Business

Messages from a derivatives seminar

They are tools for better financial management

DERIVATIVES FOR better financial management was the title of a seminar organised by the Bank of India in Chennai recently. The target audience, comprising largely finance professionals from companies and auditors would have found the presentation by the bank's General Manager (Treasury), G. Narayanan, and the speeches by the Executive Director, M. Balachandran, and the Banking Ombudsman for Tamil Nadu, R. Gopalakrishnan, useful. Derivative transactions that have particular relevance to India were discussed: using live examples, the speakers discussed interest rate swaps, currency swaps and currency options. In India, these products and services are in the domain of commercial banks.

A financial derivative is a product that derives its value from an underlying asset. Major advantages derivatives confer on the financial system are well known. They are tools for better financial and risk management; they provide immense flexibility to financial managers and help overcome inherent constraints in managing funded assets and liabilities.

Slow take-off in India

A derivatives transaction presupposes the existence of two parties with diametrically opposite motives — on the one side, a treasurer who is risk averse and on the other side a treasurer who does not mind speculating.

Neither the subject of the seminar (financial derivatives) nor the manner of the presentation to a group of professionals who may become customers of the bank was novel. Derivatives have been applied to financial transactions for a long time in the West. In India, although their use was slow to take-off — the tight regulatory set up has been an inhibiting factor — some of their applications have now become mainstream. Major banks now offer derivatives to their clientele as part of their composite treasury business. Yet, there is a subtle difference in the way a derivative product such as interest rate or currency swap is perceived at the bank level and customer levels. These have by now become less esoteric than before. The fact that a major public sector institution such as Bank of India could offer derivative products as part of a long list of treasury products and services says it all. However, derivatives have not become as commonplace as, say, an advice to hedge a forex exchange exposure through a forward contract.

In fact, when banks market these products they have learnt to be circumspect and certainly do not indulge in a hardsell. Experiences in the West, where leading banks have been accused of misleading their clients while writing derivatives, support a cautionary stance here. From the standpoint of corporate customers, many of which first acquired familiarity with derivatives in the overseas markets, the idea of using the service through an Indian bank is something that will take time getting used to. That is because for a variety of reasons government owned banks have not been in the vanguard of innovating new products. Derivatives especially have been perceived to be the speciality of foreign banks. In many cases this was true in earlier years.

But by now other categories of banks including the government owned ones have become quite adept at writing derivatives. A generation ago similar myths prevailed. The superiority of a handful of foreign banks monopolising the foreign exchange business was a myth that died hard. These banks were called exchange banks: the title was meant to signify the edge they had over Indian banks in the foreign exchange business. The point has been made that bankers working for government owned institutions are no less competent than those working for private and foreign banks. One may say that of all public sector personnel as well. Yet, for most of them the work culture has not been conducive. Rewards have been few and punishment severe in case of even one bad commercial decision.

In fact, accountability issues in the public sector have created a culture of risk avoidance. That explains why the government owned oil companies were precluded until recently from buying oil in the futures market. Not that they lacked the expertise or the skills. It is simply because their calculations have to be right all the time. Just one misjudgement and the career of the person who took the decision will come tumbling down.

C. R. L. NARASIMHAN

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