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Credit Default Swaps (CDS): Your Insurance against Unwanted Defaults [Part-1]

The Banking sector in India has been suffering from high Non-Performing Assets (NPA) since the last few decades. According to RBI’s Financial Stability Report 2021, the ongoing COVID-19 pandemic is estimated to increase Gross NPA levels by more than 50% in 2021.

Fig 1: Projected NPA levels under Stress test conditions (RBI FSR, 2021)

NPAs form the crux of inefficient Credit Risk management practices employed by various banks. Coming to think of it, have you ever thought what’d you do if you don’t want to pay hefty hospitalization fees in case of any health complication? – You’d buy a health insurance in advance, right?

Fig 2: A typical health insurance arrangement

Now, apply the same analogy in case of banks. If a bank feels the health of its loan book is not going to be well in the near-term, can’t it reach out to an ‘insurer’ and transfer some of the credit risk to the 3rd party?

Fig 3: Mechanism for transferring a Bank’s credit risk

As seen in Fig 2 & Fig 3, the risk-transfer mechanisms are quite similar – both the parties (Arun & Bank A) are transferring their Health & Credit risk respectively to a 3rd party in exchange for a small fees (premium). In Arun’s case, we call the contract an ‘Insurance Policy’ while in case of Bank A, the contract is formalized as a ‘Credit Default Swap’ (CDS). Both insurance policies and CDS operate on the same principle of promised payouts in case of certain triggers (hospitalization in 1st case and a Credit Event in 2nd case).

What is a Credit Event?

Any instance of uncertainty regarding repayment obligations of a financial contract leads to a Credit Event. There are 4 main types of Credit Events against which a Bank/Financial Institution (FI) would like to insure itself:

  • Payment Default: Chances of non-repayment of interest or principal amounts on an outstanding loan,
  • Repudiation/Moratorium: During COVID-19, RBI declared interest moratorium on various loans. These basically disrupts the entire loan repayment schedule and affects the Asset-Liability Management (ALM) efficiency of the bank,
  • Debt Restructuring: This is mostly a consequence of actual or possible Payment Default on a loan, where the loan is subjected to revised repayment terms or even partially converted to Equity to lessen the burden on the borrower,
  • Bankruptcy: It is the extreme form of a Credit Event where a firm decides to go out of business. Debtholders are most likely to receive partial recovery on the face value or nothing (in extreme case).

Credit Events are often quantified through Rating downgrades by major Credit Rating Agencies (CRA or ECAI) like S&P, Fitch, Crisil etc. Forecasting a payment default on a bank loan, a CRA may downgrade a firm’s rating from AA to BBB directly. A CDS acts as an Insurance against such Credit Events. Imagine a bank (let’s say Punjab National Bank) has given a loan of Rs. 1,000 cr. to a firm which is likely to default on its EMIs in the next few months. Won’t PNB like to insure itself against any losses (provisions) due to this unwanted Credit Event?

Now, a Risk Manager at PNB finds that the CDS for that particular borrower is trading at 7.75. What does this mean? How’ll they know how much to pay for insuring themselves? How will you, as an individual, determine whether a CDS is currently overvalued or undervalued? Find out the answers to all these questions in Part-2 of the CDS series.

Sayantan Ghosh

MBA (Finance), FMVA®