In a move that may take some sheen off derivative deals, the Reserve Bank of India on Friday proposed to increase the provisioning requirements for banks for off-balance sheet items such as forex and interest-rate derivatives and gold trading.
Higher provisioning will make bankers cautious while hawking derivatives, which have been the source of growing controversy between some banks and companies, since they will now be required to set aside more capital and raise costs.
"Though the idea is to make banks account for derivatives, the move will also make these instruments more expensive for banks and the cost will be passed on to companies," a central bank official said.
In addition, the central bank has proposed that the restructuring of derivatives contracts will have to be carried out only on a cash settlement basis. Bankers said this proposal is unclear as banks cannot restructure contracts under present norms.
If RBI's draft regulations on off-balance sheet items go through, banks will have to treat exposure to derivatives in the same way as they deal with loans. This means they will be required to apply provisioning norms for standard assets on derivatives too and set aside capital accordingly.
In addition, the central bank reiterated that for any derivative transaction the provisioning norms for non-performing assets will apply for any amount that was due for over 90 days.
The regulator also wants banks to compute their credit exposure to interest rate and forex derivatives and gold using the "current exposure method". This will mean that banks will not only have to add up the mark-to-market position on these transactions but also calculate potential future credit exposure.
The potential future credit exposure is calculated by multiplying the notional principal amount by an add-on or credit conversion factor.
While the CCF has been in place since April last year as part of the new capital adequacy framework, RBI now intends to double this for interest rate and forex derivatives. As a result, banks' total credit exposure may go up in the present context, forcing them to set aside more capital due to the Basel II norms on risk-weighted assets.
"The proposed guidelines will make banks very cautious about selling derivatives and also make transactions somewhat expensive due to the increase in CCF and provisioning norms," said a senior Bank of Baroda executive.
The move follows a central bank announcement on strengthening the prudential norms for off-balance sheet items in last month's Annual Policy Statement.
RBI's late evening circular said, "The foregoing modifications will come into effect from the financial year 2008-09. The banks will, however, have the option of complying with the additional capital and provisioning requirements, arising from these modifications, in a phased manner, over a period of four quarters, ending March 31, 2009."
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