IF- Unit IV CRR

}  While there is no formal definition of Capital Account Convertibility, the committee under the chairmanship of S.S. Tarapore has recommended a pragmatic working definition of CAC. Accordingly CAC refers to the freedom to convert local financial assets into foreign financial assets and vice – a – versa at market determined rates of exchange. It is associated with changes of ownership in foreign / domestic financial assets and liabilities and embodies the creation and liquidation of claims on, or by, the rest of the world. CAC is coexistent with restrictions other than on external payments. It also does not preclude the imposition of monetary / fiscal measures relating to foreign exchange transactions, which are of prudential nature. Following are the prerequisites for CAC:

}  Maintenance of domestic economic stability.

}  Adequate foreign exchange reserves.

}  Restrictions on inessential imports as long as the foreign exchange position is not very comfortable.

}  Comfortable current account position.

}  An appropriate industrial policy and a conducive investment climate.

}  An outward oriented development strategy and sufficient incentives for export growth.

•        RBI has issued Authorised Dealers (AD) licences to banks, all India financial institutions and a few co-operative banks to undertake foreign exchange transactions in India

•        It has also issued Money Changer licences to a large number of established firms, companies, hotels, shops, etc.

•        Money changers help facilitate encashment of foreign currencies of foreign tourists

•        Entities authorised to buy and sell foreign currency notes, coins and travellers’ cheques are called full fledged money changers

•        Those authorised only to buy are called restricted money changers

•        FEDAI (Foreign Exchange Dealers’ Association of India) is a non-profit making body formed in 1958 with the approval of RBI

•        Its members are authorised dealers and it prescribes guidelines and rules of the game for market operations, merchant rates, quotations, delivery dates, holidays, interest on defaults, etc.

FEDAI also advises RBI on market related issues and supplements RBI on strengthening the market

Exposure refers to foreign currency assets, liabilities, income and expenditure whose values will change in terms of home currency in response to exchange rate fluctuations.

Risk is the likely or probable loss from such forex exposure due to adverse exchange rate fluctuations.

Foreign Exchange Exposures can be defined as the “sensitivity of changes in the real domestic currency value of assets and liabilities or operating incomes to unanticipated changes in exchange rates”. Any company exporting or importing goods has a foreign exchange exposure. However, a company doing business in the domestic marketplace will also have a considerable foreign exchange exposure if any of its competitors are based in a foreign country.

Types of Exposures: -Foreign exchange exposures can be classified into transaction, translation, and operating exposures.

•           Transaction Exposure involves different transactions where items are traded in foreign currency, i.e., there are contractual future cash flows of the foreign currency. For example, a company may sign a contract to supply machine parts to a foreign company at a specified sell price. The company will be susceptible to fluctuations in foreign exchange markets till it receives payment and converts it into domestic currency. The company’s exposures can be calculated by deducting the potential future inflows from future outflows. There are various methods that can be employed to minimise transactional exposure risks, namely,

o          Forward contracts.

o          Price adjustment clauses.

o          Currency options

o          Borrowing and lending in foreign currency.

o          Invoicing in domestic currency, etc.

•           Translation exposure is the possibility of change in the net worth of the company due to fluctuations in home valuation of assets and liabilities denominated in foreign currency. Translation exposure occurs when an MNC’s overseas subsidiary’s earnings are translated into domestic currency prior to consolidation with the parent company’s financial statements. This can reflect in the company’s consolidated profit and loss account. Companies can adopt any of the following strategies to manage their translation exposure,

o          Adjusting the flow of funds

o          Entering into forward contracts

o          Netting of exposures.              

•        Transaction exposure is the sensitivity of realized domestic currency values of the firm’s contractual cash flows denominated in foreign currencies to unexpected changes in exchange rates. Unlike economic exposure, transaction exposure is well-defined and short-term. Some typical situations, which give rise to transactions exposure, are: (a)   A currency has to be converted in order to make or receive payment for goods and services; (b)          A currency has to be converted to repay a loan or make an interest payment; or (c)        A currency has to be converted to make a dividend payment, royalty payment, etc.  Note that in each case, the foreign value of the item is fixed; the uncertainty pertains to the home currency value. The important points to be noted are (1) transaction exposures usually have short time horizons and (2) operating cash flows are affected.

•         This is a measure of the sensitivity of the home currency value of the assets and liabilities, which are denominated, in the foreign currency, to unanticipated changes in the exchange rates, when the assets or liabilities are liquidated. The foreign currency values of these items are contractually fixed, i.e.; do not vary with exchange rate. It is also known as contractual exposure.

•        Some typical situations, which give rise to transactions exposure, are:

•        (a)        A currency has to be converted in order to make or receive payment for goods and services;

•        (b)        A currency has to be converted to repay a loan or make an interest payment; or

•        (c)        A currency has to be converted to make a dividend payment, royalty payment, etc.

Transaction exposure

• Contract specific                              

• Cash flow loss can be easily computed

• Co’s do have policies to cope up with it

• Duration is same as time period of contract

Economic exposure

• General relates to entire investment.

• V difficult to compute opportunity losses.

• Do not have any policies to cope up.

• Relatively longer duration

1)      Transaction risk : When Bank quote their rates to customers the transaction risk gets transferred from customer to bank. This is because the bank normally cover mechant transaction through an opposite transactions in the interbank market. The idea is to ensure that the anticipated Profit in each transaction is locked through the cover transaction. Any adverse rate movement between quoting to the customer and covering the transaction is accepted as normal business risk. Bank do not hedge transaction risk. 

2)      Sometimes the bank dealer may deliberately leave a transaction uncovered in anticipation of a favorable rate movement, effectively a normal business transaction get converted in to a speculation transaction popularly known as “taking a position”. If the position is created through an uncovered purchase its known as over-bought or long position, where as if position created through sale transaction known as oversold or short position. The maximum accumulation dealer can make in terms of such uncovered transactions is called “Day light Limit”. It indicates the level up to which the bank is willing to accept the exposure on behalf of dealer. If the dealer is wrong in his views the bank stipulate a stop-loss limit at which a compulsory covering of transaction to be initiated. The stop-loss signifies the loss in terms of domestic currency which the bank is willing to accept on inaccurate decision.In case if the dealer is correct in his views he takes profits in stages and achieve a near square position at the end of trading day. The Gross outstanding in all currencies at the end of the day are controlled through an “overnight limit”. The activity of freezing the possible loss on speculations through stop-loss are well-known as position risk.

3)      Credit risk: Bank continuously contract each other for forward maturities in each such case both counterparties are exposed to counterpart risk. That is the counterparty not fulfilling contractual obligation if such an event occur any day prior to settlement the other party would enter in to replacement contract to square these exposure. If this replacement contract is at the adverse rate compare to original contract rate the bank suffers a replacement contract also described as pre settlement risk.

4)      On settlement day if there is a counterparty failure after the bank has fulfilled its obligation than the principle amount would be lost in addition to which the bank may have to bear a replacement cost-plus minimum one day interest effectively the problem less on settlement today is more than 100% of contract value termed as settlement risk. These risk became a matter of risk management  example Herstelle case of 1978. In india bank control exposure to foreign counterparties through a global limit which monitor the exposure to counterparty at universal level.With in this global limit the concentration of the contract on a particular future date are monitored to prevent excessive settlement risk.

5)      Mismatched maturity risk: Bank continuously quote forward rate to their customers each such forward contract is required to covered for expected forward maturity. In active market its difficult to find counterparties for broker delivery maturities , the forward exchange rate represents two components : Spot rate and forward margin. Since exchange rates are more volatile than interest rates banks normally cover the transaction for nearest available maturity. This enables the bank to eliminate exchange risk but results in :

a) Liquidity mismatch between inflow and outflow

b) Under and over recovery of forward margin.

To simultaneously adjust both effect these bank required to undertake Swap transaction. A delay in getting the necessary swap may result in a loss on forward margin due to a shift in interest rates . Such losses are described as mismatch maturity risk

Hedging

In international parlance, hedging means a transaction undertaken specifically to offset some exposure arising out of the firm’s usual operations.

In the stock market parlance, hedging is the process of buying one security and selling another in order to produce a riskless security. Hedging involves two investments that are perfectly correlated. For example if the returns of X and Y are perfectly correlated, then to hedge, you have to buy X and sell Y or vice versa to make the net position riskless. Hedging is a mechanism to reduce price risk inherent in open positions.

INTERNAL HEDGING STRATEGIES /TECHNIQUES

• a) Natural hedge

• b) Invoicing in own currency

• C) Split currency invoicing

• D) Netting

• D) Leading and lagging

• e) Price adjustments

• f) Risk sharing agreements

• g) Review of market – product combination

EXTERNAL HEDGING STRATEGIES /TECHNIQUES

• a) Currency forward contracts

• b) Currency future contracts

• c) Currency options

• e) Money market hedge

Currency invoicing: A firm may be able to shift the entire exchange risk to the other party by invoicing its exports in its home currency and insisting that its imports too be invoiced in its home currency.

Netting and Offsetting: A firm with receivables and payables in different currencies can net out its exposure in each currency by matching its receivables with payables. For example, a firm with exports to and imports from France need not cover each transaction separately, it can use a receivable to settle all or part of a payable and take a hedge only for the net Francs payable or receivable.

Sometimes, a currency might have a receivable in one currency say, DM and a payable not in the same currency but a closely related currency such as Swiss francs; the exposure arising from the same can be offset. To explain further, for example, a loss on a payable due to an appreciation of the Swiss Franc vis-à-vis the firm’s home currency will be closely matched by the gain on the receivable due to the appreciation of DM.

Leading and Lagging: This is another way of managing exposures by shifting the timing of the exposures by leading and lagging payables and receivables. The rule of thumb is lead i.e. advance payables and lag i.e. postpone receivables in strong currencies and conversely in weak currencies.

Lead and lags in combination with netting form an important cash management strategy for multinationals with extensive intra-company payments.

The term 'Derivatives' indicates it derives its value from some underlying i.e. it has no independent value. Underlying can be securities, stock market index, commodities, bullion, currency or anything else. From Currency Derivatives market point of view, underlying would be the Currency Exchange rate, in the Indian context it is USD/INR. Derivatives are unique product, which helps in hedging the portfolio against the future risk. At the same time, derivatives are used constructively for arbitrage and speculation too. Currency Derivatives are very efficient risk management instruments and you can derive the below benefits:

  (i) Hedging: You can protect your foreign exchange exposure in business and hedge potential losses by taking appropriate positions in the same. For e.g. If you are an importer, and have USD payments to make at a future date, you can hedge your foreign exchange exposure by buying USD/INR and fixing your pay out rate today. You would hedge if you were of the view that USD/INR was going to depreciate. Similarly it would give hedging opportunities to Exporters to hedge their future receivables, Borrowers to hedge foreign currency loans for interest and principal payments, Resident Indians, who can hedge their offshore investments.

  (ii) Speculation: You can speculate on the short term movement of the markets by using Currency Futures. For e.g. If you expect oil prices to rise and impact India's import bill, you would buy USD/INR in expectation that the INR would depreciate. Alternatively if you believed that strong exports from the IT sector, combined with strong FII flows will translate to INR appreciation you would sell USD/INR.

  (iii) Arbitrage: You can make profits by taking advantage of the exchange rates of the currency in different markets and different exchanges.

  (iv)Leverage: You can trade in the currency derivatives by just paying a fixed % value called the margin amount instead of the full traded value. Currently the margin amount charged is 4-5%.

The NDF markets have generally evolved for currencies with foreign exchange convertibility restrictions, particularly in the emerging Asian economies, viz., Taiwan, Korea, Indonesia, India, China, Philippines, etc., With controls imposed by local financial regulators and consequently the non-existence of a natural forward market for non-domestic players, private companies and investors investing in these economies look for alternative avenues to hedge their exposure to such currencies. NDF market is an offshore market to trade and hedge in currencies of countries wherein there is no full convertibility (both capital account and Current Account). Few of the NDF market traded currencies are Indian Rupee, Chinese Yuan, Philippine Peso, Taiwan Dollar, and Korean Won. NDFs are distinct from deliverable forwards as the NDF s trade outside the countries of the corresponding currencies. NDF is a Non-Deliverable Forward contract which is settled in cash and only in US Dollars. The difference between the Spot rate and the outright NDF rate is arrived on an agreed notional amount and settled between the two counterparties. Trading in the NDF market generally takes place in offshore centres.

In this market, no exchange takes place of the two currencies’ principal sums; the only cash flow is the movement of the difference between the NDF rate and the prevailing spot market rate and this amount is settled on the settlement date in a convertible currency, generally in US dollars, in an offshore financial centre. The other currency, usually an emerging market currency with capital controls, is non-deliverable. In this particular respect, of course, NDFs are similar to commodities futures market where commodities, like wheat or corn, are traded in organized futures markets and positions are later settled in dollars, wheat or corn being nondeliverable. The NDF prices are generally determined by the perceived probability of changes in foreign exchange regime, speculative positioning, conditions in local onshore interest rate markets, the relationship between the offshore and onshore currency forward markets and central bank policies.

NDFs are primarily over-the-counter, rather than exchangetraded products, thus making it difficult to gauge the volume of  contracts traded, who trades the contracts, and where they are traded. At the international level, New York tends to dominate trading in Latin American NDFs, Singapore (and to a lesser extent Hong Kong) dominate trading in non- Japan Asian NDFs, while London spans these markets. The INR NDF is largely concentrated in Singapore and Hong Kong, with small volumes being traded in the Middle East (Dubai and Bahrain) as well.

Bank for International Settlements (BIS), a bank created in the 1930s to manage and monitor the repatriation from the war in Europe would have hardly thought that it would go on to provide guidelines for the risks that bankers face the world over. BIS is, today, one of the most formidable institutions in economics and financial sector. In June 2004, the BIS finalised Basel II, after five years of industry and regulatory consultation. The objective behind this regulation is to align regulatory capital measures with the inherent risk profile of a bank considering credit, market, operational and other risks. Basel I recommendation was the first among the  series of reforms suggested. The greatest drawback of the Basel I proposal was that it prescribed a onefits- all solution for all circumstances and focused on single risk to measure credit and market risk capital adequacy ratio. It does not cover the main risk element ‘Operational Risk’. BIS defines operational risk as, “the risk of loss resulting from inadequate or failed internal processes, people and system or from external events.” In short, operational risk identifies:

a. Why loss has happened, and

b. A breakdown of the causes into: Ø People Ø Process Ø System, and Ø External events

Even though India has one of the strongest  banking systems compared to many peer group countries, our credit, market and operational risk measurement and management system is lagging behind the banks of many developed countries. Basel II implementation will certainly improve the working efficiency and competitiveness of Indian banks. Basel II provides a more comprehensive and

flexible approach for measuring and managing risk. It adds a new dimension called operational risk and encourages the bank’s internal risk management methodologies.

The key difference of the new accord is the introduction of operational risk. This is not a new practice. However, the growing number of operational loss events worldwide has forced the management of the banks to look into this aspect more critically to prevent any frauds, reduce errors by implementing controls as a part of operating process. Evolving banking practices suggest that the risk other than credit and market risks can be substantial. The importance of operational risk has increased due to the following changes in operation and introduction of sophisticated methods and technology.

a. Highly automated technology, if uncontrolled can cause system failure. The loss may be much more as compared to manual system.

b. Emergence of E-banking and E-commerce has potential for internal, external fraud and system securities issues. This needs sound internal controls and back up systems.

c. Large-scale acquisitions, mergers and consolidations test the viability of integrated

Basel committee has identified the following types of operational risks:

•        People Risk – connected with placement, competency, work environment and motivation

•        Process Risk – connected with errors in processing, complexity of process, documentation and contract, violation of controls, money laundering, frauds, model and methodology errors

•        Regulatory risk – connected with failing to comply with laws

•        Technology risk – connected with system and technology failure

•        Event Risk – unanticipated changes in external environment.

•        Reputation Risk

Steps for Implementing Risk Management Broadly the following steps are followed to implement the risk management system.

Ø Study the existing process organisationwide and identify the risk that matters.

Ø Classify the risk according to criticality

Ø Set up systems and controls for monitoring and reporting to management

The European Central Bank (ECB) is the institution of the European Union (EU) that administers the monetary policy of the 17 EU Eurozone member states. It is thus one of the world's most important central banks. The bank was established by the Treaty of Amsterdam in 1998, and is headquartered in Frankfurt, Germany. The current President of the ECB is Mario Draghi, former governor of the Bank of Italy.    The European Central Bank (ECB) is the principal institution in the European Union whose purpose is to manage monetary policy for all the member states of the Eurozone. In simple terms, it is the Central Bank responsible for the management of the Euro. As such it is one of the most significant central banks in the world and any decision made concerning the Euro can ripple through to all the worlds currency markets. It was created in1998 and is headquartered in Frankfurt, Germany.

The primary objective of the European Central Bank is to maintain price stability within the Eurozone, which is the same as keeping inflation low. The Governing Council defined price stability as inflation (Harmonised Index of Consumer Prices) of around 2%. Unlike, for example, the United States Federal Reserve Bank, the ECB has only one primary objective with other objectives subordinate to it.

Three bodies function under the ECB:

·         The Governing Council: is made up of six members of the Executive Board of the ECB and the governors of each of the national banks of the countries in the Eurozone. Its primary role is providing directions for the ECB and it has the final word regarding policy implementations.

·         The Executive Board: is in charge of setting up policies and is made up of the President and the Vice-President of the ECB and four other member of the Governing Council. All the members are appointed for a non-renewable 8-year term through a common concession by the Heads of State of the Eurozone countries.

·         The General Council: consists of the President and Vice-President of the ECB and all the governors of the member state’s central banks. Its main role is to act as a forum for all the member states of the European Union (EU) to air their financial concerns. It is a temporary body, which will be dissolved once all the EU countries adopts the principals of the European Monetary Union (EMU) and officially joins the ESCB.

General Functions of the ECB: the ECB is the matriarch of all the banks which are part of the ESCB. Thus, its roles are geared towards regulating most of the major financial obligations of the National Central Banks under its wing.

·         Issuance of bank notes and coins: the authorization regarding the issuing of bank notes lies solely with the ECB. The member states can issue coins however; the ECB has the final say on the amount.

·         Account opening: any credit institution, public bodies and other financial market participants have to get authorization to open an account with the ECB and the national central banks exclusively from the ECB.

·         International relations: only the ECB will engage in negotiations and transactions with central banks and credit institutions of third party countries as well as other international organizations.

·         Open market operations:when the ECB or the national central banks have to deal in the financial markets tasks such as borrowing and lending money will lie with the ECB.

·         Other functions of the ECB include:

-          Transacting in credit operations with credit institutions and other interested parties;

-          Maintaining price stability within the Eurozone

-          Constructing rules for the efficient clearing of payment systems

-          Setting the requirements on credit organizations founded in Member States to hold minimum reserves in accounts with the ECB or the national central banks of the state in question.