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Updated: December 27, 2012 02:31 IST

Risky futures that banks can do without

Kavaljit Singh
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Diverting resources from essential developmental activities to speculative commodities trade could weaken an otherwise stable banking system

On December 10, Finance Minister P. Chidambaram proposed to add a new clause in the Banking Laws (Amendment) Bill which was not a part of the original amendments vetted by the Standing Committee on Finance last year. It allows the entry of banks in commodity futures trading in India. After strong opposition by political parties on the grounds of parliamentary impropriety, the government dropped it from the Bill on December 18.

However, this clause would be incorporated in the Forward Contract Regulation Act (Amendment) Bill which is likely to be tabled in Parliament next year. As allowing banks to trade in commodity futures signals a major policy shift in the banking sector with wider ramifications, it should be discussed in and outside Parliament.

Current status

As per the existing regulatory framework, banks in India are allowed to trade in financial instruments (shares, bonds and currencies) in the securities market. But the Banking Regulation Act, 1949 prohibits banks (domestic and foreign) from trading in goods. Section 8 of the Act states: “no banking company shall directly or indirectly deal in the buying or selling or bartering of goods, except in connection with the realisation of security given to or held by it.”

However, banks are allowed to finance commodity business and provide fund and non-fund-based facilities to commodity traders to meet their working capital requirements. Banks also provide clearing and settlement services for commodities derivatives transactions. But banks cannot trade in commodities themselves.

In addition to banks, mutual funds, pension funds, insurance companies and foreign institutional investors (FIIs) are not allowed to trade in Indian commodity futures markets.

No evidential support

The arguments supportive of the direct entry of banks into commodity trading are backed by very little hard evidence.

The proponents argue that this move would enable banks to hedge their exposure to agricultural lending that arise from price fluctuations. In reality, banks lend money to farmers (and commodity traders) but they do not have any direct exposure to commodities.

Following the same logic, should banks get directly involved in building bridges, airports, highways, dams and power plants since they have large exposures in the infrastructure sector?

At best, banks could advise borrowers to hedge their price risk in the futures markets rather than hedging themselves. By acting as a trader/broker in the commodity derivatives market, banks would be moving away from their core competence — lending money to individuals and businesses.

It needs to be emphasised here that 80 per cent of farmers in India are small farmers (owning less than two hectares of land) and not even 0.1 per cent of farm borrowers in India directly trade in commodity futures exchanges.

Further, there is no justification in allowing non-banking financial players such as mutual funds, insurance companies and foreign institutional investors (FII) in the agricultural commodity markets since they have no direct exposure to farm loans and the farming community in India.

Lack of domain knowledge

By and large, Indian banks (public and private) lack the market knowledge and the expertise to benefit from trading in commodity futures. The Reserve Bank of India (RBI) has also expressed concern at the risks posed by domestic banks that lack the expertise and skilled manpower to deal with such risky trading instruments.

The commodity exchanges are supportive of this move as higher trading volumes would boost their revenues. The real beneficiaries are likely to be big foreign banks that have considerable international experience and expertise in dealing with futures trading. Unlike small traders and hedgers, big foreign banks and FIIs could also benefit immensely from algorithmic trading and other advanced trading tools.

Already, foreign banks dominate the financial derivatives market in India. Most of these products are financial in nature with no actual bank lending involved. The off-balance-sheet exposure of foreign banks (e.g., currency forward contracts, interest rate derivatives) is currently very high in India and should be a matter of concern to policymakers. The off-balance-sheet exposure of foreign banks as a proportion of their on-balance-sheet exposure was 1,860 per cent in 2010-11.

Weak regulatory framework

The entry of banks into commodity futures trading could turn out to be a risky proposition for several valid reasons. To begin with, the commodity futures market in India is still in a nascent stage of development. Therefore, the existing regulatory environment cannot handle the sudden entry of big financial players such as banks and institutional investors.

Unlike the equity markets regulator (the Securities and Exchange Board of India or SEBI), the commodity trade regulator (Forward Markets Commission or FMC) is toothless. The FMC does not have any statutory power for compulsory registration of traders and brokers which makes it difficult to monitor and supervise traders. There are instances where the FMC has failed to curb malpractices (parallel illegal trading) and prevent excessive speculative activities which distorted the price discovery and hedging function of commodity future markets.

In addition, the existing penalty provisions are grossly inadequate and not in tune with the current trading volume in the Indian commodity derivatives markets. It may sound astonishing that the FMC — which regulates billions of dollars worth of commodity trade — does not have the power to directly impose a financial penalty on traders. Now, only a maximum penalty of Rs.1,000 can be imposed on market participants by the FMC — and through court orders on conviction. A financial penalty of a mere Rs.1,000 (enforced through a lengthy court process) does not deter potential offenders in the commodity markets.

The recent guar trading fiasco reveals how commodity exchanges are acting like casinos for speculators, moving away from their avowed objectives of price discovery and price risk management in an efficient and orderly manner. Guar seed and guar gum prices surged 900 per cent in the futures markets during the six months between October 2011 and March 2012. Such was the magnitude of speculative trading and market manipulation that twice the size of the annual production of guar was traded in the futures markets on a single day.

Under the Forward Contracts Regulation Act (Amendment) Bill, the FMC has been granted powers to impose higher financial penalties on rogue traders but the Bill is yet to see the light of day.

Autonomy

New Delhi should give more financial and administrative autonomy to the FMC which works under the supervision of the Ministry of Consumer Affairs, Food and Public Distribution. To carry out effective market surveillance activities, the FMC needs better technological tools as well as professionals with domain specialisation. The FMC is unable to recruit talented professionals due to its low remuneration policy. Most of its staff are on deputation from various government departments.

Currently, the total staff strength of the FMC is less than 90, of whom 35 perform purely administrative duties. Hence, it is not an easy task for the FMC to regulate and supervise futures trading worth billions of dollars in 21 commodity exchanges (five national and 16 regional exchanges).

Given the fact that the FMC is unable to effectively monitor and supervise existing non-financial players, it would require considerable time, resources and technical expertise to deal with the high trading volumes which the entry of banks into commodity trading would bring about.

G20 pronouncements

This policy move is contrary to the positions India has taken at the G20 and other international forums. India has always been at the forefront of international discussions seeking greater regulation, market transparency and the orderly functioning of volatile commodity markets, especially oil.

In September 2011, former Finance Minister Pranab Mukherjee strongly urged the G20 to address the issue of “excessive financialisation” behind the increase in the level and volatility of global oil prices. At the G20, India has backed the International Organization of Securities Commissions (IOSCO) ongoing work on improving the regulation and supervision of futures and physical commodity markets at the global level.

We are living in a post-crisis world where the United States, the United Kingdom and other developed countries are taking corrective steps to rein in “casino banking” which resulted in over-financialisation of the real economy. One of the key lessons to learn from the financial crisis is to avoid financialisation of commodity futures markets.

Developmental concerns

Even though there are various causes of high food inflation in India, the role of futures trading has remained contentious. In 2007, New Delhi had suspended futures trading in key agricultural commodities due to their alleged role in triggering a rapid price hike. As pointed out by G. Chandrasekhar, Commodities Editor, Business Line, “Participation of banks, MFs and FIIs can potentially distort the commodity markets instead of advancing it, as too much money would start chasing commodities in short supplies and result in inflation.”

At a time when Indian banks are struggling to raise an additional capital requirement of Rs.5 trillion before March 2018 to meet the Basel III requirements besides fulfilling mandatory financial inclusion and priority lending targets, such a move could divert resources from developmental banking to speculative trading activities which may weaken the otherwise stable banking system in the long run.

If financial inclusion is considered a necessary precondition for inclusive growth, the key policy priority should be in delivering banking services at an affordable cost to 400 million unbanked people in rural India and meeting the credit needs of small farmers and producers. Unfortunately, the government’s performance is far from satisfactory on this front.

(Kavaljit Singh works with Madhyam, a policy research institute based in New Delhi. Email: kavaljit.singh@gmail.com)

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