Rash of banking reforms: Move aimed at improving solvency

Rules of play for non-banking financial institutions get tough

The Reserve Bank, on Tuesday, tightened the prudential norms for the non-banking financial companies (NBFCs) under which they will have to account for risks towards off-balance sheet items while computing capital adequacy requirement.

These off-balance sheet items, against which NBFCs will have to make provisions, will include interest rate contracts, foreign exchange contracts, credit default swaps and other market related contracts permitted by RBI.

“Off-balance sheet exposures of NBFCs have increased with the increased participation in currency options and futures and interest rate futures. It is therefore necessary that NBFCs move over to modern techniques of risk measurement to strengthen their capital framework,” RBI said in a notification. The decision is expected to improve solvency of the NBFCs though it might put additional financial burden on them. NBFCs will have to assign adequate weights to both on and off-balance sheet items while maintaining the mandatory CRAR (Capital to Risk Asset Ratio).

The RBI said that henceforth, the NBFCs “will need to calculate the total risk weighted off-balance sheet credit exposure as the sum of the risk-weighted amount of the market related and non-market related off-balance sheet items”.

Giving justification for its move, the RBI said that with liberalisation in Indian financial markets over the last few years and growing integration of domestic markets with external markets and greater use of derivative products, asset liability management of NBFCs have become complex and large, “requiring strategic management”.

The new norms, RBI said, will be effective from April 1, 2012, for off-balance sheet items already contracted. For the new contracts, it said, the norms will apply with immediate effect.

The risk weight to each off-balance sheet items which will include interest rate contracts, foreign exchange contracts, credit default swaps and other permissible contracts will be assigned according to a pre-specified formula.

Risk mitigation norms of banks extended

To protect banks from possible default by mutual funds and FIIs in stock markets, RBI, on Tuesday, extended indefinitely the risk management provision under which banks could provide financial guarantee to such clients only after getting full rights on the pay out securities.

“Only those custodian banks, who have a clause in the agreement with their clients which gives them an inalienable right over the securities to be received as pay out in any settlement, would be permitted to issue Irrevocable Payment Commitments (IPCs),” RBI said.

The provision was to expire on December 31 but the Reserve Bank of India (RBI) has decided that “the arrangements will continue to be in force until further review.”

Stock market has been witnessing volatility in the last few months due to both global and domestic factors leading to erosion in market capitalisation.

Banks usually issue IPCs to stock exchanges on behalf of its Mutual Fund (MF) and Foreign Institutional Investor (FII) clients while executing the pay-in and pay-out on the second day after trade day (T+2) of a security on stock exchanges.

RBI further said the IPC will be treated as a financial guarantee with a Credit Conversion Factor (CCF) of 100.

“However, capital will have to be maintained only on exposure which is reckoned as CME (Capital Market Exposure) and the risk weight would be 125 per cent thereon,” it added.

Last year, the risk mitigation mechanism was put in place to protect banks from the adverse movements in the equity prices and the possibility of default by mutual funds and FIIs, while ensuring that there is no undue disruption in the capital market.

IPCs is a commitment in the form of securities from Mutual Funds and FIIs as pay out at the time of settlement. 

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