual accounts in respect of credit derivative transactions: (a) types of transactions
carried out and their corresponding risks; (b) the gains/losses, realized/unrealized from
various types of credit derivative transactions; (c) contribution of derivatives to the total
business and the risk portfolio; (d) fair value of derivative positions.

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 CONCLUSION

Banks can utilise Credit derivatives to reduce their portfolio risks. A banking system
which is well shielded against the juggernaut of credit risks forms the bedrock of a
fast growing economy. The entry of credit derivatives has heralded a new era in
credit risk management practices of Indian banks by endowing them with a unique
ability to isolate and transfer the credit risks while retaining the beneficial credit
exposures on their balance sheets. In this scenario however, it is proposed that
either the RBI,SEBI,and IRDA should demarcate their respective jurisdictional
boundaries through agreements. By using Credit derivatives a bank can manage the
loans by assessing the loss periodically,make provisions on the losses and hence
become vigilant for unexpected losses.It can diversify its loan portfolio to multiple
counterparties so that expected defaults may not lead to earnings volatility.Moreover
credit derivatives are preferred way of transferring credit risk whereby the action of
bank is invisible to the borrowers and competitors.Thus Credit Derivatives are a
specialised way to insure against credit related losses.

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 SUGGESTIONS

 Banks should use credit derivatives in to hedge against credit risks in more
diversified forms. The use of credit derivatives in India is limited and there is huge potential
for its growth. This method or reducing credit risk is cheap, efficient and flexible.

 The regulatory framework guarding the structures should be defined and revised as
more and more innovative products come into existence

 There are documentational anomalies in the draft guidelines presented by

the central bank. The RBI needs to focus on the legal risks arising due to ambiguity
in the clause regarding buyer’s intended credit protection.

 The courts may face difficulty in fully comprehending the byzantine character
of credit default swaps

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 LIMITATIONS

There are n numbers of Credit Derivatives operating in the financial system, and they can
be structured according to the need of the bank not many structures are discussed in the
project, due to time and space constraint.

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 BIBLIOGRAPHY
www.google.com

www.scribd.com

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