It was an amendment to the RBI Act in July 2006 that paved the way for banks to mis-sell exotic derivatives to companies, which led to losses of Rs32,000 crore, according to experts.
It was an amendment to the RBI Act in July 2006 that paved the way for banks to mis-sell exotic derivatives to companies, which led to losses of Rs32,000 crore, according to experts.
Normally, customers are required to pay a premium to enter into an exotic derivatives contract. But the amendment allowed what are called “zero-cost option structures” where customers don’t have to pay any premium.
Since banks did not charge a premium, they passed on the risk of monetary loss through exchange rate fluctuations to traders, said S Dhananjayan, a chartered accountant based in Tiruppur, the town that was at the centre of the derivatives’ losses scam. “Never in the history of India had these kinds of derivatives sold by banks,” he added.
“The insertion of a new clause (zero-cost structure derivatives) in the RBI master circular was the real devil, and we have internal notes of the central bank to prove that this amendment was brought at the behest of authorised dealers (who deal in foreign exchange),” said Vinod Kothari, a Kolkata-based chartered accountant. “However, the details of the banks involved are yet to be known,” he added.
The clause was incorporated sans any noise in 2006, and was effective until 2011. Though it is a case of supervisory failure on the part of the RBI, which operates under finance ministry, the then finance minister, P Chidambaram, refused to intervene in the matter saying it involves private and foreign banks so the government cannot interfere.
“Chidambaram refused to entertain us when we went to represent our case in 2008,” said Raja Shanmugam, president of Forex Derivative Consumer Forum, a forum of traders who lost money due to exotic derivatives.
It was apparent from the 2005 budget speech of Chidambaram that he was favouring legal status of such derivatives. “Over the counter (OTC) derivatives play a crucial role in mitigating the risks of corporate, banks, and other financial entities. There is, however, some ambiguity regarding the legality of OTC derivative contracts, which has inhibited their growth. I, therefore, propose to take measures to provide for clear legal validity of such contracts,” read the FM’s speech.
It was around the same time that Lehman Brothers entered India by opening its first office in Mumbai. As per its 2006 annual report and the minutes of one of its board meetings, Lehman was planning to expand in India in various finance sectors.
In 2011, the RBI penalised 19 banks — including the country’s top private and foreign banks — slapping fines of Rs10-15 lakh for violating its guidelines on derivatives.
But as per the RBI Act, the penalty should not exceed Rs5 lakh or twice the amount involved in such contravention, whichever is more. The crucial point is, “whichever is more”.
“As per the RBI’s own submission, the losses are around Rs32,000 crore. Then why did the RBI levy such small penalties?”
Is the RBI trying to hush up the issue, Dhananjayan asked.
Despite repeated attempts, RBI officials were not ready to comment. Names of many banks involved in the scam haven’t come out either.
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