For the success of a bank the effective management of credit risk is vital. Credit derivatives can play a crucial role and help to enhance the efficiency of the banks in effective management of credit risk. While credit derivatives are certainly grabbing headlines over the past few years with year-on-year volume statistics illustrating the exponential growth of this market, there is also an air of frustration.

Credit Derivatives (CDs) market is spreading its wings in all parts of the world including India. CDs help the banks to make their portfolio of loans risk-free by isolating the credit risk from the underlying asset and sell to the protection seller.

Many banks believe that credit derivatives are their strongest risk management weapon. But are they actually using this instrument effectively? "We do not think that CDs played any significant role in protecting banks from the downturn in Argentina", says a spokesman of the Bank of Spain. Many international leading banks are the villains of the credit derivatives market because they parcel up their low grade assets and sell them to unsuspecting investors. While it will help to avoid the bank's collapse when the bubble bursts, like in the case of Enron, WorldCom, Parmalat etc., it is the insurance companies and investors that take the hit and not the banks. Warren Buffett, an outspoken investor, describes CDs as being like hell—easy to get into but difficult to get out of.

One analyst says that it is like toxic waste that banks transfer from their balance sheets into the arms of unsuspecting insurers. Many banks believe that credit risk is bad and its transfer is desirable. The question is, can the transferee really manage the credit risk any better than the banker?

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