Govind Gurnani

Implications Of The Reserve Bank’s Revised Large

Exposure Framework On Forward Premium in Forex
Market

The Reserve Bank of India (RBI)’s large exposure framework (LEF)

norms for banks came into e ect from April 2019 as a part of India’s
implementation of global Basel III norms in the domestic banking
system. The principal objective of the LEF is to reduce counterparty
concentration risk in the banking system by de ning a limit (25 percent
of Tier 1 capital) on the amount of bank lending to any single
counterparty or group of connected parties. In other words, LEF norms
are aimed at lowering the risk of a sudden default by a large
counterparty endangering a bank’s solvency.

Notable Changes in the LEF norms Since April 2020

Based on the revised Basel III guidelines, the Reserve Bank introduced
two notable changes in the LEF norms e ective from April 2020.
▪ The banks have been advised to include non-centrally cleared
derivative exposures with their clients into the exposure calculation.
▪ The exposure of Indian branches of foreign global systemically
important banks ( G-SIBs) to their head o ces (HOs) has been capped
at 20 percent of Tier 1 capital in India.

These changes are worth looking into further to explore the impact on
broader nancial markets beyond traditional bank lending.

Implications of revised LEF Norms on Forward Premium in Forex

Market

Historically, the branches of foreign banks operating in India have

hedged eligible risk from derivative trades with clients through
permissible o setting back-to-back transactions with their Head
O ces. This mechanism was e ective from the standpoint of both risk
management as well as providing more liquidity in these markets. In
addition to this, foreign banks also frequently deploy their surplus
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foreign currency balances with head o ces as part of their liquidity
management strategy. This set of existing business transactions, in
combination with the inclusion of non-centrally cleared derivative
exposures, has led to a situation where foreign bank branches
faced a risk of breaching their HO exposure limits under the LEF.

In India, both corporate issuers as well as Indian banks are dependent

on accessing international forex markets through foreign banks due to
regulatory restrictions. The additional norm of capping the exposure of
Indian branches of foreign G-SIBs to their HOs at 20% under LEF as
stated above has quickly caused an impact in the foreign exchange
forward market, where forward premiums (US$/INR) for hedging
shot up as one of the common routes for absorbing surplus foreign
currency liquidity became inaccessible to foreign bank branches.

This has posed a risk to Indian markets, as foreign banks become

restricted in their ability to e ectively o set risk o ered to clients,
in deeper and more liquid global markets through their HO. This has
also resulted into reduced access to global liquidity for both
corporate issuers as well as banks who are dependent on accessing
international forex markets through foreign banks due to regulatory
restrictions.

In view of the above stated two notable changes in LEF, it remains

interesting to be seen as to how the foreign banks operating in India
look to reduce their existing or avoid adding incremental exposures to
their HOs to comply with the new limits requiring inclusion of derivative
exposures.

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