Fixed income derivatives is manna for foreign banks

Meeting year-end profit targets with a limited capital base has become easy for foreign banks following the opening up of the over-the-counter (OTC) fixed income derivative markets.

These banks are taking exposure in unlisted and non-rated public sector enterprises by helping the firms hedge their interest rate liabilities arising out of rupee resources raised from the domestic bond market.

Though the banks are not taking a direct exposure through such deals, they are receiving substantial risk-free earnings in the process.

Moreover, their capital allocation towards such exposure and credit limits remain intact, a dealer said.

Such deals are being routed through public sector banks in order to skirt international disclosure norms.

Corporates hedge their risk with public sector banks, which take direct exposure to non-rated and unlisted corporates by allocating capital provisioning and credit limits. Public sector banks, in turn, hedge their liabilities with foreign banks.

Apart from saving on the capital and credit limits, foreign banks could wash their hands of when any problem arises stating that the deal was done with an informed buyer, which is the bank, and not the corporate.

In most of the deals, sources said, the spread charged by the foreign banks are much higher than the spread negotiated between public sector and corporates as it helps both of them to hedge their interest rate outgo.

The risk for PSU banks is six times more than foreign banks as they are taking a direct exposure on such corporates.

The international disclosure norms for foreign banks and financial institutions have become critical after the largest municipality in the US, Orange County, filed for bankruptcy in 1994 after suffering losses of $1.6 billion in the financial markets following the advise of Merrill Lynch investment brokers.

Interestingly, the losses rose on account of a reversal in the interest rates stance (from soft to rigid) of the Federal Reserve.

However, a repeat of such a scenario is unlikely here, say derivatives dealers. They said Orange County was a case of leveraged swap where the exposure ran into multiple times the amount of the underlying exposure.

As per Reserve Bank of India guidelines, swaps can only be done to hedge the underlying asset.

While in some deals, banks mutually incorporate the early termination clause of the deal if any side suffers, market sources said most of the deals do not have this clause.

The big question is how savvy are public sector corporates as these London inter-bank offered rate (Libor)-linked payouts run for long periods "" of seven-ten years.

While the current advantage may look attractive, a few months down the line, the scenario may change making corporates out-of-money, if not the public sector banks themselves.