Reserve Bank bans yen swaps for banks

The Reserve Bank of India (RBI) has spiked banks' attempts to reduce interest cost on hybrid Tier I and Tier II bonds through coupon-only swaps in yen.

The RBI has banned banks from entering into yen swap transactions in respect of their innovative Tier I/ Tier II bonds saying it generates "undue" currency risk in the books of banks since there are no underlying foreign currency receivables.

A bank betting on a weaker Japanese currency enters into interest rate swaps with a counter party (other banks) which converts its periodical interest outgo on the bonds into yen from rupee.

The principal amount in an interest rate swap (notional) and is never exchanged. On the payment day, normally the difference between the two amounts is given to the party entitled to it. Interest rate swap usually involves very little cash outlay.

The counter party (a bank) in turn has an opportunity to book gains if the foreign currency (yen) strengthens. The counterparties hedge the downside risk in the OTC (over the counter) derivatives market.

Banks, mostly public sector banks, have been raising large amount of money via Tier I and Tier II bonds to shore up their capital adequacy ratio, meet credit demand and be ready for ready more stringent capital adequacy norms (Basel II) from 2007-08.

Mohan Shenoy, Kotak Mahindra Bank's group president-treasury, said, "Tier II funds are raised for balance sheet purposes. By entering into coupon only yen swaps, banks in the bargain end up taking trading positions. Balance sheet items and trading items should never be mixed."

In a recent circular, RBI has provided banks detailed guidelines on how to account for gains/ losses arising out of such coupon-only yen swaps. It has asked banks to compute gains/ losses arising out of each such swap transaction and fully provide for any losses.

Banks are also required to transfer gains to a special reserve through profit and loss account and draw down from the reserve only for meeting future losses arising out of these swap transactions. The swap transactions entered into by banks in respect of Tier I/ Tier II cannot be renewed on expiry.

A treasury head with another private sector bank said, "By entering into coupon-only swaps in yen, banks only change the risk from one currency (rupee) to another (yen) and are in no way hedging their interest cost."

Treasurers said banks have been raising Tier I and Tier II funds at rates as high as 9.5 per cent in recent times and the coupon-only swaps in yen were being used to reduce interest burden by about 50 basis points.

Banks have raised about Rs 16,000 crore of Tier I and Tier II capital in 2006 so far, compared with about Rs 14,000 crore raised in the whole of 2005. Banks are expected to raise another Rs 11,000 crore of Tier I and Tier II capital by March 2007.

Tier I bonds are perpetual in nature with no redemption date and considered alongside core capital comprising equity and unimpaired reserves, while Tier II bonds are subordinated debt which can be up to 50 per cent of Tier I capital.

Both Tier I and Tier II capital are used for computing capital to risk-weighted assets ratio of banks.

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DERISKING MEASURE

The RBI said yen swap transactions in bonds generate "undue" currency risk in banks' books as there are no underlying foreign currency receivables

Mostly public sector banks have been raising large amounts via tier-I and tier-II bonds to shore up their capital adequacy ratio

The other route for allocation of captive blocks is through a screening committee