Marked by market

Exposure to overseas credit derivatives takes a toll on Indian banks.

Union Bank of Indias Nair: Taking precautionary steps
M.V. Nair
It’s clearly India’s Rs 1,28,00,000-crore hedging gamble in the global market. Markto-market (MTM) losses, which are based on the value of positions at current market prices, have begun haunting India Inc., and particularly the banking sector, after the subprime crisis erupted in the world’s largest economy late last year. The exposure of Indian corporate in derivatives, which are used globally as a hedge against currency risk, interest-rate risk and commodity risk, is estimated to be Rs 128 trillion.

That means there’s that much of money lying in the books of commercial banks, a large part of it in the foreign banks operating in India. One estimate is that the actual losses could be anywhere between $5 billion (Rs 20,000 crore) and $10 billion, which is a little less than half a percentage point of the total derivatives exposure. The story so far: Last September, software major Hexaware announces a provision of $20-25 million for MTM losses, courtesy of a currency options and swaps deal.

Four months later, ICICI Bank suffers a similar fate, but in altogether different instruments—credit derivatives and fixed-income securities; the bank notches up MTM losses of $264.3 million. A couple of days later, engineering giant Larsen & Toubro reveals Rs 200 crore of losses, thanks to commodities hedging abroad.

Banks, for their part, have moved into overdrive. Says M.V. Nair, CMD, Union Bank of India: “We are in constant touch with our corporate clients to manage their derivatives exposure in the light of adverse currency developments.” Still, bankers are quick to dismiss the Rs 128-trillion figure as “not meaningful” as it is a “notional amount”, even as they privately admit there will be more cases of speculative calls going wrong. They argue there is nothing wrong in hedging per se as the Reserve Bank allows corporates to hedge their exposures using derivative contracts (see Exotic but Toxic).

 Exotic, but toxic

Different types of derivatives products.


 Product utility
Forex currency swapsInvolve an exchange of cash flows in two different currencies— e.g., hedging a dollar loan in a yen or euro or swiss franc currency
Credit default swapsAn insurance against credit risk. Banks that have lent for M&As buy such products floated by other banks
Collateralised debtCDOs, as they are called, are structured credit products that invest in a portfolio of fixed income assets having similarities
Credit-linked notesCLNs are issued for bonds floated by Indian companies, especially for global M&As. It pools a few loans and sells them in the market as a single product
Foreign currency options Like any stock options contract, with an underlying asset being foreign exchange currency. Used for hedging or speculation

 An option over a swap

Source: BT Research

Many Indian banks also transact in these derivatives for either ALM (asset liability management) purposes (which may be simply fixing a risk that a bank has) or for trading or for purposes of client transactions that the bank provides. Jitender Balakrishnan, Deputy MD, IDBI, says: “The situation is not as grave as made out to be. MTM losses would be recouped by India Inc. over a period of time.” Adds a senior executive at a foreign bank: “The size of the outstanding notional derivative contract amounts reported by banks does not have any correlation to the negative MTM of corporate clients.” Experts break down the Rs 128-trillion figure into two legs of transactions, one of which could be actually reversing or closing out any risk that a bank had assumed.

For instance, if a corporate has done $100 million forward and hedged this out in the market, its risk could be zero even though its notional derivative outstanding would be $200 million. Yet, there are many complex transactions that make MTM losses possible. For example, if a corporate has borrowed dollars via an external commercial borrowing (ECB) and converted them into rupees, this itself would result in a 10-15 per cent negative MTM (because the rupee has appreciated by that much).

Similarly, if a corporate has converted its dollar liability into a yen liability (given the lower interest rate) through a dollar/yen swap, this would result in a negative MTM if the yen were to appreciate significantly, as has happened in the recent past. While bankers are not revealing clients’ names, clearly those under pressure would be ECB issuers, IT services firms, metals companies and also oil & gas. A banker, on the condition of anonymity, predicts more doom by the fiscal year-end: “Just wait for the March quarter results. There may be more companies (with MTM losses).”