Since 1992, significant changes have been introduced in the Indian financial system. These changes have infused an element of competition in the financial system, marking the gradual end of financial repression characterised by price and non-price controls in the process of financial intermediation. While financial markets have been fairly developed, there still remains a large extent of segmentation of markets and non-level playing field among participants, which contribute to volatility in asset prices. This volatility is exacerbated by the lack of liquidity in the secondary markets. The purpose of this paper is to highlight the need for the regulator and market participants to recognise the risks in the financial system, the products available to hedge risks and the instruments, including derivatives that are required to be developed/introduced in the Indian system.

The financial sector serves the economic function of intermediation by ensuring efficient allocation of resources in the economy. Financial intermediation is enabled through a four-pronged transformation mechanism consisting of liability-asset transformation, size transformation, maturity transformation and risk transformation.

Risk is inherent in the very act of transformation. However, prior to reform of 1991-92, banks were not exposed to diverse financial risks mainly because interest rates were regulated, financial asset prices moved within a narrow band and the roles of different categories of intermediaries were clearly defined. Credit risk was the major risk for which banks adopted certain appraisal standards.

Several structural changes have taken place in the financial sector since 1992. The operating environment has undergone a vast change bringing to fore the critical importance of managing a whole range of financial risks. The key elements of this transformation process have been

1. the deregulation of coupon rate on Government securities,

2. substantial liberalisation of bank deposit and lending rates,

3. a gradual trend towards disintermediation in the financial system in the wake of increased access of corporates to capital markets,

4. blurring of distinction between activities of financial institutions,

5. greater integration among the various segments of financial markets and their increased order of globalisation, diversification of ownership of public sector banks and ,

6. emergence of new private sector banks and other financial institutions, and,

7. the rapid advancement of technology in the financial system.

Thus, risks to financial markets in India have arisen mainly out of the process of deregulation of interest rates, disintermediation, integration of different segments of markets and initiation of globalisation process. How have the market participants in India internalised these changes? What risk perceptions do they have? What are the avenues available for managing risks? While addressing these issues, this note is divided into three sections.

1. Section I - deals with the challenges facing the Indian financial institutions in terms of managing various types of risks.

2. Section II - discusses the products currently available for Asset-Liability Management (ALM) including derivatives - their stage of development, present structure and architecture in the context of risk management.

3. Section III - explores some policy issues.

There are essentially four types of financial risks that market participants have to cope with on a regular basis.

1. First, there is a credit risk in that a party to a contract may default.

2. Second, there is a market risk resulting from unfavourable market movements.

3. Third, there is an interest rate risk arising from adverse movements in interest rates. .

4. Fourth, there is a liquidity risk, which arises from the inability to sell in the secondary market.

There are three different but related ways of managing financial risks.

1. The first is to purchase insurance. This is a viable option only for management of certain types of financial risks such as credit risk

2. The second approach refers to ALM. (Asset/Liabilities Management) This involves careful balancing of assets and liabilities so as to eliminate net value changes. ALM is an exercise towards minimising exposure to risks by holding the appropriate combination of assets and liabilities so as to meet certain objectives of the firm (such as achieving targeted earnings, while simultaneously minimising risk).

3. The third approach, which can be used either in isolation or in conjunction with the first two options, is hedging. Hedging is similar to ALM, but while ALM involves on-balance sheet positions, hedging involves off-balance sheet positions. The most basic derivative products used for hedging are forwards, futures, swaps and options.

For many Indian banks, investment in securities represents a strategy of deployment of liabilities. In the absence of a variety of products, flexibility for ALM is reduced and banks tend to book profits or show losses on the securities portfolio regardless of the underlying liability. While Floating Rate Bonds are not popular in the absence of proper benchmarks, the repo market is still in the nascent stage. Moreover, short selling of securities is not permitted and revolving underwriting facility is hindered by certain regulatory constraints. Further, the provision that banks can have only one prime lending rate (PLR) and another long-term PLR constrains effective application of ALM.

One of the most important factors that investors take into consideration is liquidity. In thinly traded markets, investors pay a significant cost for entry and exit if they require liquidity for short periods. Currently, only banks and PDs (Primary Dealers) can create liquidity in Government securities through repos. Repos in PSU and corporate bonds is still a non-starter. This leaves out many participants who may have large surpluses on average but are liquidity strapped in the short-term. Further, the only type of repo prevalent in India is buy/sell back repo between two parties, although international markets are used to a variety of repos, which provide greater flexibility to market participants. It is imperative now that the demat process is hastened, so that a greater number of players can borrow and lend through repos.

The Indian bond market is one-sided. Activity in the market increases when interest rates are expected to come down and falls when interest rates are expected to increase. Market participants are not permitted to short-sell securities in view of the prohibition of forward trading in securities since June 1969 through a Government notification. Repeal of this Notification will require the formalisation of the respective regulatory roles of RBI and SEBI in the debt markets. One of the possibilities could be to allow controlled short-selling initially by PDs with adequate safeguards. For instance, the maximum amount that can be shorted can be specified. Once short-selling of securities is permitted, investors can hedge their positions without having to offload securities in the market.

Currently, banks are permitted to announce one PLR and another term PLR for maturity over three years. This creates inflexibility in ALM due to duration mismatches. Permitting banks to fix and announce PLRs across the term will allow them the flexibility of offering floating interest rates on deposits and give them the option of pegging their PLR to deposit rates.

Another important factor that accentuates interest rate mismatches of banks is that while a large portion of the deposits of public sector banks are term deposits carrying fixed rates of interest, banks are not permitted to charge fixed rate of interest to their borrowers. Thus, six months after sanction of say a one-year term loan at PLR, if a bank reduces its PLR, it will have to correspondingly reduce the interest rate on the loan for the remaining period of the loan. Freedom to extend fixed rate loan to borrowers could be desirable for facilitating ALM of banks and also from the borrowers point of view, particularly for projects involving infrastructure financing. Eventually, banks should be given the freedom to fix their own lending rates without any PLR prescriptions.

RUF is a medium term commitment on the part of a bank to underwrite continuous issue of short-term notes by a corporate. RUF is a flexible product enabling the corporate to raise resources at a favourable rate as compared to its normal borrowing rate. While RUF will obviously attenuate the process of disintermediation, it provides an avenue for banks to generate fee-based income in addition to providing an additional tool for its ALM. Of course, there are risks involved for a bank which provides the underwriting facility. These are the credit risk and liquidity risk.

There is a need to review existing regulations to permit banks to offer RUF subject to capital adequacy and all other prudential norms as applicable to loans. The existing ceiling of 15 per cent of an issue for underwriting etc. can be dispensed with for RUF and the facility be brought within the overall single and group borrower limit.

Derivatives are financial instruments that derive its cash flows and, therefore, its value by reference to an underlying instrument, index or reference rate. Derivative instruments can be classified as asset-liability based instruments, forward based contracts, swaps, options or some combination of the above. Such combinations may create synthetic financial instruments whereby the combined characteristics mirror those of another financial instrument. Further, derivatives may be classified as exchange-traded or over the counter. Exchange traded derivatives tend to be more standardised and offer greater liquidity than OTC contracts, which are negotiated between counterparties and tailored to meet each other party's needs.

Certain derivatives can be structured from existing assets or liabilities. For example, cash flows from certain assets can be disaggregated and repackaged into derivative securities designed to meet specific investor needs. These securities are often referred to as 'strips' for bond transactions and trenches for mortgage or loan related products. In addition, a wide variety of structured debt products with embedded options have been offered in the OTC market. Two of the more common asset liability based derivatives that could be introduced or developed in the Indian markets are Asset Backed Securitisation and Strips.

There are two broad definitions of securitisation. The first is the usage in connection with replacement of traditional bank lending by securities in the capital market. It is also used in the narrower sense to refer to the issuance of asset backed securities, which are tradable instruments supported by a pool of loans or other financial assets. The interest and principal payments on the loans provide the cash flows required to pay interest and principal to investors. Securitisation has many advantages.

1. First, Asset Backed Securitisation provides the issuer with a more flexible, cheaper and rapid means of managing the fluctuating stock of underlying assets.

2. Second, it removes the assets from the balance sheet of the originator, thus liberating capital or other liabilities for other uses such as expansion of assets, etc. Certain conditions, however, are required to be satisfied to qualify for off-balance sheet treatment in the absence of which the assets concerned will be consolidated with the seller's balance sheet for risk asset ratio purpose.

3. Third, securitisation replaces receivables with funds.

4. Fourth, the transformation of previously illiquid assets into tradable securities enables originating institutions to make more flexible use of their balance sheets. In particular, greater liquidity of traded assets permits better management of credit risk through reduction of excessive concentration in particular areas or diversification of exposure into sectors with more attractive risk/ return profiles.

5. Fifth, asset backed securitisation enables originators to remove the market risk resulting from interest rate mismatches by transferring it to investors.

The most widely used assets in off-balance sheet securitisation are housing loans, consumer and trade receivables, student loans, automobile loans and credit card receivables. Banks, financial institutions, non-bank finance companies and housing finance companies are usually sellers of asset backed securities. Internationally, mutual funds, insurance companies, pension funds and corporates are buyers of this product.

There is a vast scope for asset backed securitisation in India. Already, quite a few deals have been concluded with respect to residential mortgages, auto loans and trade/bills receivables in India. Credit enhancement has been in the form of cash collateral in a designated bank account in favour of the trustee of the transaction. A few short-term transactions in trade/bills receivables were originated by NBFCs. Credit enhancements have been in the form of letters of credit from select banks which undertake to pay in the event of default on the underlying asset.

Prohibitive stamp duties, lukewarm investor participation and inadequate foreclosure laws have hindered the growth of this market in India. Internationally, insurance companies, trusts and mutual funds are major investors in asset backed securities. In India, while insurance companies and trusts are not allowed to invest in securitised paper, there are restrictions on investments of mutual funds. Inadequate foreclosure laws increase the risk in respect of mortgage backed securities in case of default. Stamp duties on sale of assets vary across states. High stamp duties on sale of assets have resulted in all such securities deals being structured in the form of transfer of beneficial interest in the asset and not the title. Stamp duties are also an issue in the case of securitisation of mortgage and other secured loans. A question that needs to be answered is whether transfer of beneficial interest construes true sale, with legal transfer of assets to be affected only in the event of bankruptcy of the seller and the special purpose vehicle having recourse to the same remedies against borrowers as the originators. Finally, asset backed securitisation will gain momentum only if there is a liquid secondary market for debt. It is also necessary to clarify certain matters from the regulatory angle particularly from the viewpoint of capital adequacy where the transaction cannot be construed as a "true" sale. Treatment of credit enhancement provided by financial institutions' transactions need also be addressed from this consideration. Credit enhancement in certain circumstances may have to be deducted from capital or treated as a guarantee.

Strips, an acronym for separate trading of registered interest and principal of securities are the different components of a conventional bond separated and traded as distinct securities. A 10-year gilt, for example is strippable into 20 half-yearly coupons and one final redemption. The end result is a series of 21 zero coupon securities, with maturities of 6, 12, 18 months and so on. Strips are very useful instruments for participants in the financial markets. Paradoxically, they can offer safety and stability to one type of investor and be highly speculative for others. Unlike bonds that pay annual or half-yearly dividends, the total return on a strip is known at the time of purchase. Thus, strips give certainty of return, by removing reinvestment risk, but are much more sensitive to changes in yield. While the attractiveness of Strips to speculators arises from their greater leverage, the certainty component of Strips is attractive to those with long-term investment horizons. Through investment in a portfolio of strips, an investor could thus, in principle, achieve more easily a desired pattern of cash flows.

A major advantage of strips is that it helps development of a a zero coupon risk-free yield curve. This could be used as a benchmark for pricing floaters and other derivative instruments. For banks, strips offer the special advantage of a trading instrument and an instrument for duration management. The Government Securities market in India has the necessary size to make Strips a success. There are, however, several structural issues that need to be addressed before introducing strips.

First, currently there are too many issuances of Government Securities in a year with no uniformity in coupons and interest payment dates. Second, the issuance of various maturities of Government Securities need to be standardised so that coupon payment and redemption dates fall due on a certain fixed dates in a year. This will allow for fungibility of coupons and provide necessary liquidity to the market. Third, a lot depends on the pricing of Strips. This would entail changes in the present auction system so that the coupon is pre-announced and the price is determined at the cut-off yield. Finally, the infrastructure needed to facilitate strips and the clearing and settlement process need to be sorted out.