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Economy

RBI Wants Banks to Set More Aside for Unhedged Forex Exposure by Borrowers

RBI has announced draft guidelines for higher provisioning requirements while lending to corporates with “unhedged foreign currency exposure”.

A quick background: When banks lend money, they have to keep money aside as a provision to cover possible loss on the loan. This is tiny (usually less than 2%).

According to the guidelines, banks:

 

  • Must figure out how much unhedged exposure the corporate has, by getting quarterly reports from its auditors. The calculation for this can be complex – forex exposure could be from having to make payments to suppliers (oil companies for crude, for instance), pay interest/principal on forex debt (FCCB) or have debt in a foreign subsidiary. Some of this could be hedged through derivative contracts like forwards, futures or options bought from banks or a foreign exchange.

 

  • Additionally they need to subtract any “natural hedges”, where the company expects to earn that much forex from its exports or such. A company having to pay $1 million each month for imports but earns $200,000 on exports per month has an “open” position of just $800K.

 

  • On the unhedged exposure, estimate likely loss by calculating the largest annualized daily volatility of the last 10 years.

This is calculated by taking daily percentage changes in the exchange rate, finding the Standard Deviation over a year, and then annualizing that number by multiplying it with the square root of the number of trading days in that year. (Ref: FinanceTrain)

Here are the numbers for the last 10 years (and 2013 till date)

image

 

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The highest  number is 10.57% in 2008, and that’s the number banks will have to take (unless 2013 goes even higher). Apply a 10.57% move to the unhedged exposure (whichever direction is more loss making) and see how much it impacts their profits.

  • The loss impact is compared to “EBID” (Earnings after tax but adding back depreciation and interest). Based on this the banks may need a higher provisioning (0.20% to 0.80%) and in an extreme case will even require a capital hit.

image

This exercise needs to be conducted at least quarterly, and more likely, monthly if the exchange rate is “volatile”.

My view: This will hurt banks to a small extent initially, hitting their bottomlines as the impact cuts into profits. However they might increase the loan interest rates to corporates that are vulnerable.

For corporates it means loan rates could go up. However, some have access to bond markets and they might choose to go there for borrowing instead.

Who’s impacted? It will be the large FCCB borrowers (like Reliance Communications or Airtel or such) and the oil importers (HPCL, BPCL, IOC), and their banks. But that pretty much means the whole banking system.

Will it be useful? Looking at the graph it tells you that annualized daily volatility is not a great indicator of the impact. In 2008, 2011 and possibly 2013, the actual move in a year was MUCH greater than the daily volatility indicates. I would only suggest taking the higher of the two and then add another 5% buffer for fat tails. The incremental provisioning requirement is so small that loss estimates need to be much more realistic.

These guidelines are only in draft and could be changed.

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