Mumbai/New Delhi: Foreign banks operating in India are on course to register a significant increase in profits for 2007-08 and experts say that at least some of this could be on account of their success in selling complex derivatives or “exotics” that were supposed to help companies hedge or protect their foreign exchange earnings against currency fluctuations.
Such derivatives have now become the subject of a legal battle between banks and their customers—typically medium-sized companies that bought them—because of the losses arising from them. The companies claim that the banks sold the products as protection without highlighting their speculative nature, which makes them illegal in India.
None of the banks has declared profits for 2007-08, but all of them have paid advance taxes for the year. Advance taxes are paid by banks on the their internal estimates of profits for the year. Significantly, the advance taxes paid by five of the six banks with the highest exposure to derivatives increased by between 10% and 90%. Advance taxes paid by the sixth, Barclays, declined 22%.
The data on derivatives exposure of banks operating in India was presented in Parliament by finance minister P. Chidambaram in March. According to this, the total derivatives exposure of the banking system grew 291% over a two-year period to Rs127.86 trillion on 31 December.
The growth in advance tax is simply an indication that these banks expect profits for 2007-08 to be higher than they were in 2006-07. Unlike most state-owned banks, however, foreign banks operating here generate a significant portion of their profits from the so-called fee-based income—or money from business operations other than lending.
Significantly, foreign banks, as a group, have driven the rise in derivatives exposure in the Indian banking system. Their total exposure on 31 December stood at Rs98.91 trillion, a growth of 389% over two years. Their exposure stood at 77% of the total banking system’s exposure.
The heads of treasury operations at a foreign and Indian public sector bank independently said that foreign banks do tend to get the dominant share of foreign currency exposure of Indian companies, something that could influence the choice of these companies when they go shopping for a bank to hedge their currency risks. Neither of the executives wished to be identified.
Ananda Bhoumik, senior director, Fitch Ratings (India) Pvt. Ltd said that although it would be difficult to draw a direct correlation between the derivatives exposures of a bank and its surge in profits, profits from treasury operations have been high in 2007-2008. “Foreign banks typically have a high component of fee income which may be generated from derivatives...among other things,” Bhoumik added.
“Most foreign banks have seen their treasury profits surge in fiscal 2007-2008, thanks to the market conditions and favourable interest rate regime for most part of the year. Derivatives, along with other instruments such as currency swaps and remittances, have contributed to treasury profits,” said Sanjay Aggarwal, national industry director, financial services at KPMG India, an audit firm.
“The increase in advance tax payment reflects the enhanced expected profitability of the bank for the year across all our businesses and including both balance sheet and fee-based income. This is attributable to the very favourable trends in the economy and the significant expansion in the businesses of our corporate and SME (small and medium enterprise) clients, our investment banking and capital market business as well as our retail banking and other consumer businesses,” said a spokesperson for Citibank N.A.
Citibank had the largest derivatives exposure; it was Rs16.36 trillion at the end of December. The bank’s advance tax payment for 2007-08 increased 82% on-year to record Rs1,267 crore.
The other five banks declined to comment.
A derivative is a financial instrument whose value depends on an underlying instrument such as equity or currency. The law in India allows banks to sell companies derivatives on currencies only when there is an underlying foreign exchange exposure.
ICICI Bank Ltd was the only Indian bank to figure in the top seven banks in terms of derivatives exposure. The bank’s advance tax payment in 2007-08 grew 41% year-on-year to Rs1,450 crore. “The increase in advance tax payments cannot be directly correlated to profits. It is also due to the change in effective tax rate. The derivatives business forms less than 10% of the non-interest income (for the bank),” said an ICICI Bank spokesperson.
KPMG’s Aggarwal said banks that earned money from derivatives could be in for some trouble. “Some foreign banks could face customer default risk as many positions currently could turn adverse for customers due to mark-to-market losses. Banks will have to manage this over the next few months as these positions come to maturity and ensure it does not impact profits.”