Foreign Exchange and Indian Financial Sector

Swap, Foreign Exchange and Indian Financial Sector: Risk Management Frontier[2]

1. Financial Crisis and the Sector

Financial sector is at turbulent state following the occurrence of financial turmoil in the recent past. Occurrence of events could be recounted as far back as 1930s, 1987, 1997, and 2007-08, etc. which had brought many distinct features and challenges to the financial sector with more undesirable consequences. This can be ascribed to the phenomena, called “black swan”. Momentarily, we have learnt important lessons from the crises, whatever these were single or double-deep, in the recent past. But the strategy to cope with it is contingent. As a result, no major derivative clearing house encountered the trauma of the financial turmoil in 2007-08 while many investment banks were pushed to the brink and beyond after witnessing and experiencing a lack of coherent risk measures[3] (Varma 2009). These were not embedded into the structures of complex-derivatives products.

Management is prudent but is obvious to say that performance-measures are not wise at the risk-measurement frontier. Increased cost of capital sharply throws up an indication on efficiency issue of Indian banking sector although developing countries are enjoying the deregulation regime or direct control on capital flows. Asset allocations and pricing of assets are two pressing agenda with respect to the price volatility. Investment and growth take into account of the processes of analyzing the output or return or/and ‘spread' through a basket of indicators, namely, debt or borrowings (either in the form of public-sector or external commercial borrowings), credit-deposit ratio (CD) and risk adjusted return on capital (RAROC) as the major indicators of the performance measurement of this sector. In the back of the structural analysis, ownership or corporatisation of banks has gained fair amount of attention; obviously, efficiency is most sought-after criteria considered by many bankers, financial analysts and other industry experts.

In this backdrop, before going into mainframe of the discussion, it is worth mentioning about the occurrence and proliferation of the financial crisis traced back to 2007-08. A study by IMF (2008) gives a concise understanding, “financial stress episodes are more likely to be followed by severe economic downturns when they occur in the context of a rapid build-up in credit and house prices and a heavier reliance on credit by firms and households”. Relating to the banking sector, Reinhart and Rogof (2008b) assessed after taking eighteen (18) major post-war banking crises in the developed world and three in emerging markets. Their study came out with the conclusion in the light of literature reviewed by Ram Mohan (2009):

Real housing prices declined by an average of 36% over five years and equity prices by 56% over three and a half years. The unemployment rate rises by 7 percentage points on the average over a period of four years while output falls from peak-to-trough by 9% over a shorter period, two years. The real value of government debt tends to explode, rising by an average of 86% in the major post-second world war episodes (Mohan 2009: 107-108).

Having said this as a phenomenal impact on the performance of banking sector, we look at the two edges in the following sections; one is the financial sector reforms and its performance and efficiency in first-section of the paper. In second-section, we try to introduce swap, as one of the derivative-instrument for risk management which is coherently presented. Foreign exchange rate is concomitantly introduced to assess the importance of currency forward or future underlying rupee-dollar or other currencies dominated financial market, ofcourse, foreign exchange risk is arising out of market risk other than equity, interest rate and commodity. Hence, hedging the mentioned risks warrant some instruments, either be standardized or complex derivatives products. Since foreign exchange risk is an iota of the market risk, swap, either through the form of interest rate swap/plain vanilla swap or through currency or equity swap, besides the other instrument, namely, currency derivatives, has witnessed significant importance in terms of its volume and value of trade during the financial turmoil.


2. Financial Sector Reforms and Money Market

Immediately after the nationalization (two phases; 1969 and 1980), the public sector banks (PSBs) extrapolate their branches to the areas at a rapid pace. Dhade (2009) mentioned that hardly any impact was found in terms of performance and profitability of State Bank of India in Madhya Pradesh state after the entry of new private sector banks during the time period, 1994-95 to 2004-05. The author further mentioned:

Studies by Kantawala, 2004; Saveeta and Singh, 2001; Ketkar, Noulas and Agarwal, 2004 and Reddy, 2004; Verma, 2001; reveals that bank performance from profitability point of view analysing the various parameters. Their study mainly shows the concern about the declining trends of public sector banks and increasing graph of New Private Sector Banks and Foreign Banks. The profitability of the Public Sector Banks did improve relative to the Private and Foreign Banks, but they have lost ground in their ability to attract deposits at favourable interest rates in their slow technological upgradation, and in their staffing and employment practices, which has implications for their longer-term profitability (Dhade 2009: 1358).

In India, following the wave of nationalization, there was two distinct structural breaks observed, one was during nationalization stage and other during liberalisation stage. In this regard, there were many committees formed to examine or assess the financial sector with respect to efficiency, market operations, issues and strategies, performance and sectoral reforms, etc. at different point in time, namely, M Narasimham (1991), Rakesh Mohan (2000), Tarapore-I and Tarapore-II committee (1997, 2006), Percy Mistry (PM, February, 2007) and Raghuram Rajan (April, 2008; for more details, see, Lahiri 2009).

Few distinguished economists and bankers, like Shri M. Narasimhan came out with two important recommendations linked with instruments-based monetary policy by the way of introducing Ways and Means Advances (WMA), namely, Liquidity Adjustment Facility (LAF) and Open Market Operations by financial institutions (OMO) with respect to borrowing and lending requirement of the PSBs. For instance, we can look at the Reserve Bank of India's (RBI) market operations and its current status (from April'09 to March'10) in the following table.

TABLE 1: Reserve Bank of India's Market Operations (Rs. in Cr)


OMO (Net Purchase (+)/Sale(-))

LAF (Average Daily Injection (+)/Absorption (-))





































Source: Economic and Political Weekly (EPW) Research Foundation (2010). “Issues in the Financial Sector: Regulatory Architecture”, 45:16, p. 74.

Lahiri (2009) mentioned that Tarapore committee (Tarapore-I & II) recommended “measures such as reduction of the gross borrowing requirement of the government”, adopting the public sector borrowing (PSBR) as a key indicator of deficit-financing in public sector, establishing an Office of Public Debt outside the RBI, a transparent “setting out of the monetary policy objectives jointly by the government and RBI”, “for fuller capital account convertibility”, which could be implemented in three phases taken as a gradual approach, that is, 2006-07, 2007-09 and 2009-11. The committee (Tarapore-II) further recommended:

The substantive recommendations of Tarapore-II included raising the annual ceiling on external commercial borrowing (ECBs), relaxing restrictions on rupee-dominated and on long-maturity ECBs, easing restrictions on end-use of ECBs, easing up on FII investment in debt securities, and liberalizing outward investment by both individuals and corporates (Lahiri 2009: 123).

On the other hand, PM committee report did not get due attention as the committee put forward the thirst on Mumbai as International Financial centre of India. Report put an argument:

…for introduction of full capital account convertibility, an inflation-targeted monetary policy, a move from a rule-based and fragmented to a principles-based and unified financial sector regulatory architecture (Lahiri 2009: 123).

On the similar ground, Rajan committee's report served as a “broad reference” of measures such as identification of “the emerging challenges” to cater to the need of Indian banking sector with a special emphasis on performance measures of the various sub-sectors of the financial sector. Committee took both integrated and sectoral approach to craft a voluminous report with 33 recommendations. The salient-features of the recommendations grouped under six-categories mentioned below:

Inflation-targeting by RBI through the repo and reverse repo rate, …reform of regulatory architecture with principles-based regulation,…deregulation for more efficiency with opening up rupee-bond markets to foreign investors, being more liberal in allowing to set up branches and ATMs anywhere and creation of a more innovation-friendly environment…deregulation for financial sector financial inclusion by allowing more entry of well centralized deposit-taking small finance banks, liberalizing banking correspondent, regulation to allow local agents to extend financial services, allowing a system of exchangeable priority sector loan certificates (PSLC), …restructure public sector banks (PSBs) by selling small underperforming PSBs to strategic investors and observing outcome..or bringing down government's share below 50% (Lahiri 2009: 123).

If we look at the future of financial sector reforms, then one of the more relevant issues seem to be that of ownership issues of private sector, geographic spread of financial institutions, their customers-focus, and the country's overall credit to GDP ratio and assets to GDP ratio, which reached to 7% from 3 % in the recent past. In the recent years the result is quite vivid, for instance, domestic capital formation rate of 5-6% which indicates a rosy picture.

Estimate shows that USD 1.7 trillion is required for industrialization and urbanization. This is rough estimate of credit requirement which has to be met by the financial institutions. At market and sector level - Euro and Pound, Sterling. Given the credit risk, basic Credit Default Swaps (CDS) are ready to be introduced. Hence, such demand and introduction of private sector lending measures leads to financial innovation. Given the tendency of providing credit beyond the prudence, a systematic capital surcharge in the form of cap on ‘capital leverage' is also recommended. Public sector banks account for 70% of total deposits and 73% of aggregate lending. This gives rise to question of business model and public governance,-which is largely supposed to provide a level playing field.

3. Efficiency and Stability: An Indicator Approach

It is quoted by the bankers in their notes that vindications of the long-term Government-held securities which often have an implications to meet out Statutory Liquidity Requirement of the RBI apart from financing fiscal deficit, is not legitimate to be in the whims and fancies of the market. Arguably, we can put another way that financial stability is better than financial development. Conservative means of accounting on profits of sales of securities through the classification of assets, like, Held to Maturity (HTM), Available for Sale (AFS) and Held for Trading (HFT) (these are the categories of banks' portfolios of Government securities as bonds HTM are not marked to market (MTM) unlikely the other two) needs to be scanned and reviewed in the light of securitization and capital account convertibility practised as financial innovation. In fact, big five banks in the world emerged better out of the financial crisis and maintained dividends showing sub-prime mortgage of about 80% and tax-deductable income (Net Interest Income and Net Interest Margin) had pegged with a “knee-jerk” reaction. Following table reveals the concern about efficiency of banks considering an indicator approach, although level-playing field is pre-requisite to achieve the uniformity in measurement (Raghuram Rajan Committee 2008; Mohan 2009).

TABLE 2: Efficiency-measures of Banks using Indicator Approach


Nationalized bank






Business per employee (Rs. In lakhs)


(SBI Group)



Profit per employee (Rs. in lakhs)




Net NPA (%)

increasing, pegged at Rs. 15,000 crores over two years for the PSBs

Return on Assets (ROA) (%)




declining of foreign banks

Capital Adequacy Ratio (RCAR) (%)




sharply dropped to 9% in 2006-07, for last two years, it is increasing

Source: Excerpts from the Seminar delivered by Himadri Bhattacharjee, (former RBI officer) at International Finance Conference (IFC), IIM-Calcutta, 2009.

The following chart highlights the year-on-year basis growth of four major indicators precisely, namely, deposits (Rs. 4,402,943 crores including demand and time deposits), sources of money stock (M3) including currency with public (Rs.7, 69,992 crores), demand deposits with bank (Rs.7, 14,157 crores), time deposits with banks (Rs. 4,093,577 crores) and other deposits with RBI (Rs. 5,533 crores), reserve money components and sources of reserve money (Business Standard, April 13, 2010). Besides these indicators, average turnover in call money (interbank lending instrument) market[4] by banks and primary dealers showed a slightly downward trend, that is, Rs. 6,671 crores reported on April 2' 10 from Rs. 8,865 crores during April 3' 09 in case of borrowing and lending also witnessed a declining trend, from Rs. 10, 454 crores during April3' 09 to Rs. 7,373 crores in April 2' 10. It is almost similar for primary dealers also. Borrowing and lending cumulatively reached to Rs. 731 crores during April 2' 10 from Rs. 1,589 crores (excluding lending) in April 3' 09. This pattern of money market may be attributable to gradual increase in basis points (25 bps) for money market instruments, viz., cash reserve ratio (CRR, 5.75%), repurchase rate (6.00%) and reverse repo rate (3.75%) declared by RBI during the first-fortnight of April, 2010. Call money rate is discussed in section-II, under foreign exchange part.

CHART-1: Money Market and Indian Banks (SCBs and Nationalised Banks)

Source: data downloaded and compiled from Business Beacon, CMIE-Prowess.

Apart from the above indicators, soundness and stability of the banking sector is required to examine after the introduction of Basel-II accords (crude and sophisticated) in the month of March, 2008. The following table shows the Risk adjusted Capital Adequacy Ratio (RCAR) over the three year-period horizon, 1999, 2003, 2009 with an almost of four-to-six-year interval.

TABLE 3: Bank-category wise Capital Adequacy Ratio (in percentage)

Bank Groups-Year Wise








Nationalised Banks




New Private Banks




Foreign Banks




All SCBs




Source: International Finance Conference (IFC, 2009) at IIM, Calcutta

Based on above facts and figures, would it be safe to conclude that convergence is prima facie for Brazil, South Africa, India and Turkey? Can we argue that banks in India have achieved the degree of convergence with respect to efficiency given by the indicators, in global financial and economic paradigm or leave the question to judgment?

4. Performance and Efficiency: A Recent Outlook

The gain mostly from the spread earned by banks, often termed as “treasury”, has not found its place in quarterly balance sheet of major banks in India. Business Standard quotes on February 5, 2010 that “the 43 listed banks together reported a 3% decline in net profit during the December quarter…the 26 public sector banks reported a 4.8% decline in net profit during the quarter, while private lenders saw their bottom lines expand by 2.82%”. Besides, other income related to fee income, say ban on entry-load for mutual funds and the muted demand for insurance policies, has sharply declined to 13% witnessed by 43 banks together instead of having an increase to 40-60% during the last quarter amongst four quarters. But net interest income or operating spread (interest income earned from borrowers or on assets and interest expense paid out for liabilities or to lenders) and net interest margin (NII to assets ratio) figures seemed to be good.

Indian banks-private and public-recorded a double-digit growth in NIM on re-pricing of deposits and healthy credit-deposit ratio (CD). But, the private banks edged up with an NII growth of 16.1% compared with 12.23% for public sector banks…Margins continued to improve on a sequential basis for most banks aided by a sharp fall in retail one-year term deposit rates, which is currently at around 6.5-7% from over 10% last year. The decline in yield on loans appears to have stemmed in the current quarter for most banks, which is also positive for margins (“Treasury hit takes a toll on bank profits” by BG Shirsat; Business Standard, February 5, 2010).

5. Complex Financial Products: Too Risky to handle

On the day of 75th Annual Anniversary of the RBI, International Monetary Fund[5] (IMF) floated some points which would be important to build the discourse further on performance or efficiency of financial institutions (FIs). Discussion puts forward the following key lessons to make the “cushion” ready to bolster the health of banking sector amidst of the financial turmoil:

§ Financial innovations could be introduced or brought into the well-placed financial system containing state-of-the-art technology with respect to its depositors' and borrowers' base, participation of investors which results at cheap borrowing rate and also becomes relatively competitive.

§ Similarly, investing capital should rely on prudent decision. Governance and risk management should be put in place meticulously and incisively, complexity of instruments should attract proper pricing in real economy and needs a balancing mechanism between demand and supply of the instruments, unlikely for credit default swaps market which is mostly an over-the-counter (OTC) driven.

Now in subsequent section, we discuss swaps and foreign exchange rate to invoke some thoughts about pressing issues of banking-sector in regards to the productivity and efficiency. Several studies empirically show that there is causality between technical-efficiency and non-performing assets (NPAs) accumulated year-on-year basis and there are tools and techniques to measure efficiency, namely, through cost minimisation, output maximization, productivity index, thick frontier approach, distribution free approach and some stochastic measures documented in RBI report, 2008-09, for details, see, “Efficiency and Productivity of Banking Sector”, RBI-Report, Chapter-IX, 393-446).


6. Derivatives: A tool of Risk Mitigation

6.1. Interest Rate Swap and Currency Swap

Banks have twin objectives of maximizing profitability while ensuring the desired liquidity. To achieve these objectives it is imperative to maintain and manage asset and liabilities addressing various risks involved with these. Most of the times banks suffer from two kinds of risks; liquidity risk and interest rate risk. These risks possess critical amount of threat to cash flows of banks. So, managing interest rate risk (IRR) through some instruments is crucial. One such derivative instrument is interest rate swap (IRS) and currency swap. There is a huge success of one derivative product launched in India, viz. Interest Rate Derivative Product (IRS). This opens up opportunities for the risk adverse players to transfer the risk to the players who are willing to take risks. Thus, it allows the entry of many market participants to hedge their exposures. Banks usually have two methods in administering IRR; one is through on-balance sheet adjustments including assets and liabilities and the second off-balance sheet adjustments. Swap is considered as an off-balance sheet adjustment.

A swap is a privately negotiated agreement between two parties to exchange cash flows at specified intervals (payment dates) during the agreed-upon life of the contract (maturity or tenor). Entering a swap typically does not require the payment of a fee. It is cash settled OTC. Innovations in swaps introduced by few banks, like debt-swap schemes (DSS) are discussed below.

Box-1 Debt Swap Scheme

Bank of India has embarked on a very new scheme of debt swap scheme where bank helps farmers redeem their outstanding to money lenders. Bank has so far covered 121 villages under the Scheme which have been declared as money lender free villages. Disbursement amounted Rs.13.28 crore under the scheme covering 8690 accounts towards Debt Swap and Rs.17.15 crore for other ongoing farm activities of the beneficiaries (Bank of India Annual Report, accessed through, 2008-09).

Survey Results

The market survey report published by International Swaps and Derivatives Association (ISDA) manifests that major derivatives users of India are Indian oil, Reliance Industries, Bharat Petroleum, Hindustan Petroleum, TATA Steel, ONGC and SBI. The region is Ex Japan Asia. Both forex and commodity are common in all the companies. First column shows the rank with respect to revenue they earned during the year 2006-07.

TABLE 4: Market Survey of Derivatives Usage (including Swaps) by ISDA



Company Name


$ millions



Public Disclosure

Derivatives usage

Interest rate






Indian Oil



New Delhi

Basic materials









Reliance Industries




Basic materials









Bharat Petroleum




Basic materials









Hindustan Petroleum




Basic materials









Tata Steel




Basic materials









Oil & Natural Gas




Basic materials









State Bank of India












Source: International Swaps and Derivatives Association (ISDA)

TABLE 5: Valuation of Swaps used by different Banks

Notional amount of Interest Rate Swaps


2008-09 (in Cr.)

2007-08 (in Cr.)

Kotak Mahindra Bank



HDFC bank




4592.81 +26555.93








Karnataka Bank



Bank of India



Indian Bank



IndusInd Bank



Source: Annual Reports of all the banks written in the above table.

It is evident from the annual reports of banks that most of the banks had decreased the principal amount of swaps from the year 2007-08 to year 2008-09 which was after the recession. Only ICICI bank, Indian Bank and IndusInd Bank had increased total notional amount of swaps. The amount used for hedging was comparatively less than the amount used for trading purpose. Kotak Mahindra Bank and IDBI Bank utilized Rs.251.44 crores and Rs.4592.81 crores for the hedging purpose respectively.

Interest rate swaps, a capital market-innovation introduced only a few years ago, have become a very popular and effective interest-rate-hedging instrument. Using swaps, financial risk managers can easily change or transform the characters of liabilities into assets. It has been reported in number of places that interest rate swaps are more effective in mitigating the risk than other derivatives like options, futures and forwards.

7. Foreign Exchange and Financial Sector

Foreign exchange rate implies the rate at which one unit of foreign currency is available at domestic level. In floating exchange mechanism the volatility of foreign currency is very relevant and pertinent issue for study and discussion. After the liberalisation and globalisation, Indian market is linked to the global market, so the foreign exchange rate volatility has also been influencing by other global macro-economic factors. Today foreign exchange reserves (forex) have reached to USD 281.15 bn during March 26' 10 from USD 255.16 bn, a year ago with a year-on-year change reported 23.94 % (Business Standard, April 13, 2010). Hence, this figure approximately implies for a better sign of economic growth of the country. In this study four foreign exchanges are taken into consideration to highlight the percent of change (viz. rupee appreciation or depreciation). In Fig-1, the movement of change of dollar and change of sterling is almost in the same direction. The change in dollar rate is much more than sterling rate. During 2008-09, the appreciation of dollar (depreciation of rupee) was much more than appreciation of sterling. During the first phase of 2009, the sterling value appreciated much more than the rate at which dollar appreciated. Sudden appreciation of rupee against dollar during March 2007 to February 2008 was attributed to high capital inflow. In Economic Survey of India, it is stated that:

While capital inflows are often beneficial to recipient countries and an indicator of increased integration of these economies in the global market, the sheer magnitude of the flows, their more volatile nature and recent episodes of market turbulence have led to some concerns about the risks. Risks are seen as arising not so much from growing foreign direct investment, but from significant surges in short-term and more volatile flows, particularly portfolio equity investment flows and in certain countries, bank's foreign borrowings (ESI, 2007:pp.-128 )

Source: Business Beacon, CMIE-Prowess

Source: Business Beacon, CMIE-Prowess

In Fig-2, another contrasting behavior is observed between rate of change of euro and rate of change of Japanese yen during the end of 2008. Both the curves are moving almost jointly but during 2008 and early 2009, when euro depreciated, then Japanese yen appreciated.

Source: Business Beacon, CMIE-Prowess

A number of literature have addressed that foreign exchange rate in India of USD($) is determined by many factors like call rate, interest rate differential of short and long term securities between domestic and US government securities, growth in money supply and foreign exchange reserves. It has become a big challenge for the central bank to maintain rupee (denomination) rate. Central bank is gradually moving towards the fuller account convertibility while ensuring sustainable growth and price stability. To achieve these three points goals have become sine-qua-non for the RBI.

Call Rate

Call rate means the rate at which bank lends money to other banks. Bank rate is a rate at which the central bank lends money to other commercial banks and financial intermediaries. When there is higher gap between call rate and bank rate due to higher call rate, then flows of funds tightens. It builds up anticipation in investors' minds to control inflation and to inject the money supply. It is evident from the Fig-3 that during the 2007 when call rate fell, rupee appreciated. It could be due to the fact that when call rate falls or the gap between call rate and bank rate (bank rate remains almost constant) worsens then investors anticipate that the rate will go up and causes appreciation of rupee. But during 2008 end, when call rate showed an upward-trend and the gap between call rate and bank rate soared, rupee depreciated; it can be counteracted by the investors' anticipation that the rate may fall in future which results into depreciation of rupee.

Source: Business Beacon, CMIE-Prowess

Growth of Liquidity

The growth rates of broad money and foreign exchange reserves indicate increased liquidity in the economy. Such an increase in the liquidity is expected to cause depreciation in the exchange rate. An anticipation of inflation due to increased liquidity and increase in the aggregate demand are two major causes behind such depreciation. However, an increase in the foreign exchange reserves also implies an increase in the supply of foreign currency, which often results in appreciation of the domestic currency.

When central bank goes for expansionary monetary, it lowers down the interest rate to increase the demand of money and also supply of money. This graph is evident that when there is low money supply, rupee appreciates. In mid 2007, mid 2008 and mid 2009, there were very low growth in supply and the resulting effect was the appreciation of rupee in terms of dollar (see, Fig-1) except in some months of 2008 due to recession that happened during this period. Besides, earlier increase of money supply might have some lag effect on future exchange rate.

Source: Business Beacon, CMIE-Prowess

8. Remedial Measures

In recent years use of derivatives has become a major role player in mitigating the risk in financial market. In different ways it is being used by different investors. Forward market is one of them. Forward rate is the rate assumed to happen in some periods after like 1 month, 3 months and 6 months. It is a matter of great debate to decide which market leads to what viz. spot rate of dollar leads to forward or forward rate leads to spot rate. If the rupee appreciates and dollar depreciates, then rate of forward premium increases to fill the gap and likewise when rupee depreciates and dollar appreciates the premium falls and discount is given to bring back the rupee value (Fig-6). To cop up with this situation hedging has become an important way out. Guther and Siems (1995) commented that banks mostly use derivatives to hedge.

Data Source: Business Beacon, CMIE, Prowess.

8.2 Need of Credit Derivatives, Forex & Currency Swaps

The initiation of credit derivatives fell back to 1980s, when there was a need felt to securitize the mortgaged back credits. But in 1991 Merrill Lynch introduced the instrument called ‘Credit Derivative' (RBI report on ‘Introduction of Credit Derivatives in India' 2007, pp-5 of 36). Banks and other financial institutions manage their interest risk through Interest Rate Swaps. But, credit default swaps is now gaining interest from around because credit risk requires an efficient transfer mechanism. So, it is highly to needed to use some products which can help in mitigating the credit risk. Still, banks suffer from huge risk from credit default especially when they consider undertaking some risky loan proposal. The benefits banks would get from credit derivatives are of two folds 1) more utilization of capital resource and 2) designing its own risk. In one RBI report on ‘Introduction of Credit Derivatives in India' by Department of Banking Operations and Development, Central Office, Mumbai , it is clearly manifested that

“Currently, banks in India face two broad sets of issues on the credit leg of their asset -blockage of capital and loss of opportunities, for example:

(i) Banks generally retain assets - and hence, credit risk - till maturity. This results in a blocking up of bank's capital and impairs growth through churning of assets.

(ii) Due to exposure norms that restrict concentration of credit risk on their books, banks are forced to forego attractive opportunities on existing relationships” (RBI Report, 2007, pp-6 of 36)

Credit derivatives can be divided into two categories, 1) Credit Default Swaps (CDS) and 2) Total Return Swaps (TRS). In Credit Default Swaps one party pays fixed amount having exposure to credit risk to another party in return of guarantee of payment upon default by the third party. While in TRS the protection seeker pays return on assets to the risk shield provider and risk shield provider pays some floating amount. This floating amount covers the funding cost of the protection seeker. So, unlike CDS, it not only protects against credit default risk but also market risk by considering the appreciation or deprecation of asset value.

Data Source: BIS Quarterly Review, December-2009.

Other than credit derivatives, the exposure to currency risk can be hedged through currency swaps. It is done thorough exchange of principal and fixed /floating rate of interest payment in one currency and fixed or floating rate interest payment on same principal amount in another currency based on the comparative advantage of both the parties. In fig-6, it is highly evident that IRS is mostly used among the participants than credit default swaps and forex swaps. Only interest rate swaps is not sufficient to mitigate the risk. Carter and Siney (1998) and Gunther and Siems (1996) found that increase use of interest rate of derivatives also bring about greater interest risk exposure. Hirtle (1997) put forward that use of interest rate risk derivatives also increases the interest rate risk exposure to bank holding companies (BHC). Choi and Elysiani (1997) discovered that options are positively related to interest rate risk and currency risk while currency swaps reduce exchange rate risk.

9. Conclusion and Implications

The standard measure of productivity is said to have through accounting principles and standards. It consists of different indicators or ratio like profit per employee, ratio of operating cost to assets or ratio of operating income to staff expenses. Today banking sector is working to bring in changes in the system. Efficiency is a major concern to meet the competitiveness. This also makes the possibility of disaggregation of total productivity into two sectors a) productivity due to efficiency, and b) productivity due to technology. Technological changes are more radical than changes brought about due to efficiency. Technological changes are somewhat attributed to innovations, shocks or disturbances. “The challenge in bank regulation underlined by the financial crisis is to strike a balance between stability and innovation” (Mohan, Economic Times, March 18, 2010: 14). Innovation is not only in terms of designing new financial products for wider masses but also should it be dovetailed to hedge the exposures effectively and efficiently. So, long term sustainability rather long term sustainable growth is needed to the core. Smith & Stulze (1985) and Mayer & Smith (1982) argued that hedging reduces the volatility of firms' value by reducing the likelihood of costly financial distress and increase the expected value of the firm. Carter& Sinky (1998) also wrote that hedging through derivatives alleviate the incentive and monitoring problem caused by managerial risk aversion. It is also in tandem with the argument conceived by Merton (1995) that financial innovation (derivative) can improve the economic performance by lowering transaction cost or increasing the liquidity and by reducing agency cost. Thus, it gives the banks the opportunity of capital buffers to absorb risk and this results in lower cost and greater value. The efficient and effective use of derivatives can improve efficiency as it minimizes the burden of financing cost (Mayer & Smith, 1982; Merton, 1992).

Lastly, we pose the question for the judgment in the light of productivity, efficiency of Indian banking sector and available risk measures that what will be the ownership pattern of domestic banks to achieve the convergence with International banks and integration with the world-financial league. Will it either be diversified ownership or anchor or strategic investor approach?


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[2] Article is written by Shri Kushankur Dey, a third year fellow participant of the Institute of Rural Management, Anand (IRMA). The paper is written in collaborated with Shri Debasish Maitra, a second year fellow participant of IRMA. Both authors have their research interests in financial derivatives. They can be reached at xxxx respectively. Shri Sumit Jalan was also associated with this paper; he is a first year postgraduate participant at IRMA.

[3] Coherent risk measures refer to some principles-based risk measurement process, like, translation invariance, positive homogeneity, sub-additivity and monotonicity which are applicable to portfolio selection, analysis and optimization, for more details, see, Hull 2007.

[4] Data cover 90-95 percent of total transactions reported by participants; data for Sat-Friday (Business Standard, April 13' 10).

[5]Managing Financial Innovation in Emerging Markets, delivered by keynote speaker John Lipsky, First Deputy Managing Director, International Monetary Fund at the Reserve Bank of India First International Research Conference, URL accessed on Feb 14, 2010.

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