Mis-selling of derivative products: RBI acts

Industry, especially the exporting community, welcomed the recent move of the Reserve Bank of India slapping a maximum penalty, according to the Banking Regulation Act, on 19 commercial banks for mis-selling illegal derivative products to exporters.The RBI has recently imposed penalties on 19 commercial banks for contravention of various instructions issued by the central bank in respect of derivatives, such as, failure to carry out due diligence in regard to suitability of products, selling derivative products to users not having risk management policies and not verifying the underlying/adequacy of underlying and eligible limits under past performance route.

In 2007-08, many exporters suffered enormous losses from currency derivatives due to extreme volatility in the currency markets. Majority of them were small and medium enterprises (SMEs) involved in export activities which were not having enough expertise in parking their funds abroad. Now even the income-tax department is treating these losses as speculative in nature and disallowing in the computation of income of corporates/SMEs. This adds fuel to the fire of the already loss-suffered exporters. 

Though the regulator's action was very late and the amount was a paltry sum, this move of the central bank would vindicate the three-year old stand of industry associations like the Forex Derivative Consumers' Forum that the banks sold illegal products, besides helping exporters/SMEs in getting justice from various courts. In the last three years, the small and medium scale exporters suffered enormous difficulties, financial loss and mental agony pursuant to the derivative losses booked on them. 

Some exporters peg their actual financial loss in the range of Rs.1.5-2 crore annually. Further industry experts like S. Dhananjayan noted that even though the RBI charged these banks a maximum penalty as per the law, this action was grossly inadequate taking into account the actual losses suffered by the exporters were of the order of Rs.32,000 crore. Considering the huge disparity between the losses suffered and the penalties imposed, is it time to introduce legislation with more teeth so that market participants are deterred from indulging in such blatantly and patently illegal activities 

Accountability

There is a need to fix the accountability as to at which stage of the decision making process these illegal products were permitted to be sold to gullible exporters and action taken on the culpable bank officials. This requires a thorough and systematic investigation, which is beyond the domain of the RBI. However, the Fixed Income Money Market and Derivative Association of India (FIMMDA), a self regulatory organisation of bankers dealing in derivatives, obtained a stay from the Supreme Court against the Orissa High Court order, which directed for a thorough CBI probe in this issue.

In the year 2007, few banks started aggressively marketing certain exotic derivative contracts projecting the same as an alternative profit making mechanism available to exporters whereas actually these contracts had exposed the exporters to enormous risk. Within a few months, the contracts started resulting in huge losses to the exporters. 

A PIL was filed before the Orissa High Court by Pravanjan Patra in April 2009 seeking direction to order for a CBI probe on the issue of forex derivatives. The Orissa High Court ordered preliminary enquiry to be conducted by the CBI and the RBI. In response to the order, both the RBI and the CBI confirmed that serious irregularities and violation of the Foreign Exchange Management Act had taken place in these forex derivative contracts sold by banks. 

Taking into account the submissions of various parties and the findings by the CBI and the RBI, the Orissa High Court on December 24, 2009, ordered the CBI to register a case and carry out thorough investigation. During February 15 to 18, 2010, the CBI has sought presentations from various organisations including several banks, the Forex Derivative Consumers' Forum and the RBI. 

Subsequently on February 19, 2010, the Supreme Court has stayed the CBI investigation upon a petition to this effect filed by FIMMDA. The last hearing of the Supreme Court was on November 8, 2010. Now the matter will come for further hearing on September 26, 2011. 

The RBI has laid down well intended guidelines taking into account the potential damage that could be caused on account of mis-sale of these derivative products.The present derivative fiasco could have been entirely avoided if the guidelines of the RBI were followed. Instead of responsibility and circumspection, one could evidently see aggression and recklessness on the part of the banks while marketing these exotic derivative products. 

It is also worth mentioning the remark made in the Development Research Group report of the RBI under study No. 32 titled “Monetary Policy, forex markets, and feedback under uncertainty in an open economy” in page 14 of the report which reads: “In 2007, market expectations of the rupee-dollar rate had even reached 32, many corporates borrowed abroad based on such expectations increasing currency risk. Some had entered into the so called hedging deals, which were actually bets on the value of Swiss franc. With the volatility in currency markets and steep rupee depreciation in 2008, many firms lost money. Many such deals, where Indian banks were often a front for foreign banks, sidestepped existing rules that prevented leverage or underlying risk that exceeded export income. 

Although firms were not allowed to write options, deals were structured so that in effect firms were writing options. The deals were so complex that firms sometimes did not understand what the risks they are taking.” 

This is a clear finding by the RBI which reveals the extent to which banks have side stepped the regulations while selling these derivative contracts. 

Courtesy : The Hindu