Banks should brace up for higher currency risks

India’s banking sector will have to prepare itself for enhanced exchange rate risks in a liberalised capital regime that could result in a larger two-way flow of money, according to the report released by RBI today.

Further capital account reforms would increase the domestic economy’s integration with the rest of the world. Convertibility will require banks to develop appropriate capabilities to manage the varied and enhanced risks.

Besides enhanced exchange rate risks, the spill-over effects across markets will be another challenge that banks face in an open global financial system, RBI said in the report.

A strong banking sector in a fuller capital account regime is also important for implementing an appropriate monetary policy. It, however, did not elaborate on road map to liberalise the capital account.

 

It said the inability to meet these challenges might translate into instability in the financial system. In a freer capital transactions regime, the magnitude of money laundering might also go up along with the overall increase in financial flows. This will require appropriate policy responses, the report said.

In a regime of fuller capital account convertibility, banks will be expected to undertake transactions in multiple currencies. Banks will act as channels for the flow of funds in and out of the country while they receive deposits, borrow from both residents and non-residents. Their role as a channel would be also be active when they lend and invest in both domestic and foreign jurisdictions.

Non-financial entities having links with the banking system would also conduct transactions in multiple currencies when they borrow, lend and invest overseas. These transactions add to the risks of the banking system that are not so evident in a less open domestic banking system, the report added.

The banking system will also get exposed to increase in risks in areas like counterparty credit, regulatory arbitrage and derivatives transactions. “As a consequence, the banking system has to upgrade risk management capabilities.”

Banks’ own exposures to exchange rate risk, coupled with their exposures to companies that are exposed to similar risks, add to the risks. “This calls for close monitoring and prudential management of banking sector,” it added.