At a time when the risks from unhedged foreign currency exposure of companies has emerged as a big scare for the banking sector, theReserve Bank of India (RBI) has directed banks to furnish action taken reports on the issue before end-December 2012.

The direction on filing the compliance reports stems from the RBI advisory in February under which banks were told that they should “rigorously evaluate the risks” arising out of unhedged foreign currency exposure of the corporates and price them in the credit risk premium while extending fund-based and non fund-based credit facilities.

Banks were also told to put in place a “proper mechanism” to rigorously evaluate the risks arising out of unhedged foreign currency exposure of corporates and price them in the credit risk premium, and also consider stipulating a limit on the unhedged position of corporates on the basis of banks’ Board approved policy. “Detailed guidelines in this regard are being issued separately,” a government official involved in the process said.

The move is aimed at protecting banks’ credit quality, under stress in the uncertain macroeconomic environment. “Banks are also being advised to consider stipulating a limit on the unhedged position of companies, on the basis of board-approved policy,” the central bank had said in its second quarter monetary policy statement issued late last month. Banks will also need to create a system ensuring sharing of information on unhedged foreign currency exposures. This has to be in place by the end of December. Most bankers, while seeking more clarity on the issue, agreed that the lenders would broadly support the move, since it would reduce the risk of a rise in non-performing assets.

Unhedged forex exposure of corporates is a source of risk to corporates and a source of credit risk to financing banks. If the unhedged position is large, it can have serious consequences for the solvency of corporates in the event of large depreciation of the home currency and can result in large credit losses to the financing banks. Recent events relating to derivative trades showed that excessive risk taking by corporates could lead to severe distress to them and large potential credit loss to their bankers in the event of sharp adverse movements in currencies. The recent episode of volatility in rupee exchange rate has sharply underlined the importance of prudent management of foreign exchange risk.

According to data submitted by the RBI to the finance ministry in May this year, approximately 60 per cent of companies’ non-trade related exposure was reported to be unhedged, while the proportion of uncovered exposure for trade loans was lower at 40 per cent. A number of state-owned companies, especially in the petroleum sector, have a large portion of foreign currency exposure unhedged.

Oil companies such as IOC, HPCL and BPCL, which need to make purchases of oil in dollars, are therefore particularly vulnerable. Oil importers lose close to Rs 9,000 crore annually, for every rupee of depreciation.

LOOMING RISK

* Unhedged forex exposure of corporates is a source of risk to both corporates and banks

* If the unhedged position is large, large depreciation of the rupee can result in potential insolvency and huge credit losses

* According to RBI data, almost 60% of non-trade related exposure was reported to be unhedged