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Banks in a quandary over derivative deals financial scene

There are very few days when derivatives, a term previously unheard of by even bankers, do not make headlines in Indian financial and business media. And, such headlines are almost always for the wrong reasons.

On April 23, the State Bank of India Chairman announced that some of the bank’s customers were likely to record in their books notional losses as high as Rs. 650-700 crore on their derivative transactions. A few days earlier, Axis Bank (previously UTI Bank) had announced that it had made provisions of nearly Rs. 72 crore for the last quarter of 2007-08. The provisioning was for six transactions that had soured. Its customers had refused to pay.

The disclosure, the first of its kind for an Indian bank — public, private or foreign — has been widely appreciated. It is hoped that after the biggest bank in the country (SBI) indicated its problems with derivatives, other banks, especially in the public sector, will follow suit.

As of now, in the absence of transparency, there can only be guesses as to the quantum of derivative transactions that have gone bad. Some estimates place the figure as high as $5 billion. Not all these will end in acrimonious disputes between banks and their clients. In fact, most of the reported losses are of the mark-to-market variety (MTM).

As the market values relating to the underlying assets change drastically against the hedged position, there would be an adjustment by way of margin calls on the derivative transactions. In that sense, the losses, if any, are notional but if the adverse trends in the forex or interest rates continue, proving the initial bets wrong, the corporates concerned could get into real trouble. For the bank which wrote the derivatives it could be time to classify the transactions as NPAs. (This is because the average derivative transaction under reference is said be highly leveraged carrying a risk that might run into several times its initial value).

The extent of losses, indeed the total size of the derivatives market, has remained hidden from public view partly because there has been no regulatory compulsion to disclose. Even more basically, the accounting standards need to be reworked to make reporting of such transactions mandatory. The Reserve Bank of India is seized of the matter. In tomorrow’s credit policy announcement, lack of clarity in derivatives is bound to figure, although the central bank may not sensationalise the lapse.

However, the problem transactions have a knack of coming to the surface sooner or later. Some clients of a few private banks — ICICI, Kotak Mahindra and Axis — have taken the banks to courts.

Legal resolution of such disputes may not be the best way. This is because these relatively new financial instruments have not so far been adjudged by courts in India. Besides — and this is the crux of the dispute between banks and their corporate clients — these are complex instruments.

Their pitfalls (downside risks), companies now allege, were not made known to them by the banks. Aggressive selling of such instruments, it is alleged, amounts to ‘mis-selling.’ Between a large bank and a midsized corporate there is considerable ‘asymmetry’ of information in new areas of banking. Aggressive salesmanship might have persuaded even a conservative company to go in for a derivative transaction whether it is warranted or not. For the bank, it could mean big money and a leg up among peers in a ‘frontier area’.

For many Indian corporates, derivatives appeared to be a viable option to counter the twin threats of rupee appreciation and higher interest rates.

The most common form of derivatives — the forward (purchase or sale) contracts in foreign exchange — has existed for long in India. Some of the newer variants now in focus require deep understanding of several currencies besides the Indian rupee and the American dollar.The motivations behind such transactions are varied but in general the stated purpose is to hedge risks.

Speculating on currencies/interest rates was, at least for the records, not on. Incidentally, speculation, a much maligned term in India, has a rightful place in derivatives. For every person who hedges there is a party willing to speculate.

How could a hedge go wrong so comprehensively? In India, most derivatives were structured in the belief that two major currencies — the yen and the Swiss franc, both with low interest rates — will not appreciate beyond certain levels (the yen at 110 and the Swiss franc at 1.10 (both to the dollar). It pays, therefore, to convert, say, a higher cost external commercial borrowing into a Swiss currency or Japanese yen loan.

The mechanism, called a swap, is not new to India. However, it has to be fully hedged; otherwise currency movements at the farther end would upset all calculations. A hedge will cease to be that. As the dollar went into a steep decline upsetting all calculations, the companies, which had only partially hedged, were forced to realise that ‘perfectly safe’ hedges are proving to be riskier almost on a par with speculative transactions.

A hedge by definition is for minimising risks arising out of uncertain cash flows. It carries a cost such as that of entering into a forward contract or option. It is incomprehensible how these hedging transactions could be used to make profits. There has been a serious breakdown of communications between the corporates and the banks that sold them the derivatives. For the affected parties, it may not be a consolation to be reminded of a similar episode in the U. S. some 15 years ago.

There was a celebrated court battle between the consumer goods giant Proctor & Gamble and Bankers Trust Company, then a famous bank known for its aggressive selling of exotic financial products.

Two swaps sold to P&G by Bankers Trust in 1993-94 turned sour causing P&G to lose $195 million. P&G, citing some of the grounds now voiced in India, took Bankers Trust to court. After a protracted legal battle lasting over three years the matter was settled out of court.

Obviously, even in the world’s largest financial market, a leading bank and a large multinational had to go through a learning curve. Subsequently, there were big losses incurred by injudicious use of derivatives by, among others, a municipality, Orange County of California.

C. R. L. NARASIMHAN

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