THE GIST of Editorial for UPSC Exams : 16 June 2020 (Why RBI’s new draft frameworks are path-breaking for banking sector (Indian Express))

Why RBI’s new draft frameworks are path-breaking for banking sector (Indian Express)

Mains Paper 3: Economy
Prelims level: Credit default swap market
Mains level: New draft frameworks banking sector

Context:

• Two important draft frameworks put out by RBI, on securitisation of standard assets and on sale of loans, are quite path-breaking as they move the system towards the market.
• In a way, financial intermediation moves towards the market. Anything in the market tends to be more transparent, and hence, is an improvement as it feeds back into the system of sanctioning loans.
  Securitisation has functioned in a.............................

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Major advantages:

1. Bond market is replicated in a different form:

• The buying and selling of the security in the bond market is replicated in a different form here.
• EX: At a mature stage, the loan market can mimic the bond market where there are continuous trades taking place.
• The advantage for the selling bank is that it can tune its balance sheet to the overall changing risk appetite and maturity preference.
• EX: Hence, relatively riskier assets can be sold off at a discount to stabilise the balance sheet, and just like how there is continuous ALM in banks, the same can hold for the loan portfolio.
• The buyer of the loan or security would also be matching the asset to the available risk appetite and tenure.

2. How the market evolves?

• Banks would have to be probably more careful when lending because taking on risk which cannot be passed on will ensure that good behaviour prevails.
• Hence, as seen in the latest episode in the BFSI space, taking on undue risk will not make sense as it will not be able to pass it on to other institutions. Or even if there is appetite for the same, the discount at which it will go will be quite deep, which affects the P&L.

3. Junk bond market:

• Following from the above, such a market will lay the foundation of the development of a junk bond market.
• Currently, in India, such a market does not exist, and hence it will be a case of the bank loan market leading to its development.
• As buyers of high-risk assets ...........................

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4. Sale of loans will lead to finer pricing:

• An active market for sale of loans will lead to finer pricing. Right now, there are internal risk models used by banks to price loans.
• As banking is often a relationship business, there is considerable negotiation involved in pricing of the loan.
• While this has worked well in the past, things will change once there is a secondary market where the price is determined by the interplay of banks rather than being unilaterally fixed.
• This will, interestingly, address the issue of transmission of interest rates in the system, which, it is believed, is quite sticky.
• In a way, the central bank policy rate transmission will be tested by the market; the suasion being used today to make it more efficient may not work. The market will decide.

5. Role of credit rating agencies:

• The credit rating agencies (CRAs) will be a critical piece here, for the buyer of any loan or security would like to have an independent assessment of the concerned financial instrument.
• While securitisation does involve such a rating, even for sale of loans there should be a rating provided on the residual maturity, besides the initial rating provided at the time of evaluation.
• This fresh rating would need to be separately tracked by CRAs till maturity. But this is very essential for the final pricing in the market where it assumes the role of a critical input.
• In fact, unlike the primary loan disbursed where the price is based on a rating (internal), in this case the secondary market pricing will vary according to the rating reviews of an external CRA.

6. Sale of loans is a modified version of take-out finance:

• The sale of loans is a modified version of take-out finance, which was the solution mooted for the infra sector where a bank that gives a loan for a 20-year project moves out after a fixed time ............................

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Way ahead:

• A well-developed market for these two assets can also trigger some action on the CDS front. The CDS is fairly moribund in India for a variety of reasons.
• With these markets for bank loans evolving, the logical corollary would be to have some protection being offered on loans in the form of insurance.
• This is where one can see potential for the CDS market where such an opportunity would arise and can be taken as a trigger.
• On the whole, there are exciting times ahead for the Indian banking system.

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Prelims Questions:

Q1.  With reference to the coronal heating problem, consider the following statements:
1. The solar corona is the outer layer of the Sun's atmosphere.
2. The solar corona is the coolest part of the Sun.

Which of the statements given above is/are correct?
(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2

Answer: ............................

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Mains Questions:
Q1.  Why RBI’s new draft frameworks ..............................