Credit default swaps and the indian financial market

Abstract

A notable similarity between the financial markets of all major countries around the world is that they are largely driven by three distinct, yet intertwined, entities - banks, stock market and debt market. What differentiates them is the varying influence or efficiency of these three groups in determining the economic prosperity of a particular country. For example, developed countries like the USA, UK, Japan have well-functioning capital markets (i.e. debt and equity markets), which act as a source and destination of capital for borrowers and lenders respectively. On the other hand, developing countries like India and China are still dependent on banks for financing large-scale projects and spurring economic growth. Bank financing, although hugely popular in India, has its own limitations. This is best manifested in the INR 7.34 lakh crore worth of non-performing assets (NPA) in Indian banks’ books. Such high NPA levels are a result of inefficient credit appraisal mechanisms, lack of efficient credit rating systems and dearth of stringent regulatory intervention till recently. The Reserve Bank of India (RBI) has recently attacked the NPA menace by introducing the Insolvency and Bankruptcy Code, 2016 and setting up the National Company Law Tribunal (NCLT), both of which are aimed at facilitating banks to clean up their distressed loan books. The success rate of such measures is yet to come to the forefront. However, a preemptive measure to nurture a healthy financial system could have been the development of the Indian corporate bond market, which is still in its nascent stage even after years of the landmark 1991 economic reforms. Data points from around the world demonstrate how a robust corporate bond market works in lock-step with an efficient banking system by providing an alternative source of funding to real asset companies for their long-term capital requirements. An active corporate bond market also aids in efficient diversification of risks for investors. A local currency bond market is necessary in order to enable public and private sector firms to borrow for longer maturity periods and meet their investment requirements, thereby avoiding mismatches in balance sheet and foreign currency exposures. A highly liquid corporate bond market could also enable institutional investors such as pension funds and insurance companies to decrease their asset-liability mismatches by providing them with good quality long term financial assets. Corporate bond markets ensure availability of capital at a lower cost, without putting pressure on the banking system. An efficient corporate bond market would add diversity and reduce systemic risks, thereby aiding the banking system too.