08 – Managing Credit Risk—An Overview – Management of Banking and Financial Services, 2nd Edition

CHAPTER EIGHT

Managing Credit Risk—An Overview

CHAPTER STRUCTURE
KEY TAKEAWAYS FROM THE CHAPTER
  • Understand the concept of credit risk

  • Know how credit risk arises

  • Learn about credit risk mitigation techniques, such as securitization and credit derivatives

  • Understand the Basel Committee's role

  • Gain knowledge about the prudential norms for asset classification, income recognition and provisioning

SECTION I
BASIC CONCEPTS

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

Two types of losses are possible in respect of any borrower or borrower class—expected losses (EL) and unexpected losses (UL). EL can be budgeted for, and provisions held to offset their adverse effects on the bank's balance sheet. EL could arise from the risks in the industry in which the borrower operates, the business risks associated with the borrower firm, its track record of payments and future potential to generate cash flows. UL, being unpredictable, have to be cushioned by holding adequate capital. In this chapter, we will concentrate on the process by which banks identify and provide for EL.1

Banks can utilize the structure of the borrowers’ transactions, collateral and guarantees to mitigate identified and inherent risks, but none of these can substitute for comprehensive assessment of borrowers’ repayment capacity or compensate for inadequate information or monitoring. 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.

Expected Versus 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, e.g., that based on historical performance, a bank expects around 1 per cent of its loans to default every year, with an average recovery rate of 50 per cent. In that case, the bank's EL for a credit portfolio of Rs. 1,000 crores is Rs. 5 crores (i.e., 1,000 crores × 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).2
  • The amount owed by the counterparty at the moment of default (exposure at default or EAD).
  • The fraction of the exposure and net of any recoveries, which will be lost following a default event (loss given default or LGD).3

Since PD is normally specified on a 1 year basis, the product of these three factors is the 1 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 pricing4 and provisions. Credit risk, in fact, emerges from adverse variations in the actual loss levels, which give rise to the so-called UL. As described in a later chapter, the need for bank capital arises from the need to cushion against UL or loss volatility. Statistically, UL is simply the standard deviation of EL as shown in Figure 8.1.5

 

FIGURE 8.1 EXPECTED AND UNEXPECTED LOSSES

 

Source: World Bank Working Paper.

Defining Credit Risk6

Credit risk is most simply defined as the probability that a bank borrower or counterparty 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 bank's risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters.

It follows that a bank needs to manage the following:

  • The risk in individual credits or transactions (discussed extensively in the foregoing chapters).
  • The credit risk inherent in the entire portfolio.
  • The relationships between credit risk and other risks.

The elements of credit risk can, therefore, be grouped in the following manner7 (see Figure 8.2).

 

FIGURE 8.2 ELEMENTS OF CREDIT RISK

 

We will discuss these aspects in the ensuing paragraphs and the next chapter.

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 downside 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 bank's earnings take a direct hit—the bank suffers along with the borrower. The bank could price ‘risky’ borrowers higher to compensate for the risk of failure.8 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 majeure reason, it drags the bank's fortunes 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 maximise the return on the loan portfolio of the bank. Such a task is too daunting for 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 Other 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 throughout 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.9

The Basel Committee's Principles of Credit Risk Management10

Annexure 1 presents a summary of the sound practices set out by the Basel Committee to specifically address the following areas: (a) establishing an appropriate credit risk environment, (b) operating under a sound credit granting process, (c) maintaining an appropriate credit administration, measurement and monitoring process and (d) ensuring adequate controls over credit 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 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.

Classifying ‘Impaired’ Loans International accounting practices set forth standards for estimating the 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 (interest and principal) due in line with the terms of the loan agreement. Such assets are also called ‘criticized’ 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 credits 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 jeopardize 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 a sub-standard asset and, additionally, recovery of the debt in full is quite remote. Auditors may insist on a write down of the asset 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.
  • 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.

Loan Workouts and Going to Court for Recovery

The workout function has been discussed in detail in the previous chapter. 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.11

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) financing 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 receivables backed credit, factoring and loans against equipment or inventory. The DIP loan is repaid from the following sources:

  • cash flows from operations,
  • liquidation of the collateral,
  • the firm turns viable and the new lender refinances the DIP loan and
  • the DIP loan is taken over by a new DIP lender.

Credit Risk Models

Ever since Markowitz developed his pioneering Portfolio Analysis Model in 1950, quantitative models 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 portfolio's returns while reining in risk within acceptable levels.12 This maximization involves balancing of risks and returns within a portfolio, asset by asset and group of assets by group of assets.13

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. If the borrower risk has been misjudged, the loan would not be priced appropriately, implying further erosion in the bank's 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 ‘risk’ cannot be wished away, insured away, hedged away or 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 they eliminate risks altogether. How can lenders diversify their risk? By avoiding ‘concentration’ of credit.

The Basel Committee14 has identified ‘credit concentrations’ as the single most important cause of major credit problems. Credit concentrations are viewed as any exposure where the potential losses are large relative to the bank's capital, its total assets or where adequate measures exist and the bank's overall risk level. Concentrations of credit and, hence, risk can occur when the bank's portfolio contains a high level of direct or indirect credit to (a) a single borrower, (b) a group of associated borrowers, (c) a specific industry or economic activity, (d) a geographic region, (e) a specific country or a group of inter-related countries, (f) a type of credit facility or (g) a specific type of security. Sometimes, concentrations can also arise from credits with similar maturities or from inter-linkages within the portfolio.

Relatively large losses15 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.16

  • Conventional credit concentrations would include concentrations of credits to single borrowers or counter-parties, a group of connected counterparties and sectors or industries, such as commercial real estate and oil and gas.
  • Concentrations based on common or co-related risk factors reflect subtler or more situation-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 portfolios? The Basel Committee cites the following reasons:17 ‘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 and 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 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 some issues are still not tackled by the models in respect of bank lending such as predicting macro-economic cycles and industry shocks (systematic or exogenous default risk) and hedging strategies.

SECTION II
MEASURING CREDIT RISK—INTRODUCTION TO SOME POPULAR CREDIT RISK MODELS

A Basic Model

A simple method of estimating credit risk is to assess the impact of non-performing asset (NPA) write offs on the bank's profits. This can be achieved through dividing the ‘profit before taxes’ (PBT) by the NPAs. Here, PBT is more relevant since losses written off typically enjoy tax shields.

Another method of presenting this concept is to work from the net income of the bank and treat both the net income and the NPAs as a proportion of average total assets of the bank.

Accordingly, this simple measure of credit risk can be presented in the following forms:

  1. PBT/TA
    -------------
    NPA/TA
    or
  2. (PAT/[1—t])/TA
    -------------
    NPA/TA
    or simply,
  3. NPA/TA

Interpretation of the result

If the above measure yields a result of say, 0.7, it simply means that if 70 per cent of the NPAs turn into ‘loss assets’ and are written off, the bank's PBT would be eroded completely. For this reason, the resultant proportion is also called the ‘margin of safety’.

TEASE THE CONCEPT

Which is safer for the bank—the above measure being lower or higher?

Modeling Credit Risk

Financial institutions have traditionally attempted to minimize the incidence of credit risk primarily through a loan-by-loan analysis. The foundations of a more analytical framework began in the early 1960s when the first ‘credit scoring’ models were built to assist credit decisions for consumer loans. The lending institutions initially classified debtors/counterparties on default potential based only on an ordinal ranking. By the mid-1980s, particularly with the introduction of RAROC as a performance measure, many financial institutions began calibrating each credit score to a particular PD18 to estimate expected losses (EL) and ultimately economic capital.

Techniques to calculate PD can be divided into two broad categories.

  1. Empirical: These models use historical default rates associated with each ‘score’ to identify the characteristics of defaulting counterparties. Traditionally, such models used discriminant analysis (such as Z scores), but more recently logit or probit regressions are being used to define the score ‘S’19
  2. Market-based (also known as structural or reduced-form) models: These models use counterparty market data (e.g., bond or credit default swap (CDS) spreads and volatility of equity market value) to infer the likelihood of default.

Several commercial credit value-at-risk models have been developed in the last 10–15 years (e.g., Credit Metrics, KMV and CreditRisk+) that use credit risk inputs (credit data, market data, obligor data and issue/ facility data) to derive a loss distribution, by assuming that correlations across borrowers arise due to common dependence on a set of ‘systematic risk factors’ (typically, variables representing the state of the economy). Sophisticated banks generally use these models for active portfolio-level credit management (particularly, for large corporate loans) by identifying risk concentrations and opportunities for diversification through debt instruments and credit derivatives.

Table 8.1 classifies popular models according to the approach adopted by them.

 

TABLE 8.120 INDUSTRY-SPONSORED CREDIT VALUE-AT-RISK (VaR) MODELS

Approach Sponsor Model
Credit migration approach J P Morgan Credit Metrics
  Mc Kinsey CreditPortfolio
Option pricing approach KMV Corporation KMV (Kealhofer/ McQuown/ Vasicek
Actuarial approach CSFB (Credit Suisse first Boston Credit Risk+
Reduced form approach   Jarrow/Turnbull
    Duffie/Singleton

 

Table 8.2 compares these approaches on various parameters.

 

TABLE 8.221 COMPARISON OF CREDIT RISK MODELS ON VARIOUS PARAMETERS

 

Source: BIS Working Paper, 2005

 

In addition, several academic models have been developed, which can be categorized into two. The models in the first category adopt an exogenous default-trigger value of assets. In contrast, the models in the second category derive the decision to default endogenously, as part of the borrower's internal problems and are, therefore, a function of borrower characteristics22.

A description of the approaches to credit risk measurement and the popular models can be found in the next chapter.

SECTION III
CREDIT RISK TRANSFERS—LOAN SALES 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 minimises risk through diversification.

Some prominent forms of loan sales include the following.

  • Syndication: We have seen this as a form of credit in Chapter 5. 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 crores for a large project. If Bank X is nominated as the lead bank for the syndication, X will negotiate the documents with the borrower and solicit a group of banks 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 the Rs. 10,000 crores loan. Post novation, Bank X would hold, say, Rs. 2,000 crores of credit exposure to the borrower and the three buyer banks, say A, B and C, would hold the remaining Rs. 8,000 crores share among themselves in a mutually agreed proportion. Unlike syndication, A, B and C would enter into separate loan agreements with the borrower.
  • Participation: In this case, Bank X transfers to other participating banks A, B and 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, guarantees, collaterals, interest rate, fees and other covenants).
  • Securitization: This is one of the most popular and prominent forms of loan sale. The critical factor is finding a homogeneous pool of loan assets that generate a predictable stream of future cash flows.

Simply stated, securitization involves the transfer of assets and other credit exposures from the ‘originator’ (the bank) through pooling and re-packaging 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 securitization’ happens where 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 SPE or SPV that structures these assets into a homogeneous asset pool. The SPE retains the loan as collateral, sells the pool to investors and pays the bank for the loans bought from it with the proceeds from the sale of securities.

At the end of the tenure of the securitization, the residual assets are passed on to the investors. If the asset quality deteriorates, the investors have to bear the loss. The investors receive variable coupon payments depending upon the risk they decide to bear. 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.

Figure 8.3 depicts a typical securitization process.

Securitization can be seen as the method of turning un-tradable and illiquid assets into various types of securities, which can then be sold to different investors with different risk appetites. These different types of securities with different inherent risks are known as the ‘tranches’. Technically, securitization is defined as a transaction involving one or more underlying credit exposures from which tranches that reflect different degrees of credit risk are created. Credit exposures may include loans, commitments and receivables. It may take the form of a security or of an unfunded credit derivative (to be explained later). The payments to investors depend upon the performance of specified underlying credit exposures. The salient features of securitization are outlined in Annexure II of this chapter.

 

FIGURE 8.3 A TYPICAL SECURITIZATION PROCESS

Source: RBI Guidelines on Securitization.

 

The securities sold to investors are called ‘asset-backed securities’ (ABS), since they are backed by the homogeneous pool of underlying assets. Originators of ABS usually want to sell loans ‘without recourse’.23 Hence, investors usually safeguard their interests through three mechanisms—(a) overcollateralization, (b) senior/ subordinated structures and (3) credit enhancement.

  • ‘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 interest on the securities.
  • In the ‘senior/subordinated structures’, 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 holders. 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 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 spin offs include a possible lowering of interest rate risk and profitability enhancement through better asset turnover and fee-based income.

Box 8.1 provides an overview of collateralized debt obligations (CDOs) and compares them with securitization.

BOX 8.1 WHAT ARE CDOS/CBOS/CLOS?

These are the fastest growing segment 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 NPAs or under-performing assets.

Where the originating bank transfers a pool of loans, the bonds that emerge are called ‘collateralised loan obligations’ (CLOs). Where the bank transfers a portfolio of bonds and securitizes the same, the resulting securitized bonds are termed ‘collateralised bond obligations’ (CBOs). A generic name given to both these is ‘CDOs’. Some banks even securitize 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 form and issuing CBO/CLO at the instance of banks, differ in respect of the following.

  • For typical 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 securitizations of, say, mortgage 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 structures use a tranched and multi-layered structure with a substantial amount of residual interest retained by the originator.
  • Generally, CDO issues will use a reinvestment period and an amortization period. Some tranches might have a ‘soft bullet’ repayment (a bullet repayment that is not guaranteed by any third party).
  • Arbitraging is a common practice in the CDO market, where larger banks buy out loans from smaller ones and securitize them, earning arbitrage revenues in the process. There 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 rates. Since the motive of such securitizations is arbitraging, such CDOs are called arbitrage CLOs/CBOs. To distinguish these from the ones where a bank securitizes its own receivables, the latter are sometimes referred to as ‘balance sheet CLOs/CBOs’.

Yet another upcoming variety of CLOs is ‘synthetic CLOs’. Here the originating bank merely securitizes the credit risk24 and retains the loans on its balance sheet. Synthetic CLOs repackage the underlying loans into cash flows that suit the needs of the investors and are not dependant on the repayment structure of the underlying loans.

To summarize, 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’ loans or bonds or asset-backed securities from the market, pools and securitizes 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 profits 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 loans into the pool on a regular basis without having to do complex documentation for every transfer. In view of the varied repayment structure of commercial loans, cash flow CDOs typically repay through bullet repayments and, hence, have a reinvestment period, during which the cash flows from repayments are reinvested.

However, a synthetic CDO primarily acquires ‘synthetic’ assets by selling ‘protection’25 rather than buying assets for cash. Hence, the funding requirement for a synthetic CDO is much lower than that for a cash flow CDO. The amount of cash raised is limited only to the extent of expected and unexpected losses (EL and UL) 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 in Figure 8.4. Clearly, the three different ‘tranches’ have different risk characteristics.

 

FIGURE 8.4 TYPICAL STRUCTURE OF A SYNTHETIC CDO

 

Source: RBI, 2003, ‘Draft Guidelines for Introduction of Credit Derivatives in India’, Figure 6 (26 March 2003): 11.

 

TEASE THE CONCEPT

Why would banks be tempted to sell only their best assets under the securitisation process?

Let us now sum up the alternatives discussed so far in respect of a bank that has to deal with credit risk in its loan portfolio.

  1. It can continue to hold the loans, assess the EL periodically, take preventive or remedial measures to reduce the risk of loss or make a provision on the EL and allocate capital for UL.
  2. It can diversify its loan portfolio with several small loans to different counterparties, so that a few expected defaults may not lead to earnings volatility.
  3. It can negotiate a loan sale for the whole or part of the loan amount and incur the costs associated with the loan sale.

In resorting to the first alternative—(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 bank's operations, 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, banks look to sell off or securitize the loans as in the alternative (c) and this approach is seen to work well for standardized payment schedules and homogeneous credit risk characteristics. Commercial and industrial loans exhibit varied credit risk characteristics and can be sold or securitized through the CDO route as described above. In many cases, the banks themselves may not want the loans or more specifically, the ‘borrowers’ off their balance sheets and may merely want to hedge against the credit risk inherent in the loan transaction.

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 specialized way to insure against credit-related losses.

Credit derivatives are an effective means of protecting against credit risk. They come 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 borrower default, credit rating downgrades or a structural change in a security containing credit risk.

There are different types of credit derivatives, but we will take a brief look in this section at the commonly used derivatives. Some analysts classify credit derivatives into two categories in terms of how they are valued or priced, namely ‘replication’ products and ‘default’ products. Replication products, as the name suggests, replicate the money market transactions, such as credit spread options, while default products, such as credit default swaps (CDS) are priced on the basis of the PD of the asset whose risk is being transferred, the exposure at risk and the expected recovery rate. Another common classification is on the basis of performance—‘protection like’ products (e.g., credit default options and CDS) and ‘exchange like’ products (e.g., total return swaps).

In credit derivatives, there is a party (or a 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, the 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 and 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 buyer generally pays a periodic premium. However, the credit derivative may be funded in some cases. For example, the protection buyer may require the protection seller to pre-pay the entire notional value of the contract upfront (as in the case of a ‘credit-linked note’ (CLN) discussed later in this section).

As is typical of derivatives, a credit derivative 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 may 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 the actual losses suffered by the protection buyer.

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 par 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.

Box 8.2 provides an insight into the evolution of credit derivatives.

BOX 8.2 EVOLUTION OF CREDIT DERIVATIVES26

In March 1993, Global Finance carried a feature on J. P. Morgan, Merrill Lynch and Bankers Trust, which were already then marketing some form of credit derivatives. This article also prophesied, quite rightly, that credit derivatives could, within a few years, rival the USD 40 trillion market for interest rate swaps.

In November 1993, Investment Dealers Digest carried an article titled ‘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 ever 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 commentator quoted in the article said: ‘It (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 were already happening. The article was optimistic: ‘The potential change the risk profile of their loan books, for investment banks managing huge bond and derivatives portfolios, for manufacturing companies over-exposed to a single customer, for equity investors in project finance deals with unacceptable sovereign risk of credit derivatives is immense. There are hundreds of possible applications: for commercial banks which want to, for institutional investors that have unusual risk appetites (or just want to speculate) and even for employees worried about the safety of their deferred remuneration. The potential uses are so widespread that some market participants argue 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:

  • 1992: Credit derivatives emerge. ISDA 27 first uses the term ‘credit derivatives’ to describe a new exotic type of over-the-counter contract.
  • 1993: KMV 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 Westminster Bank.
  • April 1997: J P Morgan launches Credit Metrics.
  • October 1997: Credit Suisse launches CreditRisk+
  • December 1997: The first synthetic securitization, JP Morgan's BISTRO deal.
  • July 1999: Credit derivative definitions 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 derivative permits the bank to allocate this risk to another party. The bank also effectively creates a2-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.
  • Loan sales call for substantial information sharing among participants and the bank is likely to incur higher administrative costs and more obligations.

The popular credit risk transfer instruments can be summarized in Figure 8.5.

 

FIGURE 8.5 CATEGORIZATION OF CREDIT RISK TRANSFER INSTRUMENTS

 

Note: @ ‘Pure’ credit derivatives are those whose prices can be used to price other credit risk bearing instruments. The next chapter outlines the basic methodologies for pricing credit derivatives.

Some Basic Credit Derivative Structures

There are many kinds of credit derivatives and to enumerate and describe them would be beyond the scope of this book. Further, most credit derivatives, like other derivatives, can be ‘structured’ to meet the specific requirements of the protection buyers and sellers.

However, we briefly describe some popular types of credit derivatives as follows:

  1. Loan portfolio swap28: 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 derivative 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’.
    • In terms of the 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 London Inter Bank Offered Rate (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 derivative matures or on the happening 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.

    To sum up, the protection buyer makes payments based on the total returns from the reference asset—the loan to XYZ—as seen in Figure 8.6.

     

    FIGURE 8.6 TOTAL RETURN SWAP

     

    The total returns include contractual payments on the loan plus appreciation of the loan value. In return, the protection seller makes regular contracted payments, fixed or floating, which include a spread over funding costs plus the depreciation value (the ‘protection’). Both parties make payments based on the same notional amount. The protection seller gets the 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 (which can occur even where there is no default).

    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 features of this type 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.
  3. Credit default swap (CDS): The CDS provides protection against specific credit-related events and, hence, bears 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 in our earlier example) pays the protection seller (Bank B) only a fixed periodic amount over the life of the agreement.

    Figure 8.7 illustrates the mechanics of a CDS. The following chapter provides an overview of the mechanics of pricing and trading in the CDS.

    The steps in which a basic 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.

       

      FIGURE 8.7 BASIC CREDIT DEFAULT SWAP

       

      Source: The J P Morgan Guide to Credit Derivatives, 13.

       

    • 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.29

    To lower the cost of protection in a 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. Consider this 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 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 for 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.

    The other settlement method is for the protection buyer to make physical delivery of a portfolio of specified deliverable obligations in return for payment of their face amount. Deliverable obligations may be the reference obligation or one of a broad class of obligations meeting certain specifications, such as any senior unsecured claim against the reference entity.

  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 on entering into a swap contract with each other. Both of them do not have much market 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 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 the protection provided. The protection buyer will only incur default losses if the swap counterparty and the protection seller fail. This 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 the 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 debt30 in the market. Let us assume that interest rates move consistently with the market. That is, a 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 the 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 a credit-risky instrument (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.31 Credit options 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:

    • 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 collect current 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 deteriorating 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 locking in future borrowing costs without impacting their balance sheets. Prior to the 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 unutilized 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.32 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 a note called ‘CLN’. The CLN is largely similar to any other bond or note. The simplest form of a CLN is represented by a standard note with an embedded CDS. These are typically issued by a trust or SPE. The steps in issuing CLNs are as follows:
    • The bank seeking to issue CLNs (Bank A) sets up an SPE, in the form of a ‘trust’. The CLNs are intended 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 CLN 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.
    • Bank A invests the funds 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 firm XYZ 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 borrower 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.

      CLNs are used in several ways in practice. Four typical situations33 are presented as follows:

    1. Bank A has credit exposure to a firm S in a specific industry/sector. Institution C, an institutional investor, cannot, by policy or regulation, gain direct exposure to the industry that S is in, but is interested in reaping the benefits of such exposure. C therefore enters into a CLN contract with Bank A, by which A sells a note to C with underlying exposure equal to the face value of the reference asset S. In return, A receives from C, at the beginning of the contract, the face value of S in cash. In compensation, A pays to C a predetermined interest and some credit risk premium. In case of a credit event experienced by S during the contract period, A pays C the recovery proceeds of S. If the recovery value of S is less than what C paid for the asset, C suffers a loss. In case there is no credit event during the contract period, Bank A pays back to institution C the entire principal.
    2. The situation above is also applicable to any investor who wants to sell protection to Bank A through a CDS, but is unable to or does not want to access the credit derivatives market.
    3. Another common way to use a CLN is in buying protection. Bank A in the example above, the originator of the reference asset S, could buy protection from Bank B through a CLN, where A gets the value of the reference asset upfront (and pays interest and premium to the protection seller B). In a second case, Bank B could have sold protection through a CDS to A. Bank B now wants to guard itself against counterparty risk, hence initiates a CLN contract with institution C or another Bank D. If the reference asset defaults, Bank A gets compensated as in example (a) above and Bank B makes the contingent payment on the default swap, which has already been compensated by the CLN. Thus, the CLN functions like insurance in both cases.
    4. Special purpose entities (SPEs) or trusts set up in the context of the CLN (as shown in Figure 8.8) are prevalently used in the case of synthetic CDOs (to be discussed in the next chapter).
  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 investor sells 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 exposure. If necessary, the structure can include an interest rate or foreign exchange swap to create cash flows required by 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. Figure 8.9 shows the structure of a simple CLD.

     

    FIGURE 8.8 THE STRUCTURE OF A CLN

     

    Source: The J P Morgan Guide to Credit Derivatives, 25.

     

  10. Repackaged notes: Repackaging involves placing securities and derivatives in a SPV which then issues customised notes that are backed by the instruments placed. The difference between repackaged notes and CLDs 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 (Figure 8.10).

     

    FIGURE 8.9 STRUCTURE OF A CLD

     

    Source: RBI, ‘Draft Guidelines for Introduction of Credit Derivatives in India’, Figure 4 (26 March 2003): 9.

     

    FIGURE 8.10 TRANSACTIONS UNDER A REPACKAGED NOTE

     

    Source: RBI, ‘Draft Guidelines for Introduction of Credit Derivatives in India’, Figure 5 (26 March 2003): 10.

     

  11. Basket default swap: A credit derivative may be with reference to a single reference asset or a portfolio of reference assets. 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 of 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 assets, 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 assets 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. Box 8.3 sets out the operational requirements for credit derivatives as envisaged by the Basel Committee on Banking Supervision.34

BOX 8.3 OPERATIONAL REQUIREMENTS FOR CREDIT DERIVATIVES

In order for protection from a credit derivative to be recognized, 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 dates and
    • a change in the ranking in the priority of payment of any obligation, causing the subordination of such obligation.
  • Contracts allowing for cash settlement are recognized 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-event valuations of the reference asset, typically not more than 30 days.
  • The credit protection must be legally enforceable in all relevant jurisdictions
  • Default events must be triggered by any material event, 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 identity 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.
  • Where there is an asset mismatch35 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 pari passu or more junior than the underlying asset and legally effective cross-reference clauses (e.g., cross-default or cross-acceleration clauses) must apply.
  • Where 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 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 recognized.
  • CLN issued by the bank will be treated as cash collateralized transactions.
  • Credit protection given by the following will be recognized.
    • Sovereign entities, PSEs and banks with a lower risk weight than the obligor.
    • Corporates (including insurance companies) including parental guarantees rated A or better.

Source: www.bis.org.

SECTION IV
TREATMENT OF CREDIT RISK IN INDIA—SOME IMPORTANT EXPOSURE NORMS, PRUDENTIAL NORMS FOR ASSET CLASSIFICATION, INCOME RECOGNITION AND PROVISIONING

Some Important Exposure Norms36

In the earlier section, we have learnt that central banks try to limit credit risk concentration in their banking system by limiting exposure to certain sectors or activities.

Exposure is defined as including credit exposure (funded and non-funded credit limits) and investment exposure (including underwriting and similar commitments) as well as certain types of investments in companies. Exposure is taken to be the higher of sanctioned limits or outstanding advances. Further, in line with international best practices, effective 1 April 2003, non-fund based exposures are included at 100 per cent 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.37

Credit exposure comprises of the following:

  • All types of funded and non-funded credit limits.
  • Facilities extended by way of equipment leasing, hire purchase finance and factoring services. Under ‘credit exposure’, detailed guidelines are issued for industry/sector exposures, capital markets, financing equity and investment in shares including Initial Public Offerings and various other activities.

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 Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, provides, among others, sale of financial assets by banks/FIs to securitization companies (SCs)/reconstruction companies (RCs). Banks'/FIs’ investments in debentures/bonds/security receipts/pass-through certificates (PTCs) issued by a securitization company (SC)/reconstruction company (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'/FIs’ 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 view of the extraordinary nature of event, banks/FIs will be allowed, in the initial years, to exceed prudential exposure ceiling on a case-to-case basis.
  • Investments made in bonds/debentures of companies guaranteed by public financial institutions as given in the cited circular.

The concept of ‘group’ and the identification of borrowers belonging to a specific ‘group’ are to be based on the perception of the bank. The guiding principles should however be commonality of management and effective control. The RBI has specifically warned banks against splits in ‘groups’ being engineered to circumvent the exposure norms.

The salient features of the ‘exposure norms’ proposed by the RBI are given as follows:

  • The exposure ceiling limits applicable from 1 April 2002, computed based on the capital funds in India38 would be 15 per cent of capital funds (tier 1 + tier 2) in case of single borrower and 40 per cent in the case of a borrower group. However, in case of specified oil companies, the exposure limit to a single borrower can be 25 per cent of capital funds.
  • Credit exposure to a borrower group can exceed the exposure norm of 40 per cent of the bank's capital funds by an additional 10 per cent (up to 50 per cent), if the additional credit exposure is to infrastructure projects. Similarly, exposure to a single borrower may exceed the norm of 15 per cent by 5 per cent (up to 20 per cent) if the additional credit exposure is to the infrastructure sector.39
  • In addition to the above exposures, banks may enhance exposure to a borrower up to a further 5 per cent 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’.
  • Exemptions 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 in the cited circular, which can be accessed at www.rbi.org.in.

Prudential Norms for Asset Classification, Income Recognition and Provisioning40

To correspond with the classification of loans discussed in Section I, RBI instructs all banks in India to classify assets under certain categories. ‘Non-performing’ assets (NPAs) are the broad equivalent of ‘impaired’ assets discussed in Section The RBI has provided detailed guidelines for asset classification, the salient features of which are presented below.

What are NPAs? An asset, including a leased asset, becomes non-performing when it ceases to generate income for the bank. An NPA is a loan or an advance where

  • Interest and/or installment of principal remain ‘overdue’41 for a period of more than 90 days in respect of a term loan.
  • The account remains ‘out of order’42 in respect of an overdraft/cash credit (OD/CC).
  • The bill remains overdue 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 two crop seasons.
  • A loan granted for long duration crops will be treated as NPA, if the installment of principal or interest thereon remains overdue for one crop season.
  • The amount of liquidity facility43 remains outstanding for more than 90 days, in respect of a securitization transaction (undertaken in terms of guidelines on securitisation dated 1 February 2006.)
  • Derivative contracts, whose overdue receivables represent positive mark to market value, remaining unpaid for 90 days from the due date for payment.

Banks should, classify an account as NPA only if the interest charged during any quarter is not serviced fully within 90 days from the end of the quarter.

Income Recognition

Income Recognition—Policy The policy for income 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 recognized on accrual basis but is booked as income only when it is actually received. Therefore, banks should not charge and take to income account interest on any NPA.44

Reversal of Income If any advance, including bills purchased and discounted becomes an ‘NPA’ as at close of any year, the unrealized 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 unrealized finance charge component of finance income45 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 realized 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.

Asset Classification

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 remained non-performing and (b) the realizability of the dues.

  1. Sub-standard assets
  2. Doubtful assets
  3. 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 of the borrower/guarantor or the current market value of the security charged is not enough to ensure recovery of the dues to the banks in full and the asset has well-defined credit weaknesses that jeopardize the liquidation of the debt and are characterized by the distinct possibility that the banks 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 a period of 12 months.

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

Loss assets: A loss asset is one which is considered uncollectible and of such little value that its 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 or internal or external auditors or the RBI inspection, but the amount would not have been written off wholly.

Treatment of some special situations is outlined in Box 8.4.

BOX 8.4 HOW DO WE TREAT THE FOLLOWING UNDER THE ASSET CLASSIFICATION NORMS?

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 drawings over the limit. When should banks classify accounts exhibiting these characteristics as NPAs?

  • When the outstanding in the account is based on stock statements more than 3 months old.
  • If such irregular drawings 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 hoc 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’46 category.

Accounts regularized near about the balance sheet date

Where a solitary or a few credits are recorded just before the balance sheet date in a borrowal account and the account exhibits inherent credit weaknesses based on the current available data, 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 is to be treated as NPA, the entire borrowing account has to be classified as 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 asset classification 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 is 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 straightaway classified under doubtful category and provisioning should be made as applicable to doubtful assets.
  • If the realizable value of the security, as assessed by the bank/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 asset. It may be either written off or fully provided for by the bank.

Advances against term deposits, National Savings Certificates (NSCs), Kisan Vikas Patra (KVP)/Indira Vikas Patra (IVP)

Advances against term deposits, NSCs eligible for surrender; IVPs, KVPs and life policies need not be treated as NPAs. However, advances against gold ornaments, government 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, interest becomes ‘due’ only after completion of the moratorium or gestation period. Therefore, such interest does not become overdue and hence is not termed an NPA during the moratorium period. However, the advance becomes overdue if interest remains uncollected after the specified due date.
  • In the case of housing loan or similar advances granted to staff members 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.

Agricultural 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 seasons.
  • A loan granted for long duration crops (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 one crop season (period up to harvesting of the crop).
  • Where natural calamities impair the repaying capacity of agricultural borrowers, banks may decide on appropriate relief measures—conversion of the short-term production loan into 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 repudiates its guarantee when invoked. However, in respect of state government guaranteed exposures, with effect from the year ending 31 March 2006, state government-guaranteed advances and investments in state government guaranteed securities would attract asset classification and provisioning norms if interest and/or principal or any other amount due to the bank remains overdue for more than 90 days.

 

Source: RBI ‘Master Circular—Prudential Norms on Income Recognition, Asset Classification and Provisioning Pertaining to Advances’ (1 July 2009). More details can be found in this Master Circular, which can be accessed at www.rbi.org.in.

Provisioning Norms

Adequate provisions have to be made for impaired loans or ‘NPA’, classified as given in the foregoing paragraphs. Taking into account the time lag between an account becoming doubtful of 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 per cent provided for.

Doubtful Assets

  • Provision of 100 per cent to the extent the advance is not covered by the realizable value of the security (to which the bank has a valid recourse).
  • That portion of the advances covered by realizable value of the security will be provided for at rates ranging from 20 per cent to 100 per cent on the following basis:
Period for which the advance has Provision requirement (per cent) (for the secured portion)
Up to 1 year
20
1 to 3 years
30
More than 3 years
100

Sub-Standard Assets A general provision of 10 per cent on total outstanding should be made (without making any allowance for ECGC guarantee cover and securities available). The ‘unsecured exposures’47 identified as ‘sub-standard’ would attract additional provision of 10 per cent thus constituting 20 per cent on the outstanding balance. Even where ‘intangible securities’, such as rights, licences or authorizations are charged to banks as collateral for projects (including infrastructure projects), the advances will be treated as ‘unsecured’.

Standard Assets Under the existing norms, banks should make a general provision of a minimum of 0.40 per cent—1 per cent on standard assets on global loan portfolio basis. Within this framework, standard assets in specific sectors would attract lower or higher provisions. For example, provisions on loans to agriculture and SME sectors would be at 0.25 per cent. (For more details, the RBI's ongoing instructions in this regard would be a good source. It may be noted that by revising the standard asset provisioning upward or downward, RBI, in effect, signals to banks on the risk involved in financing the relevant sectors). However, these provisions need not be 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 Provisions48 Internal policies approved by the Banks’ Board would determine the level of floating provisions. Such provisions will have to be separately held for ‘advances’ and ‘investments’ and would be used only under ‘extraordinary circumstances’, as dictated in the policy and after approval from RBI.

The guidelines for provisions under special circumstances such as (a) provisions on leased assets, (b) provisions on advances under rehabilitation, (c) provisions on advances against bank term deposits, NSCs eligible for surrender, IVPs, KVPs and Life policies, as well as advances against gold ornaments, government and all other securities, (d) take out finance, (e) reserve for exchange rate fluctuation account (RERFA), (f) provision for country risk and (g) provisioning for sale of financial asset to SC/RC are provided in the quoted RBI circular, point 5.9.

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

Illustration 8.1 demonstrates the impact of provisioning and write-off on banks’ profits.

ILLUSTRATION 8.1

Profit before provisions for Bank Y is Rs. 500 crores. If the tax rate is 30 per cent, 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 crores for NPAs.
  • Provide Rs. 200 crores for NPAs and write-off the remaining Rs. 50 crores.

Option 1. Provide Rs. 250 crores for NPAs.

Profit before provision

Rs. 500 crores

Less provision for NPAs

Rs. 250 crores

PBT

Rs. 250 crores

Less tax at 30 per cent

Rs. 150. crores (since provision for NPAs is not tax deductible, tax calculated at 30 per cent of Rs. 500 crores.)

 

*NBV = Book value LESS provisions held

Profit after tax                                    Rs. 100 crores

Option 2: Provide Rs. 200 crores for NPAs and write off Rs. 50 crores.

Profit before provision

Rs. 500 crores

Less provision for NPAs

Rs. 200 crores

Less write-off

Rs. 50 crores

PBT

Rs. 250 crores

Less tax @ 30 per cent

Rs. 135 crores (since write-offs are tax deductible, tax to be calculated on PBT + provisions= Rs. 450 crores)

Profit after tax                                    Rs. 115 crores

Interpretation

Option 2 yields more profits after tax and hence would augment the capital base more than Option 1.

Calculation of NPA levels for reporting to RBI—see Box 8.5

BOX 8.5 CALCULATING THE LEVEL OF NPA49
  1. Gross advances*

  2. Gross NPAs*

  3. Total deductions (i + ii + iii + iv)

    1. Balance in interest suspense account
    2. DICGC/ECGC claims received and held pending adjustment
    3. Part payment received and kept in suspense account
    4. Total provisions held**
  4. Net advances (1–3)

  5. Net NPAs (2–3)

*excluding technical write off.50

** excluding amount of technical write off and provision on standard assets

Note: For the purpose of this statement, ‘gross advances’ mean all outstanding loans and advances including advances for which refinance has been received but excluding rediscounted bills and advances written off at head office level (technical write off).

SECTION V
TREATMENT OF CREDIT RISK IN INDIA—SECURITIZATION AND CREDIT DERIVATIVES

Securitization—The Act

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 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 as follows:

  • Incorporation of SPVs, namely, securitization company and reconstruction company.
  • Securitization of financial assets.
  • Funding of securitization.
  • Asset reconstruction.
  • Enforcing security interest, i.e., taking over the assets given as security for the loan.
  • Establishment of a central registry for regulating and registering securitisation transactions: One objective of the Securitization Act is to provide for the enforcement of security interest, that is, 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.
  • Offences and penalties.
  • Boiler-plate provisions.
  • Dilution of provisions of the SICA.51
  • Banks can sell the following financial assets to the securitization company.
    • An NPA, including a non-performing bond/debenture.
    • A ‘Standard Asset’52 where
      1. the asset is under consortium/multiple banking arrangements
      2. at least 75 per cent by value of the asset is classified as NPA in the books of other banks/FIs and
      3. at least 75 per cent (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/RC53 from any bank/FI on mutually agreed terms and conditions. The salient features of the Act relevant to banks and those relating to securitization and reconstruction companies are described in various notifications of the RBI.54

Securitization—The Indian Experience

Securitisation is not new to India. It has been used since 1992. In the early years, originators directly sold consumer loan pools to buyers and also acted as servicers to collect the periodic loan and interest payments. The late 1990s saw the emergence of liquid and transferable securities backed by the pool receivables—Pass Through Certification (PTCs as they are commonly known).

The Indian securitization market is dominated by the following asset classes:

  1. ABS such as auto loans, two-wheeler loans, commercial vehicle loans, construction equipment loans and personal loans,
  2. Residential mortgage-backed securities (RMBS) and
  3. single loan CLO and loan sell offs (LSO).

It is noteworthy that there has been no default in any of the transactions.

In India, issuers have typically been private sector banks, foreign banks and non-banking financial companies with the underlying assets being mostly retail and corporate loans. Public sector banks are yet to enter securitization in a big way.

The Indian securitization market exhibits some unique characteristics, a few of which are listed as follows:

  1. Credit enhancements to senior notes are usually provided through a cash reserve or guarantee by a highly rated institution.
  2. Most investments in securitized instruments are held till maturity.
  3. PTCs are not tradable securities. Since, the secondary market for securitized instruments is almost non-existent, almost all issues are privately placed.
  4. The predominant investors in securitized instruments are mutual funds, insurance companies and some private sector banks.
  5. In many countries where a robust market for securitization exists, ratings of securitized instruments are based on timely payment of interest. However, in India ratings are based on timely payment of principal as well as interest.

Figure 8.11 traces the growth of the securitization market over the years, mentioning specific landmark deals.

 

FIGURE 8.11 TRACING SECURITIZATION GROWTH—LANDMARK DEALS

The Securitization Market in India—2008–200955

The impact of the global financial crisis was not reflected in the Indian market till the first half of 2008–2009, largely because the transactions did not involve complex derivatives or CDS. However, as Indian banks and markets faced a liquidity crunch in the second half of the year, the investor appetite for securitized paper dwindled due to concerns about credit quality of the underlying assets. Banks were also lending cautiously and, therefore, were not in a hurry to augment liquidity through securitization.

Consequently, issuance volumes fell substantially. Figure 8.12 shows the trend.

Understandably, the maximum fall in volume (68 per cent) was in the retail asset class, comprising both ABS and RMBS. Loan Sell Offs (LSO) was the largest asset class, contributing to about 68 per cent of total issuance volume during 2008–2009, up from about 50 per cent the previous year.

2008–2009 also saw the emergence of two new asset classes—securitization of loans against gold and micro-finance loan receivables.

Credit Derivatives56

Banks in India have so far not been permitted by RBI to use credit derivatives. However, RBI has been issuing draft guidelines, whereby 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 protection for the purpose of diversifying their credit risk and reducing credit concentrations and taking exposure in high quality assets.

 

FIGURE 8.12 TRENDS IN SECURITIZATION IN INDIA 2005–09

 

Source: ICRA'S estimates

 

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 that banks may hold the derivatives in their banking books and not in the trading books except in case of CLN, which can be held as investments 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 structures are in the evolutionary stage. Therefore, as and when credit derivatives are permitted, the RBI proposes to restrict banks to use simple credit derivative structures like CDS and CLN only, involving single reference entities, in the initial phase. The credit default options will be treated as CDS for regulatory purposes.

The RBI had issued revised draft guidelines in May and October 2007 for introduction of credit derivatives (more specifically, CDS), but put it on hold after adverse credit market developments in the US and other developed countries.

The next chapter discusses the global financial crisis of 2007–2008 and gives a chronology of events that led to the crisis.

CHAPTER SUMMARY
  • Two types of losses are possible in respect of any borrower or borrower class—expected and unexpected losses or EL and UL. EL can be budgeted for and provisions held to offset their adverse effects on the bank's balance sheet. UL, being unpredictable, have to be cushioned by holding adequate capital.
  • Credit risk is most 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 relationships between credit risk 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. (a) Establishing an appropriate credit risk environment, (b) operating under a sound credit granting process, (c) maintaining an appropriate credit administration, measurement and monitoring process and (d) 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 the disclosure of credit risk.
  • International accounting practices set forth standards for estimating the 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 (interest and principal) due in line with the terms of the loan agreement. Such assets are also called ‘criticized’ or ‘non-performing’ (in India) assets.
  • Assessment of credit risk for individual borrowers and for a loan portfolio is an important task, for which various models are available, ranging from simple ones to banks’ internal models to industry-sponsored models.
  • 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 and there is a counterparty (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 forms of credit derivatives include (a) loan default swaps, (b) total return swaps, (c) CDS, (d) credit risk options, (e) credit intermediation swaps, (f) dynamic credit swaps, (g) credit spread derivatives, (h) CLNs, (i) CLDs, (j) repackaged notes and (k) basket default swaps.
  • For Indian banks, the RBI has provided detailed guidelines for ‘exposure norms’ to avoid credit concentration and for asset classification, income recognition and provisioning for credit risk. Assets are classified into (a) standard, (b) sub-standard, (c) doubtful and (d) loss, and provisions are made accordingly.
TEST YOUR UNDERSTANDING
  1. How do the following help in credit risk mitigation?

    1. Loan covenants
    2. Credit scoring/risk rating system
    3. Credit risk models
  2. Why do banks move loans off their balance sheets? What are the motivations for and risks involved in off-balance sheet transactions of banks?

  3. Can each of the following types of loans be easily securitized? Give reasons.

    1. Agricultural loans
    2. Credit card loans
    3. Loans to professionals
    4. Home loans
    5. Vehicle loans
    6. Loans for capital expenditure
  4. J bank has written off some loss assets. Which of the following is true?

    1. Its total assets and total liabilities decrease by that amount.
    2. Its total liabilities and capital decrease by that amount.
    3. Its total assets, total liabilities and capital decrease by that amount.
    4. Its total assets and capital decrease by that amount.
    5. Its total liabilities and capital increase by that amount.
  5. Rank the following according to the degree of credit risk (highest credit risk = 1, lowest credit risk = 4)

    1. Advances against hypothecation of inventory and receivables
    2. Advances against pledge of inventory
    3. Advances against gold
    4. Underwriting commitments
  6. The following data relate to K Bank.

    1. Margin of safety 0.75
    2. Return on assets (ROA) 9 per cent
    3. Total assets Rs. 2,000 crores
    4. Tax rate 40 per cent

    What is the level of NPAs of K Bank?

  7. S Bank's profits before provisioning for NPAs is at Rs. 300 crores. The bank has total assets of Rs. 7,000 crores and its NPAs form 6 per cent of total assets. Which of the following actions should the bank take in that year to maximize its return to shareholders? (Assume tax rate of 40 per cent).

    1. Make a provision of 50 per cent of NPAs
    2. Write off 25 per cent of NPAs
  8. What do we mean by the term ‘securitization is non-recourse’? Who bears the risk in non-recourse lending?

  9. What is the role of the ‘SPV’ in securitization?

  10. How is ‘securitization’ of receivables different from ‘factoring’ of receivables?

  11. The following table represents the balance sheet of Bank A before securitizing some of its assets. Can you fill in the balance sheet format alongside that indicates the balance sheet position after securitization? Assume that the pool of securitized assets have been sold at par. (Rs. in crores).

     

     

  12. How is a Credit Default Swap different from an insurance contract?

TOPICS FOR FURTHER DISCUSSION
  • What factors would bankers consider before deciding to use credit derivatives? Can you evolve a checklist?
  • Why do you think SPEs are used for issuing ABS? Why do the banks, which originate these assets, not issue these securities themselves?
  • How has the ISDA standardized credit derivative transactions?
  • Study the corporate debt restructuring scheme of the Reserve Bank of India. Would banks prefer to use this mechanism
SELECT REFERENCES
  1. Harvard Business School, An Overview of Credit Derivatives, rev. (12 March 1999), Harvard Business School Publishing.

  2. JP Morgan and Risk Metrics Group, The J P Morgan Guide to Credit Derivatives. Risk Publications, U. S.

ANNEXURE I
BASEL COMMITTEE—PRINCIPLES FOR THE ASSESSMENT OF BANKS’ MANAGEMENT OF CREDIT RISK

(Source: ‘Principles for the Management of Credit Risk,’ Basel Committee on Banking Supervision, pp. 3–4 September, 2000 accessed at www.bis.org)

Establishing an Appropriate Credit Risk Environment

  • Principle 1: The board of directors should have responsibility for approving and periodically (at least annually) reviewing the credit risk strategy and significant credit risk policies of the bank. The strategy should reflect the bank's tolerance for risk and the level of profitability the bank expects to achieve for incurring various credit risks.
  • Principle 2: Senior management should have the responsibility for implementing the credit risk strategy approved by the board of directors and for developing policies and procedures for identifying, measuring, monitoring and controlling credit risk. Such policies and procedures should address credit risk in all of the bank's activities and at both the individual credit and portfolio levels.
  • Principle 3: Banks should identify and manage credit risk inherent in all products and activities. Banks should ensure that the risks of products and activities new to them are subject to adequate risk management procedures and controls before being introduced or undertaken and approved in advance by the board of directors or its appropriate committee.

Operating Under a Sound Credit-Granting Process

  • Principle 4: Banks must operate within sound and well-defined credit-granting criteria. These criteria should include a clear indication of the bank's target market and a thorough understanding of the borrower or counter-party, as well as the purpose and structure of the credit and its source of repayment.
  • Principle 5: Banks should establish overall credit limits at the level of individual borrowers and counterparties and groups of connected counterparties that aggregate in a comparable and meaningful manner of different types of exposures, both in the banking and trading book and on- and off-balance sheet.
  • Principle 6: Banks should have a clearly established process in place for approving new credits as well as the amendment, renewal and re-financing of existing credits.
  • Principle 7: All extensions of credit must be made on an arm's length basis. In particular, credits to related companies and individuals must be authorized on an exception basis, monitored with particular care and other appropriate steps taken to control or mitigate the risks of non-arm's length lending.

Maintaining an Appropriate Credit Administration, Measurement and Monitoring Process

  • Principle 8: Banks should have in place a system for the ongoing administration of their various credit risk-bearing portfolios.
  • Principle 9: Banks must have in place a system for monitoring the condition of individual credits, including determining the adequacy of provisions and reserves.
  • Principle 10: Banks are encouraged to develop and utilise an internal risk rating system in managing credit risk. The rating system should be consistent with the nature, size and complexity of a bank's activities.
  • Principle 11: Banks must have information systems and analytical techniques that enable management to measure the credit risk inherent in all on- and off-balance sheet activities. The management information system should provide adequate information on the composition of the credit portfolio, including identification of any concentrations of risk.
  • Principle 12: Banks must have in place a system for monitoring the overall composition and quality of the credit portfolio.
  • Principle 13: Banks should take into consideration potential future changes in economic conditions when assessing individual credits and their credit portfolios and should assess their credit risk exposures under stressful conditions.

Ensuring Adequate Controls over Credit Risk

  • Principle 14: Banks must establish a system of independent and ongoing assessment of the bank's credit risk management processes and the results of such reviews should be communicated directly to the board of directors and senior management.
  • Principle 15: Banks must ensure that the credit-granting function is being properly managed and that credit exposures are within levels consistent with prudential standards and internal limits. Banks should establish and enforce internal controls and other practices to ensure that exceptions to policies, procedures and limits are reported in a timely manner to the appropriate level of management for action.
  • Principle 16: Banks must have a system in place for early remedial action on deteriorating credits, managing problem credits and similar workout situations.

The Role of Supervisors

  • Principle 17: Supervisors should require that banks have an effective system in place to identify, measure, monitor and control credit risk as part of an overall approach to risk management. Supervisors should conduct an independent evaluation of a bank's strategies, policies, procedures and practices related to the granting of credit and the ongoing management of the portfolio. Supervisors should consider setting prudential limits to restrict bank exposures to single borrowers or groups of connected counterparties.
ANNEXURE II
SALIENT FEATURES OF SECURITIZATION

The Concept

The concept is not new. ‘Securitization’, broadly defined, is simply the conversion of a typically illiquid ‘financial relationship’ into a tradable and liquid transaction. For example, trade debt on a firm's balance sheet is illiquid and signifies among others, the relationship between the firm and its suppliers. The debt is converted into a liquid transaction (instrument) in the market when it is issued as Commercial Paper (CP). The issue of ‘equity shares’ as a tradable instrument signifying ownership of a firm, is another example.

In today's capital markets, however, ‘securitization’ is synonymous with ABS—where illiquid assets (loans) on a firm's balance sheet are transformed into traded instruments by pooling the firm's interest in future cash flows from the assets, transferring these claims to another specially created entity that would use the future cash flows to pay off investors over time. Thus, securitization has enabled movement of assets from the less efficient debt markets to the more efficient capital markets, resulting in lower funding costs.

However, there is a key difference between an ABS and a typical capital market security. To the investor, the capital market security signals exposure to the issuer's business, whereas the ABS is no more than exposure to a pool of assets and has no connection with the business risks of the originator.57

The Key Players in ABS

The asset originator: Typically, this would be a bank which transfers a pool of loan assets to the securitization entity. However, it may continue to service the assets—for instance, if a pool of retail loans have been securitized, the bank may continue to collect the payments from the borrowers and pass it on to the securitization vehicle.

The issuer or the SPE: The securitisation vehicle is created as a special purpose entity. It is created for the limited purpose of acquiring the underlying assets, issuing securities and other related activities.

Rating agencies: They are responsible for rating the multiple ‘tranches’ with different risk profiles, to help investors choose securities in keeping with their risk appetite.

Trustee: The trustee holds the securitisation cash flows in separate accounts, and alerts investors and rating agencies in events of default or covenant breaches.

The underwriter: The primary responsibility of structuring the securitization—pricing and marketing the multiple tranches so that the issue is attractive to various classes of potential investors—rests with the underwriter.

The administrator: There is an important role for administrators in the CDO and Asset Backed Commercial Paper (ABCP) products. They actively manage, trade and monitor the respective loan pools.

The servicer: Typically, the servicer is also the asset originator and hence would be responsible for day to day portfolio administration, including collecting and temporarily reinvesting asset cash flows, where required.

Credit enhancement provider: In order to make the issue more attractive to investors and provide the tranches with better credit ratings, credit enhancement providers extend support.

Liquidity facility provider: Typically, liquidity support is provided to adjust for short-term lags between expected cash inflows from the underlying assets and the payment obligations under the securitization structure. Such liquidity access could be provided by financial institutions in the form of a commitment to lend or a commitment to purchase assets.

Figure 8.13 depicts the basic steps in a typical securitization deal

 

FIGURE 8.13 BASIC STEPS IN SECURITIZATION

 

The Cash Flows and Economics in Securitization

Let us assume that Bank A has identified an asset pool of Rs. 100 crores for securitization.

  1. Assume that this pool is being transferred at par value to an SPV—i.e., the outstanding principal amount of the loans in the pool, Rs. 100 crores.

  2. The SPV would also have to receive interest on the principal. This interest rate would be the weighted average interest rate of the loans in the pool. Let us assume the interest at 10 per cent per year.

  3. Now the SPV has to pay for the asset pool it holds. It does so by issuing securities. These securities will be rated (by credit rating agencies) depending on the cash flows that the asset pool is capable of generating.

  4. These cash flows will be used to repay the investors who have bought the securities issued by the SPV. It has to be noted here that Bank A will not have any claim on the cash flows (except to receive them and pass them on to the SPV), nor will the investors have any claim over Bank A's assets in case of a shortfall in cash flows (except to the extent of credit support Bank A would be providing, where agreed upon).

  5. he securities are then structured into multiple tranches—typically, senior, mezzanine and junior (with hybrid classifications such as sub senior or sub junior) or any other nomenclature to convey differentiated priority of cash flows to investors in the pool. In our pool with Rs. 100 crores of Bank A's assets, let us assume that the description of the tranches are as follows: senior – 90 per cent, mezzanine – 7 per cent and junior – 3 per cent. This implies that if losses occur in the asset pool, the junior tranche will absorb the first 3 per cent. If losses exceed 3 per cent, the mezzanine tranche will absorb up to 10 per cent (3 per cent + 7 per cent). Only if losses in the asset pool exceed 10 per cent, will the cash flows to the senior investors be impaired. This 10 per cent (in this case) cushion against losses will enable the senior tranche to be highly rated by the rating agencies, the mezzanine tranche would get a lower rating, and many times, the most junior tranche may be unrated, since the risk of loss is very high. Typically, the unrated tranche is retained by the originating Bank A.

  6. Understandably, since the risk of each tranche differs, the return would also be different. The senior tranche, which is perceived to be safe, would earn the lowest, while the junior tranche, perceived to be highly risky, would earn the highest yield. In other words, the cost of issue of the tranches to the SPV would depend on the risk of each tranche. Let us assume that the weighted average cost to the SPV is 8 per cent

  7. The SPV is only a conduit (in other words, a bankruptcy remote vehicle) and, therefore, requires an entity to carry out the functions of collecting the cash flow streams from the original borrowers in the asset pool and servicing the investors. Many times, these functions are taken on by Bank A itself, for a fee or servicing the investors can be done by a separate servicing firm. Let us assume that the fee for servicing is 70 bps per annum (that is,.07 per cent).

  8. Recollect that the weighted average interest that the pool earned when it was transferred to the SPV was 10 per cent. We have seen now that the pool pays an average interest + fee of 8 +.07 = 8.07 per cent. The difference between the two rates, 1.93 per cent, is called the ‘excess spread’. This ‘residual interest’ may be retained by the originator, Bank A or sold to willing investors.

  9. Hence, at the end of the securitization transaction, Bank A has got the following cash flows: (a) upfront cash flow of Rs. 100 crores or Rs. 97 crores in case the junior tranche bearing the first loss of Rs. 3 crores has been retained by the Bank (in both cases, the transaction takes the assets off its balance sheet and provides liquidity) and (b) the residual interest, representing the excess cash after paying investors.

  10. For the investors, especially in the more senior tranches, the transaction has assured periodic cash flows.