Unhedged Forex Exposures and Tightened Guidelines

Corporates have many activities which require expenditures in foreign currencies. A major part of these expenditures is generally on account of capital expenditure, raw material procurement and interest and principal repayment of foreign currency loans. Many corporates with rupee earnings borrow in foreign currencies to gain from lower interest rates abroad, but without adequately covering for the risk from a fall in the rupee's value that could increase their interest cost. Also, many importers do not adequately cover their dollar payables, exposing them to similar currency risks. The adverse movement in foreign exchange rates affects the financial health of the corporate which may lead to default by the corporate in servicing of loans to banks. Corporates refrain from hedging their currency risk to save cost. Therefore, the regulators in various economies have always desired to mitigate the effect of foreign exchange risk on corporates.

 

Some of the corporates who have export business in currencies matching with the expenditures in the same currencies, have natural hedge available to that extent. However there are many corporates who have significant foreign currency exposure and these corporates either are not conscious (specially the mid and SME category corporate) to risk they are exposed to the forex volatility or their call on the forex market is such that certain portion of their foreign currencies exposure is kept exposed to the volatility risk i.e. these forex exposures are not hedged.

Wikipedia defines Forex Hedging as “A foreign exchange hedge is a method used by companies to eliminate or "hedge" their foreign exchange risk resulting from transactions in foreign currencies. A foreign exchange hedge transfers the foreign exchange risk from the trading to a business that carries the risk, such as a bank. There is cost to the company for setting up a hedge. By setting up a hedge, the company also forgoes any profit if the movement in the exchange rate would be favourable to it.”

Reserve Bank of India (RBI) has tried to control this partial or full open exposure to the forex volatility of the corporate through banking control. Banks in India have to provide for Provisioning (An expense set aside as an allowance for bad loans) and also maintain minimum Capital in order to comply with the Capital Adequacy Ratio (CAR) (The World of Regulatory Rates). In order to contain the forex risk on the health of the corporates, RBI has stipulated increased higher Provisioning and Capital requirement by the banks for the unhedged foreign exchange risk of their borrowers i.e. if a corporate does not hedge its forex risk then its banks are penalized by reducing their profits through increased Provisioning and also by maintaining higher Capital (which comes at a cost to the bank). This has made banks to chase all their borrowers to undertake hedging at maximum level. I understand as of now Indian banks have not started penalizing the borrowers for their unhedged positions, however, going forward practice may change. Since, unhedged exposure of borrower affects bank’s financials, therefore, bank may charge a higher interest rate if borrower has unhedged positions.

As per RBI, the Foreign Currency Exposure (FCE) refers to the gross sum of all items on the balance sheet that have impact on profit and loss account due to movement in foreign exchange rates. This may be computed by following the provisions of relevant accounting standard. Items maturing or having cash flows over the period of next five years only may be considered. Unhedged FCE may exclude items which are effective hedge of each other. For this purpose, two types of hedges which may be considered are - financial hedge and natural hedge. Financial hedge is ensured normally through a derivative contract with a financial institution. Hedging through derivatives may only be considered where the borrower at inception of the derivative contract has documented the purpose and the strategy for hedging and assessed its effectiveness as a hedging instrument at periodic intervals. Natural hedge may be considered when cash flows arising out of the operations of the company offset the risk arising out of the FCE. For the purpose of computing UFCE, an exposure may be considered naturally hedged if the offsetting exposure has the maturity/cash flow within the same accounting year.

The loss to the borrower in case of movement in foreign exchange rates may be calculated using the annualised volatilities. For this purpose, largest annual volatility seen in the forex rates during the period of last ten years may be taken as the movement of the rates in the adverse direction. Once the loss figure is calculated, it may be compared with the annual EBID as per the latest quarterly results certified by the statutory auditors. This loss may be computed as a percentage of EBID. Higher this percentage, higher will be the susceptibility of the borrower to adverse exchange rate movements. Therefore, as a prudential measure, all exposures to such borrowers would attract incremental capital and provisioning requirements (i.e., over and above the present requirements) by the banks as under:

Likely Loss/EBID (%)	Incremental Provisioning Requirement on the total credit exposures over and above extant standard asset provisioning	Incremental Capital Requirement
Upto15 per cent	0	0
More than 15 per cent and upto 30 per cent	20 bps	0
More than 30 per cent and upto 50 per cent	40 bps	0
More than 50 percent and upto 75 per cent	60 bps	0
More than 75 per cent	80 bps	25 per cent increase in the risk weight

The calculation of incremental provisioning and capital requirements for projects under implementation is based on projected average EBID for the three years from the date of commencement of commercial operations and incremental capital and provisioning is accordingly computed subject to a minimum floor of 20 bps of provisioning requirement. The same framework is applicable for new entities also.

In light of these RBI controls, banks may also decide to reduce their exposure to corporates with high unhedged forex exposure and going forward the loan pricing would incorporate this aspect wherein the rates would be higher for higher unhedged exposure of the borrower.