The Reserve Bank of India has permitted ‘restructuring' as an approved credit event (that is, default on a previously agreed financial obligation) that can be covered by credit default swap contracts.
The RBI's move to include ‘restructuring' as a credit event is significant as it comes at a time when the bad loans problem in the banking system appears to be gradually building up. This is so because of tepid global demand for goods and services, rising input costs and interest rates moving north.
In its guidelines on credit default swaps (CDS) for corporate bonds, the RBI said a credit event (that is, default on a previously agreed financial obligation) will cover restructuring approved under the Board for Industrial and Financial Reconstruction, the corporate debt restructuring mechanism and corporate bond restructuring.
Earlier avatar
The draft guidelines on CDS for corporate bonds, which were issued in February 2011, did not permit restructuring as a credit event.
A credit event includes bankruptcy, failure to pay, repudiation/ moratorium, obligation acceleration, and obligation default.
A CDS is an agreement in which the protection buyer of the CDS makes a series of payments to the protection seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) experiences a credit event (or default).
The RBI observed that the objective of introducing CDS on corporate bonds is to provide market participants a tool to transfer and manage credit risk in an effective manner through redistribution of risk.
“Since CDS have benefits like enhancing investment and borrowing opportunities and reducing transaction costs while allowing risk-transfers, such products would increase investors' interest in corporate bonds and would be beneficial to the development of the corporate bond market in India,” the central bank said.
The users of CDS include commercial banks, primary dealers (PDs), non-banking finance companies (NBFCs), mutual funds (MFs), insurance companies, housing finance companies, provident funds, listed corporates, foreign institutional investors and any other institution specifically permitted by the RBI.
Market-makers
The market-makers include commercial banks, stand alone PDs, NBFCs having sound financials and good track record in providing credit facilities and any other institution specifically permitted by the Reserve Bank.
To improve depth of the CDS market for corporate bonds, the RBI has also relaxed the eligibility norms for market-makers.
The minimum capital to risk weighted assets (CRAR) has been relaxed to 11 per cent (12 per cent as per the draft guidelines), with core Tier-I capital of at least 7 per cent (8 per cent).
As creation of market infrastructure, such as trade repository, is essential for CDS, the RBI said the guidelines would become effective from October 24, 2011.