RBI Prudential Guidelines on Credit Default Swaps (2011)

RBI/2011-12/285 DBOD.BP.BC.No.61/21.06.203/2011‐12 November 30, 2011 The Chairman and Managing Directors/ Chief Executive Officers of All Scheduled Commercial Banks (Excluding RRBs and Local Area Banks) Dear Sir, Prudential Guidelines on Credit Default Swaps (CDS) Please refer to guidelines on single name Credit Default Swaps on corporate bonds issued vide Circular No. IDMD.PCD.No.5053/14.03.04/2010-11 dated May 23, 2011 . As indicated in the paragraph 3.5 of the circular, market participants will have to follow the capital adequacy guidelines for CDS issued by their respective regulators. Accordingly, guidelines on capital adequacy, exposure norms and provisioning to banks undertaking CDS transactions are enclosed as Annex . 2. The guidelines will be applicable on CDS transactions undertaken by Indian banks domestically or through their overseas branches / subsidiaries / joint ventures as well as Indian operations of foreign banks. While undertaking CDS transactions overseas, Indian banks should adhere to guidelines of host country, if they are more conservative / stricter than these guidelines. 3. These guidelines become applicable with immediate effect. Yours faithfully, (Deepak Singhal) Chief General Manager-in-Charge Annex Prudential Guidelines on Credit Default Swaps (CDS) 1. Introduction With a view to providing market participants a tool to transfer and manage credit risk associated with corporate bonds, Reserve Bank of India has introduced single name CDS on corporate bonds. Banks can undertake transactions in such CDS, both as market-makers as well as users. As users, banks can buy CDS to hedge a Banking Book or Trading Book exposure. The prudential guidelines dealing with CDS are dealt with in the following paragraphs. 2. Definitions The following definitions are used in these guidelines: Credit event payment - the amount which is payable by the credit protection provider to the credit protection buyer under the terms of the credit derivative contract following the occurrence of a credit event. The payment can be in the form of physical settlement (payment of par in exchange for physical delivery of a deliverable obligation of the reference entity) or cash settlement (either a payment determined on a par-less-recovery basis, i.e. determined using the par value of the reference obligation less that obligation’s recovery value, or a fixed amount, or a fixed percentage of the par amount). Deliverable asset / obligation - any obligation 1 of the reference entity which can be delivered, under the terms of the contract, if a credit event occurs. [A deliverable obligation is relevant for credit derivatives that are to be physically settled.] Reference obligation - the obligation 2 used to calculate the amount payable when a credit event occurs under the terms of a credit derivative contract. [A reference obligation is relevant for obligations that are to be cash settled (on a par-less-recovery basis).] Underlying asset / obligation - The asset 3 which a protection buyer is seeking to hedge. 3 . Classification of CDS into Trading Book and Banking Book Positions   For the purpose of capital adequacy for CDS transactions, Trading Book would comprise Held for Trading positions and Banking Book would comprise Held to Maturity and Available for Sale positions. A CDS being a financial derivative will be classified in the Trading Book except when it is contracted and designated as a hedge for a Banking Book exposure. Thus, the CDS positions held in the Trading Book would include positions which: (a)  arise from market-making; (b)  are meant for hedging the exposures in the Trading Book; (c) are held for short-term resale; and (d) are taken by the bank with the intention of benefiting in the short-term from the actual and / or expected differences between their buying and selling prices CDS positions meant for hedging Banking Book exposures will be classified in the Banking Book. However, all CDS positions, either in Banking Book or Trading Book, should be marked-to-market. All CDS positions should meet the operational requirements indicated in paragraph 4 below. 4. Operational requirements for CDS to be recognised as eligible External / Third-party hedges for Trading Book and Banking Book (a) A CDS contract should represent a direct claim on the protection provider and should be explicitly referenced to specific exposure, so that the extent of the cover is clearly defined and incontrovertible. (b) Other than non-payment by a protection purchaser of premium in respect of the credit protection contract it should be irrevocable. (c) There should be no clause in the contract that would allow the protection provider unilaterally to cancel the credit cover or that would increase the effective cost of cover as a result of deteriorating credit quality in the hedged exposure. (d) The CDS contract should be unconditional; there should be no clause in the protection contract outside the direct control of the bank (protection buyer) that could prevent the protection provider from being obliged to pay out in a timely manner in the event that the original counterparty fails to make the payment(s) due. (e) The credit events specified by the contracting parties should at a minimum cover: (i) failure to pay the amounts due under terms of the underlying obligation that are in effect at the time of such failure (with a grace period that is closely in line with the grace period in the underlying obligation); (ii) bankruptcy, insolvency or inability of the obligor to pay its debts, or its failure or admission in writing of its inability generally to pay its debts as they become due, and analogous events; and (iii) restructuring of the underlying obligation (as contemplated in the IDMD guidelines on CDS dated May 23, 2011) involving forgiveness or postponement of principal, interest or fees that results in a credit loss event (i.e. charge-off, specific provision or other similar debit to the profit and loss account); (iv) when the restructuring of the underlying obligation is not covered by the CDS, but the other requirements in paragraph 4 are met, partial recognition of the CDS will be allowed. If the amount of the CDS is less than or equal to the amount of the underlying obligation, 60% of the amount of the hedge can be recognised as covered. If the amount of the CDS is larger than that of the underlying obligation, then the amount of eligible hedge is capped at 60% of the amount of the underlying obligation. (f) If the CDS specifies deliverable obligations that are different from the underlying obligation, the resultant asset mismatch will be governed under paragraph (k) below. (g) The CDS shall not terminate prior to expiration of any grace period required for a default on the underlying obligation to occur as a result of a failure to pay 4 . (h) The CDS allowing for cash settlement are recognised for capital purposes insofar as a robust valuation process is in place in order to estimate loss reliably. There should be a clearly specified period for obtaining post-credit event valuations of the underlying obligation. If the reference obligation specified in the CDS for purposes of cash settlement is different than the underlying obligation, the resultant asset mismatch will be governed under paragraph (k) below. (i) If the protection purchaser’s right/ability to transfer the underlying obligation to the protection provider is required for settlement, the terms of the underlying obligation should provide that any required consent to such transfer may not be unreasonably withheld. (j) The identity of the parties responsible for determining whether a credit event has occurred should be clearly defined. This determination should not be the sole responsibility of the protection seller. The protection buyer should have the right/ability to inform the protection provider of the occurrence of a credit event. (k) A mismatch between the underlying obligation and the reference obligation or deliverable obligation under the CDS (i.e. the obligation used for purposes of determining cash settlement value or the deliverable obligation) is permissible if (1) the reference obligation or deliverable obligation ranks pari passu with or is junior to the underlying obligation, and (2) the underlying obligation and reference obligation or deliverable obligation share the same obligor (i.e. the same legal entity) and legally enforceable cross-default or cross-acceleration clauses are in place. (l) A mismatch between the underlying obligation and the obligation used for purposes of determining whether a credit event has occurred is permissible if (1) the latter obligation ranks pari passu with or is junior to the underlying obligation, and (2) the underlying obligation and reference obligation share the same obligor (i.e. the same legal entity) and legally enforceable cross-default or cross acceleration clauses are in place. 5. Capital Adequacy Requirement for CDS Positions in the Banking Book 5.1 Recognition of External/Third-party CDS Hedges 5.1.1 In case of Banking Book positions hedged by bought CDS positions, no exposure will be reckoned against the reference entity / underlying asset in respect of the hedged exposure, and exposure will be deemed to have been substituted by the protection seller, if the following conditions are satisfied: (a) Operational requirements mentioned in paragraph 4 are met; (b) The risk weight applicable to the protection seller under the Basel II Standardised Approach for credit risk is lower than that of the underlying asset; and (c)  There is no maturity mismatch between the underlying asset and the reference / deliverable obligation. If this condition is not satisfied, then the amount of credit protection to be recognised should be computed as indicated in paragraph 5.1.3 (ii) below. 5.1.2   If the conditions (a) and (b) above are not satisfied or the bank breaches any of these conditions subsequently, the bank shall reckon the exposure on the underlying asset; and the CDS position will be transferred to Trading Book where it will be subject to specific risk, counterparty credit risk and general market risk (wherever applicable) capital requirements as applicable to Trading Book. 5.1 .3   The unprotected portion of the underlying exposure should be risk-weighted as applicable under Basel II framework. The amount of credit protection shall be adjusted if there are any mismatches between the underlying asset/ obligation and the reference / deliverable asset / obligation with regard to asset or maturity . These are dealt with in detail in the following paragraphs. (i)  Asset mismatches Asset mismatch will arise if the underlying asset is different from the reference asset or deliverable obligation. Protection will be reckoned as available by the protection buyer only if the mismatched assets meet the requirements specified in paragraph 4 (k) above. (ii)   Maturity mismatches The protection buyer would be eligible to reckon the amount of protection if the maturity of the credit derivative contract were to be equal or more than the maturity of the underlying asset. If, however, the maturity of the CDS contract is less than the maturity of the underlying asset, then it would be construed as a maturity mismatch. In case of maturity mismatch the amount of protection will be determined in the following manner: If the residual maturity of the credit derivative product is less than three months no protection will be recognized. If the residual maturity of the credit derivative contract is three months or more protection proportional to the period for which it is available will be recognised. When there is a maturity mismatch the following adjustment will be applied. Pa = P x (t- .25) ÷ (T- .25) Where: Pa = value of the credit protection adjusted for maturity mismatch P = credit protection t = min (T, residual maturity of the credit protection arrangement) expressed in years T = min (5, residual maturity of the underlying exposure) expressed in years Example: Suppose the underlying asset is a corporate bond of Face Value of Rs. 100 where the residual maturity is of 5 years and the residual maturity of the CDS is 4 years. The amount of credit protection is computed as under:                 100 * {(4-.25) ÷ (5-.25)} = 100*(3.75÷ 4.75) = 78.95 Once the residual maturity of the CDS contract reaches three months , protection ceases to be recognised. 5.2 Internal Hedges Banks can use CDS contracts to hedge against the credit risk in their existing corporate bonds portfolios. A bank can hedge a Banking Book credit risk exposure either by an internal hedge (the protection purchased from the trading desk of the bank and held in the Trading Book) or an external hedge (protection purchased from an eligible third party protection provider). When a bank hedges a Banking Book credit risk exposure (corporate bonds) using a CDS booked in its Trading Book (i.e. using an internal hedge), the Banking Book exposure is not deemed to be hedged for capital purposes unless the bank transfers the credit risk from the Trading Book to an eligible third party protection provider through a CDS meeting the requirements of paragraph 5.1 vis-à-vis the Banking Book exposure. Where such third party protection is purchased and is recognised as a hedge of a Banking Book exposure for regulatory capital purposes, no capital is required to be maintained on internal and external CDS hedge. In such cases, the external CDS will act as indirect hedge for the Banking Book exposure and the capital adequacy in terms of paragraph 5.1, as applicable for external / third party hedges, will be applicable. 6. Capital Adequacy for CDS in the Trading Book 6.1 General Market Risk A credit default swap does not normally create a position for general market risk for either the protection buyer or protection seller. However, the present value of premium payable / receivable is sensitive to changes in the interest rates. In order to measure the interest rate risk in premium receivable/payable, the present value of the premium can be treated as a notional position in Government securities of relevant maturity. These positions will attract appropriate capital charge for general market risk. The protection buyer / seller will treat the present value of the premium payable / receivable equivalent to a short / long notional position in Government securities of relevant maturity. 6.2 Specific Risk for Exposure to Reference Entity A CDS creates a notional long / short position for specific risk in the reference asset / obligation for protection seller / protection buyer. For calculating specific risk capital charge, the notional amount of the CDS and its maturity should be used.  The specific risk capital charge for CDS positions will be as per Table-1 and Table -2 below. Table-1: Specific risk capital charges for bought and sold CDS positions in the Trading Book: Exposures to entities other than Commercial Real Estate Companies/ NBFC-ND-SI

Reproduced for reference with acknowledgment — Source: Reserve Bank of India · RBI/2011-12/285 · issued 30 Nov 2011. The plain-English explanation above is BankPulse’s own independent summary.

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