Effective management of credit risk is a critical factor in comprehensive risk management and is essential for the long-term financial health of business organizations, especially banks. Credit risk management encompasses identification, measurement, monitoring and control of the credit risk exposures.
Reserve Bank of India had issued Guidelines for Asset Liability Management in February 1999 followed by guidelines on management of other risks such as credit risk, market risk, liquidity risk, interest rate risk, foreign exchange risk and operational risks in October 1999.
Detailed guidelines for management of credit risk have been issued in October 2002.
For enabling the banks and the financial institutions, in India, to manage their credit risk effectively it was being felt appropriate to permit them the use of credit risk hedging techniques like the credit derivatives, which are over the counter (OTC) financial contracts and can help banks and financial institutions in managing the risk arising from adverse movements in the credit quality of their loans and advances, and their investments. Banks can derive many benefits from the credit derivatives such as,
- Transfer credit risk and hence free up capital, which can be used in other opportunities,
- Diversify credit risk,
- Maintain client relationships, and
- Construct and manage a credit risk portfolio as per their risk preference and appetite unconstrained by funds, distribution and sales effort.
A Working Group on introduction of Credit Derivatives in India, comprising officers from the Reserve Bank of India and industry was set up to study the need and scope for allowing banks and financial institutions to use credit derivatives, the regulatory issues involved and make suitable recommendations in this regard. The Group has since submitted its report, which is available on the Reserve Bank of India Website – www.rbi.org.in
Important Note:
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 structures are in the evolutionary stage.
Therefore, currently RBI restricts banks to use simple credit derivative structures like credit default swaps and credit linked notes only, involving single reference entities, in the initial phase. The credit default options will be treated as credit default swaps for regulatory purposes.