Thursday, June 24, 2010

RBI diktat may queer FII pitch

Foreign institutional investors (FIIs) and banks are keeping their fingers crossed on a Reserve Bank of India (RBI) rule effective July 1 that could increase capital needs, leading to higher transaction costs and temporary liquidity issues.

The central bank has said from July, the irrevocable payment commitments, or IPCs, by custodian banks to institutional funds should be treated as capital market exposure. But custodian who offer back-end services to funds maintain that their guarantees are not exposure to equities. Banks issue such payment guarantees in favour of stock exchanges on behalf of FIIs to facilitate transactions done by these clients.

"We have given our feedback and have also told RBI individually as banks that in the current format it will become difficult to confirm trades, which could cause a liquidity issue in the market," said a custodian privy to the meetings with the central bank who did not want to be identified.

Implementation of the rule first announced in 2007 has been deferred many times in the past and the latest deadline
is July 1. Some believe it may be deferred again. Deutsche Bank, Citibank, HSBC, JPMorgan and Standard Chartered Bank are some who act as custodians. RBI, in its efforts to reduce the risk in the banking system, had suggested the rule after its inspection revealed that banks were not setting aside enough capital for equity risks. The probe revealed that some banks extended loans to mutual funds and issued guarantees to stock exchanges on behalf of institutional investors.

"IPCs are in the nature of non-fund based credit facility for purchase of shares and are to be treated on a par with guarantees issued for the purpose of capital market operations,’’ RBI said on December 14, 2007. ``Such exposure of banks will, therefore, form part of their Capital Market Exposure. Banks were also advised that entities such as FIIs are not permitted to avail of fund or non-fund based facilities such as IPCs from banks."

But custodians believe that there was little risk in their business and that they could recover the funds in case of a default. "In a cash equity settlement, a custodian exposure is only to the extent of the price risk of the securities,’’ said another custodian. ``If there is a default on the purchase obligation, a custodian offsets it by disposing of the security. The risk arising out of the price movement is also taken care of by the margin framework in place."

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