As the dollar slipped below Y100 for the first time since 1995, hundreds of corporates and institutions were exposed to a brutal currency market. On Thursday, the dramatic surge in yen (as well as swiss franc) activated several high-risk structures, like knock-in options, which were lying dormant for months in corporate treasuries a development that could compel rule makers and regulators to harden their stand.
Corporates will face tough questions from auditors and soon find it hard to mask their derivatives losses. On the other hand, bankers fear that RBI may slap a general provisioning requirement on their derivatives books a move that would hurt profitability, but help cushion future losses.
Even though derivatives accounting for corporates will be mandatory only in 2011, the Institute of Chartered Accountants of India (ICAI) may ask auditors to take a hard look on companies derivatives exposures on the basis of accounting prudence. We are aware of the situation and will spell out our stand within the next few days, ICAI president Ved Jain told ET.
The Yen has appreciated 8% in the last 20 days and 12.3% since December 26. While banks have tighter derivatives accounting norms (unlike corporates) and are required to book mark-to-market losses, they do not make any provisioning on such exposures. Chances are RBI will insist on some provisioning to take care of the credit risk, besides asking for daily reporting of certain currency positions, said the treasury head of an Indian bank.
Credit risk is the risk a bank faces if a corporate refuses to pay when a derivatives bet goes wrong. Besides several companies in industries such as diamonds and textiles, who have entered into currency swaps and options with banks to lower their cost, even bigger players like a Mumbai-based pharma firm, a telecom services provider and a hospitality group company is sitting on large M-T-M losses.
(A M-T-M loss is the hit the firm has to take, if it cancels the contract today a figure that most corporates do not disclose in their balancesheets). The big hits will be in cases where firms have bought knock-in structures. In derivatives, the knock -in structure is activated when a currency gains beyond a level. Till that level, the corporate can buy it at an attractive rate.
But once the currency breaches the level agreed in the contract, the corporate has to buy it at the prevailing market rate. If the currency has surged, he has to fork out so much to meet the monthly or weekly outgos as specified in the synthetic contract.
According to a banker, several corporates had done a deal with 1$=Y100 as the knock-in level. For Swiss franc the other currency that has shown a similar appreciation against the dollar the knock-in level is 1Sw Fr= $1. On Thursday, the SwFr was trading at 1.0070 a dangerously close level for the auction to be knocked in. For Euro, the knock-in levels are E1 Euro = 1.59-66, as against the spot price of 1.56.
What many companies may have done is first enter into swap a transaction that will convert its high-interest rupee borrowing into significantly cheaper yen/Sw Franc loan. Almost simultaneously, they enter into an option contract to protect the risk on such swaps. But these knock-in structures offer only a conditional production. Some of the global banks may push up the swiss franc to get the contracts knocked in, and in the process make corporates pay up, said a banker.
Since many contracts will mature between April and August, and several more will get the knock-in contracts triggered in the next few days, some of the local banks are trying to ringfence themselves against difficult clients. A large private bank (which was recently in news) has asked all its major corporate clients who have bought derivatives contract to give an undertaking that they have fully understood the product and the risks it has.
This piece of paper would come handy if the client moves the court, accusing the bank of having sold a risky and sophisticated financial product. Few corporates have taken a similar step, while many others are renegotiating the contract with banks.
However, if there is a pure default and the corporate fails to pay, banks will have to provide for the exposure. RBI might insist on standard provisioning, even on contracts where the client is continuing to pay. This will build a cushion to protect the banks profitability in case of a default.
It may be mentioned that a few years ago, the central bank had plugged a loophole, which allowed corporates to cancel a contract (where the bet has backfired) and immediately enter into a new one to cover losses. This is no different from ever-greening of bad loans.
While RBI can throw the rule book to banks, theres very little it can do when corporates default or enter into risky structures. According to financial market experts, its up to Sebi and the Department of Companies Affairs to ensure that companies disclose mark-to-market losses with immediate effect.