OPPORTUNITIES FOR BANKS IN COMMODITY DERIVATIVES MARKET: A WIN-WIN PROPOSITION

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1 OPPORTUNITIES FOR BANKS IN COMMODITY DERIVATIVES MARKET: A WIN-WIN PROPOSITION Authored by Neha Malik National Commodity & Derivatives Exchange Limited, Akruti Corporate Park,1st Floor, Near G.E. Garden, L.B.S. Marg, Kanjurmarg (West), Mumbai Tel.: (+1-22) Fax: (+1-22) askus@ncdex.com Website: CIN: U7400MH2007NPL17422

2 Index Objective of the Study...1 Key Issues and Possible Solutions...2 to 4 Other Opportunities...5 to 6 Conclusion and the Way Forward...7 to 8

3 1 2 Objective of the Study Key Issues and Possible Solutions Commodity derivatives market in India has come a long way since its inception but it still remains way behind the equity market in terms of number of market participants and overall liquidity. The one crucial missing link in this case is the absence of banks and financial institutions on commodity exchanges as they are currently not permitted to participate in the market. According to Banking Regulation Act, 14, no banking company is permitted to directly or indirectly trade in commodities. It has been argued that participation by banks in the Indian commodity markets can create the much desired liquidity while contributing to the efficacy and efficiency of the market. This fact has often been countered by citing the case of the western markets where rise in commodity prices has been attributed to speculative activities of banks and financial institutions. The case of western markets is however, distinguished in that while holding a financial position, banks were also directly involved in the physical chain of commodities which encouraged the flow of non-public information 1. Institutional investment if coupled with a robust regulatory framework may not only increase efficiency but also facilitate price discovery in the commodity market. Bank participation in the Indian commodity markets can also be simultaneously accompanied by necessary regulatory oversight. The objective of the present study is to identify areas where banks can play a critical role in the Indian commodity markets in building the requisite infrastructure as well as facilitate liquidity creation and efficiency. Such participation by banks can prove to be a win-win situation for both banks and commodity markets in general. The ways in which banks currently have exposure to commodities include food credit which is extended to the Food Corporation of India (FCI), collateral financing, working capital advances and priority sector lending. Food credit extended by banks has been rising over time (Table 1) which indicates a rise in their commodity exposure 2. The associated risk is that of a fall in commodity prices which lowers the value of stocks held by the FCI, thereby, impacting repayment to banks. It will thus be in the direct interest of banks if the FCI was to manage its risk effectively by hedging in the commodity market. Table 1: Food credit extended by Banks (Outstanding) YEAR AMOUNT (Rs. bn) Mar Mar Mar Mar Mar Mar Mar Source: Database on Indian Economy, RBI Banks also undertake collateral financing. In this type of financing, banks sanction only a certain proportion of the total value of the loan to the borrower (Loan to Value Ratio). A better understanding of commodities may enable banks to lend at a higher loan to value ratio after a careful evaluation of the borrower s financial position. 1 Levin, C. and McCain, J., Wall Street Bank Involvement with Physical Commodities, Majority and Minority Staff Report, Permanent Subcommittee on Investigations, United States Senate, November Table A in the appendix provides a historical overview of the outstanding advances of the SCBs against sensitive commodities. 1 2

4 Apart from the above, banks also extend working capital loans to commodity processing companies (Table 2). The cost of raw material directly feeds into the margins 1of such processing companies and a rise in the former can deal a severe blow to the latter. Since such companies have little control over raw material prices, it is imperative for them to hedge against fluctuations in the latter. Risk management and hedging facilities encouraged by banks can help companies to better plan their full business cycle. Table 2: Deployment of Gross Bank Credit to the Food Processing Industry (Outstanding as on) Food Processing ( ) 1. Sugar 2. Edible Oils & Vanaspati 3. Tea 4. Others (Rs. bn) Source: Handbook of Statistics on the Indian Economy , RBI Banks are also exposed to commodities by way of their priority sector advances 3. As per Table 3, direct finance to agriculture by banks has been rising over time. Periods of high fluctuations in commodity prices may ultimately turn advances into Non-Performing Assets (NPAs) for banks. Hence, a rise in credit disbursements by banks to commodities calls for an effective risk management mechanism. One way to achieve this is for banks to hedge their risks on the commodity exchange. Since banks are not permitted to do so at present, they can begin by educating their clients about it. At the same time, they may also consider other routes of participating in the commodity markets. In the process, they may actually end up benefiting from the knock-on effects of increase in efficiency. Table 3: Direct Finance to Agriculture by Banks (Outstanding) YEAR AMOUNT (Rs. bn) Source: Handbook of Statistics on Indian Economy, , RBI Strengthening linkages between physical and financial markets for any commodity not only improves liquidity but also promotes efficiency by way of a reduction in transaction costs. This has already been observed in the American economy 4. Banks can thus, begin by providing advisory services to clients with higher commodity exposures to manage their risks by hedging. They can also undertake rural initiatives in the form of educating farmers on the benefits of commodity trading. This may also help in reducing concentration risks 5 faced by banks in the rural areas and expand their balance sheets. Though currently banks in India are not permitted to trade on behalf of their clients, RBI has certified certain banks as AD Category 1 Banks to facilitate commodity hedging in international markets 6. 3 The following items within the food and agro-based processing sector would be eligible for classification as priority sector lending by banks: i) Fruit and vegetable processing industry, ii) Food grain milling industry, iii) Dairy products, iv) Processing of poultry and eggs, meat products, v) Fish processing, vi) Bread, oilseeds, meals (edible), breakfast foods, biscuits, confectionery (including cocoa processing and chocolate), malt extract, protein isolate, high protein food, weaning food and extruded/other ready to eat food products, vii) Aerated water/soft drinks and other processed foods, viii) Special packaging for food processing industries and ix) Technical assistance and advice to food processing industry 4 The Role of Banks in Physical Commodities, IHS Global Inc., Texas. 5As per the Nachiket Mor Committee report, small banks are significantly exposed to the problem of capture and have a high exposure to the systemic risk such as fluctuation in crop prices. As a result, they have to pay a higher interest rate to their depositors which further impacts their margins. 6 Risk Management and Inter-Bank Dealings - Commodity Hedging, RBI Circular No.68, Jan

5 3 Other Opportunities In addition to the possibilities mentioned above, there are other opportunities for banks to participate in the commodity market. Some banks are already making use of the NCDEX Spot Exchange services for their default sales and are increasingly becoming aware of the benefits of the spot platform. To begin with, this can be replicated on the futures platform. The banks can adopt a calibrated approach in this regard i.e. they can begin by providing advisory services (as mentioned above) and inventory financing which can then be followed by hedging on behalf of their clients and finally, trading on commodity exchanges. 1. Inventory Financing: Banks have been lending against the traditional warehouse receipts but such lending has been perennially infested with operational risk. If banks were to instead lend against electronic warehouse receipts issued by the exchange-accredited warehouses, it may help mitigate their defaults. This implies that the bank will no more be exposed to the credit risk. In the event of a default by the depositor, the bank will be able to use the exchange platform for selling the commodity. More importantly, the bank would also not be subject to devaluation risk since the sale will happen at a pre-determined price. In addition to lending against electronic warehouse receipts issued by exchange-accredited warehouses, banks should also consider financing margins for hedgers, farmers, FPOs and value chain participants for their bonafide hedge positions in forward or futures contracts. Such lending could be considered as priority sector lending. Apart from this, the farmer (in case the depositor) by being a part of this chain will be able to fulfill his working capital requirements. It can be a tripartite agreement between the borrower (depositor), the exchange and the bank by way of which the latter can avail of the COMTRACK facility provided by NCDEX 7. Not only will the system help banks in monitoring the stocks which are hedged on the exchange from time to time, but also add to the liquidity in the exchange. While the banks are able to achieve this by availing the e-pledge facilities on the NCDEX spot platform, they are still somewhat exposed to the risk of a significant fall in prices. Since prices can be locked-in by way of commodity futures, it eliminates such devaluation risk. 2. Hedging on behalf of clients: According to the latest NSSO survey, over half of agricultural households are in debt and 42 per cent owe money to banks. This creates an urgent need for banks to advise their clients to hedge against fluctuations in prices as it has a direct bearing on the level of their defaults. The banks can also hedge on behalf of their clients which will not only enable them to lessen their credit and default risk but also provide an opportunity to earn extra income by way of a transaction fee. The banks can also incentivise their clients with lower interest rates. Before investing in commodities directly, banks can act as a facilitator to farmer aggregators and MSMEs to hedge their commodity exposure. This will help farmers in effectively managing intra-seasonality risk and boost profitability of MSMEs. 3. Professional Clearing Member (PCM): As the title suggests, a PCM is one who is responsible for clearing the trade. Banks can also serve as PCMs to clients who usually shy away from approaching the broker directly for the purpose of settlement of their trades. Banks, by virtue of their size and capital are in an ideal position to perform this role. Further, market participants may prefer this route to settle their trades because of the dedicated specialised service provided by banks. Banks on the other hand, can benefit by way of an additional fees. 4. Commodities as an asset class: Available empirical evidence suggests a negative correlation between returns from equities and those from commodities. It is also indicative of negative correlation between investing in the equity of commodity-based companies vis-à-vis commodities themselves. Asset classes such as equities and bonds also underperform in times of inflation. It has been empirically proven that in a mixed portfolio of equities, bonds and commodities, returns from commodities are the highest. 8 Moreover, returns from investing in commodities are different from investing in equities of commodity-based companies. 8 Mukherjee,K., Commodity Investments: Opportunities for Indian institutional investors, National Institute of Bank 7 COMTRACK z is an electronic commodity accounting system developed by NCDEX. Management (NIBM), India, Sept

6 4 Conclusion and the Way Forward An increase in farmer household debt with a large chunk of those that owe money to the banks calls for an urgent need for effective commodity financing. The role of the RBI thus, becomes imperative in this regard. Both the RBI and the FMC are already interacting on formal platforms and there is a need for furthering this partnership to provide a conducive regulatory framework to help both banks and commodity markets flourish. Effective hedging facilitated by banks involvement in the commodity markets will have a feedback effect on their balance sheets too, thereby, generating a positive spillover from the financial to the real sector. Commodity derivatives are an effective tool to deal with risks associated with fluctuations in commodity prices. The involvement of banks and financial institutions in commodity markets is pivotal to create the necessary depth in the market and further the process of price discovery while enabling a more effective risk-management mechanism. Instead of adopting a radical change in the present regulatory structure, the RBI can begin by permitting banks to provide advisory services and inventory financing to their clients. The banks can also start by setting up a dedicated commodity research desk. Possible sequence of entry by banks in commodity markets Provision of advisory services Since banks have high commodity exposure, they could eventually be encouraged to hedge on behalf of their clients. This will not only help them in lowering their defaults but may also expand their balance sheets which will be challenging once the Basel III norms are introduced. This may also accelerate the process of financial inclusion at the same time. A significant percentage of bank deposits are divested towards government securities as they are considered to be a safe investment. In 2014, Scheduled Commercial Banks held close to 45 per cent of central and state government securities. The usual portfolio of a bank s investments contains equities and bonds. Commodities can be considered as an additional asset class sometime in the future since investment in the equity of a commodity-based company does not serve as a substitute for investment in commodities. Collateral Financing Hedging on behalf of clients / Professional Clearing Members Commodity Trading / Investing Database on the Indian Economy, RBI Disclaimer: NICR does not represent or guarantee the accuracy or completeness of the data/information included in this publication even though NICR has taken efforts to ensure that the data/information provided is as accurate as possible at the time of inclusion in the report. NICR accepts no responsibility whatsoever for any consequence of the use of data/information contained in this publication. 7 8

7 Appendix Table A: Scheduled Commercial Banks' Outstanding Advances against Sensitive Commodities Commodities Mar-08 (Rs. cr) Mar-0 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Paddy and Rice Wheat Pulses Other Food Grains Sugar Khandsari Gur Groundnut Rapeseed/Mustardseed Linseed Castorseed Cottonseed Soyabean Other Oilseeds Groundnut Oil Rapeseed/Mustard Castor Oil Linseed Oil Cottonseed Oil Soyabean Oil Other Veg Oil Vanaspati z Cotton and Kapas Raw Jute Total Source: Reserve Bank of India