The concept of bilateral netting can be understood through a simple illustration. Let us say, there are two banks A & B. Bank A has an exposure of ₹100 to B while B has an exposure of ₹90 to A. Their gross exposure is ₹190 and without bilateral netting, the system will currently have to keep aside capital of ₹190 worth of exposure.
This is very costly and the banks will be soon forced to stop doing additional business with each other. However, the net risk for the system is only ₹10 ( ie. ₹100 – ₹90 = ₹10 ). In this example, the gross capital requirements are 19 times higher than the net requirements. If the banks are allowed bilateral netting, the capital requirement dramatically fall & they can do a lot more business.
Bilateral netting is when two parties combine all their swaps into one master swap, creating one net payment, instead of many between the parties.
Basel norms on bank capitalisation presumes the existence of a bilateral netting framework. By adopting Basel norms, without a bilateral netting arrangement, India ended up making the capitalisation requirements unnecessarily tight.
