Two developments in the interest rate derivative market on Thursday suggest that banks are responding to rising interest rates, and trying to buy protection against them. The value of a derivative security is based on the value of an underlying asset, like share prices, commodity prices or interest rates.
The most popular of these derivatives—the five-year overnight index (OIS) swaps— were trading at 7.93% on Thursday, close to their five-year highs and nearly 60 basis points (or 0.60%) above their late-December levels. “The rise in OIS swaps is a clear sign that the market expects interest rates to harden,” says Ananda Bhoumik, senior director at Fitch Ratings.
Meanwhile, ICICI Bank and investment bank Calyon Capital Markets announced on Thursday that they had closed India’s largest-ever interest-rate derivative deal in January.
The interest rate swap will enable ICICI Bank and Calyon Capital Markets to exchange the interest payments due to them on a billion dollars of underlying assets.
It is not yet clear what the exact nature of the deal is, though traders contacted by Mint guess that ICICI Bank has swapped from fixed-rate interest to floating-rate, thus betting that interest rates would rise in the future.
The activity in the swap market is significant. Indian banks have traditionally had to deal with credit risk, or the danger that borrowers may default on their loans. The expected rise in interest rates as the Reserve Bank of India (RBI) tightens the screws on money supply could force banks to deal with another type of risk—interest rate risk. The most clear and present danger comes from their bond portfolios.
Regulations force banks to invest at least a quarter of the money they collect from depositors in government bonds. The current investment of government bonds is around 28% of bank deposits, one of the highest such ratios in the world. A spike in interest rates pulls down bond prices, and bank earnings are likely to take a hit as bond prices in India tumble.
Two research papers done for the International Monetary Fund—by Ajay Shah and Ila Patnaik in January 2004 and by Amadou Sy in April 2005—gave early warnings about the risk that banks face from rising interest rates.
The central bank too has tried to convince banks to manage their interest rate risks better—and, among other measures, introduced rate swaps in 1999 to help banks hedge risks.
Some believe that banks have already protected themselves from falling bond prices by moving large parts of their bond portfolios into the held-to-maturity category, which means that these bonds will not be traded and hence are unaffected by movements in bond prices. “The situation is far less worrisome that before,” says a hedge fund manager.
But that may not be enough. Banks have had little reason to trade in interest rate swaps till now because falling interest rates were like a one-way bet that helped them earn huge profits on their bond and loan portfolios. The interest rate cycle has now clearly turned, with buoyant credit growth, rising inflation and a worried central bank.
ICICI Bank’s billion-dollar swap and the spike in traded swaps shows that higher interest rates could send banks scurrying to buy cover against higher interest rates.