Among other things, banking regulations should seek to create adequate competition in the field of banking services so that the end customer of banks has to pay reasonable charges at each bank interface. This will increase return on savings for customers as well as, importantly, help companies – particularly those from the small and medium enterprises (SME) sector – maintain and improve their business competitiveness.
My area of experience is corporate foreign exchange, and though there has certainly been progress compared to some decades ago, substantial constraints on competition remain, as a result of which many, many companies end up paying exorbitant margins to banks for foreign exchange hedging transactions. I have a client with Rs 100 crore of exports who banks with three public sector banks and pays, on average, 40 paise (from interbank) for buying a forward contract; not only is this usurious – larger, strong companies pay as little as 0.5 or even 0.25 paise per dollar – it often leads to the company not buying the hedge since he feels the price is so bad.
Smaller companies in small towns are probably hit even worse; given that the SME sector is so important in terms of both employment and exports, this is a critical issue.
To create meaningful competition, it needs to be easier for companies to buy foreign exchange hedges from any bank it chooses. While banks are required to provide a No Objection Certificate to customers who wish to buy foreign exchange hedges from another bank, there are several practical, operational and regulatory constraints:
* Unlike large companies with multiple banking arrangements, most SME borrowers have an implicit agreement with their regular banker/consortium not to divert their foreign exchange business to other banks as part of the price for availing other credit facilities.
* In any case, the Reserve Bank of India (RBI) does not allow banks to set up limits for “non-constituent” borrowers — a constituent borrower is one with funded limits. Thus, setting up standalone foreign exchange limits for clients is not encouraged in the present RBI framework.
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* RBI requires banks to monitor underlyings by making notings on the physical underlying. While banks do not do this in all cases, the rule makes it that much more difficult to take an foreign exchange hedge with a bank different than the one that has custody of the underlying, effectively locking the customer out of a potentially better foreign exchange rate.
* All banks would require security/cash margin to set up foreign exchange limits; this would render the foreign exchange hedge, even at a much better rate, too costly, unless the borrower could convince his existing banker to release some part of the collateral to the new bank.
Clearly, operational rules are stacked in favour of existing bankers with no real incentive for them to provide finer rates to their clients. To enable companies to more efficiently access the foreign exchange market for hedges, RBI should amend the regulations as follows:
(i) The regular banker/consortium should only have first right of refusal, and the borrower should be free to avail the facility from any other bank offering better quotes — without any restrictive clauses.
(ii) Working capital and other loan agreements should always have clauses that offer pari passu charge on the securities provided by the creditor bank to other banks for bona fide hedging purposes; some European Central Bank agreements already build this in
A broader point is, while there is no question about the need for stringent Know Your Customer norms, the documentation issues mentioned earlier, which often severely constrain hedging efficiency, one often wonders whether RBI should be monitoring underlying exposures at all. This should really be an issue for company managements to determine whether they have sufficient risk capital to cover hedges in excess of their actual underlying exposures. Importantly, newly set up companies and special purpose vehicles are not able to hedge any risk at all since they have no past exposures, even though the management may have very clear visibility of exposures and risk.
RBI should only be concerned with systemic issues, which could be addressed by putting an overall ceiling on derivatives outstanding at any point of time — say, not exceeding 1.5 times of the balance sheet size (assets plus liabilities), provided the company had a board-approved risk management policy. Each bank could, at its own discretion, lay down additional restrictions on limits based on its perception of the risk capital available to the company.
These are minor tweaks and well within the ethos of current regulation. Additionally, RBI should make it clear through senior level speeches, etc. that reasonable foreign exchange pricing is a “must have” for improving market efficiency and sustaining export growth.