Up to the beginning of Nineties of the last Century, the Indian Banking and Financial Institutions were controlled and direcrted by the Finance Ministry/RBI in terms of their day to day operations. Credit policy, Interest rates on deposi & advances, investments etc. are all directed. In this environment Banks did not face risks that emerge in a decontrolled competitive banking. With onset of the Financial & Banking Sector Reforms since 1992-93, the position changed. Banks were decontrolled, leading to a total transformation in their working. These we have already discussed in the topics under the Project "Indian Banking Today & Tomorrow".

Deregulation of interest rates which helped in making financial market operations efficient and cost effective has brought to the fore a wide array of risks faced by the market participants. To manage and control these risks, there has been a felt need for an appropriate financial instrument. Forward Rate Agreement (FRA) and Interest Rate Swap (IRS) are such instruments which can provide effective hedge against interest rate risks.

In the Governor's Statement on 'Mid-Term Review of Monetary and Credit Policy for 1998-99' announced on October 30, 1998, it was indicated that with a view to further deepening the money market as also to enable banks, primary dealers and all-India financial institutions to hedge interest rate risks, the Reserve Bank of India has decided, in principle, to create an environment that would facilitate introduction of interest rate swaps.

Subsequently RBI on July 7, 1999 released guidelines allowing commercial banks, primary dealers and financial institutions to undertake FRAs and IRS as products for their own balance sheet management and for market making purposes¹.

Participants who intend to undertake FRAs/IRS are, however, advised that before undertaking market making activity, they should ensure that appropriate infrastructure and risk management systems are put in place. Further, participants should also set up sound internal control system whereby a clear functional separation of trading, settlement, monitoring and control and accounting activities is provided.

A Forward Rate Agreement or an Interest Rate Swap provides means for hedging the interest rate risk arising on account of lendings or borrowings made at fixed/variable interest rates.

A Forward Rate Agreement (FRA) is a financial contract between two parties to exchange interest payments for a 'notional principal' amount on settlement date, for a specified period from start date to maturity date. Accordingly, on the settlement date, cash payments based on contract (fixed) and the settlement rate, are made by the parties to one another. The settlement rate is the agreed benchmark/reference rate prevailing on the settlement date.

An Interest Rate Swap (IRS)is a financial contract between two parties exchanging or swapping a stream of interest payments for a 'notional principal' amount on multiple occasions during a specified period. Such contracts generally involve exchange of a 'fixed to floating' or 'floating to floating' rates of interest. Accordingly, on each payment date - that occurs during the swap period - cash payments based on fixed/floating and floating rates, are made by the parties to one another.

Scheduled commercial banks (excluding Regional Rural Banks), primary dealers (PDs) and all-India financial institutions (FIs) are free to undertake FRAs/IRS as a product for their own balance sheet management or for market making. Banks/Fls/PDs can also offer these products to corporates for hedging their (corporates) own balance sheet exposures. No specific permission from Reserve Bank would be required to undertake FRAs/IRS. However, participants when they start undertaking such transactions, will be required to inform Monetary Policy Department (MPD), Reserve Bank of India and abide by such reporting requirements as prescribed by the Reserve Bank from time to time.

Banks/PDs/FIs can undertake different types of plain vanilla FRAs/IRS. Swaps having explicit/implicit option features such as caps/floors/collars are not permitted.

The benchmark rate should necessarily evolve on its own in the market and require market acceptance. The parties are therefore, free to use any domestic money or debt market rate as benchmark rate for entering into FRAs/IRS, provided methodology of computing the rate is objective, transparent and mutually acceptable to counterparties.

There will be no restriction on the minimum or maximum size of 'notional principal' amounts of FRAs/IRS. Norms with regard to size are expected to emerge in the market with the development of the product.

There will be no restriction on the minimum or maximum tenor of the FRAs/ IRS.

Banks and financial institutions are required to maintain capital for FRAs/IRS, as per the stipulations contained in Annexure 1.(appended herein)

Banks, and FIs have to arrive at the credit equivalent amount for the purposes of reckoning exposure to a counterparty. For this purpose participants may apply the conversion factors to notional principal amounts as per the original exposure method prescribed in Annexures 1. The exposure should be within sub-limit to be fixed for FRAs/ IRS to corporates/banks/Fls/PDs by the participants concerned. In case of banks and FIs, the exposure on account of FRAs/ IRS together with other credit exposures should be within single/group borrower limits as prescribed by RBI.

Further, while dealing with corporates, banks/Fls/PDs should exercise due diligence to ensure that they (corporates) are undertaking FRAs/IRS only for hedging their own rupee balance sheet exposures. Banks/Fls/PDs are advised to also obtain a certificate from the autho-rised signatory/signatories of corporate/s to the effect that the transactions undertaken by them are meant for hedging balance sheet exposures only, i.e., size and tenor of the transactions undertaken are not in excess of their underlying rupee exposures.

Ideally, participants should undertake FRAs/IRS only for hedging underlying genuine exposures. However, recognising the crucial role played by the market maker in development of the product and creating of the market itself, participants have been allowed to undertake market making activity, which would involve at times dealing in the market without underlying exposure. However to ensure that market makers do not over extend themselves, market makers are required to place prudential limits on swap positions, which may arise on account of market making activity¹.

Scheduled commercial banks, should place various components of assets, liabilities and off-balance sheet positions (including FRAs, IRS) in different time buckets and fix prudential limits on individual gaps as per the procedure laid down in the Reserve Bank of India Circular No. BP.BC. 8/21.04.098 dated February 10, 1999, on ALM system. The FRAs/IRS, etc. undertaken by banks will have to be within the prudential limits for different time buckets, approved by Boards/Management Committees of banks.

Primary Dealers/Financial Institutions should identify swap positions in each maturity bucket and place prudential limits with the approval of their respective boards.

The prudential limits on swap positions, as detailed earlier, will require vetting by the Reserve Bank after approval of respective boards, as mentioned below.

While the above procedures for setting up of limits on 'swap positions' and exposure limits may form the bottomline for the risk management, participants who can employ more sophisticated methods such as Value at Risk (VaR) and Potential Credit Exposure (PCE) may do so. They are, however, advised to report the methods followed for VaR/PCE to Monetary Policy Department with a copy to the respective departments of RBI as mentioned below:

Transactions for hedging and market making purposes should be recorded separately. While transactions for market making purposes should be marked to market (at least at fortnightly intervals), those for hedging purposes could be accounted for on accrual basis. For valuation purposes, the respective boards should lay down an appropriate policy to reflect the fair value of the outstanding contracts. Participants should adopt suitable norms for accounting of FRAs/ IRS, on the basis of general accounting principles set out in Annexure 3, after the approval of their respective boards.

For the sake of uniformity and standardisation, participants could consider using ISDA documentation, as suitably modified to comply with these guidelines for undertaking FRAs/IRS transactions. Participants may also consider the changes as suggested in the Annexure-4 before finalising the documentation but after seeking appropriate legal advice. Institutions should further evaluate whether the counterparty has the legal capacity, power and authority to enter into FRAs/IRS transactions.

Participants should set up sound internal control system. They should provide for a clear functional separation of front and back offices relating to hedging and market making activities. Similarly, functional separation of trading, settlement, monitoring and control and accounting activities should also be provided. The deals should be subjected to concurrent audit and result should be intimated to top management of the institution regularly.

A copy of the document detailing Product Policy and Internal Control System should be submitted to the Monetary Policy Department and to the respective departments of Reserve Bank as mentioned earlier.

Participants are required to report, as per the proforma indicated in Annexure-5, their FRAs/IRS operations on a fortnightly basis to Adviser-in-Charge, Monetary Policy Department, Reserve Bank of India, with a copy to respective departments as mentioned earlier.

These guidelines are intended to form the basis for development of Rupee derivative products such as FRAs/IRS in the country. The guidelines are subject to review, on the basis of development of FRAs/IRS market.

Annexure - 1

For reckoning the minimum capital ratio, the computation of risk weighted assets on account of FRAs/IRS should be done as per the two steps procedure set out below:

Step 1:

The notional principal amount of each instrument is to be multiplied by the conversion factor given below:

Step 2:

The adjusted value thus obtained shall be multiplied by the risk weightage allotted to the relevant counterparty as specified below:

• Banks/All India Financial Institutions    20 per cent

• All others (except Governments)    100 per cent

Annexure - 3

Participants may adopt suitable norms for accounting of Interest Rate Swaps and Forward Rate Agreements after the approval of their respective boards. Following may be used as general principles for framing such accounting norms:

1. Interest Rate Swap which hedges interest bearing asset or liability should generally be accounted for like the hedge of the asset or liability.

2. The Swap that is accounted for like a hedge should be accounted for on accrual basis except the swap designated with an asset or liability that is carried at market value or lower of cost or market value in the financial statements. In that case the swap should be marked to market with the resulting gain or loss recorded as an adjustment to the market value of designated asset or liability.

3. Gains or losses on the termination of swaps should be recognised when the offsetting gain or loss is recognised on the designated asset or liability. This implies that any gain or loss on the terminated swap would be deferred and recognised over the shorter of the remaining contractual life of the swap or the remaining life of the asset/liability.

4. Redesignation of Hedge items
   If a hedge is redesignated from one item of asset/liability to another item of asset/liability such redesignation should be accounted for as the termination of one hedge and acquisition of another. On the date of redesignation the swap should be marked to market and the mark to market value would be amortized over the shorter period of the remaining life of the swap or remaining life of the asset/liability. The offsetting mark to market entry adjustments would be treated as premium received or paid for hedge on the newly designated item of asset/liability and this would be amortized over the life of the redesignated asset/liability or remaining term of the swap whichever is shorter.

5. When participant is acting like a broker for matching parties and is not a Principal to the contract itself, then the fee should be recognised immediately as an income. In case where the bank acts like a Principal the fee should be amortized over the life of the contract.

The following should be used as general principles for accounting of trading transactions:

1. Trading swaps should be marked to market with changes recorded in the income statement.

2. Income and expenses relating to these swaps should be recognised on the settlement date.

3. Fee should be recognised as immediate income or expenditure.

4. Gains or losses on the termination of the swaps should be recorded as immediate income or expenses.

The following should be disclosed in the note to the balance sheet:

• the notional principal of swap agreements;

• nature and terms of the swaps including information on credit and market risk and the accounting policies adopted for recording the swaps;

• quantification of the losses which would be incurred if counterparties failed to fulfil their obligation under the agreement;

• collateral required by the entity upon entering into swaps;

• any concentration of credit risk arising from the swaps. Examples of concentration could be exposures to particular industries or swaps with highly geared companies; and

• the "fair" value of the total swaps book. If the swaps are linked to specific assets, liabilities or commitments, the fair value would be the estimated amount that the entity would receive or pay to terminate the swap agreements at balance date. For a trading swap the fair value would be its mark to market value.

Thus OTC Rupee derivatives in the form of FRC/IRS came to be traded in the Indian financial market since 1998 much before exchange traded derivatives were approved by SEBI in 2000/2001. What was the progres so far in the trading of these products? This and subsequent developments of RBI accepting the need for introduction more diversified products of the type, as also introduction of exchange traded rupee deerivatives appointed in 2002 of Jaspal Bandra Committee to study such feasibility and recommend a road-Map. These are discussed in the next article