Page 158 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 11: Credit Derivatives

3. Identify problem loans which develop credit weaknesses and initiate timely corrective Notes
action;
4. Evaluate portfolio quality and isolate problem areas; and

5. Provide information for determining adequacy of loan provision.
One main reason for establishing a systematic credit review process is to identify problems at
the incipient stage when there may be core options available with the bank for improving the
health of loan accounts at an early stage or initiating any other action, at the earliest.
Effective programmes for management of problem loans (workouts) are critical to managing
risk in the portfolio. The workout division or sick problem accounts Division of the bank should
be segregate from the credit administration division. It can help develop an effective strategy to
rehabilitate a troubled unit or to increase the amount of repayment. An experienced workout
section can also provide valuable input to any credit restructuring organised by the Credit
Administration division. Presently the Indian public sector banks have "Industrial Rehabilitation
Division", "Protested Division" and "Recovery Teams" to handle such functions.



Caselet Credit Derivatives for Banks only to manage Risks: Panel

anks will be initially permitted to use credit derivatives only for the purpose of
managing their credit risk, according to the recommendations made by the RBI
Bworking group on Credit Derivatives.
Credit derivatives are over-the-counter financial contracts, usually defined as `off-balance
sheet financial instruments that permit one party to transfer credit risk of a reference asset,
which it owns, to another party without actually selling the asset.'

It, therefore, `unbundles' credit risk from the credit instrument and trades it separately.
According to the recommendations of the working group, banks may use credit derivatives
for buying protection on loans and investments for reduction of credit risk, selling protection
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.
For the present, banks will not be permitted to take long or short credit derivative positions
with a trading intent. It means that banks may hold the derivatives in their banking books
and not in the trading books except in case of Credit-Linked Notes, which can be held as
investments in the trading book if the bank so desires.

To start with, RBI proposes to restrict banks to use simple credit derivative structures like
credit default swaps and credit-linked notes described in paragraph 2.2 (a) (i), (ii) and (iii)
only, involving single reference entities, in the initial phase. The credit default options
will be treated as credit default swaps for regulatory purposes. RBI intends to develop the
credit derivatives as a domestic product for the domestic loan and investments market,
initially.
As under the present exchange control regulations, there are certain restrictions on non-
residents to acquire, hold and dispose of immovable property in India, non-resident
entities cannot be parties to credit derivative transactions in the domestic market for the
present.
Contd...

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