Credit Default Swaps costs soar as rate hikes raise risks for banks

The risk of a default by ICICI Bank, State Bank of India, IDBI Bank and Bank of India in their debt repayment obligations has hit a nine-month high as interest rates soar and the economy slows.
Reflecting this, five-year credit default swaps (CDS) of these banks have risen to levels not since September, and look set to rise further.
“For the next six months, pressure will remain high and hence CDS of banks will soar. It is being shadowed by macro headwinds,” said Jagannadham Thunuguntala, chief strategist, SMC Capitals.

Credit default swaps are instruments that transfer the risk of a credit default by an underlying party from a buyer to a seller. Like insurance, the buyer of a swap pays a premium to the seller who commits to make good any credit default by the underlying third party —- higher the perceived credit risk, higher is the cost of a CDS. They are considered an accurate barometer of a lender’s credit quality and a sharp and sustained spike in it means impending disaster.

The Reserve Bank of India has raised the key policy rates ten times since March 2010, but inflation continues to soar. Headline inflation, or inflation based on the wholesale price index, had weighed in at 9.06% in May compared with 8.66% in April.

“The recent price hike in fuel will act as a trigger for the Reserve Bank of India to raise key policy rates by another 50 basis points as inflation will be uncomfortably high,” Goldman Sachs economists Tushar Poddar and Vishal Vaibhaw wrote in a research note on June 27.

When interest rates rise, the borrowing costs of companies shoot up and the risk of default increases as the borrowers’ repayment capacity gets affected.

Interest rate hikes cause a surge in the non-performing assets (NPAs) of the banking sector. When NPAs rise, banks get into trouble as they don’t earn any interest from such loans and have to keep aside money for bad assets.
“In a rising interest rate scenario, some pressure may build up later. It is difficult to say what will be a trigger for defaults,” R K Bansal, executive director, retail banking, IDBI Bank said.

The net NPAs of 42 listed banks rose 14% to `40,359.43 crore for the year ended March 31, 2011 from `34,529 crore in the year-ago period.
“Bad loans are likely to go up in the next few months,” Thunuguntala said.

Meanwhile, the RBI has directed banks to set aside cash for 25% of loans that have been termed doubtful for up to one year, from 20% earlier. Doubtful loans up to three years will attract a provision of 40% compared with 30% earlier and those exceeding three years will attract 100% provisioning.