More cover for derivatives

MONETARY POLICY MID-TERM REVIEW 2007-08/ SUPERVISION AND REGULATION

As far as the derivatives products go, it has been proposed to include additional risks arising out of deficient documentation or settlement risk under the supervisory process.

This is because a majority of derivatives are over the counter (OTC) products and though they have cover for general market risk, there is a need for further cover arising due to operational and credit risk.

Said a bank official, "Currently, there is no supervisory process for settlement therefore the apex bank wants to have higher cover on them."

According to the policy statement, "At present, the supervisory process consists of on-site inspection during the annual financial inspection of banks and off-site monitoring of exposures through specified returns.

In addition to market risk, however, the supervisory oversight would need to be comprehensive, targeting credit risk and operational risk also."

Explained a treasury head of a Mumbai-based public sector bank, "As derivatives are not exchange-traded, sometimes documentation of one bank vis-à-vis others could become a problem. This could lead to a default on account of deficient documents." Also, banks sometimes may have multiple exposures to the same customer.

"There may be a deposit product and a derivatives product offered at the same time," said the treasury head of another public sector bank.

The central bank, therefore, wants a supervisory oversight that will include stress testing of derivatives portfolios of banks for credit risk, particularly in view of banks resorting to multi-lateral netting for their counter party exposures.