Page 153 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes 11.3 The Indian Scenario

One of the more successful products introduced in India in the recent past has been the Interest
Rate Derivative product. Currently, there has been an increase in the use of this product with a
number of hedging benchmarks and the entry of a large number of market players. The success
of this product is due to the fact that it has helped the market to transmit the interest rate risk
from one participant to another. This transmission of the interest rate risk allows for the risk to
be hedged away by the risk averse players and reside in players who are risk takers and/or
those who are able to bear the risk.
Similarly, credit risk also requires an effective transmission mechanism. It is now imperative
that a mechanism be developed that will allow for an efficient and cost effective transmission
of credit risk amongst market participants. The current architecture of the financial market
is either characterized by lumpiness in credit risk with the banks and Development
Financial Institutions (DFIs) or lack of access to credit market by mutual funds, insurance
companies, etc.
The major hedging mechanism now available with banks and DFIs to hedge credit risk is to sell
the loan asset or the debentures it holds. Banks and Development Financial Institutions require
a mechanism that would allow them to provide long term financing without taking the credit
risk if they so desire. They could also like to assume credit risk in certain sectors/obligors.

Credit derivatives will give substantial benefits to all kinds of participants, including the financial
system as a whole, such as:
1. Banks would stand to benefit from credit derivatives mainly due to two reasons – efficient
utilisation of capital and flexibility in developing/managing a target risk portfolio.
Currently, banks in India face two broad sets of issues on the credit leg of their asset –
blockage of capital and loss of opportunities,
(a) Banks generally retain assets - and hence, credit risk - till maturity. This results in a
blocking up of bank's capital and impairs growth through churning of assets.
(b) Due to exposure norms that restrict concentration of credit risk on their books,
banks are forced to forego attractive opportunities on existing relationships.

2. Asset portfolio of banks is largely constrained by distribution system and sales
relationships. New banks possess capital but have to overcome high costs in building an
asset portfolio. Similarly, existing banks may want to diversify portfolio but may be
unable to do so because of stickiness of client relationships and switching costs.

Self Assessment

Fill in the blanks:

9. One of the more successful products introduced in India in the recent past has been the
…………………..product.
10. Asset portfolio of banks is largely constrained by ...…………... system and sales
relationships.

11.4 Credit Risk Mitigation

Credit risk management encompasses a hot of techniques, which help the banks in mitigating
the adverse impacts of credit risk.

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