Monday, March 31, 2008

Towards a forex derivative safety net

Soon credit rating agencies will have to factor in solvency of customers before they evaluate and grade banks for their financial stability.

Here are a few more skeletons falling off the cupboard of ICICI bank – customers taking it to court for alleged mis-selling of derivative contracts. Obviously the bank will plead the customer was fully aware of his downside risks while entering the contract. Unless the parties settle for out of court settlement, it could lead to a protracted legal battle.

But I suggest a few measures the banks could take before they enter into complex derivative contracts with customers –

Enter into contracts only with customers that have relationships with the bank for over 5 years;
Begin relationships with smaller sized contracts – say $ 100,000 ; every year the deal size can go up by 2x;
Go by net worth linked limits for contract sizes – say aggregate exposure should not exceed 25% of customers’ net worth;
Banks should make provisions for net exposure on a risk weighted average basis, of about 50% of negative outcome on the day of entering the contract;

All contracts should carry personal guarantees of MD /CEO and all executive directors of the customer to make good the losses to the bank if the customer defaults on its obligations under the contract;

RBI should set up a neutral authority –someone like a Notary Public- to endorse the fact that the bank has explained all possible outcomes of a derivative contract and the customer has completely understood all its risks and grant a certificate to this effect. This NOC should be a pre-condition for entering into a derivative contract. The fact of obtaining of NOC and the extent of its risky exposures should be informed to stock exchanges by the customer where it is listed within 3 days of grant of NOC by RBI.

Update : More spillover – Sundaram Brake Linings v. Kotak Mahindra Bank


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