Asking banks to increase their provisioning and provide more capital for their exposures to un-hedged forex exposures is certainly not the best solution to the problem of bloating NPAs

Reserve Bank of India (RBI) deputy governor Dr KC Chakrabarthy, in his address, at the Conference of Principal Compliance Officers of banks in April, 2013 had expressed concern of RBI on the banks’ inadequacy in monitoring the un-hedged foreign currency exposures of entities financed by banks and had cautioned them. He said, “It was through our circular of October 2001 that we had advised the banks to monitor and review the unhedged portion of the foreign currency exposures of those corporates whose total foreign currency exposure was relatively large.
 

These instructions have been reiterated over and over again subsequently. Despite all these instructions/reiterations, it is observed that un-hedged forex exposure risks are not being evaluated rigorously and built into pricing of credit by banks. As you would appreciate, the unhedged forex exposure of corporates is a source of risk not only for the corporates’ balance sheet, but also for the financing bank and, ultimately, for the financial system.”
 

“There is an underlying motivation for the corporates to keep their exposures un-hedged as hedging has a cost. But banks cannot afford to be complacent against such risky practices. They ought to have a risk limit for each of their exposure. We have already witnessed instances of accounts of corporates which carried large unhedged forex exposures on their books, turning non-performing. Theoretically, the foreign exchange rate can move to any level and expose the corporate and consequently, the bank, to infinite risk. Therefore, for good order, it is necessary that the banks, on the basis of an internal Board-approved policy, stipulate limits on the un-hedged position of corporates,” Dr Chakrabarty added.
 

As a follow-up of this observation, and in the wake of steep depreciation of rupee against US dollar in the recent past, RBI has, last month, announced tighter norms whereby banks have been asked to make incremental/additional provisioning and capital requirements for their exposures to entities that have un-hedged foreign currency exposures.
 

What are the new guidelines of RBI to banks in this regard?
 

In early 2013, it was estimated by RBI that 60% to 65% of corporates’ forex borrowings were un-hedged. With the rupee losing as much as 20% between May and August last year, the currency having hit an all-time low of Rs68.85 per dollar in late August, several companies were forced to report mark-to-market losses. Apart from the rupee depreciation, what has prompted the central bank to stipulate stricter norms is the steep growth in non-performing assets of banks during the current year. Many borrowers have either defaulted in repayment to banks or have sought restructuring of their loans due to the losses suffered on account of rupee depreciation, thereby impacting their capacity to service their debt, which in turn affected the quality of assets of commercial banks as well.
 

“The extent of un-hedged foreign currency exposures of the entities continues to be significant and this can increase the probability of default in times of high currency volatility,” the RBI said in a release detailing final guidelines.
 

As per the RBI guidelines, the first step is to ascertain the amount of un-hedged foreign currency exposures of their corporate customers and then to estimate the extent of likely loss to the borrower entities on account of the foreign currency loans not hedged by them. Apart from the financial hedge held by the corporates through derivative contracts with banks, RBI has permitted exclusion of natural hedge also available to corporate on account of export receivables, etc.
 

The banks are then required to assess the extent of likely loss to the borrower company, based on the annualised volatility of the USD-INR exchange rate and then estimate the riskiness of un-hedged position by comparing the estimated loss with the annual earnings before interest and depreciation (EBID) of the borrower company. This loss has to be computed as a percentage of EBID of the corporate. Higher this percentage, higher will be the susceptibility of the entity to adverse exchange rate movements. Therefore, RBI has said as a prudential measure, all exposures to such entities (whether in foreign currency or in Indian rupees) would attract incremental capital and provisioning requirements (over and above the present normal requirements) as under with effect from 1 April 2014.  
 

What is the effect of these guidelines on banks’ balance sheets?
                      

It is clear from the RBI guidelines that banks will have to bear the burden of additional provisioning for all their lending to corporates whose estimated forex losses exceeds more than 15% of their annual earnings before interest, taxes, depreciation, and amortisation (EBITDA), thus affecting banks’ profitability. Besides, due to the increase in the risk weight in cases where the estimated forex loss exceeds 75% of their annual EBITDA, banks will require additional capital, affecting their capital ratios as well. But the futility of this entire exercise is, despite complying with these guidelines of RBI, there is no guarantee that corporates who hold un-hedged foreign currency exposure will not fail to honour their commitments to lenders and that banks will not be faced with more non-performing assets (NPAs) due to the exchange loss suffered by their customers.
 

The question, therefore, being asked is whether it is fair to put the entire onus on the banks for the failure of the corporates to protect their own earnings from the exchange risks inherent in their foreign currency borrowings. No doubt, there is an underlying motivation for the corporates to keep their exposures un-hedged as hedging has a cost. But it is unjust to pass on this entire cost to banks, which in many cases have merely advanced them rupee finance.
 

What is the alternate solution to protect banks from impending NPAs?
 

As stated by the RBI governor in his second quarter review of monetary policy for 2013-14, if the unhedged foreign currency exposures of corporates are a cause for concern, as they pose a risk to individual corporates as also to the entire financial system, there is definitely a need to bring in much more stringent norms for reducing the risks undertaken by borrowers instead of banks being made scapegoats for the formers’ speculative misadventures.
 

The present guidelines are like treating the symptoms instead of the cause. Therefore, following alternatives are suggested for RBI to ponder over this critical issue affecting the banking system, and take such steps as are legally permissible and  practically feasible with such modifications as appropriate to protect the banks from their loans turning bad due to the losses incurred by the borrowers on account of their un-hedged currency exposure.

1. The safest bet for all is to ensure that the corporates who go for external commercial borrowings and who also wish to borrow from the local banks should mandatorily cover their positions through financial hedging with banks and institutions, if such borrowers do not have natural hedging through exports. RBI as the monitoring agency for such borrowings should make this as a pre-condition for all entities who borrow directly from abroad in foreign currency, if they do not have a natural hedge, but if they have any funded or non-funded borrowings from the local banks. This may bring down the inflow of foreign exchange into the country to some extent, as it increases the cost of borrowing for the corporates, but such a step will be in the best interest of the commercial banks which are now bleeding with high NPAs and face pressure on their profitability.

2. Banks who have foreign currency resources generated through foreign currency non-resident deposits (FCNR) should be asked give first priority to lend such resources to export houses and corporates who have natural hedge through export earnings, as the chances of their making loses due to exchange volatility is considerably lower. This would serve to incentivise exports and help in improving our country’s forex earnings as well.

3. Banks who lend such FCNR resources to those entities who do not have a natural hedge, should be compulsorily asked to hedge at least 50 of their foreign currency borrowings, with the lending bank or any other bank to the satisfaction of the lending bank, so that the risk of un-hedged position is brought down to that extent both to the borrower and the bank. The banks in turn may have to give the benefit of lower pricing on their loans to partly compensate the customers to meet the additional cost of hedging, but this would be the best bet for banks to ensure that their loan portfolios remain relatively healthy.

There will, no doubt, be hue and cry from the corporate world if you implement any of these suggestions, but RBI, as the protector of banks and their depositors, should first and foremost give precedence to the safety of the banks’ funds rather than give freedom to corporates to take risks by speculating on the currency movements, which is neither in the interest of borrowers nor of the banks who lend them finance to run their business.
 

In the context of commercial banks in our country in general and PSU banks in particular struggling to raise capital due to the prevailing sluggishness in the economy, asking them to increase their provisioning and provide more capital for their exposures to entities having un-hedged forex exposures is certainly not the best solution to the problem of bloating NPAs faced by the banking industry, more so if it is caused by the high volatility in the currency movements accentuated by the global phenomenon, over which even RBI has no control.

(The author is a banking analyst, and he writes for Moneylife under the pen-name ‘Gurpur’)