RBI may limit banks' lending to derivatives

The Reserve Bank of India (RBI) may stipulate a prudential limit to cap banks' exposure to derivatives.

According to banking sources, banks exposure to derivatives would be linked to their respective net worth, similar to the exposure to capital market.

The ceiling would be over and above the existing norms relating to banks' exposure to the derivatives market. Currently, derivatives are covered by the individual and group exposure norms.

Derivatives positions also attract capital adequacy norms based on the conversion of the exposure into credit equivalent as stipulated by the RBI.

The likely cap would be a result of the RBI concerns over excessive exposure of some banks to the derivatives market (which is non-fund based exposure) while maintaining very small fund-based exposure.

As per the data released by the RBI in its trend and progress report, contingent liabilities (which include derivatives market exposure) of foreign banks had gone up by 60 per cent from Rs 15,90,636 crore in 2004-05 to Rs 25,54,165 crore in 2005-06.

This is closely followed by new private sector banks, whose exposure to the market has gone up by 59 per cent from 4,98,008 crore to Rs 7,90,142 crore.

The new norms to be released by the RBI may also come out with appropriateness policy. This will help both the bank and its counter-party corporate to have a better disclosure of the terms and conditions of the deals before entering into a transaction.

The norms may also require the banks to disclose the risks in the derivative deals on the balance sheet either in the form of notes to accounts or balance sheet items. The banks may have to mark-to-market these deals as well.

Mark-to-market is the mechanism by which banks have to provide for deals if they run adverse to the market movement of interest rates or currency rates. The gain in the deals, though, is notional.