The present work is a study of the role of OTC derivatives used by the financial institutions like the SCB's in context to the existing regulatory framework of the Indian OTC derivatives markets. We analyse in this context the market risk factor associated with it and thus reflect upon the regulatory initiatives taken by the Reserve Bank of India towards better surveillance of OTC markets. In addition to that it also throws some light on the issues impacting the stability and development of the market.
5.1 Findings of the study in context to the OTC Derivatives
The notional value of OTC contracts is not a true measure of risk. It is the gross market value, measuring the cost of replacing all existing contracts, which shows market risk. However, for analysing the payment flows at risk, a still better measure is the gross credit exposure, which shows the aggregated market value of OTC contracts after bilateral netting has been completed.
In the Indian context, the OTC derivatives markets are well regulated by the central bank. The RBI has legalised OTC derivatives trading, where at least one of the parties in a transaction is a regulated entity. RBI allows financial institutions to use derivatives for their own balance sheet for hedging their exposures. A centralised counter party, called CCIL, is entrusted with the job of engaging in the OTC derivatives market as a reporting platform and a clearing agency for post-trading settlements. The CCP approach offers a unique model for automatic surveillance of the OTC exposure. Recently, the guarantee offered by CCIL as mentioned in my document on some OTC products has gone a long way in reducing the capital requirements for the banks.
A review of the market structure reveals that interest rate swaps (in the category of interest rate derivatives) and foreign currency forwards (in the category of foreign currency derivatives) occupy dominant positions in the Indian OTC derivatives markets. The market for IRS is primarily an overnight market and products of tenure longer than overnight have not become popular because of the absence of a vibrant inter-bank term money market. The dominance of foreign banks is an important characteristic of this market. The market for foreign currency forwards is basically a rupee-dollar forward market, where CCIL provides guaranteed settlement of the forward trades. There is also an off-shore NDF market in rupee-dollar forwards.
5.2 Conclusion:
The Indian OTC derivatives market has nothing to do directly or indirectly, to the global financial crisis. The policy implication of this study is that, unlike the new regulatory initiatives in the United States and European Union towards more regulation of the OTC derivatives markets, Indian OTC markets are reasonably well regulated. Knowing the functional value of OTC derivatives markets within the scope of financial institutions, there is no need for new moves to tighten the regulatory rope. Instead, what we need is a concerted effort towards increased disclosure, more transparency and this would lead to a better form of standardisation.
More research is needed to analyse the contribution of the OTC derivatives markets in improving financial institutions efficiency. It is still not very clear how far the Indian OTC derivatives markets have helped in price discovery in the spot markets.
5.2.1 Recommendations:
In the backdrop of the present financial crisis, for a better surveillance of the OTC markets, I propose strengthening of the CCP approach. However, at present, India has only one institution for this purpose. This is somewhat concerning if we talk about the concentration risk. The entry of one or two new CCPs for post-trade clearing and settlement should ensure competition and bring in the advantages of operational efficiency and ensure a proper regulated risk structure.
For further development of the OTC markets in India, introducing new derivative products for credit risk transfer will be a positive step. In concrete terms, this would mean introducing credit default swaps in a much flexible manner but keeping in mind the fact of clearing and settlement via a centrally regulated entity. The problems associated with these instruments could be reduced by routing them through a reporting platform and using a CCP for trade clearance and settlement.
5.3 Findings of the study in context to the Risk Mitigation Techniques
The Banks are required to have a system for monitoring the over all composition and quality of the various portfolios since credit related problems in banks is concentrated within the credit portfolio. It can take many forms and can arise whenever a significant number of credits have similar risk characteristics. Also the Bank will not necessarily forego booking sound credits solely on the basis of concentration. Banks may use alternatives to reduce or mitigate concentration. Such measures will include
pricing for additional risk,
increased holdings of capital to compensate for the additional risk,
making use of loan participation in order to reduce dependency on a particular sector of economy or group of related borrowers
Fixing exposure limits for borrowers and for various industrial sectors
Collateral security in addition to main securities stipulating asset coverage ratio on case to case basis
Personal Guarantees / Corporate Guarantees having reasonable networth.
(S. K. Bagchi, 2005; Ram Krishna Sahu, 2009: pp. 12-13)
5.3.1 Conclusion
Why do organizations take risks? The apt answer would be-to make some handsome gains. Banks, the world over, generally believe in "No Risk-No Gain", but sometimes, taking risk becomes disastrous for the organizations.
It has been evident from the above study, that if risks are not managed properly, even the survival of the bank may become under threat. Risk management has, therefore, become an important area, which needs to be looked into with great concern and care.
5.3.2 Recommendations in regard to Risk Mitigation (What to do about Risk?)
If the risk is at prospective stage, try to avoid it.
If the risk is likely to occur, and it is unavoidable, accept the risk and retain it on an economically justifiable basis.
Try to execute some effective actions as to reduce or eliminate the loss likely to be incurred due to happening of the particular risky incident.
Try to diversify within a portfolio of risks with a view to shortening the loss.
For risky business areas, introduction of prudent exposure norms, in advances, may help in minimizing the loss.
Sound risks management procedures and information systems, if put in place in the right perspective, will help in taking timely decisions for avoidance of risks.
If suitable, hedge the risk artificially i.e. counterbalance and neutralize the risk to a certain degree, by use of derivative instruments. This, in itself, is a very risky option.
Monitor various categories of risks on continuous basis and report to appropriate authority so that risks can be overcome in future.
Liquidate the risk by transfer without resources to other party.
Put in place the comprehensive internal control and audit systems with a view to controlling risks.
The effective Risk Management Process in Banks and other financial institutions, which do not result in getting rid of risks, will help in minimizing the losses.
(S. K. Bagchi. (2005). Credit Risk Mitigation - Implications of Basel II Prescriptions In Indian Banking. Retrieved 2 June, 2010, from www.icai.org/resource_file/10415549-553.pdf)
(Ram Krishna Sahu. (2009). Financial Risk Management, pp. 12-13)
