The invention of Credit Derivate Instruments (CDI) has created a mechanism by which Banks and other credit-giving institutions are able to mitigate the risks associated with the loans they give to their customers. There has been talk of bringing this innovation to Nigeria via the use of Insurance Companies. That is, to have the Insurance Companies provide insurance to lenders against the default risk of borrowers; especially the small and medium scale business borrowers. The premise for this idea being a belief that once the credit risk is removed, the lenders would be more willing to advance loans to businesses. Thus spurring increased economic activities and ultimately, economic growth.
Essentially, a CDI allows for the transfer of credit risk without the necessity of transferring the underlying asset (i.e. bank loan). There are many ways by which this can be done. However, the instrument most commonly used is the Credit Default Swap (CDS). Under this arrangement, the lender and the insurance company enter into a contract whereby the lender pays a regular premium to the insurance company to provide cover against the default risk of the borrower. So that, where the borrower defaults, the insurance company would pay to the lender an agreed amount of money to compensate the lender for the default.
Guarantees (personal and corporate) also produce the same type of effect as the CDI; it transfers the credit risk to the guarantor who would then be saddled with the obligation of seeking the repayment of the loan from the borrower. The difference between the two being that CDIs can, potentially, be easier to obtain than a guarantee; there being no need for a link between the insurance company and the borrower. Also, the insurance company gets paid to provide the cover whereas the guarantor is usually not paid to provide the guarantee (except in cases of Bank Guarantees).
Another benefit of a CDI Scheme, less talked about but no less important, is that to be derived by investors. The CDI allows an investor to make money on the default risk of a company's debt obligation without having to actually buy the underlying debt security. This is due to the fact that the instrument is tradeable, much like shares or bonds. For example, if an investor thinks that a company is likely to default on its debt obligation, he or she would buy protection using a CDS and pay the required premium. If the company then defaults, the investor can make money in two ways; first, by selling the premium he or she bought to another party, a debt-holder, at a higher rate thereby profiting off the spread between what he paid to the insurance company and what the debt-holder would pay him or her. Alternatively, he or she may purchase the debt security which has deteriorated and then get the par value from the insurance company. Insurance companies are also not left out from the benefits as they can earn additional income from underwriting CDS contracts.
Although the CDI has been criticized by many due to its ability to engender systemic risk; especially the more exotic types. The flipside of being able to transfer credit risk is that a major default by a company in one sector may have the potential of affecting unrelated institutions in other sectors of the economy. Thus making it harder to contain a financial crisis.
However, in light of its potential to engender increased lending to the real sector and also create more investment opportunities for investors, the introduction of a CDI scheme is laudable.
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