The government has just placed a very important financial sector reform in Parliament - the Bilateral Netting of Qualified Financial Contracts Bill 2020. The new law will allow financial institutions to "net" out their exposures against each other rather than have to manage exposure on a gross basis. Why is this reform so important?
Here is a simplified illustration. Let us say, there are two banks A and B. Bank A has an exposure of Rs100 to B while B has an exposure of Rs90 to A. Their gross exposure is Rs190 and, without bilateral netting, the system will currently have to keep aside capital for Rs190 worth of exposure. This is very costly and the banks will be soon forced to stop doing additional business with each other. However, the net risk for the system is only Rs10 (i.e. Rs100 minus Rs90). In this example, the gross capital requirements are nineteen times higher than the net requirements. If the banks are allowed bilateral netting, the capital requirements dramatically fall and they can do a lot more business.
A bilateral netting framework is standard in all developed financial systems across the world. Around 50 countries already have similar arrangements based on a model law designed by the International Swaps and Derivatives Association (ISDA).
Note that the adoption of Basel norms on bank capitalization presumes the existence of a bilateral netting framework. By adopting Basel norms without a bilateral netting arrangement, India ended up making the capitalization requirements unnecessarily tight (note, however, that a system of multilateral netting was created that is also a required part of the netting ecosystem).
The new law, therefore, is a major step towards freeing up the financial system to expand. It also allows the development of a Credit Default Swap (CDS) market as financial institutions can now trade CDS without being quickly shut down by spiralling capital requirements. The existence of a CDS market is critical for a vibrant corporate bond market. Again, this needs some explanation.
Most people may think that the corporate bonds market is just the debt equivalent of the equity market. However, there is a big difference. An ordinary share of a company is exactly the same as another. Hence, they are fungible and can be traded freely in the secondary market. This is what makes share markets liquid. The problem is that a bond issued today is not the same as a similar bond issued by the same entity last week. Moreover, old bonds mature and new ones are issued constantly. Except for the government and perhaps a handful of corporates, therefore, no entity issues enough of a particular bond to provide liquidity. This is why the corporate market is inherently illiquid. The way financial systems worldwide deal with this problem is to parallel trade in CDS as a proxy for the bonds. This is why bilateral netting is a pre-requirement for a vibrant corporate bond market.
Readers will have recognised that there is a risk here. Opening up the CDS market could also lead to unduly complex derivatives like those that contributed to the Global Financial Crisis 2007-08. RBI, SEBI and the Ministry of Finance are aware of this risk. The bilateral netting law took so long as it had to be carefully formulated, along with inputs from ISDA, Bank of International Settlements and other global regulators. More regulations will be introduced as appropriate but the new framework will now open up several new vistas for financial expansion.
(Sanjeev Sanyal is Principal Economic Adviser, Government of India. The opinions expressed above are personal).