BM Report
BM Report
BM Report
Narrow Banking:
Narrow banking is a term used to define a very restricted form of banking, where
institutions are not allowed to take risks by giving out loans, rather to hold on for
liquidity. Instead, incremental funds are used to invest in zero risk government bonds.
This is to prevent the bank from fresh bad loans.
As the return on these bonds are very low, the banks compensate for them by bringing
down operating costs or by getting additional cash. It was proposed by the former
Deputy Governor of Reserve Bank of India SS Tarapore during the LPG period when
some of the public banks were weak and running losses. Narrow banking reduces the net
return because risk free assets yield low return.
Need and Scope:
9. Narrow banking has both pros and cons, it can create stable payment systems by
backing transactions deposits with risk free securities. This can help contain
interest outgo and can eliminate credit risk. As this has minimum risk depositors
in case of failure government need not intervene.
10. This should be one of the elements in the banking sector, which diversifies the
industry and minimises risks and loses.
11. The main hurdles which need to be looking into for implementing narrow
banking are the economy(as whole) and the banking regulations which make this
a difficult propaganda in the present Indian scenario.
12. Treasury management skills need to be improved to implement this, otherwise it
will heighten the risks than to reduce it.
13. In the context of Basel norms, narrow banking could be employed to circumvent
capital requirements by use of tier-3 capital to support market risks.
A known example is after the Liberalisation, Privatisation and Globalisation post 1991,
there was immense competition from private and foreign players for the bank. This
resulted in losses for them which they could not bail and government had to bear the
fiscal burden of Rs 16,384 during the period of 1993-94 to 1996-97. After this narrow
banking was suggested as an option. General thumb rule is a bank with more than 15%
NPAs should be converted to narrow banks.
Shadow Banking:
It is a financial intermediary involved in facilitating the creation of credit across the
global financial system but whose members are not subjected to regulatory
oversight.This system also refers to unregulated activities by regulated institutions.
Example of intermediaries which are not subjected to regulation are hedge funds,
unlisted activities by regulated institutions are credit default swaps.
Shadow banks are different from conventional banks. Like, shadow banks cannot raise
money through deposits and have to depend on market based instruments. Secondly, as
they are not regulated, they are not as transparent as conventional ones. The liabilities
are not secured in shadow banks in opposite to commercial banks, who enjoy a
minimum guarantee from the government.
These type of entities in India are known as Non Banking Finance Corporations(or
NBFCs in short). The regulatory institution for these in India is the Reserve Bank of
India(RBI). These in India doesn't only mean finance companies, but also encompasses
who range of investment, insurance, chit-funds, merchant banks etc
Islamic Banking:
Wikipedia defines Islamic Banking as, A banking activity that is consistent with the
principles of Sharia(Islamic Law) and its practical application through the development
of Islamic Economics.
Sharia prohibits acceptance of specific interest or fee on loans(known as riba), the
payments can be fixed or floating. And investing money on businesses which in anyway
contradict islamic principles(like industries related to pork and alcohol) are
prohibited(haraam). As of 2014, these types of banks held 1% of worlds total assets.
These are expected to grow at a rate of 19.7% by 2018. They have different councils and
standards governing them. Like Shariah Supervisory Board (SSB), Islamic Financial
Services Board (IFSB); and, Accounting and Auditing Organization for Islamic
Financial Institutions (AAOIFI) which drafts the accounting standards to be followed.
There are many products which are similar to the conventional banking products, but are
very much different. For Example, In deposits and loans, the interest paid is on will
basis(as gifts) and not promised by either parties.
Need and Scope:
1. India has a big opportunity in this sector, as it has 140million muslims
(Approximately) which is around 15% of world islamic population.
2. According to survey, it has a potential market of $4 trillions. Which can be a
major tool for enhancing economic development in India.
3. Most of the foreign banks in India, have interest free windows for this in other
countries. For example, CITIGroup, HSBC, Standard Chartered etc in West Asia,
4.
5.
6.
7.
UK, US etc. As the awareness is growing in India, there is a potential market for
this, which can be tapped by both Indian and Foreign Banks.
There has to be strict regulations in place because banks are showing interest in
these interest-free banking. Otherwise, it would be impossible to follow the
islamic laws by the banks.
This not only benefits the muslim population but the whole community as whole.
This can improve the FDI and FII from Middle-east or Arab Countries who only
operate through Islamic Banks.
This banking has other features like: inclusive growth with control over inflation,
equity financing, equitable profit sharing and micro-loans.
There are not many islamic banks in India, but Many foreign banks like Citi, HSBC
have islamic banking windows in various countries.
Virtual Banking:
A virtual bank is defined as a financial institution which handles all transactions through
web, e-mail, mobile check deposits and ATM machines. They minimise the overheads
incurred by physical branches and in turn are expected to pay a higher interest on
deposits. All transactions are handled online. This is the emergence of ebanking/
netbanking, mbanking, phone banking etc. Many of the banks have launched their
mobile apps, where all the bank transactions can be carried out in a single window, from
encashment of cheque to paying for a movie ticket. For example, in ICICI bank, from
the app you can take a picture of the cheque you received and they cheque is verified
and the funds are transferred instantly and the cheque can be deposited to the bank later.
We have moved from cash to cheque to card to mobile. Cash to Cashless to Card to
Cardless now(with introduction of new technology like Apple Pay). With the affect and
effects of demonetisation, virtual banking has eased the life of many of its users.
Another such example of virtual banks is collapsible branches by ICICI, which is great
initiative by ICICI towards capturing market and contributing towards governments
financial inclusion agenda. In this system, there is one employee, with a bike, laptop and
internet connectivity, who goes to inaccessible places and carries out all the transactions
of the bank in a small space with no significant overheads.
An interest-rate derivative like interest rate swaps, caps and floors, is a financial
instrument with a value that increases and decreases based on interest rates movement. It
is often used as hedge by institutional investors, banks, companies and individuals for
protection against changes in market interest rates. They also serve as to increase or
refine the holder's risk profile.
Interest rate derivatives can be simple or complex; they can be used to vary interest rate
exposure.
Table 2: Derivatives in India: A Chronology
Date
14 December 1995
Progress
NSE asked SEBI for permission to trade index futures.
18 November 1996
11 May 1998
7 July 1999
24 May 2000
25 May 2000
9 June 2000
12 June 2000
1 August 2000
June 2001
July 2001
9 November, 2002
June 2003
13 September, 2004
1 January, 2008
1 January, 2008
29 August, 2008
2 October, 2008
th
20 September 2010
3 What is a Derivative?
Derivative is a financial instrument whose value depends upon value of underlying asset. Its
primary purpose is not to borrow or lend but to transfer price risk associated with
fluctuations to asset values. It helps in managing risk, price discovery and transactional
efficiency.
Derivatives products like futures and options are used to systematically hedge business
risk and an opportunity to earn wealth for speculators and arbitrageurs.
Unlike debt instruments, no principal amount is advanced to be repaid and no investment
income accrues. For example, A speculator on the gold futures market anticipated a price
increase from the current futures price of $ 450. The market lot being 100 oz, he buys one
lot of futures gold. 100 oz of gold at $ 450 have a value of $ 45000. But the speculator is
only required to pay out a margin or deposit of $ 4500. Now assume that a 10% increase
occurs in the price of gold, to $ 495.The value of 100 oz at $ 495 is $ 49,500. Subtracting
original contract value, the profit on the transaction is $ 4,500. As far as the speculator is
concerned, he/ she has achieved a profit of $ 4,500 on a capital of $ 4,500. In short, he/ she
has achieved a 100% profit through a 10% price rise.
Cap: This gives the purchaser protection against rising interest rates
and sets a limit on interest rates and amount of interest that will be
paid.
Floor: This sets a minimum below which interest rates cannot drop.
Underlying
Exchangetraded
futures
Equity
DJIA Index
future
Single-stock
future
Commodity
WTI crude
oil futures
Foreign
exchange
Currency
future
Credit
Bond future
Interest
rate
Eurodollar
future
Euribor
future
CONTRACT TYPES
ExchangeOTC
OTC
traded
swap
forward
options
Option on
DJIA Index
Back-tofuture
Equity
back
Singleswap
Repurchase
share
agreement
option
CommIron ore
Weather
odity
forward
derivatives
swap
contract
Option on
Currency Currency
currency
swap
forward
future
Credit
default
Option on
swap
Repurchase
Bond future
Total
agreement
return
swap
Option on
Eurodollar
Interest
Forward
future
rate
rate
Option on
swap
agreement
Euribor
future
OTC option
Stock option
Warrant
Turbo warrant
Gold option
Currency option
Credit default
option
1.4.1 Exchanges:
1.4.1.1 Exchange traded Derivatives: In India we have, NSE (shares and index), BSE
(shares and index), NCDEX (commodities), MCX (commodities) and recently opened
United Stock Exchange for Banks (currency) dealing in derivatives instruments. Operation
st
The Over the Counter Exchange: The OTCE market is an important alternative to
exchanges and report high volume trading. Not all trading is done on the exchanges. In
OTCE, trading is done on telephone and computer networks which are linked to dealers.
Trade between two financial institutions could be done with bid and offer prices being
offered simultaneously by the institutions. The OTCE trading in India is carried out in
foreign exchange and currency. Foreign Exchange and currency trading in stock exchanges
(NSE and United Stock Exchange) are allowed to be traded only in futures and not in the
spot market.
1.4.3
open outcry system involves traders and brokers operating on an exchange floor where they
communicate their deals by shouting at each other and using hand signals. On such
exchanges, the floor is a very noisy and a colourful place, and the activities seem to be
chaotic.
Difference between exchange traded and OTC derivatives
Sr. No.
Exchange Traded
Derivatives traded on a
2
3
4
OTC
Derivatives traded on a private
basis and individually negotiated
contract specifications
contract specifications
Available
easily available
each other
other
Commoditized vanilla contracts
6
7
Out
transferred
Delivery
expiry or delivery
Source: John Wiley & Sons (Asia) Pte. Ltd. The Reuters Financial Training Series, "An introduction
to Derivatives" (1999)
Banks
Individuals
Hedgers: Hedgers enter into a derivative contract to cover risk associated with the
business deal. For example farmer growing wheat is uncertain about the price he would
get during harvest season. Similarly a flour mill is unsure about the price at which it may
have to procure the wheat in future. Both the farmer and the flour meal would enter into a
forward contract where the farmer agrees to sell his wheat to the flour mill at a predetermined price. The farmer is expecting a price fall during harvest season and the flour
meal is expecting a price rise. Hence both the parties face price risk. The forward contract
in which they have entered into would eliminate the price risk for both the parties. This is
called as hedging and the participants are called as hedgers.
1.5.1
assuming risk. The speculators have an independent view of future price behavior
of the underlined asset and take appropriate position in derivatives with the
intention of making profit later. For example, the forward price in US dollars for a
contract maturing in three months is Rs. 48. If the speculator believes that three
months later the price of US dollar would be Rs. 50, he/she would buy forward
today and sell later. On the contrary if he believes that US dollar would depreciate
to Rs. 46 in one month, he would sell now and buy later. The intention is not to
take delivery of underline but instead gain from the differential in price.
Speculators render liquidity to the market and make markets competitive and
expand the market size. They also helps hedgers find counter parties
conveniently.
Arbitrageurs: Arbitrageurs perform the function of making the prices in different
markets converge and the in tandem with each other. The markets could be physical
market and the commodity exchange. Since there cannot be any disparity in prices in the
physical markets and the commodity exchange, arbitrageurs constantly monitor the prices
of different assets in different markets and identify opportunities to make profit that
emanate from mis-pricing of products in the different markets. Unlike hedgers and
speculators, arbitrageurs take riskless position and yet earn profit. For example if the
share price of Infosys is Rs. 1750/- in National Stock Exchange and Rs. 1770/- in
Bombay Stock Exchange the arbitrageurs will buy at NSE and sell at BSE simultaneously
and pocket the difference of Rs. 20/- per share. An arbitrageur takes risk neutral position
and makes profits in markets which are imperfect.
Regulation involves the following factors:
Regulator
Securities and Exchange Board of India
(SEBI)
Reserve Bank of India (RBI)
Reserve Bank of India: Reserve Bank of India (RBI) was established in 1935 and is the
Central /Federal bank of India. RBI is the regulator for financial and banking system,
formulates monetary policy and prescribes foreign exchange control norms. The Banking
Regulation Act, 1949 and the Reserve Bank of India Act, 1934 authorize the RBI to
regulate the banking sector in India. The Reserve Bank of India regulates a large segment
of financial institutions in India which includes commercial banks, cooperative banks,
non-banking financial institutions and various financial markets.. The Board for Financial
Supervision (BFS) has been mandated to ensure integrated oversight over the financial
institutions that are under the purview of the Reserve Bank.
Securities and Exchange Board of India: Securities and Exchange Board of India
(SEBI) established under the Securities and Exchange board of India Act, 1992 is the
regulatory authority for capital markets in India. In addition to the SEBI Act, the
Securities Contracts (Regulation) Act, 1956 and the Companies Act, 1956 regulates the
stock markets. SEBI regulates the securities market, institutions and intermediaries such
as stock exchanges, depositories, mutual funds and other asset management companies,
brokers, merchant bankers, credit rating agencies and venture capital funds etc. The stock
exchanges have to regulate the activities of the derivative traders and clearing agents.
The powers and functions of SEBI are as per SEBI act 1992. It also exercises power
under Securities Contract (Regulation Act) 1956, the Depositories Act 1996 and certain
provisions of Companies Act 1956. (RBI).
trading;
2. Limit price fluctuation to prevent sudden price upswing or downswing ;
3. Special margin deposits collection on outstanding purchases or sales to curb
excessive speculative activity
As regulatory measures, the Commission during shortages, take extreme steps like
skipping trading in certain deliveries of the contract, closing the markets even closing out
the contract for a specified period to overcome emergency situations. In addition to the
above measures, the regulator calls for daily reports from the Exchanges and takes proactive steps to ensure no misuse of the market. It regulates prices reflecting on the
Exchange platform by making sure that the prices are governed by the demand and supply
in the physical markets.
Other Financial Regulators in India are as follows:
Ministry of Finance (MoF)
Department of Economic Affairs
Department of Expenditure
Department of Disinvestment
Ministry of Corporate Affairs
Insurance Regulatory Authority of India
Pension Fund Regulatory and Development Authority
ADVANTAGES OF USING DERIVATIVES IN BANKS:
Apart from using derivatives for interest rate risk management (hedging
against interest rate risk), they can also be used to:
a)
b)
c)
d)
e)
f)
g) Risk, which could not be easily avoided previously, can now be insured;
h) Economic means for banks to alter their interest rate risk exposure;
i) Derivatives provide a means for banks to more easily separate interest
rate risk management from their other business objectives;
j) fosters more loan making or financial intermediation;
k) preferable to balance sheet adjustments using securities and loans
lessening the need to hold expensive capital
l) Banks can remove unprofitable activities and make up the difference
with appropriate financial instruments
Disadvantages of derivatives:
a.
b.
It can affect the banks overall risk exposure, and so seen as a potential source of
increased solvency exposure;
Knowing more about the derivatives position of a bank may not allow outside stakeholders to determine the overall riskiness of the bank. Banks invest in many non derivative instruments that are illiquid and opaque. so even if the value of their derivatives
positions were known, it would be hard to know its relationship between interest rate
INTRODUCTION
The Banking sector has played an important part in increasing and sustaining growth
in the economy. It helps in directing the nations saving into high investment options
and efficient utilization of available resources. Modern banking accept the risk to earn
profits. There are different types of risk such as credit risk, operational risk, interest
rate risk, liquidity risk, price risk, foreign exchange risk, etc. Interest rate risk refers to
the exposure of a banks financial condition to adverse movements in interest rate. It
is the risk for earnings and capital if market rates of interest vary unfavorably. This
risk arises from timing differences of changes in rates, the timing of cash flows
(reprising risk), and changes in the shape of the yield curve (yield curve risk) and
option values in the products (options risk). In all, the market value of banks assets
(i.e. loans and securities) will fall with increase in interest rates. Earnings from assets,
fees and the cost of borrowed funds are affected by changes in interest rates.
Accepting this risk is a part of banking and an important source of profitability and
value of shareholder. Changes in interest rate change its net interest income and the
level of other interest sensitive income and operating expenses, and thus changing
banks earning. Interest rate refers to volatility in net interest income (NII) or in
variation in net interest margin (NIM) i.e. NII divided by earning assets due to
changes in interest rate. Interest rate risk arises from holding assets and liabilities with
different principal and maturity or repricing dates. So an effective risk management
process for safety of banks is must to maintain interest rate risk within certain levels.
Financial markets have a nature of a very high volatility. Derivative products can
partially or fully transfer price risk by locking in asset prices. These products initially
emerged as commodity linked derivatives, which remained the base form of such
products for three hundred year. Financial derivatives came into limelight after 1970
period due to growing unstable financial market. They financial instruments whose
payoff is based on the price of an underlying asset, reference rate and index. By
1990s they accounted for about 2/3 of total transaction in derivatives products.
Markets means price determination and exchange of goods and services. Prices are
the base of the market mechanism. Derivatives are considered supporters of price
discovery in financial market and allocators of risk. An interest rate derivative is
where the underlying asset is the to pay or receive a notional amount at a given
Interest rate. The RBI introduced interest rate swaps (IRS) and forward rate
agreements (FRA) in 1999 and interest rate futures (IRF) in 2003 and reintroduced
IRF in 2009.
Gross market values, which measure the cost of replacing all existing
contracts, prove to be a better measure of market risk than notional amounts.
Even though there is a drop in outstanding amounts, significant movement in
price resulted in notably higher gross market values.
Table D5
Notional amounts outstanding
H2 2014
H1 2015
H2 2015
H1 2016
H2 2014
H1 2015
H2 2015
H1 2016
628,003
551,489
492,707
544,052
20,837
15,485
14,492
20,701
75,043
73,607
70,446
74,036
2,936
2,539
2,579
3,063
36,596
36,699
36,331
38,853
1,202
932
947
1,340
Currency swaps
24,042
23,566
22,750
23,485
1,348
1,283
1,345
1,462
Options
14,405
13,342
11,365
11,697
386
324
287
261
...
...
...
...
505,443
434,507
384,025
418,082
15,586
11,062
10,148
15,096
All contracts
Foreign exchange contracts
By instrument
Other products
Interest rate contracts
By instrument
FRAs
80,818
74,633
58,326
71,842
145
143
114
255
Swaps
381,141
319,821
288,634
311,474
13,925
9,796
8,993
13,480
Options
43,484
40,053
37,065
34,743
1,516
1,124
1,042
1,361
24
...
...
...
...
6,968
7,544
7,141
6,631
612
606
495
515
2,495
2,801
3,321
2,537
177
168
147
172
Options
4,473
4,743
3,820
4,094
435
438
348
343
Other products
Equity-linked contracts
By instrument
Table D7
Total
H1 2016
USD
H1 2016
EUR
H1 2016
JPY
H1 2016
GBP
H1 2016
CHF
H1 2016
CAD
H1 2016
SEK
H1 2016
Other
H1 2016
418,082
71,842
1,501
69,732
66,106
608
148,898
38,525
606
37,491
35,080
428
120,459
20,008
110
19,872
19,771
26
49,740
17
0
13
10
3
41,857
8,039
64
7,971
7,939
4
3,562
726
7
718
703
1
8,728
9
1
1
0
7
4,675
1,631
167
1,432
1,328
32
40,163
2,887
546
2,233
1,275
107
15,096
255
13
224
196
17
3,862
235
12
208
185
15
6,401
8
0
7
4
1
1,441
0
0
...
2,205
5
0
5
5
0
119
0
0
0
0
0
218
0
0
0
0
121
1
0
1
1
0
728
5
1
4
1
1