Banks are more in the news these days – for a variety of reasons with negative impact of course. Of all these, the one connected with mis-selling of interest rate derivative products is causing considerable damage.
The kind of allegations we hear with regard to such derivative products have occurred in almost all the jurisdictions at some time or other in the past.
Failure to carry out due diligence – with regard to suitability of products, selling derivative products to users not having risk management policies, verifying the underlying, adequacy of understanding and basic eligibility to resort to such products – have led to such allegations.
OTC derivative products help customers to hedge against fluctuations basically in currency exchange and interest rates. Banks sell currency and interest rate derivatives to enable their customers to improve their earnings. The tempting exchange and interest rates that such derivative instruments offer always come with risks that most customers either ignore or think are academic.
When things go wrong, one serious allegation normally the customers make against the banks is that they were compelled by the banks to acquire them and frankly stated that they did not understand the products in greater detail.
Of course, when they are on the right side and make huge money in the process, they claim they are the masters of the market place and they knew very well that the markets would behave that way only. In situations where derivative deals are no longer hedges, but pure currency or interest rate bets such mishaps and subsequent allegations and claims are bound to happen.
May be the banks fail to carry out due diligence regarding the suitability of products and sale of derivatives to users not having the right risk management policies. May be the banks are driven by the target culture – to achieve stipulated profit numbers and to earn more bonus, they indulge in selling meaningless derivative products to their customers with hefty fees collection.
An understanding of the following aspects may help customers and banks in ascertaining the suitability of derivative instruments
– Knowledge and expertise to understand the risks associated with derivative instruments.
– In particular, how they are valued and priced and the sources of risk
– Understanding that the derivatives are basically financial instruments
– The benefits of the derivatives should match the business objective
– Recognition that these instruments can be more volatile than investing directly in the underlying
– Acceptance that one can lose the entire capital invested in derivative instruments
– Understanding that there can be a counter party risk
Thus derivatives can become effective valuable tool only if properly used and can also turn into wild beast if liberties are taken to indulge in overtrade or speculate.
The derivative strategies must be consistent with the scope and objectives of business. They should be applied on a case to case basis according to business’s risk-return preferences.
Given these objectives, certain types of derivative instruments and strategies may be even inappropriate for some businesses
One can manage these basic derivative risks by following steps
Step 1 – Understand the purpose of using the derivative uses (trading, hedging, or funding)
Step 2 – Recognize a leveraged derivative can magnify the contract’s price fluctuations
Step 3 – Understand a derivative instrument’s risk in worst case scenarios
Step 4 – Establish a loss strategy and stick with it
Derivative instruments facilitate risk sharing, risk shifting or hedging. They also enable one in the process of price discovery. At the same time, they also land one in new risks that are potentially capable of destabilizing even matured and successful businesses and sometimes even matured economies. Some of these risks are potently negative and their consequences are very grave.
Basically these consequences arise from mainly from the ‘abuse’ or ‘misuse’ of the derivative instruments through fraud, manipulation, tax evasion or avoidance and distortion of information which is vital for the market efficiency. Some others pertain to the negative consequences from trading.
Inappropriate and undisciplined derivative instruments can result in the creation of new risks in the form of greater levels of market risk for a given amount of capital in the financial system leading to higher degrees of financial sector vulnerability.
They pose a very serious challenge to the safety and soundness of financial markets.
They may also therefore warrant immediate regulatory remedy.
As we all know, self regulation is the best regulation. Starting point for such self regulation is prescription and practice of best practices.
Going by the market experience and practice, suggested framework for derivatives practice may include
– Derivatives policies and strategy formulation
– Transaction execution, confirmation, settlement
– Exposure identification, measurement and management
– Accounting policies, standards and business rules
– Governance – reporting, performance measurement
Ideally any best practices frame work should facilitate the business to answer critical questions in the conduct of derivative transactions.
– Are there written policy guidelines describing the objectives and scope for the use of derivative instruments?
– What type / kind of specific derivative products and strategies are permitted?
– Any outer limits prescribed for taking up these derivative transactions?
– Are these guidelines consistent with the overall business strategy and do they conform to the types of operations?
– Does the Board of Directors or other relevant oversight management groups understand what risks are being assumed?
– Whether these authorizations for derivative transactions have been unambiguously understood and documented?
– Are there mechanisms to spot deviations? Whether these mechanisms are independent and sophisticated?
– When such deviations take place, are they reported to the authorities and their approval, authorisation or confirmation obtained??
– Whether a senior manager’s approval is necessary for binding the business organization to a derivative transaction?
– Are there independent supervisory personnel responsible for developing, executing and derivative strategies and transactions?
– Are there counter checks (maker-checker concept) for derivative transactions taken up? How soon they are counter checked?
– Is there a methodology in place for measuring and monitoring market risk? (value at risk, stress testing, horizon analysis)
– What are the liquidity implications?
– Is there any active secondary market for the derivative transaction?
– Are there agreements or contracts in place to document and govern derivative transactions?
– Are these agreements in ISDA format and legally enforceable?
– Whether netting and settlement procedures are adequately covered in these agreements?
– What are the accounting policies for derivative transactions?
– What are the prescriptions for periodical revaluation of derivative transactions?
– What are the disclosure norms for derivative transactions?
– What are the capital implications for derivative transactions?
– What are the reporting mechanisms?
The benefits of having such a best practices framework for derivatives transactions can be highlighted by looking at what happened to banks and customers in the market place for not having such a framework in the first place or not observing them scrupulously if they had one.
Coming to back to our topic of discussion, we also hear this mis-selling of interest rate derivatives is also connected with reported rigging in LIBOR. If it were so, then it is a dangerous combination.