 In a brilliant plot contained in a Malayalam movie, the villain seeks to assassinate a low ranked police officer who has some incriminating evidence against him. To ensure that he covers his track, the police personnel is killed while on a duty along with the chief minister. The net result is that the probe focuses on the assassination of the CM and not on the policeman.
The Rs 60,000 crore waiver contained in the Budget is akin to the assassinated CM, drawing our critical response. Then pray, who is the low ranked policeman?
The answer to the above question is contained in para 97 of his Budget speech the FM seeks to "move forward to expand the market for corporate bond. Accordingly he seeks to take measures to develop the bond, currency and derivatives markets that will include launching exchange-traded currency and interest rate futures and developing a transparent credit derivatives market with appropriate safeguards.
Has the potency to dynamite banks...
In his fetish to integrate the Indian financial sector with the global, the finance minister has ushered in a time-bomb for the Indian financial sector. Taking forward the R H Patil Committee report, the FM has proposed that the government would take steps to create an exchange-traded market for corporate bonds. This in my considered view has the potency to dynamite our banks, financial institutions and other participants in the financial markets.
As if on cue from the FM, the Reserve Bank of India (RBI) had brought out a draft paper on the interest rate futures on 4 March 2008. Just as the RBI was hosting the report in its website, on that very same day and perhaps even the hour, the minister of state for finance Pawan Kumar Bansal reported Parliament that ICICI has been visited with a loss of approximately Rs 1000 crore while dealing with exposure to credit derivatives.
The coincidence could not have been more startling.
Gambling, thy name derivatives?
To explain the issues involved, let me introduce the reader to the concept of derivatives which are financial instruments that have no intrinsic value. These contracts basically hedge the risk of owning things that are subject to unexpected price fluctuations, e.g. foreign currencies, wheat, rice, stocks or bonds. Nowadays it includes interest rates or for that matter even weather.
Further, there are two main types: futures, or contracts for future delivery at a specified price and options that give one party the right but not the obligation to buy from or sell to the other side, for a small price to 'manage risks.'
More income betting on reserves than from core activities...
And when currencies or prices of commodities or stock exchange indices gyrated against each, it was often found that profits and losses were inextricably linked to the management of such risks. Crucially betting on these risks provided more income to firms than from their core operations.
When prices of commodities and currencies gyrated, often violently, traders at a global level faced newer and higher risks. And in the process newer theories were introduced, more complex instruments revealed and, in the process of neutralising higher risks, once again newer theories were written - a classical case of catching the tiger by the tail.
It may be noted that Enron- till then hailed as an aggressive user of many of these exotic products - had made extensive use of energy and credit derivatives. Subsequently, it suffered huge losses and became one of the largest American firms to go bankrupt in its history after systematically attempting to conceal huge losses.
And 2008 seems to be a blast to the past. In January 2008, the French Bank Société Générale, is estimated to have lost USD 7.5 billion (approximately
Rs 30,000 crore) in unauthorised futures trading. But in this entire melee, what has been forgotten is the fundamental characteristic of these contracts. What is trading in index numbers if not wager? Is it not speculation per se packaged in sophisticated language, exotic terms and backed by legislation and regulators?
And now the virus spreads to India
One understands that some of these contracts are not legally recognised in India. Consequently, these contracts are entered into by Indian corporates, mostly foreign banks and the new generation banks, often under the lure of earning significant profits outside India.
As already mentioned, ICICI Bank has incurred a loss in the current financial year by indulging in such transactions. And ICICI bank is not alone.
 Many corporates have wide exposure Forex drivatives...
In fact many corporates in India (as well as banks) are reported to have enormous exposures to Forex derivatives with concomitant risks. What is galling is the fact that many of these contracts are entered into by corporates without any underlying need or requirement. And that remains central to the issue on hand. This requires some explanation.
To explain issue on hand let me borrow the definition of banking as it stands in the statute book. According to the Banking Regulation Act, 1949, banking is defined as accepting deposit of money from public for the purpose of lending or investment. In short, banking is simply taking money from one as deposit and lending to an other.
But this definition was drafted during innocent times. And times have changed, perhaps drastically, so much so that 'modern' banking is beyond comprehension of even qualified finance professionals. For an outsider it would seem that most of these modern, second generation and private sector banks in India are casinos carrying on the business of what goes inside a casino.
In fact, should they not carry out these titillating activities they can never add the appellation 'modern' or for that matter 'second generation' to their brand equity. Such is the imperial demand of the modern times. Moreover, anyone who has a contrary view is instantly labelled as primordial or Neanderthal by the beneficiaries of this system.
As press reports emanate from far flung places as Karur and Tiruppur one realises that banks, like drug peddlers encouraging users of drug by providing easy and cheap drugs, have lured small and part time businessmen to enter into what is popularly called 'exotic derivative contracts.' As I understand from corporate India and my fellow professionals, the bait was first to 'allow' these corporates to make easy money in the first few transactions entered by the banks with the corporates.
Corporates, emboldened by such initial success, recklessly began to take bigger bets. And when their bets went awry, they are now stuck with massive losses. However, it may be interesting to note that banks may not end up with the concomitant profits. And that is the crux of the issue.
A plain reading of the contracts reveal that even Shylock would not have constructed such a skewed contract in his favour as the banks have done our corporates. Crucially with were our corporates gullible enough with all their professional management to enter into such contracts?
This is merely a sample of what goes in the arcane world of finance. It is indeed a sorry state of affairs to note that the best of minds in India are engaged in surpassing Shylock. And all these look extremely farcical especially after the players have employed professionals who have cleared tough competitive professional examinations. Isn't all these an attempt to make money out of thin air; a grand attempt to milk the horns of a bull?
 RBI, SEBI, Registrar of Companies… where are the regulators?
It may be noted that the RBI had brought out a circular stating inter alia that such contracts can be entered into by banks only if there is an underlying foreign exchange transaction. This means that only genuine exporters and importers can enter into such transactions based on their legitimate requirement of foreign exchange.
What is being increasingly witnessed is that both the corporates and banks have thrown caution to winds as banks have not insisted on any underlying contracts. And that has provided a window of opportunity to corporates from honouring their commitments as any contract violating the RBI directive is void in the first place.
Another dimension that requires immediate attention of the RBI is that, of late, many banks have converted their treasury departments into profit centres and fixed profit targets for the same. This is similar to fixing profit targets for cashiers. And when that happens, it is natural for cashiers to pay you Rs 900 for every Rs 1000 withdrawn.
No wonder, when such targets were fixed, treasury managers went on an overdrive selling such products to corporates. And this is a serious ethical and corporate governance issue and to me, remains at the root of the problem.
What has added fuel to the fire is that the US dollar has been consistently weakening against all major currencies across the world in 2007. And banks with foreign exchange experts in their panel have invariably ensured corporates 'notionally' end up purchasing the USD and the banks end up purchasing other global currencies.
And when the USD depreciated against other currencies, corporates found themselves to be holding the wrong end of the stick. How could banks provide such patently unethical advice to clients when they were in the know of an impending depreciation of the USD?
Naturally, corporates are visited by huge losses. As and when losses are actually booked, in some cases it could wipe out the net worth of corporates several times over. And that is why the banks are worried - they may not be the beneficiaries of such transactions.
And all these happen with SEBI, RBI and Registrar of Companies maintaining a thunderous silence.
And corporates are no small time sinners either
As events unfold, corporates, especially public companies (some with independent directors on their Board), are no less guilty. Managements claim that they were completely unaware of these transactions entered into by their own employees. In an astonishing case of self-indictment, the management of a public company has even gone on record in an affidavit before the High Court of Madras stating that it was not at all aware of these contracts!
And when pointed out the fact that they enjoyed the profits from such transactions for the year ended 31 March 2007, (which was taken into account and also audited when the affidavit was filed before the courts), they have claimed complete ignorance- yes ignorance coupled with injured innocence - on the matter. As the stench from this imbroglio overwhelms us, it is increasingly clear that RBI, SEBI, and the Registrar of Companies have lots to do and to answer. 
Playing with OPM
Readers may note that it does not matter to identify who should be the beneficiary of such transactions - the banks or
the corporates. Either way, it is the common man who is the loser. In case of banks, we lose as depositors and shareholders and if corporates lose, we lose as shareholders.
And in India experts have estimated the loss arising from such transaction to be running into several thousand crore. While one is not privy to the exact methodology by which the experts have calculated these figures, one is certain that there could be something significant and with it that has the potency to dynamite the Indian financial sector.
It is time to realise that both corporates and banks are playing with other people's money (OPM). And the regulators have to intervene in the matter decisively and at once. It needs to set up a high power committee comprising eminent bankers, lawyers, media personnel, finance and foreign exchange experts to set the matter right. Allowing the issue to fester any longer would irreparably harm the Indian economy. In any emerging economy, banks cannot turn into casinos and corporates into gamblers.
PS: It is indeed inexplicable that many such contracts have been reported from the southern part of the country, where corporates are supposedly conservative. Watch out, Chennai is emerging as the new Las Vegas! |
