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BANK FINANCIAL MANAGEMENT Indian Institute of Banking & Finance MACMILLAN 'THE ARCADE', WORLD TRADE CENTRE, CUFFE PARADE MUMBAI 400 005 Misson • To develop professionally qualified and competent bankers and financial professionals primarily through a process of education, training, examination, consultancy/counselling and continuing professional development programs. • To be the premier Institute for developing and nurturing competent professionals in banking and finance field. • • • • •
To facilitate study of theory and practice of banking and finance. To test and certify attainment of competence in the profession of banking and finance. To collect, analyse and provide information needed by professionals in banking and finance. To promote continuous professional development. To promote and undertake research relating to Operations, Products, Instruments, Processes, etc., in banking and finance and to encourage innovation and creativity among finance professionals so that they could face competition and succeed.
© INDIAN INSTITUTE OF BANKING & FINANCE, MUMBAI, 2010 (This book has been published by Indian Institute of Banking & Finance. Permission of the Institute is essential for reproduction of any portion of this book. The views expressed herein are not necessarily the views of the Institute.) All rights reserved. No part of this publication may be reproduced or transmitted, in any form or by any means, without permission. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. First edition, 2010 MACMILLAN PUBLISHERS INDIA LTD Delhi Bangalore Chennai Kolkata Mumbai Ahmedabad Bhopal Chandigarh Coimbatore Cuttack Guwahati Hubli Hyderabad Jaipur Lucknow Madurai Nagpur Patna Pune Thiruvananthapuram Visakhapatnam Companies and representatives throughout the world
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Contents Foreword MODULE A International Banking 1. Exchange Rates and Forex Business 2. Basics of Forex Derivatives 3. Correspondent Banking and NRI Accounts 4. Documentary Letters of Credit 5. Facilities for Exporters and Importers 6. Risks in Foreign Trade - Role of ECGC 7. Role of Exim Bank, Reserve Bank of India, Exchange Control in India - FEMA and FEDAI and Others MODULE B Risk Management 8. Risk and Basic Risk Management Framework 9. Risks in Banking Business 10. Risk Regulations in Banking Industry 11. Market Risk 12. Credit Risk 13. Operational Risk and Integrated Risk Management 165 183 194 236 257 286 MODULE C Treasury Management 14. Introduction to Treasury Management 15. Treasury Products 16. Funding and Regulatory Aspects 17. Treasury Risk Management 18. Derivative Products 19. Treasury and Asset-Liability Management MODULE D Balance Sheet Management 20. Components of Assets and Liabilities in Bank's Balance Sheet and their Management 21. Banking Regulation and Capital 22. Capital Adequacy - The Basel-II Overview 23. Supervisory Review 24. Pillar 3 - Market Discipline 25. Asset Classification and Provisioning Norms 26. Liquidity Management 27. Interest Rate Risk Management 28. RAROC and Profit Planning
389 402 407 413 421 428 436 456 479
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INTERNATIONAL BANKING UNITS 1. Exchange Rates and Forex Business 2. Basics of Forex Derivatives 3. Correspondent Banking and NRI Accounts 4. Documentary Letters of Credit 5. Facilities for Exporters and Importers 6. Risks in Foreign Trade - Role of ECGC 7. Role of Exim Bank, Reserve Bank of India, Exchange Control in India - FEMA and FEDAI and Others
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UNIT 1 Exchange Rates and Forex Business STRUCTURE 1.0 Objectives 1.1 Introduction 1.2 Foreign Exchange - Definition and Markets Check Your Progress (A) 1.3 Factors Determining Exchange Rates 1.4 Exchange Rate Mechanism Check Your Progress (B) Exchange Arithmetic - Few Examples 1.5 Foreign Exchange Dealing Room Operations 1.6 RBI/FEDAl Guidelines Check Your Progress (C) Let Us Sum Up Key Words Answers to Check Your Progress Terminal Questions References for Further Reading
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1.0 OBJECTIVES The objective of this unit is to understand: The definition and types of exchange rates The mechanism and the marlcets The Factors affecting rates The Related guidelines How a dealing room operates and Forex operations in India - Various guidelines 1.1 INTRODUCTION The world trade, export and import of commodities, cross-border movement of manpower and capital, travel and tourism and export of services, all necessitate the need for exchange of currency of one country to the currency of another country. The export of goods manufactured in India, to USA, are paid in US dollars, where the exporter needs to convert the USD proceeds of the bill into Indian rupees. Similarly, import of capital goods from Germany into India, billed in Euro, is to be paid in Euro, by converting Indian rupees into Euro. Thus conversion of currencies from the currency of invoice to the home currency of the exporters will be generally required for all cross border trades. This is Foreign Exchange. For the Indian exporter or the importer, the US dollars or Euro is foreign exchange, while for the American (buyer of Indian goods) or the German (seller of capital goods), Indian rupee is foreign exchange. Thus, in today's world, when nations push for greater inflow or outflow of goods, capital or services, foreign exchange has become an integral part of the world financial system. The term Foreign Exchange is more broadly used to denote foreign currency, i.e. currency of any country, as well as the exchange of currency of one country into that of another. Can we think of not exporting our surplus produces or not importing the new technology, machineries or consumables into India? Can we do without import of capital, to fund our country's growth related investments? Travel, tourism, exports, imports of goods and services, repatriation of savings by expatriates, all depend on foreign exchange. 1.2 FOREIGN EXCHANGE - DEFINITION AND MARKETS Foreign Exchange Management Act (FEMA), 1999, (Section 2) defines foreign exchange as: "Foreign Exchange means foreign currency, and includes: (i) All deposits, credits and balances payable in foreign currency, and any drafts, traveler's cheques, letters of credit and bills of exchange, expressed or drawn in Indian currency and payable in any foreign currency, (ii) Any instrument payable at the option of the drawee or holder, thereof or any other party thereto, either in Indian currency or in foreign currency, or partly in one and partly in the other." Thus, broadly speaking, foreign exchange is all claims payable abroad, whether consisting funds held in foreign currency with banks abroad or bills, checks payable abroad.
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In other sense, a foreign exchange transaction is a contract to exchange funds in one currency for funds in another currency at an agreed rate and arranged basis. Exchange rates thus denote the price or the ratio or the value at which one currency is exchanged for another currency. The number of units of one currency, which exchange for a given number of units of another currency, is the exchange rate of the currency. For example, 1 US dollar is equal to Rs 48.10, or 1 Euro is equal to 1.47 US dollar. The exchange rate is a dynamic rate, which varies from day-to-day, minute-to-minute and second to second, and in practice a few times per second, depending upon a variety of factors. We shall learn more about the forex markets and other aspects as we go ahead. Foreign Exchange Markets Foreign exchange markets comprise a large spectrum of market participants, which include individuals, business entities, commercial and investment banks, central banks, cross border investors, arbitrageurs and speculators across the globe, who buy or sell currencies for their needs. It is a communication system-based market, with no boundaries, and operates round the clock, within a country or between countries. It is not bound by any four-walled marketplace, which is a common feature for commodity markets, say vegetable market, or fish market. It is a profit centre with simultaneous potential for losses. Forex markets are dynamic markets and work round-the-clock, in different time zones, in which various countries are located. Geographically, forex markets extend from Tokyo and Sydney in the east, through Hong Kong, Singapore, Bahrain, London and New York in the west. If we view the markets as per GMT, when the London and other European markets start the day it is almost lunch time for the Indian markets, and when the Indian markets are about to close, the New York market is about to begin its day. Further, while the New York market operates for sometime alongside the London and European markets, the markets in the east: Tokyo, Hong Kong and Singapore are ready to start, before New York closes. The Indian and Middle East markets are ready to start the day, before close of Singapore and Hong Kong markets. The world currency market is a very large market, with a large number of participants. Major participants of forex markets are: • Central Banks - managing their reserves and using currency markets to smoothen out the value of their home currency. • Commercial Banks - offering exchange of currencies to their retail clients and hedging and investing their own assets and liabilities, as also on behalf of their clients, and also speculating on the movements in the markets. • Investment Funds/Banks - moving funds from one country to another using exchange markets as a vehicle for investments as also hedging their investments in various countries/currencies. • Forex Brokers - acting as middleman, between other participants, and at times taking positions on their books. • Corporations - moving funds between different countries and currencies for investment or trade transactions or even speculation in currency markets.
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6 I BANK FINANCIAL MANAGEMENT • Individual - ordinary or high net worth individuals using markets for their investment, trade, personal, and travel and tourism needs. As given here, the participants not only use the forex markets for trade or travel purposes, but also for investments, hedging and speculative, thus generating large volumes for the market. It may be surprising to note that the global forex market handles total turnover of approx. US dollar 3.20 trillion (USD 3200 billion ) per day, while the daily world trade turnover is approx. 2.00 % of this forex turnover. This means that around 98% of the global forex trading relates to investments, or speculative trading. The Indian forex markets too, trade over USD 30 billion per day. which is again a good multiple of the India's average daily export /import trade turnover, mostly because of regulatory exchange control regime and restrictive flow offoreign currency. The forex markets are highly dynamic, that on an average the exchange rates of major currencies (say GBP/USD) fluctuate every four seconds, which effectively means it registers 21,600 changes in a day (15 X 60 X 24). Now that means that you look aside for a second and when you turn back for the rate, the same could have moved either way. Forex markets usually operate from 'Monday to Friday' globally, except for the Middle East or other Islamic countries which function on Saturday and Sunday with restrictions, to cater to the local needs, bur are closed on Friday. The bulk of the forex markets are OTC (over the counter), meaning that the trades are concluded through telephone or other electronic systems (dealing systems of various news agencies, banks, brokers or Internet-based solutions). Banks in London quite commonly deal with banks in Paris, Frankftirt, Mumbai and New York and even in Tokyo or Singapore, which are totally in a different time zone. Large dealing rooms of global banks or Corporates, operate round the clock, to be with all major markets across the globe. A few traders, are provided dealing platforms in their homes, to enable them to trade in any time zone. Now with the internet accessibility on the mobile, the markets can be accessed any time any place. Major banks, which act as market makers offer two-way quotes, (buy and sell), and leave upon the caller to either buy or sell as per his needs. This generates greater market depth and volumes. Thus the characteristics of foreign exchange market can be listed as under: a 24-hour market an over the counter market a global market with no barriers/no specific location a market that supports large capital and trade flows highly liquid markets high fluctuations in currency rates (every 4 seconds) settlements affected by time zone factor markets affected by governmental policies and controls of one currency
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2. The exchange rates of major currencies fluctuate every 3. The Forex markets are dynamic and round the clock markets. True/False 4. Forex markets are not affected by government policies. True/False 5. A large part of the total global forex turnover results from global commodities trade. True/False 1.3 FACTORS DETERMINING EXCHANGE RATES The quotations in the Forex markets depend on the delivery type of the foreign currencies, i.e., exchange of strearns of the two currencies being exchanged. The spot rates, being the base quotes in the forex markets are more dynamic and are effected by varied reasons, a few of which are fundamental and other technical. The main factors, which influence movement of exchange rates, can be summarised as under: (a) Fundamental Reasons These include all those causes or events, which affect the basic economic and monetary policies of the concerned government. The causes normally affect the long-term exchange rates, while in the short- run, many of these are found ineffective. In a long run, exchange rates of all currencies are linked to fundamentals, as given under: • Balance of payment - generally a surplus leads to a stronger currency, while a deficit weakens a currency. • Economic growth rate - a high growth leads to a rise in imports and a fall in the value of currency, and vice versa. • Fiscal policy - an expansionary policy, e.g., lower taxes can lead to a higher economic growth. • Monetaiy policy - the way, a central bank attempts to influence and control interest and money supply can impact the value of currency of their country. • Interest rates - high domestic interest rates tend to attract overseas capital, thus the currency appreciates in the short term. In the longer term, however, high interest rates slow the economy down, thus weakening the currency. • Political issues - political stability is likely to lead the economic stability, and hence a steady currency, while political instability would have the opposite effect. (b) Technical Reasons Government controls can lead to an unrealistic value of a currency, resulting in violent exchange rates. Freedom or restriction on capital movement can affect exchange rates to a larger extent. This is a recent phenomenon, as seen in Indonesia, Korea, etc. Huge surpluses generated in the petroleum exporting countries, (due to the sudden spurt in petroleum prices), which could not be utilised in these countries, had to be invested overseas. This creates huge movement of capital overseas and resultant appreciation of the relative currency. Capital tends to move from lower yielding to higher yielding currencies, and results, is movement in exchange rates.
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8 I BANK FINANCIAL MANAGEMENT (c) Speculation Speculative forces can have a major effect on exchange rates. In an expectation, that a currency will be devalued, the speculator will short sell the currency for buying it back cheaper at a later date. This very act can lead to vast movements in the market, as the expectation for devaluation grows and extends to other market participants. Speculative deals provide depth and liquidity to the market and at times, act as a cushion too, if the views do not lead to a contagious effect. 1.4 EXCHANGE RATE MECHANISM Types and Calculation Due to the vastness of the market, operating in different time zones, most of the Forex deals are done on SPOT basis, meaning thereby that the delivery of the funds takes place on the second working day following the date of deal/contract. The rate at which such deals are done is known as SPOT rates. Spot rates are the base rates for other FX rates. The date of delivery of funds on the date, on which the exchange of currencies actually takes place, is also referred to as 'value date'. The delivery of FX deals can be settled in one or more of the following ways: Ready or Cash Settlement of funds takes place on the same day (date of deal), e.g., if the date of Ready/Cash deal is 5 October 2009 (Monday), settlement date will also be 5 October 2009. Tom Settlement of funds takes place on the next working day of the date of deal, e.g., if the date of TOM deal 5 October 2009 (Monday), settlement date would be 6 October 2009 (Tuesday, provided it is a working day for the markets dealing as well as where currency is to be settled). If Tuesday is a holiday, in any of the 2 countries, the settlement date will be next working day in both the countries. Spot Settlement of funds takes place on the second working day after/following the date of contract/deal, e.g., if the date of Spot deal is 5 October, 2009 (Monday), settlement date will be 7 October, 2009. (Presuming all markets are working on 5, 6 and 7 October 2009). If not, it will the next working day in both the countries. Forward Delivery of funds takes place on any day after Spot date, e.g., if the date of forward deal is 5 October 2009 (Monday), for value settlement date 30 October 2009 or 30 November 2009, it is a forward deal.
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Spot and Forward Rates As explained earlier, in the Forex market all rates quoted are generally 'Spot Rates'. The spot rates are for delivery of currency or exchange of the strearns of currencies dealt in, on the second working day from the date of deal or transaction. Say USD/INR quoted as 1 USD = 48.10 Rupees, or GBP/USD quoted as 1 GBP = 1.6050 USD or EURO/USD as 1.4750. The volume, depth and volatility of the spot market is higher due to large participation of market players in the spot trades. On the other hand, when the delivery of the currencies is to take place at a date beyond the Spot date, i.e., beyond two working days, then it is a forward transaction, and the rate applied is called forward rate, which is generally different from the spot rate. Let us now see, why and how this is so? Forward Margins - Premium and Discounts Forward rates are derived from spot rates, and are function of the spot rates and forward premium or discount of the currency, being quoted. Forward rate = Spot rate + Premium (or - Discount). If the value of the currency is more than that being quoted for Spot, then it is said to be at a Premium, while if the currency is cheaper at a later date than spot, than it is called at a Discount. To, simplify, if the forward value of the currency is higher than (costlier) the spot (present) value, then the currency is said to be at a Premium, say, if the spot GBP against USD is being quoted at L6000, and 1 month forward as L6050, than GBP is dearer, value one month forward, and a premium of 50 pips is being charged for the same. Similarly, if the forward value of a currency is cheaper than the present value (spot), the currency is said to be at a Discount. In the above example, where the spot GBP is quoted as 1.6000, against USD, and 3 month forward as L5900 (100 pips), while the GBP is at a premium, the USD, the other currency is at a discount against the GBP. Let us take another example. Indian rupee spot being quoted as 48.10/11, against USD i.e., 1 USD is being bought at 48.10 and sold at Rs 48.11. Now if the six-month premium being quoted is 68/69 paise, it means that the USD is being quoted dearer in forward, and is being quoted as 48.78/80 Here the USD is at a premium, while the INR at a discount, thereby meaning that the USD is costlier for future value, while the Indian Rupee is cheaper for future value. Thus, a correlation is clearly established as the quotes are for a pair of currencies, where one is exchanged for another, (GBP/USD, USD/INR, USD/SGD, Euro/USD, USD/JPY, etc.). The forward premium and discount are generally based on the interest rate differentials of the two currencies involved, as also on the demand and supply of forwards in the market. The demand and supply depends upon various factors, which include, movement of capital in normal times as well as
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10 I BANK FINANCIAL MANAGEMENT out of fright/ fear (flight of capital), status of exports and imports, trade balance as also balance of payment, other flnancial and fiscal status of countries, freedom to invest and move in and out, infrastructure and labour position, political stability and activity , speculative activities, etc. In a perfect market, with no restrictions on finance and trade, the interest factor is the basic factor in arriving at the forward rate. If the rate of interest, say in the US, for three months prime bank bills is 2% p.a. while similar paper in London can be purchased at a rate of interest of 4% p.a., there will be a flow of funds from USA to London to take advantage of higher yield shown by the UK bills. (Assuming there are no exchange controls and free movement of capital is allowed.) The US investor will have to buy GBP by surrendering his USD (owned or borrowed) in the spot market and the GBP so obtained by him would be invested in the UK bills. This will lead to a demand for GBP in the spot market. At the maturity of pound bills, the pounds received would be reconverted to US dollars. This will lead to a demand for USD in the forward. This gain or sacrifice will be adjusted in the forward rate of currencies (as forward margin premium or discount), dealt in the foreign exchange market, to ensure a no-profit, no-loss situation. Therefore, the forward price of a currency against another can be worked out with the following factors: (i) Spot price of the currencies involved. (ii) The interest rate differentials for the currencies. (iii) The term, i.e., the future period for which the price is worked out. It would be relevant to emphasize here that the forward rate so worked out is no indicator of the future trend of the currency values. Direct and Indirect Quotes As mentioned elsewhere, the price of the currency can be expressed either as one unit of home currency, equal to so many units of foreign currency, or as one unit of foreign currency equal to so many units of home currency. Under direct quotes, the local currency is variable, say as in India, 1 USD = Rs 48.10. The rates are called direct, as the rupee cost of foreign currency is known directly. These quotes are also called Home Currency or Price Quotations. On the other hand, under indirect method, the local currency remains fixed, while the number of units of foreign currency varies. For example, Rs 100 = 2.05 USD. It would be worthwhile to mention that globally a practice is being followed where all currencies, (except a few) are quoted as direct quotes, in terms of USD (1 USD = so many units of another currency). Only in case of GBP (Great Britain Pound/British Pound), Euro, AUD (Australian Dollars), and NZD (New Zealand Dollars), the currencies are quoted as indirect rates, i.e., one GBP, Euro, AUD, or NZD = so many units of USD.
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EXCHANGE RATES AND FOREX BUSINESS I 11 So, the currency rates, as generally quoted on a given day, can be under : USD/INR-Rs 48.10/11 perUSD, GBP/USD-USD 1.6000/10 per GBP, EURO/USD - USD 1.4710/20 per EURO, USD/JPY- JPY 91.50/60 per USD, USD/CHF- 1.0390/00 per USD, USD/SGD 1.4175/95 per USD, USD/HKD 7.7475/00 per USD, AUD/USD 0.8730/40 per USD, Cross Rates When we deal in a market where rates for a particular currency pair are not directly available, the price for the said currency pair is then obtained indirectly with the help of cross rate mechanism. This can be explained with the following example: Suppose, we intend to get a quote for Euro/rupee and no one is prepared to quote Euro/Rs directly in the market. We can work out a Euro/Rs quote through Euro/USD and USD/Rs quotes. Euro/USD quote would be available in the international markets and USD/Rs would be available in the domestic market. By crossing out USD in both the quotes, we can arrive at an effective Euro/Rs quote. This is the basis for working out cross rates. Cross rate mechanism is a possible solution for calculation of rates for currency pairs which are not actively traded in the market. For example, we need to quote GBP against INR, but in India, usually GBP is not quoted directly, as such we need to take rates for USD/|NR and GBP/USD to compute GBP/INR rate. If, USD/INR is 48.10/11, and GBP/USD is 1.6000/10, then, to GBP/INR rate, we need to cross both the given rates, which would give us GBP/INR rate as Rs 76.9600/77.0200. Or say if USD/ JPY is 91.50/60, the rate for Rupee /JPY would be Rs 53.50/60 per 100 JPY (JPY being quoted per 100 units, due to their values) . Fixed vs. Floating Rates The fixed exchange rate is the official rate set by the monetary authorities for one or more currencies. It is usually pegged to one or more currencies. Under floating exchange rate, the value of the currency is decided by supply and demand factors for a particular currency. In some cases, even fixed exchange rates are allowed to fluctuate between definite upper and lower bands, as fixed by the monetary authority of the country. Since 1973, the world economies have adopted floating exchange rate system. India switched to a floating exchange rate regime in 1993 ( from currency basket peg where currency fluctuations depend on fluctuations in the basket of currencies- decided upon the trade relationships.) Bid and Offered Rates The buying rates and selling rates are also referred to as bid and offered rates. In a USD/INR quote, of 48.10/11, quoting bank is bidding for USD at 48.10 and is offering to sell the USD at 48.11. On the other hand, in a GBP/USD rate 1.6000/10, the quoting bank is willing to buy GBP at 1.6000 and willing to sell at 1.6010. Exchange Arithmetic - Theoretical Overview All foreign exchange calculations have to be worked out with extreme care and accuracy and also the use of decimal point has to be correctly placed. Constant check is also required to minimise the risk of mistake, as the markets work on very thin margins. An error in one quote may erode, earnings from several trades/transactions. Chain Rule
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It is used in attaining a comparison or ratio between two quantities linked together through another or other quantities and consists of a series of equations, commencing with a statement of the problem in the form of a query and continuing the equation in the form of a chain so that each equation must start in terms of the same quantity as that which concluded the previous equation. Per Cent and Per Mille A percentage (%) is a proportion per hundred, e.g., 1 % is one part in every hundred parts such as Rupee 1 per Rupees 100, while per mille means per thousand, e.g., 1 per mille is one part in every thousand, such as Rupee 1 per Rupees 1,000. Percentage or per mileage can also be used to ones advantage in checking roughly any calculations, such as interest when allowed in a rate of exchange. V^alue Date This is the term used to define the date on which a payment of funds or an entry to an account becomes actually effective and/or subjected to interest, if any. In the case of payments on Telegraphic Transfers (TT) the value date is usually the same in both centres, i.e., payment of the respective currency in each centre takes place on the same day, so that no gain or loss of interest accrues to either party. Such payments are said to be valuer compensee, or, simply, here and there. If there is time lag between receipt of funds at one centre and payment of funds at another centre, compensation should be paid to party, which is out of funds. Normal mode of compensafion is interest, which should be recovered/paid separately. This may be done by adjusting the value date if acceptable to both the parties. Thus, the date of settlement of funds is known as value date. Arbitrage in Exchange Arbitrages consist in the simultaneous buying and selling of a commodity in two or more markets to take advantage of temporary discrepancies in prices. As applied to dealings in foreign exchange, arbitrage consists of the purchase of one currency for another in one centre, accompanied by an almost immediate resale against the same currency in another centre, or in operations conducted through three or more centres and involving several currencies. A transaction conducted between two centres only is known as simple or direct arbitrage. Where additional centres are involved, the operation is known as compound
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r EXCHANGE RATES AND FOREX BUSINESS I 13 or three (or more) point arbitrage. Such operations must be carried out with the minimum time delay if advantage is to be taken of temporary price differences, and they require a high degree of technical skill. Speed in handling the deals would be the foremost aspect in such deals, as markets usually tend to move towards such deals and the differences get wiped out in no time. Rates quoted to merchants, or for retail transactions are specified by the nature of transactions. By this, the different rates could be applied for TT, Bill transactions. Foreign Money or Cash transactions, Travellers Cheques transactions, or even personal checks buying. The rates would be different for buying or selling transaction, levying different margins over the interbank rates, depending upon the nature of transaction. Check Your Progress (B) Fill in the blanks 1. Main factors effecting exchange rates are technical, 2. In a spot contract, settlement of funds takes place on the _ the date of contract. 3. If the currency is costlier in forward, it is said to be at a __ . 4. If the forward value of the currency is cheaper, it is said to be at a 5. The date of settlement of funds is known as _____ date. 6. The rate at which the quoting party is ready to buy the currency is called and speculation. ________ working day following rate. 1.5 FOREIGN EXCHANGE DEALING ROOM OPERATIONS The Forex dealing room operations comprise functions of a service branch to meet the requirements of customers of other branches/divisions to buy or sell foreign currency, manage foreign currency assets and liabilities, fund and manage nostro accounts as also undertake proprietary trading in currencies. It acts as a separate profit centre for the bank/institution. The Dealers, who are actually involved in the buying and selling of currencies, or undertaking market activities are the most critical manpower, as their understanding of the job, risk taking capacity and speed in decision-making, all lead to lot of profits for the dealing operations. On the other hand, a small mistake, a misjudgment may wipe off all days profit in a second. A good dealer needs to have a good understanding of the changing nature of things. Certain psychological qualities are prerequisites. The ability to work under stress, willingness to accept responsibilities, the ability to make decisions quickly, a good measure of aggressiveness and above all, a willingness to recognise that one can be wrong. There must exist an atmosphere of complete trust within a dealing room. A dealer has to maintain two positions - funds position and currency position. The funds position reflects the inflow and outflow of funds, i.e. receivables and payables. Any mismatches in the receivables and payables will throw open interest rate risks, in the form of a possible overdraft interest in nostro accounts, loss of interest income on surplus credit balances. It is very important for a dealer to properly maintain the funds position and manage the funds.
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14 I BANK FINANCIAL MANAGEMENT The currency position, on the other hand, deals with the overbought or oversold positions, arrived after taking various merchant or interbank transactions, and the dealer will be concerned with the overall net position, which exposes the dealer to exchange risks from market movements. The dealer has to operate within the permitted limits prescribed for the exchange position by the management. The funds position comprises of items that are Ready in nature, effecting funds position immediately, as also those in the nature of forwards, which effect funds position at a later date, thus the dealer also needs to manage gap positions in different currencies. The other part of the dealing room is Back Office, which takes care of processing of deals, accounts, reconciliation, etc. This function is of the equal importance, any laxity in this area would also land the institution into unforeseen trouble. Either, it may negate the efforts of the dealers to generate profits, or it could be so lax that the dealers indulge in misreporting or wrong doings, without the notice of the back office it has both a supportive as well as a checking role over the dealers. The third part, is Mid-Office, which deals with the risk management, and parameterization of risks for forex dealing operations. It acts as a check over the risk taken by the dealers as also supplements them by giving market information. Mid office is also supposed to look after the compliance of various guidelines /instructions and is an independent function. With the increasing volume of foreign exchange transactions arising out of expanding international trade, both in goods and services, cross border flow of money, and also because of the Authorised dealers undertaking foreign exchange trading, the necessity for exercising management control over profit/loss evaluation and adhering to the prescribed guidelines/limits needs no emphasis. Reserve Bank of India has approved the guidelines on Uniform Standard Accounting Procedure for valuation of foreign exchange profits and losses by authorised dealers, issued by Foreign Exchange Dealers' Association of India (FEDAI). which require banks to undertake profit /loss evaluation of forex positions at the end of each month not withstanding the practice of passing accounting entries at quarterly intervals. However, the mechanisation of dealing operations facilitates profit evaluation at lesser frequencies as well, and in some organizations on daily basis. As per extant guidelines, each foreign currency position covering all components of foreign currency (exchange) position, viz., mirror accounts of the currency, foreign currency notes held, import suspense account, all spot and forward positions, including export bills (both sight and usance), transactions which are reported to the position desk but not adjusted in the accounts, i.e., actual vouchers not put through, overdue contracts - inter-bank, if any and merchant contracts, and other foreign currency assets and liabilities—should be revalued separately. Foreign Exchange Dealers' Associadon of India advises the valuation rates based on ongoing market rates on month-end dates, to enable the authorised dealers to revalue their foreign currency positions. Management and Control of a Dealing Room Reserve Bank of India, has advised that the Board of Directors of banks should frame an appropriate policy and fix suitable limits for its Forex dealing functions.
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iTI EXCHANGE RATES AND FOREX BUSINESS i 15 The management of dealing room operations should focus on risk associated with foreign exchange dealing room operations, which arise due to complex nature of foreign exchange markets and the volatile nature of exchange rate movements. The major risks associated with foreign exchange dealing operations, where the management needs to frame policies and keep a constant vigil, can be summarised as under: Operational Risk: It is a risk arising on account of human errors, technical faults, infrastructure breakdown, faulty systems and procedures or lack of internal controls. Exchange Risk: It is the most common and obvious risk in foreign exchange dealing operations and arise mainly on account of fluctuations in exchange rates and/or when mismatches occur in assets/ liabilities and receivables/payables. Credit Risk: It is a risk of loss which arises due to inability or unwillingness of the counter party to meet the obligations at maturity of the underlying transaction. Credit risk is further classified into pre-settlement risk and settlement risk. Pre-settlement risk is the risk of failure of the counter party before maturity of the contract thereby exposing the other party to cover the transaction at the ongoing market rates. Settlement risk is the risk of failure of the counter party during the course of settlement, due to the time zone differences, between the two currencies to be exchanged. That is, where one party performs its part of the contract by delivering the currency to be delivered by it but the counter party fails before delivering the currency to be delivered by it. in a different time zone. Liquidity Risk: Liquidity risk is the potential for liabilities to drain from the bank at a faster rate than assets. The mismatches in the maturity patterns of assets and liabilities give rise to liquidity risk. Thus, it is a risk, which may arise due to a party to foreign exchange transaction unable to meet its funding requirements or execute a transaction at a reasonable price. Gap Risk/Interest Rate Risk: In the course of its business, a bank buys and sells currencies for spot and forward value. It may not be always possible for the bank to match its forward purchase and sales. Thus, if the purchase and sale take place for different value, while the bank may completely stand hedged on exchange front, it creates a mismatch between its assets and liabilities referred to as GAP. These gaps are to be filled by the bank by paying/receiving appropriate forward differentials. These forward differentials are in turn a function of interest rates and any adverse movement in interest rates would result in adverse movement of forward differentials thus affecting the cash flows on the underlying open gaps or mismatches. Therefore, it is the risk arising out of adverse movements in implied interest rates or actual interest rate differentials. Market Risk: The risk that arises due to adverse movement of market variables when the players are unable to exit the positions quickly. Legal Risk: It is the risk arising on account of non-enforceability of contract against a counter party. Systemic Risk: This risk is the possibility of a major bank failing and the resultant losses to counter parties reverberating into a banking crisis.
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Coimtiy Risk: It is the risk of counter party situated in a different country unable to perform its part of the contractual obligations despite its willingness to do so due to local government regulations or political or economic instability in that country. Sovereign Risk: It is a sub-risk in the overall country risk in that certain state-owned entities themselves quoting their sovereign status claim immunity from any recovery proceedings of fulfillment of any obligations they had originally agreed to, as in these countries, the sovereign status cannot be questioned even in a court of law. A comprehensive and accurate management control of dealing room operations would cover assessment of the above risk exposures and their management. It is to be noted that foreign exchange dealing room operations are considered to be profit centres in most of the major banks and a complete risk aversion will only help the management to avoid loss. To generate profit, it is essential to have a proper risk appetite to optimise profit, through proper risk-reward trade off. Details about these risks and their management and control would be covered under the unit Risk Management. Foreign exchange dealing operation is a highly specialised function and has to be performed by well- trained personnel. Typically a dealing room should consist of dealing and back-office staff who are responsible for the follow-up of deals put through by the dealers. The need for effective control over dealing room operations is of great importance as possibilities exist for manipulation of exchange rates, dealing positions, washing names, mismatches, etc. A supreme principle of operational procedures and the area of dealing room activities is a clear functional separation of dealing, back office accounting (processing and control) and reconciliation. The above details on the dealing room and its operations make it clear that the operations are crucial and important to any bank or institution. The contribution of exchange profit (from merchant transaction as well as trading operations) has its own place in the bottom line of the bank, as such large players in major markets, have deployed a large number of dealers and other staff, supported by sophisticated communication and IT systems with huge investments, to handle the forex dealing operations. These large dealing rooms have separate desks for traders, as also for derivatives, each of which specialises in its own product, and are constantly in the market to make money for the bank. In India too, a number of banks have large dealing rooms, and have grown to cater to various products, as permitted by Reserve Bank of India. 1.6 RBI/FEDAI GUIDELINES The Reserve Bank of India, being the central bank of the country and the custodian of nation's foreign exchange reserves, has prescribed guidelines for authorised dealers, permitted by it, to deal in foreign exchange and handle foreign currency transactions. FEMA 1999, also prescribes rules for persons, Corporates, etc., in handling foreign currencies, as also transactions denominated therein. The Reserve Bank of India has issued 'Authorised Dealers' (AD) licenses to banks and all-India financial institutions to undertake foreign exchange transactions in India. At present there are over 90 ADs, which
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r EXCHANGE RATES AND FOREX BUSINESS I 17 include all public sector banks, foreign and a large number of private banks, a few all-India financial institutions and a few Scheduled cooperative banks. The RBI has also issued Money Changer licenses to a large number of established firms, companies, hotels, shops, etc., to deal in foreign currency notes, coins and traveller's cheques, to facilitate encashment of foreign currency for foreign tourists. Entities authorised to buy and sell foreign currency notes, coins and traveller's cheques are called Full Fledged Money Changers (FFMCs) while those authorised only to buy are called Restricted Money Changers (RMCs). Categorization of Authorized Dealers: In the year 2005, the categorization of dealers authorized to deal in foreign exchange has been changed by the Reserve Bank of India. Now, the entities so authorized are called as Authorised Persons, with category, denoting their level of authority to undertake variety of transactions, as under: Authorised Person - Category I: Authorised Dealer Banks, Financial Institutions, and other entities allowed to handle all types of foreign exchange transactions. (Earlier known as Authorised dealers). Authorised Person - Category II: Money changers, allowed to undertake sale/purchase of foreign currency notes, travellers cheques, as also handle foreign exchange transactions relating to remittance facilities allowed to residents, like Travel abroad, studies abroad, medical needs, gifts, donations, etc. (Earlier known as Full fledged Money Changers-FFMCs). .Authorised Person - Category III: Entities allowed to undertake only purchase of foreign currency notes and traveller's cheques, (Earlier these entities known as Restricted Money Changers-RMCs). Foreign Exchange Operations, undertaken without any boundaries or controls, can adversely effect the movement of exchange rates and the value of currency, besides profitability of the entity dealing in an arrogant manner. As such, for regulated, disciplined market operations, RBI has prescribed broad guidelines with regard to foreign exchange operations. RBI guidelines include guidelines related to open positions, gaps, borrowing and lending in foreign currencies, interbank dealings in India and Overseas Markets, hedging of bank's own exposures as well as that of its resident and nonresident clients. Foreign Exchange Dealers Association of India. FEDAl, on the other hand, is a non-profit making body, formed in 1958 with the approval of Reserve Bank of India, consisting of Authorised dealers as members. FEDAI prescribes guidelines and rules of the game for market operations, merchant rates, quotations, delivery dates, holidays, interest on defaults, etc. In terms of RBI directives, all authorized dealers are members of FEDAI and it is mandatory for them to follow the guidelines/directives issued by FEDAI. FEDAI guidelines also prescribe rules-related to handling of export-import bills, transit period, crystallisation of bills and other related issues. It also advises RBI on market-related issues and supplements the efforts of RBI to strengthen the foreign exchange market in the country. A few of the major FEDAI guidelines/rules can be summarized as under: 1. All export bills to be allowed standard transit period, as prescribed, for the purpose of allowing concessional interest rates and calculation of notional due dates.
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18 I BANK FINANCIAL MANAGEMENT 2. Export bills drawn in foreign currency, purchased/discounted/negotiated, must be crystallized into rupee liability, in case of delay in realization of export bills. The same would be done at TT selling rate. The prescription of crystallisation of export bills on the 30 th day from the due date /notional due date, has since been relaxed for bank's to decide on the days for crystallisation on their own , based on nature of commodity, country of export etc. The crystallisation period can vary from bank to bank, customers to customers, etc, but cannot exceed 60 days. 3. Sight Bills drawn under Import letters of credit would be crystallized on the tenth day after the date of receipt if not yet paid. 4. All forward contracts must be for a definite amount with specific delivery dates. 5. Option period can be specified by the customer, in case of option contracts, but in any case the delivery period under the option contract shall not exceed beyond one month. All such contracts must state the start and end dates. 6. Cancellation of forward contracts - All contracts, which have matured and have not been picked up, shall be automatically cancelled on the seventh working day, after the maturity date. 7. All cancellations shall be at bank's opposite TT rates, TT selling rate for purchase contracts and TT buying rate for sale contracts. 8. In the event of delay in payment of interbank foreign currency funds, interest at 2% above the prime rate of the currency of the specified banks shall be paid by the seller bank. 9. In the event of delay in payment of rupee settlement funds, interest for delayed period at 2% above the NSE MIBOR ruling on each day. 10. All currencies to be quoted as - per unit of foreign currency = INR, while JPY, Indonesian Rupaih & Kenyan Schilling are to be quoted as 100 unis of foreign currency = INR. 11. FEDAI also prescribes code of conduct for forex dealers, as also guidelines with regard to dealings with forex brokers. Let us also see some of the RBI guidelines, applicable to authorized persons, with regard to their operations and risk management of their own asset /liabilities and products that can be offered to clients: (a) AD Cat I - Banks are allowed to open/'close rupee accounts (non-interest bearing) in the names of their overseas branches or correspondents (except Pakistani banks operating outside Pakistan) without prior reference to RBI. (b) Opening of Rupee accounts in the name of Exchange Houses for facilitating private remittances through exchange houses requires prior approval of RBI. (c) AD Cat I - Banks are allowed to opea'close foreign currency accounts abroad to route foreign exchange transactions handled by then. Banks are also allowed to maintain balances in these accounts, as approved by their Board. (d) AD Cat-1 Banks are free to undertake investments in overseas markets in money market instruments and/or debt instruments, issued by foreign state with a residual maturity of less than one year and rated as per guidelines. (e) Surplus hands in Nostro accounts can be utilized for granting loans to resident constituents for meeting their foreign exchange or rupee working capital or capital expenditure needs, extending I
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r EXCHANGE RATES AND FOREX BUSINESS I 19 credit facilities to Wholly Owned Subsidiaries/Joint Ventures of Indian companies abroad, subject to conditions. (f) Loans/overdrafts: All borrowings of banks, including ECB, and temporary overdrafts in nostro accounts not adjusted within five days, shall not exceed 50% of their unimpaired Tier 1 capital or USD 10 million, which ever is higher. Overseas borrowings for the purpose of extending export credit in foreign currency. Tier II capital placed by foreign banks head offices with their Indian branches and Capital funds raised by issue if innovative perpetual instruments or debt capital instruments shall not be a part of the above ceiling for raising foreign currency funds. (g) Banks can allow residents to book forward exchange contracts to hedge their exchange risk exposure in respect of a transaction for which sale or purchase of foreign exchange is permissible under the FEMA 1999. (h) Banks should satisfy about the genuineness of the underlying documentary evidence and exposure, irrespective of the transaction being current or capital account in nature. The particulars of the forward contract booked should be marked on the documents, and copies retained thereof for verification. It must be ensured that the maturity of the contract must not exceed the tenor of the underlying. (i) Banks can allow their importer and exporter customers to book forward contact on the basis of a declaration of an exposure and based on past performance up to an average of the previous three financial years (April-March) actual import/export turnover or previous year's actual turnover, which ever is higher, subject ot certain conditions. (j) Similarly, Small and Medium Enterprises (SME) can book forward contracts to hedge their direct or indirect exposures, without production of the underlying, subject to the condition that the SME enjoys credit facilities with the bank with which it desires to book the forward contract, and the quanturn of forward contracts is in alignment with the credit facilities availed by it, and certain other conditions, as specified. (k) Banks can also allow resident individuals, who are banking with them, to book forward contracts up to a limit of USD 100,000.00, with the condition that contracts booked under this facility will normally be on deliverable basis, the notional value should not exceed USD 100,000.00, and the forward contract may be booked for tenors up to one year only. (1) Banks are also allowed to offer other derivative contracts, such as Interest Rate Swap or Coupon Swap or foreign currency Option or Interest Rate Cap or Collar or Forward Rate Agreement contract, to resident entities who have borrowed foreign exchange in accordance with the provisions of FEMA 1999. These offerings and cover there of, shall be subject to certain conditions as specified. (m) Bank can also offer Foreign Currency - Rupee Swap to resident persons that has a foreign exchange or a rupee liability to hedge long term exposure, with certain conditions. (n) Banks can enter into cross currency options with their customers on back-to-back basis, subject to certain conditions. (o) Banks can also enter into foreign currency - rupee options with their customers on back-toback basis. They can also run a book for this product, subject to RBI permission.
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20 I BANK FINANCIAL MANAGEMENT Check Your Progress (C) Fill in the blanks: 1. 2. 3. 4. 5. The dealers are officials, who are actually involved in the and The section which handles processing of deals, reconciliation, etc., is called Banks permitted to deal in foreign exchange are called ___________________ persons. of currencies, office. day Import bills drawn under Letters of Credit must be crystallized into Rupees on the from the date of receipt of documents, if not paid by that date. In terms of FEDAI rules, besides, Japanese Yen, ___ , is the other currency which is quoted as 100 units= so much Rupee.. Exchange Arithmetic - A Few Examples Example 1 Inflow of USD 100,000.00 by TT for credit to your exporter's account, being advance payment for exports (credit received in nostro statement received from New York correspondent). What rate you will take to quote to the customer, if the market is 48.09/11? Answer It will be purchase of USD from customer for which USD will have to be sold in the market. Say when USD/Rs is being quoted as 48.09/11, meaning that market buys USD at Rs 48.09 and sells at Rs 48.11. We shall have to quote rate to the customer on the basis of market buying rate, i.e. 48.09, less our margin, as applicable, to arrive at the TT Buying Rate applicable for the customer transaction. Example 2 On 3.10.09, your exporter customer tenders an export bill for USD 500,000.00, drawn 120 days from the date of shipment, (shipment date 3.10.2009) due date 1.2.2010. Compute applicable rate, presuming (a) exchange margin of 0.15%, (b) Spot Rupee 48.14/15 and premium Spot Jan.45/46 paise, (c) Rate to be quoted to nearest 0.25 paise, and rupee amount to be rounded off, and (d) Applicable interest at 8.50% for Post shipment export finance upto 180 days and Commission on bills purchased 0.0625 % to be charged upfront . Answer (i) Calculation of bill buying rate Spot rate Less: 0.15% margin Add: Premium Rate for the transaction
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(ii) Calculation of amount payable to the customer: USD 500,000.00 at 48.5175 = Rs 2,42,58,750.00 Interest 120 days @8.50 % = 677916.00 Commission @0.0625% = 15162.00 Amount payable to exporter customer: 2, 35,65,672.00 Example 3 Retirement of import bill for GBP 100,000.00 by TT Margin 0.20%, ignore cash discount/premium, GBP/USD 1.5975/85, USD/INR 48.14/15. Compute Rate for Customer Answer For retirement of import bill in GBP, we need to buy GBP, to buy GBP we need to give USD and to get USD, we need to buy USD against Rupee, i.e. sell Rupee. At the given rates, GBP can be bought at 1.5985 USD, while USD can be bought at 48.15. The GBP/INR rate would be 76.9678. (1.5985 x 48.15), at which we can get GBP t market rates. Thus the interbank rate for the transaction can be taken as 76.9675. Add Margin 0.20% 0.1539. Rate would be 76.9675+ 0.1539 = 77.1214 or say 77.1225 for effecting import payment. (Bill Selling Rate). Example 4 On 15 September, a customer requests for booking of a forward contract for export bill of USD 150,000.00, to be realised in the month of December. Given that USD/INR spot is 48.45/50 and forward premium is as under: October : 18/19 paise November: 30/32 paise December: 41/43 paise Margin to be charged 0.05 paise per USD. Answer For calculating rate for forward purchase contract, we need to take forward premium for November, the one that the market would pay, i.e. 30 paise. Spot rate as 48.45, getting forward interbank rate as 48.75 and deduct 0.05 paise as margin to arrive at 48.70, the customer forward rate for delivery of export proceeds during December, full month at the option of the customer (Forward TT Buying Rate). Forward margin for the period prior to the start of the delivery period would be passed on, as the customer has an option to deliver currency on he first day itself, i.e. ist December. Example 5 On 1 June 2009, a customer requests to book forward contract, for retirement of import bill for USD 100,000.00, due for payment on 15 September 2009. Given rates: Spot USD/INR 48.27/29, forward premium - Spot June: 10/12, Spot July 21/23, Spot August 32/34, Spot Sept. 43/45 and August to 15 Sept. 6/7 Charge Margin of 0.20%. Answer Being a merchant sale forward booking transaction, rate would be calculated as under: USD/INR spot to be taken as 48.29 Premium payable: Spot August 34 paise August -15th Sept. 1 paise Add: Total premium 41 paise 0.41 Thus IB forward rate would be: 48.70
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Add: Margin 0.20% 0.10 Rate for customer 48.80 Example 6 Your foreign correspondent maintaining a nostro Rupee account with your bank, wants to fund his accoimt by purchase of Rs 30.00 million, against US dollars. Assuming that the USD/INR interbank market is at 48.2550/2650, what rate would be quoted to the correspondent, ignoring exchange margin. Calculate amount of USD you would receive in your USD nostro account, if the deal is struck. Answer The transaction is to sell Rs 30.00 million, against US dollars, and hence we would quote the lower of the two rates, i.e. 48.2550 (Sell low maxim). If the deal is struck, the foreign bank would pay USD 621697.23 to our USD nostro account, Example 7 M/s BCD wants to remit JPY 100,00 million by TT value spot, as payment of an import invoice. Given that USD/INR is at 48,2500/48,2600 and USD/JPY is 90,50/60, and a margin of 0.15% is to be loaded to the exchange rate, calculate rate to be quoted and the Rupee amount to be debited to the account of M/s BCD. Answer Since JPY is to be sold against Rupee, and the rate is not directly given, we would use cross rate mechanism to calculate the same. We need to buy JPY against USD and USD against INR for the deal. Thus, USD/INR rate would be 48.2600 (market USD selling rate - high) and USD/JPY at 90.50 (market JPY selling rate - low). The JPY/INR rate would be 48.2600/90.50 = 0.533260 per JPY i.e. per 100 JPY Rs 53.3260 Margin of 0.15 0.0799 53.4059 Rounded off to 53.4050 Total Rupee amount to be debited to the account of M/s BCD would thus be Rs. 534,05,000.00 [Note: JPY is quoted as per 100 Yen, as per FEDAI guidelines] Example 8 You are required to book forward sale contract for USD 1.00 million delivery 3rd month and another forward purchase contract for USD 2.00 Million for delivery 2nd month. Given that USD/INR spot is 48.9100/9200, premium quoted as under, calculate rates for merchant transactions, if the exchange margin of 0.15% is to be loaded for the purchase transaction and 0.20% for the sale transaction. Premium (in paise): Answer 1 m 2 m 3 m (a) Calculation of rate for forward sale of USD 1.00 million: Spot rate to be taken (higher rate of the market) 3 m premium to be charged Add: Margin 0.20% (b) Calculation of rate for forward purchase of USD 2.00 million: Spot rate to be taken (lower rate of the market) 1 m premium to be paid/passed on
Less: Margin 0.15% Rounded off to 0750/0850 1800/1900 2750/28500 48.9200 0.2850 49.2050 0.0984 49.3034 or 49.3025 48.9100 0.0750 48.9850 0.0735 48.9115 or 48.9125
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Note: For a sale contract premium for the full period, up to end date of the contract shall be charged, i.e. full 3 months, whereas, for purchase contract, premium would be passed on only up to the beginning of the contract period, i.e. only up to the start date, or for 1 month only. Example 9 A forward purchase contract for USD 500,000.00 booked 2 months back at 49.2500 is due for delivery 2 days later (spot date). The customer is informed by the drawee of the bill that the payment will be delayed by one month. Given that the interbank spot is 47.5675/5775 and one month forward premium is 09/10 paise, and margin on TT buying and TT selling would be 0.15%, calculate rate for cancellation of the existing contract and also give indicative rate for re-booking of one month fixed date or option contract beginning one month from spot date. Also, calculate the amount to be debited/credited to the customer's account on spot date, upon cancellation of the contract. Answer (a) The existing forward contract would have been booked at TT buying rate, and hence it has to be cancelled at opposite TT selling rate, computed as under; Interbank USD/INR spot (higher of the two) 47.5775 zlc/c/.-Margin 0.15% 0.0714 49.2500 = Rs 2,46,25,000 47.6500 = Rs 2,38,25,000 The contract would be cancelled at Rupee amount at contracted rate USD 500,000 Less amount at cancellation rate USD 500,000 Amount due to the customer (to be paid to his account on spot date) (b) Indicative rate for contract proposed to be re-booked; If the contract is booked with option of one month beginning spot date; Interbank rate Less: Margin 0.15% 47.6489 47.6500 Rs 8,00,000 47.5675 0.0714 47.4961 or say 47.4950
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If the contract is booked for delivery fixed date one month forward, or the option is beginning after one month, premium for 1 month would be passed to the customer as under: Interbank rate 47.49 50 Add: Premium for one month Some statistics: 0.0900 47.5850 • Global forex turnover April-2007 USD 3.210 trillion per day as compared to USD 1.90 trillion per day n April 2004, and USD 1.20 trillion in April 2001. • Average daily forex turnover in April in India USD 3 billion, 7 billion and 34 billion in 2001,2004 and 2007 respectively. Let Us Sum Up Foreign exchange markets play an important role in the global economy. It is a 24-hour and over the counter market, with different type of players. The market operates on a professional basis and helps in developing not only the forex markets but also the world trade and flow of funds. Being part of the global market, the Indian foreign exchange market is no exception, and has developed fine market practices over the years, in line with the ongoing liberalization, privatization and globalization ('LPG' process) initiated in India. The working of forex markets across all time zones and its sheer size, lays emphasis on the importance of the dealing room operations, its organisation, management and control. Following of prescribed guidelines and parameters would help in development of an orderly market as also growth of the dealing functions for an institution. Keywords Foreign Exchange: Exchange of one currency into another or foreign currency. Rate of Exchange: The price of one currency in terms of another or a simple arithmetic expression of value of one currency in terms of another currency. Foreign Exchange Market: The market where foreign currencies are dealt with. OTC Market: Over the counter market. Authorised Persons: Banks/Institutions/money changers authorised to deal in foreign exchange. Value Date: The date of settlement of funds. Cross Rate: Price of a currency pair, not directly quoted, arrived from price of two other currency pairs. FEDAI: Foreign Exchange Dealers' Association of India. Forward Contract: It is a binding contract for purchase/sale at a future date. Premium/Discount: It represents interest rate differential in a forward contract. Premium: A currency is said to be at a premium if it commands more units of another currency at a future date. Discount: A currency is said to be at a discount if it commands less units of another currency at a future date. Swap: It is an exchange of specific strearns of payments over an agreed period of time. Fixed Exchange Rate: Official exchange rate fixed by the monetary authorities. Floating Exchange Rate: Market exchange rate decided by supply and demand factors. Direct Exchange Rate: Exchange rate expressed in terms of home currency quotations.
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Indirect Exchange Rate: Exchange rate expressed in terms of foreign currency quotations. Ready/Cash Rate: Value to be settled on the same day - value today. Tom Rate: Value to be settled tomorrow, next day. Spot Rate: Value to be settled on the second working day from the date of transaction. Forward Rate: Value to be settled beyond spot value. Foreign exchange risk: Risk that a bank may suffer losses as a result of adverse exchange rate movements during a period in which it has an open position, in an individual foreign currency. Transaction exposure: Transaction exposure measures the risk involved due to change in the foreign exchange rate between the time the transaction is executed and the time it is settled. Translation exposure: This exposure relates to valuation of foreign currency assets and liabilities at the end of accounting year at current realisable values. Operating exposure: Operating exposure is a measure of sensitivity of future cash flows and profits of a bank to unanticipated exchange rate changes. Open position: The extent to which assets and outstanding contracts to purchase a currency exceed liabilities plus outstanding contracts to sell that currency and vice versa. Overnight position: A limit on the maximum open position left overnight, in all major currencies Day-light position: A limit on the maximum open position in all major currencies at any point of time during the day. Such limits are generally larger than the over-night position. Options: A foreign exchange option is a contract for future delivery of a currency in exchange for another, where the holder of the option has the right, without an obligation, to buy (or sell) the currency at an agreed price, the strike or exercise price, on a specified future date. Call option: The right to buy under the option. Pm option: The right to sell under the option. Futures: Futures are forward contracts with a standard size, standard maturity date governed by a set of guidelines stipulated by the exchange concerned for settlement and payments. Currency swaps: When two counter parties agree to exchange specific amounts of two different currencies at the outset and repay these over time in instal-ments, reflecting interest and principal. Interest rate swaps: When interest payment strearns of different character are periodically exchanged between the contracting parties. Answers to Check Your Progress A. 1. (i) foreign currency; (ii) Exchange; 2. four seconds; 3. True; 4. False 5. False B. 1. Fundamental; 2. Second 3. Premium; 4. Discount, 5. Value. 6. Bid C. 1. Buying and selling; 2. Back Office; 3. Authorized 4. lO"^. (tenth) S.Indonesan Rupaih / Keniyan schilling. Terminal Questions 1. Foreign Exchange markets are (a) regional markets (b) domestic markets (c) global markets (d) localized exchange traded markets Ans: 2. Foreign exchange does not include: (a) Deposits payable in foreign currency (b) Instruments drawn in foreign currency and payable in a foreign currency (c) instruments drawn in Indian rupees on a checking account of the drawer and payable abroad
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(d) instruments drawn in Indian rupees on a current account of an Indian company and payable in India. Ans: 3. Out of the several factors, the following factor does not have an effect in the movement of exchange rates: (a) Political instability (b) Increase in domestic interest rates (c) Change in Taxation policy (d) Increase in domestic tourism Ans: 4. Spot dealing in FX market means: (a) Delivery of funds is on the 30th working day from the date of deal. (b) Delivery of funds is on the second working day from the date of deal. (c) Delivery of funds is next date from the date of deal (d) Delivery of funds is one week after the date of deal. Ans: 5. The rate at which the quoting bank is ready to sell the currency is called (a) Bid rate (b) Offer Rate (c) TT Buying Rate (d) Swap rate Ans: 6. Operational Risk does not include: (a) movement in exchange rates (b) Human errors (c) Technical Faults (d) Systemic failures. Ans: 7. Cancellation of forward contacts is to be done at: (a) Opposite Bill rate (b) Opposite Cash rate (c) Opposite TT rate (d) Opposite TC rate Ans: 8. Crystallisation of export bills is to be done: (a) On the 10th day from the due date of the bills. (b) Before the due date (c) On the 30th day from the notional due date / actual due date (d) On the due date itself Ans: 9. Fill in the blanks: (a) Exchange rate denotes a , at which one currency exchanged for another. Markets, with no barriers. (b) Foreign Exchange Markets are __ (c) The currency appreciates due to inflow of overseas capital, if local interest rates are (d) deals provide depth and liquidity to the market.
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(e) Direct quotes are also called _________ currency quotations. (f) The part of dealing room operations, which deals with risk management is called ____ office. (g) Risk of loss arising due to inability or unwillingness of the counter party to meet its obligations is called risk. (h) guidelines prescribe code of conduct for dealers brokers. 10. Quote rates: (a) TT Buying rate for inward payment of USD 250,000, if Interbank rate is 49.00/02, and margin to be charges is 0.08%. (b) Bill selling rate for import bill of USD 100,000, if Interbank market is 48.5600/5700, and margin to be charged at 0.20%.
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(c) TT buying rates for GBP 50,000/- inward payment, if USD/INR is 48.50/52 and GBP/USD is 1.6050/60. Ignore margins. (d) TT selling rate for issue of draft for JPY 100,000, if USD/INR is 47.9400/9450 and USD/JPY 99.50/55. No margins. Give rupee amount to be charged. (e) Rate for forward purchase booking of USD 100,000 delivery 3rd month (full month) if USD/ INR spot is 48.7850/7950 and premium is lM-0.0800/0.0900, 2M-0.1600/01700 and 3M2500/2550. Ignore Margins. (f) Forward sale contract USD 500,000 delivery 2nd month (full month). If spot and forward rates are same as given in (e) above margin 0.15% to be charged. (g) What rate would a forward purchase contract of USD 100,000 due on spot date be cancelled if interbank spot is 48.5125/5175 and exchange margin on TT purchase is 0.08% and TT selling is 0.15%. (h) Calculate difference to be charged/paid to the customer, in the above question, if the original contract was booked at Rs 49.7500 per USD. References for Further Reading 1. Reserve Bank of India Guidelines for Internal Control for Foreign Exchange Business, Master Circulars, Circulars, issued from time to time. 2. FEMA 1999. 3. FEDAI Rule Book and various circulars on the subject. 4. FEDAI Study booklets for Orientation workshops. 5. Gardner, D.C., Financial Distance Learning Workbooks. 6. Rajwade, A.V., Foreign Exchange Intl. Finance and Risk Management A.V. Rajwade. 7. Bhardwaj, H.P., Foreign Exchange Handbook. 8. All earlier publications of IIBF.
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UNIT 2 Basics of Forex Derivatives STRUCTURE 2.0 Objectives 2.1 Introduction 2.2 Definition of Risk and Risks in Foreign Exchange Operations Check Your Progress (A) 2.3 Management of Risk and Guidelines on Risk Management 2.4 What are Derivatives - History and Development Check Your Progress (B) Let Us Sum Up Keywords Answers to Check Your Progress Terminal Questions References and Books for Further Reading
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2.0 OBJECTIVES The objective of this unit is to understand: What is risk and the various risks in forex operations Guidelines related to risk management of forex risks Definitions and features of various derivative products Forex derivatives and their usage Appreciate whether derivatives are instruments to manage risk or is a risk in itself 2.1 INTRODUCTION Any activity you indulge in is associated with uncertainty which may result in some loss or some gain. In financial parlance, risk is associated with a loss that is expected to be incurred due to happening or non happening of certain events. It is an unplanned event with financial consequences resulting in loss or reduced earnings. The risk could be more or less depending upon the area of operation, volume, number of players, etc. The arena of international trade and foreign exchange operations is also prone to risks, mainly due to the complex nature of transactions, the individual characteristics of different currencies as also a vast area of operations. Like in any other human activity, risk cannot be avoided in international trade and foreign exchange operations. While in the international trade buyer risk, seller risk, shipping risk, etc., keep the parties on vigil, the foreign exchange operations are plagued with exchange risk, settlement risk, liquidity risk, country risk, sovereign risk, interest rate risk, and operational risk. Risk and return have a direct relationship between them in as much as higher risks means higher returns. In the process of earning higher returns, one can enhance the risks beyond manageable levels. Therefore, risks needs to be accepted and managed effectively and efficiently to minimize the adverse effect and maximize the profit/goals of the organization. The risks related to volatility in prices, exchange and interest rates of exposures such as commodities, currencies or shares and bonds, need innovative instruments that could hedge their value. Derivatives are such instruments, which when added to the exposure will neutralise or alter to acceptable levels, the uncertainty profile of the exposure. The values of these financial instruments are derived from the values of the underlying exposures. Some of the popular derivative instruments in foreign exchange market are forward contracts, options, swaps, forward rate agreements and futures. One of the avowed virtues of derivative instruments is that they enhance the system of information transmission by offering greater liquidity with lower transaction costs. They are also supposed to service a productive economic function by providing a mechanism by which risk transfers are facilitated between players who are less willing to bear risk to those who are more willing to do so. Very importantly, derivative instruments offer a vehicle to manage risk. Man has always struggled to manage risk. Risk arises because of uncertainty, as man is unable to visualize the potential state on some future date. He tries to manage risk by seeking to ensure the existence of suitable state of affairs on the future date and to that extent, minimize the possible detrimental effects of an adverse situation at that point of time.
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Now, let us go in detail and study the risks in the international trade and then the hedging tools, viz., derivative instruments. 2.2 DEFINITION OF RISK AND RISKS IN FOREX OPERATIONS A risk can be defined as an unplanned event with financial consequences resulting in loss or reduced earnings. An activity where the result is uncertain and there is a chance of loss, may be called a risky proposition, due to the uncertainty or unpredictability of the activity or trade in future, even though this activity may ultimately result in profit or gain. While, in human life, the risk is related to illness, impairedness or loss of life, in commercial and business activities, the business profit or loss would depend upon how the business is run or its affairs managed. In other words it can be defined as the uncertainty of the outcome. A risk in any currency, commodity or an object is due to any exposure in that particular currency, commodity or the object. As explained in Unit 1, forex operations and markets are somewhat different from other commodity markets and peculiar in nature, due to the reasons that they are largely over the counter market, open 24 hour-a-day, without any single location and barriers, fluctuations registered almost every four seconds, movements in other markets, effects of controls/policies of respective governments, delayed settlements due to time differences, etc. These peculiarities expose the participants to various risks. The participants, as such, have to exercise extreme caution in managing forex operations. Any laxity on their part may result in losses and exposures, ruining the whole business. Some of the very common risks faced in foreign exchange operations are: exchange risk, settlement risk, liquidity risk, country risk, sovereign risk, interest rate risk, operational risk, etc. Let us check on these risks individually which have been discussed below: A. Exchange Risk Movements in exchange rates can adversely affect the value of our foreign exchange holdings, i.e. receivables and payables (purchases and sales), if not covered at the appropriate time, with due watch on the market moves. Normally, the dealer is expected to cover the transactions immediately (by entering into matching and opposite transactions), without loss of time. In case this is not done, then he is exposed to exchange risk. This is the most common and obvious risk in foreign exchange dealing operations. The markets may move against him, resulting in loss. Thus, the dealer has to immediately cover his positions and keep constant watch on his positions and the market moves, so as to not to get affected by adverse movements. A position in a given currency arises when assets and outstanding contracts to purchase that currency exceed the liabilities plus the outstanding contracts to sell that currency. In the former case, the bank will have a long (overbought) position and would be exposed to a risk if the currency depreciates in value. In the latter case, the bank will have a short (oversold) position and would stand to lose if the currency appreciates in value. This overbought or oversold position is the open position for the dealer. In the present world, when globe is literally wired, major currencies of the world viciously floating against each other, the risk of open position assumes considerable significance. As due to market lot requirements, thin trading on select days, or other events, it may not be possible to cover each and every transaction individually, this risk has to be controlled and managed by prescribing suitable limits (daylight and overnight limit, single deal limit - trading position limit, volume limit, overall overnight open position limit, stop loss limit, gap - forward mismatch limit, etc.). In fact, it is a practice to accumulate and keep positions open, taking a
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view on the movement of exchange rates, like possible depreciation/appreciation of currencies, etc., but all within the prescribed limits. Reserve Bank of India has authorized the boards of respective banks to specify and approve limits relating to forex operations. Banks, according to their merchant turnover requirements, trading skills and volumes, as also considering the capital base, fix various limits for their forex dealing operations. Basically, foreign exchange exposures can be classified into three types: (i) Transaction Exposure: Arising due to normal business operations consequent to which the value of transactions will be affected. This is affected by the transactions undertaken which may expose the company/firm to currency risk, when compared to the value in home currency. (ii) Translation Exposure: This arises when firms have to revalue their assets and liabilities or receivables and payables in home currency, at the end of each accounting period. This also is affected due to consolidating the accounts of all foreign operations. These are not actual costs or gains, but notional, as the actual loss or gain is booked at the time of actual translation of the exposure. (iii) Operating Exposure: This affects the bottom-line of the firm /company, not directly due to any foreign exchange exposure of the firm /company, but due to other external factors in the market/ economy, like changes in competition, reduction in import duty increasing competition from imported goods, reduction in prices by other country exporters- effecting exports, increase in import duty by other country -trade tariff, etc- causing reduction in exports, etc. B. Settlement Risk (Pre-settlement and Settlement Risks) The international financial system evolves around foreign exchange markets. Forex markets facilitate conversion of currencies, movement of funds, global investments, travel and tourism, all culminating into a huge daily turnover, of over US$ 1.5 trillion. This volume is transacted between the market participants worldwide without the use of one single central clearing house it is truly over the counter market. In the absence of such a single, global, centralized clearing house, each foreign exchange market participant has to make and receive payments on an individual basis. This entails counter-party credit risk for each transaction. Any disruption in the market due to sudden doubts about the solvency of one of the market participants could have serious repercussions for the global trade and finance and for the international banking system as a whole. Thus credit risk in foreign exchange operations, is the risk of failure of a counter party, whether a bank or a customer, to meet obligation at maturity of the contract, which could result in the need for resultant open position to be covered at an ongoing rate. This could happen prior to settlement by one of the parties or subsequent to execution by one party but before execution by the other one. The risk is, thus, classified into pre-settlement risk and settlement risk. Pre-settlement risk is the risk of failure of the counter party, due to bankruptcy, closure or any other reason, before maturity of the contract thereby compelling the bank to cover the contract at the ongoing market rates. This entails the risk of only market differences and is not an absolute loss for the bank. Settlement risk is the risk of failure of the counter party during the course of settlement due to the time zone differences between the two currencies to be exchanged. That is, where the bank, in earlier time zone, say Japan, or Australia, performs its part of the contract by delivering the
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currency to be delivered by it but the counter party, in another time zone, say Germany, fails before delivering the currency to be delivered by them. Such an event means complete risk and loss for the bank, which is in the earlier time zone. In other words, at its core, settlement of a foreign exchange trade requires the payment of one currency and the receipt of another. In the absence of a settlement arrangement that ensures that the final transfer of one currency will occur if and only if the final transfer of the other currency also occurs, one party to a foreign exchange transaction could pay out the currency it sold but not received the currency it bought. This principal risk in the settlement of foreign exchange transaction is variously called foreign exchange settlement risk or temporal risk or Herstatt risk (named after the 1974 failure of the Bankhaus Herstatt in Germany). This can happen because banks operate in different time zones. As the nature of trade and forex business does not make it possible to totally eliminate the settlement risk, more particularly due to countries situated and operating in different time zones, the risk is recognized by the market participants by applying credit lines (limits) to each counter party to reduce the risk. The credit limits take the form of maximum outstanding limit as well as daily delivery limits for each bank. The settlement risk could be avoided, if only settlement systems, operating on a single time basis, as also on real-time gross settlement basis, are put in place. This would eliminate the time zone problems and also would pay only on 'if received' basis. The time zone differences could be eliminated, if the global books are linked to a single time zone, say GMT closing. C. Liquidity Risk When a party to a foreign exchange transaction is unable to meet its funding requirement or execute a transaction at a reasonable price, it creates Liquidity Risk. It is also the risk of the party not being able to exit or offset positions quickly at a reasonable price. Here, for whatever reason, the market turns illiquid and positions cannot be covered or liquidated, except for high price. For example, in a deal of US dollar purchase against rupee, if the party selling US Dollar is short of funds in the nostro account, then it may not be possible for him to generate/borrow or buy USD to fund the USD account. Liquidity risk is said to have arisen, in such an occasion. For this, proper funds and cash management practices have to be followed by the dealers. Therefore, liquidity risk is the potential for liabilities to drain from the bank at a faster rate than assets. The mismatches in the maturity patterns of assets and liabilities give rise to the liquidity risk. Liquidity risk could also arise, in case the markets turn illiquid, leading to higher bid-offer spreads or even market makers getting out of the market. For protecting against the liquidity risk, the bank has to resort to control the mismatches between maturities of assets and liabilities. This is done by fixing limits for maturity mismatches and reduce open positions. D. Country Risk /Soverign Risk Country risk arises when a foreign entity or a counter party, private or sovereign, may be unwilling or unable to fulfil its obligations for reasons, other than the usual reasons or risks which arise in relation to all lending and investment. Dealing in foreign currencies and with counter parties in another country, will sometimes result in country risk. Movement of funds across international borders creates uncertainty with regard to their receipts and payments and this uncertainty is defined as country risk. The foreign parties may be unwilling or unable to fulfil their obligations for reasons, such as imposition of exchange and other controls by the central bank or the government regulation, on which the parties do not
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have any control (externalization). Country risk is considered very high in the case of countries which are facing problems related to foreign exchange reserves, balance of payments, management of resources, liquidity, etc. Country risk is usually controlled by fixing countrywise exposure limits and being dynamic, has to be constantly monitored, more particularly in case of difficult countries. The difficult countries, may give high returns, as not too many countries, banks or parties wish to take exposure in such countries. It would be worthwhile to mention that country risk is different from the usual credit and other risks associated with lending decisions, like credit risk, settlement risks, liquidity risk, etc. A country risk arises, when the counter party or the borrower or the buyer is a good credit risk and does not have any desire to default, but by local laws or directives, is forbidden by the government or the central bank to honour the commitment. A sovereign risk is larger, when the counter party is the foreign government itself or any of its agencies, and enjoys sovereign immunity under the laws, with no legal recourse to other party. Another dimension of sovereign risk could be a change in the government policies, or the change in the government itself, which could invalidate the previous contracts and thus forbid the parties concerned to complete or take recourse for the same. While sovereign risk cannot be completely avoided, when dealing with another country, it can be suitably reduced by inserting disclaimer clauses in the documentation and also making the contracts and the sovereign counter parties subject to a third country jurisdiction. E. Interest Rate Risk Interest rate risk or GAP risk, as it is otherwise known, arises due to adverse movement of interest rates or interest rate differentials. It also refers to the potential cost of adverse movement of interest rates that
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the bank faces on its deposits/borrowings/lending, or the currency swaps, forward contracts, forward rate agreements, or other interest rate derivatives. The increasing capital flows in the global financial markets by the day, the economic disparities between nations and the increased use of interest rates as a regulatory tool for macro- economic controls, to regulate global economies, have resulted in significant volatility in interest rates. While, in the course of its business, the bank buys and sells currencies for spot and forward value, borrows and lends foreign currencies, enters into swaps, futures or options relating to interest rates, it is not practical and also always possible to match its forward purchase and sales, borrowing and lending, creating a mismatch between its assets and liabilities. This mismatch is referred to as GAP. These gaps are to be filled by the bank by paying/receiving appropriate forward differentials or resorting to other interest rate derivatives. The forward differentials are, thus a function of interest rates. Any adverse movement in interest rates would result in adverse movement of forward differentials thus effecting the cash flows on the underlying open gaps or mismatches. Besides, deployment of foreign currency resources is not exactly for matching maturities, exposing the bank to an interest rate risk due to uneven cash inflows and outflows. Interest rate risk also occurs when different bases of interest rates are applied to assets and corresponding liabilities. If the degree of fluctuations in the two different interest rates is different, affecting the spread originally envisaged, then interest rate risk is said to have occurred. With the integration of foreign exchange and money markets, the dealers manage interest rate risks frequently by undertaking appropriate swaps, or matching funding actions or through appropriate risk mitigating interest rate derivatives. To reduce interest rate risks. Individual and aggregate gap limits are fixed for the international banking operations. Some banks adopt strategy to determine the interest rate scenario, undertake appropriate sensitivity exercises, for estimating the potential profit or losses based on interest rate projections and devise suitable hedging strategy and adopt various risk-assessing models, like value at risk, interest rate sensitivity test, etc., and use derivative products like interest rate swaps, currency swaps and forward rate agreements for managing the interest rate risk. F. Operational Risk Being a critical area of operations, operational risk is another important risk that should be managed by a dealing room. It may occur due to deficiencies in information systems or internal control or human errors or other infrastructure problems that could lead to unexpected losses. If the infrastructure provided to the dealing room, such as computer systems, communication systems, including telephone lines, etc. fail to function due to some error or fault, the operations in the dealing room would come to a grinding halt and exposed to various risks. Operational risk can be controlled by providing state of art systems, specified contingency plans, disaster control procedures, and sufficient back-up arrangements for man and machine, and a duplication process at a different site (mirroring).
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G. Legal Risk Legal risk arises when it transpires that the counter party with whom the transaction has been undertaken, does not have the legal or regulatory authority to enter into such transaction. In other words, the counter party is incapacitated for engaging in such a deal, resulting in nonenforceability of contract. Legal risk also includes compliance and regulations related risks, arising out of non-compliance of prescribed guidelines or breach of governmental rules, leading to wrong understanding of rules and penalties by the enforcing agencies. Check Your Progress (A) 1. Risk is an _______ event. 2. The values of Derivatives are derived from its ___ . 3. State whether the given statements are True or False: (a) Movements in exchange rates may result in loss for the dealer's open position. (b) Reserve Bank of India has not authorized banks to approve limits relating to foreign exchange operations. (c) Settlement risk can be avoided only if settlements are made on real- time basis. (d) Herstat Risk, (failure of the bank of the same name) was not in any way related to settlement defaults. (e) Any adverse movement in interest rates could affect the bank's profitability. (f) Non-compliance of regulations is a legal risk. (g) Derivative instruments are a vehicle to manage risks. (h) International trade is risk free. 4. Fill in the blanks (a) (b) (c) (d) (e) (f) In case of excess of assets over the liabilities, the dealer will have Settlement risk arises due to the absence of a single global _______________________ position. Liquidity risk can be managed by practicing proper control of Country risk is a ______ risk and can be controlled by fixing Sovereign risk can be managed by suitable by subjecting such sovereign entities to _ limit. clauses in the documentation and also jurisdiction. Operational risk can be controlled by putting in place state of art plans. _, specified 2.3 MANAGEMENT OF RISK AND GUIDELINES ON RISK MANAGEMENT To manage risk, it is important to identify and appreciate the process of measurement of risks as a prerequisite. Some risks, like exchange risk, interest rate risk, etc., are easy to be quantified, while some other risks like country risk, operational risk, legal risk, etc., cannot be
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mathematically quantified and can only be qualitatively compared and measured. Some risks like gap risks in foreign exchange operations
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can be measured using modem mathematical and statistical tools like 'value at risk', etc. Thus only after the risk is identified and assessed, question of management of risk arises. We have seen that risk is an unforeseen event, and to avoid risk proactive measures could be taken so as to either eliminate the same or reduce the same. Thus risk management is a process focusing upon steps to contain or avoid risks and losses there from. Since certain risks may not be avoided totally, its management would depend upon the expected rewards, risk appetite as also profile of the risk portfolio held. A sound risk management process would start with a detailed policy, a specific limit structure for various risks and operations, a sound management information system, and specified control, monitoring and reporting process. Putting in place sound risk management policies, understood and laid down by the top management/board, would be a prerequisite for determining the risk exposures being faced by the bank. Measures to determine the market risks, credit or liquidity risks can be put in place in accordance with the laid down policies. Thus the risk management process starts from the top, i.e. the Board of Directors, which should prescribe and approve a detailed policy for management of various risks being faced or expected to be faced by the bank. This policy would also specify limits for various types of trades, functions as also upper limits for exposures. All these limits would be based on the risk appetite of the bank vis-a-vis the expected rewards in taking the risks. (Risk-reward equilibrium) After the benchmarks are set out by the board, the top management has to involve in implementation of the plans, by putting in place required manpower, various infrastructure, tools, etc., to help the dealing staff in better functioning so as to avoid risks as also to measure and contain risks. The top management has not only to implement the policies approved by the board, but also ensure compliance to regulatory requirements. The risk policy framework should cover the goals and objectives, delegation of responsibilities, specify activities to be undertaken and level of acceptable risks, besides the authority to undertake such functions and a system of review. While implementing the risk policies, the top management has also to take appropriate measures to ensure proper and regular measuring and monitoring of the risks. Risk management Policies require constant focus and attention and need to be reviewed on a regular basis. The nature of risks, the market scenario and the tools, MIS, and risk containment measures keep on changing with the business profile. Risk management is dynamic and needs to remain in constant focus of the users as well as the top management. The Guidelines The broad policy approved by the Board of Directors and the steps for implementation taken by the top management would all be within the overall guidelines laid by the central bank of the country and/or other regulatory authorities. Reserve Bank of India and FEDAI have issued guidelines for management of risk in international trade and foreign exchange, which itself limit the risk in the forex operations. RBI has issued Internal Control Guidelines (ICG) for foreign exchange business, which covers various aspects of dealing room operations, code of conduct for dealers and brokers and other aspects of risk
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control guidelines, including set up of the dealing room, back office, and risk management structure. Under ICG, banks are required to put in place various dealing limits for their forex operations, which can be briefly summarized as under: (i) Overnight limit: Maximum amount of open position or exposure, a bank can keep overnight, when markets in its time zone are closed. (ii) Daylight limit: Maximum amount of open position or exposure, the bank can expose itself at any time during the day, to meet customers' needs or for its trading operations. (iii)Gap limits: Maximum inteiperiod/month exposures which a bank can keep, are called gap limits. (iv) Counter party limit: Maximum amount that a bank can expose itself to a particular counter party. (v) Country risk: Maximum exposure on a single country. (vi) Dealer limits: Maximum amount a dealer can keep exposure during the operating hours. (vii) Stop loss limit: Maximum movement of rates against the position held, so as to trigger the limit - or say maximum loss limit for adverse movement of rates. (viii) Settlement risk: Maximum amount of exposure to any entity, maturing on a single day. (ix) Deal size limit: Highest amount for which a deal can be entered. The limits is fixed to restrict the operational risk on large deals. Besides above limits, banks approve panel of brokers through whom deals could be undertaken, the currencies in which the bank/dealers would deal in, Value of Risk limit, Nostro Balances limit. Overdraft limits, etc. Further, the master circular on Risk Management and Interbank Dealings, issued by Reserve Bank of India, specifies risk management facilities that are available to residents and nonresidents, to hedge their forex exposures, as also facilities for authorized dealers, for managing exposures on their foreign currency assets and liabilities. The guidelines permit booking of forward contracts by customers on the strength of underlying exposure/transaction or merely on the basis of past turnover. There are guidelines on undertaking interest rate swaps. Foreign currency and rupee options, etc.. Interbank dealings, procedures, norms for position and gap limits, authority to undertake FX derivatives, foreign currency accounts, borrowing/lending in foreign currency and various reports to be submitted to the Reserve Bank of India are also prescribed in the Master Circular. Thus, while the RBI has prescribed the broad guidelines on operations and risk management aspects of FX dealing room, detailed guidelines have been issued by FEDAI on certain aspects. Most of the guidelines and risk management framework is to be finalized and approved by the board of the bank, to be implemented by the top management, treasury head and the MID office functionaries. Mitigation of Settlement Risk- Indian scenario: In India, CCIL conducts netted settlements for various segments of money and Forex markets. CCIL takes over the settlement risk, for which it creates a large pool of resources, called Settlement Guarantee Fund (SGF), which is used to cover outstanding of any participant, in case of defaults. In case of settlement of Forex deals, the participant bank send a file with details of deals to be settled, giving amounts in foreign currency, deals rates, amount in Rupee, and value dates along with counter party banks, which CCIL settles on netted basis, leading to only one inflow or
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outflow of foreign currency and INR for one bank. The only condition is that both the counter parties should be members of CCIL in the related segments. CCIL handles a large volume of settlements daily. CCIL: Clearing Corporation of India is an institution created for the purpose of clearing and settlement in Repos, CBLOs, gilts and inter bank Forex deals. It is a clearing corporation, which takes over the settlement risks of the banks, and undertakes settlement in various instruments on net settled basis. For inter bank Forex settlement, it handles USD /fNR deal settlement with netted amounts being paid / received to /from the participant banks. 2.4 WHAT ARE DERIVATIVES - HISTORY AND DEVELOPMENT Derivatives, are often viewed with a certain degree of awe. It is often felt that derivatives are shrouded deep in mystery. As explained in the beginning of this unit, derivatives refer to a variable, which has been derived from another variable. Interest in derivative products may mostly arise out of interest in the underlying product, but it can also be without any interest in the underlying. Even if so, the values of derivatives and the underlying are interrelated and irrespective of the fact that one has interest in both or only the later, the two will affect each other's prices. The underlying can be any product, literally anything ranging from agricultural products, foreign exchange, interest rates, oil, gas, gold or silver, stocks and stock indices, financial instruments (Treasury Bills, Bonds, etc.) or anything in the world, which itself is traded. Thus derivatives are derived from markets, products, risks or any underlying on which they are based. Derivatives have been in use for hundreds of years, in the form of futures or options, when high seas cargoes were bought and sold in future prices (or priced for future delivery) or rice produce sold for future delivery by Japanese farmers. The future transactions were then done in various pockets, in anticipation of future deliveries. The explosion of the market could be linked to or coincided with the collapse of Bretton Woods fixed exchange rate regime (35 USD = 1 Ounce of Gold) and suspension of US Dollars' direct links to gold in the 1970s. The de-linking of US dollars to a fixed parity of gold, effected volatility in exchange rates as also the interest rates. The increased volatility thus lead to the creation and explosion of a financial derivatives market which has since then grown manifolds. In early 1970s, the Chicago Mercantile Exchange introduced the world's first exchange traded currency future contract. Later in 1975, the first interest rate futures were introduced. Several exchanges then introduced exchange rate and interest rate futures contracts. By 1983, the derivative markets saw further growth with currency options trading in Philadelphia Stock Exchange. Trading in Currency Futures and options gave the world a whole new range of risk management techniques for managing exchange risk, which helped in growth of global trade, investments and cross- border remittances. This was the time (early 1980s) when interest rate swaps were also introduced. Interest rate swaps helped borrowers and lenders to switch their borrowings/lendings from fixed to floating rate structures or vice a versa, as per their views on the interest rate movements.
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Mid-1980s saw a boost in the derivatives market, with a host of exchange rate, interest rate as also commodity price risk derivative tools/products being traded in various exchanges, which was evident from the fact that Chicago exchange handled millions of derivatives contracts annually. Initially, the derivative products were used mainly by the hedgers as actual users of the underlying contracts, who used these products for managing their risks. The importers, exporters, financiers, borrowers, buyers, etc., were the major users of these products. Gradually, individuals and institutions tracked the prices of derivative products, much similar to speculation in commodity prices or cross currency prices. They started speculation in futures, options and swap prices. This gave depth and volumes to the derivative markets. Further, there were people who would be always on a look out for opportunities of mispricing and uneven pricing on the markets, and arbitraged between market differences, until the differences disappeared. Thus, hedgers, speculators and arbitrageurs provided depth, volumes and initiative for newer derivative products, so that a large number of exchanges offered these products with spurt in volumes by the day. The derivative products in a short lifespan of 25 years, have seen tremendous growth, which can be observed from the fact that in April 1988, the average daily turnover in derivatives was to the order of USD 1.3 trillion while, the notional amounts outstanding for OTC contracts and exchange traded contracts stood at USD 72 trillion and USD 14 trillion respectively in June 1998. (BIS Data). The main reasons for this growth in derivatives market were increased volatility in the financial and commodity assets during 1970 and 1980s, the oil shocks in 1971 and thereafter, the need to insulate exchange risk for incomes in different currencies, arising out of increased global investments, technological advancements providing real-time information systems and 24-hour financial trading platforms, also development of pricing models and instruments based on computer-generated work sheets, the political developments and the increasing professionalism amongst all market participants, be it banks, traders, actual users, companies, investors, etc. Check Your Progress (B) Fill in the blanks: 1. Some risks, like ______ 2. 3. risk and risk are easy to be quantified. A sound risk management would start with a sound risk management _ . Risk management is _____ and needs to remain in constant focus of the users as well as the 4. 5. 6. 7. management. is the maximum exposure on a single country. Highest amount of deal, a deal is allowed to be made is called limit. A risk limit, which triggers, on adverse movement of exchange rates is called In India, settlement risk is largely mitigated by settlements through _________________ limit. Details of forex derivatives are given in Module C (Treasury Management).
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Let Us Sum Up Risk management nevertheless is an interesting game, more so in the international trade and finance, where the boundaries are global. Proper perception of risks undertaken and then the measures to contain the risks is a must for any trader, bank or institution. Use of variety of derivative products with a proper understanding as also constant watch over the positions and the hedge could lead to ample profits on one hand, but could lead to a doom, if not handled with care. The growth of the global markets, and also the Indian markets, where several products are now permitted and being offered, has given ample opportunity to the student of this area of financial world to explore, understand and use the financial products for maximization of profits. Keywords Risk: Uncertainty Exchange Risk: Risk arising out of fluctuations in exchange rates. Settlement Risk: A kind of credit risk. Liquidity Risk: It is funding risk. County Risk: It is associated with problem countries. Sovereign Risk: It is a subcategory of country risk and arises on account of sovereign entities. Interest Rate Risk: It arises due to changes in interest rates. Derivatives: They are hedging instruments. Forward Contract: It is a binding contract for purchase/sale at a future date. Premium/Discount: It represents interest rate differential in a forward contract. Option: Contracts confer upon the holder the right without the obligation to take up the contract. Premium: In an option contract represents the fee charged by the option writer. Swap: It is an exchange of specific strearns of payments over an agreed period of time. Futures: It is a contract traded on an exchange to make or take delivery of a commodity. Answer to Check Your Progress A. I. Unforeseen; 2, underlying; 3. (a) True, (b) False; (c ) True (d) False, (e) True (f) true (g) true (h) false. 4. (a) long (b) clearing house, (c ) mismatches, (d) dynamic, country (e) disclaimer, third country, (f) systems, contingency . B. 1. foreign exchange, interest rate; 2 policy; 3. dynamic, top; 4. country limit. 5. Dealsize 6. Stoploss 7. CCIL. Terminal Questions Fill in the blanks: 1. A risk can be defined as an reduced earnings. event with financial consequences resulting in loss or 2. Movements in exchange rates can adversely affect the of our foreign exchange holdings, 3. The exposure arising due to normal business operations consequent to which the value of transactions will be affected is called exposure. 4. risk is the risk of failure of the counter party, due to bankruptcy, closure or any other reason, before maturity of the contract. 5. For protecting against the risk, the bank has to resort to control the mismatches between maturities of assets and liabilities. 6. Interest rate risk arises due to adverse movement of
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rates. 7. Overnight limit is the waximum amount a bank can keep ovemight, when markets in its time zone are ___ . 8. The maximum movement of rates against the position held, so as to trigger the limit - or say maximum loss limit for adverse movement of rates, is called __ . 9. Banks are allowed to use derivatives to manage risks of their assets and liabilities, and also for ____ purposes. 10. Thus forward contracts are a firm and ____ contracts entered into by two parties. 11. The currency with lower interest rate would be at a ____ premium in future, 12. A _______ contract conveys an agreement to buy a specific amount of a commodity or financial instruments at a particular price on a stipulated future date. 13. The options convey the right to buy or sell an agreed quantity of currency, commodity on index value, at an agreed price, without any to do so. 14 . ______ option can be exercised only at maturity date (fixed date) 15. In 2008, Currency futures have also been started in the ___ markets. References for Further Reading 1. Reserve Bank of India Guidelines for Internal Control for Foreign Exchange Business, Master Circulars, Circulars, issued from time to time. 2. FEMA 1999. 3. FEDAI Rule hook and various circulars on the subject. 4. FEDAI Study Booklets for Orientation workshops. 5. Books by D.C. Gardner. 6. Rajwade, A.V., Foreign Exchange International. Finance and Risk Management. 7. All earlier publications of IIBF.
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UNIT 3 Correspondent Banking and NRI Accounts STRUCTURE 3.0 Objectives 3.1 Introduction 3.2 Correspondent Banking - Bank accounts 3.3 Electronic modes of transmission/Payment gateways - SWIFT, CHIPS, CHAPPS, etc. Check Your Progress (A) 3.4 NRI Banking 3.5 NRE Accounts - Rupee and Foreign Currency Accounts Check Your Progress (B) 3.6 Facilities to NRIs 3.7 Advances to Non-residents and Third Party Advances Against NRI deposits/Guarantees Check Your Progress (C) Let Us Sum Up Key words Answers to Check Your Progress Terminal Questions References for Further Reading 3.0 OBJECTIVES The objective of this unit is to understand the concept of correspondent banking, their need and services rendered by them, the electronic modes of transmission, which facilitate fast and reliable communication, and transmission of secured financial messages throughout the globe. The unit also takes us through the concept of NRI banking and accounts as also various facilities available to NRIs for investment in India. 3.1 INTRODUCTION The international trade and finance is based on the network of international banks as well as the support and services provided by other banks in foreign countries. The relationship between foreign banks to facilitate cross border handling of trade documents, receipts and payments, etc. have come a long way, that international trade and finance, without correspondent banks cannot be thought of in this era of globalisation. The large number of Indians living abroad, send remittances to their country, for sustenance of their near and dear ones, as also for savings purposes. NRI funds constitute a large corpus, for the country's forex resources, and have a place of importance of its own. The segment has been offered facilities of opening different types of accounts, as also various investment facilities, both on repatriable and non- repatriable basis. Let us see, the bouquet of services being offered to the NRI customers by the banks, and related RBI guidelines. 3.2 CORRESPONDENT BANKING -ACCOUNTS AND OTHER SERVICES Correspondent banking in its true sense, is the relationship between two banks which have mutual accounts with each other, or one of them having account with the other. However, in a larger sense, this means a relationship and servicing of banking needs, as agents, without having account relationship also. This was due to a large number of banks offering correspondent banking services and it was not possible to have and maintain accounts with a large number of them, but the growing needs of the international business, required help and services from a large number of banks, across the globe. Thus, correspondent banking is a practice, where a bank is able to handle business in another city or country, through local banks there at, the local bank acting as an agent of the former, and charging fees for the services rendered. This system eliminated the need to have a global network of branches, which involved high costs and volumes to service the branches. Further, it was not possible for all international banks to obtain permission for opening of branches in several
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countries, due to restricted foreign bank/ branch licensing policies adopted by some countries. Thus the correspondent banking system allows the bank to take advantage of the business opportunities in other countries, without a branch network of its own and with minimum operational costs. 1. Functions Handled by Correspondent Banks As correspondent banking is based on the services that are provided by one bank to the other bank, it is largely used in international business operations. The functions covered by such arrangements can be largely summarised as under: A. Account Services These services require having account relationship with the foreign bank. (i) Clearing House functions: The correspondent bank offers services related to handling of outward payments, receipts of inward payments and collections, through the account maintained with it. The account is also used for reimbursement of LC claims, check collections draft/ cheques issue on the account. The services include providing of statement of account at predefined intervals, as also advices and details of transactions, which went through the account. The services would include providing an intra-day line of credit for passing of payment instructions, in anticipation of covers to be received later in the day. (ii) Collections: Correspondent banks provide services as agents for collection of export/import bills as well as checks, in their country. They also credit the proceeds of such collections after realization to the account maintained with them. Besides, this service may include, follow up for payments, reminders, noting and protesting of bills of exchange, as also taking steps to safe-guard the interest of the client bank. The foreign bank also collects clean instrument for credit to the account of the bank. (iii)Payments: The correspondent bank handles and executes all payment instructions of the client bank, by debiting to the account maintained with it. The payments could be inter-bank payments, for settlement of FX deals or customer payments for imports of goods and services. The payments can be for beneficiaries in the same city, country or other countries, depending upon the location of beneficiaries' correspondent bank accounts. (iv) Overdrafts and loan facility: The correspondent bank, by virtue of having an account of the client bank, also grants overdrafts for temporary needs, say, overnight, to fill up short-term funding gaps. It can also consider granting of loans on short-term basis, based on credit assessment of the foreign bank. (v) Investment Services: The correspondent bank offers services related to investment of overnight surplus balances in the account, beyond a minimum peg balance, at the domestic call rates minus a small margin. It also offers investment of funds in short-term deposits, cash management services as also in specific securities for the client bank. B. Other Services These services would not normally require account relationship, and can be offered on standalone basis, depending upon the relationship and credit assessment by the correspondent bank. (i) Letter of Credit advising (ii) LC confirmations (iii)Bankers Acceptances (iv) Issuances of Guarantees — bid-bond, performance, etc. (v) Foreign Exchange services, including derivative products (vi) Custodial services
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(vii) Trade referrals and credit reports on foreign parties (viii) Services related to investment of overnight surplus funds, short-term deposits, as also securities, etc. (ix) Other fund raising services, like placement of shares, bonds, ADR/GDR etc. (x) Training and seminars on various topics/on latest developments. 2. Bank Accounts We have seen in the earlier part that correspondent banking include one of the major functions of account relationship, even though it may not be a prerequisite. The account facilitates, handling of receipts and payments, collections and reimbursements, in the country and in the currency of the correspondent bank. The foreign currency accounts maintained by a bank, with another bank are classified as Nostro, Vostro and Loro accounts. NOSTRO account: It means "Our account with You". For example, SBI, Mumbai maintaining an USD account with ClTl Bank New York is Nostro account in the books of SBI, Mumbai. VOSTRO account: It means " Your account with Us". Say American Express Bank, New York, maintaining A Rupee Account with SBI, Mumbai, is Vostro account in the books of SBI, Mumbai. LORO account: It refers to accounts of other banks, i.e. "his account with them". For example, Citi Bank referring to Rupee account of American Express Bank, with SBI Mumbai, or some other bank referring to the USD account of SBI, Mumbai with Citi Bank, New York. Mirror account: While a bank maintains Nostro account with a foreign bank, (mostly in foreign currency), it has to keep an account of the same in its books. This is more or less a reflection or a shadow of the nostro account. The entries in the mirror account are used for reconciliation of entries in the nostro account. The mirror account is maintained in two currencies, one of which is the foreign currency and the other one is the home currency. Bank accounts, are a major function in the realm of correspondent banking, and generate good revenue for the international banks, in the form of surplus balances, charges on debits/credits handled, payment commissions, etc. 3.3 ELECTRONIC MODES OF TRANSMISSION/PAYMENT GATEWAYS - SWIFT, CHIPS, CHAPPS, RTGS, ETC. The vastness of global trade and finance, and the related payments and transfers from one bank to another, one country to another, as also numerous interbank payments and receipts, can only be executed with the help of various payment gateways and telecommunication systems, which have proved to be foolproof over a long period of time. 1. Swift SWIFT stands for Society for Worldwide Interbank Financial Telecommunications. This is a cooperative society, owned by member banks and financial institutions, providing secured telecommunication and one point contact with 8,300 member financial institutions, spread over 209 countries. The system has built in security system with an automatic authentication of financial messages, through bilateral key exchange (BKE), and is available 24 hours a day and 365 days in a year. The system is cost effective with cost of an average message grossly lower by almost one-fourth than the conventional telex systems. SWIFT has since introduced new system of authentication of messages between banks, whereby banks are required to have a authentication key exchanged between themselves, through a set fonnat by use of Relationship Management Application (RMA), ( also called Swift BIC, i.e. Bank Identifier Code).
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2. Chips CHIPS (Clearing House Interbank Payment System), is a major payment system in the USA, operating since 1970. It is a fully automated; computer based messaging and net settlement payment system used by major banks for settlement of a large part of US dollar payments in the USA. CHIPS was established by New York Clearing House, as a substitute to paper checks. Over the period, CHIPS has grown both in volumes, with a membership of 48 currently. The participating banks use the system throughout the day for sending and receiving electronic payment instructions, which at the end of the day are netted and net payment received/paid by each bank to the clearing house. The net position is then debited or credited to each bank's account with Federal Reserve. The system uses CHIP participant codes to identify the participants, and UID numbers to identify the beneficiary account. The banks maintaining US dollar Nostro accounts with any of the US based banks are given a specific UID number, which facilitates Straight Through Processing (STP) of most of the Interbank payments and receipts, through the system. CHIPS is operative only in New York, and as such, is mainly used for foreign exchange Interbank settlements and Euro Dollar settlements. 3. Fedwire This is another US payment system operated by Federal Reserve Bank, operated all over the US states since 1918, and handles majority of domestic payments. It is an automated computer-based messaging and payment system, working on gross settlement basis. All US banks maintain accounts with Federal Reserve Bank, and are allotted an 'ABA numbers' to identify the senders and receivers of payments. As compared to CHIPS, this is a large system, with over 8,000 participants, and handles a large number of payments across USA, covering Interbank transfers out of New York, local borrowings and lending, commercial payments, and also some securities transaction related payments for domestic banks. 4. Chaps Clearing House Automated Payments System (CHAPS), is a British equivalent to CHIPS, handling receipts and payments in LONDON. This system works on the same principles as CHIPS, working on the net payment settlement system. CHAPS is used by a large number of banks in UK, with about 16 member banks and over 400 indirect members, using the system through some large bank.
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5. Target Trans-European Automated Real-Time Gross Settlement Express Transfer system is an EURO payment system comprising 15 national RTGS systems working in EUROPE. These are interconnected by common procedures and uniform platform for processing high value payments by over 30,000 participating institutions across EUROPE. This facilitates receipts and payments of funds across the Euro zone (all member countries). 6. RTGS-plus and EBA These are other Euro clearing systems, with RTGS plus, being a German hybrid clearing system and operating as an European-oriented real time gross settlement and payment system. RTGS plus has over 60 participants. The EBA-EURO I, with a membership of over 66 banks, in all EU member countries, works as a netting system with focus on cross border Euro payments. For retail payments, EBA has another system, called STEP 1, with around 200 members across EU zone. STEP 2 is also in use in EU zone, which facilitates straight through processing (STP) to member banks, using industry standards. 7. RTGS/NEFT in India RTGS: Reserve Bank of India has implemented Real Time Gross Settlement (RTGS) system for the banks in India, where banks can remit funds to other banks through this mechanism,. The RTGS system is managed by IDBRT, Hyderabad, which connects all banks to a central server maintained at RBI. Each bank maintains a pool account with the RBI for inflow and outflow of funds received /paid through RTGS. The bank has to monitor the balances in the account through out the day, so as to keep it sufficiently funded, to take care of outward remittances. For customer remittances, the minimum amount for RTGS transfers is Rs. 1.00 lac. NEFT: This is another funds transfer facility for banks in India, which runs on a batch process method. This is used for small remittances by customers from an account with one bank to another account in another bank. The funds adjustment for NEFT is also done through the pool accounts maintained by individual banks. Both RTGS and NEFT have facilitated faster funds transfer for bank customers, across the country, leading to a great reduction remittances/payments sent earlier through cheques/drafts. Check Your Progress (A) Fill in the blanks: (i) _______ (ii) For using bank. banking, eliminates the need to have a global network of branches. services, it is a must to have an account relationship with the correspondent
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(iii) account means your account with us. vostro (iv) Mirror account is the shadow account of ________ account. nostro (v) Authentication of financial messages in SWIFT is based on exchange of RMA/ BIC (vi) CHAPS is the British equivalent of _______ in the USA. CHIPS (vii) The RTGS of the EURO zone is called ____ . Target (viii) NEFT is used for ______ of funds in India. 3.4 NRI BANKING For any country, with a large population of natives working abroad as expatriates, serving the nonresidents, becomes important, particularly in view of the need to shore up foreign exchange reserves. India too, needs to service the requirements of its people, staying abroad for business or profession, or even settled abroad. As such, specific rules for opening of accounts and maintenance of non resident Indians, its operations, repatriability, interest payments, investments and other facilities have been framed by the Government of India under FEMA as also Reserve Bank of India. 1. Definition of NRI As per the FEMA 1999, Non-Resident Indian means: (a) A person resident outside India who is a citizen of India, i.e. (i) Indian citizens who proceed abroad for employment or for carrying on any business or vocation or for any other purpose in circumstances indicating indefinite period of stay outside India. (ii) Indian citizens working abroad on assignments with Foreign Governments, Government Agencies or International/Multinational Agencies like United Nations Organizations (UNO), International Monetary Fund (IMF), and World Bank, etc. (iii)Officials of Central and State Governments and Public Sector Undertaking deputed abroad on assignments with Foreign Govt. Agencies/Organizations or posted to their own offices including Indian Diplomatic Missions abroad. (b) A person of Indian origin who is a citizen of any other country other than Bangladesh or Pakistan, if (i) He, at any time, held an Indian passport (ii) He or either of his parents or any of its grand parents was a citizen of India by virtue of Constitution of India or Citizenship Act 1955 (57 of 1955) (iii)The person is a spouse of an Indian citizen or a person referred in sub clause b(i) or (ii) above. Thus, in general, an NRI is a person of Indian nationality or origin, who resides abroad for business or vocation or employment, or intention of employment or vocation, and the period of stay abroad is indefinite.
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A person is of Indian origin if he has held an Indian passport, or he/she or any of his/hers parents or grandparents was a citizen of India. As such, government officials going abroad on posting to Indian missions or World Bank, IMF, etc., are NRIs. Similarly, tourists on brief visit to foreign countries are not categorized as NRIs. Students going abroad for higher studies, are considered as NRIs specifically as per RBI guidelines, even though their visit abroad is not for indefinite period nor for business or vocation. A spouse, who is a foreign citizen, of an Indian citizen or a person of Indian origin, is also treated as a person of Indian origin, for the purpose of opening of bank accounts and other facilities granted for investments into India, provided such accounts or investments are in the joint names of spouses. Overseas corporate bodies (OCB): Overseas firms, trusts or companies, predominantly owned by non resident Indians are called Overseas Corporate Bodies. The level of ownership of NRIs in such bodies, should be minimum 60 %, by one or more NRI owners. The facilities for investment into India, granted to OCBs were almost similar to those granted to individual nonresident Indians. However, effective 16.09.2003, OCBs have been completely de-recognised as an investor class by Reserve Bank of India. Accordingly, they are now not allowed to make fresh investments in India, under various routes/schemes, available under the extant guidelines/FEMA. Let us now have a look at the types of account that can be maintained by NRIs and their operational aspects. 3.5 NRE ACCOUNTS - RUPEE AND FOREIGN CURRENCY ACCOUNTS NRIs have been provided with various schemes to open bank accounts and invest in India. The types of account facilities available at present are: 1. Non-Resident (External) Rupee Account (NRE) 2. Non-Resident Ordinary Rupee Account (NRO) 3. Foreign Currency (Non-Resident) Account (Banks) [FCNR (B)] As can be observed from the name, first two types of accounts are maintained in Indian rupees, while the third one can be maintained in one of the major foreign currencies. For opening of any Non-Resident Account, the bank has to obtain an application in the prescribed form along with an undertaking that the account holder shall inform the bank the date of arrival, as and when he returns for permanent settlement. The bank should also obtain necessary document, like copy of passport, visa, employment certificate (wherever required) to confirm non-resident status. Let us now discuss the types of account one by one: 1. Non-Resident (External) Rupee Account NRE accounts, as they are called, can be opened and maintained by Non-Resident Indians, by (i) remittances from abroad by way of TT, checks, drafts, or even transfer from another NonResident account, as also (ii) by tendering of foreign currency travellers cheques or notes by the NRI during his temporary visit to India, provided the bank is satisfied about his non-resident status. NRE account can be opened as Saving Bank account, Current Account, Recurring Deposit Account or Term Deposit with a minimum period of one year. NRE accounts can be opened as Joint Accounts, in the name of two or more non-resident individuals, who are persons of Indian nationality or Indian origin. Opening of NRE account, jointly with a person resident in India is not permitted. No lien is permitted to be marked on the balances held in NRE savings accounts.
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Permitted credits The following credits are freely permitted to be credited to NRE accounts: (a) Remittance to India in any permitted currency (b) Personal cheques drawn on foreign currency account of the account holder (c) Travellers cheques and bank drafts drawn in any permitted currency (d) Foreign currency/bank notes tendered during his temporary visit. (e) Transfer from any other NRE/FCNR(B) Accounts. (f) Any other credit if covered under general permission or specific permission granted by Reserve Bank of India. Permitted debits The following debits are freely permitted in the NRE accounts: (a) Local disbursements/payments (b) Remittance outside India (c) Transfer to any NRE/FCNR(B) Account (d) Investments in shares/securities, etc. Other facilities NRE accounts also offer following other facilities to NRI depositors: (a) A checking account with checkbook facility in Savings or Current account is allowed. (b) Full repatriation of deposit amount including interest permitted. Maturity proceeds can be transferred to another NRE or FCNR account with same or another bank, as desired by the depositor. (c) Nomination facility is permitted. Nominee can be either resident or non-resident. (d) Income by way of interest on balances held in NRE account is exempted from income tax, gift tax and wealth tax. (e) Residents can operate the account on the basis of power of attorney granted by the account holder. However, the power of attorney holder cannot repatriate funds outside India. (f) Banks may allow temporary overdrawing up to Rs 50,000 in NRE saving account. However, such overdrafts must be cleared within two weeks by remittance from abroad or from any other NRE/ FCNR account. As seen above, these NRE accounts are maintained in Indian rupee, as such, the exchange fluctuation risk lies on the depositor.
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Interest on NRE deposits: As per extant RBI guidelines, the interest rates on NRE deposits are, currently, payable as under: NRE Savings accounts: Interest is payable at 3.50 percent, similar to resident savings account. NRE Term deposit accounts: Maximum of LIBOR plus 175 basis points (bps -100th part of 1 per cent) for the relative tenor, to be fixed on the last working day of the preceding month, and applicable for fresh deposits or renewals during the subsequent month. Tenor: NRE term deposits can be made for a minimum period of one year, with a maximum up to 3 years. However, banks can take deposits for higher tenors, at the maximum interest, as for deposits of three years. 2. Non-Resident Ordinary Rupee Account (NRO) These accounts are Rupee accounts and can be opened and maintained by any person resident outside India and also by Foreign Tourists, who are on a short visit to India on tourist visa. The new accounts are to be opened by sending fresh remittances from abroad or transfer of funds from NRO/NRE/FCNR accounts. Typically, when a resident becomes a non-Resident, his domestic Rupee account, has to be redesignated as an NRO account. This is basically a domestic account of an NRI, opened and maintained to facilitate credits which accrue in India, from investments that were made prior to his leaving the country, rent, LIC maturities, or income from other investments made on non-repatriable basis. NRO accounts can be opened in Indian rupees only as Saving bank account. Current account. Recurring Deposit account and Term-Deposit account, and most of the regulations for interest rates, tenor, etc., applicable are similar to those for domestic deposit accounts. The interest on NRO accounts is subject to deduction of Income Tax at source, as prescribed. NRO accounts can be opened as Joint Accounts, with resident Indians. Permissible Credits The following credits are freely permitted to be credited to NRO accounts: (a) Any remittance from abroad in permitted currency. , (b) Currency tendered during visit to India of the account holder. (c) Any legitimate dues in India of the account holder, (rent, interest, dividend, maturity proceeds of Units of UTI, LIC policy maturities, etc.). (d) Transfer from other Rupee accounts of Non residents. Permissible Debits The following debits are permissible in NRO accounts, without restrictions: (a) All local payments in Indian rupees. (b) Remittance outside India of current income in India of the account holder net of applicable taxes, (interest, dividend, rent, etc.). (c) Any other transactions if covered under general or specific permission granted by RBI. Other Facilities (a) An amount up to USD 1 million can be repatriated out of funds held in NRO account for permissible transactions, subject to payment of income tax at applicable rates . (b) Where an account is opened of foreign tourist on his temporary visit, the balances held in the account by way of remittance from abroad or conversion of foreign currency, can be converted back to foreign currency and paid to the account holder, provided the account is maintained for a period not exceeding six months.
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(c) When a resident of India becomes a non-resident Indian, his existing account should be immediately converted into NRO account. (d) Nomination facility is available in NRO account. 3. Foreign Currency (Non-Resident) Account (Banks) [FCNR(B) Accounts] These are foreign currency accounts, which can be opened by Non-Resident Indians. These accounts can be opened and maintained by Non-Resident Indians, in designated currencies only, viz., US Dollar, EURO, Great Britain Pounds and Japanese Yen, CAD and AUD. NRIs can open these accounts only in the form of Term Deposits, with a minimum period of one year and maximum period of three years. The deposits are in foreign currency and are repaid in the currency of issue, along with interest, in foreign currency itself Joint accounts: Joint accounts can be opened in the name of two or more non-resident individuals, who are persons of Indian nationality or Indian origin. Permitted credits and debits: All credits and debits, as permitted for NRE Rupee accounts are permitted for FCNRB accounts. Other Facilities (a) There is no exchange risk for the account holder as the account is maintained in foreign currency. (b) Repatriation of principal amount along with interest is permitted. (c) The interest on the deposit shall be paid on the basis of 360 days to a year, cumulative on half-yearly intervals of 180 days. (d) Nomination facility is available. (e) Income earned by way of interest is exempted from income tax. (f) No operation by way of power of attorney to the resident is permitted, since there are no local withdrawals. (g) Forward Cover can be booked to hedge the balance held in FCNR account. Interest on FCNR (B) accounts: In terms of extant RBI guidelines, Interest on FCNRB deposits is payable at prevailing LIBOR plus 100bps, for the respective tenors, prevailing on the last working day of the previous month, and is applicable for all fresh deposits and renewals of deposits during the subsequent month. Tenor: FCNR deposits can be made for a minimum period of one year and maximum of five years. FEDAI announces the LIBOR rates for computation of interest on NRE and FCBR deposits, on the last working day of the month, so that the interest rates of banks are linked to similar benchmark. Check Your Progress (B) Fill in the blanks: (i) (ii) (iii) (iv) (V) (vi) (vii) (viii) A person must be of Indian origin or an Indian passport holder, staying abroad for indefinite period, to qualify for status of an _____ . The minimum period for NRE term deposit is ___ . NRE savings account is a ______ account.
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FCNRB Accounts are necessarily ____ deposit accounts maintained in designated foreign currencies. Interest earned on bonds, invested before getting NRI status, can be credited to __ account. An amount up to USD______ , can be repatriated every year out of balances held in NRO account, for permissible transactions. The maximum period for FCNRB deposits is In FCNRB deposits the depositor does not bear years, risk. 3.6 FACILITIES TO NRIS Non-resident Indians have been allowed to invest in India, in various securities, schemes, and avenues, so that the precious foreign exchange earned by them is used for the development of the country. The investment by NRIs are now regulated by the regulations prescribed under Foreign Exchange Management (Transfer or issue of security by a person resident outside India) Regulations, 2000. These regulations cover issuance of security by an Indian company or entity to a person resident outside India and purchase and sale of security by a person resident outside India. 1. Investments in Shares/Securities Investments by NRIs have been broadly categorized into two segments: (i) On Repatriation basis (ii) On Non-repatriation basis. The investment on repatriable basis can be made in shares, bonds, securities, from the funds brought from abroad in freely convertible currencies or by debit to NRE/FCNR account of the investor. General permission has been granted under the regulations, to any person, resident outside India, to purchase equity or preference shares or convertible debentures of an Indian company, subject to conditions and industry/company investment caps, as stipulated. However, investment in shares and securities by NRIs have been further classified under following categories: 1. Investment under Foreign Direct Investments 2. Investment under Portfolio Investment Scheme 3. Purchase and sale of shares on non-repatriable basis 4. Purchase and sale of securities other than shares and convertible debentures of an Indian company. NRIs can purchase shares or debentures of an Indian company, subject to specified conditions, as laid down in the FEMA, regulations 2000, referred to earlier. NRIs can invest in shares of Indian companies listed in recognised stock exchange under Portfolio Investment Scheme (PIS), through a designated AD branch, on repatriation as well as non-repatriation basis. NRIs can transfer such securities to another NRI, as also to a resident, by way of gift. The investment under any of the above mode, can be under the Automatic route of RBI, under international issuance of ADR/GDRs, or under specific approval of the Government, wherever sectoral caps have been prescribed. While, RBI has granted general permission for remittance of sale proceeds (net of applicable taxes), of a security sold by an NRI, which was originally bought or acquired out of fresh remittances from abroad or from balances held in NRE/FCNRB accounts, securities purchased on non-repatriable basis, sale proceeds are to be credited to the NRO account of the investor, and taxes applicable as local investments.
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NRIs are also permitted to invest in exchange traded derivative contracts, approved by RBI, out of Rupee resources held in India on non -repatriation basis, subject to limits prescribed by SEBI. 2. Other Investment Avenues 1. Units of UTI, mutual funds NRIs are permitted to invest in units of UTI or other mutual funds on repatriable as well as nonrepatriable basis. 2. Company deposits NRIs are permitted to invest in company deposits on repatriable basis, provided the deposits are for a minimum period of 3 years, are within the ceiling prescribed by RBI for the company to accept deposits and are made out of fresh remittances or from balances held in NRE/FCNRB deposits. 3. Investment in partnership firm or proprietorship concern An NRI is permitted to invest in a partnership firm or a proprietorship concern, by way of capital contribution, provided (i) the concern is not engaged in agricultural /plantation activity or real estate business or dealing in immovable property, with a view to earning profit from it, and (ii) the contribution should be by way of fresh inward remittances into India or out of balances held in NRE/FCNRB deposits accounts. The amount so invested shall be permitted to be repatriable out of India, subject to taxes. 4. Investment in Immovable Property (a) A person resident outside India, who is a citizen of India, is permitted to acquire any property in India other than agricultural/plantation/farm house, and transfer the same to any person resident in India or to a person resident outside India, who is an Indian citizen. (b) NRI can acquire such a property, out of funds received in India by way of inward remittance from any place outside India, or from the balances held in any non-resident rupee account or foreign currency account maintained in India. (c) NRI can also acquire such a property by way of gift by a person resident in India, or from a person resident outside India, who is a citizen of India or from a person of Indian origin, resident outside India. (d) NRI can also acquire any immovable property in India by way of inheritance from a person resident outside India, who had acquired such property in accordance with the foreign exchange law, prevailing at the time of such acquisition by him. Repatriation of sale proceeds of immovable property-: Banks are allowed to permit repatriation of sale proceeds of immovable property, other than agricultural land/plantation/farm house, by an NRI, provided: (a) The property so acquired was in accordance with the foreign exchange laws in force at the time of acquisition by him. (b) The sale proceeds required to be repatriated does not exceed the foreign exchange brought in to acquire the property. (c) In case of residential property, the repatriation of sale proceeds is restricted to not more than two properties. (d) Banks are now permitted to allow repatriation of funds out of balances held by NRIs in their Nonresident accounts up to USD 10,00,000 per year, representing sale proceeds of immovable property held by them, without any lock in period, subject to payment of applicable taxes.
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Further, a non-resident Indian is also permitted to acquire any commercial or other property, which is incidental or necessary to his business interests in India, like, branch offices, etc. and which is permitted under the law of the land. 5. Other investments NRis can also, without any limit, purchase on non- repatriation basis, dated Government securities, treasury bills, units of domestic mutual funds, units of money market mutual funds. However, they are not permitted to make investments in Small Savings Schemes, including PPF. 3.7 ADVANCES TO NON-RESIDENTS, AND THIRD PARTY ADVANCES AGAINST NRI DEPOSITS/GUARANTEES, OTHER LOANS 1. Rupee loans in India Banks are permitted to grant loans to Non-resident Indian account holders against the security of funds held in Non-Resident term deposit account schemes. The purpose of such loans can be either of the ones given hereunder: (i) Personal purpose or for carrying on business activities except for the purpose of re-lending or carrying on agriculture/plantation activities or for investment in real estates. (ii) Making direct investment in India on non-repatriable basis by way of contribution to the capital of Indian firms/companies. (iii)Acquisition of house/flat for his own residential use in India. Credit of loan amount: The loan so granted shall be credited to NRO account only and not to NRE/ FCNR (B) accounts. Amount of loan: Presently, loans against NRE / FCNR deposits can be allowed only upto Rs 100 lacs, in terms of RBI guidelines. Margin: Banks shall maintain reasonable margin and may determine the same on case-to-case basis. Repayment: Repayment of loan shall be either inward remittance from abroad through normal banking channel/maturity proceeds of the deposit or out of local resources in the NRO rupee account. 2. Foreign Currency Loans in India Banks may give foreign currency loan to the account holders against security of funds held in FCNR (B) deposits and not against the third party deposits, to the account holder only. The documents should be executed by the account holder and not by the power of attorney holder The maturity of loan should not exceed the maturity date of the deposit. Loan shall be sanctioned for purposes other than investments in India. Repayment should be made either from fresh remittance from abroad or from the maturity proceeds of the deposit. 3. Loans to Third Parties Banks may grant loans to third parties against the security of funds held in non-resident deposit accounts, provided, (i) There is no direct or indirect foreign exchange consideration for the non-resident depositor agreeing to pledge his NRE/FCNR (B) deposits to enable the resident individual/firm/company to obtain such facilities. (ii) Regulations relating to margin, rate of interest, purpose of loans, etc., shall be as per RBI guidelines.
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(iii)The loan should be utilised for personal purposes or for carrying on business activities except for the purpose of re-lending or carrying on agriculture/plantation activities or for investment in real estates. (iv) Non-Resident depositor should himself execute the loan documents in the presence of the bank officials and witness acceptable to the bank. (v) Loan should not be granted on the basis of power of attorney. 4. Housing Loan in rupees to Non-resident Indians Banks may grant housing loan to non-resident Indians, for acquisition of a residential accommodation in India, subject to following conditions: (a) The quanturn of loan, margin money and the period of repayment shall be same as applicable for resident Indians. (b) The loan amount shall not be credited to NRE/FCNR (B) account. (c) The loan shall be fully secured by equitable mortgage of the property proposed to be acquired and if necessary also by lien on the borrower's other assets in India. (d) Repayment shall be by remittance from abroad or by debit to his NRE/ FCNR (B)/NRO account or rental income derived from renting out the property acquired by utilization of the loan. Check Your Progress (C) True or False 1. NRIs can acquire shares or property by way of inheritance from a person resident outside India. True 2. NRI cannot acquire shares on repatriable basis. False 3. NRIs cannot invest in any partnership firm as owners/partners. False 4. NRIs can acquire property by purchase out of balances held in NRE accounts. True 5. Banks can permit repatriation of sale proceeds of a house property, held in NRO account up to USD 1.00 million per year. True 6. Loan/Overdraft of Rs 500 lacs, can be granted to a resident Indian against security of an FCNRB deposit. False 7. There is no need to get the documents of loan signed by the NRI depositor in the presence of the bank officials. False 8. The housing loan granted to an NRI can be credited to his NRE account False 9. Interest on NRO deposits, is subject to deduction of tax at source as per local income tax rules. True Let Us Sum Up We have seen how the areas of correspondent banking, bank accounts as well as payment gateways help the business and banking world in international trade and finance. The correspondent banking is based on the premise of relationship and goes a long way in servicing
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banks in other countries. In this era of electronics and telecommunications, products like SWIFT, CHIPS, TARGET, etc., play an important role in faster and secure communications and payments across the globe. The non-resident segment has its own place of importance in the Indian Banking. The variety of bank accounts, and products for investment available to NRI clients, definitely speak of the importance this segment has in the Indian economy on a macro level. The unit would therefore be of use to the readers to understand the various aspects of NRI banking, as also some of the procedural aspects related thereto. Keywords Nostra: Our Account with you. Vostro: Your account with us. Loro: Their account with them(third party/bank). Swift: A communication system which provides transmission of financial messages, certifying the authenticity, across the globe between members. Target: A payment system of European umon. Non-Resident Indian: Who is not a resident, has gone out of India with an intention of business or vocation, and period of stay is indefinite. FCNRB Accounts: Foreign currency accounts which can be opened by Non-resident Indians. NRO account: Rupee accounts of non residents , which are non repatriable in nature and are used for domestic transactions. Answers to Check Your Progress (A) (i) correspondent; (ii) payments; (iii) vostro; (iv) nostro; (v) RMA/ BIC (vi) CHIPS; (vii) Target. (B) (i) NRI; (ii) one year; (iii) Rupee; (iv) term; (v) NRO; (vi) one million (vii) five (viii) exchange; (C) 1. True; 2. False; 3. False; 4. True; 5. True; 6. False; 7. False; 8. False; 9. True. Terminal Questions 1. Correspondent banking does not include (a) Account maintenance. (b) Opening of branch on behalf of a bank. (c) Authentifying and advising of LCs (d) Collection of cheques and bills. 2. LORO account is : (a) My account with you, (b) Mirror of a nostro account (c) Your account with me. (d) His account with a third bank. D 3. SWIFT is a (a) National messaging system. (b) System to transmit financial messages between banks globally. (c) National RTGS system of India. (d) System managed by a large corporate house in Belgium.
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6. As per FEMA, a non resident is (a) A person working in Dubai for last three years. (b) A tourist touring European countries for last fifteen days. (c) A software engineer working on a project in California USA, from his site in Hydrabad. (d) A student on a visit to Australia on study tour ,while doing his MBA at IIM Indore. An NRI cannot open following accounts in India (a) FCNR deposit in Australian dollars for a period of two years. (b) NRE savings bank account, with check book facility. (c) FCNR deposit in Canadian Dollars for a period of 10 years. (d) An NRE term deposit for a period of 5 years. State whether the following persons can open NRE accounts with a bank in India: (a) A person of Indian origin, who is staying in Japan for last 3 months, and is employed by a US firm, dealing in computer software. (b) A lady of US origin, whose husband is of Indian origin, and is settled in France for last five years and runs a restaurant in France. (c) A Doctor of Indian origin, who has gone to UK to attend a conference, and will resume his duties at AIIMS, Delhi after 10 days. (d) A person of Indian origin, who had gone to Canada for further studies last year, and has now taken up a job there, as a Lecturer. (e) A person of Indian origin, who has gone to Australia for doing one year Masters in Management True or false: (a) Target facilitates global funds payments. (b) NRO accounts can be opened jointly with a resident Indian relative. (c) FCNR deposits can be maintained in INR. (d) A Student, studying abroad is allowed a non resident status for banking accounts. (e) NRE term deposit can be issued for a maximum period of 10 years. (f) Non residents can invest in equity markets in India. (g) An NRI can deposit foreign currency notes into his NRE savings account during his visit to India. References for Further Reading 1. Reserve Bank of India Guidelines for Internal Control for Foreign Exchange Business, Master Circulars, Circulars, issued from time to time. 2. FEMA 1999. 3. FEDAI Study Booklets for Orientation workshops. 4. Facilities for Non-Resident Indians - RBI publication. 5. All earlier publications of IIBF.
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UNIT 4 Documentary Letters of Credit STRUCTURE 4.0 Objectives 4.1 Introduction 4.2 Definition of Letter of Credit 4.3 Types of Letters of Credit Check Your Progress (A) 4.4 Operations of Letter of Credit 4.5 UCPDC 600 and Important Articles. 4.6 Liabilities, Responsibilities and Rights of the Parties Check Your Progress (B) 4.7 Documents under LC - Scrutiny, Crystallisation, Follow-up for Bill under LC and Safeguards for Banks 4.8 Risks Relating to LC Transactions Check Your Progress (C) 4.9 Stand by Letter of Credit (Guarantees) 4.10 Uniform Rules for Bank-to-bank Reimbursements (URR - 525) Check Your Progress (D) 4.11 Incoterms 4.12 Case Studies Let Us Sum Up Keywords Answers to Check Your Progress Terminal Questions References for Further Reading
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4.0 OBJECTIVES The objective of this chapter is to make readers understand the concept of documentary credits, its functioning, and role of UCPDC-600, which governs the LC transactions globally, the responsibilities of various parties to the LC transaction, Standby LCs, as also the uniform rules for reimbursements. 4.1 INTRODUCTION A Letter of Credit/Documentary Credit is a very common and familiar instrument, used for trade settlements across the globe. It is a link between buyers and sellers, reinforcing the buyer's integrity by adding to it, his banker's undertaking to pay, while sellers need to make shipments of goods specified and present shipping documents to banks, before getting the payment. Thus, for international trade, where buyers and sellers are far apart in two different countries, or even continents, the letter of credit acts as a most convenient instrument, giving assurance to the sellers of goods for payment and to the buyers for shipping documents, as called for under the credit. In order to bring uniformity in matters pertaining to letters of credit documents and transactions, international Chambers of Commerce (ICC), established in 1919 and headquartered in Paris, has framed uniform rules and procedures for issuance and handling of transactions under letters of credit, so that parties to letters of credit transactions uniformly interpret various terms and are bound by a common rale. These rales and procedures are called Uniform Customs and Practices for Documentary Credits (UCPDC). The UCPDC was first brought out in 1933, and has been revised from time to time in 1951, 1962, 1974, 1983, 1993 with the last revision in 2007. The current update of UCPDC is the publication No. 600 of ICC, which has been implemented with effect from 1.7.2007. 4.2 DEFINITION OF LETTER OF CREDIT A documentary credit or/and letter of credit, ( DC or LC) can be defined as a signed or an authenticated instrament issued by the buyer's banker, embodying an undertaking to pay to the seller a certain amount of money, upon presentation of documents, evidencing shipment of goods, as specified, and compliance of other terms and conditions. An LC can also be defined as an undertaking issued by the bank, on behalf of the importer or the buyer, in favour of the exporter or the seller, that, if the specified documents, showing that a shipment has taken place, or a service has been supplied, are presented to the issuing bank or its nominated bank, within the stipulated time, the exporter/seller will be paid the amount specified. Thus, in an LC transaction, following parties are involved: (i) The buyers/importers or the applicant - on whose behalf LC is opened, (ii) The sellers/exporters or the beneficiary of the LC, (iii)The opening bank (buyers bank), who establishes the LC (iv) The advising bank (bank in sellers country), who acts as an agent of the issuing bank and authenticates the LC. (v) The confirming bank - who undertakes to pay on behalf of the issuing bank. (vi) The negotiating bank (sellers bank or bank nominated by the opening bank), (vii) Reimbursing bank - who reimburses the negotiating or confirming bank. The advising bank, confirming bank and the negotiating bank could be the same. 4.3 TYPES OF LETTERS OF CREDIT
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UCPDC are universally recognized set of rules framed by ICC, governing LC business, and have over the years become an indispensable tool for international business. Since LC ensures payment to the exporter against constructive delivery, by way of handing over the documents to the title to goods, to the paying or negotiating bank, it is a comfort to the sellers (exporters) and buyers (importers) that has been a backbone of international trade. The UCPDC gives guidance and assistance to all concerned parties to LC transaction, specifically emphasizing upon the duties and responsibilities of the opening bank, buyers and sellers, advising, negotiating and the reimbursement bank, as also specifying the acceptable practices, in case of no specific instructions in the LC. UCPDC-600, i.e. the publication no. 600 of ICC, is the latest version of UCPDC and was made effective I July 2007. We shall learn further about the clauses of the UCPDC and how they help the parties to the transaction, let us first go through the types of Letters of Credit, that are in use in the international market. Following are the basic types of Letters of Credit: (a) Revocable LC is the one which can be amended or cancelled at any moment by the issuing bank without the consent of any other party, as long as the LC has not been drawn or documents taken up. The value of such revocable LC is very limited and therefore these are very rarely issued and accepted. In case the negotiating bank has taken up the documents under revocable LC, prior to receipt of cancellation notice, the issuing bank is liable to compensate/reimburse the same to the negotiating bank. (b) Irrevocable LC is the one, which holds a commitment by the issuing bank to pay or reimburse the negotiating bank, provided conditions of the LC are complied with. Such an LC cannot be amended or cancelled without the consent of all parties concerned. The Irrevocable Letter of Credit is an unconditional undertaking by the issuing bank to make payment on submission of documents conforming to the terms and conditions of the All LCs issued, unless and otherwise specified, are irrevocable Letter of Credit. (c) Irrevocable Confirmed Letter of Credit is an L/C, which has been confirmed by a bank, other than the issuing bank, usually situated in the country of the exporter, thereby taking an additional undertaking to pay on receipt of documents conforming to the terms and conditions of the Letter of Credit. The confirming bank can be the advising bank, which on receipt of request from the issuing bank takes this additional responsibility. The confirming bank has to inform the issuing bank if it does not agree to add its confirmation and has no obligation to add confirmation to the amentiments issued thereafter The confirming bank looks into various risks involved and takes a decision to add its confirmation. In short, the confirming bank steps into the shoes of the issuing bank and performs all functions of the issuing bank. (d) Transferable LC: A transferable Letter of Credit is available for transfer in full or in part, in favour of any party other than the beneficiary, by the advising bank at the request of the issuing bank. There can be more than one second beneficiary, i.e. the LC can be split and transferred in favour of more than one second beneficiary. However, such second beneficiary cannot further transfer the LC in favour of another third party. To be transferable, a credit must specifically be made transferable. (e) "RedClause " LC: Such an LC enables the beneficiary to avail pre-shipment credit from the nominated/ advising bank. The LC bears a clause in "Red Letter" authorising the nominated bank to grant advance to the beneficiary, prior to shipment of goods, payment of which is guaranteed by the opening bank, in case of any default or failure of the beneficiary to submit shipment documents.
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(f) Sight/Acceptance, Deferred Payment, or Negotiation LC: Within the above types of LCs, the LCs can be Sight LC, Acceptance LC, Deferred Payment LC or Negotiation LC. Under a Sight LC, the beneficiary is able to get the payment on presentation of documents conforming to the terms and conditions of the LC at the nominated bank's counters. In an Acceptance Credit, the bill of exchange or drafts are drawn with certain usance period, and are payable, upon acceptance, at a future date, subject to receipt of documents conforming to the terms and conditions of the Letter of Credit. The usance period may be certain number of days from the date of shipment or date of bill of exchange, etc. A Deferred Payment Credit is almost similar to acceptance credit, except that there is no bill of exchange or draft drawn and is payable on certain future date, subject to submission of credit conformed documents. The due date is generally mentioned in the Letter of Credit. The absence of bill of exchange saves the beneficiary from the cost of stamp duty or other levies, as applicable in certain countries. In a Negotiation Credit, the issuing bank undertakes to make payment to the bank, which has negotiated the documents, i.e. give the value for draft and/or documents drawn under the Letter of Credit. The documents negotiated should be strictly as per the terms and conditions of the LC. The LC may be freely negotiable or may be restricted to any bank nominated by the LC issuing bank. (g) Back to Back LC: When an exporter arranges to issue an LC in favour of local supplier to procure goods on the strength of export LC received in his favour, it is known as Back-toBack Letter of Credit. Generally, Back-to-Back LC is for procurement of goods locally or for import of goods for meeting the export LC commitments. Check Your Progress (A) Fill in the blanks: 1. between a buyer and a seller to facilitate 2. A documentary credit is a link provided by an international trade. 3. It is an _____ by the opening bank to pay, subject to conditions laid therein. 4. The buyer of the goods, opening an LC is also called an _ . 4. International Chambers of Commerce has issued guidelines, practices for LC transactions, known as 5. An LC which allows the openers/opening bank to back out, and cancel the LC is called _ Letter of Credit. 6. The LC which facilitates financing to the supplier prior to shipment is known as 7. An LC that can be transferred in favour of another beneficiary is called __ LC. 8. When an LC is opened for procurement of goods, on the backing of an export LC, it is called LC. 4.4 OPERATIONS OF LETTER OF CREDIT With the involvement of the several parties, the LC transaction operates between the two nations, as explained in the following diagram: As shown in the diagram above, the transaction flows as under: (i) The buyer and seller enter into the sales contract, for purchase/sale of certain amount of specified goods at specified rates, but agree to cover the transaction under Letter of Credit. (ii) The buyer in country A (applicant/opener) requests his bank, to open LC in favour of the seller in country B (beneficiary) for the specified amount.
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(iii)the buyer's bank, i.e. opening bank, issues the LC and sends the same to the beneficiary in country B, through its own branch or correspondent (or at times directly, if the beneficiary is known). (iv) the advising bank in country B, advises the LC after authenticating the signatures/swift message. The bank, in country B, which advises the LC to the beneficiary, is called Advising Bank. (v) the seller desires for the LC to be confirmed by some bank, in his own country, the bank, which agrees to do so, at the request, and as per arrangement and on behalf of the opening bank, is called the Confirming Bank. The seller now prepares the goods, and ships as per instructions in the LC, submits the documents called for in the LC to the confirming bank, which examines the same and if found in conformity to the LC terms, negotiates the documents and pays to the beneficiary. This bank now becomes the negotiating bank, and steps into the shoes of the issuing bank, and by this act of negotiation, becomes rightfiil owner of the documents and claimant of the amount under LC from the opening/issuing bank. The negotiating bank sends the documents to the opening bank, and claims reimbursement from the reimbursing bank, for the amount paid, to the beneficiary, from the designated bank. The bank, which reimburses the amount to the negotiating bank, is the reimbursing bank, and is usually the NostroA/bstro bank of the opening bank. The issuing bank, on receipt of the documents, presents the same to the openers/importers and gets the payment of the same on presentation/acceptance or due date, as the case may be. Upon payment by the applicants/openers, to the issuing bank, and release of documents to the title of goods, as also other documents, as called for under the LC, the LC transaction is complete. 4.5 UCP 600, IMPORTANT CHANGES A. The New UCP ICC, Paris, appointed Task Force to undertake revision of the UCP 500, which began its work in 2003, after approval from the Banking Commission. The Task Force after working for over three years prepared a draft of the new UCP. The Drafting group constituted members from 9 countries, which had 15 meetings before the draft was finalized. A Consultative group, comprising of 41 members from 26 countries was also formed to discuss the Draft. The Draft was also referred to National Committees, including ICC India, and key issues identified, taking in to account various ICC opinions, DOCDEX decisions, various papers, court decisions, etc. After extensive working, discussions, deliberations on various articles, practices, and need to simplify the Articles, the ICC Banking commission approved the Draft of UCP 600 , in its meeting on 25 October 2006, bringing the new UCP in to force w.e.f July 2007. B. Main Features of UCP 600 The UCP 600 was a major review in the history of Uniform Rules for Documentary Credits. The new UCP was leaner, with only 39 Articles, as compared to 49 in the earlier version. While some articles of the earlier version were deleted, some of the articles were merged, and a few new articles added. The major thrust was on a simplified language of articles. Groupings The Articles of UCP 600 can be grouped as under: Article 1-5: Definitions, Interpretations, Independence of LCs and Underlying contracts. Article 6-10: Availability, Expiry date and place. Obligations of issuing and Confirming bank. Advising credits and Amentiments.
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Article 11-17: Pre-advised credits, Nominated bank. Reimbursement arrangements, Complying presentations, Original documents, etc. Article 18: Commercial invoice Article 19-27: Transport documents Article 28: Insurance documents Article 29-33: Extension, Tolerance, Partial and Installment drawings and Hours of presentation. Article 34-37: Disclaimers Article 38-39: Transferability and Assignment of proceeds Important changes in the articles of UCP 600 and their implication for banks in handling letter of credit transactions: 1. UCP 600 does not apply by default to letters of credit issued after July 1st 2007. A statement needs to be incorporated into the credit (LC) that expressly states it is subject to these rules. Article 1 of UCP 600 also leaves open the possibility for either party to exclude the application of any part of UCP 600 as long as the exclusion is stipulated in the credit. 2. Revocable Credits (Article 2): The term Revocable Credits, which can be amended or cancelled at any time without notice to the seller, cease to exist in UCP 600. Article 2 explicitly defines a credit as "any arrangement, however named or described, that is irrevocable and thereby constitutes a definite undertaking of the issuing bank to honour a complying presentation." Article 3 states that "A credit is irrevocable even if there is no indication to that effect." and Article 10 makes it clear that "a credit can neither be amended nor cancelled without the agreement of the issuing bank, the confirming bank, if any, and the beneficiary" (seller). Therefore, a prudent seller shall stipulate in the sales contract that the "buyer will open an irrevocable letter of credit". 3. Definitions and Interpretations (Articles 2 and 3): A new section of Definitions and Interpretations has been introduced in the UCP 600. This includes definitions of "Advising bank", "Applicant", "Banking day", "Beneficiary", "Complying presentation", "Confirmation", "Confirming bank", "Credif, "Honour", "Issuing bank", "Negotiation", "Nominated bank", "Presentation", "Presenter". In addition to that, the following terms are now clearly defined: "singular/plural", "irrevocable", "signatures", "legalizations", "Branches of a bank", "Terms describing issuer of a document", "Prompt etc", "on or abouf, "to", "until", "till", "from", "between", "before", "from", "after", "first half, "second half", "beginning", "middle", "end". Deferred payment undertakings - Articles 7 and 8: Articles 7 and 8 establish a definite undertaking by issuing and confirming banks to reimburse on maturity whether or not the nominated bank prepaid or purchased its own acceptance or deferred payment undertaking before maturity. Article 12(b) expressly provides authority from an issuing bank to a nominated bank to discount (prepay or purchase) a draft that it has accepted or a deferred payment undertaking that it has given. Advising of credits-Article 9: At present an advising bank only has to verify the apparent authenticity of the credit that it has advised. Under article 9(b) it has to certify that the document that it advises to the beneficiary is the same document that it received. The obligation is also extended to any second advising bank.
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6. Amentiments - Article 10: Article 10 now deals exclusively with amentiments and article 10(c) provides: '. The beneficiary should give notification of acceptance or rejection of an amentiment. If the beneficiary fails to give such notification, a presentation that complies with the credit and to any not yet accepted amentiment will be deemed to be notification of acceptance by the beneficiary of such amentiment. As of that moment, the credit will be amended.' Thus, a beneficiary is deemed to have given notice of acceptance of a proposed amentiment upon presentation of compliant documents. 7. Time Allowed Banks for Document Review (Article 14): Under UCP 500, banks had a "reasonable time . not to exceed seven banking days" in which to honor or dishonor documents. UCP 600 has brought down the period to a maximum of five "banking days". Article 2 defines a banking day as "a day on which a bank is regularly open at the place at which an act subject to these rules is to be performed." 8. Non-Matching Documents (Article 14): UCP 500 required documents that were "on their face" inconsistent with one another to be rejected as discrepant. Article 14(d) of the new UCP 600, seeks to resolve the problem of inconsistency in data by clarifying that there is no need for a mirror image but rather: 'Data in a document, when read in context with the credit, the documents itself and international standard banking practice, need not be identical to, but must not conflict with, data in that document or any other stipulated document.' 9. Examination of Documents: As per Article 14, Banks now only have 5 banking days to accept or refuse documents. This replaces the "Reasonable time not exceeding 7 banking days". The period for presentation (usually 21 days) only applies to original transport documents. This means that if only a copy or no transport document is required by the credit, and a period for presentation is requested, then the credit should expressly state that the document should be presented within a certain period of time from a defined moment or event. Addresses of beneficiaries and applicants need no longer be as mentioned in the documentary credit. They must however be within the same country. Contact details (Like phone and fax numbers) may be disregarded - and if stated they need not be as in the credit. The shipper /consignor of the goods, may not be the beneficiary of the Credit.(Article 14k) 10. Non-Documentary Requirements: Under UCP 600, Banks should disregard all nondocumentary requirements. This means that any requirement in the credit that is not specifically part of a required document will be ignored by the bank in determining conformity.(Article-14-g). 11. Complying Presentation - Article 15: Under UCP 500 it was not evident when an issuing or nominated bank had to start the settlement process, but under UCP 600 it is now clear that this begins when the bank determines that a presentation is compliant. 12. Discrepant Documents, Waiver and Notice - Article 16: Under UCP 500 a bank which refuses documents had the option of holding them at the presenter's disposal or handling them in accordance with the presenter's prior instructions, such as to return them. Article 16 in UCP 600 now encompasses additional options designed to avoid banks sitting on discrepant documents and issues relating to forced waivers. The options are as follows: • hold documents pending further instructions from the presenter; or • hold documents until it receives a waiver from the applicant and agrees to accept it, or receives further instructions from the presenter prior to agreeing to accept a waiver; or return the documents; or act in accordance with instructions previously received from the presenter. There is no provision for payment under reserve or indemnity.
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13. Original Documents (Article 17): Article 17 of UCP 600 defines original documents with more precision. An original document will be any of the following: "any document bearing an apparently original signature, mark, stamp, or label of the issuer of the document, unless the document itself indicates that it is not an original. OR any document that appears to be written, typed, perforated or stamped by the document issuer's. OR any document that appears to be on the document issuer's original stationery OR any document that states it is original, unless the statement appears not to apply to the document presented." 14. Transport Documents - Articles 19-24: The requirement that a bill of lading must show that goods are shipped on board a named vessel has been made much simpler which will hopefully lead to less confusion. It is now acceptable that a "Charterer" (or a named agent on behalf of the charterer) can sign a Charter Party Bill of Lading. If an agent signs on behalf of a "Master" on a Charter Party Bill of Lading then the name of the master need not appear from the document. The articles of UCP 500 relating to transport documents have been revised to resolve confusion over the identification of carriers and agents. Under UCP 600 a generic set of rules generally applies to all transport documents (other than charter party bills of lading). These include the following: The document must indicate the name of the carrier and be signed by: (a) the carrier or named agent for or on behalf of the carrier; or (b) the master or named agent for or on behalf of the master. Any signature by the carrier, master or agent must be identified as that of the carrier, master or agent. Any signature of an agent must indicate whether the agent has signed for or on behalf of the carrier for or on behalf of the master There is no need to name the master n the case of charter party bills of lading: These no longer need to indicate the name of the carrier They may now also be signed by the charterer, although it is difficult to envisage a situation where an FOB buyer/ applicant would wish to rely on a bill of lading signed by the seller/ beneficiary and vice versa in the case of a CIF sale. Transport documents also no longer need to bear the clause 'clean' in order to comply with any credits that require a document to be 'clean on board'. 15. Insurance Documents - Article 28: Documents providing for wider coverage than stipulated in a credit will be acceptable. Banks will also be able to accept an insurance document that contains reference to any exclusion clause. For the insurance documents the following has been changed: "Proxies" can now sign on behalf of the insurance company or underwriter. Percentage to be covered will be understood as a "minimum" coverage required. The document may contain reference to any "exclusion clause". The risks must be covered at least between the shipment points stipulated in the credit. 16. Partial Drawings and Partial Shipments - Article 31: The articles contain new interpretation of partial shipments. 17. Force Majeure - Article 36: Despite suggestions for an option to allow a grace period of five banking days after a bank reopens for the presentation of documents, the position remains as it was under UCP 500 - i.e. banks will not honour or negotiate under a credit that expired during the force majeure event.
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Transferahle Credits - Article 38: Article 38 (k) mentions that presentation of documents by or on behalf of a second beneficiary must be made to the transferring bank. The UCP 600 has now seen usage for over two years, and has brought in new clarity in rules and practices, which have helped openers, beneficiaries and all intermediary banks, reduce ambiguity and disputes. 4.6 LIABILITIES, RESPONSIBILITIES AND RIGHTS OF THE PARTIES 1. The Applicant The applicant of the L/C must give complete and precise instructions for issuance of Letter of Credit and any amentiment thereof The LC must not include excessive details or give any reference of credit previously issued, to avoid any confusion or misunderstanding (Article 5). The applicant should indemnify banks against any obligations imposed by foreign laws (Article 18). 2. The Issuing Bank Issuing bank is the party acting on behalf of the applicant and should, therefore, ensure itself about the creditworthiness of the applicant. The issuing bank gives a definite undertaking to make payment in case of sight and accept and pay on maturity in case of acceptance or deferred payment, to authorize bank to negotiate and to reimburse the negotiating bank, provided that the stipulated documents are presented under the Letter of Credit (Articles 2,9). The LC or amentiment issued must be precise and there should be no ambiguity in the instructions and details mentioned in the LC (Articles 5, 20, 21). It is the responsibility of the issuing bank to examine the documents with a reasonable care and determine by international standards whether the documents appear on face, to be complying the terms of the credit. If it wishes to refuse the documents, it should do so in a reasonable time, i.e. within five banking days following the date of receipt of documents (Article 16). The issuing bank, solely on its own judgement, can approach the applicant for waiver of discrepancy. The discrepancies pointed out should also be reported to the bank, from which the documents were received, by expeditious means. The notice must state as to documents are being held pending further instructions from the negotiating bank or being returned (Article 16). 3. Advising Bank The advising bank has option to choose as to whether it wishes to advise a LC or not. If it agrees to advise the LC, then h must do so by taking reasonable care in checking the authenticity of the credit. In case, it decides not to advise a LC, then it must inform the issuing bank immediately. If the advising bank is unable to establish the authenticity of LC then it must immediately inform the issuing bank and must also inform the beneficiary about the same (Article 9). 4. Confirming Bank A confirming bank gives a definite undertaking in addition to that of issuing bank, at the request of the issuing bank, to make payment on presentation of documents as per the terms and conditions of the LC. The confirming bank, advising bank and nominated bank can be the same. In case, it does not agree to add its confirmation, it must inform the issuing bank without delay. It may also choose to advise amentiments without adding its confirmation, however, intimation must be sent to the issuing bank and the beneficiary (Article 8). 5. Negotiating Bank It is the responsibility of the negotiating bank or nominated bank to examine the documents as per UCP or international Standard Banking Practice (ISBP), and take a decision to negotiate the
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documents, only if they appear on their face to be in compliance with the terms and conditions of the LC (Articles 12, 14). 6. Reimbursing Bank Article 13 deals with Bank-to-Bank Reimbursement clause. Reimbursing bank shall reimburse the claiming bank, the amount of claim lodged, subject to the condition that it has received reimbursement authorisation from the issuing bank and having accepted the same. The reimbursements and all the parties concerned are bound by Uniform Rules for Bank-to-Bank Reimbursements (URR-525) as discussed later in this chapter. 7. Beneficiary The beneficiary of the LC also has various rights and responsibilities under Letter of Credit transactions. A beneficiary can in no case avail himself of the contractual relationship existing between the banks or between the applicant and the issuing bank (Article 4). 8. Protection to Banks Banks do not assume any responsibility for genuineness of the documents submitted or any discrimination in the contents mentioned in the documents (Article 34). Banks are not responsible for any loss arising due to delay in transmission or loss of messages, documents, or telecommunication. No responsibility is taken by the banks for errors in translation/interpretation of technical terms (Article 35). Banks also do not take responsibility for any loss arising due to close of their business by the acts of god, commotions, civil riots, floods or any other causes beyond their control (Article 36). Banks do not take any responsibility for the acts of the correspondent banks, whether the bank was chosen by the applicant or by itself The applicant is liable to pay the charges, if the charges were on account of the third party and could not be collected. Further, the applicant is liable for any acts done or losses occurred due to foreign laws (Article 37).
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Check Your Progress (B) 1. State whether the following statements are True or False. (a) The issuing bank generally advises LC through advising Bank. true (b) The reimbursing bank negotiates the documents and pays to the beneficiary. false (c) The applicant has no obligation to indemnify banks against any obligations imposed by foreign laws. false (d) If the advising bank is unable to establish the authenticity of LC and then it must immediately inform the issuing bank. true (e) The applicant is liable for any acts done or losses occurred due to foreign laws. true 2. Fill in the blanks. (a) (b) (c) (d) (e) It is the responsibility of the bank to examine the documents, before making payment. In case the advising bank does not advise the LC, it must inform of its decision to the bank immediately. The advising bank must ensure the ____of LC before advising the same to the beneficiary. In case the reimbursing bank does not pay to the negotiating bank, the ultimate liability lies with the bank. As per UCPDC 600, the issuing bank has documents drawn under the LC. banking days to accept or refuse the 4.7 DOCUMENTS UNDER LC - SCRUTINY, CRYSTALLISATION, FOLLOW- UP FOR BILLS UNDER LC AND SAFEGUARDS FOR BANKS 1. Documents under LC and Scrutiny of Documents Documents are basic requirement of any trade and it evidences the carrying and completing of any trade transaction, whether the transaction is local or international. In fact, documents have a more important place in the international trade, since interest of buyer, seller, buyer's country's requirements as well as seller's country's requirements are to be fulfilled. Similarly, scrutiny of documents presented under an LC is a very crucial and sensitive issue. Since the decision of payment or acceptance of liability for payment, by the issuing bank or conforming bank, solely depends upon the documents under the. Letter of Credit subject to conformity and terms of conditions of the L/C, the person scrutinising the documents has to be extra vigilant and give full attention to the job. The documents should be scrutinized from the point of articles of UCPDC as well as the terms and conditions mentioned in the Letter of Credit and then decide whether the documents appear on face to be consistent with the requirement of LC, UCPDC and other laws of the land. The person scrutinising the documents should be well-conversant the exchange control guidelines
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and articles governing the UCPDC besides having knowledge of Trade Regulations prevailing in the country. Let us now see some specific requirements of some of the important documents called for under the Letter of Credit. Bills of Exchange Bills of exchange, being one of the most important financial documents, is drawn by the beneficiary on the LC issuing bank. It envisages the issuing bank to make the payment immediately, if it is drawn at sight and accept and pay on due date, if it is drawn on acceptance basis. It should, in normal due course, satisfy the following requirements: (i) It should be drawn by the beneficiary on the issuing bank and payable at tenor mentioned in the Letter of Credit. (ii) It should indicate the number of Letter of Credit along with issuing bank's name, under which it is drawn. (iii)It should, unless and otherwise specified, be drawn in the currency of Letter of Credit and should not exceed the amount of Letter of Credit. (iv) Any corrections should be duly authenticated. Invoice An invoice is a commercial document and is a basic necessity of trade documents. It is prepared by the beneficiary giving details of goods, quantity and value in unit terms, weight and total value of goods. Following specific points should be kept in mind, while preparing or examining the invoice: (i) It should be made out by the seller/beneficiary, as stipulated in the Letter of Credit. It should, unless and otherwise specified in the Letter of Credit, be made out in the name of the applicant/openers of the LC. (ii) Description of goods must correspond with the description of goods given in the LC. Invoice must indicate the order number/contract number/proforma invoice number and number of LC along with issuing bank's name. The invoice value should not, invariably, exceed the LC value. (iii) Terms of sale contract, such as FOB, C&F, CIF, etc., should be indicated in the invoice. Other particulars like Bill of Lading number, shipping marks, import license number (if any), gross weight, net weight, packing details, etc., should also be mentioned in the invoice. If invoice is issued for an amount in excess of the amount permitted by credit (when not specifically prohibited by terms of LC), as per Article 18 b of UCPDC, the drawing should not exceed the amount of credit. Bill of Lading Bill of lading is a transport document evidencing movement of goods from the port of acceptance to port of destination. It is a receipt issued by the ship owner or its authorized agent, stating that the goods indicated therein (quantity, quality, description, etc.) are shipped on specific date and through specific vessel and deliverable to the person mentioned therein as the consignee or to his order, after payment of all dues to the shipping company. (i) The bill of lading should be in sets with the number of non-negotiable copies, as stipulated in the Letter of Credit. (ii) It should bear the signature of the ship owner or its authorised agent. (iii)The description of goods should correspond with the requirements in terms of Letter of Credit and as mentioned in the invoice. (iv) Bill of lading should bear the Letter of Credit number along with the name of the issuing bank.
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(v) Payment of freight should be clearly indicated in the Bill of Lading, as per the requirement of the Letter of Credit. (vi) The Letter of Credit should call for "shipped on board" Bill of Lading, and accordingly, the BL should bear such clause. (vii) It should be drawn to the order of the shipper, blank endorsed or in favour of the issuing bank, as stipulated in the Letter of Credit. (viii) The date of shipment should be within the date stipulated in the Letter of Credit. (ix) Partial shipments or trans-shipment, if permitted in the Letter of credit should be clearly indicated in the Bill of Lading. (x) The gross weight, net weight should be as indicated in the invoice. (xi) The BL should not generally be dated prior to the date of issuance of LC, unless specifically provided therein. (xii) The BL should not be claused, unless specified permitted under the LC. Insurance Policy/Certificate It must be issued and signed by the insurance company or their agents. (Article 34a) It should not be issued by the broker. (Article 34b) The date of issuance of insurance must be on or before the date of shipment or it must be endorsed by specific notation that the cover is effecfive from the date of shipment. (Article 34c) The currency of issuance must be same as the currency of LC. [Article 34f(i)] Unless otherwise specified, it should be issued for an amount of 110% of CIF/CIP value of goods. (Article 34f(ii)) The policy should clearly indicate the voyage it is covering, i.e., the port of shipment, port of destination and should also mention the point of termination of insurance coverage. Claims should be made payable in the country of applicant. All originals (if issued more than one) must accompany the documents. The policy must be blank endorsed. The description of goods in the insurance policy/certificate should be in conformity with that given in the LC. Certificate of Origin Certificate of origin determines the origin of goods. It must be issued and signed by an independent authority, such as Chamber of Commerce, informing origin of goods, value, invoice number, Bill of Lading number, etc. Details appearing in the certificate of origin must be consistent with other documents. It must be ensured that origin of goods is not from any warfighting country, i.e., consisting of banned hazardous goods. Packing List, Weight List and Other Documents All other documents like packing list, weight list, Phytosanitory Certificate for goods meant for human consumption (eatables), shipping company's certificate, beneficiary's certificate, etc., should be made out as per the terms of the LC. All documents must be consistent with each other 2. Crystallisation of Foreign Currency Liability The issuing bank on receipt of documents drawn under its Letter of Credit, has an obligation to pay immediately, if the documents are drawn at sight or accept and agree to pay on due date, if the documents are drawn on acceptance basis, provided the documents are drawn strictly as per the terms of the LC. In case the documents are drawn at sight, in terms of extant FEDAI guidelines, the issuing bank can hold the documents for a maximum period of 10 days after the receipt of documents at its counter, in foreign currency. In case the bill is not retired or paid by the importer within this period, the issuing bank would crystallise the liability into Indian rupees, on the 10th day, at Bill
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Selling Rate or rate at which forward contract was booked. The crystallisation can be effected earlier than 10th day with a specific written request from the importer/applicant. In case of usance bills, the foreign currency liability would be crystallised on the due date, into Indian rupees. 3. Follow-up of Bills under LC As per the extant guidelines, the foreign currency liability of import bill drawn under LC, is crystallised into Indian rupees on 10th day after receipt of documents at the counters of the issuing bank, in case of sight bills and on due date, in case of usance bills. In case the importer has been sanctioned import loan facility, the rupee liability is debited to the loan account. If not, the issuing bank is required to follow up with the importer, for payment of bill amount, as being done in case of other outstanding and overdue advances. It is not necessary that importer shall retire the bill on the due date for crystallization as he may choose to retire only after receipt of goods. In such cases, the banks would recover interest as prescribed by Reserve Bank of India directives. The bank would recover normal interest from the date of negotiation to date of crystallisation and penal interest thereafter. 4. Evidence of Import by the Importer Authorized dealers, while opening Letter of Credit for their importer clients or effecting payment for imports, shall take an undertaking from the importer that they shall submit exchange control copy of Bill of Entry within the prescribed period. The submission of Bill of Entry, duly approved by the customs ascertains that there is actual import of goods in the country. Authorised dealers, on non-receipt of Bill of Entry within six months from the date of payment, shall follow up with the importer for submission of Bill of Entry and if not submitted within another three months, shall report the same in the BEF statement, being submitted on half yearly basis to Reserve Bank of India.
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5. Safeguards for Banks Every bank has its own internal guidelines for sanctioning Letter of Credit facility to their importer clients. Since the transaction involves overseas payments and movement of goods, Reserve Bank of India has advised banks to have thorough and clear-cut guidelines while sanctioning such facility. The importer clients should be well-versed with, the trade, for which he is importing goods and banks are required to follow due diligence and 'Know Your Customer' guidelines meticulously. Banks should be extra cautious while handling large value transactions, where the transactions are offered 100% cash margin or where there is sudden spurt in the business volume of the importer. Banks should ensure to obtain creditworthiness report on the overseas seller, from a reputed credit agency. The dealing staff should be well-versed with the existing exchange control guidelines and scrutinise the documents received under Letter of Credit properly and with due care. The clauses incorporated in the Letter of Credit should correlate with trade control requirements, internal guidelines, etc., and seek necessary approvals from the competent authority, whenever the transactions are received beyond the delegated powers. There should be strict follow up for submission of Exchange Control copy of Bill of Entry, to ensure that goods have arrived into the country. In the case of Sight Bills, if the importer does not come forward to retire the documents, measures should be initiated to take possession of the goods and ensure insurance as well. Banks should be more vigilant and cautious, while sanctioning usance LC facility. The facility should be sanctioned for reputed and well-known clients and adequate security should be ensured, since the goods are delivered on acceptance basis. The banks should make proper follow-up of bills not retired and rupee liability is outstanding. 4.8 RISKS RELATING TO LETTER OF CREDIT TRANSACTIONS Letter of Credit is considered to be the most convenient mode of settlement of payment in international trade. The mode secures the payment for the opener/seller, as the payment is received from the negotiating/ paying bank on tendering of the documents evidencing shipment of goods, and other documents called for under the LC, while the buyer/beneficiary is secured, as the payment will be made only after receipt of documents conforming to the terms and conditions of the Letter of Credit (i.e., shipment taking place). However, like every other trade transaction, this mode of international trade also has certain inherent risks. The risks involved mostly are rejection of documents due to discrepancies, law of land mling over the UCPDC, embargoes, currency restrictions, etc. There have been instances, where the payments under the Letter of Credit was stopped, even after acceptance of documents by the bank, through stay orders from court of law, non-acceptance of documents till the arrival of goods, raising disputes for the quality of goods, even after accepting the documents and taking possession of goods and taking the matter to court, etc. Such instances have raised a question on the safety of LC transactions. However, Letter of Credit continues to be favourable mode for settling trade transactions. Banks should, therefore, open Letter of Credit on behalf of their regular customer only and ensure that he is well-versed with the trade. The bills of Lading should be called for in the name of the bank indicating the name and address of the importer Letter of credit should not be opened for import of goods, which are in the restricted item list and wherever the item is licenced, Exchange Control copy of the licence in favour of the importer should be obtained before opening the LC.
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All precautions applicable to fund-based limits should be applied while sanctioning Letter of Credit (non-funded) facility. In case, the importer is offering adequate cash margin covering the transaction, still enquiry regarding trade activities and his actual requirements should be made. A satisfactory report on the overseas seller should be called and kept on records. Banks should ensure that importers hedge their large value transactions by booking forward contract, thereby minimising the exchange risk. The buyer, before entering into trade relation should enquire about the creditworthiness of the overseas seller. He should prefer to obtain a satisfactory report on the overseas party from a reputed credit-rating agency. He should ensure to incorporate adequate clause in the Letter of Credit, so that safety of import of goods is assured and the documents are received as per his requirement. He should be well-versed with the Exchange Control requirements of the seller country and the goods being imported are permitted to leave the shores of that country. The seller of the goods is equally concerned about the safety of his payment. He should make sure that documents are prepared strictly as per the terms of the Letter of Credit, leaving no chance for the issuing bank to point out any discrepancy. He should ensure that goods dispached are as per the contract/ requirement of the buyer, particularly where the documents are drawn under usance Letter of Credit. He should also be aware of the related trade control guidelines prevailing in the country of the buyer and also the legal procedures being followed in that country for Letter of Credit transactions, to save himself of any mishaps. Above risks, in no way degrade the reputation enjoyed by the Letter of Credit related trade transactions but as the saying goes 'A bumt child dreads the fire', few instances in the international market, creating bad examples, pave way for the precautions to be taken even while adopting the safest mode of the LC. Check Your Progress (C) Fill in the blanks: 1. Bill of Exchange, if required under the LC, will be drawn by the beneficiary 2. Invoice is a _______document. commercial 3. _______ is a document evidencing shipment of goods by sea. Bill of Lading 4. The insurance must be of _____ % of the invoice value, if not specifically provided in the LC. 110% 5. A tolerance of _______ in amount can be allowed, if the amount of LC indicates about or approximately. 10% 6. In case of________, the foreign currency liability would be crystallised on the due date, into Indian Rupees. usance bills 7. The importer is required to submit _____ , evidencing import of goods into India. Bill of Entry 8. Banks should open Letter of Credit on behalf of their ___ only. regular customers 4.9 STANDBY LETTER OF CREDIT (GUARANTEES) International trade has been dominated by LC transactions, whereby the seller is assured of payment by submitting documents in compliance and conformity with the terms and conditions
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of the letter of credit. Standby Letter of Credit has often been used in situations where there is 'non-performance' or to put it in a layman's word, almost a substitute of guarantee. The usage of standby LC is mostly witnessed in countries like the USA, where guarantees are not used, and standby LC acts as a substitute for guarantee. This type of Letter of Credit is opened by banks in countries, where there is restriction on issuance of guarantees and therefore stand-bys provide a suitable substitute for performance or financial guarantees. The documents required are bare minimum, like proof of delivery of goods, proof of nonperformance or simple claim form. However, until very recently, its usage was very much restricted in India, but, with several measures being adopted to liberalise the trade regulations and simplify procedures for imports, the Reserve Bank of India, has approved to adopt International Standby Practices (ISP- 98), a set of rules, relating to standby LCs, formulated by international Chamber of Commerce in 1998. A such, it is now in order for the authorised dealers to issue stand by LCs, either under ISP-98 or UCPDC-600, as agreed upon mutually by the parties concerned. 1. Usage of Standby LC by Authorized Dealers Banks can establish stand-by LC for the following transactions: As a document of promise in respect of 'non-performance' situation especially as a substitution to the guarantees which Authorized Dealers are permitted to issue under FEMA, 1999, such as issuing a guarantee in respect of any debt, obligation or other liability incurred by: (a) An exporter on account of exports into India (b) Owed to a person resident in India by a person resident outside India for a bona fide trade transaction, duly covered by a counter guarantee of a bank of international repute/resident abroad. (c) Exporters may also opt to receive stand by LC in respect of exports from India. 2. Commercial Standby LC for Import of Goods Banks have been permitted by Reserve Bank of India, to issue standby LCs towards import of goods into India. Since standby LCs covering import of goods are susceptible to certain attendant risks in the absence of evidence of shipment/insurance cover, importers should be advised and explained of the risk factors involved/chances of abuse in acceding to the request for establishment of standby LCs for import of goods into India. The following safeguards may be taken where standby LCs are issued: (a) The facility of issuing commercial standby shall be extended on a selective basis and to the following categories of importers only: (i) Where such standbys are required by applicants, who are independent power producers/ importers of cmde oil and petroleum products. (ii) Special category of importers, viz., Export Houses/Trading Houses/ Star Trading House/Super Star Trading Houses/100% EOUs (iii)Public Sector Units/Public Limited Companies with good track record. (b) Satisfactory credit report on the overseas supplier should be obtained by the issuing bank, prior to issue of Standby LC. (c) Invocation of the Commercial Standby LC by the beneficiary should be supported by proper evidence. The beneficiary of the credit should furnish a declaration to the effect that the claim is made on account of failure of the importer to abide by his contractual obligations. Following documents must also be presented: Copy of invoice Non-negotiable set of documents including a copy of non-negotiable bills of lading/transport document.
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A copy of Lloyds/SGS inspection certificate, wherever provided for, as per the underlying contract. Incorporation of suitable clause to the effect that in the event of such invoice/shipping document has been paid by the authorised dealer earlier, provisions to dishonour the claim quoting the date/manner of earlier payment of such document may be considered. The applicant of a commercial stand by (Indian importer) shall undertake to provide evidence of imports in respect of all payments made under standby (Bill of Entry). Authorized dealer shall follow up evidence of import as provided for under FEMA, in all cases of payments made under such stand-by. 3. Implications of some of the Articles of ISP-98 Before issuing Stand-by LC, the bank as well as the opener/applicant must understand the implications of the clauses of the ISP-98, detailed as under: Article 1.02: ISP-98 Rule supplements the applicable law to the extent not prohibited by that law. Hence, if there is any provision in the rule which conflict with the Indian law, such provision would not be applicable. Article 1.09: Business Day - Business day means a day on which the place of business at which the relevant act is to be performed is regularly open; and Banking Day means a day on which the relevant bank is regularly open at the place at which the relevant act is to be performed. Article 3.13: Expiration Date on Non-Business Day. Article 3.14: Closure on a Business Day and authorisation of another reasonable place for presentation. Article 5.01: Timely Notice of Dishonour - The article provides for timely notice of dishonour as per the provisions contained therein. Articles 10.0 and 10.02 relating to syndication/participation under the standby LC may be taken note of by the banks issuing such standbys under syndication/consortium loan arrangements among authorised dealers. 4.10 UNIFORM RULES FOR BANK-TO-BANK REIMBURSEMENTS (URR-525) Banks, while issuing Letter of Credit, incorporate a clause authorising the negotiating bank to claim reimbursement of the value of documents negotiated. The international Chamber of Commerce has brought out the uniform rules for bank-to-bank reimbursement, set out in ICC Publication No. 525. The responsibilities of issuing bank, claiming bank, reimbursing bank and all other related parties, as incorporated in the Letter of Credit, have been specified in said rules. 1. General Provisions and Definitions A. Application of URR Following standard clause should be incorporated in the reimbursement authorisation by the issuing bank that it sends to reimbursing bank, to bind all the parties concerned. 'This reimbursement authorisation is subject to the Uniform Rules for Bank-to-Bank Reimbursements drawn under Documentary Credits, ICC Publication No. 525.' This means that reimbursing bank is bound by all the rules set up in URR, by accepting reimbursement instructions. The claiming bank is, however, not a party to it and the arrangement of reimbursement is solely between the issuing bank and reimbursing bank. B. Definitions (a) Issuing bank: The bank that has issued the letter of credit and provided reimbursement authorisation. (b) Reimbursing bank: The bank having accepted the reimbursement authorisation instructions from the issuing bank provides reimbursement.
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(c) Claiming bank: The bank that pays and incurs a deferred payment undertaking accept draft(s) or negotiates under a credit and presents a reimbursement claim to the reimbursing bank. (d) Reimbursement authorization: Instructions/authorization, independent of the credit, issued by issuing bank to a reimbursing bank to reimburse the claiming bank. C. Reimbursement Authorizations The reimbursing bank is no way concerned or bound by any provisions incorporated in the Letter of Credit even if any reference has been made in the reimbursement authorisation of any terms and conditions of the Letter of Credit. The reimbursement authorisation is totally a separate transaction from the credit. 2. Liabilities and Responsibilities • The issuing bank is responsible for providing information required to the reimbursing bank under these rules. • The issuing bank must not request a certificate of compliance to be submitted by the claiming bank to reimbursing bank. • The reimbursement authority must not have an expiry date. • The reimbursing bank is not obliged to honour a claim, except its undertaking. • Reimbursement authority must be issued by an authenticated means and no mail confirmation should be sent for such tele-transmission. • Reimbursement authorisation must state that they are subject URR-525 and must contain (a) the credit number, (b) the currency and amount, (c) additional amount payable and tolerance, if any, (d) the name of the claiming bank, and (e) the party responsible for payment of charges - both claiming banks and reimbursing banks. • Reimbursement authorisation must be precise and complete and should not accompany copy of documentary credit. 3. Authorizations, Amentiments and Claims • All reimbursement authorizations and amentiments must be issued in the form of authenticated tele- transmission or signed letter and no mail confirmation should be sent. • All authorizations and amentiments issued must be complete and precise. • The reimbursing bank has every right to accept or reject any amentiments. • Except in cases, where a reimbursement undertaking has been given, the issuing bank can, at any point of time, cancel or amend its reimbursement authorisation, by issuing notice to the reimbursing bank. • An irrevocable reimbursement authorisation cannot be amended or cancelled without the agreement of the reimbursing bank. • The reimbursing bank cannot cancel or amend reimbursement undertaking without agreement with the claiming bank. • The claiming bank must claim reimbursement in the form of tele-transmission unless specifically prohibited by the issuing bank or by signed letter • If a time draft is required to be submitted by the claiming bank, the same must be accompanied by the reimbursement claim. • Reimbursing bank shall have reasonable time, not exceeding three banking days, to process the claims. • In case the reimbursing bank decides not to reimburse the claim, it must inform the claiming bank and the issuing bank by expeditious means (preferably tele-transmission). • The reimbursement claims should not be presented more than 10 days prior to due date, if any, for claiming reimbursement.
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4. Miscellaneous Provisions • All claims for loss of interest, loss of value, due to any exchange rate fluctuations or claim of any charges, or any other loss resulting due to non-fulfilment of obligations by the reimbursing bank, should be settled between the claiming bank and reimbursing bank. • The reimbursing bank's charges should normally be for the account of the issuing bank. In case the charges are to the account of third party, information should be provided by the issuing bank in letter of credit and reimbursement authorisation. • The issuing bank shall be bound by and should indemnify the reimbursing bank against all obligations and responsibilities imposed by foreign laws and usages. • Reimbursing bank assumes no responsibility for the consequences arising due to delay or loss in transit of any message, interruption of their business by the act of god, riots, commotions, insurrections, wars or any other cause beyond their control or by strike or lock out. Check Your Progress (D) 1. Stand-by Letters of Credit are a substitute of ____ . Guarantee 2. Standby LCs are issued by banks as a document of promise in respect of non __ . performance 3. Uniform rules framed by ICC for bank-to-bank reimbursements are set out in the ICC publication URR-525 4. The reimbursing bank is in no way concerned or bound by the provisions incorporated in the Letter of Credit 5. The reimbursement authority must not have an expiry 6. Reimbursement claim must not be presented ______ reimbursement. 10 7. The reimbursing bank charges are normally on account of date. _ days pior to due date for claiming bank. Ans: issuing 4.11 INCOTERMS Parties to contract are not aware of different trade practices in their respective countries which can cause misunderstanding resulting in unnecessary disputes. As such ICC published a set of international rules for the interpretation of trade terms known as "Incoterms" The ICC publication on Incoterms has been updated several times, with latest version being 2000. Incoterms apply to contract of sale but not contract of carriage. They deal only with the relationship between seller and buyer. These can be broadly classified into four categories. Some of the incoterms are: (a) Departure: (i) Ex-works (named place) e.g. Ex-works Jamnagar, or Ex-works Pune. (b) Main Carriage Paid (i) CFR: Cost and Freight (named port of destination) e.g. CFR JNPT, CFR Chennai
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(ii) CIF: Cost, Insurance and Freight (named port of destination) e.g. CIF JNPT, or CIF Chenai port. (iii)CPT: Carriage Paid To (named place of destination) CPT Dubai (iv) CIP: Carriage and Insurance Paid to (named place of destination) CIP Dubai (c) Main Carriage Unpaid (i) FCA: Free Carrier (named place) FCA Mumbai (ii) FAS: Free Alongside Ship (named port of shipment) FAS, Mumbai port (iii)FOB: Free On Board (name port of shipment) FOB , Mangalore (d) Arrival (i) DAF: Delivered At Frontier (named place) DAF, Sharjah (ii) DES: Delivered Ex Ship named port of destination) DES, Sharjah (iii)DEQ: Delivered Ex Quay (named port of destination) DEQ Mumbai (iv) DDU: Delivered Duly Unpaid (named place of destination) DDU Shaijah (v) DDP: Delivered Duty Paid (named place of destination) DDP Sharjah
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Several other Incoterms are in use, which need to be known while transacting foreign trade or handling of trade documents. 4.12 CASE STUDIES Case 1: Credits v/s contracts Article 4, states that a credit by its nature is separate from the sale or other contract on which it is based and banks are in no way concerned with or bound by such contracts. It also states that the issuing bank must discourage any attempt by the applicant to include the details of the contact, proforma invoice, etc, as an integral part of the LC. Further, Article 5 of UCPDC 600, states that banks deal in documents and not in goods and services. Even then, the applicants at times attempt to get the documents refused due to reasons, such as (i) goods not as per proforma invoice (ii) obtain stay /injunction against the opening bank to honour payment of the documents received under LC, due to the reason that the beneficiary has not sent the goods as shown, as mentioned in the contract or as given to understand. Thus there could be a breach in the contract between the buyer and the seller, but the documents under LC could be perfecdy in compliance of the terms of LC, thus making the issuing bank liable to pay / honour. Courts, in many cases, have been putting stays /granting injunctions and stopping issuing banks to pay to the negotiating bank and debiting applicants accounts. While issuing banks' on their own, should not, in connivance or other wise, try to excuse itself from making payments/ honoring the documents, with such reasons, which link the discrepancies to the sale contracts or the quality of goods, the National courts/ law, being above the UCPDC, they are bound to wait for the stay /injunction to be lifted before making payment to the negotiating banks. The recovery of the amounts of documents from the applicant is altogether a separate issue, as it is a matter of taking credit risk by the opening bank on the applicant. Thus, recovery of amount from the applicant must also not be linked to the honoring of payment to the negotiating bank. Case 2. Case of Date of documents Bank A issues LC dated 1.10.2009, in favour of a beneficiary in UK. The last date of shipment as per LC is 15.10.2009 and last date of negotiation 31.10.2009. The beneficiary presents documents to Bank B, for negotiation on 05.10.2009, with documents evidencing shipment of goods on 30.09.2009, which sends the documents to the opening bank, asking to reimburse as per LC terms. The opening bank, on receipt of documents notices that, the shipment was made on 30.09.2009 and the invoice was dated 2.09.2009, while the inspection certificate, analysis certificate and packing list were dated 25.09.2009 The issuing banic on receipt of documents rejected the documents, notifying discrepancy that documents were dated prior to date of credit. Article 14 i, specifically provides that documents could be dated prior to the date of LC, but should not be dated after the date of presentation. While, the LC is silent about the date of documents, documents presented need to be dated as per LC terms, if so provided in the LC. As such, assuming that the LC did not provide for dates of the documents, the rejection by the opening bank is not as per UCPDC.
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Case 3. Partial Shipments An LC, covering shipment of 1000 cartons consisting of 15000 pieces of shirts, (readymade garments), from Chennai port to Dubai port, provides that partial shipment is not allowed. The beneficiary hands over 500 cartons of Shirts, to the shipping company on 15.7.2009 and another 500 cartoons on 18.7.2009. The Shipping Company issues BL for the first 500 cartons on 17.7.2009 and another BL covering 500 cartoons on 19.7.2009. Both the consignments are to be shipped by a vessel that is due to leave Chennai port on 21.7.2009. Thus the total goods under the LC , i.e. 1000 cartons, are shipped on a single vessel, but with two BLs. The LC issuing bank, on receipt of documents drawn under the LC rejects the documents, stating the shipment is not made under one BL and as such constitutes partial shipment, which is not permitted under the LC. The issuing bank, informs the negotiating bank that goods are held at their disposal and further instructions are awaited. As per article 31 of UCP, a presentation of documents consisting of more than one set of transport documents, covering shipment of goods on the same means of transport and has same journey, will not be considered as partial shipment, even if they indicate different dates of shipment. As such, in the given scenario, the rejection of documents by the LC opening bank is not correct as per the Article 31 of UCP, and the bank must pay /honour the documents. Case 4. Notice of Dishonor The LC issuing bank on receipt of documents on 15.9.2009 (Tuesday) took two days to examine the same and referred the documents to the applicants for their acceptance on 17.9.2009 (Thursday). The applicants came up with a discrepancy in documents, on 22.9.2009 (Tuesday) evening, stating that the documents need to be rejected as the BL was not stamped with "On board" stamp and initialed by the shipping company. The issuing bank sent a Swift message of rejection to the negotiating bank on 23.9.2009. On receipt of Swift message from the issuing bank, informing rejection of documents and discrepancy, as informed by the applicant, the negotiating bank referred the matter back to the opening bank stating
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that the message of refusal and notification of discrepancy was not received within the time period of 5 working days, and as such claimed to be reimbursed as per LC terms. Article 16 d of UCP states that the notice of refusal and discrepancy must be given latest by the closing hours of the 5 th working day from the date of presentation. In the instant case, the opening bank was correct in sending the swift message on 23.9.2009, which was S''' working day, subsequent to the date of receipt of documents. Since, 19'^ and were Saturday and Sunday and 21.9.2009, being a holiday in India, on account of Ramadan ID, the opening bank was right in sending the notice of refusal / discrepancy on 23.9.2009, which was in compliance with the meaning of the said article. CASE 5. Insurance An LC calls for insurance from ware house to warehouse, and insurance to cover 110% of the invoice value. Bank A negotiates and forwards documents, covering invoice for USD 17920.00 under a Multi model transport document (Combined Bill of Lading) dated 15.9.2009. to the opening bank, under the said LC. The insurance enclosed to the documents is for USD 20,000.00 and is dated 17.9.2009. As per the Article 28 of UCP, the insurance must indicate the amount of insurance. It should be at least 110% , of the invoice value if the LC is silent on this requirement and must not be dated prior to the date of transport document. In the given scenario, the insurance is dated after the date of multimodal transport document, which should be covering the voyage of goods from the godown of the seller, and is more than the given percentage for insurance coverage, i.e. more tan 110%. Banks would normally accept some difference in insurance coverage which could be due to rounding off of the values/cover amount, but still can be used as a discrepancy to refuse the documents. However, a document dated after the date of shipping document, is clearly a discrepancy, and requires specific approval from the applicant.. Let Us Sum Up With the growing cross-border trade, the volume of international trade under Letter of Credit has increased manifold. This growth has been possible due to UCPDC specifying detailed guidelines on commonly used practices and customs, thereby increasing the comfort to the exporters and importers and eliminating the chances of disputes between the parties. The responsibilities and the rights bestowed upon the parties to the LC make the transaction safer and provide comfort to all concerned. Although the most commonly used LC is irrevocable LC, the various types detailed above are also in vogue considering the nature of transaction and the need of the parties. The importance of ISP and the URR also needs to be understood properly, as they play a very important role in explaining the uniform practices and procedures to be followed while handling Stand-by LCs and reimbursements. LC transactions are at times risky, but a proper and careful handling of the documents, and the transactions, have lead to the growth of faith in the product across the globe for several years now. Keywords
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Advising Bank: The bank through which, the issuing bank arranges to advise the Letter of Credit the beneficiary. Applicant: The party on whose behalf the Letter of Credit is opened. Confirmation: Responsibility taken by a bank on behalf of the LC issuing bank to make payment against presentation of credit conformed documents. Issuing bank: The bank that issues Letter of Credit on behalf of the applicant and issues reimbursement authorisation. Letter of Credit: A mode of payment in international trade, where LC issuing bank, on behalf of the applicant undertakes to make payment to the bank, having negotiated the documents, on presentation of documents as per the terms of the Letter of Credit. Back-to-back LC: An LC issued on the backing of another LC, mostly local LC opened for procurement of goods locally, based on export LC. Bill of Exchange: A document drawn by the supplier (creditor) on the buyer or LC opener/opening bank, as the case may be, claiming the amount to be paid under the bill/LC. Bill of Lading: A transport document, evidencing movement of goods by sea. Crystallisation: Conversion of the foreign currency bill in to home currency liability. Standby letter of credit: An LC issued in lieu of guarantees, as a document of promise in respect of nonperformance. Answers to Check Your Progress A. 1. opening; 2. undertaking; 3. applicant; 4. UCPDC; 5. revocable; 6. Red clause; 7. transferable; 8. Back-to-back LC. B. 1. (a) True; (b) False; (c) False; (d) True; (e) True; 2. (a) Negotiating; (b) Opening; (c ) Authenticity; (d) opening, (e) five C. 1. beneficiary, 2. commercial; 3. Bill of Lading; 4 110%; 5. 10% 6. usance bills; 7. Bill of Entry; 8. regular customers. D. 1. guarantees; 2. performance; 3. URR-525; 4. Letter of Credit; 5. expiry; 6. 10; 7. issuing. Terminal Questions 1. Mark which statement is correct: (i) (a) The LC must have an applicant and a beneficiary. (b) The LC must have an advising bank and a confirming bank. (c) The negotiating bank is not responsible to examine the documents. (d) The advising bank has no option decide whether it wants to advice the LC or not.
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H (ii) (a) Irrevocable LC cannot be revoked or cancelled , but can be amended without the concurrence of the parties concerned. (b) Red clause LC is called so because it is all over printed in RED letters. (c) Confirmed LC is confirmed by a bank , usually in the country of the exporter, for giving additional comfort to the exporter (d) Transferable LC can be further transferred by the first, second , third , even without specific mention in the original LC. (iii)Back to Back LC is (a) LC opened on the backing of an Export order (b) LC opened on the backing of an Import Order (c) LC opened on the backing of an Export LC (d) LC opened on the backing of an Import LC.. (iv) UCPDC 600 IS (a) Set of rules applicable to CC transactions (b) Set of mle having 500 articles. (c) Set of rules framed by ICC governing LC business globally . (d) Set of universally applicable rules governing LC business in India only. (vi) ICC is: (a) The issuer of the LC under UCPDC (b) The trade body governing the UCPDC rules (c) A Trade body for Indian exporters helping to increase exports (d) The confirming bank, which governs rules for LC drawn under UCPDC. (vi) In an LC transaction, following parties are not involved (a) the exporter (b) the issuing bank (c) the advising bank (d) the opening banks representative office in benificiary's country, who helps source business for the issuing bank. (vii) Bill of entry is required to show that (a) the goods have been exported out of the country. (b) the invoice contains fair price and there is no over/under invoicing (c) the goods have come into the country of import (d) the importer has paid the import bill (viii) The incoterms which confirms that the price of the goods is inclusive of Insurance and Freight upto the port of destination, is called (a) C&F (c) CPT (b) CIF (d) CFI
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References for Further Reading 1. Reserve Bank of India Guidelines for Internal Control for Foreign Exchange Business, Master Circulars, Circulars, issued from time to time. 2. FEMA 1999 3. FEDAI Rule Book and various circulars on the subject. 4. FEDAI Study Booklets for Orientation workshops. 5. Narayan, Sbankar S., Export Finance and Banking Procedures in India. 6. UCPDC-600, ISP-98 and URR-525. 7. All earlier publications of IIBF.
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UNIT 5 Facilities for Exporters and Importers STRUCTURE 5.0 Objective 5.1 Introduction 5.2 Exchange and Trade Control Guidelines for Exporters 5.3 Facilities for Exporters Check Your Progress (A) 5.4 Export Finance 5.5 Exporters Gold Card Scheme 5.6 Forfaiting and Factoring Check Your Progress (B) 5.7 Exchange and Trade Control Guidelines for Importers 5.8 Import Finance 5.9 Trade Credit - Supplier's Credit and Buyer's Credit Check Your Progress (C) 5.10 Case Study on Pre- and Post-Shipment Finance Let Us Sum Up Keywords Answers to Check Your Progress Terminal Questions References for further Reading
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5.0 OBJECTIVE The objective of this unit is to facilitate the understanding of the exchange and trade control guidelines that are applicable to the exporters and importers, as also various Credit and NonCredit facilities available to them. It would cover the types of finance, procedures, as also the other facilities available to them. 5.1 INTRODUCTION In India, Export trade is regulated by the Directorate General of Foreign Trade (DGFT), which functions under the Ministry of commerce and Industries, of Government of India. While the policies and procedures required to be followed for export trade are announced by the DGFT, financing of export trade and facilities granted under FEMA regulations are governed by the RBI regulations/guidelines. Similarly, import trade is also governed by DGFT, with regulations relating to imports and other payments, as provided under FEMA, are governed by RBI regulations. Exchange Control regulations as well as Imports and Exports Trade Control regulations are applicable to all transactions related to international trade. The Reserve Bank of India, with powers delegated under FEMA 1999, regulates the Exchange Control and receipts/payments of foreign exchange part through various guidelines, FEMA amentiments, while the office of the Director General of Foreign Trade (DGFT), regulates the Trade Control part, through the Exim Policy and periodic announcements with a view to expand or control the international business of the country. The Reserve Bank of India also governs the broad parameters of the guidelines in financing of exporters, to make available credit to exporters at international levels of interest rates to enable them to compete in the international markets. Similarly, guidelines and procedural requirements for import of goods, so as to guard the precious foreign exchange reserves on one hand and to expand the base for improved technology and competitive environment, are also covered in the Exim Policy for import of goods and services. The authorized dealer has to ensure compliance of several guidelines including not allowing the banned or restricted items of export/import, without proper approvals. Let us now see what the guidelines and facilities are and how they help the exporters/importers to move towards increasing international trade. 5.2 EXCHANGE AND TRADE CONTROL GUIDELINES FOR EXPORTERS 1. Importer-Exporter Code Number Every person/firm/company engaged in Export-Import trade has to apply for and obtain an importer- exporter Code Number (IEC Number) from the Director General of Foreign Trade (DGFT). This is a registration number of the firm/company for international trade and the exporter/importer has to invariably quote this code number in all declarations/forms, etc., a few of which are explained below: 2. Export Declaration Forms Section 7(1),(3) of FEMA, all export of goods from India, whether in physical form or any other form, requires to be declared in the prescribed forms to the effect that full value of exports will be realized within the prescribed period and in the prescribed manner The prescribed forms are GR, PP, SOFTEX and SDF forms which are used for the purposes noted below: (i) (ii) (iii) (iv) GR Form PP Form SOFTEX Form SDF Form
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Exports made otherwise than by post Exports made by post parcel Export of software in non-physical form. With the introduction of Electronic Data Interchange (EDI) system at certain Customs offices, where shipping bills are processed electronically, the GR form has since been replaced by a declaration in form SDF (Statutory Declaration Form). The SDF form should be submitted in duplicate (to be annexed to the relative shipping bill) to the concerned Commissioner of Customs. After verifying and authenticating the declaration in form SDF, the commissioner of customs will handover to the exporter one copy of the shipping bill marked 'Exchange Control Copy' in which form SDF has been approved for being submitted to the authorized dealer Exemptions Following exports/shipments out of India are exempted from Export Declaration Forms, in terms of Regulation 4 of notification No 23/2000-RB date 3.5.2000 of FEMA: (a) Trade samples of goods and publicity material supplied free of payment. (b) Personal effects of travellers, whether accompanied or unaccompanied. (c) Ship's store, trans-shipment cargo, and goods supplied under orders of Central Government. (d) Goods or software, when accompanied by a declaration by the exporter that they are not more than USD 25,000 in value, (c) Gifts of goods, valuing not over Rs 5,00,000 along with declaration of exporters. (f) Aircraft or aircraft engines and spare parts for overhauling or repairs abroad, subject to conditions. (g) Goods imported free of cost, on re-export basis. (h) Goods not exceeding USD 1000 per transaction, exported to Myanmar, under bilateral trade agreement. (i) Goods sent out of India for testing subject to re-import. (j) Defective goods sent for repairs, subject to re-import. (k) Other exports permitted by RBI, subject to conditions, as specified. (l) Goods permitted by development commissioners of EPZ, Technology parks, SEZ, etc. 3. Prescribed Time Limits A. For Submission of Export Documents The exporter is required to submit the export documents, along with the duplicate/exchange control copy of GR/PP/SDF form within 21 days from the date of shipment to an authorised dealer, for collection, purchase, discount or negotiation, as the case may be. Even in cases of direct shipment of goods, the relative documents are to be submitted to the bankers, within this time limit. B. For Realisation of Export Bills It is obligatory on the part of the exporter that the amount of exports is realized and repatriated into India, within the stipulated time period. While no time period has been prescribed for units in special economic zones (SEZs), Status holder exporters, 100% EOUs, and units set up under EHTPs, STPs and Biotechnology parks, like trading house, export house, etc., are permitted to realize the exports within 12 months. Goods exported to a warehouse established outside India, for sale in other country, on realization of sale proceeds but within 15 months from the date of exports. In all other cases, the maximum time prescribed by Reserve Bank of India for realization of export proceeds is 12 months from date of shipment.
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If the bill is not realised within this time stipulated, the exporter should apply to his AD for extension of time in ETX form. All overdue bills which are not realized within the due date should be followed up vigorously and reported to Reserve Bank of India in a half-yearly statement XOS (To be submitted by each AD branch for June and December each year). 4. Prescribed Method of Payment The payment for export proceeds should be received through the medium of the Authorised Dealers (ADs), in any one of the following manners: (a) Form of bank draft, pay order, etc. (b) Foreign currency notes, travellers' checks from the buyer. (c) Payment out of FCNR, NRE account of the buyer. (d) Through international credit cards, when goods are sold during the overseas visit of the exporter concerned. (e) In Indian rupees, when transaction are with persons resident in Nepal. (f) In the form of gold/silver/platinum by gem and jewellery units situated in SEZs, provided the contract provides for the same. The above payments are to be received through an AD, however in exceptional cases where the track record of the exporter is good, ADs will accept the amount received by exporters direct by cheque, DD, etc. For the purpose of realization of export proceeds, following classification can be made, (a) Countries under Asian Clearing Union (ACU) Export proceeds from any of the ACU countries (Bangladesh, Burma Myanmar, Islamic Republic of Iran, Pakistan, Sri Lanka and Nepal) should be settled in US dollar or ACU EURO, terms through a separate dollar/Euro account maintained by the AD for this purpose. A separate dollar/Euro account is maintained to distinguish ACU transactions separately. For all practical purposes, it will be treated as identical US dollar currency, but for settlement purposes it will be denominated as ACU dollar Trade transactions in Myanmar can be settled in any freely convertible currency, in addition to ACU mechanism. Maldives is also joining the ACU from 1.1.2010. Note: Even though Nepal is also one of the participating countries under ACU mechanism for trade settlement, it is exempted under ACU currency settlement arrangements. (b) Other than ACU Countries (i) Payment in Rupees from the account of a bank situated in any country in this group. (ii) Payment in any permitted currency like US dollars, UK pound. Euro, Yen, etc. 5.3 FACILITIES FOR EXPORTERS - FACILITIES/REMITTANCES CONNECTED WITH EXPORTS (a) Agency Commission on Exports Agency commission can be allowed either by remittance or deduction from invoice value by the ADs subject to the condition that it has been declared in the relative GR/PP/Softex form, and accepted by the customs authorities, and that the relative shipment has already been made. (b) Reduction in Invoice Value Exporters may allow reduction in invoice value, on account of cash discount to overseas buyers, for prepayment of usance bills. The discount can be allowed for the unexpired period at the stipulated rate of interest or a LIBOR of the currency. In other cases, where the export bill has been negotiated or sent for collection, if reduction in invoice value is required to be allowed, ADs can approve the reduction, if satisfied about the
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genuineness of the request, provided (i) the reduction does not exceed 25% of the invoice value, the reduction is not in respect of commodities subject to minimum price restrictions, (floor price) and the exporter should not be in the exporters caution list of RBI. The reduction can be allowed without any percentage restriction, in case the exporter is in the export business for last three years, the track record is satisfactory and the export bills outstanding in the account is not more than 5% of the average annual export turnover of the preceding three calendar years. (c) Claims Against Exports Banks can allow claims against export bills, provided the relative export proceeds have been realized and repatriated to India, and the exporter is not in the caution list of the Reserve Bank of India. (d) Refund of Export Proceeds Refund of export proceeds can be allowed by the AD, through whom the proceeds of the export bill were originally received, provided the exporter has submitted the evidence of re-import of goods into India on account of poor quality, trade dispute, etc. (e) Extension of Time Limit If the export bill is not realized within the prescribed period of six months from date of shipment, for reasons beyond control, the exporter is required to make an application in form ETX to the AD, which has handled the export bill, and seek extension of time limit for realization of export proceeds. The AD is permitted by the Reserve Bank of India, to grant extension of time limit for realization of export proceeds beyond twelve months from the date of export, up to period of six months at a time, irrespective of the invoice value of export, provided the export covered under the invoice is not under the investigation by directorate of Enforcement/CBI, the bank is satisfied that the non realization is beyond the control of the exporter and the exporter undertakes to get the bill realized during the extended period. Any extensions beyond 12 months from the date of export, can be granted by the AD, if the total export outstanding of the exporter should not be more than USD 1.00 million or 10% of the average of export realizations during the preceding three years, which ever is higher. All cases, which do not fall under any of the above categories, and do not comply with the restrictions given above, should be forwarded to the Reserve Bank of India, for prior approval for extension of time limits. Also, cases under investigation by Enforcement Directorate or CBI, or other investigating agencies, would require prior approval of RBI for extension of time limit. All the export bills, remaining un realized beyond six months from the date of export, should be reported in XOS statement to RBI, on half yearly basis. (f) Extension of time and self write off of unrealized export bills All exporters have been allowed to write off outstanding export dues and extend the prescribed period of realisation, provided, the aggregate value of such exports bills written off, (including reduction in invoice value), and bills extend ed for realisation, does not exceed 10 %> of the export proceeds due during the financial year, and that the export bills are to under investigation. (g) Effective Date of Realization In terms of FEDAI rules, the effective date of realization of an export bill is the date of credit in the bank's 'nostro' account in case of Foreign Currency bills, and in case of Rupee bills the effective date of realisation is the date of debit in the 'vostro' account. As such, in case of foreign currency bills, the value date of credit is taken as the date of credit and interest charged up to this date on advance allowed against the particular export bill.
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(h) Foreign Currency Accounts (i) Overseas Foreign Currency Account: The Reserve Bank of India permits exporters to open foreign currency accounts in foreign countries, or in India, to hold export proceeds, for the purpose of making payments for the goods imported. This can be opened to save on exchange fluctuations as also operating cost and time in bringing the proceeds into India and remit back for payment purposes. Participants in international trade fairs/exhibitions have been allowed to open temporary foreign currency accounts, to deposit sale proceeds. The balances in these accounts have to be repatriated to India, within one month from the close of the exhibition/trade fair (ii) Diamond Dollar Account (DDA): Exporters-importers dealing in rough and polished diamonds or diamond-studded jewellery, with a track record, of at least, three years and average export turnover of Rs 5.00 crores, can open Diamond dollar account with an AD, for transacting business in foreign exchange. An exporter can maintain up to 5 DDAs. In October 2009, the eligibility to open a Diamond Dollar account has been revised to track record of two years and average turnover of Rs 3.00 crores. (iii)EEFC Account: Any person resident in India, who is an earner of foreign currency (including Special Economic Zones, Software Technology Parks, Export Processing Zones and status account holders), can open and maintain with an authorised dealer in India, a foreign currency account known as Exchange Earners Foreign Currency Account (EEFC), and can currently credit up to 100% of the inward payments received in foreign currency to this account. These EEFC accounts are in the nature of current account, and are non-interest bearing. Balances in EEFC accounts can be used for any current account transactions, including repayment of packing credit advances, whether availed in Rupee or foreign currency. Check Your Progress (A) Fill in the blanks: (a) Every person/firm or company must have import trade. (b) SOFTEX form is used for export of _ code, issued by DGFT, to engage in exportsoftware (c) The exporter is required to submit the export documents, along with the copy of GR/PP/SDF form within ___ days from the date of shipment to an authorized dealer 21 (d) Export proceeds from any of the ACU countries should be settled in US dollar terms through a separate______ account maintained by the AD for this purpose. ACU dollar (e) The exporter is required to apply in form ____ for permission for extension of time limit for realization of export proceeds. ETX (f) An export unit in SEPZ, can retain __ account with the AD. (g) The effective date of realization of a foreign currency bill will be the account. per cent of the export proceeds in his date of credit to the 5.4 EXPORT FINANCE The Reserve Bank of India has framed specific guidelines for finance to exporters, so as to allow finance at concessional interest rates, to make exporters compete with their competitors from
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other countries, as also to boost the exports from the country. The finance to exporters can be rupee finance, or it can be finance in foreign currency. The Reserve Bank of India has issued broad directives to banks, on the subject of export finance, and banks are free to charge interest rates up to the ceilings prescribed. The RBI also prescribes the manner of charging interest, etc. An exporter may require financial assistance for procurement of goods as also to fund the export bills. Finance allowed to an exporter, to fund the need for procurement of raw material, manufacturing and upto the stage of packing and shipment, is called Pre-Shipment Finance/Loan (PCL). While on the other hand, finance against export bills, when the shipment is already made, is called Post Shipment Credit or Post-Shipment Export Finance (PSEF). The Reserve Bank of India has also permitted banks to allow both Packing credits as well as post- shipment advances to exporters in Indian rupees as also in foreign currencies. Let us see the rules related to rupee advances first, before going to the foreign currency export credit to exporters. Pre-shipment finance can be of two types: 1. Packing Credit (PCL), 2. Advance against Govt, receivables, i.e. Duty Drawback, etc. Post-shipment finance can be of various types, as under: 1. Export bills purchased/discounted/negotiated (FBP/FUBD/FBN) 2. Advance against bills sent on collection 3. Advances against exports on consignment basis 4. Advances against undrawn balances 5. Advances against Duty Drawback 1. Pre-Shipment Finance As given above, pre-shipment finance, generally known as Packing Credit Loan (PCL) or Export Packing Credit (EPC), as is essentially a working capital advance allowed for the specific purpose of procuring/ processing/manufacturing of goods meant for export. It could cover all costs prior to shipment of finished goods, i.e. packing, local transportation, labour charge, etc. For allowing Packing Credit advances it is a pre-requisite that the borrower must have a firm export order or an Export Letter of Credit, and that the loan so allowed must be liquidated out of relative export proceeds. Here, in certain cases, the bank can waive submission of order or LC at the time of availing of advance. While making appraisal of an export credit proposal, banks are supposed to follow the guidelines/rules issued by RBI, DGFT, ECGC, and each bank's internal system for granting advances. Normally, the following broad guidelines need to be ascertained: A. Pre-sanction 1. The borrower is bank's customer 2. He should have Export/Import Code number (IEC) allotted by Director General of Foreign Trade. 3. His name should not appear under the caution list of RBI. 4. He should not be under the Specific Approval list of ECGC. 5. He has the capacity to execute the order within stipulated time and has a genuine and valid export order or Letter of Credit for export of goods. 6. All 'Know Your Customer' guidelines are complied with. 7. The export credit limit should commensurate with the expected turnover as well as cost of inputs.
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8. The total period sanctioned should be as per the manufacturing cycle or the process cycle of the goods being manufactured. Normally, quanturn of finance will be fixed on the FOB value of the contract or the LC or the domestic value of the goods whichever is less after deducting the profit margin. Advance for the freight and insurance charges are not to be disbursed at the initial stage itself If the contract or the LC is on CIF basis, the FOB value will be arrived at by deducting 13% to 14% (representing freight and insurance) from the CIF value, if the dispatch is through sea and around 25% if the dispatch is by air. After arriving at the FOB value, the usual margin, i.e., profit margin stipulated in the terms of sanctions to be deducted. 9. Normally the total period of PCL should not exceed 180 days. Banks can grant extensions beyond 180 days up to 360 days, based on their assessment and need of the customer. Any extension beyond 360 days, would cease to qualify for concessional rate of interest to the exporter, ab initio. 10. The Rate of Interest is linked to the Benchmark Prime Lending Rate (BPLR) of each bank, and is concessional for first 180 days, (maximum PLR minus 2.50%). 11. Banks may adopt a flexible attitude with regard to debt-equity ratio, margin and security norms but there could be no compromise in respect to viability of the proposal and the integrity of the borrower 12. Exporter's credit requirements at pre- and post-shipment stages are to be considered in total. B. Post-sanction 1. No PCL has been availed by him against the same order/LC from any other bank. 2. Bank should call for Credit Report/Status reports on the foreign buyers. 3. The exporter should submit stock statements for the goods on which PCL has been allowed. 4. If the exports are covered under letters of credits, banks would need to be satisfied about the standing of the credit opening bank. 5. Banks may also look into the regulations, the political and financial conditions of the buyer's country. 6. After proper sanctioning of credit limits the disbursing branch should inform ECGC the details of limit sanctioned in the prescribed format within 30 days from the date of sanction. (Wherever advances are covered under Whole Turnover Policies of ECGC.) 7. The advance should be liquidated on submission of relative export bills, by way of allowing post shipment finance against those bills. (Even in case post-shipment limits are not sanctioned, PCL should be liquidated by allowing post-shipment advance to the extant of PCL, by earmarking PCL limit. Once goods have been shipped, we cannot continue with a pre-shipment advance against these goods.) 8. In case after allowing PCL, exports do not take place, the advance is treated as local advance, and interest at domestic penal rates is to be charged. 9. With the recent liberalization and deregulation of various guidelines, banks have been allowed operational flexibility for liquidation of packing credit advances. 10. Existing packing credit may be liquidated with any other export proceeds against which no packing credit has been availed by the exporter. Banks should also ensure that the exporter has not availed any packing credit with any other bank against this export proceeds. C. Special Cases for allowing Packing Credit Advances (a) Packing credits can be allowed to sub-suppliers also at the first stage under the Rupee credit scheme. Packing credit can be granted on the basis of the inland LC opened by a bank at the request of the Export Order holder.
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(b) Banks have been authorized to grant pre-shipment advances for exports of any commodity without insisting on prior lodgement of letters of credit/firm export orders under 'Running Account' facility subject to the following conditions: (i) The facility may be extended, provided the need for 'Running Account' facility has been established by the exporters to the satisfaction of the bank. (ii) The banks may extend the 'Running Account' facility only to those exporters whose track record is good. (iii)In all the cases where pre-shipment Credit Running Account facility has been extended, letters of credit/firm orders should be produced within a reasonable period of time. In the case of commodities covered under Selective Credit Control, banks should insist on production of letters of credit/firm orders within a period of one month from the date of sanction. (iv) In case of PCL allowed for purchase of seeds, for export of de-oiled cake, the proceeds from local sale of oil can be used to liquidate PCL, within a period of 30 days from the date of advance. 2. Post-Shipment Finance Post-shipment finance is essentially an advance against receivables, which is in the form of export documents. It involves handling of export documents, sending it to the foreign bank/buyer and collecting proceeds thereof The responsibility of an AD is increased in the post-shipment part, since the realisation of export proceeds of the export bills is monitored by the Reserve Bank of India. Some of the major exchange control regulations and other aspects concerning export finance at the post-shipment stage are listed below: 1. The exporter should hold valid IEC code and each shipment should accompany the prescribed declaration (GR/PP/SOFTEX/SDF) form in which the value of export has been declared and duly certified by the customs authority. 2. The shipping documents along with relative GR form must be submitted to an AD within 21 days from the date of shipment. If there is any genuine delay beyond the control of the exporter, AD has been delegated with powers to condone the delay and accept the shipping documents even after 21 days from the date of shipment. 3. In case of rupee finance, the bill is to be purchased/discounted/negotiated at appropriate bill buying rate of the bank, keeping in view the tenor or notional due date of the bill. 4. The rate of interest should be within the broad guidelines fixed by RBI, concessional for first 90 days, higher for next 90 days or maximum 180 days from the date of shipment, and still higher beyond 180 days. 5. The payment should be received in an approved manner within the prescribed time limit, i.e., usually within six months from the date of shipment. However, RBI has now permitted certain categories of exporters to realize the proceeds within 360 days also. Let us now go through different types of post-shipment finances: A) Export bills purchased/discounted The export bills, representing genuine trade transactions, strictly drawn in terms of the sale contract/live firm contract/order may be discounted or purchased by the banks, against proper sanctioned limits. The bills drawn on sight basis, i.e. Documents against Payment, are purchased and those drawn on usance, i.e. Documents against Acceptance basis, are discounted by the bank. Since the export is not covered under Letter of Credit, risk of non-payment is higher in such documents. The risk is more pronounced in case of documents under acceptance. In order to
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safeguard the interest of the bank and also the exporter, banks may opt for coverage of credit risks through the guarantees/ policies for post-shipment advances, offered by ECGC. The bank will normally be covering the advance under Whole Turnover Post-Shipment Guarantee Scheme. In addition to this guarantee, exporter should be advised to go for a separate buyer-wise policy. By having this additional policy, wider coverage will be available to the exporter in case of any default. Bank should make vigorous follow-up for due dates, and payments for bills purchased/discounted by them. B. Export bills negotiated Negotiation of documents takes place, when export documents, drawn under Letter of Credit, are presented to the bank and financed by the bank. These documents should be scrutinized carefully with the terms and conditions of the LC, before negotiation, since the LC issuing bank undertakes to honour its commitment to pay/accept/reimburse, only. If the beneficiary submits the stipulated documents conforming to terms of LC. Further, as the operation of Letter of Credit is governed by Uniform Customs & Practices for Documentary Credits (2007 Revision) of the International Chamber of Commerce. Brochure No. 600, compliance of the terms of LC and other Articles of UCPDC is a must, to ensure our claim for payment and not give chance to the issuing bank to refuse the reimbursement. The issuing bank has all rights to refuse payment in case of discrepant documents. As such examination of documents, has its own importance, which preceed negotiation of export documents. Some of the discrepancies commonly observed are listed below: 1. Late shipment of goods. 2. Submission of documents after the expiry- of the LC. 3. Late presentation of documents even when the LC is current, (particularly when partial shipments are to be made after gap of time) 4. Excess drawings than LC amount. 5. Shipments made from and shipped to ports other than those stipulated in the LC. 6. Partial shipments/Trans-shipments effected which are not authorised by the LC. 7. Bill of Lading/AWB not properly signed, not properly dated and not properly stamped. Alterations, if any, not properly authenticated. Mostly, 'ON BOARD' stamp not affixed or not authenticate or dated. 8. Presentation of insufficient and/or incomplete set of B/L. 9. Presentation of Claused Bill of Lading/Received for Shipment Bill of Lading/Short Form Bill of Lading - when not permitted in the LC. 10. Variations in the weight in the invoice and the weight list and other documents. 11. Presentations of inconsistent documents, like invoice, packing list, weight list, insurance certificate/ policy, certificate of origin, inspection certificate. Bill of Lading/AWB, which are inconsistent with each other. 12. Inadequate insurance amount. 13. Presentation of insurance documents unsigned, undated, unstamped and drawn in a different currency other than the currency of the LC. 14. Description of goods including charges in the invoice presented, not authorized by LC. 15. Incomplete or incorrect Drafts/Bills of Exchange. 16. Insufficient number of copies of various documents as called for in the LC. 17. Non-submission of certain documents as called for in the LC. 18. Shipping marks in Invoice and Bill of Loading differ.
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19. On Deck shipment, when LC does not specifically pennits it. 20. Charter Partly Bill of Loading submitted. 21. Short shipment. The above discrepancies are commonly-found discrepancies, and more could be listed, based on LC specific conditions. As such, in case of discrepant documents are tendered, the bank should make an effort to get the discrepancies rectified by the exporter. In case of discrepancies, it could either make the payment against a guarantee of the beneficiary, or make the payment under reserve to the beneficiary's banker, or obtain the authority of the LC opening bank to negotiate the documents in spite of the discrepancies noticed therein. Dispatch of export bills under Letter of Credit: If the bills are drawn in conformity with the LC terms and the bank has negotiated the bill, the documents should be dispatched to the LC opening bank without delay. C. Advances against bills sent on collection basis In some cases the bills will be sent on collection basis, either when the export credit limits are fully utilized, or in cases when the bills, drawn under LC, are discrepant or even when, the exporter himself requests for sending the bills on collection basis, in order to delay the realisation in anticipation of the strengthening of the foreign currency. Banks allow advance against these collection bills to an exporter, as rupee finance, without fixing the Foreign Currency liability. Concessive rate of interest can be charged for this advance also up to the transit period in tlie case of DP Bill and transit period + Usance Period + grace period (if any) in the cases of Usance Bills. Beyond this period, the interest rate will be subject to the various rates prescribed as per RBI guidelines by the banks themselves. For computing the eligible transit period (NTP), the period will commence from the date of acceptance of the export documents at the branch for collection. Before extending this facility to the exporter, branch should ensure that they have proper delegated sanctioning powers to allow such facility. In some banks sanctioning of advance against collection bills is not vested with all the sanctioning authorities. D. Advances against exports on consignment basis Goods are exported on consignment basis for approval and sale abroad and remittance of sale proceeds by agent/consignee at the risk of the exporters. Under such type of exports, the sale proceeds are remitted for the part of goods sold, and in case of unsold goods, goods are sent back to the exporter The overseas branch/correspondent of the bank is instructed to deliver the documents to title of goods, to the consignee, against Trust Receipt. Advances granted against the export bill covering goods sent on consignment basis will be liquidated from remittance of the sale proceeds within six months from the date of shipment, conforming to the Exchange Control Regulations. In the case of exports through approved Indian-owned warehouses abroad, the time limit for realization would be 15 months. E. Advances against undrawn balances In certain line of export trade, it is the practice of the exporter to leave a part of the amount unpaid for some time, as undrawn balances, which is settled by the buyer after satisfying himself about the weight, quality, etc., on arrival and inspection or analysis of the goods. Authorized dealers can handle such bills, provided the undrawn balance is in conformity with the normal level of balance left undrawn in the particular line of export trade, subject to a maximum of 10% of the bill export value.
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The exporter should give an undertaking that he would surrender or account for the balance of the proceeds within the period prescribed for realisation. A proper follow-up should be made for the realisation of the undrawn balance. The authorised dealer will retain the duplicate copy of the GR form till such time the full export proceeds are realised. Advance against undrawn balance can be made at a concessive rate of interest for a maximum period of 90 days, with specific margin held for such advances, in view of the likely hood of some part of this undrawn balance usually being deducted for quality claim, reduction in weight, etc. F. Advances against duty drawback In case of certain commodities, particularly engineering items, the domestic cost of production is higher in relation to international prices, due to which the exporters of such commodities are given support from the government, to make them competitive in the overseas market. The Government of India and other agencies provide export incentives under the Export Promotion Scheme. This can only be in the form of refund of excise and customs duty known as Duty Drawback. Banks grant advances to exporters against their entitlements under above category of export incentives, at lower rate of interest for a maximum period of 90 days. These advances are in the nature of unsecured advances, and as such should he allowed along with main export credit facilities (Pre and post-shipment credit). For such advances, after the shipment is made, the exporters lodge the claim supported with relevant documents to the Customs Authorities. The customs will process the claim and disburse the eligible amount. While the claims are processed, which may take time, the exporters avail advance against these claims. The advances are liquidated out of the settlement of claims lodged by the exporters. The bank should ensure that the bank is authorized to receive the claim amount directly from the concerned Government authorities. Other Conditions 1. Period of Finance The concept of Normal Transit Period (NTP) is applicable to all export bills for calculating the due date or the notional due date. The NTP allowed at present is 25 days for all foreign currency export bills. The Notional Due date, as such for demand bills will be 25 days from the date of handling, and that for Usance bills it shall be usance period plus 25 days NTP. Banks allow concessional interest rates on export bills up to the Notional Due Date of the bill, calculated on the basis of the tenor of the bill and the NTP. As such for Demand Bills, Post-Shipment advance is allowed at concessional interest rate for a period up to the Normal Transit Period (NTP) of the bill, while for Usance bills, the advance at concessional rate is allowed for the transit period + usance + grace period if any, but in any case not exceeding 180 days from date of shipment. For example, for a sight bill drawn in USD, submitted to the bank on 1.7.2009, the NTP allowed will be 25 days, and the Notional due date (NDD) of the bill will be 25.7.2009. The advance will be allowed at concessional interest rate for 25 days, after which the bill/advance will be treated as overdue. Similarly in case of a 90 days DA (Usance) bill in GBP, tendered to the bank on 1.7.2009, the NTP will be 25 days and NDD 25 + 90 days, i.e. 23.10.2009., considering that no grace period is allowed(ignoring holidays).
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In case of a fixed due date export bill, where due date is linked to the date of bill of exchange or the Bill of Lading(shipping documents, etc. No Normal Transit Period is allowed, as the actual due date is already available/can be computed beforehand. In such cases, the period of concessional advance will also be calculated likewise. 2. Quanturn of Finance In the case of post-shipment advances, normally no margin is maintained for bills drawn under LCs, however banks tend to keep a small margin of 10%, in order not to finance the profit margins of the exporters. In the case of export bills purchased against contracts/firm orders, some banks prescribe certain amount of margin, ranging from 10% to 25%, depending upon the additional security available, type of bill (DP or DA), past track record of the exporter, value of connection, etc. 3. Crystallization of Overdue Bills All export bills drawn in foreign currency, purchased, discounted or negotiated, enter into the forward foreign currency position of the bank, and the liability of the exporter is to realise the same by the given due date and deliver the foreign currency to the bank. In case of non-realisation of export bill by the given due date, the foreign currency liability of the exporter would continue, till the bill is realized or the liability is converted into the home currency, i.e., Indian rupee in our case, and liability fixed for the exporter As such to restrict the period of this uncertain liability, FEDAI rules provide for crystallization or conversion of exporter's foreign exchange liability into rupee liability on the 30th day from expiry of the normal transit period in case of demand bills and on the 30th day after the notional due date in case of unpaid usance bills at the prevailing TT selling rate. If the 30th day falls on a non-banking day, on the following next-working day, crystallization should be effected. Banks have now been given freedom to decide on the number of days to be allowed for crystallisation of export bills, depending upon the nature of commodity, country of exports and nature of transaction. As such, banks can now allow different period for crystallisation of export bills to customers, depending upon a variety of factors. 4. Export Credit in Foreign Currency With a view to make credit available to exporters at internationally competitive interest rates, banks in India have been permitted to extend export credit in foreign currency to its exporter clients, at LIBOR linked rates, as under: 1. Pre-shipment Credit in Foreign Currency (PCFC) PCFC can be allowed to exporters in foreign currency, as being allowed in INR. The PCFC can be allowed in USD, Pound Sterling, Euro or JP Yen, out of foreign currency balances available with the bank in EEFC, FCNRB, RFC, RFCD accounts, or from borrowings from banks/correspondents abroad, from line of credit arranged for the purpose, as also by generating foreign currency funds from rupee swaps. The PCFC can be allowed initially for a maximum period of 180 days, and further extensions can be considered as in the case of Rupee PCL. The spread for pre-shipment credit in foreign currency is related to international reference rates, such as LIBOR/EURO LIBOR/EURIBOR, and at present, banks are allowed to charge interest not exceeding 2.00% over the benchmark for 180 days. Any period beyond 180 days would attract 2% above the given rate. The amount of PCFC allowed can be utilised for domestic inputs or for imports. In case of domestic inputs, the foreign currency loan is converted into rupee, while in the other case (imports), the amount so disbursed can be remitted directly to the overseas supplier.
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PCFC is to be liquidated by discounting/rediscounting the foreign currency bill, under EBR scheme (details follow). 2. Export Bill Rediscounted Abroad (EBR) EBR scheme is a scheme to finance export bills in foreign currency, and is equivalent to the FBP/FUBD or FBN under Rupee financing. As in the case of PCFC, EBR can be allowed by banks out of own funds or borrowings or generating foreign currency funds from Swaps, as also by arranging Bankers Acceptance Facility (BAF) from overseas banks. EBR can be allowed for a maximum of 180 days, at LIBOR plus 2.00% interest rate, as in the case of PCFC. The proceeds of the bill handled under EBR, so discounted or purchased or negotiated, would go for adjustment of PCFC if any, taken against the particular order or LC. If no PCFC has been taken by the exporter, the foreign currency amount can be converted at prevailing TT buying rate, and rupee amount credited to exporters account. Banks are permitted to allow export credit in foreign currency, out of their foreign currency liabilities (FCNRB, EEFC, RFC, etc. deposits) as also resort to borrowing funds from overseas correspondents, without any ceiling. Banks can also borrow funds from local interbank markets for the purpose. Banks are also allowed to generate foreign currency funds by undertaking Rupee/Foreign currency swaps. 5.5 GOLD CARD STATUS FOR EXPORTERS Based on the indications made by the Government (Ministry of Commerce and Industry), in the Foreign Trade Policy 2003-04 to launch a Gold card scheme for creditworthy exporters with good track record for easy availability of export credit on best terms, the RBI, in consultation with select banks and exporters, has drawn up a gold card scheme, which envisages certain additional benefits based on the record of performance of the exporters. The gold card holder would enjoy simpler and more efficient credit delivery mechanism in recognition of his good track record. The salient features of the scheme are: (i) All creditworthy exporters, including those in small and medium sectors with good track record would be eligible for issue of gold card by individual banks as per the criteria to be laid down. (ii) Gold card under the scheme may be issued to all eligible exporters including those in the small and medium sectors who satisfy the laid down conditions. (iii)Gold card holder exporters, depending on their track record and credit worthiness, will be granted better terms of credit including rates of interest than those extended to other exporters by the banks. (iv) Applications for credit will be processed at norms simpler and under a process faster than for other exporters. (v) Banks would clearly specify the benefits they would be offering to gold card holders. (vi) The scheduled charges and fee-structure in respect of services provided by banks to exporters under the scheme will be relatively lower than those provided to other exporters. (vii) The sanction and renewal of the limits under the scheme will be based on a simplified procedure to be decided by the banks. Taking into account the anticipated export turnover and track record of the exporter the banks may determine need-based finance with a liberal approach.
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(viii) 'In-principle' limits will be sanctioned for a period of 3 years with a provision for automatic renewal subject to fillfilment of the terms and conditions of sanction. (ix) A stand-by limit of not less than 20 per cent of the assessed limit may be additionally made available to facilitate urgent credit needs for executing unexpected/sudden orders. In the case of exporters of seasonal commodities, the peak and off-peak levels may be appropriately specified. (x) In case of unanticipated export orders, norms for inventory may be relaxed, taking into account the size and nature of the export order (xi) Requests from card holders would be processed quickly by banks within 25 days/15 days and 7 days for fresh applications/renewal of limits and ad hoc limits, respectively. (xii) Gold card holders would be given preference in the matter of granting of packing credit in foreign currency. (xiii) Banks would consider waiver of collaterals and exemption from ECGC guarantee schemes on the basis of card holder's creditworthiness and track record. (xiv) The facility of further value addition to their cards through supplementary services like ATM, intemet banking, international debit/credit cards may be decided by the issuing banks. (xv) The applicable rate of interest to be charged under the gold card scheme will not be more than the general rate for export credit in the respective bank and within the ceiling prescribed by RBI. In keeping with the spirit of the scheme banks will endeavour to provide the best rates possible to gold card holders on the basis of their rating and past performance. (xvi) In respect of the gold card holders, the concessive rate of interest on post shipment rupee export credit applicable up to 90 days may be extended for a maximum period up to 365 days. (xvii) Gold card holders, on the basis of their track record of timely realization of export bills, will be considered for issuance of foreign currency credit cards for meeting urgent payment obligations etc. (xviii) Banks may ensure that the PCFC requirements of the gold card holders are met by giving them priority over non-export borrowers with regard to granting loans out of their FCNR (B) funds etc. (xix) Banks will consider granting term loans in foreign currency in deserving cases out of their FCNR (B), RFC etc. funds, (banks may not grant such loans from their overseas borrowings under the 50 per cent window of overseas borrowings.) (xx) The credit to Indian exporters should be at rates of interest not exceeding Libor + 3.50 per cent. Individual banks have framed their own gold card policies, with rebates in interest/other charges and other benefits to gold card holders, as envisaged in the RBI guidelines. 5.6 FACTORING AND FORFAITING Besides the regular financing avenues from banks, the exporters also have access to other avenues of financing which also act as risk management products. Factoring and forfaiting are the two products, which allows the exporters to sell their book debts and raise finance. Let us see how these products work and what benefits accrue to the exporters. 1. Factoring Factoring is defined as a continuing agreement between a financial institution (known as 'Factor') and the business concern (the exporter/seller) selling goods or services to track customers on
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Open Account Basis, whereby the factor purchases the clients' book debts, either with or without recourse to the client and in relation thereto controls the credit extended to the customers and administers the sales ledger. As given above, the purchase of book debts is central to the function of the factoring, while credit control and administration of sales ledger are other services provided by the factor. While factoring has a long history, dating back to several centuries, in India, it was recently introduced in early 90s after recommendation of Kalyanasundaram Committee, set up to examine the feasibility of introduction of factoring in India which were accepted by the Reserve Bank of India. A factor provides different services, which can be described as under: (a) Debt Administration: Managing the sales ledger of the client, saving his administrative cost of book keeping, invoicing, credit control and debt collection. This would also include v/ork of following up for the debt collection. (b) Credit Protection: As professionals, factors, will have the facility for credit intelligence to enable them to assess credit risk and advise their clients accordingly. The database on the individual buyers built up over a period of time, by the factor could be used by the client for a fee. (c) Factor Financing: While in India financing is an essential activity for a factor, in certain countries it may not be an essential service. Generally, a factor will be willing to advance up to 75-80% of the outstanding debts. Factor Mechanics: For factoring operations, the basic need is to have a factoring agreement between the factor and the client. Besides these two parties, the purchaser, who has purchased the goods from the client, is also a party to the factoring deal, which normally evolves on the steps as given below: 1. The client/exporter approaches the factor with requisite details of business, debtors and orders in hand, which he intends to get factored. 2. The factor, (export factor), contacts his counterpart in the country of the importer/buyer, (known as import factor), to assess the creditworthiness of the debtor/buyer, to set limits on him. 3. The export factor, then signs an agreement with his client, detailing terms of services, along with indicative limits on the buyers/importers. 4. The clients submit two copies of the invoices drawn on the buyer/debtors, and get finance up to the extent approved. 5. The export factor sends one copy of the invoice to his counterpart, in the country of the importer, for collection of debt, when due. 6. The import factor, collects the debt, on due date and remits proceeds to the export factor, enabling him to adjust his outstanding. The balance amount is released to the exporter, after adjusting for interest, charges, etc. In case on non-payment by the debtors on due date, the import factor settles the dues, and steps in to the shoes of the client/export factor for recovery of dues from the debtor. Factoring could be done in a variety of systems; 1. Single factor system — where usually the exporter and the importer decide to have a common factor, with offices/branches in both the countries, to speed up the process and reduce costs. 2. Two factor system - where two different factors in two countries are used, both independently rendering services to the exporter and the importer 3. Direct export factoring - in this case, only one factoring company, based in exporters country is engaged, who makes all arrangements, assessment of credit of the debtor, etc., on his own.
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4. Direct import factoring - here only one factor, based in importers country is engaged. He is engaged by the importer to primarily facilitate financing of debts. A dvantages of Factoring (a) Immediate financing up to 75-80% of the invoice value. (b) No need for LC, thus saving costs for the importer (c) Credit check on importers/buyers. (d) Sales ledger maintenance. (e) Credit protection on all approved debtor limits. (f) Advisory services for new areas, countries. 2. Forfaiting Another product for financing of export receivables is Forfaiting. It can be defined as a mechanism for financing by discounting of export receivables, without recourse to the exporter/seller, for a medium term, on a fixed rate basis, for the full value of the contract/invoice. In another words, forfaiting is the purchase by the financer, of medium term export claims on the buyers, without recourse to the exporters. It is a source of finance and not a type of credit insurance, as such no other costs, other than financing costs are involved in the transaction. The financer agrees to finance the transaction on the basis of the standing of the importer, his country risk, and at times, does so on the strength of guarantee of the importer's bank. Since forfaiting generally covers medium-term financing, export of capital goods, projects, etc., made on medium term basis, are eligible for forfaiting. However, there is no restriction for financing of medium term exports only, as such exports of commodities, consumer goods, where exports are normally made for short periods of say up to 12 months are also financed through this route. Mechanism of a Forfaiting Transaction There are five parties to any forfaiting transaction. Other than the exporter, importer and the financer, the banks of the exporter and the importer are also involved. After getting the proposal from the exporter, the forfaiter ascertains the country risk, as also the credit worthiness of the importer. If need be, the importer is advised to get guarantee of his bank for payment of invoices on him. The discount charges for the transaction would depend upon the quality of credit, country risk and the nature of transaction. If the conditions are agreeable to the parties concerned, a contract is signed between the exporter and the forfaiter. Thereafter, the exports are made and bill so raised, discounted by the forfaiter. Forfaiting is done against the bill of exchange or the promissory note, duly accepted by the importer and guaranteed by his bank. This is known, 'availing of the bill of exchange'. The cost charged by the forfaiter, usually covers the commitment fees, discount/financing charges as also documentation fees. The commitment fees usually ranges between 0.50 to 1.50% per annum, on the unutilized portion of the value of contract, and is charged for the period the commitment is given. The commitment fee is non refundable. Discount charges are market-related financing costs, based on LIBOR for the period of credit, plus a margin to cover forfaiters risks. In India, RBI has permitted Exim Bank to facilitate financing of medium-term export bills through Forfaiting. Benefits of Forfaiting to Exporters (a) Takes away political and commercial risks associated with export receivables. (b) Makes available 100% finance against the invoice drawn. (c) Without recourse facility. (d) Freedom from credit administration, and follow-up.
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(e) Cost saving on export credit insurance, besides related paperwork. (f) Fixed rate financing, freedom from movement of interest rates for the tenor of the bill. Check Your Progress (B) Fill in the blanks: (a) Finance allowed to an exporter, to fund the needs procurement of raw material, manufacturing and up to the stage of packing and shipment, is called finance. pre-shipment (b) While considering export credit, it must be ensured that the exporter's name does not appear under the exporter's __ of RBI, and _______ list of ECGC. caution list, specific approval (c) Normally the total period allowed for PCL should not exceed _ days. 180 (d) PCL advance should be liquidated on submission of relative export bills, by way of allowing finance against those bills. post shipment (e) PCL allowed without prior lodgement of order or LC is called account facility. Running (f) Post-shipment finance is essentially an advance against . receivables (g) In case of rupee finance, the bills is to be purchased/discounted/negotiated at appropriate rate. ________ of documents takes place, when export documents, are drawn under Letter of Credit. (i) The NTP allowed at present is generally __ days for all foreign currency export bills. 25 (j) In case of non-realisation of a export bills purchased/discounted, the same should be usually crystalised on the day from the NDD. 30th (k) The present interest cap for PCFC/EBR for 180 days is Libor plus %. 3.50 (m) Guaranteeing payment of a bill of exchange, is called __ . (n) A factor would finance generally ____ % of the invoice value, while forfaiting could be done for ________________________ value of invoice. and are the two other methods of financing exports. 5.7 EXCHANGE AND TRADE CONTROL GUIDELINES FOR IMPORTERS Keeping in view the need to conserve the precious foreign exchange, and to guard the country from scrupulous imports and bogus outward remittances, various export-import regulations and exchange control guidelines have been prescribed from time to time. While the physical movement of goods into India is regulated by Exim Policy formulated by the Director General of Foreign Trade (DGFT), the regulations relating to payment of such imports are governed by Exchange Control Regulations framed on the basis of Foreign Exchange Management Act, 1999 (FEMA 1999). (a) Importer-Exporter Code (lEC): As explained earlier, first and foremost, the importer customer has to have a valid lEC, issued by the office of DGFT. (b) Approved commodity: OGL or Import licenses: While ADs are required to ensure that the goods imported or intended to be imported are as per the current export-import policy, the goods can be under the Open List (OGL), which can be freely imported, or can be imported
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under specific license issued for the purpose by the DGFT. This has to be ensured prior to making import remittance, handling of import bills for collection or opening of letters of credit for import of goods. For this purpose, the ADs should verify the Export-Import Policy Book or the public notices issued by the DGFT. (c) Payments for imports: Any person who wants to make a remittance for imports, exceeding USD 500 or its equivalent, should make an application in form A1 (as prescribed by RBI) to the authorised dealer. This form contains the details of the currency, the total value of imports, commodity, the license number, etc., along with an undertaking by the importer and Authorized Dealer that they will comply with the Exchange Control Regulations. Payment for imports should be to the debit of party's account. The approved method of payment relating to imports is as applicable to receipt in exports like Asian Clearing Union and other group. (d) Time limit for import payment. The remittance against imports should be completed not later than six months from the date of shipment. Any delay beyond this period should be justified by proper explanation from the importer. If the payment is to be made on a deferred payment arrangement (i.e, payment beyond six months and up to a period of three years) it will be treated as Trade Credits. ADs can remit interest on import bills, sight basis as also usance bills, generally up to a period of six months, and up to 3 years in case of trade credits. (c) Advance remittances: ADs may allow remittances of advance payment against imports of goods, to the extent and subject to the following conditions: (i) Up to USD 100,000 or its equivalent, after duly satisfying about the transaction, nature of trade and standing of the supplier, etc. (ii) If the amount of advance remittance exceeds USD 100,000, or its equivalent, an irrevocable standby letter of credit or a guarantee from a bank of international repute situated outside India or a guarantee of a bank in India, if such a guarantee is issued against the counter guarantee of an international bank situated outside India. (iii)The requirement of guarantee may not be insisted upon in case of remittances above USD 100,000 and up to USD 5,000,000, subject to a suitable policy approved by the bank's Board of Directors, to undertake such transactions. (iv) All cases beyond USD 5,000,000 should be referred to RBI, for prior approval. (v) Within the above ceilings, advance remittance may be permitted after verifying the documentary evidence indicating the cost of the goods and the proof of insistence by the overseas supplier on advance payment must be produced by the importer. (vi) The importer holds exchange control copy of a valid import licence for importing goods under reference or the goods not covered under the negative list. (vii) Remittance is made direct to the overseas supplier or his bank, and not to any agent of the supplier. (viii) Physical import into India should be made within six months (three years in case of capital goods) from the date of remittance and the importer should give an undertaking to produce documentary evidence of import within fifteen days from the close of the relevant period. (ix) In case of non-import of goods into India, the AD should ensure that the amount of advance remittance is repatriated to India or is utilized for any other purposes permissible under the extant rules or regulations. F. Evidence of Imports
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To ascertain importation of goods into India, importers are required to produce and submit to the AD who has handled opening of LC or the remittance of import bill, the exchange control copy of the Bill of Entry/Postal appraisal form or Customs assessment certificate, duly approved by customs. Authorized dealers are required to cross check the particulars in the Bill of Entry with the particulars of LC opened/ remittance made for imports. In terms of extant RBI guidelines, an AD has to ensure receipt of Bill of entry in all cases where the value of foreign exchange remitted for import exceeds USD 100,000 or its equivalent, within three months from the date of remittance. In case the Bill of Entry is not submitted within one month another reminder should be sent by registered post with acknowledgement due. If the importer has defaulted in submission of Bill of Entry within 21 days from the date of issue of registered reminder, AD should forward a statement consisting list of such defaulters to RBI on half yearly intervals, in the form of BEF furnishing the details of these import transactions. For the purpose of monitoring receipt of bills of entry, proper records should be marked in the LC Register/Remittance Register. AD should in all cases acknowledge receipt of exchange control copy of Bill of Entry from the importers by issuing acknowledgement slips containing all details of Bill of Entry received by them. The Bill of Entry should be preserved by authorised dealer and made available to Internal Auditors/RBI Inspectors for verification. In case of import through postal service and courier service, postal/courier wrapper must be obtained and preserved. In case of imports by a company listed on a stock exchange, whose net worth is not less than Rs 100 crore as on the date of last balance sheet, ADs may accept either the copy of Bill of Exchange or a certificate from the CEO or the auditor of the company, certifying that the goods for which the remittance was made, have actually been imported into India, provided that the foreign exchange remitted is less than USD 1,000,000 or its equivalent. Banks have been advised to have their own policy, duly approved by their Board of Directors, for follow up of the submission of evidence of import involving amount of USd 100.000 or less. 5.8 IMPORT FINANCE 1. Import Letter of Credit This is the most used method of financing imports. The importer gets LC limits sanctioned from his bank and establishes LC on DA basis (usance), there by getting credit from the overseas supplier on the strength of his banks credibility (LC). At times import LC are also used to generate liquidity, by way of establishing DA LCs for commodities, which can be sold immediately on sight basis, or for cash. We have seen how Letters of credit work, in earlier unit. LC transaction also support Buyers credit and suppliers' credit, being other modes for financing of imports, are discussed later in this unit. 2. Import Loan Such loans are at times granted against imported raw material, or goods meant for trading. The loans can be against pledge of goods or hypothecation to the financing bank. Importers prefer such loans, even at higher rates of interest, to hoard goods and to take benefit of depreciating domestic currency. The financing against imported material/stocks and local stocks is at times differentiated, due to difference in interest rates, surcharge, interest tax laws, etc., which are imposed keeping in view the need for restrictions required for imports and the position of country's forex reserves, where outflows are required to be monitored and checked.
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5.9 TRADE CREDIT - SUPPLIER'S CREDIT AND BUYER'S CREDIT 1. Supplier's Credit Supplier's Credit is credit directly extended by the overseas supplier of goods to the importer. As in domestic markets, in the international markets also, the payment terms are either sight or on credit. The period of credit, normally depends on the necessity for the exporter/seller of the goods to increase sales, the demand of the goods in the market, requirement of the importer and the current market practices. The exporter may avail finance against the bills, after making the shipment, from his banker and the bank would receive funds on the maturity date. However, the exporter shall be liable to repay his bank, in case the overseas buyer does not make payment on due date. In India, the period of supplier's credit is governed in terms of exchange control guidelines issued by Reserve Bank of India. Earlier, importers in India were allowed to avail supplier's credit, for a period of up to six months from the date of shipment, without any approval of Reserve Bank of India. However, supplier's credit availed beyond six months from the date of shipment, was termed as short-term loan, and therefore, required Reserve Bank of India's approval. Subsequently, with the implementation of more and more liberalized steps by the Government, and Reserve Bank of India and also due to comfortable position of country's forex reserves, relaxations were announced for import of goods as well. To facilitate their operations and to make approvals hassle free, the suppliers' credit extended by the overseas supplier, for a period of more than six months from the date of shipment and up to less than three years has been termed as 'Trade Credit'. Any credit extended for three years or more shall be in the category of External Commercial Borrowings (ECB). Banks can now, at their level itself, approve proposals received from their importer clients, for availing supplier's credit for a period beyond six months from the date of shipment, with maturity up to three years, for import of all items pennissible under the Exim Policy, up to USD 20 million per import transaction. Similarly, for import of capital goods, banks can approve proposals for supplier's credit, with maturity up to less than three years, up to USD 20 million per transaction. 2. Buyer's Credit The buyer's credit is credit arranged by the importer (buyer), from a bank/financial institution outside his country, to settle the payment of imports. In short, it is credit arranged by the buyer to settle import payments, irrespective of the period of credit. In this type of credit, the supplier of the goods need not worry about the payment, as the payment is assured by the bank/financial institution, provided he completes his responsibility as per the requirement of the buyer The modus operandi is that, in some cases on one hand the supplier (exporter) is not ready to give any credit (supplier's credit) while the buyer (importer) is also not in a position to make immediate payment. As such, the importer approaches his bank and requests for arrangement of payment to the exporter on immediate terms. The bank, through their own resources, or correspondent relationships, ties up with a foreign bank/financial institution, and after agreeing upon on the pricing/costing, makes arrangement to make payment to the exporter on submission of shipping documents. The importer then repays on the due date. In India, the buyer's credit, as in the case of supplier's credit also, is regulated by exchange control guidelines issued by Reserve Bank of India, from time to time. In terms of earlier guidelines, buyer's credit, irrespective of the period of credit, required Reserve Bank of India's approval. In an era of restricted regulations, efforts were made to restrict imports and thereby
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conserve precious foreign exchange. Accordingly, importers were not freely allowed to raise foreign currency loans and had to approach Reserve Bank of India for necessary approvals. Now in a liberalised era and with the comfortable position of country's foreign exchange reserves. Reserve Bank of India has permitted banks to approve at their level itself, proposals received from their importer clients, for availing buyers' credit for a period with maturity up to one year, for import of all items permissible under the EXIM Policy, up to USD 20 million per import transaction. Similarly, for import of capital goods, banks can approve proposals for buyers' credit, with maturity less than three years for am amount not exceeding USD 20 million per transaction. Interest ceilings: The present ceilings for all in cost, including interest for buyers/suppliers credit, as fixed by RBI is as under: (i) Up to 365 days, LIBOR plus 200 bps (ii) Above one year -upto 3 years LBOR plus 200 bps. Above ceilings are for all in cost, and include management fees, arrangement fees, etc. CHECK YOUR PROGRESS (C) (i) Fill in the blanks: (a) Every Importer must have an code issued by DGFT. Export Import Code (IEC) (b) For making payment of an import bill, the importer has to apply to authorised dealer in form (c) The remittance against imports should be completed not later than the date of shipment six (d) Advance remittance for imports can be allowed up to USD _ 100,000 guarantee of an international Bank. months from , without insisting on In case of advance remittances for commodities, physical imports should be made within months. duly (e) (0 (g) (h) As per RBI guidelines, any credit up to a period of less than three years is called _ credit, while credits for three years and more are called ECB. Trade credit (i) Banks can approve, proposals for availing buyer's credit for a period with maturity up to ___________ , for import of all items permissible under the Exim Policy, up to USD _ million per import transaction. As an evidence of having made the imports, the importer has to submit __ approved by customs, to the AD. ________ credit is credit directly extended by the overseas supplier of goods to the importer. (ii) State whether the following sentences are True or False: (a) The Reserve Bank of India, with powers under Exim policy, regulates the Exchange Control and receipts/payments of foreign exchange. false
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b) Every person/firm/company engaged in Export Import trade has to apply for and obtain an Importer-Exporter Code Number (lEC Number) from the Director General of Foreign Trade true (c) SOFTEX form is used for declaration of Export of software. true d) Trade samples of goods and publicity material supplied free of payment must be declared on the statutory declaration form. false e) Payment of export bills can be received by debit to FCNR, NRE account of the buyer. true f) Exports to Nepal are to be paid through ACU mechanism. false g) Status account holders are allowed to retain 100% of the eligible credits received in EEFC account. true h) Export bill financing is known as PCL. false i) In case after allowing PCL, exports do not take place, the advance is still treated as export credit. false j) At present banks are allowed to charge interest on PCFC, for 180 days at a maximum of LIBOR plus 1.00%. false 5.10 CASE STUDY ON PRE- AND POST-SHIPMENT FINANCE Case: A textile exporter, with estimated export sales of Rs. 300 lacs during the last year and projected sales of Rs.500 lacs for the current year, approaches the bank for granting credit facilities. The bank sanctions following facilities in the account: PCL/FBP/FUBD/FBN . Rs. 100.00 lacs Sub limits: PCL (25 % margin on fob value) Rs. 50.00 lacs FBP (10 % margin on bill amount) Rs. 50.00 lacs FUBD (15 % margin on bill amount) Rs. 50.00 lacs FBN (nil margin) Rs. 100.00 lacs He gets an order for USD 50,000.00 CF, for exports of textiles- dyed/hand printed, to UK, with shipment to be made by 15.9.2009. On 2.6.2009 he approaches the bank for releasing PCL against this order of USD 50,000.00. The bank releases the PCL as per terms of sanction. On 31.8.2009, the exporter submits export documents for USD 48,000.00, against the order for USD 50,000.00. The documents are drawn on 30 days usance (D/A) as per terms of the order The bank discounts the documents at the days applicable rate, adjusts the PCL outstanding and credits the balance to the exporter's account, after recovering interest up to notional due date. Interest on PCL recovered separately. The documents are realized on 29.10.2009, value date 27.10.2009, after deduction of foreign bank charges of USD 250.00. The bank adjusts the outstanding post shipment advance allowed against the bill on 31.8.2009. Bank charges interest at - PCL- 8.50 % upto 180 days, and post shipment at 8.50 % upto 90 days and 10.50 % thereafter. Overdue interest is charged at 14.50%.
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the USD/INR rates were as under: — 2.6.2009: Bill Buying 48.20, bill Selling 48.40. — 31.08.2009: TT buying 47.92, Bill buying 47.85, TT selling 48.08, Bill selling 48.15., premium for 30 days was quoted as 04/06 paise. Now give answers to the following: 1. What is the amount that the bank allows as PCL to the e.xporter against the given export order, considering insurance and freight costs of 12%. (i) Rs. 15,90,600 @ (ii) Rs. 2410000.00 (iii) Rs. 2120,800.00 (iv) Rs. 1815000 2. What exchange rate will the bank apply for purchase of the export bill for USD 48,000.00 tendered by the exporter: (i) 47.89 (ii) 47.85 (iii) 47.91 (iv) 47.96 3. What is the amount of post shipment advance allowed by the bank under FUBD. for the bill submitted by the exporter: (i) Rs.l9,54,728 (ii) Rs 19,52,280 (iii) Rs.19,53,912 (iv) Rs.22,98,720 4. What will be the notional due date of the bill submitted by the exporter: (i) 30.10.2009 (ii) 30.9.2009 (iii) 25.10.2009 (iv) 27.10.2009 5. Total interest on the export bill discounted, will be charged up to; (i) notional due date 25.10.2009 (ii) value date of credit 27.10.2009 (iii) date of realisation 30.10.2009 (iv) date of credit to nostro account 29.10.2009 Ans. 1: USD 50,000.00 @ 48.20 = Rs.. 2410000.00 - less 12% for insurance and freight cost i.e Rs. 289,200 = Rs.21,20,800.00 (fob value of the order. Less margin 25% i.e. Rs.530,200.00 balance Rs 15,90,600.00 Ans. 2: 47.89 - Bill buying rate on 31.8.2008 - 47.85 plus 4 paise premium for 30 days, this being a DA bill. € Ans 3: USD 48,000.00 @ 47.96 =Rs. 23,02,080.00, less 15% margin on DA bill, i.e. Rs. 345312.00 = Rs 19,56,768.00 Ans 4: Bill submitted on 31.8.2009- drawn on 30 days DA plus normal transit period of 25 days 31.8.2009 plus 30 days plus 25 days, i.e. total 55 days from 31.3.2009 i.e. 25.10.2009 Ans 5: Interest is charged up to the date the funds have been credited to the banks nostro account, the effective date of credit is the value date of credit, i.e. 27.10.2009. Let Us Sum Up We have seen that on one hand, the exporters in India are required to comply with several guidelines under FEMA, Exchange control and Trade Control, while on the other hand, they are given several facilities on trade front as also by allowing concessional finance. The importers are also required to comply with import trade control and RBI guidelines, but that is required considering the country's policy to gradually open up on trade front, due to low reserves all these years. Various concessions and freedom, now available to any Indian exporter or importer, have resulted in growth of country's international trade during last few years. The fi-eedom allowed
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under the policy of Trade Credit, has also helped the Indian businessman to grow his business, by getting cheaper credit facilities from overseas markets. Keywords lEC code: A code number must for all persons/firms/companies engaged in export import trade, issued by the office of DGFT Softex form: An export declaration form used for export of software in non-physical form. EEFC Accounts: A foreign currency account, which can be opened and maintained by any exchange earner, an individual, firm or corporate. PCL: An advance allowed for procurement of goods, manufacturing and shipment of good for export purposes. PSEF: Advance against export bills. NTP: Notional Transit Period allowed to each bill, for calculation of notional due date. Crystallisation of export bill: Conversion of foreign currency liability of an export billon the 30th day from due date, in case of non-payment. PCFC: Packing credit allowed in foreign currency. EBRD: Post shipment finance in foreign currency. Factoring: Financing and maintenance of book debts by another party. Forfaiting: Financing of export bills on non-recourse basis. Buyer's credit: Credit arranged by buyer/importer to finance the transaction. Supplier's credit: Credit arranged by the supplier/exporter for financing the transaction. Bill of entry: A document, certified by customs authorities, evidencing import of goods. Answers to Check Your Progress A. (a) lEC; (b) Software; (c) 21; (d) ACU dollar; (e) ETX, (f) 100, EEFC; (g) Value, nostro. B. (a) pre-shipment; (b) caution list, specific approval; (c) 180; (d) post shipment; (e) Running; (f) receivables; (g) bill buying; (h) negotiation; (i)25; (j) 30th, (k) 3.50; (1) Factoring, forfaiting; (m) availing; (n) 75-80%, ftill. C. (i) (a) lEC; (b) Al; (c) six, (d) 100,000; (e) six; (f) bill of entry; (g) suppliers; (h) Trade, (i) One year, 20. (ii) (a) False; (b) True; (c ) True; (d) False; (e) True; (f) False; (g) True; (h) False; (I) False; (j) False Terminal Questions 1. lEC number is required for: (a) Import of capital goods. (b) Filing of bill of entry with customs. (c) Uundertaking any export or import transaction (d) Receiving gift from relatives abroad. 2. Banks cannot allow export credit for: (a) Supplies to special economic zones established within the country. (b) Supplies to merchant exporters, where the payment is received in rupees from the bankers of the exporters. (c) Supplies to oil mills for export of oil cake, where a large part of packing credit is adjusted by sale of oil in the local markets (d) Supplies to a manufacturer in india, who makes import substitute spare for machineries. 3. An export to a State Electricity Board, covering supply of Transmission towers, under a World Bank financed Project, will be called exports (a) Global (b) Merchant
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(c) Deemed (d) Sub-supplier 4. Export credit in foreign currency can be presently allowed to exporters in India at a maximum interest rate of (a) Libor plus 200 bps. (c) Libor plus 350 bps. (b) BPLR-250bps. (d) BPLR plus 100 bps. 5. 6. 7. Packing Credit Loan (PCL) (a) Is allowed against export bills on consignment basis. (b) Can be allowed to local manufacturer for supply of goods for exports. (c) Is another mode of financing imports. (d) Can be allowed in local currency only. An Authorised dealer bank/branch, needs to submit to Reserve Bank of India, statement on half yearly basis, showing details of import bills, where evidence of imports has not been submitted within the stipulated time: (a) XOS (b) BEF EEFC accounts can be maintained: (c) ETX (d) STAT 8 (a) By individuals receiving grants in Rupees from abroad, under FCRA. (b) By companies going in for External Commercial Borrowings. (c) By companies having imports of goods for domestic consumption.. (d) By receivers of inward remittance by way of export proceeds. 8. A financing arrangement, where the transaction is financed by a financial institutions in the exporter's country or any third country, based on the arrangements made by the importer or his bank, is called: (a) A transaction under Documentary Credit (b) A transaction of Supplier's Credit (c) A transaction of Buyer's Credit (d) A transaction finance through Factoring 9. As per extant FEDAI guidelines, crystallization of export bills purchased/discounted, is to be done as under: (a) On the 10th day after due date of the bill (b) On the 20 th day from the date of handling of the bill. (c) On the 45 th day from the due date (d) As prescribed by each bank or as per the arrangement between the bank and the customers. 10. Factoring is defined as: (a) Agreement between the exporter and importer to factor the price of shipping goods into the export invoice. (b) Agreement between the financial institution and the importer to manage the Credit portfolio of the exporter (c) Agreement between the financial institution and the exporter for purchase of the later's book debts and control the credit extended to the importers.
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(d) Agreement between the exporter's Bank and the importer's bank for discounting of export receivables without recourse. References for Further Reading 1. Reserve Bank of India Guidelines for Internal Control for Foreign Exchange Business, Master Circulars, Circulars, issued from time to time. 2. FEMA 1999. 3. FEDAI Rule Book and various circulars on the subject. 4. FEDAI Study Booklets for Orientation workshops. 5. Sbankar Narayan S., Export Finance and Banking Procedures in India. 6. UCPDC 600, ISP 98 and URR 525. 7. All earlier publications of IIBF.
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UNIT 6 Risks in Foreign Trade Role of ECGC STRUCTURE 6.0 Objectives 6.1 Introduction 6.2 Definition of Risk and Risks in international Trade 6.3 Country Risk Check Your Progress (A) 6.4 Export Credit Insurance in international Trade 6.5 ECGC of India Role and Products 6.6 ECGC Policies 6.7 Financial Guarantees 6.9 Other Special Guarantees and Schemes Check Your Progress (B) Let Us Sum Up Keywords Answers to Check Your Progress Terminal Questions References and Books for Further Reading
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6.0 OBJECTIVES The objective of this unit is to make readers understand: • What is risk and various risks in international trade. • Management of these risks and various guidelines related to risk management. • Role and products of ECGC of India and how it supports exports financing to help increase exports from the country. 6.1 INTRODUCTION We have seen in the earlier unit that any activity you indulge in is associated with uncertainty which may result in some loss or some gain. The arena of international trade is also not free from such uncertainties or In the international trade buyer risk, seller risk, shipping risk, etc., need to be kept in view and managed effectively. Risks needs to be accepted and managed effectively and efficiently to minimize the adverse effect and maximize the profit/goals of the organization. International Trade is largely dependent of financing by banks; as such countries have developed export credit guarantee corporations to take care of credit risks of the export financing institutions. In India, this role is played by ECGC of India Ltd. Various policies offered by ECGC; to financing banks and exporters help insure export finance and exporters' money, which can lead to growth of exports for the country. Now, let us go in detail and study the risks in the international trade and the role of ECGC and its products. 6.2 DEFINITION OF RISK AND RISKS IN INTERNATIONAL TRADE A risk can be defined as an unplanned event with financial consequences resulting in loss or reduced earnings. An activity which may give profits or result in loss may be called a risky proposition, due to the uncertainty or unpredictability of the activity or trade in future. While, in human life, the risk is related to illness, impairedness or loss of life, in commercial and business activities, the business profit or loss would depend upon how the business is ran or its affairs managed. In other words it can be defined as the uncertainty of the outcome. A risk in any currency, commodity or an object is due to any exposure in that particular currency, commodity or the object. Like currency risk. Commodity price risk. Interest rate risk, etc. it is an integral part of international trade. International trade is affected by a number of additional risks, more than those that affect domestic trade. This is because of its vast arena of operations, where the buyer and the seller are located in different countries, the goods and the value of goods move in opposite directions, the currency of the country of the buyer and the currency of the country of the seller have their own values which undergo frequent change frequently, while the invoicing may be in a third currency, acceptable to both. Sometimes it is possible to identify, isolate and quantify the risks, while at other times, it may not be possible to do so. While we have deliberated upon risk in foreign exchange operations, in Unit 2, we now see what other risks, effect the international trade operations: A. Buyer Risk: The seller faces risks relating to non-acceptability, non-payment, quality acceptance, credit risk, etc. B. Seller Risk: The Buyer faces the risk relating to the seller not shipping the goods after receiving advance payment, may ship poor quality goods and may ship the goods after considerable delay, which may either lead to cancellation or delays in further orders taken by the buyer or even penalties in delays/ non-shipment.
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Over the period, when the buyer/seller undertake a few transactions, know each other's business, practices and commitments well, the buyer's and seller's risk reduces to a great extent. C. Shipping Risk: Include risks arising due to other intermediaries in the international trade, like shipping companies, handling agents, port authorities, local transporters, or even loaders, etc., which may lead to delays, or non-shipment of goods in time, due to a variety of reasons,like, goods being mishandled, goods abandoned, goods siphoned, goods wrongly delivered, goods delivered at another destination, goods appropriated for freight payment. Transshipment risk, strike by local transporters causing delay in reaching goods to ports, strike by porters effecting loading of goods into the ship, backlog/unavailability of containers due to delayed train movements, attack by sea pirates causing delays, breakages, loss of goods, etc. Due to above risks, beyond the control of buyers and sellers, nations at times declare shipping, and other related activities as essential services to promote cross border trade, particularly when the country is largely dependent either on exports or imports. D. Other Risks: Some of the other risks like, bank failure risk, settlement risk, risk of competition, genuineness of documents, price risk, legal risk, spread risk, market risk (absorption/rejection), etc. could affect the parties to the international trade. We can also categorise the risks in international trade as under: (a) Credit Risk: Relates to credit worthiness of the buyer, and could result in non payment of export bills, due to any reasons, like financial cmnch, defaults, insolvency, etc. (b) Legal Risk: Relates to any amentiment in the laws of the sellers or buyer's country, which could result in inability of the seller to export or of the buyer to remit proceeds of invoices. This could be due to embargoes on countries, ban or restriction on export of particular goods, ban or restriction on remittance of funds to particular countries, etc. (c) Country Risk and Political Risk: Relates to the developments in the country of buyer or seller, leading to default in export or payments. This could be due to uncertainty in laws, uncertainty in financial position of the countries, unharmonious relationship between countries, or fluid political situation. Countries' bad forex reserves position could lead to shortage of foreign exchange and inability to buy foreign exchange, resulting in externalization issues. (d) Operational Risk: Relates to operational issues at both ends or even at supporting organizations place. Strikes at seller's factory or even at sellers' raw material suppliers' factory, transporters, loaders, banks, clearing agents, etc. Similarly, operational break outs or failures of systems, connectivity, and communication break downs, commotions and other strikes, or errors by operating staff, etc. could lead to non shipment, or delay in shipment, shipment of defective or damaged goods, delays in making payments or receiving payments, etc. (e) Exchange Risk: Relates to movement on currencies. Any exporter or importer faces exchange risk, directly or indirectly. Invoicing in currency, other than home currency, strengthening or weakening of currency in which imports are billed, weakening of currency from where competitors import goods or supply goods to the same buyers/countries, etc could result in exchange risk to the exporter or the importer. For example, after the exports, invoiced in foreign currency are made, strengthening of the home currency when payment is received, would result in exchange loss. Similarly, strengthening of home currency to a higher extent, as compared to competitors' home currency, could result better pricing by competitors and in shifting of orders to other country.
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6.3 COUNTRY RISK Country Risk - RBI guidelines: As given above, international trade is prone to country risk, due to chances of loss in cross border trades, which can be caused by events in a particular country, affecting the profitability of the business or recovery of trade credits or investments. There could be several reasons leading to defaults by the buyers, due to reasons not within his control, but for the Governmental, political, economic or legal reasons of the land. Reserve Bank of India has prescribed country risk guidelines for authorised dealer banks. In terms of these guidelines, banks are required to have their own country risk policy and have a system of grading/ rating of countries, based on a set of parameters. Where banks do not have their own system of rating of countries, they can adopt the country risk ratings, of ECGC of India. The country risk classification of ECGC of India, classifies countries into seven categories. Banks are also required to make provisions in case its exposures to any one country is one percent or more of its total assets, as on the last balance sheet date. The country risk exposures of a bank shall include exposures by way of balances abroad, deposits placed abroad, investment abroad in bonds, debentures, overseas lending to corporates, as also trade finance exposures. Factors, which need to be assessed, while reviewing the country risk, can be enumerated below; (i) Political Stability/Instability (ii) International Relations (iii) Economic Policy (iv) Gross Domestic Product (GDP) (V) Inflation (vi) Exchange Rate - Volatility (vii) Level of Foreign Trade (viii) Balance of Payment (ix) External Debt (X) International Reserves (xi) IMF Quotas (xii) International Rating (xiii Past Track Record on Payments (xiv) Overall Assessment )
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RBI has suggested that, banks can have their own system for assessing country risk- i.e. set their own parameters for categorizing countries, as per risk. However, banks, who cannot have their own country risk assessment, and classification, can adopt the country risk classification, published by ECGC. ECGC adopts a seven fold classification, covering presently 204 countries. It updates and publishes the country risk classification on quarterly basis. The country risk classification as on 30.9.2009 is as under; Insignificant Risk - A1 Low Risk - A2 Moderately low risk - B1 Moderate Risk - B2 Moderately high risk - C1 High Risk-C2 Very High Risk - D Besides above, 20 countries have been placed in Restricted Cover Group I, where revolving limits are approved by ECGC, valid for 1 year. 13 countries have been placed in Restricted Cover Group II, where specific approval is given, on a case to case basis, on merits. Thus, we have seen that risks in international trade are a part of the activity, and are more than the domestic trade. The mantra to mitigate risk is to act cautiously, with proper planning of movement of goods and money and also by setting limits for counterparties, wherever, felt necessary. Further these risks can be mitigated to a large extent, with the help of credit insurance, which also covers country risk. Direct exchange risk can be covered with tools, such as forward cover, futures, options, etc. or even timing the inflows and out-flows of foreign exchange. Foreign currency accounts also help to mitigate exchange risk of the exporters and importers. It must be ensured that the tools used to mitigate risk, do not add to the risks, thereby meaning that products, which are understood well and can be controlled, only be used to mitigate the original risks. We have studied the forex derivatives and their uses in Unit 2. We can now move to see how credit insurance is helpful in international trade and how it works in India. Check Your Progress (A) Fill in the blanks: 1. Risk is an event. _, due to buyer and sellers being located in different countries. Ans: Unforeseen 2. International trade is surrounded by various risks 3. Shipment of goods being delayed due to strike by port staff will be categorized as operational 4. Movement in price of home currency vis a vis the currency of invoice, would lead to risk. exchange 5. Political uncertainty in a country, leading to fall of the incumbent Government, would be a risk for its trade partners. Country risk 6. True or False: (i) Forward contracts can be used to mitigate country risk.
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false (ii) International trade is risk free. false (iii) Risk is an integral part of any activity true (iv) Exchange risk cannot be mitigated. false (v) In international trade, only exporters face risk. false 6.4 EXPORT CREDIT INSURANCE IN INTERNATIONAL TRADE Exports grow on the backing of export financing by banks. Governments, in order to support exports, provide cheap financing options and provide comfort to exporters and financing banks, by way of export credit insurance. Export credit insurance, provides protection against losses from political and commercial risk to the exports and financing institutions Countries have set up special corporations to provide these services of export credit insurance. Some general insurance companies also provide credit guarantee for exports. Credit insurance lowers the cost of borrowing/financing, as the Government agency bears the risk of default as per policy terms. Usually, the insurance is on risk sharing basis- as such it covers a large part of credit default, but requires the insured exporter/financer to bear some part of the loss. In India, export credit is guaranteed by ECGC of India, which was set up by the Government of India, to support growth of export. Several countries, small or big have institutions to guarantee credit for exports, like ECGD in USA, in Germany, etc. Globally, some of the non- life insurance companies offer credit insurance products. These products are meant specifically for providing risk cover to exporters, for any default on their export receivables. In India, too some non -life insurance companies, (e.g. New India assurance company) offer export credit insurance for defaults in receivables. 6.5 ECGC OF INDIA - ROLE AND PRODUCTS 1. About Export Credit Guarantee Corporation of India Ltd. It is a credit guarantee institution, set up for the promotion of exports, by protecting the exporters from any financial loss due to the buyer's failure to pay or due to the problem of externalization in the country of import, by issuing various types of policies to the exporters. At the same time, ECGC issues various types of guarantees to banks, financing exporters, which protect banks in case of loss from their advances to exporters. In other words, ECGC provides credit enhancements to augment the credit worthiness of the exporters so that they could get more and better facilities from banks. In 1957 the Government of India established Export Risks Insurance Corporation (ERIC) to provide credit risk insurance to exporters, which was then transformed to Export Credit Guarantee Corporation Ltd., in 1964. ECGC was established with the primary goal to support and strengthen the export promotion drive in India so that the trade gap between exports and imports is reduced to a minimum. 2. Main Activities of ECGC ECGC provides a wide range of credit risk insurance cover to exporters against loss in export of goods and services. It also offers guarantees to banks and financial institutions to enable exports to obtain facilities, credit or otherwise, from banks. Recently they have started giving credit reports of overseas buyers also. (A) Some of the main policies offered by ECGC to the exporters are:
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(i) Standard Policies to exporters to protect them against payment risks involved in exports on short-term credit. (ii) Small Exporters Policy basically a Standard Policy, but incorporating certain improvements in terms of cover to enable to encourage small exporters. (iii)Specific Shipment Policies designed to protect firms in India, against payment risks involved in (a) Exports on Deferred Payment Terms (b) Insurance for Buyers' Credit and Lines of Credit (c) Services rendered to Foreign Parties (d) Construction Works and Turnkey Projects Undertaken Abroad. (iv) Exports (Specific Buyer) Policy (v) Export Turnover Policy (vi) Buyer Exposure Policy (vii) Consignment Exports Policy (viii) Multi-buyer Exposure Policy. (B) The guarantees/policies offered by ECGC to the banks are: (i) Export Credit Insurance for Banks (Whole turnover- Packing Credit)-EC1B (WT-PC). (ii) Export Production Finance Guarantee (iii)Export Credit Insurance for Banks (Whole turnover- Post shipment Credit)-ECIB (WT-PS). (iv) Export Finance Guarantee (v) Export Performance Indemnity (vi) Export Finance (Overseas Lending) Guarantee (vii) Transfer Guarantees Besides above, ECGC also offers some Special Schemes, such as Transfer guarantees, (covering risk on transfer of funds), Scheme for Small Exporters, Exchange Fluctuation Risk Insurance Scheme, etc. 6.6 ECGC POLICIES Let us now go through the main features of some of the policies and guarantees. A. Standard Policies The Standard Policies of ECGC provide cover for exporters for short-term exports. The different types of policies are: (i) Shipment (Comprehensive Risk) Policy - to cover both commercial and political risks from the date of shipment. (ii) Shipment (Political Risks) - to cover only political risks from the date of shipment. (iii)Contracts (Comprehensive Risks) Policy - to cover both commercial and political risks from the date of contract. (iv) Contracts (Political Risks) Policy - to cover only political risks from the date of contract. Standard policies cover following risks: (i) Commercial Risks - covering Insolvency of the Overseas Buyer, Protracted Default by the overseas buyer to pay for goods accepted by him within a specified period usually 4 months from the due date. Repudiation - Buyers' failure to accept goods subject to certain conditions. (ii) Political Risks - which covers imposition of restrictions on remittance by the Government in buyers' country or any Government action which may block or delay payment to exporter, war, revolution or civil disturbances in buyers' country. New Import Licensing restrictions or cancellations of a valid import license in the buyers' country, intermption or diversion of voyage outside India resulting in payment of additional freight or insurance charges which
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cannot be recovered from the buyer, any other cause of loss occurring outside India, not normally insured by general insurers and beyond the control of both the exporter and the buyer. Standard policies do not cover following risks: (i) Commercial disputes raised by the buyer. (ii) Causes inherent in the nature of goods. (iii)Buyer's failure to obtain necessary import or exchange authorization from authorities in his country. (iv) Default or insolvency of any agent of the exporter or collecting bank. Loss or damage to goods which can be covered by general insurers. (v) Exchange rate fluctuation risk. (vi) Failure of the exporter to fulfill the terms of the export contract or negligence on his part. The cover granted by ECGC on Standard policies is 90% of the value of exports. The premium for such policies varies for different countries and payment terms. B. Small Exporters' Policy The Standard Policy (Shipments comprehensive Risks Policy) issued by the Corporation to exporters is a declaration type of policy and is issued to cover shipments that may be made in period of 24 months ahead. For the purpose of issuing the Policy, a Small Exporter is defined as an exporter whose anticipated total export turnover for the period of 12 months ahead is not more than Rs 50 lacs. (Projected Export Turnover) This policy provides cover against Commercial risks, covering insolvency of the buyer, failure of the buyer to make the payment due within 2 months from the due date, buyer's failure to accept the goods. due to no fault of the exporter, provided that legal action against the buyer is considered to be inadvisable. It also provides cover against Political risks, covering: (i) imposition of restrictions by the Government of the buyers' country or any Government action which may block or delay the transfer of payment made by the buyer (ii) War, civil war, revolution or civil disturbances in the buyers' country, (iii) New import restrictions or cancellation of a valid import license, (iv) Intermption or diversion of voyage outside India resulting in payment of additional freight or insurance charges which cannot be recovered from the buyer Small exporters policy does not cover losses arising due to the following risks: (a) Commercial disputes including quality disputes raised by the buyer, unless the exporter obtains a decree from a competent court of law in the buyers' country in his favour (b) Causes inherent in the nature of the goods. (c) Buyer's failure to obtain necessary import or exchange authorization from authorities in his country. (d) Insolvency or default of any agent of the exporter of the collecting bank. (e) Loss or damage to goods, which can be covered by general insurers. (f) Exchange rate fluctuation. (g) Failure of the exporters to fulfill the terms of the export contract or negligence on his part. (h) Non payment under LC due to any discrepancy pointed out by the LC opening bank. This policy is issued for a period of 12 months and its coverage is 95% where the loss is due to commercial risks and 100%, if the loss is caused by any of the political risks and the waiting period for claims is four months from the due date of payment.
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C. Specific Shipment Policies - Short-Term The Specific Shipment Short-Term Policies provides cover against commercial and political risks involved in export of goods on short-term credit not exceeding 180 days. Cover under these policies can be taken for shipment(s) made/to be made by the exporter to a buyer under a contract. These policies can be availed of by exporters who do not hold Comprehensive policy covering shipments in the specific contracts. Short-term policies could be: (a) Specific shipments policy covering commercial and political risks (b) Specific shipments (political risk) policy, to cover only political risk at the Postshipment stage in cases where the buyer is an overseas Government or payments are guaranteed by a Government or by banks or are made to associates, and (c) Specific Shipments (insolvency and default of L/C opening bank and political risks) Policy. Commercial risks covered by the Short-Term policies, include: • Insolvency of the buyer, • Failure of the buyer to make the payment due within a specified period normally 4 months from the due date, • Buyers' failure to accept the goods (subject to certain conditions) Political risks covered under this policy are: • Imposition of restrictions by the Government of the buyer's country or any Government action, which may block or delay the transfer of payment made by the buyer, • War, civil war, revolution or civil disturbances in the buyer's country, • New import restrictions or cancellation of a valid import licence, intermption of voyage outside India resulting in payment of additional freight or insurance charges which cannot be recovered from the buyer, • Any other cause of loss occurring outside India, not normally insured by general insurers and beyond the control of both the exporter and the buyer. Short-Term policies do not cover following losses: (a) Commercial disputes including quality disputes raised by the buyer unless the exporter obtains a decree from a competent court of law in the buyer's country in his favour, (b) Causes inherent in the nature of goods, (c) Buyer's failure to obtain necessary import or exchange authorization from authorities in his country, (d) Insolvency or default of any agent of the exporter or of the collecting bank, (e) Loss or damage to goods, (f) Exchange rate fluctuation, (g) Failure of the exporter to fulfill the terms of the export contract or negligence on his part. D. Exports ( Specific buyers) Policy Exports - Buyerwise Policies - Short Term (BP-ST) provides cover to Indian exporters against commercial and political risks involved in export of goods on short-term credit to a particular buyer. All shipments to the buyer in respect of whom the policy is issued will have to be covered However, there is a provision to permit exclusion of shipments under LC. These policies can be availed of by exporters who do not hold Standard Policy and also by exporters already having Standard Policy. These policies are of three types: (a) Buyerwise (commercial and political risks) Policy - short-term (b) Buyerwise (political risks) Policy - short-term. (c) Buyerwise (insolvency & default of L/C opening bank and political risks) Policy - shortterm.
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E. Buyer Exposure Policy A variant to this policy is Buyer Exposure policy, which is specifically designed for large exporters to enable them to cover their exposure on a particular buyer on the basis of expected exposure. Two types of exposure policies - one for covering the risks on a specified buyer and another for covering the risks on all buyers - are offered. The Buyer Exposure policy, provides flexibility to exporters to choose to obtain exposure based cover on a selected buyer, which provides cover against commercial and political risks attached to the buyer for both non-LC and LC transactions. A separate Buyer Exposure Policy is issued for each buyer covering all the exports to be made to the buyer during a period of twelve months. If the exporter has opted for commercial and political risks cover, failure of the LC opening bank in respect of exports against LC will also be covered, for the banks with World Rank (WR) up to 25,000 as per latest Banker's almanac. For covering any bank with ranking beyond that level, the exporter has to obtain specific approval from the branch, which issued the policy prior to making the shipment. For covering the political risks only, in respect of LC transactions or shipments to associates. Buyer Exposure policy with endorsement restricting the cover to political risks only with significantly less premium is offered. This policy can be availed by exporters holding Standard Policy in respect of any of their buyers, where shipments to the buyers covered under Buyer Exposure Policies can be excluded from the purv iew of the Standard Policy, so that double premium payment and cover can be avoided. F. Export Turnover Policy Export Turnover policy is a variation of the standard policy for the benefit of large exporters who contribute not less than Rs. 10 lacs per annum towards premium. Therefore all the exporters whose turnover is likely to exceed the premium payable to ECGC by Rs. 10 lacs in a year are entitled to avail of it. This policy envisages projection of the export turnover of the exporter for a year and the initial determination of the premium payable on that basis, subject to adjustment at the end of the year based on actuals. It provides for an additional discount in premium with an added incentive for increasing the exports beyond the projected turnover and also offers simplified procedure for premium remittance and filing of shipment information. It also provides for higher discretionary credit limits on overseas buyers, based on the total premium paid by the exporter under the policy. The turnover policy is issued with a validity period of one year. In most of the other respects the provisions relating to standard policy will apply to turnover policy. G. Consignment Exports Policy Economic liberalization and relaxing of trade barriers for trade have lead to new methods of trade - supplies and payments. One of the methods now being increasingly adopted by Indian exporters is consignment exports where the goods are shipped and held in stock at overseas centers, ready for sale to overseas buyers, as and when orders are received. Thus there is a time lag between the shipment and actual sale to the buyer, in such trade systems. To protect the Indian Exporters from possible losses when selling goods to ultimate buyers, ECGC has introduced a Consignment Policy Cover, to take care of such needs. There are two policies available for covering consignment export (a) Consignment Exports (Stockholding Agent), and (b) Consignment Exports (Global Entity Policy) The consignment exports (Stock-holding Agent) policy provides cover subject to: (i) Merchandise shipped to an overseas entity in pursuance of an agency agreement;
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(ii) The overseas agent is an independent and separate legal entity with no associate/sister concern relationship with the exporter; (lii) The agent's responsibilities could be any or all of the following, viz., receiving the shipment, holding the goods in stock, identifying ultimate buyers and selling the goods to them in accordance with the directions, if any, of his principal (exporter); and (iv) The sales being made by the agent would be at the risk and on behalf of the exporter (whether or not such sales are in the agent's own name or otherwise) in consideration of a commission or some similar reward or compensation on sales completed. 6.7 FINANCIAL GUARANTEES While it is essential that exporters continue to get timely and adequate export credit both at preshipment and post-shipment stage, so that the best possible potential for exports can be realized, banks will be willing to release such facilities freely only if the advances are utilized properly and realized in time. ECGC, with the intention of giving protection to the bankers against losses on account of their financial lending to their exporter clientele, has been giving guarantees to financial institutions/'banks. This in turn leads to an additional security for the bankers and thus translates into adequate financial support to exporters. ECGC issues following types of guarantees looking to the various needs of exporters/financial institutions: 1. Packing Credit Insurance 2. Export Production Finance Guarantee 3. Post-shipment Export Credit Insurance 4. Export Finance Guarantee 5. Export Performance Guarantee 6. Export Finance (Overseas Lending) Guarantee 1. Packing Credit Insurance Any loan given to an exporter for the manufacture, processing, purchasing or packing of goods meant for export against a firm order or letter of credit qualifies for packing credit guarantee. It is issued for a period of one year against a proposal made for the purpose and covers all advances that may be made by the bank during the period to a given exporter within an approved limit. The claim is payable, in case the pre-shipment credit granted is not paid within 4 months from the due date of the loan. Export Credit Insurance for Banks (Whole turnover- Packing Credit)-EC1B (WT-PC), is issued by ECGC to banks wherein a higher percentage of cover is available at a lower premium since a large volume of business is offered to cover in this guarantee. Bank is required to notify the limits sanctioned to their exporter customer within 30 days of the sanction and banks are required to take the approval of the Corporation if they exceed an agreed value, called Discretionary limit. The premium and cover available varies from bank to bank and is specifically approved/prescribed by the ECGC, during the annual renewal of the guarantee. The premium ranges from 6 to 10 paise per Rs 100.00 per month, and cover ranges from 50 to 75%. 2. Export Production Finance Guarantee This guarantee covers the advances given by banks against incentives/receivable at the Preshipment stage. While the extent of cover and the premium are the same as for packing credit guarantee, banks having ECIB (WT-PC) are eligible for concessional premium rate and higher coverage. 3. Post-Shipment Export Credit Insurance
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Advances against export bills by way of purchase, negotiation or discount or rupee finance by banks are covered under this guarantee. Under this guarantee, the exporter should hold suitable shipments or contracts policy of ECGC to cover the overseas credit risks. Export Credit Insurance for Banks (Whole turnover - Packing Credit) - ECIB (WT-PC), is issued by ECGC on whole turnover basis also, wherein the advances granted by the bank to exporters by way of purchase, negotiation, or discount of export bills or advances against export bills sent on collection are covered. In this a higher percentage of cover is available at a lesser premium. The premium for this guarantee is 5-9 paise per Rs 100.00 per month and cover is usually 6075%. Wherever, the exports are covered under individual policy taken by the exporter, the cover under whole turnover guarantee increases to 75-90%. 4. Export Finance Guarantee When banks grant post-shipment advances to their exporters against export incentives receivables in the form of cash assistance, duty drawback, etc., it can be covered under this guarantee. The cover available is 75% of the finance, while the premium ranges from 7 paise upwards. 5. Export Performance Indemnity It is issued by ECGC in the nature of a counter guarantee to the bank against possible losses that they may suffer on account of the guarantees issued by them on behalf of its exporter clients. Guarantees are required to be issued on account of exporters clients, in favour of overseas buyers, for performance of contracts. Bid-bonds, quality, etc. Guarantees are also required in favour of customs, for import of capital as well as raw material free of customs duty, or on reduced duty, against export commitments. 6. Export Finance (Overseas Lending) Guarantee If a bank financing an overseas project provides a foreign currency loan to the contractor, it can protect itself from the risk of non-payment by the contractor by obtaining Export Finance (Overseas Lending) guarantee. The premium on such guarantee are payable in Indian Rupees. 7. Other Special Guarantees and Schemes A. Transfer Guarantee When a bank in India adds its confirmation to a foreign letter of credit, it binds itself to honour the drafts drawn by the beneficiary of the letter of credit without recourse to him provided such drafts are in accordance with the terms of the letter of credit. The confirming bank will suffer a loss if the foreign bank fails to reimburse it with the amount paid to the Exporter. It is this transfer guarantee that safeguards banks in India against a possible loss arising out of such risks. B. Exchange Fluctuation Risk cover Scheme The cover under the scheme is available for payment scheduled over a period beyond 12 months up to a maximum period of 15 years. Cover under the scheme is available for payments specified in US dollar, Pound Sterling, EURO, Japanese Yen, Swiss Francs, UAE Dirham and Australian Dollars. However, cover can be extended for payments specified in other convertible currencies at the discretion of the ECGC. The contract cover provides a franchise of 2%. Loss or gain within a range of 2% of the reference rate will go to the exporters' account. If loss exceeds 2%, ECGC will make good the portion of loss in excess of 2%, but not exceeding 35% of the reference rate. In other words, gains/losses up to 2% and beyond 35% of reference rate will be to the exporters' account. Gains or losses beyond 2% and up to 35% will be to ECGC's account. C. Maturity Factoring
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ECGC full fledged factoring service takes care of the export credit guarantee for the exporters, besides their financing needs. Factoring service covers financing and collection of receivable of series of transactions between the buyer and the seller. It also includes credit protection, besides improving exporter's cash flows. Factoring applies when the export has sales on open account, on a continuous relationship, the past track record of the seller is clear, the buyer is given a notice of assignment, and the sale does not involve counter trade. ECGC factoring service provides: Facilitates purchase of account receivables Provides upto 90% finance against approved transactions Full credit guarantee on buyer's default or insolvency. Maintenance of sales ledger Follow-up for collection of export proceeds Eligibility: Exports with good track record Dealing on DA terms/open account terms with buyers Having unexpected bulk orders to execute Exporters facing large working capital shortfall by way of bill financing The facility allows exporters to avail additional finance, eliminates the need for routing export bills through commercial banks and also the need for follow up with the buyers for payments. The export factoring also reduces the administrative costs to the exporters. 6.9 OTHER ASPECTS RELATING TO ECGC-POLICIES AND GUARANTEES (i) Credit guarantees and policies of risk sharing basis: All ECGC policies and financial guarantees are issued on risk sharing basis, i.e. the cover provided by ECGC is not for 100 % value of exports made or finance allowed by Banks, but the exporter or the financing bank, who takes the policy or the financial guarantee has to bear a small part of the loss to share the loss incurred in the export financing. The maximum cover is for 90% —95 %, of the value/financed amount. (ii) Since ECGC provides credit insurance for export credit allowed by banks/exporters, its policies and guarantees fall under the purview of Insurance Regulatory & Development Authority (IRDA). The Schemes of ECGC are thus; governed by IRDA and certain guidelines as applicable to general insurance shall apply to these schemes. As in case of any other insurance, even banks, which were earlier required to pay the premium on ECGC financial guarantees, on monthly basis, in arrears ( after the end of the month) on the basis of products of financed amounts, are now required to pay up front one month premium, based on previous years' average, so as to comply with the IRDA guidelines. (iii)Monthly declarations are to be submitted by exporters having policies covering their whole export turnover Similarly, banks having financial guarantees covering Pre-shipment and Post- shipment finance, are required to submit a monthly declaration to local offices or nearest offices of ECGC, showing total amounts financed during the month and products thereof along with the premium for the month. (iv) The whole turn over insurance cover issued to banks, by ECGC, are now called as Export Credit Insurance for Banks-(WT-PC) and Export Credit Insurance for Banks - (WT-PS). . (v) ECGC proscribes: Discretionary Limits (DL) for financial guarantees, up to which limit banks are permitted to allow finance without prior approval of ECGC, and only a notification
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(report) is to be sent in prescribed format. In other cases, where the limits sanctioned is beyond the DL, prior approval of ECGC is required to be obtained before release of limits. (vi) Notice of Default and lodging of Claiitis: Under the financial guarantees, banks are required to file with ECGC, a notice of default within 4 months from the due date or one month from the date of recall. Similarly, claims are to be filed within 6 months form the date of lodging default notice. (vii) Since the policies and guarantees are on risk sharing basis, any recovery made by the exporter or the financing bank, is to be refunded to the ECGC in the ratio the risk has been shared. For example, in case of an export bill where claim has been settled under WT-PS, for 65% of the outstanding amount of advance, the bank, on getting collateral securities realized for a part amount, has to pay back 65% of the realized amount to ECGC, thus continuing the risk sharing ratio at 65:35. (viii) For a large majority of countries, the Corporation places on limit for covering political risks. Such countries are referred to as 'open cover' countries. However, in the case of certain countries, where the political risks are very high, cover is granted on a restricted basis. In respect of the few remaining countries under restricted cover, which are high risk countries, specific approvals are given on the merits of each case. The period of validity of specific approval is six months. In addition ECGC provides the list of borrowers, Directors, Corporates, etc., under their Specific Approval List (SAL) for which, in case of finance, banks should seek prior approval from ECGC. Check Your Progress (B) Fill in the blanks: 1. 2. 3. 4. 5. 6. 7. ECGC was established with the primary goal to support and strengthen the __ promotion drive in India. Standard policies cover ______ of the Overseas Buyer. Political Risks covered under specific policies, include Imposition of restrictions on remittance by the _____ in buyers' country. Standard policies do not cover _____ fluctuation risk. Small exporters policy is issued for a period of ____ months. ________ Guarantee covers post-shipment advances against export incentives receivables in the form of cash assistance, duty draw-back, etc. Maturity Factoring provides 100% credit guarantee protection against Let Us Sum Up We have seen that foreign trade is besieged with several types of risks, which need to be taken care when handling international trade transactions. Proper perception of risks and the measures to contain the risks is a must for any trader, bank or institution. We have also seen that export credit insurance plays an important role in increasing exports, by providing insurance for export credit to exports/financing institutions. ECGC of India provides
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credit insurance to exporters and financing banks, in India. ECGC of India has various policies for exporters and banks, to suit a variety of needs. It may be noted that policies given by ECGC are on risk participation basis, where, the exporters/banks have to bear some loss, on claim being raised on ECGC for any loss under the policy. Keywords Risk: Uncertainty Policies of ECGC: Credit insurance policies are given to individual exporters to cover risk of nonpayment by the buyer of goods or other events. insiinincc covcr (Guarantees) of ECGC: Insurance cover (Guarantees) are given to financing banks to cover the risk of non-payment by the exporter or the drawee of the export bills, financed by them. Maturity factoring: A guarantee scheme, under which, the factor pays only on the due date of the export receivable, and not at the time of drawing of the export bill. The financing of the bill, is done by another fmancer, on its strength.
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RISKS IN FOREIGN TRADE - ROLE OF ECGC Loss sharing: Insurance by credit insurance companies does not cover 100 % of loss, but a part of the loss is to be borne by the insured. Answer to Check Your Progress A. 1. Unforeseen; 2,risks; 3 operational.; 4 exchange.; 5. country; 6. (i) False; (ii) False; (iii) True; (iv) False, (v) False B. 1. export 2. insolvency 3. Government 4. currency 5. 12 6. Export finance 7. bad debts. Terminal Questions Objective Type Fill in the blanks: does not honour the payment of the bill. 1. An exporter is exposed to credit risk, if the _________ 2. The importer is exposed to _____________ risk, if the supplier sends goods not as per the specifications and quality as agreed upon. 3. A last minute delay in shipping the goods due to strike by port staff, leads to risk in international trade. 4. Political , could lead to country risk for the buyer and sellers in international trade. 5. ECGC provides export credit _____________ , to exporters. 6. ECGC policies re covered under insurance guidelines issued by __________ . 7. Defaults under ECFC financial guarantees to banks is to be filed within ________ months from the due date of advance. 8. ECGC country risk classification is a _____________ fold classification. Mark the correct option: 1. A risk is: (a) related to illness, which does not effect the human life (b) related to events which do not effect the profits of the organization. (c) related to unplanned event with financial consequences resulting in loss. (d) a certain event, where outcome is known. 2. (a) Country Risk is when the buyer or borrower is forbidden by the Government to honour his commitment. (b) Failure of counter party is called liquidity risk. (c) Settlement Risk arise due to problems related to mismatch of funds or liquidity. (d) Interest Rate risk arises with favourable movement of interest rates. 3. Operational Risk does not occur if; (a) Strike at the port. (b) Non loading of gods on the desired ship, due to rains. (c) Delay in supplies by sub-suppliers. (d) Delay in payment by the buyers.
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138 BANK FINANCIAL MANAGEMENT 4. ECGC policies do not cover: (a) Exchange fluctuation risk. (b) risk due to insolvency of the buyer. (c) risk due to default by the shipping company. (d) Risk due to new licencing imposed by the buyers country. 5. Exchange Fluctuation Risk of ECGC: (a) covers all exports payments upto six months period. (b) covers 100 % exchange fluctuation of Indian exporters. (c) covers exchange fluctuation above 2% and upto 50 % only (d) covers exchange fluctuation above 2% and upto 35 % only. 6. General policies of ECGC do not cover: (a) Commercial dispute between the buyers and the sellers. (b) Insolvency of the buyer. (c) Restrictions imposed by buyers country, (d) Default by buyer to pay for goods already accepted. 7. The guarantees given by ECGC. to cover loss on advances for incentives receivable by exporters at pre-shipment stage, is called; (a) Post-Shipment Export Credit Guarantee (b) Packing Credit Guarantee (c) Export Production Finance Guarantee (d) Export Finance Guarantee 8. Credit guarantees are on risk sharing basis, means that: (a) The buyer and seller share the risk of default of any one of them. (b) The buyer shares the defaulted amount with the insurance company. (c) The seller shares the risk with the financier. (d) The financier shares the risk with the insurance company. References for Further Reading 1. Reserve Bank of India Guidelines for Internal Control for Foreign Exchange Business, Master Circulars, Circulars, issued from time to time. 2. FEMA 1999. 3. FEDAI Rule book and various circulars on the subject. 4. FEDAI Study Booklets for Orientation workshops. 5. ECGC product brochures and circulars/website 6. All earlier publications of IIBF.
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UNIT 7 Role of Exim Bank, Reserve Bank of India, Exchange Control in India - FEMA and FEDAI and Others STRUCTURE 7.0 Objectives 7.1 EXIM Bank - Role, Functions and Facilities Check Your Progress (A) 7.2 Reserve Bank of India - Role and Exchange Control Regulations in India 7.3 Foreign Exchange Management Act (FEMA) 1999 Check Your Progress (B) 7.4 Role of FEDAI and FEDAI Rules Check Your Progress (C) 7.5 Short Notes on Other Topics : ECB and ADR/GDRs and FCCB Check Your Progress (D) Let Us Sum Up Keywords Answers to Check Your Progress Terminal Questions References for Further Reading
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7.0 OBJECTIVES The objective of this unit is to understand the functions and role of EXIM Bank, Reserve Bank of India, FEMA and its important provisions, FEDAI and other related agencies in the development and control of international banking business in India. International banking and trade involves transactions between two countries, currencies and as such are controlled, supervised, regulated and supported by the central bank of the country, while assisted and supported by various other agencies like EXIM bank, insurance companies, ECGC, FEDAI, etc. The control and support functions make the trade and markets grow in a manner, which best suits the country, as also is in line with the broad policy framework of the nation - monetary and fiscal, which include value of currency, balance of payment and trade, the needs and capabilities of the country. 7.1 EXIM BANK - ROLE, FUNCTIONS AND FACILITIES The Exim Bank of India was established in 1981, under the Export Import Bank of India Act 1981, an Act of Parliament, as a principal financial institution for providing financial assistance and services and for coordinating the functions of institutions engaged in financing of export import trade in the country, specially on a long-term basis. It arranges lines of credit to other Governments, for promoting exports of goods made in India. The functions and operations of Exim Bank evolve around following philosophy: 1. To make exports internationally competitive, by offering finance at competitive rates and conditions. 2. To develop alternate financing solutions. 3. To provide data, information and advice for new export opportunities to Indian exporters. 4. To provide selective production, marketing and financing for Indian products to make them internationally competitive. 5. To respond to export problems of Indian Exporters and pursue policy resolutions. 1. Financing Programmes EXIM Bank's lending activities to the trade, banks and other institutions, can be listed as under: A. For Exporters and Importers (i) Suppliers' Credit: Export credits extended to Indian exporters to enable them to offer deferred credit to overseas buyers. (ii) Consultancy and Technology Services: Financial assistance to exporters for offering deferred credit to overseas buyers of Indian Consultancy, technology and other services. (iii)Pre-shipment Credit: Finance for executing contracts involving manufacturing cycle of over six months. (iv) Project Finance to Export Oriented Unit: Term loans for setting up of export oriented units in export processing zones as also Domestic Tariff area (DTA) Units exporting minimum 25% of annual sales. (v) Import Finance: Financing of imports which are export related, i.e., imports by exportoriented units, imports of computer systems for development and export of software, import of plant and machinery, technology up gradation, expansion of production capacity for export markets. (vi) Overseas Investment Finance: Finance to Indian companies towards their equity participation in joint ventures abroad.
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Exim Bank has also been permitted by RBI to facilitate financing of medium-term long term export bills through Forfaiting. Exim Bank also allows finance in foreign currency, at internationally competitive interest rates to Indian exporters for their regular pre-shipment credit requirements. The export bills are handled by the commercial bankers of the company, with an undertaking that the payment of the export bill, upon receipt, shall be passed on to EXIM Bank for liquidation of the finance allowed by them against the goods/bill. B. For Commercial Banks (i) Export bills Re-discounting: Commercial banks in India, authorised to deal in Foreign Exchange, are given refinance facility for their export bills portfolio, and thus can rediscount their short- term export bills with an usance period not exceeding 180 days. (ii) Stnall Scale Industry (SSI) Export Bills Rediscounting: For rediscounting of export bills, by banks, drawn by SSI units. (iii)Refinance of Export Credit: This scheme covers refinance of deferted payment loans allowed by authorised dealers in foreign exchange, extended for export of Indian goods. (iv) Refinance of Term Loans: Under this scheme, banks can get refinance up to 100% of the term loans allowed to eligible export oriented units, computer software exporters, for procuring capital goods. (V) Guarantees: EXIM Bank also participates with Commercial banks in India in issue of guarantees such as advance payment, performance, retention money and guarantees for borrowing abroad for execution of export contracts. C. For Foreign Governments, Foreign Importers and other Financial Institutions (i) Overseas Buyer's Credit: Exim Bank offers credit to foreign importers directly, for import of eligible Indian goods and related services, helping them to get credit on goods purchased from India. (ii) Lines of Credit: Exim Bank sanctions Lines of Credit to foreign Governments for allowing term finance for import of eligible Indian goods and related services by them or financial institutions, specified by them. The Indian exporter of goods and services gets payment on submission of shipment documents or proof of completion of service/job, while the foreign Government pays at a later date as per tenor of line of credit. (iii)Relending Facility' to Banks Overseas: Exim Bank allows Relending facility to international Banks to provide term finance to their clients overseas for import of eligible Indian goods. 2. Deferred Payment Exports/Project Exports Under the existing Exchange Control Regulations exporters are required to realise full export proceeds within a period of six months from the date of shipment, except for certain specified type of exporters. like status holders, etc. Such exports are determined to be on cash basis. Whenever export proceeds are proposed to be received fully or partly beyond the statutory time limit of six months, these are treated as deferred payment exports. The goods eligible for deferred payment export are segregated into two categories, viz.. Group A comprising exports of capital and production goods, and Group B, comprising consumer durables and industrial manufacture. For availing finance against exports on deferred payment basis, the exporter is required to approach the sponsoring bank, the main banker or the lead bank of the exporter, which can approve such projects valued up to Rs 25.00 crores, subject to conformity with guidelines. Proposals of value not exceeding Rs 100 crores are to be referred by the sponsoring bank to
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EXIM Bank, for in principle clearance at bid stage itself, along with copies thereof to RBI and ECGC. For contracts valued more than Rs 100 crores, an inter institutional working group which meets at EXIM Bank and acts as a focal point has to consider the proposal at pre-bid stage. The working group members comprise of officials from EXIM Bank, ECGC, RBI-FED and sponsoring banks. 3. Assistance for Project Exports/Turnkey Projects/Construction Projects Export of engineering goods on deferred payment terms and execution of turnkey projects and civil construction contracts abroad are collectively referred to as Project Exports. Project Export contracts are generally of high value and exporters undertaking them are required to offer competitive credit terms to be able to secure orders from foreign buyers in the face of stiff international competition. Turnkey projects are those which involve supply of equipment along with related services like design, detailed engineering, civil constructions, erection and commissioning of plant. Typical projects include supply, erection and commissioning of boilers or plants for manufacture of cement, sugar, textiles, chemicals. Construction Projects: It involves civil works, structural works as well as associated supply of construction materials and equipment. While the element of equipment is smaller in construction projects as compared to turnkey projects, the line of demarcation could be very thin. Construction projects include civil works for roads, railway lines, airports, irrigation canals and dams, buildings, technical and consultancy service contracts involving provision of personnel furnishing of know how, skills, operation and maintenance services and management contracts are covered under the banks financing programme. EXIM Bank extends funded and non-funded facilities for industrial turnkey projects, civil construction contracts as well as technical and consultancy service contracts. The non-funded facilities would include, Bid Bond, Advance Payment Guarantee, Performance Guarantee, Guarantee for Raising/Borrowing Overseas, Other Guarantees for customs duty exemption, security deposits, etc. Funded facilities granted by Exim Bank could include Pre-shipment Rupee Credit for procuring material against rupee payment from local suppliers, pre-shipment credit in foreign currencies to finance cost of imported inputs for manufacture and export products to be supplied under the projects. Post-Shipment Rupee Credit on deferred payment terms covering eligible Indian Capital and engineering goods and related services. EXIM Bank also considers Foreign Currency Loans at competitive rates to finance purchase of third country materials, equipments and constructions machinery. These facilities are extended by EXIM Bank individually or in participation with Commercial Banks. 4. Other Services and Programmes (i) Consultancy and technology services, wherein Indian consultants are assisted by way of long- term financial assistance, manpower and expert recruitment, preparation of project reports, plans, transfer of technology, etc. (ii) Ch -erseas investment finance, wherein corporates interested in joint ventures abroad, are provided equity finance by Exim Bank. The equity participation can be by way of export of plant and machinery, for which long-term export finance is considered by Exim Bank. (iii)Import loans for financing imports from third countries for projects to be executed in foreign countries.
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(iv) International merchant banking services include foreign currency financing and advisory services for raising low cost finance for projects abroad to be executed by Indian companies. (V) Export Marketing Fund (EMF): Exim Bank is the nodal agency, designated by the Government of India (GOI), to manage the Export Marketing Fund (EMF) to accelerate the export growth of target products with industrialized markets. EMF-1 was a component of World Bank loan to India of USD 250 million for Industrial Export (Engineering products) project, while EMF-2, amounting to USD 37 million is a component of a World Bank loan to India for export development. EXIM Bank has also launched Export Marketing Finance EMF-3 from its own resources. Private Sector Companies and joint sector companies, who have the overall resources, capability potential, top management commitment and on export strategy to penetrate and retain presence particularly in developed country markets are eligible for use of EMF support. The funds are to support any manufactured export and in addition, computer software. The activities which are eligible for EMF support include: • Desk research • Overseas field market research • Minor product adaptation • Overseas travel • Product inspection services • Training Establishing overseas operations: • Travel to India by overseas buyers • Front-end promotional expenditure • Research and development • Equipment for plant modemisation/capacity enhancement • Tooling, jigs and fixtures • Testing/quality control equipment (vi) Product Liability Insurance (PLI): In developed countries product liability consciousness of the public is very high, resulting in a large number of litigation and high awards. This forces exporters to indemnify themselves against risk of incidence of product liability through product liability insurance offered by insurance companies. As the cost of PLI premium is high, which acts as a deterrent to market entry efforts of Indian exporters adversely, due to its affect on price competitiveness, EXIM bank's PLI programme enables the exporters' market entry efforts by sharing the initial costs of PLI premium. Registered Indian exporters endeavoring to export to OECD (Organization for Economic Cooperation and Development) countries are eligible for support under the programme. (vii) Export Vendor Development Lending Programme (EVDLP): Manufacturer, exporters and trading export houses source goods from vendors for export on a regular basis. Such indirect exports constitute a significant component of the country's exports. The EVDLP enables exporters to support vendor development. Exporters are granted Rupee loans for implementing strategic vendor development plans, for increased supply of exportable goods, through creation strengthening of backward linkages with vendors. Such activities include: • Acquisition of production machinery • Purchase of tooling, moulds, jogs, dyes and ancillary equipment • Core working capital assistance extended by exporters to vendors
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• Soft expenditure on vendors development such as vendor training, technical assistance to vendors EVDLP is exporter specific and aimed at capacity enhancing schemes to export large volumes through outsourcing products from vendors. (Sub-suppliers). Products purchased from vendors may be finished or semi-finished or intermediate products with the exporter adding value to the product in the form of further processing or marketing them. Thus EXIM Bank, as a specific institution for development of exports, has been undertaking various activities, besides financing to support all efforts of the Indian exporting community. This includes commodity exports as also exports of projects, consultancy, software, etc. 5. EXIM Bank line of credit programme for other countries: Under this route, EXIM Bank grants line of credit to Governments of other countries, for supporting their development plans, which allows the Indian exporter to get instant credit from EXIM Bank, upon exporting the goods/services and submission of export documents through their regular bankers. The beneficiary Government gets a long tenor of say 3-5 years to pay for the products and services, thus allowing them deferred payment credit. The exporters, get orders from the operating agency in the buyer's country, which is issued under the line negotiated with EXIM Bank. The EXIM Bank also issues a letter to the exporters about availability of lines for the order received by them. The exporter then, based on the order and letter of lines received from EXIM bank proceeds to get pre-shipment finance for procurement/manufacturing of goods. Once shipment is made, documents are to be submitted as per the order/LC, and reimbursement claimed from EXIM Bank, under the line available with them. Over the past few years, EXIM Bank has been quite aggressively expanding its financing programmes and has been continuously looking out for fresh borrowers, even by taking over financing from traditional bankers. The Bank has been helpful to Indian companies for their international ventures, take over of overseas projects, imports of large projects and machinery involving foreign currency funding, as also domestic imports and exporters for their imports and exports financing requirements. Check Your Progress (A) True or false: (a) Exim Bank was set up to develop the local bill discounting market. false (b) Exim Bank allows finance to local manufactures for producing goods for exports. false (c) Exim Bank is a subsidiary of RBI. true (d) Exim Bank also arranges issuance of guarantees for development of export/import business. true (e) The Export marketing funds mn by Exim Bank is to promote imports into India. false (f) Exim Bank allows credit line for promoting exports to developing countries, which helps these countries a facility of deferred credit. true
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7.2 RESERVE BANK OF INDIA - ROLE AND EXCHANGE CONTROL REGULATIONS IN INDIA Reserve Bank of India, being the central bank of the country, is empowered under the statute to control and regulate the foreign exchange reserves and policies related to international trade, inflow/outflow of foreign exchange, as also has supervisory powers over the persons authorized to deal in foreign exchange. It has the responsibility of maintaining the external value of Rupee, and thus can issue instructions on the subject of exchange control from time to time. Exchange control was introduced in India, due to severe constraints of foreign exchange during Second World War, with the Defense of India Rules 1935 (DIR 1935) issued as legislation. Later on, in 1973, the Rules were modified and introduced as an Act - FERA 1973, which came into effect from 1.1. 1974. Further, with the opening up of the economy, the FERA 1973 was repealed and a new Act FEMA 1999 was introduced, effective 1. 6. 2000. FEMA Regulations: As per Section 11(1) of FEMA 1999, Reserve Bank of India, is empowered to give any direction with regard to making payment or doing or desist from doing any act relating to foreign exchange or foreign security, for the purpose of securing compliance with the provisions of the FEMA, and any rules, regulations, notifications or directions made there under Under Section 11(3) of FEMA 1999, RBI may after giving reasonable opportunities of being heard, impose on the authorized person, a penalty which may extend to Rs 10,000.00 (Rupees Ten thousand) for contravention of any direction given under FEMA or failure to file any return under this Act. In case of continuing contravention, an additional penalty, which may extend upto Rs 2,000.00 per day, for which such contravention continues, may be imposed. As such, the Reserve Bank of India issues various guidelines under AP (DIR) series circulars, and other circulars, or issues specific directions to any authorized person, from time to time, to safeguard the interest and provisions of FEMA, and to comply with the responsibilities put on RBI under the Act. The guidelines and directions, so issued, relate to foreign exchange transactions relating to exports, imports, remittances, travel and tourism, investments in India, repatriation of funds, non-resident Indian segment, as also overseas investment by Indian residents. We have covered the exchange control guidelines related to exports, imports, NRIs, foreign exchange transactions, etc., in respective units. Another important task handled by the Reserve Bank of India is compilation of data related to export- import trade, forex markets, non-resident deposits, as also international assets and liabilities. The data collected by RBI from authorized dealers, goes into compilation of national level data on international trade, status of forex flows, and overall international assets and liabilities of the country. This data being cmcial for management of international trade relationship, as also the value of Rupee, is called for by RBI under FEMA regulations, and strict penal action imposed for non-submission, wrong submission or delayed submission. The data is to be submitted to RBI in the form of returns/statements, some of which are: (i) R Return - fortnightly data on forex operations, (ii) BAL Statement - statement showing balances in nostro, vostro accounts, (iii)STAT 5 - data on transactions related to FCNRB deposits, (iv) STAT 8 - data on transactions in NRE and NRO deposit accounts, (v) NRDCSR - consolidated data on non-resident deposits, (vi) International Banking Statistics (IBS) - quarterly data on all international assets and liabilities,
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(vii) Statement of Remittances sent under Liberalized Scheme for Residents (presently USD 200,000.00) - Monthly. (viii) Statement of Trade Credit - Buyer's Credit and Supplier's Credit - Monthly (ix) XOS - half-yearly exports outstanding statements, showing all overdue exports bills remaining unrealized. (x) BEF - statement showing details of imports where remittances have been effected but proof of imports (bill of entry) not submitted by the remitter. (xi) FEMIS - daily data on forex dealing room operations. Bank wide R Returns: The Reserve Bank of India, vide its instructions issued in 2007, desired that banks should endeavor to submit a single bank wide R Return. Those banks, which were not having the required IT infrastructure, have been advised to ensure to submit the bank wide R Return from fortnight starting 1.1.2009. While the new private sector banks and foreign banks and a few private banks, already using bank wide core banking solutions, started submitting Single R Return, the remaining old private sector banks and public sector banks have now started submitting a single R Return to RBI. 7.3 FOREIGN EXCHANGE MANAGEMENT ACT, (FEMA) 1999 FEMA, 1999 was enacted by the statute of the parliament, and was brought into force w.e.f 1. 6. 2000. The Act is applicable to all transactions in foreign exchange, undertaken in India or by persons resident in India. Earlier Foreign Exchange Regulation Act 1973 (FERA, 1973) regulated the area of foreign exchange, which had its origin from Defence of India Rules 1935, and later on FERA 1947. The foreign exchange regulations have come a long way since 1935, 1947 and 1973, and with the introduction of a liberalized regime under FEMA 1999, there has been a considerable relaxation in regulatory provisions related to foreign exchange transactions. The objective of FEMA is to facilitate external trade and payments and to promote the orderly development and maintenance of foreign exchange market in India, while the objective of FERA was to conserve the foreign exchange resources of the country and to ensure proper utilisation thereof in the interests of the economic development of the country. Under FEMA any violation of the provisions of the Act is to be dealt under the Civil law only, while under FERA, it was to be dealt under Criminal law. 1. Important Provisions of FEMA The provisions of FEMA relating to exports, imports, exchange rates, currency of payments, nonresident Indians, etc. have been covered in the respective chapters. Reserve Bank of India, has powers delegated under FEMA to issue guidelines, call for reports, data, as also to impose penalties, for violation of provisions of FEMA and for not complying to its directions. We briefly cover the FEMA guidelines applicable to resident Indians with regard to foreign travel, miscellaneous remittances and other areas as under; A. Foreign Travel The main provisions with regard to foreign travel are: (i) Drawal of exchange for travel to Nepal and Bhutan is prohibited. (ii) Payment in rupees for purchase of foreign exchange may be done in cash, if the rupee equivalent is not more than Rs 50,000. (iii)In case the rupee equivalent exceeds Rs 50,000, the payment should be made by crossed cheques, a banker's cheques or a pay order or a demand draft. (iv) Out of the total foreign exchange drawn, foreign currency notes and coins can be given by the authorized dealer, up to: (a) the entire amount in case of travel to Islamic Republic of
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Iran, Russian Federation or other states of erstwhile Russia, (b) Upto USD 5,000 for travel to Libya or Iraq, and (c) not exceeding USD 3,000 in all other cases. (v) A person resident in India can possess or retain foreign currency notes up to USD 2,000 or its equivalent, subject to specific rules on acquiring of such foreign exchange. However, a resident can possess foreign currency coins without any limit. (vi) While selling foreign exchange for travel abroad, the passport of the traveller need not be endorsed, unless specifically requested for by him. (vii) The traveler should surrender unspent foreign exchange within 180 days from the date of return. (viii) The unspent foreign exchange can be deposited by the resident in the Resident Foreign Currency Account (RFCD), with any Authorized Dealer (ix) For private visits, foreign exchange up to USD 10,000 or equivalent in one calendar year for one or more visits ( except Nepal and Bhutan), can be drawn. (x) For business visits, foreign exchange not exceeding USD 25,000 can be released to a person, for each visit, irrespective of the period of stay. Beyond this, prior approval of RBI has to be obtained. Drawal of foreign exchange out of RFCD or EEFC accounts can be made over this limit. (xi) For participation in international seminars, conferences, etc., an amount of USD 25,000 can be released per person. (xii) Person traveling abroad, for employment, or for immigration purposes, can draw foreign exchange not exceeding USD 100,000. (xiii) A person can draw an amount up to the estimate of the foreign hospital/doctor, for medical treatment. However, exchange upto USD 100,000 can be drawn, without submission of any estimate. (xiv) Persons going abroad for studies abroad, can draw exchange upto USD 100,000 per academic year. B. Other Remittances FEMA also allows residents to make remittances for following purposes also: (i) Gift remittance per remitter/per donor up to USD 5,000 in one calendar year, to relatives, friends, etc., abroad (ii) Donation per remitter/per donor up to USD 5,000 in one calendar year to charitable/religious/ cultural organisations. (iii)Subscription to Magazines/Periodicals can be allowed by the Authorized Dealers, except for the banned/proscribed magazines. (iv) Consultancy Services: Remittance to overseas consultants up to USD 1,00,000 per project. (v) International Debit/Credit Card/A TM Card: Residents can use their Credit/Debit or ATM cards while on visits abroad, which can be paid off through the designated AD branch, up to the entitlement of foreign exchange for visits abroad. Prohibitions: (a) Remittance towards purchase of lottery tickets, banned proscribed magazines, sweepstakes, money circulation schemes, etc., is not permitted. (b) Remittance of income from racing, riding not allowed. (c) Exchange for current account transaction with any person resident in Nepal or Bhutan is not permitted. (d) Remittance of prize money/sponsorship for sports events abroad, over USD 100,000 not allowed,
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(prior permission of RBI/GOl required). C. Indian Investments Abroad (i) From FERA 1973 - which had its main aim to conserve foreign exchange, India moved to FEMA 1999, which had its motto to facilitate external trade and payment and to maintain orderly growth of exchange markets. Section 6 (3) of FEMA also authorised RBI to regulate the transfer or issue of any foreign security by a person resident in India and the classes of permissible Capital a/c transactions & limit up to which exchange is admissible, (in consultation with Central Government). (ii) For Indian investments abroad, FEMA Notification No 19/20 - RB - 2000 dated 3'"'^ May 2000 - Transfer or Issue of any Foreign Security - As amended by various notifications, as also directions issued by way of AP (Dir Series) Circulars, are applicable. (iii)Extant guidelines/regulations prohibit following investments abroad: 1. Investments in Real Estate and Banking 2. Investments by Indian Entity Caution Listed - under investigation by the Enforcement Directorate - Defaulter to the Banking system etc. 3. Investments by Trasts (iv) Indians can invest abroad by way of: (a) Joint Venture: A foreign entity formed, registered or incorporated in accordance with the laws and regulations of the host country in which the Indian party makes a direct investment (b) Wholly Owned Subsidiary: A foreign entity formed, registered or incorporated in accordance with the laws and regulations of the host country, whose entire capital is held by the India party (v) Eligible investors Corporates including registered partnership firms Individuals Mutual funds Investment by a Firm: Partnership firms registered under the Indian Partnership Act 1932 engaged in any bonafide business activity &having a good track record are permitted to make investments, by submitting form ODA to the designated branch of an AD upto 100% of their net worth. Individual partners can hold the shares for and on behalf of the firm in overseas JV/ WOS if the host country regulations or operational requirements warrant such holdings. Investment in Overseas Companies: Listed Indian companies can invest in companies abroad listed on a recognised stock exchange which has share holding of at least 10%) in an Indian company listed on a recognised stock exchange in India(as on Jan 1 of the year of investment). Individuals: Can invest in overseas companies(subject to same restriction) and in rated bonds and fixed income securities without any monetary limit Mutual Funds: Can invest in companies (subject to same restriction),in ADRs/GDRs of Indian companies and also rated debt instruments within an overall cap of $1 billion May obtain permission from SEBI (vi) Methods of Funding: Indians can invest abroad in by way of any one of the following: Balances held in EEFC Accounts, Capitalisation of exports made to the investee company abroad, Purchase of foreign exchange from markets out of Rupee resources, Proceeds of ADRs/GDRs, without binging in foreign currency funds in to India. Swap of shares (subject to conditions) (vii) Obligation
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Receive share certificates/other document as evidence of investment-within six months/as permitted • Repatriate dues receivable to India-within 60 days of falling due • Submit APR to RBI-within 60 days of expiry of statutory period prescribed for fmalisation of audited accounts along with a note on working, CA certificate, FIRC, -Audited financial statements. • Transfer by sale (a) Indian party can sell any share or security held by it in a JVAVOS under Automatic route provided no write off is involved (d) Indian listed companies can disinvest even in case such disinvestment results in a write off of the capital invested upto 10% of their previous year's export realisation • Pledge of shares (c) Can pledge shares with an AD for availing credit facility for itself JV/WOS abroad (viii) Role of ADs • Designate select branches at different centres to handle the ODI transactions • Allow investments upto permissible limits, on receipt of form ODI in triplicate& form A2 • Report of remittance in form ODI (Part 1 and II) is to be forwarded to RBI, after affecting the remittance, in duplicate • Certify that regulatory approvals obtained for investments in financial sector • ODI form need not be forwarded to RBI • Partnership firm remittances to be forwarded with superscription "Remittance by partnership firm" in form ODI • Incase of investment by more than one Indian party, form ODI to be signed jointly by all the investing parties • Maintain parfy wise record in respect of each JWA\'OS separately • AD may allow remittance towards loan to JWAVOS/issue guarantee to JVAVOS • Indian party to submit details of capitalisation of export or other dues/royalties/consultancy fees in form ODA to the designated AD. • Capitalisation to be reckoned while computing cap of 100% • Custom certified copy of invoice to be obtained &to be forwarded to RBI within 15 days of effecting the shipment of goods • Capitalisation of export proceeds or other entitlements, which are overdue, require prior approval of RBI, for which Indian party has to file application in form ODI to RBI (ix) Identification number • RBI, on receipt of form ODR from AD, allots for each of the JVAVOS unique identification number • To be quoted in all future correspondence by the AD & Indian Party • Additional investment in an existing overseas concern to be allowed only after RBI has allotted the number (X) FORM-ODI Form ODI is a single form introduced by RBI for all Overseas investments in JVAVOS by Indian entities. The new form has four parts as under: Part I contains Details of the Indian Party (investor), details of the investment in the new project. Details of investment in existing project. Funding of JV/WOS, declaration by the Indian party and Certificate by the statutory auditors of the Indian Party. Part II of the ODI form, is for reporting of details of remittances.
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Part III of ODI form, is an annual Appraisal Report (APR) to be submitted by the chartered Accountant through the designated AD branch, and Part iv is a report on closure/disinvestment/voluntary liquidation/winding up of JVAVOS. 2. Foreign Currency Account in India Resident Indians can maintain following foreign currency accounts in India: A. Exchange Earners Foreign Currency (EEFC) Accounts Resident persons, companies or firms can open and maintain EEFC accounts, for the purpose to transacting foreign exchange business. Every recipient of foreign exchange is allowed to retain 100% of the amount in a foreign currency account, with any AD. This account is non-interest bearing current account. There is no restriction on withdrawal in rupees out of balances held in EEFC accounts. Payments towards Current account transactions, including payment for import of goods and services, and capital account transactions can be freely debited to EEFC accounts, up to the limits permitted by the respective rules. B. Resident Foreign Currency (RFC) Accounts Reuiming Indians, who were non-residents earlier and are now returning to India for permanent settlement, are permitted to open a foreign currency account with any AD, to keep their foreign currency assets held outside India, or any other monetary benefits from the employer outside India. The account holder can credit foreign exchange received outside India as gift, or in heritance from a person resident outside India, also. C. Resident Foreign Currency (Domestic) Account - RFCD A person resident in India is allowed to open and maintain a Resident Foreign Currency account with an AD, out of the foreign exchange acquired by him in the form of currency notes, or travellers cheques, while on a visit to any country outside India, (not from business), or as an honorarium or gift for service rendered in India to any person who is not a resident of India, and is on a visit to India, or represent unspent foreign exchange acquired for travel abroad. The account is a non-interest bearing account, in the nature of current account. Debits to the accounts can be for any current account transactions, which are in accordance with various provisions in this regard, as also for Capital account transactions, as provided, under FEMA regulations. D. Diamond Dollar Account (DDA) The facility of opening Diamond Dollar Accounts has been granted to diamond exporters, as the products they export is imported in raw form, from abroad. India imports, rough diamonds and exports polished diamonds to various countries in the world. As such, since the diamond exports usually need to remit a large part of their realisation of export proceeds for payment of import bills, they can park their foreign currency funds in these diamond dollar accounts and remit funds to retire their import bills, without incurring any exchange risk. As per RBI guidelines, exporters with two years in export trade of diamonds can open DDA accounts with any Authorised dealers. Large exporters can open accounts with more than one AD, with a maximum of 5 accounts. For this purpose, large exporters are those,whose annual average turnover is equal to or greater than Rs.3 crores. Authored Dealers can credit 100 % of the export realisation to DA accounts. Check Your Progress (B) True or False: 1. As per FEMA 1999, Reserve Bank of India, is empowered to give any direction for the purpose of securing compliance with the provisions of the FEMA.
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true 2. RBI has no powers to take any penal action for non-submission of information/statements called for under provisions of FEMA. false 3. Drawal of foreign exchange for travel to Nepal is similar to drawl for visit to UK. false 4. For private visits, foreign exchange up to USD 10,000 per year, can be drawn. true 5. There is no restriction for drawl of exchange for medical treatment even if no estimate is produced. false 6. Remittance towards purchase of lottery tickets is allowed under FEMA. false 7. Interest can be paid on balances held in EEFC accounts. false of rupee, and thus can issue instructions on Fill in the Blanks: (a) RBI has the responsibility of maintaining the the subject of exchange control from time to time. External value (b) Payment in rupees for purchase of foreign exchange may be done in cash, if the rupee equivalent is not more than Rs . _________________________________________________ can be released to a person, 50,000 (c) For business visits, foreign exchange not exceeding USD for each visit, irrespective of the period of stay. 25,000 (d) Subscription to Magazines/Periodicals is allowed, except for the Banned (e) RFC fixed deposit accounts are _____ bearing current accounts. interest (f) RFCD accounts can be opened by _____ Indians. magazines. resident 7.4 ROLE OF FEDAI AND FEDAI RULES A. About FEDAI FEDAI is a non-profit making body, established in 1958, with the approval of Reserve Bank of India, to take over certain functions of the then Exchange Banks Association (foreign banks). RBI had made it mandatory for all authorized dealers to abide by the rules and terms and conditions prescribed by FEDAI for transacting foreign exchange business. The total membership of FEDAI was 89, as on November 2009, which comprised of foreign banks, public sector banks, private banks, cooperative banks as well as financial institutions, authorized by RBI to deal in foreign exchange. The main objective of FEDAI is to regulate the dealings of, and between authorised dealers and further their interests. However, FEDAI has been playing a pivotal role in the framing of uniform rules for the market participants (several of which have since been withdrawn as a measure of
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liberalisation of markets), development of forex markets as also undertaking ground work for further relaxation and development of markets. The functions of FEDAI can be listed as under: (i) Framing uniform rules and guidelines for ensuring level playing field. (ii) Playing the supporting role of catalytic for growth of India's external sector along with RBI and other organizations. (iii)Providing training to bank officers, including conducting seminars, workshops on the topics related to foreign exchange and exchange markets. (iv) Granting accreditation to forex brokers. (v) Providing guidance and information to members on various aspects of foreign exchange business and markets. (vi) Preparation for further relaxation of forex markets, particularly derivatives market. (vii) Market research facilities for measurement and management of risk. (viii) Counselling and guidance on forex business. With the growth and development of markets, and liberalization thereof of forex markets, FEDAI has also adopted to a new role with focus on value added services to member banks. B. FEDAI Rules FEDAI has formulated various rules for the foreign exchange operations of Authorised Dealers, with an intention to have uniformity in dealings, and ensuring level playing field, particularly during the initial years of the development of the markets. Some of the rules have since been deleted from the rule book, keeping in view the required liberalization of the economy, the trade policy as also to infuse competitiveness amongst banks, which ultimately benefited the exporter/importer customers. We shall first look into some important rules presently applicable to authorised dealers: Rule I. Hours of Business Each AD to fix its own working hours for various types of forex business, including dealing room operations. For dealers, extended dealing hours, if any, should be duly approved by the Management. Rule 2. Export Transactions (i) Cn-stallization of Bills: In view of the exchange risk inherent to the forex transactions, in case of delay in realization of export bill negotiated/purchased or discounted, the foreign exchange liability of the exporter must be crystallized into Rupee liability, on the 30th day after expiry of the Notional Transit Period ( NTP ) in case of demand bills and on the 30th day after notional due date in case of usance bills. The rule has since been relaxed for bank's to decide on the days for crystallisation on their own, based on nature of commodity, country of export etc. The crystallisation period can vary from bank to bank, customers to customers, etc. The difference in exchange rate between the rate at which the bill was purchased/discounted/negotiated and the rate at which crystallisation is done, should be recovered/paid to the customer The advance so allowed as such continues as a Rupee advance, from the date of crystallisation till the date of payment/recovery. However, banks have retained the original 30 day rule for customers in general. (ii) Application of interest: Interest rates as prescribed by RBI shall be applicable for all export transactions and concessional rate of interest should be applied for the normal transit period in case of demand bills and up to notional due date in case of usance bills. In case of realisation prior to the NDD, the banks should refund the interest for excess number of days,
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to the exporters. Also, premium passed earlier for the period should be recovered, as per prevailing market rates. (iii)NTP: For all bills in foreign currencies: 25 days. (For exports to Iraq, NTP shall be 60 days from the date of shipment, in case of exports to Iraq under UN guidelines). For Rupee bills - bills drawn under LC where reimbursement is provided at same centre (locally): 3 days, at any centre in India, other than the place of negotiation: 7 days. For Rupee bills not drawn under LC-20 days. (iv) Authorised dealer should pay interest for the delay in payment to the exporters on export bills sent for collection and realized, if the delay is more than the prescribed period from the date of receipt of credit advices/statements. Rule 3. Import Transactions (i) For retirement of import bills, whether under LC or otherwise, bank's bill selling rate ruling on the date of retirement of bills or the forward rate, shall be applied. (ii) All foreign currency bills under LC, if not retired on receipt, shall be crystallized into Rupee liability, at TT Selling rate, on the 10th day after the date of receipt of documents. Rule 4. Clean Instruments (i) All foreign currency inward remittances up to an equivalent amount of USD 5000 shall be immediately converted into Indian rupees. Remittances above this amount, shall be converted upon getting option of the beneficiary within the maximum prescribed period. (ii) Beneficiary of inward remittance should be compensated in case the proceeds are not paid within 10 days from the date of receipt of remittance, or an advice of receipt is not sent within 3 days. Such compensation will be at 2% p.a. over the savings bank rate. Rule 5. Forward Contracts (i) Exchange contracts will be for definite amounts and periods. (ii) The customer, subject to the period not exceeding beyond one month, may specify option period for the delivery. Contracts must state the first and the last date of contracts, e.g. from 1-31 January 2009 or from 17 January to 16 February 2009, etc. (iii)The option of delivery lies with the merchant, whether a buyer or a seller. (iv) The bank shall pay/recover swap difference, if any, if it accepts or gives early delivery. (v) In case an extension of contract is sought, all contracts should be cancelled at appropriate TT selling or buying rate and re-booked at the current rate of exchange. (vi) Forward contracts can be cancelled on or before the maturity at the request of the customer, against recovery/payment of difference in rates, as the case may be. (vii) In case no instructions to cancel the contract are received from the customer, all overdue contracts shall be cancelled on the 7th working day after the maturity date. In such cases, where contracts are cancelled after due date, no difference, if accruing to the customer will be paid to him. He shall however be liable to pay adverse difference, if any. Rule 6. Business with Exchange Brokers (i) Business shall only be undertaken through accredited exchange brokers. (ii) No exchange contract will be made with a broker as a principal. (iii)Banks are also required to submit a monthly statement to FEDAI showing details of deals executed through brokers, where exchange difference, if any has been paid by the brokers due to movement in rates. Rule 7. Interbank TT-Settlement (i) For smooth settlement of interbank transactions, the buyer bank must pay the Rupee equivalent on the value date, as per the instructions of the seller bank, and the seller bank
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must arrange to deliver the foreign currency funds on the value date, into the nostro account as per the instructions of the buyer bank. (ii) In case of any default or delay in settlement of Rupee or foreign currency funds, the buyer bank or the seller bank shall pay compensation to the other party, at the prescribed rate. FEDAI publishes prime rates for major currencies on monthly basis. FEDAI rules earlier contained guidelines on calculation of exchange rates for customers, margins, as well as schedule of charges/commissions to be levied on various types of export/import transactions. However, gradually these guidelines were withdrawn, and banks were given freedom to fix/quote their own rates of exchange and commissions/charges. The margins on exchange rates as also the rates of commissions have reduced to a great extent, lowering the costs to the corporates. Check Your Progress (C) Fill in the blanks: (i) FEDAI, is a__________ making body, established with the approval of Reserve Bank of India, to take over certain functions of the then Exchange Banks Association. Non profit (ii) The functions of FEDAI include framing ____ rules and guidelines for ensuring level playing field. uniform (iii) The NTP allowed for all bills in foreign currencies is generally __ days. 25 (iv) As per FEDAI rules, banks shall undertake business only through exchange brokers. accredited (v) Import bills should be crystallized on the ____day, if not paid by the date. 10th (vi) Export bills should be generally crystallized on the _ due date. 30 (vii) Overdue forward contracts should be automatically the due date of contract. day from the due date/notional _ on the 7th working day, from cancelled 7.5 SHORT NOTES ON OTHER TOPICS 1. External Commercial Borrowings In a broader sense, it would include commercial bank loans, buyer's credit, supplier's credit, bonds, loans from ODAs, multilateral agencies. However, taking a limited view, ECBs would include medium and long-term loans as permitted by Reserve Bank of India and the Government of India. ECBs have been permitted by the Government of India as a source of finance for fresh investments and for expansion of existing facilities. Since these constitute international debt for the country, the Government keeps some ceiling or a cap on ECBs in line with its debt management policies. Buyers credit or suppliers credit (trade credit) for three years and above also come under the category ofECBs. ECBs availed by residents are governed by provisions of section 6, FEMA 1999, as amended from time to time. The updated guidelines have been covered under RBI Master circular dated 1. 7. 2009 on the subject. ECBs can be availed under Automatic Route or Approval Route.
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(i) Automatic Route ECB for investment in real estate sector, industrial sector, infrastructure sector will not require any approval from RBI or Government of India, can be accessed by companies, registered under Companies Act. This route is not available for individuals, tmsts and non-profit making organisations, and financial intermediaries such as banks, housing finance companies, etc. For raising funds under this route, funds have to be raised from internationally recognised sources, such as banks, capital markets, export credit agencies, suppliers of equipment, etc. The maximum amount that can be raised under this route can be: (a) USD 20 million, with a minimum average maturity of three years. (b) Above USD 20 million and up to USD 500 million with average maturity of five years. The ail in cost, which includes interest and other expenses, except commitment fees, prepayment fees or other fees payable in Indian Rupees should be 300 basis point above six months Libor for average maturity period of three to five years, and 500 bps above six months Libor for average maturity of over five years. The borrower may enter into an agreement with the recognized lender for raising ECB, within the prescribed guidelines, without prior approval of RBI and ensure to comply with the reporting requirements. It will be the borrowers' responsibility to ensure compliance of all prescribed guidelines related to end - use, cost, ceilings, etc. (ii) Approval Route Under this route financial institutions dealing with infrastructure financing or export credit, and banks or institutions participating in textile or steel sector restructuring, as approved by Government of India, as also others not falling under automatic route are eligible to borrow funds from overseas market. The funds are to be raised from recognised lenders, with similar caps for all in costs, as in the case of automatic route. There are restrictions on end use of the funds so raised under this route. Issuance of guarantees or standby LCs or letter of undertaking or letter of comfort by banks or financial institutions for raising ECBs is not allowed, except permitted by Reserve Bank of India. 2. American Depository Receipts (ADRs) ADR is an instrument similar to GDR and is issued in the capital markets of USA alone. Generally, far more stringent rules and regulations prevail for bringing out an ADR issue. An American Depository Receipt is a receipt or a certificate issued by a US bank, representing title to a specified number of shares of a non-US-company. The US bank is a depository in this case. ADR is the evidence of ownership of underlying shares. ADRs are freely traded in the USA, without actual delivery of underlying non-US-shares. ADRs can be created in two ways: 1. LnsponsoredADRs One way to create ADR is by an arrangement which is not initiated by the company concerned, but is generally set up by one or more US brokers, when it is observed that a large number of American investors are interested in dealing in the shares of a non-US-company. The brokers then ask a US depository bank to create ADRs. The depository has to register the ADRs with the Securities and Exchange Commission (SEC), which is the main securities regulator in USA. However, as the ADRs are not initiated by the company concerned, the depository may not be able to fulfil the reporting requirements of the SEC. Therefore, the depository asks exemption from these.
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he depository banic receives the compensation or the income from issuance of certificates and from cancellation fees. It also deducts fees from dividend payments. The company whose shares are linked to this kind of ADRs, is not required to pay any costs to the depository. The trading of ADRs takes place in some of the stock exchanges in USA such as NASDAQ or NY stock exchange. 2. Sponsored ADRs In this case the issuing company actively promotes the company's ADRs in the USA, choosing a single depository bank, which assumes sole responsibility for administration and dividend payment. In this case, the administrative costs involved in issuing the ADRs are borne by the issuing company. The proceeds of the ADR issue are also received by the company. The registration of ADRs with SEC (Securities Exchange Commission) is not compulsory. The company needs to submit its annual reports to SEC. Unregistered ADRs are not eligible for listing on any of the American stock exchanges. However, trading in such ADRs may take place on the NASDAQ's bulletin board. If the ADRs are to be registered with SEC, the financial statements of the company need to be prepared in accordance with US Generally Accepted Accounting Principles (US GAAP) and fiilfil listing requirements of at least one of the US stock exchanges. The size of ADR can expand or reduce depending upon demand, as depository banks can issue or withdraw corresponding shares in the local market. Generally, raising forex funds through ADR/GDR route is preferred to external commercial borrowing route. Commercial borrowing adds to the country's external debt burden, which is not the case with ADR/GDRs. 3. Global Depository Receipts (GDRs) A GDR is a dollar denominated instrument, tradable on a stock exchange in Europe or private placement in USA, representing one or more shares of the issuing company. The shares are acquired by a bank in Europe, which then issues its own "receipts" or "certificates" to the investors. This bank is called a "depository" and such certificates are called "Global Depository Receipts," in short, GDRs. These GDRs can be traded on the European exchange. A holder of a GDR can at any time convert it into the shares that it represents. However, till conversion, the GDRs do not carry any voting rights. The company, which has issued GDRs, has no commitment to pay any amount in foreign exchange, and thus has no exposure in foreign exchange. As a result, it has no foreign exchange risk. The dividend paid by the company is in local currency. The holder of the GDR has to get the amount converted in US dollars at the prevailing exchange rate. As the GDR represents shares, there is no redemption involved. The company doesn't have to make any payment either in foreign exchange or in local currency for the repayment of GDRs. This arrangement thus, works to the advantage of the company as also is convenient for the holder of the GDRs, as it can be traded on a
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foreign stock exchange where they are Hsted. Ahematively, the holder can convert the GDR into its underlying shares, sell these on the local stock exchange, and then convert the proceeds into US dollars at the prevailing exchange rate. The main features of GDRs are as under: 1. GDR has a distinct identity from the underlying shares. 2. GDRs do not appear in the books of the issuing company. However, the underlying shares appear in its books. 3. The issuing company collects the GDR proceeds in foreign currency. It may then use these proceeds for meeting the foreign exchange component of its project cost, repayment of foreign loans, or for its domestic expenditure. 4. A GDR holder has the option to convert the GDR and hold the underlying equity shares. 5. GDRs are normally listed on Luxembourg exchange and traded at two other places besides the place of listing-OTC market in London and private placement market in USA. 6. GDR does not entitle the holder any voting rights. However, the holder gets the voting rights, when he prefers to convert GDRs into underlying shares. 7. GDR is an instrument governed by international law. 8. Pricing of GDR would generally be in line with the pricing of underlying shares. However, based on international market conditions and perceptions about domestic currency, the GDR may be at discount or at premium compared to domestic share prices. 9. The GDR market is a global one. It is therefore exposed to international influences, like prices of other securities in the financial market or interest rates in the US market. Currency markets also have impact on GDR prices. 4. Foreign Currency Convertible Bonds (FCCB) Foreign currency bonds market is an important source of raising funds. The issuers, at times issue convertible bonds, which are equity related, and are convertible in part or full, into equity of the issuing company at a later date, say a few years from the date of issue. It can be said that the bonds have warrants attached to it, which entitles the holder to get equity shares in the company, say at an agreed price, or ratio. FCCBs, in similar nature, are fully or partly convertible bonds, which give right to the holder to convert the amount into equity shares, at a pre-agreed price. Here, keeping in view the right being given for acquiring equity, the interest rate is very fine, as compared to a pure debt bond. FCCBs also have optional conversion into shares, at the option of the bond holder The bondholder would exercise the right to convert the bond into shares, when the market price of the equity shares, is higher than the exercise price, otherwise, the bondholder would like to get back the money from the issuer Indian companies are allowed to issue FCCBs, in terms of RBI guidelines. Check Your Progress (D) Fill in the blanks: (a) ECBs can be availed under --- Route or approval Route. automatic (b) In case of unsponsored ADRs, the company whose shares are linked to this kind of ADRs, is --- to pay any costs to the depository. not required (c) The administrative costs involved in issuing the ADRs are borne by the issuing company, in case of --- ADRs.
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sponsored (d) A GDR holder has the option to convert the GDR and hold the underlying equity --- . shares (e) GDR does not entitle the holder any--- rights. voting Let Us Sum Up We have seen the role played by the Reserve Bank of India, Exim Bank, ECGC, and FEDAI in the field of international banking. The development of forex markets and the international trade in India, could not have been possible without the support and vision of these agencies. The FEMA 1999, has transformed the scenario, and given an open field to the Indian exporter and importer as also public at large, to get into the international trade and finance with an open heart. The policies framed by FEDAI to provide a level playing field to all banks, and gradual opening up the competitive environment has also given an edge to the trade, by reducing their transaction costs. The policies and guarantees of ECGC, provide comfort to financing community, thereby making available large resources for export trade. And the new guidelines on ECB as also opening up of the global markets for generating foreign currency funds through ADR/GDR, also have its own contribution to the development of Indian financial markets and industry. It can be very well said that the institutional set up and the liberalization of policies have both led to the country achieving new heights in the field of international trade and finance. Keywords Exchange Control: The controls imposed by the Government or the central bank of the country restricting the inflow and outflow of foreign exchange. Authorised Persons: Persons authorized to deal in or handle transactions related to foreign exchange, in terms of FEMA 1999. EEFC Accounts: Foreign currency accounts allowed to be maintained in India by earners of foreign exchange. Pre-shipment Credit: Credit allowed for procuring, processing, manufacturing and packing of goods meant for exports. Post-shipment Credit: Credit allowed against export bills, after shipment has taken place. Refinance: Secondary financing of bills or credit portfolio, already financed by banks or institutions, as a support to primary financers. Lines qf Credit: Credit limits for funded or non-funded business allowed by banks or financial institutions to other banks, or Governments or other parties. FEDAI rules: Rules made by FEDAI, applicable to all authorised dealers, to ensure level playing field. Crystallization of Bills: Conversion of the bill liability into Rupee liability. External Commercial Borrowings, in a broader sense would include commercial bank loans, buyer's credit, supplier's credit, bonds, loans from ODAs, multilateral agencies. GDR: Global Depository Receipt - a dollar denominated instrument, tradable on a stock exchange in Europe or private placement in USA, representing one or more shares of the issuing company. ADR: An American Depository Receipt is a receipt or a certificate issued by a US bank, representing title to a specified number of shares of a non-US-company. Unsponsored ADR: One way to create ADR is by an arrangement which is not initiated by the company concerned, but is generally set up by one or more US brokers, when it is observed that
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a large number of American investors are interested in dealing in the shares of a non-UScompany. Answers to Check Your Progress A. (a). False (b). False (c).True (d). True (e) False (f) True B. 1. True; 2. False; 3. False4. True; 5. False; 6. False; 7. False; (a) External value; (b) 50,000; (c) 25,000; (d) Banned; (e) interest; (f) resident. C. (i) non-profit, (ii) uniform, (iii) 25; (iv) accredited; (v) 10 (vi) 30; (vii) cancelled. D. (a) automatic (b) not required (c ) sponsored (d) shares (e) voting Terminal Questions True or False: 1. Exim Bank was established under Companies Act 1956, to promote financing of LC bill financing in India. 2. Exim Bank extends lines of credit to foreign Governments to promote exports from India. 3. Exim Bank is the nodal agency for Export marketing Fund of Government of India. 4. FEMA 1999, replaced Defense of India Rules. 5. Indian residents can draw exchange up to the limits prescribed for visit to Nepal. 6. While visiting abroad to Europe, an Indian resident can spent exchange up to the eligibility by using his international credit card. 7. Investment abroad by a tmst, registered under Charitable Tmsts Act, is allowed up to USD 5.00 million per year 8. Resident Indians can park their surplus foreign currency balances, left out after return from abroad, in their RFCD account with a bank in India. 9. As per FEDAI guidelines, forward contract booked by an exporter needs to be cancelled on the 7 th working day, from the due date, if not picked up within the delivery period. 10. Corporates can raise funds through ECBs for any amount, with the tenor and pricing left to the discretion of the borrower and the lender 11. ADRs can be registered in USA, under Securities and Exchange Commission. 12. GDRs can be converted in to shares that it represents. References for Further Reading 1. Reserve Bank of India Guidelines for Internal Control for Foreign Exchange Business, Master Circulars, Circulars, issued from time to time. 2. FEMA 1999. 3. FEDAI Rule Book and various circulars on the subject. 4. FEDAI Study Booklets for Orientation workshops. 5. All earlier publications of IIBF.
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MODULE B RISK MANAGEMENT UNITS 8. Risk and Basic Risk Management Framework 9. Risks in Banking Business 10. Risk Regulations in Banking Industry 11. Market Risk 12. Credit Risk 13. Operational Risk and Integrated Risk Management
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UNIT 8 Risk and Basic Risk Management Framework STRUCTURE 8.0 Objectives 8.1 Introduction - What is Risk? 8.2 Risk, Capital and Return 8.3 Why Risk Management Let Us Sum Up Check Your Progress 8.4 Basic Risk Management Framework Let Us Sum Up Keywords Terminal Questions Answers to Check Your Progress Answers to Terminal Questions 8.0 OBJECTIVES This chapter will be helpful in: • Understanding Concept of Risk • Conceptual understanding of the linkages among risk, capital and return • Why risk needs to be managed 8.1 INTRODUCTION - WHAT IS RISK? In most cases, we observe that there is deviation in what we achieve from what we had planned or what we had expected. This unpredictability of future is due to uncertainties associated with the steps that we undertake in the process or various external factors that influence the processes that are necessary to achieve our planned objective. Let us understand it through an example. Say we have to keep an appointment that is very important and we have to reach in time for it. In order to keep the appointment, one has to get ready well in time, arrange a transport and travel the distance to the place of appointment. All these factors are inseparably associated with the process of reaching the place of appointment. There are uncertainties associated with all of them. One may get ready early or be delayed, transport may become available well in time or there may be difficulty and delay in getting it, there may be traffic jam or traffic disorder or traffic flow may be very smooth, the vehicle may breakdown on the way or it may be a trouble-free drive. If everything goes well, one would reach well in time. The uncertainties associated with the factors do not hurt him. But these uncertainties may also become instrumental in one's failing to reach in time. In other words, there is the risk of reaching late for the appointment, which is due to the uncertainties associated with factors mentioned above. These factors are the risk elements or contributors to the uncertainty. Risk would arise when these uncertainties affect adversely. We may define 'Risks' as uncertainties resulting in adverse outcome, adverse in relation to planned objective or expectations. 'Financial Risks' are uncertainties resulting in adverse variation of profitability or outright losses. As for as profit or loss of business depends up on the net result of all cash inflows and cash outflows, uncertainties in cash inflows and/or outflows also create uncertainties in net cash flow or profits. Factors that are responsible for creating uncertainties in cash outflows and cash inflows are the risk elements. In a simple case of a trading business that involves purchase of goods for sale with some administrative and transportation costs, cash inflows would arise from sale. The variation in sales volume and unit price realisation would create uncertainties in cash inflows. Similarly, cash outflow would arise from purchases and administrative and transportation costs. Uncertainties in
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purchase price (assuming goods are always available at a price) and other costs would create uncertainties in cash outflows. Uncertainties in both, cash outflows and inflows would result in uncertainties in net cash flow or profits. This can affect profits favourably or unfavourably. If sales price and/or sales volume are more than what was expected or purchase price decline or other expenses incurred are less, it will result in higher profits. But, if sales volume and/or sales price decline or purchase price rises or other expenses increase, it will result in lower profits or even outright losses. Risk of the business would lie where profits are adversely affected. This can happen due to adverse impact of uncertainties associated with sales volume, sales price, purchase price and administrative and transportation expenses, which are risk factors or risk elements. Uncertainties associated with risk elements impact the net cashflow of any business or investment. Under the impact of uncertainties, variations in net cash flow take place. This could be favourable as well as unfavourable. The possible unfavourable impact is the 'RISK' of the business. In the same example, suppose that the trader engages in trading of a commodity where demand fluctuates wildly and/or prices also change substantially over a short period, as is observed in case of trading in shares. In such cases if everything moves favourably, the trader can earn very high profits. Reverse would be true if everything moves adversely. In other words, variability in net cash flow would be high in such cases and because of that it may result in higher profits or in adverse situations, higher losses. We call such business a business with higher risk. Similarly, if variability in net cash flow is lower, it will result in lower profits and lower losses and the business would have lower risk. Lower risk implies lower variability in net cash flow with lower upside and downside potential. Higher risk would imply higher upside and downside potential. We may also consider another case where say a retired person has invested Rs 1 lakh 6.50% (payable half yearly) RBI bond that has a maturity of 5 years. The gentleman would receive interest of Rs 3,250 every half-year and would receive back the principal after the maturity period is over. The cash flow associated with the said investment, as we all know, does not have any uncertainty associated with it. In other words, this is a risk-free or zero-risk investment for the period it is invested. It may also be noted that this investment being risk-free, returns are also one of the lowest as compared to other investment opportunities available in the market. Zero-Risk would imply no variation in net cash flow. Return on zero-risk investment would he low as compared to other opportunities available in the market. 8.2 LINKAGES AMONG RISK, CAPITAL AND RETURN The above summarisations also enable us to determine key drivers in managing a business. It also gives a linkage with the capital required for carrying out a business. In simple terms minimum capital required for a business should be such that it is able to meet the maximum loss that may arise from the business to avoid bankruptcy. A business with large variation in net cash flow would be a business with higher risk. The profit potential and loss possibilities would be higher in such businesses due to higher variability of net cash flow. Capital requirements would be higher because of possibilities of higher losses. Similarly, a business with lower variation in net cash flow would be a business with low risk. The profit potential as well as loss possibilities would be lower in such businesses due to low variability of net cash flow. Capital requirements would also be lower because of possibilities of lower losses. This is the basic linkage between risk and capital.
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In addition, returns expected from a business would be in relation to the risks associated with the business. To understand risk and return linkage, let us take an example. Let us say there are two investment opportunities before you. Cash flows from both these investments over a five-year period are given below. (Rs in WOs) 1 Cash Flow Year I Year 2 Year 3 Year 4 Year 5 Total from Investment I 6 6 6 6 6 30 Investment 2
If we ignore the time value of money, both these investments yield Rs 30,000 over five-year period or @12% p.a. simple, assuming initial investment at Rs 50,000. From return on investment point of view both are equal, but intuitively, without going into the arithmetic, one is more likely to prefer Investment 1. This is because of steady strearn of cash flow associated with it. Investment 2 would have a chance to become equally acceptable provided return on it is higher than what it is now, say @14% p.a. simple. This 2% additional return is the risk premium or cost of risk. Higher the risk is higher would be this premium. Where we compare two investment options, comparing the return on investment may not lead us to a correct conclusion as risks associated with these investments may differ. It would be desirable to account for risks as well. Returns net of risk would be the proper basis of comparing investments. In other words, risk in a business or investment is netted against the remm from it. This is called Risk Adjusted Return on investment. The Risk Adjusted Return happens to be the key factor in investment decisions of investors. Therefore, key driver in managing a business is seeking enhancement in risk-adjusted return on capital (RAROC). Higher the RAROC, higher is the reward to investors/shareholders and more preferable such investment would be to the market. The return on equity, which is computed from financial statements of a company, fails to capture risks in the revenue model and therefore, is not quite reliable tool in investment decision making. In other words, capital requirement of a business or revenue model would depend upon the risks associated with the business or revenue model and expected return on the investment would also factor in the risks associated with it. Higher the risks in a business model, higher would be the capital requirement and return expectations. The reverse is also True. This is the linkage between risk, return and capital. 8.3 WHY RISK NEEDS TO BE MANAGED We know that uncertainties associated with risk elements impact the net cash flow of any business or investment. Under the impact of uncertainties, variations in net cash flow take place. This could be favourable as well as unfavourable. The possible unfavourable impact is the "RISK" of the business. However, it should be understood that the 'unfavourable impact of uncertainties' or 'risk in a business' is not constant or of a fixed magnitude. It can vary depending on the degree of severity of adverse variations of uncertain factors. To clarify the point, let us revisit the example of the simple trading business discussed in Section 8.1 that involves purchase of goods for sale with some administrative and transportation costs. Apparent uncertainties in this business would include variation in sales volume, unit price realisation, purchases and other costs. Adverse impact on the business would arise if sales volume and/or sales price decline or purchase price rises or other expenses increase. In a simation where unit price falls after purchases have been made, the business would incur loss. If
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purchased quantity is less or unit price rises within a short time, the loss suffered in the business would be low and perhaps can be absorbed in the profits made during the planned period. However, if purchased quantity is more and unit price realisation remains low over a considerable period or unit price has undergone a structural change, the losses can be severe and may wipe out a part of the capital invested in the business or even the entire capital and affect its survival. The criticality of risk management in the management processes of any organisation becomes apparent when viewed from the angle of the very survival of an organisation particularly in severely adverse business situations. In such situations, the cash flows are affected and losses may be high enough to wipe out the capital employed in the business resulting in its bankruptcy. Such a situation may be avoided if loss potential of a business can be controlled. The loss potential of a business is strongly correlated to the uncertainties of business factors as it is the outcome of their adverse impact. In other words, the loss potential of a business is cortelated to the risks in the business, and therefore, risk exposure of a business needs to be managed so as to limit potential losses in adverse situations to a level that can be absorbed by the organisation without affecting its continuity. This aspect of risk management creates an imperative to develop methods to measure risk so that an organisation is aware of the risk it is carrying for its business, i.e., it has a measure of its potential losses in severely adverse situations and may ensure adequate capital availability for its continuance or limit its risk exposure to the extent of capital available. While measure of potential losses in severely adverse situations determines adequacy of capital for continuity, the losses arising on account of risks in a business nevertheless have to be accounted for. This is done by treating it as t oost of business. There is a probability of loss associated with all risks. This is factored into pricing. This is another aspect of risk management processes which not only identifies various risks in the business or revenue model but also estimates probability of loss associated with such risks. It may be noted that tl" process is critical as overestimation of loss on account of risks may result in overpricing resulting ' ss of business. Underestimation of losses, on the other hand, may result in lowering of profits, wl. would affect planned RAROC. Controlling the level of risk to an orgai .lion's capacity to bear the risk is the essence of risk management and it requires not only identification of risks but also its measurement, control, mitigation and estimating the costs of risk. Since risk management happens to be a job that requires special skills and has an objective which is more orientated towards control aspect of the business, it not only requires a separate setup in the organisation, it also needs a vvell-defined framework that guides the risk management function. Let Us Sum Up 1. We may define 'risks' as uncertainties resulting in adverse outcome, adverse in relation to planned objective or expectations. 'Financial Risks' are uncertainties resulting in adverse variation of profitability or outright losses. 2. Uncertainties associated with risk elements impact the net cash flow of any business or investment. Under the impact of uncertainties, variations in net cash flow take place. This could be favourable as well as unfavourable. The possible unfavourable impact is the 'RISK' of the business. Lower risk implies lower variability in net cash flow with lower upside and downside potential. Higher risk would imply higher upside and downside potential. 3. Zero Risk would imply no variation in net cash flow. Return on zero risk investment would be low as compared to other opportunities available in the market.
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4. Capital requirement of a business or revenue model would depend upon the risks associated with the business or revenue model and expected return on the investment would also factor in the risks associated with it. Higher the risks in a business model, greater would be the capital requirement and return expectations. The reverse is also True. This is the linkage between risk, return and capital. Controlling the level of risk to an organisation's capacity to bear the risk is the essence of risk management and it requires not only identification of risks but also its measurement, control, mitigation and estimating the costs of risk. Check Your Progress A) Investment in Post Office time deposit is (i) Zero-risk investment (ii) Low-risk investment (iii)Medium-risk investment (iv) High-risk investment Ans: Zero-risk investment B) Zero-risk investment implies (i) Zero variation in cash flow from investment (ii) Investment in zero coupon bonds (iii)Investment in government securities (iv) Investment in bank fixed deposit Ans: Zero variation in cash flow from investment C) Which of the following statements is correct? (i) Higher the risk-higher would be risk premium (ii) Higher the risk-lower would be risk premium (iii)Lower the risk-higher would be risk premium (iv) None of the statements is correct Ans: Higher the risk-higher would be risk premium D) Which of the following statements is correct? (i) Higher the risk in a business, higher would be capital requirement (ii) Higher the risk in a business, higher would be return expectation (iii)Higher the risk in a business, higher would be capital requirement and higher would be return expectation (iv) None of the statements is correct Ans: Higher the risk in a business, higher would be capital requirement E) What is most critical function of Risk Management? (i) Controlling the level of risk to an organization's capacity (ii) Identification of risks (iii) Estimating the costs of risk (iv) Measurement of risk Ans: Controlling the level of risk to an organization's capacity 8.4 BASIC RISK MANAGEMENT FRAMEWORK Following are the basic considerations that should be taken into account for designing a risk management framework in an organisation: 1. Management of risk is a major concern of top management. Successful implementation of risk management process emanates from the top management and the main challenge centres on facilitating implementation of risk and business policies simultaneously in a consistent
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manner. Modem best practices consist of setting risk limits based on economic measures of risk while ensuring best risk adjusted return keeping in view the capital that has been invested in the business. It is a question of taking a balanced view on risks and returns and that too within the constraints of available capital. 2. Management of risks begins with identification and its quantification. It is only after risks are identified and measured that we may decide to accept the risk or to accept the risk at a reduced level by undertaking steps to mitigate the risk, either fully or partially. In addition, pricing of the transaction should be in accordance with the risk content of the transaction. 3. Risk management happens to be a job that requires special skills and has an objective which is more orientated towards control aspect of the business, it requires a separate setup in the organization. Response to these considerations calls for risk management framework in an organization that has well articulated processes covering the following areas: Organization for Risk Management Risk Identification Risk Measurement Risk Pricing Risk Monitoring and Control Risk Mitigation These areas, with particular reference to banking, have been discussed in some details in the following pages: 8.4.1 Organisation for Risk Management Usually, risk management organization consists: • The Board of Directors • The Risk Management Committee of the Board • The Committee of senior-level executives • Risk management support group
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The Board of Directors has the overall responsibility for management of risks. The Board articulates risk management policies, procedures, aggregate risk limits, review mechanisms and reporting and auditing systems. The Board should decide the risk management policy of the bank and set limits for various risks. The Risk Management Committee is a Board level Sub-Committee. The responsibilities of Risk Management Committee with regard to risk management aspects include the following: • Setting guidelines for risk management and reporting • Ensure that risk management processes conform to the policy • Setting up prudential limits and its periodical review • Ensure robustness of risk measurement models • Ensure proper manning for the processes The Committee of senior-level executives is responsible for implementation of risk and business policies simultaneously in a consistent manner and decides on the business strategy to achieve these objectives. It also sets up operating prudential limits and is the review authority for the line management. Risk management support group analysis monitors and reports the risk profiles to the committee of senior-level executives. It also examines the effects of various possible changes in market variables and recommends the action needed. They are also responsible for the critical functions of independent risk monitoring, measurement, analysis and reporting. 8.4.2 Risk Identification Nearly all transactions undertaken would have one or more of the major risks, i.e., liquidity risk, interest rate risk, market risk, default or credit risk and operational risk with their manifestations in different dimensions. Although all these risks are contracted at the transaction level, certain risks such as liquidity risk and interest rate risk are managed at the aggregate or portfolio level. Risks such as credit risk, operational risk and market risk arising from individual transactions are taken cognizance of at transaction- level as well as at the portfolio-level. Aggregated risk determines capital needs. Performance of bank at the aggregated level in terms of risk- adjusted return that it generates is the key corporate issue. Therefore, risk preference as well as total enterprise-wide risks is a corporate level issue. Guidance for risk-taking, therefore, at the transaction level has to emanate from the corporate level. Products approved at corporate level with due screening procedures and appropriate safeguards and a limit on exposure, product-wise as also amount-wise, provide for necessary guidelines in risk taking. In fact, the guidelines help in standardising risk content in the business undertaken at the transaction level. Any new product or any deviation from the directed procedures and safeguards add to the risk content of the exposure and needs a clearance at the corporate level, where risk return characteristics and risk quantification forms the basis of decision-making. Impact of risk taking at transaction level on the portfolio risk is a critical issue here. In essence, risk identification consists of identifying various risks associated with the risk taking at the transaction level and examining its impact on the portfolio and on capital requirement. As we would see later, risk content of a transaction is also instrumental in pricing the exposure as risk adjusted return is the key driving force in management of banks. Risk identification is best explained by taking an example. Say Branch B has extended a loan of Rs 1 crore in accordance with the corporate policy and guidelines for a period of 5 years at a rate of interest 1% over BPLR (Base Prime Lending Rate) of the bank, BPLR being 10%. The loan is to be repaid in equal quarterly installments with one-year moratorium. Funding of the loan is to
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be done from a deposit of three years of the same amount, interest rate on it being 6%. What are the risks associated with the transaction without taking into account CRR/SLR requirements? The deposit would become payable at the end of three years, whereas the loan would stand repaid to the extent of 50% only (assuming that there is no default). At the end of three years, it will face Funding Risk. In case there is default, Time Risk would also arise. These would be liquidity risks associated with the transaction. The interest on loan is linked to BPLR of the bank whereas the deposit is carrying a fixed rate of interest. If BPLR were reduced during the first three-year period, Basis Risk would arise. After the three-year period, when the question of funding the loan would arise, deposit rate may not remain same. So the transaction would face Gap or Mismatch Risk at the end of three-year period. As the loans get repaid, the repayment proceeds have to be deployed elsewhere. The rate at which this may be done may not be at par with the interest rate being charged on the loan amount. As a result the bank would face Reinvestment Risk. There would always be a possibility that the loan amount is prepaid or the deposit amount is withdrawn prematurely adding to the risk as Embedded Option Risk. These would be Interest Rate Risks associated with the transaction. In addition, there would be Default or Credit Risk and Operational Risks in the transaction. This transaction would also impact risks at the aggregate level, but it may be noted that the incremental risk in the portfolio may also be less than the risks taken at the transaction level. 8.4.3 Risk Measurement Risk management relies on quantitative measures of risk. The risk measures seek to capture variations in earnings, market value, losses due to default, etc. (referred to as target variables), arising out of uncertainties associated with various risk elements. Quantitative measures of risks can be classified into three categories. • Based on Sensitivity • Based on Volatility • Based on Downside Potential Sensitivity Sensitivity captures deviation of a target variable due to unit movement of a single market parameter Only those market parameters, which drive the value of the target variable are relevant for the purpose. For example, change in market value due to 1% change in interest rate would be a sensitivity-based measure. Other examples of market parameters could be exchange rates and stock prices. The interest
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TABLE 8.1 Computation of Mean of Volatility of Stocks of ABC Ltd. Week Closing Stock (Rs) Deviation . from Squared Price Mean Deviation 1 124 0.38 0.15 2 134 10.38 107.84 3 120 (3.62) 13.07 4 128 4.38 19.22 5 113 (10.62) 112.69 6 112 (11.62) 134.92 7 128 4.38 19.22 8 110 (13.62) 185.38 9 137 13.38 179.15 10 119 (4.62) 21.30 11 121 (2.62) 6.84 12 126 2.38 5.69 13 136 12.38 153.38 14 133 9.38 88.07 15 120 (3.62) 13.07 16 112 (11.62) 134.92 17 124 0.38 0.15 18 132 8.38 70.30 19 113 (10.62) 112.69 20 129 5.38 28.99 21 115 (8.62) 74.22 22 134 10.38 107.84 23 131 7.38 54.53 24 112 (11.62) 134.92 25 139 15.38 236.69 26 112 (11.62) 134.92 n 123.62 Variance Volatility 82.70 9.09 Note: The 'Mean' is the sum of observed values divided by the number of observations (26). The variance is the sum of squared deviations divided by number of observations. The volatility is the square root of variance. rate gap is the sensitivity of the interest rate margin of the banking book. Duration is the sensitivity of investment portfolio or trading book. Usually, market risk models use sensitivities fairly widely. This measure suffers from couple of drawbacks. First, it is only with reference to one market parameter and does not consider impact of other parameters, which may also change
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simultaneously. Secondly, sensitivities depend on prevailing conditions and change as market environment changes. Volatility It is possible to combine sensitivity of target variables with the instability of the underlying parameters. The volatility characterises the stability or instability of any random variable. It is a common statistical measure of dispersion around the average of any random variable such as earnings, mark-to-market values, market value, losses due to default, etc. Volatility is the standard deviation of the values of these variables. Standard deviation is the square root of the variance of the random variable. It is feasible to calculate historical volatility using any set of historical data, whether or not they follow a normal distribution. Alternatively, implicit volatility may also be computed using option prices, if quoted in the market using Black and Scholes option pricing formula. Implicit volatility has an advantage as it is forward-looking since option price being quoted is also forward looking. The calculation of historical mean and volatility requires time series. Defining a time series requires defining the period of observation and the frequency of observation. The calculation of historical volatility based on defined time series appears in the box below. Computation of Historical Volatility Based on Defined Time Series Defining a time series requires defining the period of observation and the frequency of observation. For instance, if we have to determine volatility of a given stock price, period of observation could be taken, as one year and frequency of observation could be daily closing price of the stock. The volatility so computed would daily volatility of the stock. If the frequency of observation were weekly or monthly, volatility so computed would be weekly volatility or monthly volatility respectively of the stock. The computation of weekly volatility of the stock of ABC Ltd., based on historical observation, period of observation being 6 months is given here. We can also compute daily volatility by changing the frequency of observation from weekly to daily or can compute monthly volatility, based on monthly observation. We may also convert daily volatility into weekly or monthly volatility using 'Square root of time rule'. The equation is given below. Volatility over a time horizon 'T' = Daily Volatility x Square root of'T' For example, if daily volatility of a stock were, say 1.5%, the monthly volatility would be 1.5 x 5.48 (square root of 30) or 8.22. Here T is 30 days as the time horizon is one month. It may be noted that volatility would be more if the time horizon is more. Volatility helps us to capture possible variations around the average of target variable, both upside and down side. Using historical observations on the target variable, it is possible to estimate upside and downside potential of the target variable with a reasonable accuracy. Downside Potential Risk materialises only when earnings deviate adversely. Volatility captures both upside and downside deviations. Downside potential only captures possible losses ignoring profit potential. It is the adverse deviation of a target variable. The downside potential has two components - potential losses and probability of occurrence. Potential losses may be estimated but difficulty lies in estimating probabilities. Hence, downside risk measures require prior modelling of the probability distribution of potential losses. Worstcase scenario serves to quantify extreme losses but has low probability of occurrence. Downside potential is the most comprehensive measure of risk as it integrates sensitivity and volatility with the adverse effect of uncertainty. This is the measure that is most relied upon by banking and
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financial service industry as also the regulators. The value at risk (VaR) is a downside risk measure. The risk measures are essentially forward looking and they estimate possible firture losses that may arise within certain confidence level based on historical data. 8.4.4 Risk Pricing Risks in banking transactions impact banks in two ways. Firstly, banks have to maintain necessary capital, at least as per regulatory requirements. The capital required is not without costs. The cost of capital arises from the need to pay investors in bank's equity and for internal generation of capital necessary for business growth. Each banking transaction should be able to generate necessary surplus to meet this costs. The pricing of transaction must take that into account. Secondly, there is a probability of loss associated with all risks. This also needs to be factored into pricing. To explain this, let us take the case of a bank that has 100 credit accounts with say Level 2 risks according to some measure. Say, historical observation indicates that there is an average loss of 2% on Level 2 accounts. This loss is the cost associated with such risk. This is to be factored into in pricing. The intention is to defray the possible losses across similar transactions. In this case, risk premium of 2% may be added in pricing. Risk pricing implies factoring risks into pricing through capital charge and loss probabilities. This would be in addition to the actual costs incurred in the transaction. The actual costs incurred are cost of funds that has gone into the transaction and costs incurred in giving the services, which are incurred by way of maintaining the infrastructure, employees and other relevant expenses. Pricing, therefore, should take into account the following: 1. Cost of Deployable Funds 2. Operating Expenses 3. Loss Probabilities 4. Capital Charge It should also be mentioned here that cost of funds should correspond to the term for which it is deployed. This is because five-year funds may have a different cost than one-year fund due to time value of money. It may be noted that pricing is transaction-based. This is one of the key reasons for risk measurement at transaction level. 8.4.5 Risk Monitoring and Control The key driver in managing a business is seeking enhancement in risk-adjusted return on capital (RAROC). Therefore, approach to risk management cannot be in isolation or in stand-alone mode. The approach to risk management centres on facilitating implementation of risk and business policies simultaneously in a consistent manner. Modem best practices consist setting risk limits based on economic measures of risk while ensuring best risk adjusted return, keeping in view the capital that has been invested in the business. It is a question of taking a balanced view on risks and returns and that too within the constraints of available capital. In order to achieve the above objective, banks put in place the following: 1. An organizational structure. 2. Comprehensive risk measurement approach. 3. Risk Management Policies adopted at the corporate level, which is consistent with the broader business strategies, capital strength, management expertise and risk appetite.
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4. Guidelines and other parameters used to govern risk taking including detailed structure of prudential limits, discretionary limits and risk-taking functions. It is not enough to put in place a structure for the purpose. It is equally important to ensure that the organisation functions in a manner it has been planned. A feedback of the actual functioning is therefore necessary for the purpose of control. In addition to that, the feedback received on the actual performance requires monitoring also to ensure that the divergence between the planned performance and actual performance is kept at the level that is acceptable. This requires the following: 1. Strong Management Information System for reporting, monitoring and controlling risk. 2. Well laidout procedures, effective control and comprehensive risk reporting framework. 3. Separate risk management framework independent of operational departments with clear delineation of responsibility for management of risk 4. Periodical review and evaluation. The banks establish an adequate system for monitoring and reporting risk exposures and assessing the bank's changing risk profile. The bank's senior management or board of directors should on a regular basis, receive reports on the bank's risk profile and capital needs. These reports should allow senior management to: • Evaluate the level and trend of material risks and their effect on capital levels • Evaluate the sensitivity and reasonableness of key assumptions • Assess bank's risk profile on a continuous basis and make necessary adjustments to the bank's strategic plan accordingly. The bank's internal control structure is essential to the process. Effective control of the process includes an independent review and, where appropriate, the involvement of internal or external audits. The bank's board of directors has a responsibility to ensure that management establishes a system for assessing the various risks, develops a system to relate risk to the bank's capital level, and establishes a method for monitoring compliance with internal policies. The board should regularly verily whether its system of internal controls is adequate to ensure well-ordered and prudent conduct of business. This is normally carried out through a separate Board Committee on Risk Management. The banks conduct periodic reviews of its risk management process to ensure its integrity, accuracy, and reasonableness. Identification of large exposures and risk concentrations, accuracy and completeness of data inputs into the bank's assessment process and stress testing and analysis of assumptions and inputs are all a part of control and monitoring processes. 8.4.6 Risk Mitigation Since risks arise from uncertainties associated with the risk elements, risk reduction is achieved by adopting strategies that eliminate or reduce the uncertainties associated with the risk elements. This is called 'Risk Mitigation'. In case of the example of a trading business cited under Section 8.1 above, one may like to enter into a sale and purchase contract. Since a sale contract would specify volume and the price, the uncertainty associated with them would be contained. A purchase contract would eliminate the uncertainties associated with purchase price. One may also have contract with transport services provider and eliminate risks in his trading business to a large extent provided his contract counterparties keep their commitment. It may be noted that in the process he would bring in another risk element, namely the uncertainty associated with the ability of the contract counterparty to keep his commitment. It may also be noted that while entering into various contracts the trader would also foreclose his option to take advantage of any rise in sales price or reduction in purchase price. In other words, upside potential of profits would
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also get reduced. In fact, this is one of the most critical aspects of risk mitigation measures. While they help in reducing adverse impact on profits, it limits upside potential as well. Nevertheless, one achieves stability in his net cash flow and risks stand reduced. In banking, we come across a variety of financial instruments and number of techniques that can be used to mitigate risks. The techniques to mitigate different types of risk are different. For mitigating credit risk banks have been using traditional techniques, such as collateralisations by first priority claims with cash or securities or landed properties, third party guarantees, etc. Banks may buy credit derivatives to offset various forms of credit risk. For mitigating interest rate risk banks use interest rate swaps, forward rate agreements or financial Futures. Similarly, for mitigating forex risks banks use forex forward contracts, forex options or futures and for mitigating equity price risk, equity options. Risk mitigation measures aim to reduce downside variability in net cash flow but it also reduces upside potential simultaneously. In fact, risk mitigation measures reduce the variability in net cash flow. In addition, risk mitigation would involve counterparty and it will always be associated with counter-party risk. It may also be stated here that markets have responded to the counterparty risk by establishing 'Exchanges' such as stock exchange, commodity exchanges, futures and options exchanges. Such 'Exchanges' take up the role of counterparty and have established rules for risk minimizafion. As a result, when we enter in to a contract with exchange as counterparty, counterparty risk remains, but gets reduced very substantially. In OTC deals, however, counterparty risk would depend upon the risk level associated with party to the contract. 8.4.7 Risk Mitigation through Diversification and Portfolio Risk Risks can be mitigated through diversification. In order to understand the concept of risk diversification let us take an example. Say Mr X has a business - business A - that had the following net cash inflow (i.e., all cash inflows net of all cash outflows) in the last five years. (Rs in WOs) Cash Flow O Year Year 2 Year 3 Year 4 Year 5 Total Mean Standard Std. 1 from Deviation Deviatio n to Mean Business A 10 34 8 11 36 7.20 3.56 0.49 The business had variations in cash flow and therefore risks. The risk in this case may be measured using mean and standard deviation of the past performance. The ratio of standard deviation to mean is a measure of comparing risks associated with similar cash flows. The said ratio in case of Business A is 0.49 or 49%. But, Mr X say has another four businesses and net cash flows from these businesses along with that of Business A are tabulated below. Net cash flow of all the businesses of Mr X, which is the sum total of net cash flows from all the businesses is also shown in the following table. If we study the ratio of standard deviation to mean of all his businesses, the said ratio is different for different businesses, the maximum and minimum being 61% and 36% respectively. It may however, be noticed that the ratio of standard deviation to mean in case of total portfolio is only 0.25 or 25%, which is less than the minimum observed in case of individual businesses. This observation is attributed to the fact that variations in net cash flows arising out of all these businesses are not unidirectional. While, cash inflows in the year 2 had decreased in respect of
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businesses A and C over that in year 1, the same has increased in respect of businesses B, D and E in the year 2 over year 1. As a result, variation in net cash inflow of the portfolio has been less. This is called diversification of risks. Because of this reason, risk associated with a portfolio is always less than the weighted average of risks of individual items in the portfolio. (Rs in WOs) Cash Flow Year1 Year 2 Year3 Year 4 Year5 Total Mean Standard Standard from . Deviation Deviation + Mean Business A 10 3 4 8 11 36 7.20 3.56 0.49 Business B 3 8 1 6 4 22 4.40 2.70 0.61 Business C 12 8 9 2 4 35 7.00 4.00 0.57 Business D 6 9 2 3 5 25 5.00 2.74 0.55 Business E 7 12 5 8 6 38 7.60 2.70 0.36 Total 38 40 21 27 30 156 31.20 7.85 0.25 Portfolio
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In banking business the same concept prevails. Suppose that a branch has taken a credit exposure on a borrower that has risk at level 2 say according to some measure of risk. Likewise the said branch and several other branches together have also taken level 2 credit exposures on say another 99 borrowers. Now the portfolio consists of 100 accounts with level 2 risks. The portfolio risk level would not be a level 2 risk. It would have a lower risk level than level 2. Again, this would be due to effect of diversification, as all these 100 accounts will not behave in a unidirectional manner. Risks in these accounts will not materialize simultaneously thereby reducing the portfolio risk. This would be true for all types of risks. Let Us Sum Up A risk management framework provides for facilitating implementation of risk and business policies simultaneously in a consistent manner so that a balanced view on risks and returns and within the constraints of available capital can be taken. It should include identification and its quantification of risks as well as provide for pricing of risks appropriately. Risk management framework may have well-articulated processes covering the following areas: Organization for Risk Management Risk Identification Risk Measurement Risk Pricing Risk Monitoring and Control Risk Mitigation The Board of Directors has the overall responsibility for management of risks. Supervision aspects are overseen by Risk Management Committee, which is a Board level Sub-Committee. The Committee of senior level executives is responsible for implementation of risk and business policies simultaneously in a consistent manner. Risk management department functions as a support group. Risk identification consists of identifying various risks associated with the risk taking at the transaction level and examining its impact on the portfolio and capital requirement. The risk measures seek to capture variations in earnings, market value, losses due to default, etc. (referred to as target variables), arising out of uncertainties associated with various risk elements. Quantitative measures of risks can be classified into three categories: 1. Based on Sensitivity 2. Based on Volatility 3. Based on Downside Potential Downside potential is the most comprehensive measure of risk as it integrates sensitivity and volatility with the adverse effect of uncertainty. Risk pricing implies factoring risks into pricing through capital charge and loss probabilities. This would be in addition to the actual costs incurred in the transaction. The actual costs incurred are cost of funds that has gone into the transaction and costs incurred in giving the services, which are incurred by way of maintaining the infrastructure, employees and other relevant expenses. It is equally important to ensure that the organization functions in a manner it has been planned. A feedback of the actual functioning is therefore necessary for the purpose of control. In addition to that the feedback received on the actual performance requires monitoring also to ensure that the divergence between the planned performance and actual performance is kept at the level that is acceptable. Risk reduction is achieved by adopting strategies that eliminate or reduce the uncertainties associated with the risk elements. This is called 'Risk Mitigation'. Risk mitigation measures aim to reduce downside variability in net cash flow but it also reduces upside potential simultaneously. Risks can be mitigated through diversification.
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Keywords Uncertainty; Adverse outcome; Risk; Financial risk; High Risk; Low Risk; Zero Risk; Risk adjusted reUim; Risk adjusted return on capital; (RAROC); Risk Management Processes; Potential Losses; Banking book; Trading book; Maturity mismatch; Market value of equity; Integrity risk; Risk diversification; Portfolio risk; Sensitivity; Volatility; Downside potential; Terminal Questions (A) Capital charge component of pricing accounts for 1. Cost of capital 2. Internal generation of capital 3. Loss provision Which of the following is True? (i) All the statements are correct (ii) Statements 1 and 2 are correct (iii) Statements 2 and 3 are correct (iv) Statements 3 and 1 are correct Statements 3 and 1 are correct (B) Daily volatility of a stock is 0.5%. What is its 10-day volatility? (i) 5% (ii) 0.25% (iii) 1.58% (iv) None of these 1.58% (C) Risk mitigation results in 1. Reduction of downside potential 2. Reduction in profit potential Which of the following is True? (i) All the statements are correct (ii) Statement 1 is correct (iii) Statement 2 is correct (iv) Both are incorrect All the statements are correct Answers to Check Your Progress (A)(i), (B)(i), (C)(i), (D)(i), (E)(i) Answers to Terminal Questions A.(iv), B.(iii), C.(i); UNIT 9 Risks in Banking Business STRUCTURE 9.0 Objectives 9.1 Risk Identification in Banking Business 9.2 The Banking Book 9.3 The Trading Book 9.4 Off-Balance Sheet Exposures
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9.5 Banking Risks - Definitions Let Us Sum Up Keywords Terminal Questions Answers to Terminal Questions 9.0 OBJECTIVES This chapter will be helpful in: • Understanding Concept of banking book and trading book • Various risks encountered in banking business 9.1 RISK IDENTIFICATION IN BANKING BUSINESS Banking business lines are many and varied. Commercial banking, corporate finance, retail banking, trading and investment banking and various financial services form the main business lines of banks. Within each line of business, there are sub-groups and each sub-group contains variety of financial activities. Bank's clients may vary from retail consumer segment to midmarket corporate to large corporate to financial institutions. Banking may differ appreciably for each segment even for the similar services. For example, lending activities may extend from retail banking to specialized finance. Again, specialized finance may extend from specific fields with standard practices, such as exports and commodities financing to structured financing implying specific structuring and customization for making large and risky transactions feasible, such as project financing or corporate acquisitions. Banks also assemble financial products and derivatives and deliver them as a package to its clients as a part of specialised financing commensurate with the needs of its clients. We may have a fair idea of the wide array of business lines of the banking industry from Table 9.1: TABLE 9.1 Business Lines Corporate Finance Trading and Sales Retail Banking Private Banking Commercial Banking Business Lines of the Banking Industry Sub-groups Activities Corporate Finance, Municipal/Government Finance, Merchant Banking Advisory Services Sales, Market making. Proprietary Positions, Treasury Prime Brokerage Retail Banking Private Lending and Card Services Commercial Banking Payments and Settlement External Clients Mergers and acquisitions, underwriting, privatisations, securitisations, research, Government debts, debt and equity syndications, IPO, secondary private placements Fixed income, equity, foreign exchanges, commodities, credit, funding, own position securities, lending and repos, brokerage, debt Retail lending and deposits, banking services, tmst and sales Deposits, banking services, trust and estates, investment advice merchant/commercial/corporate cards, private lables and retail Project finance, real estate, export finance, trade finance, factoring, leasing, lending, guarantees, bills of exchange
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Payments and collections, funds transfer, clearing and settlement (Contd. ) Business Lines Agency Services corporate actions Asset Management Retail Brokerage Sub-groups Custody Corporate agency Corporate trust Activities Escrow, depository receipts, securities lending. Issuer and paying agents Discretionary and non-dis- Pooled, segregated, retail, institutional, closed, open cretionary fund management Retail brokerage Execution and full service Source: Document on international Convergence of Capital Measurement and Capital Standards - A revised framework from Basel Committee on Banking Supervision - Annexure VI. Product lines also vary across client segments. Standard lending products include short-term and long- term loans with specified repayments, demand loans and various other lines of credit, such as bill purchase and bills discounting facillities, cash credit etc. In the retail segments banks have variety of consumer loans such as auto loans, house-building loans, etc. Banks also offer guarantees, letters of credit, etc., which are in the nature of off-balance sheet transactions. There are various deposit products that vary for different segments and different needs. Banks also offer market products, such as fixed income securities, shares, foreign exchange trading and derivatives like standard swaps and options. The key driver in managing all the business lines are enhancing risk adjusted expected return. This is the common factor for all business lines. But management practices vary across business lines and subgroups and activities within each business lines as profitability of various business lines/activities differ and so does the risk factors associated with them. From the risk management point of view, banking business lines may be grouped broadly under the following major heads. • The Banking Book • The Trading Portfolio • Off-Balance Sheet Exposures Risks associated with each of them are discussed in the following: 9.2 THE BANKING BOOK The banking book includes all advances, deposits and borrowings, which usually arise from commercial and retail banking operations. All assets and liabilities in banking book have following characteristics: 1. They are normally held until maturity 2. Accrual system of accounting is applied Since all assets and liabilities in the banking book are held until maturity, maturity mismatch between assets and liabilities result in excess or shortage of liquidity. This is commonly known as 'Liquidity Risk'.
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In addition, interest rate changes take place during the period, such assets and liabilities are held in the banking book. Therefore interest rates on assets as well as liabilities change on their maturity. This affects net interest margin, i.e., interest received net of interest paid. This is called 'Interest Rate Risk'. Further, the asset side of the banking book generates credit risk arising from defaults in payments of principal and/or interest by the borrowers. This is called 'Default Risk' or 'Credit Risk'. Since banking book is not open to market, it is not exposed to market risk. In addition to all these risks, exposures under banking book suffer from what is termed as 'Operational Risk'. These arise due to human failures of omission or commission, deficiencies in information system and system failure, inadequacy or non- adherence to internal processes, external events etc. The banking book is mainly exposed to liquidity risk, interest rate risk, default or credit risk and operational risks. Summary All assets and liabilities in the banking book are normally held until maturity and accrual system of accounting is applied on them. The banking book is mainly exposed to liquidity risk, interest rate risk, default or credit risk and operational risk. 9.3 THE TRADING BOOK The trading book includes all the assets that are marketable, i.e., they can be traded in the market. Contrary to the characteristics of assets and liabilities held in banking book, trading book assets have following characteristics: 1. They are normally not held until maturity and positions are liquidated in the market after holding it for a period 2. Mark-to-Market system is followed and the difference between market price and book value is taken to profit and loss account. Trading book mostly comprises of fixed income securities, equities, foreign exchange holdings, commodities, etc., held by the bank on its own account. Derivatives that are held for trading in the market or over the counter (OTC) and for hedging exposures under trading book would also form a part of trading book. Trading book is subject to adverse movement in market prices until they are liquidated. This is termed as 'Market Risk'. Trading book may have market overseas as well if it is so permitted by laws of the land. This adds to the demand and hence adds to the market liquidity. Instrument having lower demand have lower trading volume and are exposed to liquidation risk where trading may trigger off adverse price movement. Trading book is also exposed to Credit Risk or Default Risk, which arises due to failure on the part of the counter party to keep its commitment. Trading book is also exposed to operational risks that arise from human failures of omission or commission, deficiencies in information system and system failure, inadequacy or non-adherence to internal processes, external events, etc. Trading book is mainly exposed to market risk, including liquidation risk, default or credit risk and operational risk. Summary The positions in the trading book are normally held for liquidating them in the market after holding it for a period. The difference between market price realized and book value is accounted for as profit/loss. Trading book is mainly exposed to market risk, market liquidity risk, default or credit risk and operational risk. 9.4 OFF-BALANCE SHEET EXPOSURES
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Off-balance sheet exposures are contingent in nature. Where banks issue guarantees, committed or backup credit lines, letters of credit, etc., banks face payment obligations contingent up on some event. These contingencies adversely affect the revenue generation of banks. Banks may also have contingency receivables. Here banks are the beneficiaries subject to certain contingencies. Derivatives are off-balance sheet market exposures. They may be swaps, futures, forward contracts, foreign currency contracts, options, etc. Contingent exposure may become a fund-based exposure. Such exposures may become a part of the banking book or trading book, depending upon the nature of off-balance sheet exposure. Therefore, off- balance sheet exposures may have liquidity risk, interest rate risk, market risk, default or credit risk and operational risk. Summary Off-balance sheet exposures may become fund-based exposure based on certain contingencies. Both, contingencies given (where bank provides benefit) and contingencies receivable (where bank is the beneficiary) may form off-balance sheet exposure. Off-balance sheet exposures may have liquidity risk, interest rate risk, market risk, default or credit risk and operational risk. 9.5 BANKING RISKS - DEFINITIONS From the discussion above, we may summarise the major risks in banking business or 'Banking Risks'. They are listed as follows: Liquidity Risk Interest Rate Risk Market Risk Default or Credit Risk Operational Risk The risks mentioned above are defined in the following paragraphs. It is to be mentioned here that each of these risks manifests in different dimension. They are outlined and explained in brief 9.5.1 Liquidity Risk The liquidity risk of banks arises mainly from funding of long-term assets by short-term liabilities, thereby making the liabilities subject to rollover or refinancing risk. Liquidity Risk is defined as the inability to obtain funds to meet cash flow obligations at a reasonable rate. For banks, funding liquidity requirement is crucial and therefore any liquidity shortfall has to be met at times at a cost which is more than planned or normal costs. At the extreme, banks may even fail to fund the liquidity gap resulting in default with its serious consequences. The liquidity risk in banks may be of the following types: Funding Risk This arises from the need to replace net outflows due to unanticipated withdrawal/non-renewal of deposits (wholesale and retail); Time Risk This arises from the need to compensate for non-receipt of expected inflows of funds i.e. performing assets turning into non-performing assets; and Call Risk This arises due to crystallization of contingent liabilities. This may also arise when a bank may not be able to undertake profitable business opportunities when it arises. 9.5.2 Interest Rate Risk Interest Rate Risk (IRR) is the exposure of a Bank's revenue to adverse movements in interest rates. Interest Rate Risk (IRR) refers to potential adverse impact on Net Interest Income or Net Interest Margin or Market Value of Equity (MVE), caused by changes in market interest rates. Interest Rate Risk can take different forms. IRR can be viewed in two ways: Its impact is on the earnings of the bank or its impact on the economic value of the bank's assets, liabilities and offbalance sheet positions. Gap or Mismatch Risk
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A gap of mismatch risk arises from holding assets and liabilities and off-balance sheet items with different principal amounts, maturity dates or repricing dates, thereby creating exposure to unexpected changes in the level of market interest rates. An example of this risk would be where an asset maturing in two years at a fixed rate of interest have been funded by a liability maturing in six months or a liability maturing over a period but getting repriced periodically. The interest margin would undergo a change after six months /repricing period, causing variation in net interest income. Basis Risk The risk that the interest rate of different assets, liabilities and off-balance sheet items may change in different magnitude is termed as basis risk. An example of basis risk would be to say in a rising interest rate scenario asset interest rate may rise in different magnitude than the interest rate on corresponding liability creating variation in net interest income. The degree of basis risk is fairly high in respect of banks that create composite assets out of composite liabilities. The Loan book in India is funded out of a composite liability portfolio and is exposed to a considerable degree of basis risk. The basis risk is quite visible in volatile interest rate scenarios. When the variation in market interest rate causes the Nil to expand, the banks have experienced favourable basis shifts and if the interest rate movement causes the Nil to contract, the basis has moved against the banks. Yield Curve Risk In a floating interest rate scenario, banks may price their assets and liabilities based on different benchmarks, i.e. treasury bills' yields, fixed deposit rates, call money rates, MIBOR, etc. In case the banks use two different instruments maturing at different time horizon for pricing their assets and liabilities, any non-parallel movements in yield curves would affect the Nil. The movements in yield curve are rather frequent. Thus, banks should evaluate the movement in yield curves and the impact of that on the portfolio values and income. It may be noted that yield curve risk is a type of basis risk and this arises with respect to different maturity sectors. An example would be when a liability raised at a rate linked to say 91 days T Bill is used to fund an asset linked to 364 days Treasury Bills. In a rising interest rate scenario both, 91 days and 364 days Treasury Bills may increase but not equally due to non-parallel movement of yield curve creating a variation in net interest earned. Embedded Option Risk Significant changes in market interest rates create the source of risk to banks' profitability by encouraging prepayment of cash credit/demand loans term loans and exercise of call/put options on bonds/debentures and/or premature withdrawal of term deposits before their stated maturities. The embedded option risk is becoming a reality in India and is experienced in volatile situations. The faster and higher the magnitude of changes in interest rate, the greater will be the embedded option risk to the banks' Nil. The result is reduction of projected cash flow and income for the bank. Reinvestment Risk Uncertainty with regard to interest rate at which the future cash flows could be reinvested is called reinvestment risk. Any mismatches in cash flows would expose the banks to variations in Nil as the market interest rates move in different directions. Set Interest Position Risk
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Where banks have more earning assets than paying liabilities, interest rate risk arises when the market interest rates adjust downwards. Such banks will experience a reduction in Nil as the market interest rate declines and increases when interest rate rises. Its impact is on the earnings of the bank or its impact on the economic value of the bank's assets, liabilities and OBS positions. 9.5.3 Market Risk Market risk is the risk of adverse deviations of the mark-to-market value of the trading portfolio, due to market movements, during the period of holding. This results from adverse movements of the market prices of interest rate instrument, equities, commodities and currencies. Market Risk is also referred as Price Risk. Price risk occurs when assets are sold before their stated maturities. In the financial market, bond prices and yields are inversely related. The price risk is closely associated with the trading book, which is created for making profit out of short-term movements in interest rates. The term Market Risk applies to (i) that part of IRR which affects the price of interest rate instruments, (ii) Pricing Risk for all other assets/portfolio including commodities like gold that is held in the trading book of the bank and (iii) Foreign Currency Risk. Forex Risk Forex risk, also termed as Exchange Risk, is the risk that a bank may suffer losses as a result of adverse exchange rate movements during a period in which it has an open position, either spot or forward, or a combination of the two, in an individual foreign currency. Market Liquidity Risk Market liquidity risk arises when a bank is unable to conclude a large transaction in a particular instrument near the current market price. 9.5.4 Default or Credit Risk Credit Risk is most simply defined as the potential of a bank borrower or counterparty to fail to meet its obligations in accordance with agreed terms. For most banks, loans and corporate bonds are the largest and most obvious source of credit risk. Counterparty Risk This is a variant of credit risk and is related to non-performance of the trading partners due to counterparty's refusal and or inability to perform. The counter-party risk is generally viewed as a transient financial risk associated with trading rather than standard credit risk. Country Risk This is also a type of credit risk where non-performance by a borrower or counter-party arises due to constraints or restrictions imposed by a country. Here reason for non-performance is external factors on which the borrower or the counterparty has no control. 9.5.5 Operational Risk Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. Strategic risk and reputation risk are not a part of operational risk. Operational risk may loosely be comprehended as any risk, which is not categorised as market or credit risk. Scope of operational risk is very wide. It includes Fraud risk. Communication risk. Documentation risk, Competence risk. Model risk, Cultural risk, External events risk. Legal risk, Regulatory risk. Compliance risk. System risk and so on. Two of these, which are frequently used - transaction and compliance risk has been defined below, which form the part of operational risk. Transaction Risk
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Transaction risk is the risk arising from fraud, both internal and external, failed business processes and the inability to maintain business continuity and manage information. Compliance Risk Compliance risk is the risk of legal or regulatory sanction, financial loss or reputation loss that a bank may suffer as a result of its failure to comply with any or all of the applicable laws, regulations, codes of conduct and standards of good practice. It is also called integrity risk since a bank's reputation is closely linked to its adherence to principles of integrity and fair dealing. We have mentioned above that Strategic Risk and Reputation Risks fall outside the scope of Operational Risk. These are defined as: Liquidity Risk Funding Risk 1 Time Risk | Call Risk Risks in Banking and Financial Services Intt Rate Risk Gap Mismatch Risk Basis Risk Reinvestment Risk FIGURE 9.1 Market Risk | Forex Riskj 1 Price Risk 1 Liquidation Risk Counter Party Risk Fraud Risk Documentation Risk Yield Curve Risk Embedded Option Risk Competence Risk Liquidity Risk Cultural Risk Legal Risk Compliance Risk Market Risk ] | Credit Risk~| | Operational Risk | [other Risks]
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Communications Risk Reputation Risk Transaction Risk Strategic Risk Model Risk External Events Risk Regulatory Risk System Risk Strategic Risk Strategic Rislc is the risk arising from adverse business decisions, improper implementation of decisions, or lack of responsiveness to industry changes. This risk is a function of the compatibility of an organisation's strategic goals, the business strategies developed to achieve those goals, the resources deployed against these goals and the quality of implementation. Reputation Risk Reputation Risk is the risk arising from negative public opinion. This risk may expose the institution to litigation, financial loss, or a decline in customer base. Riskfaced by banking andfinancial services may be summarised as shown in Fig. 9.1. Let Us Sum Up 1. From the risk management point of view, banking business lines may be grouped broadly under the following major heads: (i) The Banking Book (ii) The Trading Portfolio (iii) Off-balance Sheet Exposures 2. All assets and liabilities in the banking book are normally held until maturity and accrual system of accounting is applied on them. The banking book is mainly exposed to liquidity risk, interest rate risk, default or credit risk and operational risks. 3. The positions in the trading book are normally held for liquidating them in the market after holding it for a period. The difference between market price realised and book value is accounted for as profit/loss. Trading book is mainly exposed to market risk, market liquidity risk, default or credit risk and operational risk. 4. Off-balance sheet exposures may become fund-based exposure based on certain contingencies. Both contingencies given (where bank provides benefit) and contingencies receivable (where bank is the beneficiary) may form off-balance sheet exposure. Off-balance sheet exposures may have liquidity risk, interest rate risk, market risk, default or credit risk and operational risk. Keywords Banking Book; Trading Book; Off-balance Sheet Exposures; Liquidity risk; Interest rate risk; Default or credit risk; Operational risks; Funding Risk; Time Risk; Call Risk; Gap or Mismatch Risk; Yield Curve Risk; Basis Risk; Embedded Option Risk; Reinvestment Risk; Net Interest Position Risk; Price Risk; Forex Risk; Market Liquidity Risk; Counterparty Risk; Country Risk; Strategic Risk; Reputation Risk. Terminal Questions Tick the Correct Answer (A) Financial Risk is defined as (i) Uncertainties resulting in adverse variation of profitability or outright losses
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(ii) Uncertainties that result in outright losses (iii) Uncertainties in cash flow (iv) Variations in net cash flows Variations in net cash flows (B) Strategic Risk is a type of (i) Interest rate risk (ii) Operational risk (iii) Liquidity risk (iv) None of these None of these (C) A bank funds its assets from a pool of composite liabilities. Apart from credit and operational risks, it faces (i) Basis risk (ii) Mismatch risk (iii) Market risk (iv) Liquidity risk Basis risk (D) A branch sanctions Rs 1 crore loan to a borrower, which of the following risks the branch is taking 1. Liquidity risk 2. Interest rate risk 3. Market risk 4. Credit risk 5. Operational risk (i) All of them (ii) 1, 2 and 3 only (iii) 1, 4 and 5 only (iv) 1, 2, 4 and 5 only 1, 2, 4 and 5 only (E) Premature payment of a term loan will result in interest rate risk of type (i) Basis risk (ii) Yield curve risk (iii) Embedded option risk (iv) Mismatch risk Embedded option risk Answers to Terminal Questions A.(iv), B.(iv), C.(i), D.(iv), E.(iii)
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UNIT 10 Risk Regulations in Banking Industry STRUCTURE 10.0 Objectives 10.1 Regulation of Banking Industries - Necessities and Goals 10.2 The Need for Risk-based Regulation in a Changed World Environment 10.3 1988-BaseI Accord 10.4 1996 Amentiment to Include Market Risk 10.5 Basel II Accord - Need and Goals 10.6 Basel II Accord 10.7 Capital Charge for Credit Risk 10.8 Capital Charge for Operational Risk 10.9 Pillar 2 - Supervisory Review Process 10.10 Pillar3-MarketDiscipline 10.11 Simplified Standardised Approach 10.12 Impact on Emerging Markets and Smaller Banks Let Us Sum Up Keywords Terminal Questions Answers to Terminal Questions Annexure: Regulatory Capital Requirement for Indian Banks
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10.0 OBJECTIVE This chapter will be helpful in understanding: Necessity of regulating banking business How regulations affect banks Goals of regulators in regulating banking business Systemic Risk Cross border regulation 1988 Basel Accord 1996 Amentiment to Basel 1 Accord Basel 11 Accord 10.1 REGULATION OF BANKING INDUSTRIES - NECESSITIES AND GOALS Banking and financial services, all over the world, are regulated usually by Monetary Authority of the land. This is because banking and financial services are the backbone of an economy. A healthy and strong banking system is a must for any economy to function smoothly and to prosper. As we have seen, banks have risks and risk taking is their business. But if risk-taking is not regulated properly, banks may fail and it would have a disastrous effect on the economy. Therefore, Monetary Authorities across the world regulate functioning of the banks. In India, this function, as we all know, is with Reserve Bank of India, Country's monetary authority. Regulations have a decisive impact on risk management. The regulatory framework sets up the constraints and guidelines that inspire risk management practices, and stimulates the development and enhancement of the internal risk models and risk management processes of banks. Regulations promote better definitions of risks, and create incentives for developing better methodologies for measuring risks. Regulations have several goals. They are: 1. Improving the safety of the banking industry, by imposing capital requirements in line with bank's risks Note: Regulatory Authorities impose recognition of the core concept of the capital adequacy principle and of 'risk-based capital', which means banks' capital should be in line with risks. This implies a quantitative assessment of risks as well. 2. Levelling the competitive playing field of banks through setting common benchmarks for all players 3. Promoting sound business and supervisory practices. 4. Controlling and monitoring 'Systemic Risk' 5. Protecting interest of depositors as depositors cannot impose a real market discipline on banks Systemic Risk Systemic risk is the risk of failure of the whole banking system. Individual bank's failure is one of the major sources of the systemic risk. This happens because of high interrelations that exist on an ongoing basis between banks through mutual lending and borrowing and other commitments. The failure of a single bank generates a risk of failure for all the banks that have ongoing commitments with the defaulting bank. Receivables from the failed bank become nonavailable putting the counterparty bank into a cash or fund crunch. In fact, because of contagion effect, all banks may be affected, triggering off a systemic risk. Systemic risk is a major challenge for the regulator 10.2 THE NEED FOR RISK-BASED REGULATION IN A CHANGED WORLD ENVIRONMENT A number of factors helped stabilise the banking environment in the seventies. Strong and constraining regulations weighed heavily on the banks' management. Commercial banking meant essentially collecting resources and lending. Limited competition facilitated a fair and stable profitability. Concerns for the safety of the industry and monetary management were the main priorities for regulators. The rules limited the scope of the operations of the various credit
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institutions, and limited their risks as well. There were low incentives for change and competition. Deregulation in economy came to promote faster growth as a regulated environment hardly provides any incentive for competition and change. Deregulation increased competition between players unprepared by their past experiences, thereby resulting in increasing risks for the system. Competition also promoted globalisation. Cross-border transactions, which resulted from global competition created by multinational enterprises. A regulatory framework, on a cross-country basis, for reconciling risk control and yet maintaining a level playing field for fair competition became necessary. This was undertaken by the Basel Committee on Banking Supervision (BCBS). Why BCBS? On 26th June 1974, a number of banks had released Deutschmarks to Bank Herstatt in Frankfurt in exchange for dollar payments that were to be delivered in New York. Due to differences in time zones, there was a lag in dollar payments to counterparty banks during which Bank Herstatt was liquidated by German regulators, i.e., before the dollar payments could be effected. Note: The risk of settlement that arises from time-difference came to be known as 'Herstatt Risk'. The Herstatt incident prompted the G-10 countries (the G-10 is today 13 countries: Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, Netherlands, Spain, Sweden, Switzerland, United Kingdom and United States) to form, towards the end of 1974, the Basel Committee on Banking Supervision (BCBS), under the auspices of the Bank for international Settlements (BIS), comprising of Central Bank Governors from the participating countries. BCBS has been instrumental in standardising bank regulations across jurisdictions with special emphasis on defining the roles of regulators in cross-jurisdictional situations. The committee meets four times a year It has around 30 technical working groups and task forces that meet regularly. 10.3 1988 BASEL ACCORD The period 1980 was the post-deregulation era (in India deregulation started in nineties). Deregulation inspired competition indeed resulted in increasing the risks of the bank and it translated in several bank failures. This outlined the need for risk control and linking banking risks with banks' capital. In 1988, the Basel Committee published a set of minimal capital requirements for banks, known as the 1988 Basel Accord. These were enforced by law in the G10 countries in 1992. The Japanese banks were permitted an extended transition period. The 1988 Basel Accord primarily sought to put in place a framework for minimum capital requirement for banks that was linked to credit exposure. Keeping in view different accounting practices in vogue across the world, it also defined the capital for the purpose of capital adequacy. Bank assets were classified into five buckets, i.e., grouped under five categories according to credit risk carrying risk weights of 0, 10, 20, 50 and 100%. Assets were to be classified into one of these risk buckets based on the parameters of counterparty (sovereign, banks, public sector enterprises or others), collateral (e.g., mortgages of residential property) and maturity. Generally, government debt was categorised at 0% , bank debt at 20%, and other debt at 100%. Off-balance sheet exposures such as performance guarantees and letters of credit were brought into the calculation of risk-weighted assets using the mechanism of variable credit conversion factor. Banks were required to hold capital equal to 8% of the risk-weighted value of assets. Since 1988, this framework has been progressively introduced not only in member countries but also in almost all other countries having active international banks.
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The accord provided a detailed definition of capital. Tier 1 or core capital, which includes equity and disclosed reserves, and Tier 2 or supplementary capital, which could include undisclosed reserves, asset revaluation reserves, general provisions and loan-loss reserves, hybrid (debt/equity) capital instruments and subordinated debt. 10.4 1996 AMENTIMENT TO INCLUDE MARKET RISK In 1996, BCBS published an amentiment to the 1988 Basel Accord to provide an explicit capital cushion for the price risks to which banks are exposed, particularly those arising from their trading activities. This amentiment was brought into effect in 1998. Salient features of the amentiment are given below: 1. Allows banks to use proprietary in-house models for measuring market risks 2. Banks using proprietary models must compute VAR daily, using a 99th percentile, one-tailed confidence interval with a time horizon of ten trading days using a historical observation period of at least one year. 3. The capital charge for a bank that uses a proprietary model will be the higher of the previous day's VAR and three times the average of the daily VAR of the preceding 60 business days. 4. Use of 'back-testing' (ex-post comparisons between model results and actual performance) to arrive at the 'plus factor' that is added to the multiplication factor of three. 5. Allows banks to issue short-term subordinated debt subject to a lock-in clause (Tier 3 capital) to meet a part of their market risks. 6. Alternate standardized approach using the 'building block' approach where general market risk and specific security risk are calculated separately and added up. 7. Banks to segregate trading book and mark to market all portfolio/position in the trading book. 8. Applicable to both trading activities of banks and non-banking securities firms. Does BCBS have Powers to Enforce? 'The Committee does not possess any formal supranational supervisory authority, and its conclusions do not, and were never intended to, have legal force. Rather, it formulates broad supervisory standards and guidelines and recommends, statements of best practice in the expectation that individual authorities will take steps to implement them through detailed arrangements - statutory or otherwise which are best suited to their own national systems. In this way, the Committee encourages convergence towards common approaches and common standards without attempting detailed harmonization of member countries' supervisory techniques. One important objective of the Committee's work has been to close gaps in international supervisory coverage in pursuit of two basic principles: that no foreign bank establishment should escape supervision; and that supervision should be adequate.' 10.5 BASEL-II ACCORD - NEED AND GOALS Linking of risks with capital in terms of the Basel I Accord needed a revision for the following reasons: Credit risk assessment under Basel I was not risk-sensitive enough. Capital need assessment under the Basel I accord was not being able to differentiate between banks with lower risks and banks with higher risks. For example, exposure on a company with AAA rating and a company with B rating were treated identically for the purpose of capital adequacy. Both would be placed in 100% risk weight category although, risks associated with them would be quite different. It promotes financial decision-making on the basis of regulatory constraints rather than on the basis of economic opportunities. Capital requirement for all corporate accounts being the same, it encouraged financing of assets with more risks for higher returns. Whereas a sound decision
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should take into account risk and return characteristics of an asset, it was discouraged, as capital requirement was not differentiated based on risk characteristic of assets. It did not recognize the role of credit risk mitigants, such as credit derivatives, securitizations, collaterals and guarantees, in reducing credit risk. It did not take into account operational risks of banks. The fundamental objective to revise the 1988 Accord has been1. To develop a framework that would strengthen the soundness and stability of the international banking system. 2. To ensure that it does not become a source of competitive inequality among internationally active banks and yet have a capital adequacy regulation that is sufficiently consistent. 3. To help promote the adoption of stronger risk management practices by the banking industry. 10.6 BASEL-II ACCORD The revised accord is also called Basel II. The BCBS has since released the document, "International Convergence of Capital Measurement and Capital Standards: A Revised Framework" on 26 June 2004. Its significant features are:
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1. Significantly, more risk-sensitive capital requirements takes into account operational risk of banks apart from credit and market risks. It also provides for risk treatment on securitisation. 2. Greater use of assessment of risk provided by banks' internal systems as inputs to capital calculations. 3. Provides a range of options for determining the capital requirements for credit risk and operational risk to allow banks and national regulators to select the approaches that are most suitable. 4. Capital requirement under new accord is the minimum. It has a provision for supplementary capital that can be adopted by national regulators. 5. The accord in fact promotes stronger risk management practices by banks by providing capital incentive for banks with better risk management practices. Note: Capital requirement under Basel II does not include liquidity risk, interest rate risk of banking book, strategic and business risks. These risks would be under 'Supervisory Review Process', if supervisors feel that the capital held by a bank is not sufficient, they could require the bank to reduce its risk or increase its capital or both. In the matter of interest rate risk on banking book it has put in place a criteria for 'Outliers'. Where a bank under 200 basis point interest rate shock faces reduction in capital by 20% or more, such banks would be outliers. The Basel II Accord is based on three pillars 1. Minimum capital requirement 2. Supervisory review process 3. Market discipline Structure of Basel-II Pillar 1 — Minimum Capital Requirement 1. Capital for Credit Risk 1. Standardised Approach 2. Internal Ratings Based (IRB) Foundation Approach 3. Internal Ratings Based (IRB) Advanced Approach 2. Capital for Market Risk 1. Standardised Approach (Maturity Method) 2. Standardised Approach (Duration Method) 3. Internal Models Method 3. Capital for Operational Risk 1. Basic Indicator Approach 2. Standardised Approach 3. Advanced Measurement Approach Pillar 2 - Supervisory Review Process 1. Evaluate risk assessment 2. Ensure soundness and integrity of banks' internal process to assess the adequacy of capital 3. Ensure maintenance of minimum capital - with PCA for shortfall. 4. Prescribe differential capital, where necessary - i.e., where the internal processes are slack. Pillar 3 - Market Discipline 1. Enhance disclosure 2. Core disclosures and supplementary disclosures
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3. Timely - semi annual Pillar 1 - Minimum Capital Requirement Basel 1 Accord and the 1996 amentiment thereto has defined capital requirement as Capital = Min. Capital Ratio (8%) x (Credit Risk + Market Risk) The Revised Capital Accord or Basel II defines the capital requirement as Capital = Min. Capital Ratio (8%) x (Credit Risk + Market Risk + Operation Risk) It is to be noted that there is no change • In the definition of capital • In the minimum capital ratio, which remains 8% • In the calculation of market risk and it remains as per 1996 Amentiment The changes are in • Method of calculating risk in credit exposures • By way of capital charge on operational risk In the following paragraphs, we shall describe the changes very briefly. 10.7 CAPITAL CHARGE FOR CREDIT RISK Standardised Approach The standardised approach is similar to the current accord in that banks are required to slot credit exposures into supervisory categories based on observable characteristics of the exposures (e.g., whether the exposure is a corporate loan or a residential mortgage loan). The standardised approach establishes fixed risk weights corresponding to each supervisory category and makes use of external credit assessments to enhance risk sensitivity compared to the current accord. The risk weights for sovereign, inter-bank, and corporate exposures are differentiated based on external credit assessments. The risk weights are inversely related to the rating of the counter party. An important innovation of the standardised approach is the requirement that loans considered 'past due' be risk weighted at 150% unless, a threshold amount of specific provisions has already been sent aside by the bank against that loan. The standardized approach also stipulates special treatment of certain exposures on a portfolio basis viz. 'retail' and 'SME' exposures. The exposures to these sectors attract a uniform risk weight of 75% irrespective of the individual risk rating of the component exposures. Credit risk mitigants (collaterals, guarantees, and credit derivatives) can be used by banks under this approach for capital reduction, based on the market risk of the collateral instruments or the threshold external credit rating of recognised guarantors. Reduced risk weights for retail exposures, small and medium size enterprises (SME) category and residential mortgages have been proposed. The approach draws a number of distinctions between exposures and transactions in an effort to improve the risk sensitivity of the resulting capital ratios. Internal Rating Based Approach One of the most innovative aspects of the New Accord is the IRB approach to measurement of capital requirements for credit risk. The IRB Approach offers the following two options: Foundation IRB Approach (FIRB) and Advances IRB Approach (AIRB) version. The IRB approach differs substantially from the standardised approach to the extent that banks' internal assessments of key risk parameters serve as primary inputs to capital calculation. Since the approach is based on banks' internal assessments, the potential for more risk-sensitive capital requirements is substantial. The salient features of IRB Approach are as under:
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The IRB Approach computes the capital requirements of each exposure directly before computing the risk-weighted assets. • Capital charge computation is a function of the following parameters: (i) Probability of Default (PD) (ii) Loss Given the Default (LGD) (iii) Exposure at Default (EAD) (iv) Maturity (M) • The risk-weighted assets are derived from the capital charge computation. The IRB approach does not allow banks to determine all of the elements needed to calculate their capital requirements. Instead, the risk weights and thus capital charges are determined through the combination of quantitative inputs provided by banks and formulae specified by the Committee. The IRB approach uses banks' internal assessments of key risk drivers as primary inputs to the capital calculation. The risk weights and resultant capital changes are determined through the combination of quantitative inputs provided by banks and formulae specified the Committee. The IRB calculation of risk weighted assets for exposures to sovereigns, banks, or corporate entities relies on the following four parameters: 1. Probability of default (PD), which measures the likelihood that the borrower will default over a given time horizon 2. Loss given default (LDG), which measures the proportion of the exposure that will be lost if a default occurs 3. Exposure at default (EAD), which for loan commitment measures the amount of the facility that is likely to be drawn in the event of a default. 4. Maturity (M), which measures the remaining economic maturity of the exposure.
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The differences between foundation and advanced IRB approaches are captured in the Table 10.1 based on who provides the inputs on the various parameters: Differences between Foundation and Advanced IRB Approaches Advanced IRB Bank Supervisor Supervisor Bank or Supervisor Function provided by the committee Historical data to estimate PD [5 years] Bank Bank Bank Bank Function provided by the committee Historical loss data to estimate LCD [7 years] and historical exposure data to estimate BAD [7 years] plus that for PD estimation For retail exposures only advanced IRB is prescribed where, obviously, the maturity parameter is omitted. Securitization, provisions and specialized lending have been accorded special treatment. 10.8 CAPITAL CHARGE FOR OPERATIONAL RISK Operational risk is an important risk faced by banks and according to BCBS banks need to hold capital to protect against losses from this. This is a new area where the Committee has developed a regulatory capital approach. As in the case of credit risk, the committee has reckoned banks' rapidly developing internal assessment techniques and seeks to provide incentives to banks for improving upon those techniques, and more broadly, banks' management of operational risk over a period of time. The New Framework provides three options for computing capital charge for Operational Risk with increasing sophistication and risk sensitivity. Base II encourages banks to move along the spectmm of available approaches as they develop more sophisticated operational risk measurement systems and practices. Internationally active banks and banks with significant operational risk exposures are expected to use an approach that is more sophisticated. Within the Basel II framework, operational risk is defined as the risk of losses resulting from inadequate or failed internal processes, people and systems, or external events. Operational risk identification and measurement is still in an evolutionary stage as compared to the maturity that market and credit risk measurements have achieved. As in credit risk, three alternate approaches are prescribed: 1. Basic Indicator Approach 2. Standardized Approach 3. Advanced Measurement Approach (AMA) Table 10.2 captures the provisions of the proposed accord across different approaches: TABLE 10.2 Provisions of the Proposed Accord across Different Approaches Calculation of capital charge Basic Indicator 15% of average gross income over three years Qualifying criteria None Standarised Average gross income segregated into eight business lines, viz., retail banking, retail brokerage and asset management, which carry capital charge of 12%: commercial banking and agency services attract 15%; corporate finance, trading and sales and payment and settlement carry charge of 18%.
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Total capital charge is the sum of capital charges across business lines. Active involvement of board of directors and senior management. Existence of conceptually sound operational risk management system Systematic Tracking of loss- data. Capital charge equals internally generated measure based on: • Internal loss data • External loss data • Scenario analysis • Business environment and internal control factors Risk mitigation up to 20% allowed. Measurement integrated into day-to-day risk management Review of management and measurement processes by internal/external audit. Minimum five years loss-data. Compliance of BCBS' 'Sound Practices for Management and Supervision of Operational Risk" is also required. 10.9 PILLAR 2 - SUPERVISORY REVIEW PROCESS Pillar 2 introduces two critical risk management concepts: the use of economic capital, and the enhancement of corporate governance, encapsulated in the following four principles: 10.9.1 Principle 1 Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels. The key elements of this rigorous process are: 1. Board and senior management attention 2, Sound capital assessment 3. Comprehensive assessment of risks 4. Monitoring and reporting 5. Internal control review 10.9.2 Principle 2 Supervisors should review and evaluate bank's internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process. This could be achieved through: 1. On-site examinations or inspections 2. Off-site review 3. Discussions with bank management 4. Review of work done by external auditors 5. Periodic reporting 10.9.3 Principles Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the medium. 10.9.4 Principle 4 Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored. Participations under Pillar 2 seek to address the residual risk not adequately covered under Pillar 1, such as a concentration risk, interest rate risk in banking book, business risk and strategic risk.
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'Stress testing' is recommended to capture event risk. Pillar 2 also seeks to ensure that internal risk management process in the banks is robust enough. The combination of Pillar 1 and Pillar 2 attempt to align regulatory capital with economic capital. 10.10 PILLAR 3 - MARKET DISCIPLINE The focus of Pillar 3 on market discipline is designed to complement the minimum capital requirements (Pillar 1) and the supervisory review process. (Pillar 2). With this, the Basel Committee seeks to enable market participants to assess key information about a bank's risk profile and level of capitalisation - thereby encouraging market discipline through increased disclosure. Public disclosure assumes greater importance in helping banks and supervisors to manage risk and improve stability under the new provisions, which place reliance on internal methodologies providing banks with greater discretion in determining their capital needs. It has been agreed that such disclosures will depend on the legal authority and accounting standards existing in each country. Efforts are in progress to harmonise these disclosures with Internal Financial Reporting Standards (IFRS) Broad Standards (International According Standards 30 and 32). 10.11 SIMPLIFIED STANDARDISED APPROACH In order to assist banks and national supervisors where circumstances may not warrant a broad range of options, the Committee has developed the 'simplified standardised approach' (outlined in Annex 9 of the Revised Framework). The annex collects in one place the simplest options for calculating risk- weighted assets; salient features of the SSA are as below. • SSA uses only rating by Export Credit Agencies (ECAs) for sovereign exposures. Bank and CSU ratings are linked to the rating of the sovereign on the same lines as available in the SA. • Risk weights for corporate borrowers depends upon the rating assigned to them by a rating agency approved for that purpose and varies from 20% in case of top rated company to 100% in case of an unrated corporate. • In the case of domestic banks, the risk weight depends on the CRAR of the respective bank and in the case of foreign banks the risk weight is related to the rating assignment to the bank by international rating agencies. Banks intending to adopt the simplified standardised methods are also expected to comply with the corresponding supervisory review and market discipline requirements of the New Framework. The Basel II document clarified that the SSA should not be seen as another approach for determining regulatory capital. Rather it collects in one place the simplest options for calculating risk-weighted assets. 10.12 IMPACT ON EMERGING MARKETS AND SMALLER BANKS In an attempt to assess the impact of Pillar 1 requirements of capital adequacy, BCBS did undertake a few quantitative impact surveys (QIS), the last of which is referred to as QIS - 10. The results indicated that, in general, banks' required capital would decrease with respect to credit risks and increase with respect to operational risks. However, in Asia and other emerging markets, several factors may raise the required capital even for credit risks, as real estate continues to be widely used as collateral for business loans, and the standardised approach, which is the most likely approach for many banks, places a 150% risk weight on non-performing loans. Basel II will increase the level of capital that is required for banking institutions in the emerging markets, mainly owing to the new operational risk charge, which will be higher if the basic indicator approach is used.
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By application of differential risk weights on the basis of sovereign rating as a benchmark, the capital inflows in emerging markets could be seriously attracted, as most of the borrowers in such markets will be categorised under the speculative grade. Smaller banks would find the investments on Basel II compliance too big for their existing budgets. Let Us Sum Up Banking and financial services are regulated because banking and financial services are the backbone of an economy. A healthy and strong banking system is a must for any economy to function smoothly and to prosper. Regulations have a decisive impact on risk management. Regulations seek to improve the safety of the banking industry, ensure a level playing field, promote sound business and supervisory practices, control and monitor 'Systemic Risk' and protect the interest of depositors. Deregulation increased competition between players unprepared by their past experiences, thereby resulting in increasing risks for the system. Globalisation and cross-border transactions needed a regulatory framework on a cross-country basis, for reconciling risk control and yet maintaining a level playing field for fair competition became necessary. In 1988, the Basel Committee published a set of minimal capital requirements for banks, known as the 1988 Basel Accord. The 1988 Basel Accord primarily sought to put in place a framework for minimum capital requirement for banks that was linked to credit exposure. Keeping in view different accounting practices in vogue across the world, it also defined the capital for the purpose of capital adequacy. In 1996, BCBS published an amentiment to the 1988 Basel Accord to provide an explicit capital cushion for the price risks to which banks are exposed, particularly those arising from their trading activities. This amentiment was brought into effect in 1998. Linking of risks with capital in terms of the Basel I Accord needed a revision for the following reasons: 1. Credit risk assessment under Basel I is not risk-sensitive. 2. It promotes financial decision-making on the basis of regulatory constraints rather than on the basis of economic opportunities. 3. It did not recognise the role of credit risk mitigants. The 1988 Accord has been revised with the objectives to develop a fi-amework that would strengthen the soundness and stability of the international banking system, to ensure that it does not become a source of competitive inequality among internationally active banks and yet have a capital adequacy regulation that is sufficiently consistent and to help promote the adoption of stronger risk management practices by the banking industry. 10.12.1 Basel-II Accord The revised accord is also called Basel II. The BCBS has since released the document, "International Convergence of Capital Measurement and Capital Standards: A Revised Framework" on 26 June, 2004. Its significant features are: • Significantly, more risk-sensitive capital requirements and takes into account operational risk of banks. • Greater use of assessment of risk provided by banks' internal systems as inputs to capital calculations. • Provides a range of options for determining the capital requirements for credit risk and operational risk.
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Capital requirement under new accord is the minimum. It has a provision for supplementary capital that can be adopted by national regulators. • The accord in fact promotes stronger risk management practices by banks by providing capital incentive for banks with better risk management practices. The Basel-II Accord is based on three pillars 1. Minimum capital requirement 2. Supervisory review process 3. Market discipline 10.12.2 Structure of Basel-II Pillar 1 - Minimum Capital Requirement Capital for credit risk • Standardised Approach • Internal Ratings Based (IRB) Foundation Approach • Internal Ratings Based (IRB) Advanced Approach Capital for Market Risk • Standardised Approach (Maturity Method) • Standardised Approach (Duration Method) • Internal models method Capital for Operational Risk • Basic Indicator Approach • Standardised Approach • Advanced Measurement Approach Pillar 2 - Supervisory Review Process • Evaluate risk assessment • Ensure soundness and integrity of banks' internal process to assess the adequacy of capital • Ensure maintenance of minimum capital - with PCA for shortfall. • Prescribe differential capital, where necessary, i.e., where the internal processes are slack. Pillar 3 - Market Discipline • Enhance disclosure • Core disclosures and supplementary disclosures • Timely - semi-anual Keywords Banking Regulations; Systemic Risk; Contagion Effect; Deregulation; Capital adequacy; Backtesting; Risk Sensitive; Credit Risk Mitigants; Supplementary Capital; Capital Incentive; Outliers; Supervisory Categories; External Credit Assessments; SME; Off-site Review; Residual Risk; QIS. Terminal Questions (A) Systemic risk is the risk of (i) Failure of a bank, which is not adhering to regulations (ii) Failure of two banks simultaneously due to bankruptcy of one bank (iii) Where a group of banks fail due to contagion effect (iv) Failure of entire banking system Failure of entire banking system
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(B) Central Bank Governors of G-10 countries participate in the Basel Committee on Banking Supervision. Total number of members: (i) 10 (ii) 11 (iii) 12 (iv) 13 13 (C) 1988 Capital Accord framework accounted for 1. Credit risk 2. Market Risk 3. Operational risk 4. Defined capital component Which of the following is true? (i) All of them (ii) 1,2 and 4 (iii) 1, 3 and 4 (iv) 1,2 and 3 1,2 and 4 (D) Back testing is done to (i) Test a model (ii) Compare model results and actual performance (iii) Record performance (iv) None of the above Compare model results and actual performance (E) Under Basel II, capital requirement under the accord is (i) The maximum capital that is required to be maintained (ii) The minimum capital that is required to be maintained (iii) The capital as specified by the regulatory authority is required to be maintained (iv) None of the above The capital as specified by the regulatory authority is required to be maintained (F) Capital charge for credit risk requires input for PD, LGD, HAD and M. Under advanced IRB approach, who provide the input for LGD. (i) Bank (ii) Supervisor (iii) Function provided by BCBS (iv) None of the above Bank Answers to Terminal Questions 1. (iv), 2.(iv), 3.(ii), 4.(ii), 5.(iii), 6.(i) ANNEXURE TO UNIT 10 Regulatory Capital Requirement for Indian Banks under Basel II Risks in banking business when materiahzes results in revenue losses. Under normal circumstances such losses stands absorbed in the surplus generated in the business. Such losses can be estimated and is termed 'Expected Losses'. This loss is treated as cost and is offset
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through appropriate pricing of various banking products and services. However, in abnormal circumstances such losses may exceed not only the estimates for expected losses but also exceed the surplus generated in the business and even beyond. This is termed 'Unexpected Losses' and may be estimated with certain level of confidence. Capital maintained for banking business should at the minimum be equal to the unexpected losses. Such a level of capital would correspond to 'Economic Capital'. However, regulatory authorities provide directives on the capital that banks are required to maintain, which is termed 'Regulatory Capital'. Banks operating in India are required to maintain regulatory capital as per the directives issued by country's regulatory authority i.e. Reserve Bank of India. Reserve Bank of India, for this purpose, have issued guidelines specifying prescribed minimum capital adequacy ratio that banks are required to maintain, criteria for capital funds and modalities for computation of risk weighted assets (as per Basel II). Effective from 31 st March, 2009 all Commercial banks in India, other than local areas banks and RRBs, are required to compute risk weighted assets based on standardized approach for credit risk, standardized duration approach for market risk and basic indicator approach for operational risk. It may be mentioned that migration to internal rating based approach for credit risk, internal model based approach for market risk and standardized approach/advanced measurement approach for operational risk would be permitted by RBI on a case by case basis for which banks are to obtain necessary approval from RBI. The following paragraphs provide a broad idea of extant directives on regulatory capital requirements. These directives have been discussed in the following paragraphs under the following heads. • Minimum Capital Requirement • Capital Funds • Computation of RWAs for Credit Risk - Standardized Approach • Computation of Capital Charge for Market Risk - Standardised Duration Approach • Computation of Capital Charge for Operational Risk - Basic Indicator Approach • Computation of CRAR The extant guidelines in detail, however, are available in RBI's Circular DBOD No.DB.BC.21/21.06.001/ 2009-10 dated 1st July, 2009 on the subject "Master Circular Prudential guidelines on Capital Adequacy and Market discipline - Implementation of the New Capital Adequacy Framework (NCAF)." Minimum Capital Requirement Banks are to maintain a minimum level of tier I capital and total capital (Tier I + Tier II) based on the level of risk weighted assets. The ratio of tier I capital to total risk weighted assets is called 'Tier I CRAR' and the ratio of total capital to total risk weighted assets is called 'Total CRAR'. CRAR stands for capital to risk weighted assets ratio. Total CRAR Banks which have implemented Basel-II framework effective 31 March, 2008, were required to maintain minimum capital to risk weighted ratio (CRAR) for the financial year 2008 - 09 at 9% of risk weighted assets calculated as per Basel-II framework Oor 8.1% of risk weighted assets calculated based on Basel- I framework, whichever is more. For the financial year 2009 - 10 and beyond, they are required to maintain a minimum capital at 9% of risk weighted assets calculated as per Basel-II framework or 7.2% of risk weighted assets calculated based on Basel-I framework, whichever is more. Banks which have implemented Basel-II framework effective 31 st March, 2009, are required to maintain minimum capital to risk weighted ratio (CRAR) for the financial year 2009 - 10 at 9%
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of risk weighted assets calculated as per Basel-II framework or 8.1% of risk weighted assets calculated based on Basel- I framework, whichever is more. For the financial year 2010 - 11 and beyond, they are required to maintain a minimum capital at 9% of risk weighted assets calculated as per Basel-II framework or 7.2% of risk weighted assets calculated based on Basel-I framework, whichever is more. Total CRAR is to be computed as given below: (Eligible total capital funds) - (RWAs for Credit Risk + RWAs for Market Risk + RWAs for Operational Risk) Tier-I CRAR In addition to above, effective 31st march, 2010 all the banks have to maintain Tier-I Capital Adequacy ratio at 6% at least. Tier-I CRAR is to be computed as given below: (Eligible Tier I capital funds) - (RWAs for Credit Risk + RWAs for Market Risk + RWAs for Operational Risk) Capital Funds The liabilities in a bank's balance sheet that qualifies as tier I capital and tier II capital have been specified. Total capital is sum of Tier I capital and Tier II capital. Tier-I Capital Funds Tier-I capital funds would include the followings: 1. Paid up equity capital, statutory reserves and other disclosed free reserves 2. Capital reserves arising out of sale proceeds of assets 3. Innovative perpetual debt instruments (IPDIs), which meet the regulatory requirements advised by RBI for this purpose limited to maximum of 15% of total Tier-I capital as on 31 st March of the previous financial year. 4. Perpetual non-cumulative preference shares (PNCPS), which meet the regulatory requirements advised by RBI for the purpose subject to a limit such that total of IPDIs and PNCPS does not exceed 40% of total Tier-I capital at any point of time. Tier-I capital would equal the sum of these items but net of • Intangible assets • Deferred tax assets (DTAs) associated with accumulated loss • DTA (excluding DTA associated with accumulated loss) net of deferred tax liabilities (DTLs), if it has a positive value. • Certain other items* *Note: In addition to the above, regulatory authority has prescribed certain other deductions from capital for the purpose of computing regulatory capital. The details are available in the Circular referred to above. Total Capital Funds Total capital fund equals to Tier-I capital fund (computed in accordance with the Para mentioned above) and Tier-II capital. Elements of Tier-II capital are: • Revaluation reserves at a discount of 55% • General provision on standard assets, floating provisions, provisions held for country exposure, investment reserve accounts and excess provision subject to a maximum of 1.25% of total risk weighted assets. • Upper Tier-II capital which includes PNCPs, redeemable non-cumulative preference shares (RNCPS) and redeemable cumulative preference shares (RCPS) issued in accordance with the regulatory guidelines for the purpose.
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• Subordinated debts issued and computed in accordance with the regulatory guidelines for the purpose. • Innovative perpetual debts instruments (IPDIs) and Perpetual non-cumulative preference shares (PNCPS) held in the books in excess of the prescribed limit and not included for computing Tier-I capital. The Tier-II capital will be sum up of the items mentioned above, but is limited to a maximum of 100% of Tier-1 capital. Computation of RWAs for Credit Risk - Standardised Approach Capital for credit risk is required to meet abnormal losses arising out of risk of default of bank's borrowers. However, in so far as risk of default across various borrowers and exposures differ, capital requirement also differs. In view of this, under standardised approach, different but prescribed risk weights are assigned to borrowers/types of exposure to differentiate risk of default associated with them. Exposure duly risk weighted with appropriate risk weight is termed risk weighted asset (RWA). Capital requirement for credit risk is based on RWA. Total RWAs for credit risk of a bank is the sum of risk weights of customer-wise credit exposures covering its entire credit outstanding where, the risk weight of an exposure depends upon the type of borrower and exposure and the level of adjusted exposure. Revised framework for capital adequacy adopted by Reserve Bank of India specifies varying risk weight depending upon type of exposures/ borrowers. The adjusted exposure would depend upon outstanding fund based facilities, un-availed portion of the sanctioned fund-based facillities and outstanding non-fund based facilities net of allowable reductions if such exposures are secured by permissible securities. Therefore, determination of total RWAs for credit risk of a bank is basically a five stage process comprising of: Determining Adjusted Exposure Determining Allowable Reduction Determining Applicable Risk Weight Determining RWA for the Exposure Consolidation of RWAs of all Exposures Determining Adjusted Exposure Total exposure on a borrower is sum total of exposure on account of1. Outstanding balances in fund based facillities 2. Un-availed portion of the sanctioned fund-based facillities and 3. Outstanding non-fund based facillities. The computation of exposure on account of these three items is to be carried out in the manner given below. 1. Exposure on Outstanding Balances in Fund-based Facillities: This equals total of outstanding balances under Fund-based facillities including outstanding balances under term loans. 2. Un-availed Portion of the Sanctioned Fund-based Facillities: Exposure on account of unavailed portion of the sanctioned fund-based facillities would be 'Nil' in respect of borrower where commitments are cancellable at any time by the bank without prior notice or where commitments are automatically cancellable upon deterioration of borrower's credit worthiness. However, in absence of it, exposure on account of un-availed portion of the sanctioned fund-based facillities would be equal to 20% of un-drawn portion (i.e., Limits Sanctioned - Balance Outstanding) under all fund based facillities with maturity up to and inclusive of one year + 20% of Un-drawn portion of the Term Loan, which is to be drawn within 1 year + 50% of Un-drawn portion of the Term Loan, which is to be drawn after 1 year Note:
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• Un-drawn portion of term Loan refers to that portion of Term Loan, which is yet to be disbursed. • Where a Term Loan is to be disbursed in phases and subsequent phases would be disbursed only after confirmation/consent/approval to be received from sanctioning authority, loans to be disbursed under subsequent phases may not be treated as un-drawn portion of Term Loan as Bank may not disburse the Term Loan. 3. Outstanding Non-fund-hased Facillities: Non Fund-based exposure may consist of Financial Guarantees, Acceptances, Performance Guarantees, Bid bonds, Standby Letters of credit, Clean Letters of Credit, Documentary Letters of credit, Unconditional take out finance, Conditional take out finance, etc. For computing credit equivalent of non-fund based exposures, outstanding under Non-Fund Based facillities are to be multiplied by corresponding Credit Conversion Factors (CCFs). RBI has specified Credit Conversion Factors for various non-fund based exposures (enclosure 1). The sum total of credit equivalent of all non-fund based exposures would be the exposure on account of outstanding non-fund based exposures. However, credit risk on non-fund based facillities such as interest rate contracts/exchange rate contracts, depends upon market volatility of interest rate and exchange rate. Credit risk on these items also depends upon remaining maturity of these contracts. Hence, credit equivalent for off balance sheet items is determined based on present exposure (this is the positive value of mark to market - as this happens to be the exposure of the bank on its counterparty) and potential credit exposure that may arise in future (this is determined by multiplying contract amount with relevant CCFs). In addition to it, risk of failed delivery/payment by counterparty also exists in such contracts. In determining risk weight for such exposures, these factors are also taken into accounts. For further details, reference may be made to RBI's guidelines referred earlier. The following is an example that explains computation of exposure on a borrower. Example To explain the method of computing exposure on a borrower account, we have assumed a hypothetical case where following is the position of exposure on the borrower. Nature of Facillities Limit Sanctioned (Rs in '000') Balance Outstanding (Rs In '000', Cash Credit Bills Purchased Packing Credit Term Loan Total 200 60 40 200 500 100 30 30 40 200 Undrawn portion under fund-based limit other than Term Loan = (3.00 lakh - 1.60 lakh) = 1.40 lakh Out of the undisbursed portion of the Term Loan amounting to Rs. 1.60 lakh, Rs.0.60 lakh is to be disbursed within 1 year and Rs.1.00 lakh is to be disbursed after 1 year. Financial Guarantee 100 90 Acceptances 100 80 Performance Guarantee 90 80 Bid Bonds 20 20 Stand by Letter of Credit 120 50 Clean Letter of Credit 150 50 Documentary Letter of Credit 100 40 Unconditional take out Finance 100 100 Conditional take out Finance 50 50
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The exposure on the borrower account may be calculated as shown below: 1. Outstanding balances in fund-based facillities in the above case is Rs 200,000 2. Un-availed portion of the sanctioned fund-based facilities = 20% of un-drawn portion (i.e.. Limits Sanctioned - Balance Outstanding) under all fund based facilities other than term loans + 20% of Un-drawn portion of the Term Loan, which is to be drawn within 1 year + 50% of Undrawn portion of the Term Loan, which is to be drawn after 1 year = 20% of 140,000 + 20% of 60,000 + 50% of 100,000 = Rs 90,000 3. Outstanding non-fund based facillities: Exposure on account of non-fund based facillities is calculated in the following table: SI No. Nature of NFB Exposure Outstanding NFB Exposure (1) (2) (3) 1. Financial Guarantee 90 2. Acceptances 80 3. Performance Guarantee 80 4. Bid bonds 20 5. Stand by Letter of Credit 50 6. Clean Letter of Credit 50 7. Documentary Letter of Credit 40 8. Unconditional take out Finance100 9. Conditional take out Finance 50 Total 560 Credit Conversion Factor Applicable (%) (as per Annexure) (4) 100 100 50 50 100 100 20 100 50 Credit Equivalent of NFB Exposure (3) X (4) (5) 90 80 40 10 50 50 100 25 453 Total credit equivalent of non fund-based exposure in the above table comes to Rs. 453,000. Hence, Total Exposure on the Account = 1 + 2 + 3 = 200,000 + 90,000 + 453,000 = Rs. 743,000 Determining Allowable Reduction Exposure computed in terms of para above would stand reduced if the exposure on a borrower is secured by 1. Deposits under lien 2. Approved financial collaterals Benefit of exposure reduction on account of deposits under lien, approved financial collaterals and guarantees is permissible only if certain terms and conditions are met. For ready reference, gist of the terms and conditions have been annexed (Enclosure 2). 1. Deposits under Lien: In case of loans and advances secured by bank deposits under lien, allowable reduction in exposure is to be determined using the following formula. Allowable Reduction = C x [1 - //^j. ] x M^ Subject to a maximum of Exposure amount (i.e., where allowable reduction is more than amount of exposure, allowable reduction would equal to amount of exposure) Where:
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• C is the value of Bank Deposit • Hp. = "0" if exposure and collateral are in same currency • Hj-^ ="0.08" where exposure and collateral are in different currencies • Mf- Maturity factor (enclosure 3) Note: Normally, in cases where deposits under lien and loans and advances are in the same currency and is well-documented, allowable reduction would equal to the value of deposit under lien. 2. .ipproveJ Financial CoUatcrah-: In case of loans and advances secured by eligible financial collaterals other than bank deposits (enclosure 4), allowable reduction in exposure is to be determined using the following formula. Allowable Reduction = [C x (1 x A^ _ £ x Subject to a maximum of Exposure amount and minimum of Zero (i.e., where allowable reduction is more than amount of exposure allowable reduction would equal to amount of exposure. Further, where allowable reduction is negative; it should be taken as Zero.) Where: • £■ is exposure net of margin and allowable reduction on account of Lien Deposits, where available • C is the value of eligible financial collateral • Hj^ = "0" if exposure and collateral are in same currency • Hj-^ = "0.08" where exposure and collateral are in different currencies • //g is Haircut appropriate to the exposure (enclosure 5) • H^ is Haircut appropriate to the collateral (enclosure 6) • Mf= Maturity factor (enclosure 3) Illustration on credit risk mitigation: Example 1 An exposure of Rs 100 lakhs is backed by financial collateral of A+ debt security of Rs 30 lakhs issued by others. The tenor of the exposure is 3 years. The residual maturity of the financial collateral is 2 years. In this case, the financial collateral is an eligible credit risk mitigant. As the residual maturity of the collateral is less than the residual maturity of the exposure, maturity mismatch is also there. However, there is no currency mismatch. Let us first determine the hair cut of the collateral. C* = C X ( 1 - - = 30 X ( 1 - 6% - 0%) = 30 X 94% = 28.20 Where C* = Haircut adjusted collateral value
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iri C = Original collateral value H^ = Hair cut applicable to the collateral Hj^ = Hair cut on account of currency mismatch between collateral and exposure. = 0.08 in all cases where this is applicable. Let us now determine what would be the value of the haircut-adjusted collateral after adjustment on account of maturity mismatch. P = C* X - 0.25)/(r- 0.25) = 28.2 x (2 - 0.25)/(3 - 0.25) = 28.2 x 1.75/2.75 = 17.95 Where P = Value of credit risk mitigant adjusted for maturity mismatch C* = value of the collateral adjusted for any hair cut. t = minimum of T and residual maturity of the credit protection expressed in years. T = minimum of 5 years and residual maturity of the exposure expressed in years. The adjusted collateral value is Rs. 17.95 lacs. The value of the exposure after risk mitigation would be E = Max = Max = 82.05 Net Exposure qualifying for Capital Adequacy is Rs.82.05 lacs. Example 2 An exposure of Rs.100 lakhs is backed by lien on fixed deposit of Rs. 30 lakhs. There is no maturity mismatch. In this case, the credit risk mitigant is on-balance sheet netting. Hence Rs. 30 lakhs should be reported under Col. 7. The net exposure qualifying for Capital Adequacy is Rs. 70 lakhs after netting. Here hair cut for credit risk mitigant is zero. Example 3 An exposure of Rs.100 lakhs is backed by guarantee of state Government for the full amount. There is no maturity mismatch. As State Government is a sovereign, guarantee of state govt, is an eligible credit risk mitigant. In this case, the net exposure qualifying for capital adequacy is Rs.100 lacs as there is no maturity mismatch. Example 4 An exposure of Rs.100 lakhs is backed by financial collateral in the form of NSCs of Rs 30 lakhs and eligible A+ debt securities issued by others of Rs. 50 lakhs. The residual tenor of the exposure is 3 years and the residual maturity of both the collaterals is 3 years. There is no maturity mismatch. The weights of NSCs and A+ debt security in the basket of assets are 30% and 50% respectively. Based on residual maturity hair cut applicable to NSCs is 2% and that to A+ debt security is 6%. H^ = 30% + 2% + 50% X 6% = 10.60% The value of hair cut adjusted collaterals would be C* = 80 x (1 _ 10.60%) = 80 x 96.4% = 77.12 The adjusted collateral value is Rs.77.12 lacs. Net Exposure qualifying for capital adequacy would be E = Max < 0, (current value of exposure- adjusted value of collaterals)>= Max < 0, (100-77.12)>= 22.88 lacs Determining Applicable Risk Weight Applicable risk weight depends on the type of exposure. Various types of exposures and applicable risk weights are available in the RBI guidelines referred. Broadly, from the view point of risk weights, exposures may be grouped as follows:
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Standard assets where risk weights assigned are independent of Rating Standard assets where risk weights assigned are based on Rating Non-performing assets where risk weights assigned are independent of Rating tandard assets where risk weights assigned are independent of Rating include exposures on Central Government of India and accounts guaranteed by it, RBI, DICGC and CGTSI (risk weight is zero) State Governments in India and accounts guaranteed by them and ECGC (risk weight is 20%) Govts of Foreign Sovereigns of India and accounts guaranteed by it, where exposures denominated in domestic currency of the foreign country made out of resources in the same currency raised in the jurisdiction of the foreign country (risk weight is zero) Exposures Unrated but Re-structured/Re-scheduled Exposures on Staff Members of Bank Exposures for the purpose of acquiring residential property that is or will be occupied by borrower or that is rented and secured by Mortgage of Residential Property Exposures (both FB & NFB) secured by Mortgages on Commercial Real Estate Exposures in the Nature of Personal Loans Exposures, which are Capital Market Exposure Exposures on Venture Capital Funds Exposures on NBFCs Regulatory Retail Exposures Standard assets, where risk weights assigned are based on rating, include exposures on Exposures on Governments of Foreign Sovereigns of India and accounts guaranteed by it, which are denominated in the currency of the foreign country Exposures on Banks Exposures on Domestic/Foreign Public Sector Entities Exposures on Primary Dealers Exposures on Corporates Securitization Exposures Note: A transaction wliich meets tlie RBI guidelines on securitisation of standard assets qualifies for special treatment provided for capital adequacy purposes. Banks as an investor may apply rating-based risk weights for computation of RWAs. However, where banks act as an originator or credit enhancer or liquidity provider or underwriter has to assess RWAs on account of such exposures in a manner detailed in the RBI guidelines referred. Non-performing assets, where risk weights assigned are independent of rating include exposures on All NPAs secured by residential property with specific provision less than 20% of outstanding NPA NPAs secured by residential property with specific provision of 20% or more but less than 50% of outstanding NPA NPAs secured by residential property with specific provision of 50% or more of outstanding NPA NPAs fully secured by land & building and/or plant & machinery with specific provision of 15% or more of outstanding NPA NPAs not covered above with specific provision less than 20% of outstanding NPA NPAs not covered above with specific provision 20% or more but less than 50% of outstanding NPA • NPAs not covered above with specific provision 50% or more of outstanding NPA Risk Weight on Exposures Covered under Eligible Guarantees Applicable risk weight on exposures covered under eligible guarantees may be substituted with the risk weight of the guarantor Accounts guaranteed by sovereigns, banks, DICGC/CGTSI, ECGC and entities rated AA(-) or better by approved rating agencies. In India, approved rating agencies are CRISIL, ICRA, FITCH and CARE. international rating agencies approved for the purpose are Standard and Poor, Moody's and FITCH. Nominal guaranteed amount may be adjusted for maturity mismatch and currency mismatch using the following formula.
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Adjusted Guaranteed Amount = G x (1 - Hf^) x Mf Where: • G is nominal Guaranteed Amount • Hf^ = "0" if exposure and guaranteed amount are in same currency • Hfj^ = "0.08" where exposure and guaranteed amount are in different currencies • Mf= Maturity factor (enclosure 3) The guaranteed portion is to be assigned risk weight in accordance with the rating of the guarantor If the rating of the guarantor is AAA, the risk weigh to be applied is 20% and if the rating of the guarantor is AA(+) or AA or AA(-), risk weight to be applied is 30%. However, before taking the benefit of eligible guarantees, it should be ensured that terms and conditions specified in Enclosure 2 are met. Determining RWA for the Exposure Risk weight of an exposure on account of credit risk would equal adjusted exposure, i.e., total exposure net of allowable reductions on account of available financial collaterals multiplied by risk weight applicable to the exposure. However, where an account is covered under eligible guarantee(s), adjusted guaranteed amount(s) would have risk weight applicable to guarantor(s) and the balance net of adjusted guaranteed amount(s) would have risk weight applicable to the exposure. Consolidation of RWAs of all Exposures Consolidated risk-weighted assets of a bank would be the sum total of risk weights of all its credit exposures. Note: Computation of RWAs under revised approach is very much data intensive. A gist of account-wise data required and reference tables that need to be referred are given below. 1. Total Fund-based limit sanctioned excluding Term Loan 2. Total outstanding balance under Fund-based facillities 3. Term Loan balance outstanding 4. Undrawn portion of the Term Loan - of which (i) Amount to be drawn within 1 year (ii) Amount to be drawn after 1 year Note: 1. Undrawn portion of term Loan refers to that portion of Term Loan, which is yet to be disbursed. 2. Where a Term Loan is to be disbursed in phases and subsequent phases would be disbursed only after confirmation/consent/approval to be received from sanctioning authority, loans to be disbursed under subsequent phases may not be treated as un-drawn portion of Term Loan as Bank may not disburse the Term Loan. Non Fund-based limits and outstanding balances (facility-wise) along with margin if any, specifically prescribed to for Non Fund-based facility/facillifies. Deposits under lien (see terms and condifions mentioned below): These are cash margin including certificate of deposits, fixed deposit receipts and other deposits with the bank. The following conditions are to be satisfied for applying on balance sheet netting. (a) There is a well-founded legal basis for netting or offsetting regardless of whether the borrower is insolvent or bankrupt. (b) Bank is able at any time to determine the value of loans/advances and deposits with the same counterparty that are subject to the netting agreement. (c) Bank monitors and controls the relevant exposures on a net basis. 7. Other financial collaterals if any
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8. Where guaranteed by ECGC/CGTSI/Banks and amount covered under guarantee. 5. 6. Note: Bills discounted under LC would be an exposure whicb is deemed to be guaranteed by banks. Consequently, any outstanding under bill discounting/negotiation under LC should be taken as exposure on banks. 9. If it is guaranteed by any other guarantor rated "AA-" or better. Note: Guarantor's Rating Certificate issued by anyone of the 4 Rating Agencies, i.e., CRISL, ICRA, FITCH and CARE should be available in record. In addition to the above, the following tables are to be referred to which are enclosed with this Circular: 1. Credit Conversion Factors 2. Haircut for Exposure - H^ 3. Haircut for Collateral - H^ 4. Table for Maturity Factor - (A^) 5. Eligible Financial Collaterals 6. Risk Weight for Various Exposures Computation of Capital Charge for Market Risk - Standardised Duration Approach Capital for market risk is required for abnormal losses that may arise on account of adverse movement in market prices, which in turn, depends upon adverse movement in interest rates and adverse changes in the factors related to individual issuer. Consequently, capital required for market risk is made up of two components, one accounting for movement in interest rates and another accounting for factors related to individual issuer. The former is termed 'Capital for General Market Risk' and the latter is termed 'Capital for Specific Risk'. Capital for market risk is sum of both these components. It may be noted that capital for market risk is computed in terms of capital required which is not the case with computation of capital for credit risk where risk weighted assets is computed first. In case of market risk, capital is computed directly and equivalent risk weighted assets is computed by dividing capital required by 0.09. In terms of extant directives capital for market, risk is to be maintained for following exposures: • Securities held for trading (HFT and AFS categories) • Derivatives - trading and hedging positions • Open position limits - gold and foreign exchange It may be mentioned here that securities under HTM (Held to Maturity) category and matured securities held under HFT and AFS category are treated as banking book exposure and hence do not attract capital for market risk. Instead, they attract capital for credit risk. Capital Charge for Specific Risk Extant guidelines prescribe a standardised capital charge for specific risk, which depends on issuer, type of security and remaining maturity of security. This varies from 0% for central and state Government securities to 100% (full deduction) for securities, which are eligible for capital status issued by non- scheduled banks with negative CRAR and securitised debt exposures that are rated B and below or are unrated. Capital charge prescribed for various investments are available in RBI guidelines referred. Capital Charge for General Market Risk
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Capital charge for general market risk is computed under standardised duration method, using the following formula: Capital Charge for General Market Risk of a Security = Modified Duration of the Security x Market Value of the Security x Assumed change in Yield Where assumed change in yield is prescribed by regulator and that varies from 60 basis points to 100 basis points, depending upon remaining maturity of the security (refer table below). Capital charge for general market risk of all the securities in a portfolio would equal sum of the change for each security computed in the manner described above. However, where a portfolio includes derivatives, i.e., swaps, futures, FRAs and options, capital charge for general market risk of the portfolio would equal algebraic sum of capital charge for general market risk for each security computed in the manner described above but would attract certain adjustments. This is discussed have: Derivatives create short positions in the portfolio and provide interest rate risk mitigation. Rising interest rate affects long positions in the portfolio adversely, but has favourable impact on short positions and therefore short positions reduce adverse impact of rising rate of interest on the portfolio. The reverse is also true. Short positions created on account of exposures on derivatives get netted of in the process of algebraic addition while computing capital charge for market risk. This has the effect of reducing the capital charge for the portfolio. However, in so far as changes in interest rate for assets and that for liabilities are rarely same even for any given maturity, impact of interest rate changes is not off-set fully. This is the basis risk and is accounted for in capital computations by way of vertical disallowance of netted position. The extant guidelines provide for 5% disallowance of amount netted within a given maturity band. Various maturity band prescribed for the purpose is given Table A. 10.1. Where the netting takes place across various maturity bands, yield curve risk arises also as changes in interest rates across various maturities are rarely same. This is accounted for in capital computations by way of horizontal disallowance of position netted across maturity bands. The extant guidelines provide for 30% to 100% disallowance of amount netted across maturity bands. Horizontal disallowances prescribed for the purpose are given in the Table A. 10.1. The following example would clarify the adjustments required that would arise if a portfolio has short positions. Under extant regulatory directives short positions may arise only through derivatives as short sale of securities is not yet permitted in India. Let us assume that a portfolio consists of 1. Long position in securities with remaining maturity of 2 years and general market risk capital charge of Rs 100 Crores. 2. Long position in securities with remaining maturity of 5 years and general market risk capital charge of Rs 450 Crores 3. Derivatives creating short position with remaining maturity of 6 months and general market risk capital charge of Rs 100 Crores TABLE A10.1 Assumed Change in Yield Vs Remaining Maturity Horizontal Disallowance VsTime Band Zones Time Band (Based on Assumed Horizontal Change Remaining Maturity) in Yield (Basis Disallowanc e Points) Within Zones
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Horizontal Disallowance between Zone 1 & 2 Horizontal Disallowance between Zone 2 & 3 Horizontal Disallowance between Zone 1 & 3 1 month or less 100 40% 1 to 3 months 100 3 to 6 months 100 6 to 12 months 100 1 to 1.9 years 90 30% 1.9 to 2.8 years 80 2.8 to 10.6 years 75 10.6 to 4.3 years 75 40% 4.3 to 5.7 years 70 5.7 to 7.3 years 65 7.3 to 9.3 years 60 9.3 to 10.6 years 60 10.6 to 12 years 60 12 to 20 years 60 over 20 years 60 40% 40% 100% 4. Derivatives creating short position with remaining maturity of 2 years and general market risk capital charge of Rs 50 Crores Computation of Capital charge for general market risk of the portfolio would be algebraic sum of general market risk capital charge for all these items subject to adjustments required for vertical and horizontal disallowance. Sum of general market risk capital charge for all these items equals Rs 400 crores (100+450-10050 = 400). Vertical disallowance would equal to 5% of netting in a single maturity band. In this case items 1 & 4 fall in the maturity band of 1.9 to 2.8 years (refer table) and amount netted equals Rs 50 Crores. 5% of Rs 50 Crores i.e., Rs 2.50 Crores would be vertical disallowance. Item 3 of the portfolio creates a short position of Rs 100 Crores in the maturity band of 3 to 6 months in zone I that requires to be netted from long positions in other maturity bands. The nearest maturity band of 1.9 to 2.8 years in zone 2 has a net long position of Rs 50 Crores. Balance of Rs 50 Crores is to be netted against long position in the maturity band of 4.3 years to 5.7 years in zone 10. Horizontal disallowance between zone 1 and zone 2 is 40% of amount netted and equals 40% of Rs 50 Crores i.e., Rs 20 Crores. Further, horizontal disallowance between zone 1 and zone 3 is 100% of amount netted and equals 100% of Rs 50 Crores i.e., Rs 50 Crores. Total horizontal disallowance amounts to Rs 70 Crores. The capital charge for general market risk of the portfolio would be algebraic sum of general market risk capital charge for all these items (Rs 400 Crores) plus adjustments required for vertical disallowance (Rs 2.50 Crores) and horizontal disallowance (Rs 70 Crores) totaling Rs 472.50 Crores. Note: 1. In case of securities held under available for sale category capital charge for market risk computed by adding capital charge for specific risk and capital charge for general market risk is compared with capital required treating it as banking book exposure. Higher of these two is taken as capital charge for securities held under AFS category.
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2. In case of shares, capital charge for specific risk is 9% of market value and capital charge for general market risk is also 9% of market value. Hence, capital charge for market risk for shares is taken @18% of market value of shares held. 3. Capital charge for market risk for open positions in foreign exchange and gold is 9% of limits or actual whichever is higher 4. Capital charge for market risk for derivatives are computed after converting into positions in the relevant underlying in the same manner as in respect of securities. Capital charge for market risk computed by adding capital charge for specific risk and capital charge for general market risk on each position. For details, reference may be made to RBI guidelines referred. Total capital charge for market risk is assessed by consolidating capital charges for specific risk and general market risk of all the items in the portfolio. The proforma for consolidation of capital charge for market risk is given below. Interest Rate General Market Risk • Net position • Vertical disallowance • Horizontal disallowance • Options Specific Risk Equity General Market Risk Specific Risk Foreign Exchange and Gold Total Capital Charge for Market Risk (1+2 + 3) Total capital charge for market risk can be converted into equivalent risk weighted assets by dividing it by 0.09. This is required to compute total risk weighted assets. Computation of Capital Charge for Operational Risk - Basic Indicator Approach Capital for operational risk is required for abnormal losses that may arise on account of inadequate or failed processes, people and systems or from external events. It may be noted that capital for operational risk, as in case of market risk, is computed in terms of capital required. Capital is computed directly and equivalent risk weighted assets is computed by dividing capital required by 0.09. In terms of extant directives capital for operational risk is computed as per following formula. This approach for computation of capital for operational risk is called 'Basic Indicator Approach'. Capital charge for operational risk = 15% of (sum of gross income, where positive, over previous three years/number of the previous years for which gross income is positive) Where 'Gross Income' equals Net Profit + Provisions and Contingencies + Operating Expenses - Reversal during the year in respect of provisions and write-offs made during previous year - Income recognised from disposal of movable and immovable property - Profits or losses from sale of securities under 'HTM' category - Income from legal settlements in favour of the bank - Extraordinary or irregular items of income and expenditure - Income derived from writing insurance policies and insurance claims in favour of the bank The above formula gives capital charge for operational risk and it, as in case of capital charge for market risk, is converted into equivalent risk weighted assets by dividing it by 0.09. This is required to compute total risk weighted assets. Computation of CRAR Tier-I capital funds, Tier-II capital funds, RWAs for credit risk, capital charge for market risk and capital charge for operational risk is assessed in accordance with the guidelines discussed.
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Capital charge for market risk and capital charge for operational risk is converted into equivalent risk weighted assets by dividing them by 0.09 to compute RWAs for Market Risk and RWAs for Operational Risk. Tier-I CRAR and total CRAR is computed using following formulae. Tier-I CRAR is computed as given below: (Eligible Tier I capital funds) (RWAs for Credit Risk + RWAs for Market Risk + RWAs for Operational Risk) Total CRAR is computed as given below: (Eligible total capital funds) ^ (RWAs for Credit Risk + RWAs for Market Risk + RWAs for Operational Risk) The following example would clarify the approach further A bank has computed its Tier I capital - Rs. 1000 Crores. Tier-II Capital - Rs 1200 Crores RWAs for Credit Risk - Rs 10,000 Crores Capital charge for market risk - Rs 500 Crores Capital charge for operational risk - Rs 300 Crores What would be the bank's Tier-I CRAR and total CRAR? Solution RWAs for Credit Risk = Rs 10,000 Crores RWAs for Market Risk = Rs 500/.09 = Rs 5,556 Crores RWAs for Operational Risk = Rs 300/.09 = Rs 3,333 Crores Total RWAs = Rs 18,889 Crores Tier I Capital = Rs 1,000 Crores Tier II Capital = Rs 1,200 Crores Total Capital = Rs 2,000 Crores Maximum tier II capital that can be taken into account for the purpose of CRAR is 100% of tier I capital. Tier-I CRAR = (Eligible Tier I capital funds) - (Total RWAs) = 1000/18889 = 5.29%. Total CRAR = (Eligible total capital funds) - (Total RWAs) = 2000/18889 = 10.59%. It may be noted that tier I capital of the bank is less than required level. ENCLOSURE 1 TABLE A10.2 Credit Conversion Factors SI. No ' ' Type of Non-fund-based Exposure Credit • i Conversion !.' Factor (%) 1. Standby LC financial guarantee acceptance i.e. general guarantees 100 of indebtedness 2. Transaction related contingent items i.e. performance points, bid 50 bonds, warrantees, LCs related to broad transaction 3. Documentary credit collateralized by underlying shipment - LC 20 issuing as well as confirming 4. Sale and purchase, asset sale with recourse where credit risk 100 remains with the Bank. 5. Forward asset purchases, forward deposits and partly paid shares and securities, which represent commitments with certain draw down. (Contd. ) SI. No Type of Not^-fund-Based Exposure 1 i1
Credit Conversion Factor (%)
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Note issuance facilities and revolving underwriting facilities.
Other commitments (e.g. formal standby facilities and credit lines) 50 with an original maturity of over one year. 8. Similar commitments with an original maturity up to one year 20 9. Commitments that is unconditionally cancelable at any time by the 0 bank without prior notice. 10. Take-out Finance in the books of taking-over institution 100 50 (i) Unconditional take-out finance (ii) Conditional take-out finance 11. Foreign exchange contracts such as cross currency interest rate » swap forward foreign exchange contracts, currency futures, currency options; purchased etc. 12. Single currency interest rate swap ♦♦ 13. Interest rate contract of the type basis swap, forward rate *** agreement, interest rate futures, interest rate option purchased etc. Positive value of total replacement cost (by marking to market+1% of principal amount if residual maturity is less than one year or 5% of principal amount where residual maturity is one year or more. ** Total replacement cost obtained by marking to market with positive value only. If the value is negative it is to be ignored. *** Total replacement cost obtained by marking to market with positive value +0.5% of notional principal amount if the residual maturity is one year or more. Where residual maturity is less than one year this will be equal to replacement cost obtained by marking to market with positive value ENCLOSURE 2 Operational Requirements - For Availing Exposure Reduction on Account of availability of collaterals, guarantees etc. This would arise when an account is supported with credit risk mitigation by way of one or more of the following: 1. Financial collaterals 2. On balance sheet netting 3. Guarantees However, before benefit of risk mitigation measure can be taken into account for claiming capital R;duction, conditions prescribed under the framework have to be satisfied. The minimum requirement Ihiit has to be met by a Bank before availing of the benefit are given below against type of risk mitigation. /. Financial Collaterals Operational Requirements • Legal certainty - All documentation used in collateralized transaction must be binding on all parties and legally enforceable in all relevant jurisdiction. Banks must have conducted sufficient legal review which should be well documented to verily this. • It must be ensured that the Bank has the right to liquidate and take legal possession in a timely manner in the event of default, insolvency and bankruptcy and take all steps necessary to ftilfill legal requirements to maintain bank's interest in the collateral (for example registering it with the register).
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Credit quality of borrower/ counter party and the value of collateral must not have a material positive correlation, (for example securities issued by counter party or by a related group entity would be ineligible). • Banks must have clear and robust procedure for timely liquidation of collateral to ensure that any legal condition required for declaring the default of the counter party and liquidating the collateral are observed and the collateral can be liquidated promptly. • Where collateral is held by a custodian, there should be a clear demarcation of the collateral from custodian's own asset. 2. On-balance sheet netting Operational Requirement • Bank has a well founded legal basis for concluding that the netting or offsetting agreement is enforceable in each relevant jurisdiction regardless of whether the counterparty is insolvent or bankrupt. • Bank is able at any time to determine the loans/advances and deposits with the same counterparty that are subject to the netting agreement; and • Bank monitors and controls the relevant exposures on a net basis. Loans/advances are treated as exposure and deposits as collateral. The haircuts will be zero. However, where currency mismatch exists haircut would be 0.08. Adjustment for maturity mismatch, as explained above, would also be applicable. 3. Guarantees Operational Requirement • Guarantees should be direct, explicit, irrevocable and unconditional. • Substitution approach is applied. Thus only guarantees issued by entities with a lower risk weight dian the counterparty will lead to reduced capital charges since the covered portion of the counterparty expo;sure is assigned the risk weight of guarantor, whereas the uncovered portion retains the risk wefglit of the underlying coimterparty. • Conditions of legal certainty must be met. • On the qualifying default/non payment of the counterparty, the bank may in a timely manner pursue the guarantor for any monies outstanding under the documentation governing the transaction. The guarantor may make one lump sum payment of all monies under such documentation to the bank, or the guarantor may assume the future payment obligations of the counterparty covered by the guarantee. The bank must have the right to receive any such payments from the guarantor without first having to take legal actions in order to pursue the counterparty for payment. • The guarantee is an explicitly documented obligation assumed by the guarantor • The guarantee covers all types of payments the underlying obligor is expected to make under the documentation governing the transaction, for example notional amount, margin payments, etc. Where a guarantee covers payment of principal only, interests and other uncovered payments should be treated as an unsecured amount. Range of eligible guarantors (counter - guarantors) (i) Sovereigns, sovereign entities (including BIS, IMF, European Central Bank and European Community ,ECGC,CGTS1 and the Muhilateral Development Banks listed below), PSEs, banks and primary dealers with a lower risk weight than the counterparty. Multilateral Development Banks: • World Bank Group: IBRD and IFC • Asian Development Bank • African Development Bank
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• European Bank for Reconstruction & Development • Inter-American Development Bank • European Investment Bank • European Investment Fund • Nordic Investment Bank • Caribbean Development Bank • Islamic Development Bank • Council of Europe Development Bank (ii) Other entities rated AA or better This would include guarantee cover provided by parent, subsidiary and affiliate companies when they have a lower risk weight than the obligor Proportional cover Where the amount guaranteed, or against which credit protection is held, is less than the amount of the exposure, and the secured and unsecured portions are of equal seniority, i.e. the bank and the guarantor share losses on a pro-rata basis capital relief will be afforded on a proportional basis, i.e. the protected portion of the exposure will receive the treatment applicable to eligible guarantees, with the remainder treated as unsecured. Guarantee cover would be adjusted for currency and maturity mismatch as explained above. ENCLOSURE 3 Maturity Mismatch of Financial Collaterals/Guarantees - Mf Collateral value is to be adjusted based on maturity factor. Maturity factor is to be determined in accordance with the following guidelines: (i) Where remaining maturity of the deposit at the time of sanction is less than the remaining maturity of the exposure at the time of sanction and lien document does not provide for automatic renewal/adjustment, maturity mismatch exists. (ii) Where there is no maturity mismatch Mf = 1 (iii)Where there is a maturity mismatch and maturity of collateral at the time of sanction is less than 1 year Mj-= 0 (This implies that benefit of financial collateral for the purpose of reduction in exposure will not be available) (iv) Where maturity mismatch exists and remaining maturity of the collateral at the time of sanction is 1 year or more, A/^is to be taken from the "Table for Maturity Factor - (Mf)" RBI guidelines. ENCLOSURE 4 Eligible Financial Collaterals The following collateral instruments are eligible for recognition in the comprehensive approach: (i) Cash (as well as certificates of deposit or comparable instruments, including fixed deposit receipts, issued by the lending bank) on deposit with the bank which is incurring the counterparty exposure. (ii) Gold: Gold would include both bullion and jewellery. However, the value of the collateralized jewellery should be arrived at after notionally converting these to 99.99 purity. (iii) Securities issued by Central and State Governments. (iv) Kisan Vikas Patra and National Savings Certificates provided no lock-in period is operational and if they can be encashed within the holding period. (v) Life insurance policies with a declared surrender value of an insurance company which is regulated by an insurance sector regulator.
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(vi) Debt securities rated by a chosen Credit Rating Agency in respect of which the banks should be sufficiently confident about the market liquidity where these are either: (a) Attracting 100% or lesser risk weight i.e., rated at least BBB (-) when issued by public sector entities and other entities (including banks and Primary Dealers): or (b) Attracting 100% or lesser risk weight i.e. rated at least PR3/P3/F3 for short-term debt instruments. (vii) Debt securities not rated by a chosen Credit Rating Agency in respect of which the banks should be sufficiently confident about the market liquidity where these are: (a) issued by a bank; and (b) listed on a recognized exchange; and (c) classified as senior debt; and (d) all rated issues of the same seniority by the issuing bank are rated at least BBB(-) or PR3/ P3/F3/A3 by a chosen Credit Rating Agency; and (e) the bank holding the securities as collateral has no information to suggest that the issue justifies a rating below BBB(-) or PR3/P3/F3/A3 (as applicable) and: (f) Banks should be sufficiently confident about the market liquidity of the security. (viii) Equities (including convertible bonds) that are listed on a recognized stock exchange and are included in the following indices: 'BSE- SENSEX' and 'BSE-200' of the Bombay Stock Exchange; S&P CNX NIFTY' and 'Junior NIFTY' of the National Stock Exchange, in the jurisdiction of bank's operation. (ix) Units of Mutual Funds regulated by the securities regulator of the jurisdiction of the bank's operation mutual funds where: • a price for the units is publicly quoted daily i.e., where the daily NAV is available in public domain; and • mutual fund is limited to investing in the instruments listed in this paragraph. ENCLOSURE 5 Table for Haircut for Exposures (He) Notes: 1. Haircut would depend upon counterparty, its rating and maturity of transaction. 2. Counterparty means the party with whom the bank has entered into a transaction. 3. Where counterparty is not rated, it should be treated as unrated. 4. Haircut for exposure for various combinations of counterparty, rating and maturity are listed in the table below.
S.No. Counterparty /Borrower Category
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Maturity (years) External Rating Haircut for of Transaction Exposure (%)
Govt. Of India /State Govts, of Up to 1 year India, RBI, DICGC & CGTSI
Govt. Of India /State Govts, of More than 1 year Unrated India, RBI, DICGC & CGTSI and up to 5 years
Govt. Oflndia/State Govts, of India, RBI, DICGC & CGTSI
