(I) Prologue. The risk of change in borrowerâs ability to repay a debt is known as Credit Risk and is perhaps the most significant risk associated with the primary ...
Credit Default Swaps: Opening a New Pandora’s Box? Raghav Sharma*, Siddhartha Shukla**
(I)
Prologue………………………………………………………………………..2
(II)
Understanding „Credit Default Swaps‟………………………...………..…..…2
(III)
CDS: Jinx for the Financial System?............................…..…………………....3
(IV)
Problem of Moral Hazard……………..…………………………………..……5
(V)
Problem of Adverse Selection……………………………………………..…...7
(VI)
Conclusion……………………………………………………………………...8
* B.Sc. LL.B. (Hons.), 4th year, National Law University, Jodhpur. ** B.B.A. LL.B. (Hons.), 4th year, National Law University, Jodhpur.
Electronic copy available at: http://ssrn.com/abstract=1262708
Credit Default Swaps: Opening a New Pandora’s Box? (I)
Prologue The risk of change in borrower‟s ability to repay a debt is known as Credit Risk and is
perhaps the most significant risk associated with the primary function of „financial intermediation‟ performed by the banks. Functioning as „risk engines‟ of the national economy, banks warehouse large chunks of credit risk and therefore any impact on their long term financial health due to increased credit risk may have serious repercussions on the economy as a whole. Given the importance of banks as the primary credit creators, the Reserve Bank of India (“RBI”) had introduced capital adequacy and provisioning norms in accordance with the globally accepted risk management practices prescribed under the twin Basel Accords. However, on the international plane banks have been permitted to manage credit risk through „risk transfer instruments‟ called credit derivatives which help the banks to retain the financial benefits of loans while obviating the associated risks. Taking a cue from these international developments, the RBI is going to introduced „plain vanilla‟ Credit Default Swap (“CDS”).1 Though the advantages of CDS as a „risk transfer instrument‟ have been well documented by the RBI, it has chosen to maintain an eerie silence on the possible downsides of CDS. Thus, to fully gauge the repercussions of CDS, it becomes imperative to assess the propriety of RBI‟s decision by seeking an answer to this simple question: Will CDS, as pithily put by Warren Buffett2, really turn out to be “time bombs” and “financial weapons of mass destruction”? This paper attempts to ransack the Pandora‟s Box that CDS may open for the Indian banks and thus identify the long term negative implications which the Central Bank seems to have blissfully ignored.
(II) Understanding ‘Credit Default Swaps’ A CDS is a „swap contract‟ whereby one party agrees to swap an asset/obligation for certain payment by the counterparty on the occurrence of pre-defined default event known as the 1
Draft Guidelines on Credit Default Swaps (hereinafter „Draft Guidelines, 2007‟) on May 16, 2007.
2
See Warren Buffett, Letter to Berkshire Hathaway Shareholders, at p.14, 21 February , 2003, available at accessed 01 February, 2008.
2 Electronic copy available at: http://ssrn.com/abstract=1262708
Credit Event. In such a transaction, one party, known as the Protection Buyer (“PB”), can transfer the credit risk associated with its investments (assets, loans etc.) to the counterparty, known as the Protection Seller (“PS”), while retaining the legal ownership of the asset/obligation. The party in respect of whom the protection is availed of is known as the Reference Entity and the concerned asset/obligation from which the credit risk is unbundled acts as the Underlying Asset/Obligation in the transaction. The credit risk is transferred via settlement obligation under the contract that is triggered by a pre-defined credit event which may include, inter alia, failure to pay, bankruptcy, repudiation, moratorium or restructuring of the reference entity. The payment obligation of PS is determined on the basis of a pre-defined Reference Asset/Obligation. The swap may occur in the following three ways: (1) Physical Settlement through delivery of a Reference Asset/Obligation by the PB to the PS in consideration of payment of face value of the asset by the latter. (2) Cash Settlement through payment by the PS of the difference between the face value of the Reference Asset/Obligation and its market value at time of occurrence of the credit event. (3) Fixed Amount Settlement through the payment of a pre-determined amount by the PS to the PB.
In consideration, the PB pays a fixed premium amount to the PS on a periodical basis. Thus, through the settlement mechanism, while the PB becomes assured of getting the payment on default of the Reference Entity, the PS gains the premium without any funded exposure to the Reference Entity in absence of any default.
(III) CDS: Jinx for the Financial System? As mentioned above, the advantages of CDS relating to transfer of credit risk and its positive implications have been sufficiently highlighted by the RBI. The crucial question, which needs to be properly addressed, is: Will the use of CDS pose long term risks to the functioning of banking institutions and the financial system? The core reason for ushering in the use of CDS lies in the advantages it proffers to individual financial institution through transfer of undesired credit risk to counterparties. Such transfer, it is argued, increases the overall financial stability by rendering individual institutions
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less vulnerable to „risk paralysis‟. However, on a closer look, it is crystal clear that CDS does not „eliminate‟ the credit risk for the system as a whole; it merely transfers the risk from one participant to another within the system. Internationally, it has been observed that CDS transactions slowly tend to concentrate credit risk in the hands of the few risk taking banks. Due to inter-linkages in the banking system, the failure of one such institution, due to overconcentration of risks, may trigger a “domino effect” in terms of defaults by many related institutions on a significant scale.3 In addition, the use of CDS will sire the following new risks for the financial system4: (1) Liquidity Risk: The risk of bank‟s inability to meet its obligations under the CDS contract as and when they become due. (2) Transaction Risk: The risk arising due to failure of the participants to fully understand the nature of contracts and the extent of risk transferred thereon. (3) Credit Risk: The risk of default by the counterparty and erosion in the market value of the reference asset. (4) Compliance Risk: The risk of a loss because a contract cannot be enforced due to faulty documentation or contrary construction by courts.
Secondly, the hitherto existing mechanism for banks to guard against credit risks is the traditional loan sale market. However, empirical evidence strongly suggests that introduction of CDS strangulates the development of loan sale market5 and thus harms the interest of the participants who may prefer to use the traditional means of risk transfer. Thirdly, the international experience evidences that a one CDS contract may form an Underlying Asset/Obligation for another CDS contract, i.e., the PS in one CDS transaction will become a PB with respect to a third party in the second CDS contract. Such multiple onward transfers by the Protection Sellers, coupled with complex legal documentation, will make it practically 3
Report by Deutsche Bundesbank, Credit Default Swaps-Functions, Importance and Information Content, 2004, at p.48 accessed 01 February, 2008.
4
See André Scheerer, Credit Derivatives: An Overview of Regulatory Initiatives in the U.S. and Europe, (2000) 5 Fordham J. Corp. & Fin. L. 149, pp. 162-170.
5
Gregory R. Duffee and Chunseng Zhou, Credit Derivatives in Banking: Useful Tools for Managing Risk? (01 November, 1999), at p .35 accessed on 01 February, 2008.
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impossible to identify true credit risk holder. Isn‟t this sufficient to spell doom for the borrower in times of financial distress as the terms of loan will not be pliable to change by renegotiation?6 Lastly, from the perspective of banks, newer risks may manifest due to excessive credit creation by the banks as reduction of risks will significantly increase both their capacity and willingness to lend. Such a practice will amplify the generation of bad credit and associated risks which will thereafter be transferred into the financial system.7
(IV) Problem of Moral Hazard Financial intermediaries, involved in lending, interact with their borrower/customers through two kinds of lending: Relationship Lending and Transactional Lending. Traditionally, a bank prefers the Relationship Lending route which has given rise to the concept of Relationship Banking. The aforesaid concept necessitates that banks should develop enduring long term relationship with the borrowers beyond the current loan transaction, e.g., helping borrowers in times of financial distress by restructuring loan contracts.8 Per contra, the term „Transactional Lending‟ implies that the relationship between the financial intermediary and the borrower/customer is limited to the transaction at hand and the financing is done on an arm‟s length basis. Relationship Banking is based on two essential features viz. (1) access of banks to “confidential customer-specific information”, and (2) multiple interactions with the customer to evaluate the profitability of the investments which provides banks with the special ability to monitor the borrowers.9 Due to superior access to customer specific information, banks act as „monitors‟ to supervise the credit quality and corporate governance standards of the borrower. Such monitoring is indispensable to avoid default on part of the borrower and to avert the consequent risk of borrower‟s liquidation, an option which is economically inefficient for the 6
See R. Michael Farquhar, The Next Wave: Why You Should Care About Credit Default Swaps, 24 American Bankruptcy Institute Journal 18 (2005). 7
International Monetary Fund, Global Financial Stability Report, 2006, accessed 01 February, 2008.
at
p.62
8
Arnoud W.A. Boot, Relationship Banking: What Do We Know?, (2000) 9 Journal of Financial Intermediation 7, at p.7.
9
Arnoud W.A. Boot, Id; See Gorton, G.B., and G.G. Pennacchi, Banking and Loan Sales: Marketing Nonmarketable Assets, (1995) 35 Journal of Monetary Economics 389-411.
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bank as a lender.10 The objective behind Relationship Banking is to perform a value-enhancing function in respect of the loan by allowing flexibility in renegotiation of lending contracts and monitoring of the collateral for a loan as the borrower reposes trust in the expertise of the bank.11 In our opinion, CDS will make a huge dent in Relationship Banking and monitoring function of the banks. The first problem relates to creation of a „Moral Hazard‟ on part of the banks. Moral Hazard is an economic concept which describes the incentive created by a contract, usually an insurance contract, for one party to do nothing and create losses that the party will not eventually bear. In case of banks, the transfer of credit risk through CDS will extinguish their incentive to monitor the credit quality of the borrower or enhance the value of the loan through Relationship Banking.12 Such risk of Moral Hazard is corroborated by the failure of Enron. Large banks like JP Morgan Chase and Citigroup which had lent substantial sums to Enron but failed to provide the requisite oversight to prevent its demise. Post-Enron enquiries have unraveled that one of the major reasons for such lax attitude of these banks was the use of credit derivatives through which they had already hedged themselves against risks from Enron‟s default. 13 Given such a background, it cannot be denied that there may be cases where CDS may provide a perverse incentive to the PB to act in a manner that makes the Reference Entity default on its obligations.14 Moreover, we argue that the ability of banks to monitor the borrowers is a special adjunct of the banker-customer relationship and the PS in a CDS transaction cannot effectively perform the same function. The CDS transactions will inevitably compel the PS to heavily rely on ratings provided by the Credit Rating Agencies. Since the credibility of these agencies itself has been questioned in the wake of their serious lapses in the Enron and the Sub-
10
Douglas W. Diamond, Financial Intermediation as Delegated Monitoring: A Simple Example, Federal Reserve Bank of Richmond Economic Quarterly Volume 82/3, 51 (Summer 1996), at p.65.
11
Arnoud W.A. Boot, supra note 8, at pp. 13-14.
12
Stefan Arping, Playing Hardball: Relationship Banking in the Age of Credit Derivatives, at p.2 accessed 01 February, 2008; John Kiff and Ron Morrow, Credit Derivatives, (Autumn, 2000) Bank of Canada Review 3, at p.9; Bank for International Settlement, Credit Risk Transfer, CGFS Publications No. 20, February 6, 2004, at p.18,21 (herein after „BIS, Credit Risk Transfer‟).
13
Frank Partnoy & David A. Skeel, Jr., The Promise and Perils of Credit Derivatives, (2007) 75 U. Cin. L. Rev. 1019, at pp. 1032-33.
14
Id, at pp. 1034-35.
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Prime Mortgage crisis, therefore, it will be practically impossible for the PS to effectively substitute bank as a „monitor‟. Furthermore, in the practical scenario, lending by a large bank to a corporate borrower acts as a “certification” of the latter‟s credit quality which lowers the cost of funding when the borrower accesses the capital market. Any disclosure of a CDS transaction, resulting in the transfer of credit risk, will diminish the confidence of investors in the aforesaid certification and thus foreclose the low cost funding option to the corporate borrowers. 15 However, the proponents of CDS have vehemently argued that monitoring function will not be impeded as the maturity period of a CDS contract may not always match the maturity period of the loan and in such a case the bank retains the risk of late default. Coupled with this is the risk of reputational damage to the bank in case it shirks its essential monitoring responsibilities.16 The extent to which this particular instance may counter the generic risks posed by the use of CDS will remain a matter of empirical observation.
(V) Problem of Adverse Selection The „problem of adverse selection‟ questions the viability of the CDS transactions in absence of disclosure norms ensuring „information parity‟ between the PB and the PS. This economic concept, more famously known as the „lemons‟ problem, is relatable to the situation of information asymmetry. According to the theory, the seller always has more information about his goods than what the buyer has resulting in a situation of information asymmetry. Due to this the buyer cannot distinguish between good and bad quality goods beforehand and thus, the seller may easily pass off bad quality goods as high quality ones. To protect his interest, the buyer pays lesser price for even the high quality goods and disincentivised by such a scenario, the seller, eventually, sells only the bad quality goods. This drives out the high quality goods altogether from the market. 17 In a CDS transaction, banks, as lenders, possess more information about their borrower Reference Entities than the concerned PS and thus, on applying the lemons rule, it is crystal clear 15
BIS, Credit Risk Transfer, at p.21.
16
See John Kiff and Ron Morrow, supra note 12, at p.10.
17
See George A. Akerlof, The Market For "Lemons": Quality Uncertainty and the Market Mechanism, The Quarterly Journal of Economics, Vol. 84, No. 3 (Aug., 1970), pp. 488-500, at pp. 489-490.
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that eventually credit risk of only poor quality loans will be traded in the CDS market.18 Thus, to avoid any such failure of the CDS market, it is imperative for the RBI to incorporate certain minimum mandatory disclosure norms for the PB which will enable the PS to an independent assessment of the Reference Entity‟s credit quality.
(VI) Conclusion It is apparent that CDS will eliminate credit risk for banks at the cost of generating new risks for the financial system and compromising the interest of the Reference Entity, the passive entity in the whole transaction, in situations necessitating restructuring of the terms of the loan agreement. The problem of moral hazard demonstrates that its use will drastically alter the traditional functioning of banks. To crown it all, the „adverse selection‟ principle points out that even after inflicting such huge costs on the financial system, the CDS market may itself fail to take off. In the United States, it is currently apprehended that the aforementioned problems in the CDS market, which is double the size of the entire US stock market, may trigger a „domino effect‟ resulting in enormous financial losses equivalent to those borne by financial institutions in the recent sub-prime mortgage crisis.19 Can such negative spin offs be pushed under the carpet by the bank regulator? The answer is an emphatic „No‟. In light of the above analysis, it is our considered opinion that there is a need to forewarn the CDS participants about these downsides to enable them to put in place appropriate mechanisms, e.g. meaningful disclosure standards, to mitigate their long term implications. In absence of such a pragmatic and cautious approach, CDS may indeed turn out to be „financial weapons of mass destruction‟ for the Indian financial system.
18
See Sabine Henke et. al., Credit Securitization and Credit Derivatives: Financial Instruments and the Credit Risk Management of Middle Market Commercial Loan Portfolios, CFS Working Paper Nr. 98/07 (January, 1998); BIS, Credit Risk Transfer, at pp. 17-18.
19
See Gretchen Morgenson, Arcane Market Is Next to Face Big Credit Test, The New York Times, 17 February, 2008; Aline Van Duyn & Gillian Tett, Markets Assess the Costs of a Monoline Meltdown, Financial Times, 20 February, 2008.
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