H R Khan: Managing currency and interest rate risks - new challenges
for banks & corporates
Session keynote address by Shri H R Khan, Deputy Governor of the Reserve Bank of India,
at the 2nd FT-Yes Bank International Banking Summit, Mumbai, 16 October 2012.
* * *
The speaker acknowledges the contributions of Ms. Dimple Bhandia, Shri. Rakesh Tripathy and Shri. Surajit Bose
of the Reserve Bank of India.
It is a pleasure to be here at the 2nd FT-Yes Bank International Banking Summit amidst a
very distinguished set of panellists and audience. I must compliment the organisers for
selecting a very wide range of subjects - subjects which are as varied as they are topical in
the world as we live in today - for discussions. The subject for this session "Managing
currency and interest rate risks - new challenges for banks and corporations" is very relevant
in the post crisis world of elevated financial market volatility. Managing market risk has
always been at the core of the risk management function of banks and, increasingly, of
corporates. As the subject of the discussion appropriately suggests, the recent global crisis
has, indeed, posed "new" challenges for banks and end-users in managing currency and
interest rate risks. Such new challenges have emerged due to excessive volatility both in
terms of dimension and direction witnessed in almost all classes of financial assets. Since
banks and corporates are often required to take decisions that can impact them much later,
such a state of excessive volatility makes it difficult for concerned economic agents to make
optimal and informed decisions.
Institutions, both financial and non-financial, have endured extreme levels of market volatility
in recent years. Long standing correlations across and within asset classes broke down,
traditionally held beliefs about the valuation of securities were turned on their heads,
currencies and interest rates moved into ranges hitherto not witnessed, and definitely not
anticipated. And all of this happened within an environment of significant economic and
geopolitical uncertainty amidst slowing growth, posing considerable challenges for banks and
corporates alike. Scenarios which had been consigned to the "tail" of normal distributions
even in traditional stress testing exercises suddenly became actual scenarios, leaving
institutions scrambling for new techniques and paradigms to manage currency and interest
rate risks. This has been, as we know, eloquently captured by Nassim Nicholas Taleb in his
black swan theory which describes occurrence of highly unexpected events causing high
impact.
Prolonged period of systemic risks and heightened volatility
The onset of the global financial crisis in 2007 set the stage for a prolonged period of
systemic risks, anxiety and unprecedented levels of volatility in financial markets. It left policy
makers grappling for measures - both conventional and unconventional - as they scrambled
to deal with bankrupt financial institutions, frozen inter-bank markets, increasingly volatile
financial markets, persistently high levels of unemployment and a stagnating real economy.
The increased volatility injected an additional element of uncertainty into financial markets
and created significant feed-through effects into the real economy. Financial and
nonfinancial companies, faced with the challenges of anticipating costs and pricing their
products, adopted a more cautious approach to business planning and their hiring and firing
policies.
Going forward the heightened volatility in financial markets is unlikely to moderate soon.
Global economic conditions remain fragile. The green-shoots of recovery which had emerged
during 2010 have given way to uncertainty about the prospects of global growth in developed
and emerging markets alike. Unemployment remains at unsustainably high levels in many
advanced economies. Unconventional monetary policy measures have become the norm in
the advanced world as one central bank follows another in announcing novel measures to
kick start their respective economies. New phrases have entered the dictionary of the central
bankers - "Operation Twist", "Outright Monetary Transactions", "Funding for Lending"
scheme, to name just a few. All of these have resulted in considerable uncertainty about the
impact of such measures, the longevity and extent of the measures and the timing and
impact of scaling back such measures, as and when they are finally unwound. These
uncertainties have inevitably found expression in increased volatility in financial markets.
There is yet to emerge any credible and sustainable solution to the sovereign debt crisis
plaguing the Eurozone. There remains continuing uncertainties about the future of the
European Monetary Union. Several measures have been taken recently towards resolving
the issues facing the Eurozone. These include policy announcements about European
banking and fiscal integration, announcements of new rounds of asset purchase
programmes, statements from senior policy makers in support of the single currency, etc.
These have stabilized markets by reducing probability of tail risks and have bought critical
time and elbow room for policy makers.
Nevertheless, critical risks and vulnerabilities remain. A definite strategy to the resolve the
Eurozone sovereign crisis remains elusive and policy execution risks are high given the
widespread popular discontent about the proposed austerity and other fiscal measures.
There are increasing signs of fragmentation along national lines in the euro zone while
banks' balance sheet adjustments and funding difficulties are only adding to the credit
constraints being posed by trends in deleveraging as banks strive to attain higher levels of
capitalization. Downside risks to global growth are non-trivial and further uncertainties are
being posed by political developments in the US including the looming "fiscal cliff". All or any
of these issues have the potential to trigger considerable market instability.
The uncertainties in the advanced economies are finding their way to developing nations
through trade, finance, commodity price and confidence channels. Critically, the uncertainties
are reflected in the volatility of capital flows to emerging market - a volatility which is
reverberating in domestic financial markets. In cases of countries such as ours the
uncertainties posed by global headwinds are accentuating domestic macro-economic
challenges. Due to increased channel of inter-linkages between the domestic markets and
the rest of the world, the domestic markets have not been able to remain isolated from the
global developments. Just to drive home the point, let us look at the ratio of its external trade
to GDP. In the case of India, the ratio has increased four-fold - from 8 per cent of GDP in
1972 to nearly 40 per cent now. Taking cognisance of the growth of non-trade cross border
flows, a more meaningful measure of a country's global integration can be the ratio of
two-way flow of goods and finance in and out of a country to its GDP. In the Indian context,
this ratio has increased eight fold over last four decades, from 14 per cent in 1972 to well
over 100 per cent now. These statistics clearly reflect the country's growing trade and
financial integration with the rest of the world. While increased integration gives better
business opportunities in normal times, during such volatile times, it would also pose
challenges for banks and corporates as they seek to manage their risks while continuing to
find viable funding sources for their activities both in Indian and abroad and conduct their
business in general. Apart from linkages with the global developments, there are several
domestic factors which are also important in the context of increasing trend of volatility in
domestic financial markets such as widening current account deficit, growth slowdown,
growing fiscal deficit, sticky inflation, governance related issues, downward revision in
sovereign rating outlook and the threat of a downgrade of the country's sovereign rating to
below investment grade, to name just a few. Government of India has, of course, taken a
series of measures to address many of the challenges in the recent weeks.
Given very limited role that we can play in influencing the global environment characterized
by frequent bouts of risk-on/risk-off sentiments, I would like to touch upon the changing
scenario in domestic financial markets and its implications for currency and interest rate risk
management. Thereafter, I would briefly touch upon the challenges these developments
pose for banks and corporates and what lessons can be learnt.
Currency and interest rate risk in the Indian context
After remaining stable for nearly two years, the Indian Rupee started depreciating very
sharply last year immediately after the credit rating of the US was downgraded by the S&P.
As compared to an appreciation of 1.1 per cent during 2010-11, the Indian Rupee fell by
more than 12 per cent during 2011-12 (Chart 1). The downward pressure on the Indian
Rupee was also marked by heightened volatility. A sharp depreciation within a short period of
time had a destabilizing impact on the general market sentiment. As may be seen (Chart 2),
the Indian Rupee was relatively less volatile till July 2011 but the level of volatility increased
significantly thereafter. There was some moderation in volatility after a series of policy
measures were announced by Government of India and the Reserve Bank of India during
last quarter of 2011. These measures were aimed at augmenting capital flows and imposing
certain restrictions on banks and corporates in order to curb speculative uni-directional bets
on the Indian Rupee by such entities. Apart from taking policy measures, the Reserve Bank
did also intervene to maintain orderliness in the foreign exchange market by curbing
excessive volatility and in the process stabilizing the market sentiments.
During the current financial year 2012-13, after depreciating by more than 10 per cent till
June 2012, the Indian Rupee started recovering gradually in response to major central
banks' decision to go for further policy easing and the announcements of next round of
reform measures by the Government. The appreciation is, however, also associated with
some degree of volatility.
At the same time, it can be said that the Indian Rupee is not the only currency that has been
experiencing increased volatility. There are other BRIC currencies, emerging market
currencies and even Euro that have seen such sharp movements. In fact, the movement of
the Indian rupee seems to be broadly tracking the fortunes of the Euro against the US dollar -
a testimony perhaps to the degree to which global markets are influencing conditions in
domestic financial markets (Chart 3).
Before I move to the issue of managing the currency risk, let me briefly touch upon another
equally critical macro-economic variable-interest rate that also poses risk to banks and
corporates alike and needs to be managed. In contrast to the Indian Rupee movement, the
movement in domestic interest rates (as represented by the generic 10-year yield of bonds
issued by Government of India) has been range bound (Chart 4) with reduced volatility in
recent months as compared to the past (Chart 5).
The trends in interest rate movements have been influenced by a host of factors, such as,
policy actions on the rate front and open market operations conducted by the Reserve Bank,
upward revision in FII investment limits in Government securities, broadening of investor
base for investment in Government securities, persistence of inflationary pressure, etc.
Measures taken by the Reserve Bank
As stated earlier, in the face of increasing volatility in the financial markets and a significant
depreciation of the domestic currency, a host of measures have been taken by the Reserve
Bank and the Government of India since the beginning of last quarter of 2011. These include,
inter alia, the
following:
I Limits on investment in debt securities comprising government securities and
corporate bonds by foreign institutional investors were enhanced;
ii. Interest rates on rupee denominated non-resident deposits were deregulated while
rates foreign currency denominated deposits increased;
iii. The all-in-cost ceiling for External Commercial Borrowings (ECBs) was rationalized;
iv. Following administrative measures aimed at discouraging speculative activities were
initiated:
a. Reduction in limits for booking forward contracts under past performance route
and only on fully deliverable basis;
b. Forward contracts once cancelled cannot be rebooked;
c. Net Overnight Open Position Limits (NOOPL) of the Authorized Dealer (AD)
banks were reduced across the board; and
d. AD banks were advised that their intra-day open position/daylight limit should
not exceed the existing NOOPL approved by the Reserve Bank;
v. Interest rate on export credit in foreign currency was deregulated;
vi. Foreign exchange earners were asked to convert 50 per cent balances in their
Exchange Earners Foreign Currency (EEFC) accounts with AD banks into rupee
balances and credited to the rupee accounts. Subsequently, the erstwhile stipulation
of allowing credit of 100 per cent foreign exchange earnings was restored subject to
certain conditions, such as, the total of the accruals in the account during a calendar
month should be converted into Indian Rupees on or before the last day of the
succeeding calendar month after adjusting for utilization of the balances for
approved purposes or forward commitments;
vii. Positions taken by banks in currency futures/options cannot be offset by undertaking
positions in OTC market, and the NOOPL of the banks as applicable to the positions
involving the Indian Rupee as one of the currencies will not include positions taken
by banks on the exchanges.
Much has been said and discussed about the impact of the policy measures. There has been
some criticism within the financial and commercial circles that the policy initiatives have been
a step backwards and that they have introduced rigidities in the domestic foreign exchange
market and constrained the ability of banks and corporates to hedge their risks. I do not
intend to go into the details of the raison d'être for each of these measures but would rather
confine myself to a few general remarks in this regard. The Reserve Bank undertook the
administrative measures to curb the speculative trends. These measures arose from a set of
practices and behavioural traits which had emerged in domestic financial markets and
aggravated the pressures on domestic financial markets. To name just a few: corporates
often leave their foreign exchange exposures unhedged to benefit from the movement of the
currency in their favour and save the cost of hedging rather than concentrating on their core
business to generate profits. Derivatives are often used as instruments for generation of
profit rather than as instruments for risk mitigation. Import exposures were typically left
unhedged or the hedge ratio was very small. The past performance facility was made
available to corporates to enable them to plan their foreign currency exposures. Without a
delivery mandate, the facility was instead used to speculate on currency movements.
It needs to be appreciated that none of the measures which have been taken in the recent
months have in any way restricted or constrained the abilities of corporates to manage their
genuine foreign exchange exposures. All that has been done is curbing the scope available
for taking speculative bets on the Rupee that resulted in enhanced volatility. Within the
overarching prerequisite of facilitating genuine hedging needs of the customers, Reserve
Bank would consider further relaxations in a calibrated manner. Infact Reserve Bank has
already relaxed some of the measures in July 2012 so that the genuine hedging
requirements of the real sector are not affected. Exporters have now been allowed to cancel
and rebook forward contracts to the extent of 25 percent of the contracts booked in a
financial year for hedging their contracted export exposures. Similarly, AD Category I banks
have been permitted to exclude their Net Options Position and the positions taken by the
overseas branches from their NOOPL, for positions involving the Indian Rupee as one of the
currencies.
Managing currency and interest rate risks
The events during the crises have compelled banks and corporates to start taking a broader,
more sophisticated approach to analyzing their risk exposures. These events have forced
banks and corporates to go back to the first principles of risk management and that is of
identifying risks, measuring them and managing them. Prior to the crisis, a prolonged period
of stable financial markets, incentivized banks and corporates alike to take on more and
more risks on their balance sheets. A one way trend in currency rates prompted corporates
to leave their foreign exchange exposures to generate profits if the currency moved
favourably. Low and stable interest rates acted as incentives for increasing leverage. When
financial markets turned volatile, the currency started depreciating and the funding markets
started drying abroad, many of these corporates were left vulnerable. Not surprisingly a
recent analysis reveals that the major reasons for cases being referred to the CDR cell in the
last few years were high leverage or huge open foreign exchange positions of companies.
The experiences during the crises, therefore, entail many important lessons for managing
currency and interest rate risks. First, the experiences have reemphasized the importance of
corporates focussing on their core businesses and not looking at currency mismatches to
generate extra profit. Second, the recent experiences have also highlighted the risks
associated with un-hedged exposures. The third set of lessons relate to the careful selection
of hedging instruments. Many corporates, large and small, burnt their fingers dabbling in
complex derivative products. Many leant, the hard way, that there are no free lunches and
that "zero cost structures" and "unlimited payoffs" are but figments of fertile imagination.
Fourth, is the importance of stress testing or, at least, of anticipating and preparing for
potential worst case scenarios. For many corporates, the last few years of slower growth and
trade, would arguably have been easier to handle, had they focussed on proper
management of currency and interest rate risks. Fifth, the risks associated with excessive
leverage have very clearly been brought out by the crisis. The recent experiences have, thus,
under-scored the age old lesson of the downside of excessive "greed".
On its part, the Reserve Bank has continuously been making efforts in sensitising the banks
and the end-users for judicious use of available derivative products in India in managing both
currency as well as interest rate risk. While there is a comprehensive regulatory frame work
put in place for OTC derivatives products to hedge currency risk, such as forwards, swaps,
options, etc. exchange traded currency futures and options have also been permitted in order
to provide the benefit of transparent pricing and better risk management.
Long-term forex derivatives
The forward market in India is pretty liquid up to one year. The liquidity in forward market for
tenor beyond one year, however, is unsatisfactory and poses difficulties for market
participants who want to hedge a long term forex exposure. Mostly they deal with the
problem by booking contracts up to one year and then roll it over till the maturity of the
exposure. This strategy partially addresses their long term risk, reducing exchange rate risk
to the risk of a less volatile forward premium. While there has been no regulatory restriction
put on bookings of longterm forwards as such, there is asymmetry in this segment in the
sense that it is dominated by demand on the buy side. Further, the illiquidity also owes to the
absence of a Rupee (term) interest rate swap market, and this makes it difficult for the
market makers to price a long term forward contract.
MTM of the forex derivatives
Another related issue in this context that I would briefly like to touch upon is marked to
market (MTM) on outstanding forex derivative contracts and the reluctance on part of some
of the corporates on entering into such contracts for fear of MTM losses, should the price of
the underlying variable move in other direction. It needs to be emphasized that the MTM is a
dynamic concept representing the fair value of the contracts taking into account the market
movements and essentially represents the replacement cost of the derivative contracts.
These accounting losses should, therefore, be looked at in totality along with the economic
rationale of the hedges undertaken. While we have had a series of informal dialogues with
industry representatives, banks, auditors and even some corporates on the issue for a better
understanding, there seems to be no unanimity as far as the applicability of the existing
accounting guidelines are there. Generally speaking, a corporate entering into a derivative
contract as a perfect hedge should be indifferent to the price movements during the period of
the contract as any MTM loss in the derivative contract should be near equal to the MTM
gains in the underlying. If, however, different accounting norms are followed for both the
hedged item as well as the hedging instrument, there could be a possibility of timing
mismatch in the profit and loss statement resulting into undue volatility in the bottom line of
the corporates. I understand that companies that prepare financial statements under Indian
Generally Accepted Accounting Principles (GAAP) or International Financial Reporting
Standards (IFRS) have the option to apply "hedge accounting" principles to these
transactions in order to minimize volatility in the profit or loss statement and reflect the risk
management objective of these arrangements. It is necessary that industry representative
bodies, such as, Foreign Exchange Dealers' Association of India (FEDAI) and the Institute of
Chartered Accountants of India (ICAI) discuss the issues involved and come out with some
clarity on the issue for the larger benefit of all the stakeholders.
Limited appetite for risk mitigation products
For mitigating foreign exchange exposure risks of Indian corporates/importers, facilities of
onshore hedging of the Indian Rupee exposure of the non-resident buyers/sellers have been
introduced. There has been hardly any interest to promote this facility among the
non-resident business associates. As far as managing interest risk is concerned, interest rate
swaps (IRS), forward rate agreements (FRAs) are permitted derivative products in the OTC
market. The IRS market has evolved over the past decade and is fairly liquid though activity
is concentrated at few tenor points (mostly up to five years) and among few participants
(foreign banks and a few private sector and foreign banks account for more than 80 per cent
of trading activity). One of the issues with the IRS market in India is that trades are mostly
concentrated on overnight MIBOR as benchmark in absence of a liquid term money market.
In order to offer alternative hedging tool to the market participants, exchange traded interest
rate futures (IRF) on 10 year notional GoI coupon bond and 91-day T-bills were also
introduced. After witnessing good amount of trading activity during initial few months
immediately after the launch, the trading activity has reduced considerably. Reserve Bank
has also permitted introduction of IRF contracts on two and five year Government Securities
on cash settlement basis to provide the products at the shorter end which would offer flexible
hedging options to the market participants. These products, however, are yet to be
introduced by the exchanges. There have been various reasons put forward by market
participants for IRF not being used by them. Recently, the Reserve Bank constituted Working
Group on "Enhancing Liquidity in Government Securities and Interest Rate Derivatives
markets" (Chairman: Shri R. Gandhi). The Group has made several recommendations for
improving liquidity in both the IRS and IRF market, such as, electronic trading platform for the
IRS market, central counter party (CCP) mechanism for providing guaranteed settlement of
trades executed through the electronic platform, standardisation of the IRS contracts,
permitting insurance companies, pension funds and other financially sound entities to
participate in IRS market, IRF based on overnight call borrowing rate; permitting cash-settled
10 year IRF, etc. Reserve Bank has also permitted single-name credit default swaps (CDS)
in India for hedging credit risk separately. Since the launch of the product, however, only few
trades have been executed. Various reasons have been attributed for the lack of trading
interest in CDS in India. One of them is that banks are yet to put in place internal policies for
trading in CDS. Though International Swap and Derivatives Association (ISDA) master
agreements have been finalised by the Fixed Income Money Market and Derivatives
Association of India (FIMMDA), participants have to enter into bilateral ISDA agreements for
transacting in CDS. When insurance companies and mutual funds, which are likely to be
permitted by their respective regulators soon, start participating in the CDS market, one
hopes the volumes will pick-up.
Risk of long-term floating rate loans to individuals
It has been observed that a major chunk of the loan portfolio of banks these days comprises
floating rate products, especially in the retail segment, with loans for housing sector
extending up to 20 years or so. On the other hand the interest rate paid by them on deposits
is predominantly fixed and these deposits generally are of upto a maximum of five year
maturity. This obviously can result in serious asset liability mismatch in their balance sheets
apart from subjecting the unsophisticated borrower to interest rate risk over a longer horizon.
While there are options available to banks to manage this mismatch through raising of long
term resources via bonds, securitization of assets, hedging of interest rate risk using
derivative products, etc. the retail borrowers are not well-equipped to use any hedging
instrument to hedge the interest rate risk. There have been some suggestions, such as,
allowing banks to issue more long-term bonds, treating banks' exposure to fix-rate long-term
housing loans eligible for priority sector, and encouraging large institutional investors like
pension funds, provident funds, insurance companies, etc. to invest in bonds floated by bank
so that long-term fixed rate loans can be extended to the retail borrowers. In order to assess
the feasibility of introducing more long-term fixed interest rate loan products, particularly for
the retail customers by banks, the Reserve Bank has set up a Committee (Chairman: K. K.
Vohra) that is expected to submit its report shortly.
Management of interest rate and currency risks by banks
Let me now turn to the challenges for banks for management of currency and interest rate
risks. Banks are essentially in the business of managing risks. In particular, they are required
to handle interest rate mismatches as well as currency mismatches in their capacity as
authorized dealers and market-makers in the currency market. The events of the last few
years have proved that banks, even in their own interest, have to take on at least some of the
onus of risk management of their clients. The Reserve Bank has also assigned responsibility
on banks for ensuring suitability and appropriateness while transacting derivative instruments
with the corporates and also ensuring that the corporates have appropriate risk management
framework. More specifically, before offering any derivative product to clients, banks should
obtain Board resolution from the corporates which should explicitly mention, inter alia, (i) the
limit assigned by the corporate to the bank, (ii) the names and designation of the officials of
the company authorised to undertake particular derivative transactions on behalf of the
company (iii) specific products that can be transacted by such designated officials, etc.
Keeping in view the implications of excessive risks taking by the corporates and impact of
consequential risks on their balance sheets and the financial system, banks have also been
advised to evaluate the risks arising out of unhedged foreign currency exposure of the
corporates and price them in the credit risk premium while extending fund based and
nonfund based credit facilities to them. Banks have also been advised to consider stipulating a
limit on unhedged position of corporates on the basis of policy approved by the Board of the
banks. Absence of proper oversight over corporate's business particularly their currency and
interest rate risks has come to the fore now when we have witnessed a number of cases of
corporates seeking restructuring/CDR, many of whom have got into difficulties due to foreign
exchange related losses and excessive leverage, restructuring/defaults of overseas
ECB/Foreign Currency Convertible Bonds (FCCB) obligations, loss to the overseas branches
of Indian banks who have subscribed Credit Linked Notes (CLNs) under the FCCB issues.
This does not, in any way, take away the primary responsibility of the corporates towards
their own risk management system but the joint effort can go a long way towards preventing
the kind of legal disputes which arose in the recent past.
Banks enter into derivative contracts for the purpose of hedging their own risks. They also
play an important role as market makers in the derivatives markets to enable their customers
to hedge their risks. Client trades are typically covered on a back-to-back basis by banks in
the inter-bank market, implying that the banks are hedged as far as market risks on client
related transactions are concerned but they continue to hold on to the credit risks arising
from the exposure to their clients. Banks also typically maintain "open" positions as part of
their trading book of their derivative portfolio and these positions engender market risks for
the banks. The management of both risks is critical for banks, especially in the current
environment of increased uncertainties and market volatility.
Banks also carry a significant amount of interest rate risk in their investment portfolio due to
holding of the Statutory Liquidity Ratio (SLR) bonds and non-SLR securities. Managing risks
in the investment portfolio, thus, acquires additional significance in an environment of
increased volatility of interest rates notwithstanding the HTM dispensation available to banks
up to certain limits. Typically, banks have been using a combination of duration targets and
duration gap analysis for managing risks arising out of movements in interest rates. A series
of stress tests are being conducted periodically by the Reserve Bank on the impact of
interest rate shocks on the banking and trading books of banks. The results have been
presented in the Financial Stability Reports (FSR) published by the Reserve Bank of India.
They suggest that while banks are largely resilient to the shocks involving both parallel and
non-parallel shifts in the yield curve, there are a few banks which are significantly impacted.
Hence, there remains a need for banks to be vigilant in managing risks on this front.
As reported in our FSR, the empirical analysis of the portfolio of select banks conducted in
the Reserve Bank a few months back revealed that banks were carrying a significant
quantum of risks in their portfolios on a gross basis though on a net basis the positions were
relatively matched (Chart 6). The chart shows that gross positive MTM position of the
derivative portfolio of some banks is significant in relation to their capital funds. In some
cases, the gross positive MTM is several multiples of their capital funds. This clearly
suggests that banks remained exposed to and, would need to manage the risks of
counterparty failures. A series of scenario and sensitivity stress tests were also conducted on
the derivative portfolios of banks as part of the above exercise. The sensitivity analysis
involved the application of a series of interest rate and exchange rate shocks to the
derivatives portfolio of banks. The scenario analysis was based on a set of historical
scenarios of heightened volatility. The stress test results showed that, for some banks, the
impact of the s