Banks' derivatives exposure may be capped

RBI to overhaul norms for all foreign currency derivatives.

The Reserve Bank of India is planning to overhaul the norms for all foreign currency derivatives. The move could increase the provisioning requirements and restrict banks' exposure to credit derivatives and currency and interest rate structures.

Sources familiar with the developments said the central bank has sought data from banks to assess their total exposure to foreign currency derivatives, both in the domestic and in the overseas markets.

While exposures in the domestic market relates mainly to interest rate and currency options and swaps, international investment includes credit derivative structures like credit-linked notes based on foreign currency loans and bonds raised by Indian companies abroad.

In addition, RBI has also asked banks to explain the procedure adopted for "marking to market" the portfolio for valuation before the end of the financial year 2007-08.

Based on the exercise, the banking regulator is likely to limit the level of bank exposure to forex derivatives of any kind. It may also specify stringent risk management norms for banks to enter into derivatives purely for trading or speculative purposes.

If RBI goes ahead with the move, the cap would be akin to the ceiling on equity market exposure. RBI has asked banks to limit their capital market exposure to 40 per cent of their net worth, with direct exposure limited to 20 per cent.

In its inspection of the banks, RBI has found that most of the banks have entered into derivatives as speculative transactions and not purely for hedging the existing credit or investment portfolio.

Speculative transaction is made to purely gain out of unwanted movements in currency or interest rate without any underlying position. Essentially, a bank should enter into such transactions to protect its portfolio from interest rate or currency risk or credit default risk.

As part of the proposed valuation norms, RBI could also ask banks to mark to market the derivative portfolio maintained in the held-to-maturity (HTM) category. The move would bring Indian norms at par with international best practices, said a source.

Globally, heavy notional losses are pared by shifting the investment from HTM to available for sale (AFS). In the present round of turbulence in the financial markets, most global giants have had to write down the value of their investment due to price fluctuations, most of which is notional.

At present, banks are putting derivatives in the "held to maturity" category since these are not traded. As per the current valuation norms, any instrument which is not traded is put into HTM category and this need not be valued.

Market-based valuation and provision for losses is only done for portfolio under "available for sale" category, which is actively traded by banks. While gains are notional in the marked-to-market exercise, losses have to be provided for.

At present, sources said, most banks did not have a model or valuation of credit derivatives since there was no market or instrument in India. As a result, there was a need for uniform valuation norms for derivative instruments which, at present, varies across banks.

Sources said RBI may also ask the Institute of Chartered Accountants of India to work our separate accounting standards for valuation of credit derivatives.

At present, accounting for interest rate and currency derivatives are covered under the new accounting standard "� AS 30 and AS 31.

Credit derivative exposure and losses on such investment is a new phenomenon for the Indian banks as a fallout of the sub-prime crisis globally. In the domestic market, most of the investment in forex derivatives has turned into notional losses because of the adverse movement in currencies like the Swiss franc and the Euro.