RBI relaxed Eligibility Norms for Using Credit Default Swaps (CDS) on Corporate Bonds

The Reserve Bank of India (RBI) on 24 May 2011 relaxed the eligibility norms for using credit default swaps (CDS) on corporate bonds.  The apex bank permitted restructuring as an approved credit event that can be covered by credit default swap contracts. The RBI’s move to include restructuring as a credit even assumes significance since it came at time when the bad loans problem in the banking system is beginning to build up because of tepid global demand for goods and services, rising input costs and interest rates moving north.

The bank relaxed the eligibility norms for using credit default swaps (CDS) on corporate bonds. The capital adequacy requirement for banks was reduced from 12 per cent to 11 per cent and the requirement of core capital was brought down from 8 per cent to 7 per cent. The eligibility norms regarding CDS would be applicable from 24 October 2011.

In its guidelines on credit default swaps (CDS) for corporate bonds, the RBI mentioned that credit event will cover restructuring approved under the Board for Industrial and Financial Reconstruction, the corporate debt restructuring mechanism and corporate bond restructuring.

The RBI held that the objective of introducing CDS on corporate bonds is to provide market participants a tool to transfer and manage credit risk in an effective manner through redistribution of risk. CDS have benefits like enhancing investment and borrowing opportunities and reducing transaction costs while allowing risk-transfers and hence will help to increase investors' interest in corporate bonds and would be beneficial to the development of the corporate bond market in India.

The draft guidelines on CDS for corporate bonds, which were issued in February 2011 had not permitted restructuring as a credit event. A credit event includes bankruptcy, failure to pay, repudiation/ moratorium, obligation acceleration, and obligation default.

CDS is an agreement in which the protection buyer of the CDS makes a series of payments to the protection seller and in exchange it receives a payoff if a credit instrument (typically a bond or loan) experiences a credit event (or default).

The users of CDS include commercial banks, primary dealers (PDs), non-banking finance companies (NBFCs), mutual funds (MFs), insurance companies, housing finance companies, provident funds, listed corporates, foreign institutional investors and any other institution specifically permitted by the RBI.