Tuesday, January 27, 2009

RISKS in an INTERNATIONAL TRANSACTION

In any business transaction, there are risks. However, these risks are enlarged when dealing internationally. Added to commercial risks present in a domestic transaction are foreign exchange risks as well as country risks.
COUNTRY RISKS
Political Stability:
Political Instability resulting from internal or external conflict can jeopardize any imports/exports transactions of the companies involved in trade activities with such countries. It may result in delayed payments at best to outright default at worst.
Economic Environment:
Adverse economic conditions in the country may get reflected in the poor paying capacity of the companies operating there (also, unstable currency).
Legal Infrastructure:
In case of Trade Disputes, a solid legal framework assures a company of a quick and just solution.
Foreign Exchange Restrictions:
Forex restrictions in an importer’s country can limit an importer’s ability to make payments for its international purchases.
FOREIGN EXCHANGE RISKS
1. Foreign Currency Volatility:
A volatile foreign currency may result in uncertainty in terms of value of future payments in that currency.
COMMERCIAL RISKS
1. Reliability of Information:
The very fact that International Trade partners are seperated by large geographical, cultural and political distances, implies that they tend to have limited information on each other’s financial standings and business track records. As a result, the mutual level of cofidence and trust on each otheris low.
2. Trade Dispute:
Dispute resolution mechanisms in each country are different and international trade disputes are more complicated to resolve that domestic trade disputes. Hence, in case of a default, unilateral termination of contract or any other trade dispute, the legal proceedings may turn out to be very expensive and long drawn.

Unquoted SLR securities3

Central Government Securities
i) Banks should value the unquoted Central Government securities on the basis of the prices/ YTM rates put out by the PDAI/ FIMMDA at periodical intervals.
ii) The 6.00 per cent Capital Indexed Bonds may be valued at “cost”, as defined in circular DBOD.No.BC.8/12.02.001/ 97-98 dated January 22, 1998 and BC.18/12.02.001/ 2000-2001 dated August 16, 2000.
iii) Treasury Bills should be valued at carrying cost.

State Government Securities

State Government securities will be valued applying the YTM method by marking it up by 25 basis points above the yields of the Central Government Securities of equivalent maturity put out by PDAI/ FIMMDA periodically.

Other ‘approved’ Securities

Other approved securities will be valued applying the YTM method by marking it up by 25 basis points above the yields of the Central Government Securities of equivalent maturity put out by PDAI/ FIMMDA periodically.

Unquoted SLR securities3

Central Government Securities
i) Banks should value the unquoted Central Government securities on the basis of the prices/ YTM rates put out by the PDAI/ FIMMDA at periodical intervals.
ii) The 6.00 per cent Capital Indexed Bonds may be valued at “cost”, as defined in circular DBOD.No.BC.8/12.02.001/ 97-98 dated January 22, 1998 and BC.18/12.02.001/ 2000-2001 dated August 16, 2000.
iii) Treasury Bills should be valued at carrying cost.

State Government Securities

State Government securities will be valued applying the YTM method by marking it up by 25 basis points above the yields of the Central Government Securities of equivalent maturity put out by PDAI/ FIMMDA periodically.

Other ‘approved’ Securities

Other approved securities will be valued applying the YTM method by marking it up by 25 basis points above the yields of the Central Government Securities of equivalent maturity put out by PDAI/ FIMMDA periodically.

Investment Reserve Account (IRA)

In the event, provisions created on account of depreciation in the ‘AFS’ or ‘HFT’ categories are found to be in excess of the required amount in any year, the excess should be credited to the Profit & Loss account and an equivalent amount (net of taxes, if any and net of transfer to Statutory Reserves as applicable to such excess provision) should be appropriated to an IRA Account in Schedule 2 – “Reserves & Surplus” under the head “Revenue and other Reserves”, and would be eligible for inclusion under Tier-II within the overall ceiling of 1.25 per cent of total Risk Weighted Assets prescribed for General Provisions/ Loss Reserves.
Banks may utilise IRA as follows:
The provisions required to be created on account of depreciation in the AFS and HFT categories should be debited to the P&L Account and an equivalent amount (net of tax benefit, if any, and net of consequent reduction in the transfer to Statutory Reserve), may be transferred from the IRA to the P&L Account.
Illustratively, banks may draw down from the IRA to the extent of provision made during the year towards depreciation in investment in AFS and HFT categories (net of taxes, if any, and net of transfer to Statutory Reserves as applicable to such excess provision). In other words, a bank which pays a tax of 30% and should appropriate 25% of the net profits to Statutory Reserves, can draw down Rs.52.50 from the IRA, if the provision made for depreciation in investments included in the AFS and HFT categories is Rs.100.
(vii) The amounts debited to the P&L Account for provision should be debited under the head ‘Expenditure - Provisions & Contingencies’. The amount transferred from the IRA to the P&L Account, should be shown as ‘below the line’ item in the Profit and Loss Appropriation Account, after determining the profit for the year. Provision towards any erosion in the value of an asset is an item of charge on the profit and loss account, and hence should appear in that account before arriving at the profit for the accounting period. Adoption of the following would not only be adoption of a wrong accounting principle but would, also result in a wrong statement of the profit for the accounting period:a)the provision is allowed to be adjusted directly against an item of Reserve without being shown in the profit and loss account, OR
(b) a bank is allowed to draw down from the IRA before arriving at the profit for the accounting period (i.e., above the line), OR
(c) a bank is allowed to make provisions for depreciation on investment as a below the line item, after arriving at the profit for the period, Hence none of the above options are permissible.(viii) In terms of our guidelines on payment of dividend by banks, dividends should be payable only out of current year's profit. The amount drawn down from the IRA will, therefore, not be available to a bank for payment of dividend among the shareholders. However, the balance in the IRA transferred ‘below the line’ in the Profit and Loss Appropriation Account to Statutory Reserve, General Reserve or balance of Profit & Loss Account would be eligible to be reckoned as Tier I capital.

valuation of bank portfolio

Held to Maturityi)

Investments classified under HTM need not be marked to market and will be carried at acquisition cost, unless it is more than the face value, in which case the premium should be amortised over the period remaining to maturity. The banks should reflect the amortised amount in ‘Schedule 13 – Interest Earned : Item II – Income on Investments’, as a deduction. However, the deduction need not be disclosed separately. The book value of the security should continue to be reduced to the extent of the amount amortised during the relevant accounting period. 2
ii) Banks should recognise any diminution, other than temporary, in the value of their investments in subsidiaries/ joint ventures, which are included under HTM and provide therefor. Such diminution should be determined and provided for each investment individually.
3.2 Available for Sale

The individual scrips in the Available for Sale category will be marked to market at quarterly or at more frequent intervals. Securities under this category shall be valued scrip-wise and depreciation/ appreciation shall be aggregated for each classification referred to in item 2(i) above. Net depreciation, if any, shall be provided for. Net appreciation, if any, should be ignored. Net depreciation required to be provided for in any one classification should not be reduced on account of net appreciation in any other classification. The book value of the individual securities would not undergo any change after the marking of market.
3.3 Held for Trading

The individual scrips in the Held for Trading category will be marked to market at monthly or at more frequent intervals and provided for as in the case of those in the Available for Sale category. Consequently, the book value of the individual securities in this category would also not undergo any change after marking to market.2 Please refer to the Mailbox clarification dated July 11, 2007.

Investment Fluctuation Reserve

(i) With a view to building up of adequate reserves to guard against any possible reversal of interest rate environment in future due to unexpected developments, banks were advised to build up Investment Fluctuation Reserve (IFR) of a minimum 5 per cent of the investment portfolio within a period of 5 years.
(ii) To ensure smooth transition to Basel II norms, banks were advised in June 24, 2004 to maintain capital charge for market risk in a phased manner over a two year period, as under:
(a) In respect of securities included in the HFT category, open gold position limit, open foreign exchange position limit, trading positions in derivatives and derivatives entered into for hedging trading book exposures by March 31, 2005, and
(b) In respect of securities included in the AFS category by March 31, 2006.
(iii) With a view to encourage banks for early compliance with the guidelines for maintenance of capital charge for market risks, it was advised in April 2005 that banks which have maintained capital of at least 9 per cent of the risk weighted assets for both credit risk and market risks for both HFT (items as indicated at (a) above) and AFS category may treat the balance in excess of 5 per cent of securities included under HFT and AFS categories, in the IFR, as Tier I capital. Banks satisfying the above were allowed to transfer the amount in excess of the said 5 per cent in the IFR to Statutory Reserve.(iv) Banks were advised in October 2005 that, if they have maintained capital of at least 9 per cent of the risk weighted assets for both credit risk and market risks for both HFT (items as indicated at (a) above) and AFS category as on March 31, 2006, they would be permitted to treat the entire balance in the IFR as Tier I capital. For this purpose, banks may transfer the balance in the Investment Fluctuation Reserve ‘below the line’ in the Profit and Loss Appropriation Account to Statutory Reserve, General Reserve or balance of Profit & Loss Account.

classification of bank portfolio

Classification
i) The entire investment portfolio of the banks (including SLR securities and non-SLR securities) should be classified under three categories
viz. ‘Held to Maturity’, ‘Available for Sale’ and ‘Held for Trading’. However, in the balance sheet, the investments will continue to be disclosed as per the existing six classifications:
viz. a) Government securities, b) Other approved securities, c) Shares, d) Debentures & Bonds, e) Subsidiaries/ joint ventures and f) Others (CP, Mutual Fund Units, etc.).
ii) Banks should decide the category of the investment at the time of acquisition and the decision should be recorded on the investment proposals.
2.1 Held to Maturityi). The securities acquired by the banks with the intention to hold them up to maturity will be classified under ‘Held to Maturity (HTM)’.
ii). Banks are allowed to include investments included under HTM category upto 25 per cent of their total investmentsThe following investments are required to be classified under HTM but are not counted for the purpose of ceiling of 25 per cent specified for this category;a.Re-capitalisation bonds received from the Government of India towards their re-capitalisation requirement and held in their investment portfolio. This will not include re-capitalisation bonds of other banks acquired for investment purposes.
b.Investment in subsidiaries and joint ventures (A Joint Venture would be one in which the bank, along with its subsidiaries, holds more than 25 percent of the equity).c.The investments in debentures/bonds, which are deemed to be in the nature of advance. [Refer sub-paragraph (vii) below]iii). Banks are, however, allowed since September 2, 2004 to exceed the limit of 25 percent of total investment under HTM category provided:
d) the excess comprises only of SLR securities, and
e) the total SLR securities held in the HTM is not more than 25 percent of their DTL as on the last Friday of the second preceding fortnight.ii)The non-SLR securities, held as part of HTM as on September 2, 2004 may remain in that category. No fresh non-SLR securities, are permitted to be included in HTM, except the following:
(a) Fresh re-capitalisation bonds, received from the Government of India, towards their re-capitalisation requirement and held in their investment portfolio. This will not include re-capitalisation bonds of other banks acquired for investment purposes.
(b) Fresh investment in the equity of subsidiaries and joint ventures.
(c) RIDF / SIDBI deposits
iii) To sum up, banks may hold the following securities under HTM:
(a) SLR Securities upto 25 percent of their DTL as on the last Friday of the second preceding fortnight.
(b) Non-SLR securities included under HTM as on September 2, 2004.
(c) Fresh re-capitalisation bonds received from the Government of India towards their re-capitalisation requirement and held in Investment portfolio.
(d) Fresh investment in the equity of subsidiaries and joint ventures
(e) RIDF/SIDBI deposits.
(vi) Profit on sale of investments in this category should be first taken to the Profit & Loss Account, and thereafter be appropriated to the ‘Capital Reserve Account’. Loss on sale will be recognised in the Profit & Loss Account.
(vii) The debentures/ bonds must be treated in the nature of an advance when:
The debenture/bond is issued as part of the proposal for project finance and the tenure of the debenture is for a period of three years and aboveOrThe debenture/bond is issued as part of the proposal for working capital finance and the tenure of the debenture/ bond is less than a period of one yearAnd the bank has a significant stake i.e.10% or more in the issue
Andthe issue is part of a private placement, i.e. the borrower has approached the bank/FI and not part of a public issue where the bank/FI has subscribed in response to an invitation.
Since, no fresh non-SLR securities are permitted to be included in the HTM, these investments should not be held under HTM category and they should be subjected to subject to mark- to-market discipline. They would be subjected to prudential norms for identification of non-performing investment and provisioning as applicable to investments.
2.2 Available for Sale & Held for Trading
i) The securities acquired by the banks with the intention to trade by taking advantage of the short-term price/interest rate movements will be classified under ‘Held for Trading (HFT)’.
ii) The securities which do not fall within the above two categories will be classified under ‘Available for Sale (AFS)’.
iii) The banks will have the freedom to decide on the extent of holdings under HFT and AFS. This will be decided by them after considering various aspects such as basis of intent, trading strategies, risk management capabilities, tax planning, manpower skills, capital position.
iv) The investments classified under HFT would be those from which the bank expects to make a gain by the movement in the interest rates/market rates. These securities are to be sold within 90 days.
v) Profit or loss on sale of investments in both the categories will be taken to the Profit & Loss Account.
2.3 Shifting among categories
i) Banks may shift investments to/from HMT with the approval of the Board of Directors once a year. Such shifting will normally be allowed at the beginning of the accounting year. No further shifting to/from HTM will be allowed during the remaining part of that accounting year.
ii) Banks may shift investments from AFS to HFT with the approval of their Board of Directors/ ALCO/ Investment Committee. In case of exigencies, such shifting may be done with the approval of the Chief Executive of the bank/Head of the ALCO, but should be ratified by the Board of Directors/ ALCO.
iii) Shifting of investments from HFT to AFS is generally not allowed. However, it will be permitted only under exceptional circumstances like not being able to sell the security within 90 days due to tight liquidity conditions, or extreme volatility, or market becoming unidirectional. Such transfer is permitted only with the approval of the Board of Directors/ ALCO/ Investment Committee.
iv) Transfer of scrips from one category to another, under all circumstances, should be done at the acquisition cost/ book value/ market value on the date of transfer, whichever is the least, and the depreciation, if any, on such transfer should be fully provided for. Banks may apply the values as on the date of transfer and in case, there are practical difficulties in applying the values as on the date of transfer, banks have the option of applying the values as on the previous working day, for arriving at the depreciation requirement on shifting of securities.