The Union Budget announced yesterday has a number of radical measures that need elaboration. One of them is Bilateral Netting. This may seem like an arcane technical change, but it will lay the foundation of a functioning corporate bond market in India 1/n
So, what is bilateral netting? It allows two financial institutions to set off exposures to each other for the purposes of capital & margin. Illustration: Bank A has an exposure of Rs100 to Bank B, and Bank B has an exposure of Rs90 to Bank A. The gross exposure is Rs190 2/n
With the imposition of capital requirements, the banks have to keep aside capital for Rs190. However, the net exposure is only Rs10. With bilateral netting, banks will only have to look at the net position thereby freeing up capital (in this illustration 19:1 ratio). 3/n
Basel type capital requirements presume netting, and most countries already have it. India introduced Basel 3 without bilateral netting (multilateral is allowed). However, freeing up capital is not the biggest gain but the corporate bond market. 4/n
Netting will allow development of a properly regulated corporate default swap market in line with international practice (RBI & SEBI are fully aware of the issues). In turn, this puts in place the necessary conditions for a liquid corporate debt market. 5/n
The Indian corporate bond market is effectively closed to most companies except the very largest. This opens the door for smaller companies to tap it. And yes, this will need to be properly regulated & supervised - including the integrity of rating agencies. 6/n
In addition to the netting reform, the investment limit for FPIs in corporate bonds has been hiked from 9% to 15%. Other measures for boosting this market will be considered. Suggestions welcome. n/n
