Banks’ exposure to derivatives, LCs falls 26.4% on slowdown

Banks’ exposure to derivatives, LCs falls 26.4% on slowdown

Mumbai: Contingent liability or the off-balance-sheet (OBS) exposure of banks, which includes derivatives, letters of credit and guarantees, declined 26.4% to Rs107 trillion at the end of March 2009 from Rs145 trillion last year, driven by the economic slowdown and Reserve Bank of India (RBI) regulations on OBS.

This decline comes after the exponential growth that banks saw in the last three years. The OBS exposure of banks had increased nearly 88.44% to Rs145 trillion in 2007-08 as more companies rushed to hedge their foreign exchange contracts to tide over the volatility in currency markets, according to RBI’s annual report on banking. The increase in 2007-08 was over and above the 80.2% growth seen in 2006-07.

While OBS items are not directly funded by banks, they remain as liabilities on the books of banks, which need to honour the commitment if the client companies fail to do so.

“The economic slowdown had affected corporate activity in 2008-09,’’ said the corporate banking head of a private sector bank who did not want to be quoted as he is not the official spokesperson of the bank. “Expansion, investments and borrowing plans of corporates had slowed down hence the number of forward contracts entered by corporate India saw a dip which also led to a drop in exposure."

Another corporate banking head of a foreign bank who also did not wish to be named as he is not authorized to speak to the media said: “Banks have stayed away from the derivative business after some companies took legal action against banks’ mis-selling of exotic derivative products on account of which companies had to incur huge losses."

Many private banks including ICICI Bank Ltd, HDFC Bank Ltd, Axis Bank Ltd, Yes Bank Ltd and Kotak Mahindra Bank Ltd were sued by corporations for the mis-selling of derivative products.

Foreign banks’ exposure to derivatives, letters of credit and guarantees declined 31.2% to Rs70 trillion at the end of March 2009 from Rs102.1 trillion last year. New generation private sector banks’ exposure to such products dipped 29.7% to Rs16.25 trillion from Rs23 trillion. The exposure of public sector banks to OBS items, meanwhile, has risen 2.3% to Rs19.09 trillion from Rs18.66 trillion.

“Foreign and private banks in 2008-09 on account of the liquidity crunch and rising non-performing loans were reluctant to take exposure on corporates," said a senior general manager in charge of corporate credit in a Mumbai-based public sector bank. “Corporates were forced to come to public sector banks and hence the rise in guarantees given on behalf of corporates and forward contracts.’’

The Reserve Bank of India, on 30 May, modified the guidelines on OBS items to check the rapid growth in banks’ exposure to guarantees and derivatives. The new norms proposed modifications in conversion factors, risk weights and provisioning requirements for specific off-balance-sheet exposures of banks. It also said restructuring of the derivatives contracts, including foreign exchange contracts, should be carried out only on a cash-settlement basis.

In derivatives transactions, any amount of receivable that remains unpaid for 90 days from the specified due date for payment should be classified as a non-performing asset of the bank. These modifications came into effect from fiscal 2009.

The banks were, however, given the option of complying with the additional capital and provisioning requirements arising from these modifications in phases, over four quarters, ended 31 March.