By Taponeel Mukherjee

Feb 19 (IANS): Innovation in the Indian capital markets is needed to both boost growth and resolve the balance sheet issues of banks. Besides improving the corporate bond market and lending standards, work needs to be done to create a covered bond market to assist better lending standards.

Covered bonds are bonds backed by both a pool of assets and by recourse to the borrower – providing dual recourse for the lender. Covered bonds have been a tool for credit across the world for centuries, and the outstanding amount in Europe, according to the 12th edition of the European Covered Bond Fact Book, was 2.5 trillion euros at the end of 2016. India needs to establish a covered bond market to provide a useful additional tool for credit flow in the economy.

Given its dual recourse feature, the covered bond market encourages more risk-averse investors such as pension funds and insurance companies, with large pools of capital, to participate in the market. Having dual recourse also allows investors to lend for a longer duration and at a lower interest rate. This helps bring down the cost of credit and allows institutions issuing covered bonds to match asset liability for longer periods of time.

For instance, if a financial institution makes housing loans for a 10-year period, access to a covered bond market will allow it to borrow for longer as opposed to the short-dated bank deposits on its balance sheet. This is particularly applicable to the India, since most banks fund long-dated assets using short-dated liabilities such as fixed deposits. This creates refinancing risk for banks, causing instability in the financial system. A well-developed covered bond market helps create a more stable financial system.

India faces some challenges in the credit markets, and innovation is the key to improving lending standards. To start with, the covered bond market must be applicable only to a few sectors that need a push. Housing can be one, since the lower cost of credit can make the sector a lot more affordable in India. It is important to start with one sector, or a few sectors at most, to help develop the covered bond market.

There are three important points to be kept in mind to ensure the success of a covered bond market. Firstly, the demarcation of assets in the asset pool must be carefully defined legally and executed operationally. India needs to create an independent central agency that will monitor the segregation of the assets in the pool. It will be tasked with ensuring that assets in the pool are not used as collateral for any other purpose.

Secondly, the agency will have to ensure that the pool of assets maintains its value and assets are added or removed from the pool by the borrower when required to maintain the agreed asset value. There can be no two ways about this condition.

Thirdly, strict limits must be ensured in terms of how much a particular financial institution can issue as covered bonds as a percentage of its balance sheet. This will ensure that not all assets of a financial institution are encumbered through a covered bond pool.

In summary, it is important for India to learn from how the covered bond market developed in Europe and helped in developing a robust credit system. Without doubt, a covered bond market is one of many different solutions that must be used to create a more robust capital market in the country. That said, a successful covered bond market is contingent upon a well-defined legal framework and its effective implementation.