BackRs128 trillion derivatives on banks’ books
Rs128 trillion derivatives on banks’ books
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Indian banks and companies may have become more vulnerable to risks, especially those arising from innovative foreign exchange and interest rate hedges, over the past two years.
Banks operating in India had Rs127.86 trillion ($3.16 trillion) of derivatives on their books as on 31 December 2007, according to a statement tabled on Tuesday in the Rajya Sabha by the country’s finance minister P. Chidambaram. That number, which refers to the “outstanding notional principal amount of derivatives" according to the statement, was 291% higher than the corresponding number on 31 December 2005. Foreign banks operating in India, as a group, accounted for an exposure of Rs98.91 trillion, a growth of 389% over the 2005 number. This number also translates into 77% of derivatives exposure among banks operating here. It is almost five times the bank credit in early March.
GROWING VULNERABILITY (Graphic)
A senior executive at a large private bank said that the growth in the exposure to derivatives signalled three trends: increasing globalization of the economy which makes companies hedge their foreign currency exposure; the willingness of companies to try new risk hedging tools; and the ability of foreign banks, which have experience in selling and managing such instruments, to scale up their derivatives business here. The executive, who did not wish to be identified, said that the exposure of banks to derivatives is largely on account of their clients’ exposure to foreign exchange risks. Banks do not have to bring in additional capital to scale up their derivatives business; their ability to lend, for instance, is usually curtailed by the amount of capital they have on their books. The banker said that this explained how foreign banks have been able to aggressively ramp up their derivatives business.
To be sure, the magnitude of the banks’ exposure to derivatives and the concept of derivatives itself should not be cause for concern. Over the past few years, derivatives have emerged as popular financial instruments that promise better returns or insulate companies from risks in global finance or both.
By itself, a number such as Rs127.86 trillion does not mean much. On the positive side, it reflects a growingmaturity in the Indian market as appetite for sophisticated derivatives increases. But, some firms could well be buying such derivatives without understanding the risks involved. Derivatives include all manner of tools that allow companies to hedge their foreign currency exposure and interest rate risks. Forex hedges help companies that have significant cross-currency transactions to cope with exchange risks. The data presented by the minister’s statement does not include or refer to exposure to equity derivatives or collateralized debt obligations, or CDOs.
The foreign exchange risks are likely to involve straight dollar-rupee (or rupee-dollar hedges) or more complex multi-currency hedges. Between April and now, the rupee has appreciated 6.16% against the dollar. Exporters typically hedge against an appreciation in the local currency against the one in which they bill.
The local arm of Citibank NA had an exposure to derivatives of Rs16.30 trillion at the end of December, the minister’s statement said, reflecting a 600% increase over two years. On that date, the bank had the largest derivatives exposure among all banks licensed to operate in India.
Among Indian banks, ICICI Bank had the largest exposure of Rs7.67 trillion. HDFC Bank had an exposure of Rs5.04 trillion and State Bank of India; Rs4.68 trillion.
Mint couldn’t immediately ascertain how the Rs127.86 trillion breaks up into exposure in forex hedges, and other derivative instruments. But, experts say that within hedges, the usual split between direct dollar-rupee hedges and more complex multi-currency ones would be around 85:15. One of these experts, who did not wish to be identified, also cautioned that while the overall exposure related to derivatives may seem large, the actual money changing hands would be much lower.
In early March, P.K. Bansal, minister of state for finance, told the Rajya Sabha that ICICI Bank’s overseas operations had reported mark-to-market losses of $264.34 million on account of its exposure to CDOs. In a 6 March interview with Mint, ICICI Bank’s joint managing director and chief financial officer, Chanda Kochhar said that the bank’s portfolio of CDOs was “good but, if the global spread widens we will have to book notional mark-to-market losses again." When the price of the underlying asset depreciates, companies that have invested in credit derivatives built around these assets have to account for the loss in their books. This is called marking to market.
A CDO is a type of asset-backed security that has become popular over the past decade and the global CDO market is currently worth more than $2 trillion. A CDO is usually backed by pools of bonds and loans.
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