KOCHI: Though the Indian financial services industry has addressed most of the risks in the system, one important risk, however, has largely remained trapped within lenders' balance sheets - credit risk.
For years, India has steadily built sophisticated financial markets that allow investors and institutions to trade almost every major form of risk.
Equity investors hedge through futures and options, companies protect themselves against currency fluctuations using foreign exchange derivatives, while banks routinely manage interest-rate risks through swaps.
The Reserve Bank of India's final framework for credit derivatives aims to address that gap, laying the foundation for what could eventually become a deeper market where the risk associated with loans and corporate debt can be transferred without changing ownership of the underlying assets.
The move comes at a time when India's financial system is entering a new phase. Bank credit continues to expand, corporate bond issuances are rising, infrastructure financing requirements are growing rapidly and private credit funds are becoming increasingly active.
Insurance companies and pension funds are also managing much larger pools of long-term capital than ever before.
All these institutions are taking credit risk. Yet India has had only limited mechanisms to redistribute that risk once it is created.
RBI's framework seeks change
The regulations permit a wider use of credit derivatives such as Credit Default Swaps (CDS) and Total Return Swaps (TRS), instruments that have long been part of financial markets in developed economies but have remained largely underutilised in India.
CDS functions much like insurance against default. A bank or investor holding a loan or corporate bond can transfer only the default risk to another participant by paying a periodic premium, while continuing to own the underlying asset and receive its interest income.
If the borrower defaults, the protection seller compensates the buyer for the agreed loss.
Total Return Swap
A Total Return Swap goes a step further. Instead of transferring only the default risk, it transfers the entire economic return of a loan or bond — including interest income, gains or losses arising from changes in its value, as well as the credit risk — to another investor, even though legal ownership of the asset remains unchanged.
The ability to transfer risk without selling the underlying asset has several implications. Banks can reduce excessive exposure to sectors such as infrastructure, commercial real estate or power without shrinking their loan books.
Investors in corporate bonds can hedge part of their credit exposure, potentially encouraging greater participation in the bond market. Insurance companies, pension funds and other long-term investors can selectively assume credit exposure that matches their investment objectives.
At the same time, those unwilling to retain such risks can transfer them to institutions with greater risk appetite.
“Perhaps the biggest beneficiary could be India's infrastructure financing programme,” noted a banker while talking to businessbenchmark.news
Right move
The country requires massive long-term investments in highways, ports, airports, renewable energy projects, metro rail systems, logistics infrastructure and data centres.
While banks remain the principal source of such funding, keeping large concentrations of credit risk on their balance sheets can eventually constrain fresh lending. A functioning credit derivatives market enables that risk to be distributed more efficiently across the financial system, improving banks' capacity to support new projects.
India has functioned for decades without a meaningful credit derivatives market. But as the financial system grows larger and more interconnected, the absence of efficient risk-transfer mechanisms can result in concentrated exposures, lower lending flexibility and slower development of the corporate bond market.
Credit risk
The RBI's framework, therefore, is not merely about introducing two financial instruments. It is about completing an important piece of India's financial market architecture by creating conditions for credit risk to be priced, managed and redistributed more efficiently.
Whether the market eventually develops into a liquid and widely traded segment will depend on participation from banks, insurers, mutual funds and other institutional investors.
But by liberalising a framework that remained dormant for years, the RBI has signalled that India's next stage of financial market development may be less about creating more credit and more about creating a market where credit risk itself can move freely to those most willing to bear it.
