Credit Default Swaps: Opening a New Pandora's Box

Abstract

Credit Risk Management has acquired a pivotal place in the Indian banking system as the banks are adopting globally accepted Basel II standards. In order to resolve the growing anxiety over credit risks, the RBI is now seeking to arm the banks with new financial tools to transfer these risks from their balance sheets on the lines of such international developments. Thus, the RBI, on May 16, 2007, released the Draft Guidelines on Credit Default Swaps, proposing a regulatory framework for such transactions.

This research paper aims to explore the downsides of the Credit Default Swaps (CDS) as a 'risk transfer instrument'. Specifically, we deal with the problems of Moral Hazard and Adverse Selection associated with use of CDS.

Keywords: Adverse Selection, Banking, Credit, Default, Financial System, India, Moral Hazard, RBI, Risk, Swaps