## _wp07251 - Section 1

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---

### I. Introduction
- Definition:
  - Capital account convertibility defined as a policy permitting capital to flow more freely in and out of a country.
- Paper purpose:
  - Review potential and existing financial stability challenges to Fuller Capital Account Convertibility (FCAC) in India.
  - Study how prudential regulation and supervision is addressing these challenges.
- Main conclusion:
  - Regulatory and supervisory measures alone are not enough and will need to be complemented by improvements in Indian banks’ risk management and further development of the domestic capital markets.
- Context and comparative figures:
  - Total foreign bank claims on India are about US$104 billion, comparable to those on China and Russia.
  - Indian banks’ claims on other countries are four times less than this total.
- Expected changes with FCAC:
  - Cross-border transactions will increase and involve different currencies, many countries, on-balance sheet lending and funding, off-balance sheet derivatives, and other complex financial transactions.
- Risk categories to be augmented with FCAC:
  - Market risk: interest rate and foreign exchange risks become more complex; need to quote rates and manage open positions in new currencies; potential for volatility spillovers.
  - Credit risk: new dimensions such as transfer risk, settlement (Herstatt) risk, and country/sovereign risk.
  - Liquidity risk: positions in foreign currency–denominated assets and liabilities, and potentially large and uneven flows in different currencies complicating ALM.
  - Derivatives transaction risk: both market and counterparty credit risk in OTC derivatives; collateral insufficiency and increased difficulty collecting/analyzing counterparty information.
  - Operational and legal risk: legal differences across jurisdictions (e.g., bankruptcy codes, secured transactions for repos).
  - Regulatory risk: potential for regulatory arbitrage and complexity from new instruments and large cross-border institutions requiring stronger cooperation among domestic and foreign regulators.
- Emphasis:
  - First line of defense rests on financial institutions’ ability to identify, measure, and manage risk through quality internal risk management and control policies.
- Complementary needs for FCAC readiness:
  - Adequate prudential regulation and supervision covering existing and new risks.
  - Developed capital markets with liquidity, infrastructure, and market discipline to provide risk management instruments.

### II. What Are the Existing Challenges to FCAC?
- Overall assessment:
  - Indian banks’ risk management needs further improvement to address FCAC challenges.
  - RBI has noted the need to accelerate strengthening of Indian banks’ risk management systems.
  - The Tarapore Report notes skill and competency levels required for FCAC are “somewhat limited.”
  - IFC Report (2007) examines regulatory framework needed for banks and market participants to manage risks.
- Human resources and incentives:
  - Public sector banks dominate the Indian financial system and view HR systems as a major area needing improvement.
  - FICCI survey of banks: 92 percent of public sector respondents stated they do not have sufficient autonomy to offer attractive incentive packages to employees.
- Interest rate and liquidity risk management shortcomings:
  - Most banks have ALM frameworks but have not internalized ALM as part of overall risk assessment and capital planning; data limitations persist.
  - ALCO role remains narrowly confined to decisions on interest rates.
- Growth and concentration in off-balance sheet (OBS) derivatives:
  - Market activity in the OTC derivatives market quadrupled from 1998 to 2004 (BIS Triennial Central Bank Survey, 2005).
  - Combined share of the top 15 banks in OBS exposures grew from around 74 percent in March 2002 to 82 percent of total OBS exposures in March 2006.
  - 62 percent of OBS exposures in March 2006 is accounted for by foreign banks.
  - Need for an adequate prudential and regulatory framework to address derivatives risks.
- Tarapore Report key recommendations for FCAC readiness:
  - Liquidity risk: banks should monitor liquidity at head/corporate office on a global basis, including domestic and foreign branches; monitor liquidity positions for each currency.
  - Market risk: adopt duration gap analysis; consider internal limits on interest rate risk exposures; RBI to link open position limits to banks’ capacity to manage foreign exchange risk and to their unimpaired Tier I capital.
  - Derivatives availability and infrastructure: banks will require more derivatives instruments—interest rate futures and options, credit derivatives, commodity derivatives, equity derivatives—and RBI should establish appropriate infrastructure including robust accounting framework, independent risk management, internal control, senior management oversight, comprehensive guidelines on derivatives (including prudential limits where necessary), and appropriate disclosures.
- IFC Report (2007) noted needs for enabling banks to offer/use risk management services:
  - Operations in derivatives for hedging core commercial banking book and for clients on an agency basis.
  - Identical structure for currency, interest rate, and credit derivatives markets whether denominated in local or foreign currency.
  - Ability to hedge political risk through derivatives and insurance.
  - Ability to hedge market risk and operational risk.

### III. How Is Prudential Regulation and Supervision Addressing the Challenges From FCAC?
- RBI initiatives and recent measures aimed at strengthening banks’ risk management toward international best practice.
- Liquidity and interest rate risks:
  - RBI advised use of impact and scenario analysis of changes in yield structures.
  - In 2006 RBI issued draft guidelines advising use of a Duration Gap Approach (DGA) in conjunction with the Traditional Gap Approach (TGA).
  - Draft guidelines require banks to compute volatility of earnings and equity under various interest rate scenarios and fix internal limits under both earnings and economic value perspectives.
- Risks in derivatives transactions:
  - Legal recognition of the OTC derivatives market improved by amendment of the RBI Act in 2006, overcoming limitations of the Securities Contract Regulation Act that recognized exchange-traded derivatives but not OTC derivatives.
  - RBI now regulates the interest rate and foreign exchange OTC derivatives market and has set up an internal group to formulate new comprehensive guidelines to replace existing instrument-specific ones.
- Selected Risk Management Initiatives (RBI sources):
  - Risk Management:
    - Market Risk Management Guidance Note (2002)
    - Credit Risk Management Guidance Notes (2001, 2002)
    - Risk Management Systems in Banks Notes (1999)
  - Risk-Based Supervision:
    - Risk Based Supervision Discussion Paper (2001)
  - Asset-Liability Management (ALM):
    - Guidelines on ALM Draft Amendments (2007)
    - Improvements to ALM framework, including duration gap approach (DGA) and granular approach to liquidity risk measurement (2006)
    - ALM Guidelines (1999)
  - Operational Risk:
    - Operational Risk Guidance Note (2005)
  - Stress Testing:
    - Stress Testing Guidelines (2006)
  - Derivatives Instruments:
    - Draft Guidelines on Credit Default Swaps (2007)
    - Amendment to the RBI Act (2006) establishing legality of OTC derivatives, empowering RBI to regulate the interest rate and foreign exchange OTC derivatives market
    - Derivative/Hedge Accounting Discussion Paper (2006)
    - Prudential norms for classification, valuation, and operation of investment portfolio by banks (2006)
    - Fair value accounting in line with IAS 39
  - Government Securities:
    - Government Securities Bill enacted (2006), allows strips, hypothecation, pledge, and lien of Government securities, maintenance of records in electronic form
    - Short-selling in Government securities introduced (2006)
- Closing note:
  - The RBI has taken a number of regulatory measures to address the risks associated with derivatives instruments.

### IV. Conclusions (Section 1)
- Progress:
  - Regulatory and supervisory initiatives have advanced but are insufficient on their own.
- Necessary complementary actions:
  - Further improvements in banks’ internal risk management practices and human resources capacity.
  - Continued development of domestic capital markets to provide liquidity, infrastructure, and risk management instruments.
- Integrated approach required:
  - Strengthened prudential regulation and supervision, improved bank risk management, and deeper capital markets are all required to manage the risks arising from Fuller Capital Account Convertibility in India.

---

### _wp07251 - Section 2

### Prudential measures, derivatives accounting, and market practices
- Regulatory measures in place:
  - Holding of minimum defined regulatory capital for all OBS exposures.
  - Collection of periodic supervisory data.
  - Transparency and disclosure requirements.
- RBI emphasis:
  - Due diligence regarding customer appropriateness and suitability of products.
  - Use of risk mitigation techniques such as collateral and netting arrangements.
- Prior gap:
  - Lack of prudential accounting guidelines for derivatives.
- RBI actions in 2006:
  - Issued guidelines for the valuation and accounting of derivatives and more generally banks’ investment portfolio (both 2006) to introduce fair value accounting norms for derivatives broadly in line with international accounting norms (IAS 39) with the objective of bringing all derivative transactions “on-balance sheet” as against “off-balance sheet” as being done currently.
  - Commercial banks and primary dealers are now allowed to begin transacting in single-entity credit default swaps.

### Stress testing
- RBI issued draft guidelines on stress testing (2006) covering major risk areas.
- Banks are required to conduct stress tests to estimate the resources needed to reduce the risk identified and meet the minimum capital adequacy requirement.
- Frequency guidance:
  - Banks advised to apply stress tests at varying frequencies dictated by business requirements, relevance, and cost.
  - Exposures to sensitive sectors and high risk category assets would have to be subjected to more frequent stress tests.

### Financial sector stability and development self-assessment
- A forthcoming self assessment of financial sector stability and development will assess preparedness of the Indian financial system for fuller capital account convertibility.
- This exercise follows the 2001 FSAP and a number of self-assessments of international standards and codes.
- The self-assessment will partly rely on the IMF-World Bank Handbook on Financial Sector Assessment (2005).

### Basel II implementation
- Basel II objectives:
  - Make banks’ regulatory capital more sensitive to risk.
  - Recognize developments in risk measurement and risk management techniques (e.g., Internal Rating Based (IRB) Approach).
  - Align regulatory capital closer to economic capital.
- Implications:
  - Indian banks with stronger risk management practices would benefit from lower regulatory capital requirements.
  - Banks with poor risk management—e.g., reliance on external ratings—would be penalized by higher capital requirements.
- Credit risk treatment changes:
  - Current risk weights set by asset class and range from 0 percent to 100 percent.
  - Under Basel II standardized approach, risk weights will depend on the individual risk rating of each counterparty and the ceiling risk weight increases to 150 percent.
  - Capital requirements for credit exposures, including cross-border portfolios, will depend on the risk weights of individual counterparties and could potentially increase depending on portfolio quality.
- Roadmap and migration deadlines:
  - Foreign banks operating in India and Indian banks having presence outside India are to migrate to the standardized approach for credit risk and the basic indicator approach for operational risk, with effect from March 31, 2008.
  - All other scheduled commercial banks are encouraged to migrate to these approaches no later than March 31, 2009.

### Conclusions: market development, infrastructure, and policy priorities
- Determinants of institutions’ risk management capacity:
  - Availability of instruments to manage risk, liquidity of financial markets, quality of market infrastructure, and level of market discipline (as recognized in the Tarapore Committee Report).
- Key market shortcomings:
  - Term money market is limited.
  - Domestic yield curve for government securities exists up to 30 years but depth and liquidity are limited.
  - Corporate bond market is relatively small and illiquid.
  - Market for securitized assets has fallen short of expectations.
  - OTC derivatives market is growing rapidly but its prudential and regulatory framework has just been laid out.
- Authorities’ actions to address gaps:
  - RBI Working Group on Screen Based Trading in Government Securities (2004).
  - RBI Internal Technical Groups on Money Market and on Central Government Securities Market (2005).
  - Government Securities Act allows stripping of bonds into separately-tradable principal and interest payments.
  - High Level Expert Committee on Corporate Bonds and Securitization (appointed 2006) produced recommendations helpful for better risk management.
- Recommendation:
  - Revisit measures—and the pace of their implementation—needed to prepare India’s financial system to manage risks from FCAC, with particular focus on developing domestic capital markets.

*Source: _wp07251 - Section 1 (IMF Working Paper WP/07/251, October 2007) — Capital Account Convertibility and Risk Management in India by Amadou N. R. Sy*

### Section 1

### _wp07251 - Section 1

### I. Introduction
- Defines capital account convertibility as a policy permitting capital to flow more freely in and out of a country.
- Paper’s purpose:
  - Review potential and existing financial stability challenges to Fuller Capital Account Convertibility (FCAC) in India.
  - Study how prudential regulation and supervision is addressing these challenges.
- Main conclusion highlighted in the paper:
  - Regulatory and supervisory measures alone are not enough and will need to be complemented by improvements in Indian banks’ risk management and further development of the domestic capital markets.
- Context and comparative figures:
  - Total foreign bank claims on India are about US$104 billion, comparable to those on China and Russia.
  - Indian banks’ claims on other countries are four times less than this total.
- Expected changes with FCAC:
  - Cross-border transactions will increase and involve different currencies, many countries, on-balance sheet lending and funding, off-balance sheet derivatives, and other complex financial transactions.
- Risk categories that will be augmented with FCAC:
  - Market risk: interest rate and foreign exchange risks become more complex; need to quote rates and manage open positions in new currencies; potential for volatility spillovers.
  - Credit risk: new dimensions such as transfer risk, settlement (Herstatt) risk, and country/sovereign risk.
  - Liquidity risk: positions in foreign currency–denominated assets and liabilities, and potentially large and uneven flows in different currencies complicating ALM.
  - Derivatives transaction risk: both market and counterparty credit risk in OTC derivatives; collateral insufficiency and increased difficulty collecting/analyzing counterparty information.
  - Operational and legal risk: legal differences across jurisdictions (e.g., bankruptcy codes, secured transactions for repos).
  - Regulatory risk: potential for regulatory arbitrage and complexity from new instruments and large cross-border institutions requiring stronger cooperation among domestic and foreign regulators.
- Emphasis on first line of defense:
  - Financial institutions’ ability to identify, measure, and manage risk depends on the quality of internal risk management and control policies.
- Complementary needs for FCAC readiness:
  - Adequate prudential regulation and supervision covering existing and new risks.
  - Developed capital markets with liquidity, infrastructure, and market discipline to provide risk management instruments.

### II. What Are the Existing Challenges to FCAC?
- Overall assessment:
  - Indian banks’ risk management needs further improvement to address FCAC challenges.
  - RBI has noted the need to accelerate strengthening of Indian banks’ risk management systems.
  - The Tarapore Report notes skill and competency levels required for FCAC are “somewhat limited.”
  - IFC Report (2007) examines regulatory framework needed for banks and market participants to manage risks.
- Human resources and incentives:
  - Public sector banks dominate the Indian financial system and view HR systems as a major area needing improvement.
  - FICCI survey of banks: 92 percent of public sector respondents stated they do not have sufficient autonomy to offer attractive incentive packages to employees.
- Interest rate and liquidity risk management shortcomings:
  - Most banks have ALM frameworks but have not internalized ALM as part of overall risk assessment and capital planning; data limitations persist.
  - ALCO role remains narrowly confined to decisions on interest rates.
- Growth and concentration in off-balance sheet (OBS) derivatives:
  - Market activity in the OTC derivatives market quadrupled from 1998 to 2004 (BIS Triennial Central Bank Survey, 2005).
  - Combined share of the top 15 banks in OBS exposures grew from around 74 percent in March 2002 to 82 percent of total OBS exposures in March 2006.
  - 62 percent of OBS exposures in March 2006 is accounted for by foreign banks.
  - Need for an adequate prudential and regulatory framework to address derivatives risks.
- Tarapore Report key recommendations for FCAC readiness:
  - Liquidity risk: banks should monitor liquidity at head/corporate office on a global basis, including domestic and foreign branches; monitor liquidity positions for each currency.
  - Market risk: adopt duration gap analysis; consider internal limits on interest rate risk exposures; RBI to link open position limits to banks’ capacity to manage foreign exchange risk and to their unimpaired Tier I capital.
  - Derivatives availability and infrastructure: banks will require more derivatives instruments—interest rate futures and options, credit derivatives, commodity derivatives, equity derivatives—and RBI should establish appropriate infrastructure including robust accounting framework, independent risk management, internal control, senior management oversight, comprehensive guidelines on derivatives (including prudential limits where necessary), and appropriate disclosures.
- IFC Report (2007) noted needs for enabling banks to offer/use risk management services:
  - Operations in derivatives for hedging core commercial banking book and for clients on an agency basis.
  - Identical structure for currency, interest rate, and credit derivatives markets whether denominated in local or foreign currency.
  - Ability to hedge political risk through derivatives and insurance.
  - Ability to hedge market risk and operational risk.

### III. How Is Prudential Regulation and Supervision Addressing the Challenges From FCAC?
- RBI initiatives and recent measures aimed at strengthening banks’ risk management toward international best practice.
- Areas covered by recent initiatives:
  - Liquidity and interest rate risks:
    - RBI advised use of impact and scenario analysis of changes in yield structures.
    - In 2006 RBI issued draft guidelines advising use of a Duration Gap Approach (DGA) in conjunction with the Traditional Gap Approach (TGA).
    - Draft guidelines require banks to compute volatility of earnings and equity under various interest rate scenarios and fix internal limits under both earnings and economic value perspectives.
  - Risks in derivatives transactions:
    - Legal recognition of the OTC derivatives market improved by amendment of the RBI Act in 2006, overcoming limitations of the Securities Contract Regulation Act that recognized exchange-traded derivatives but not OTC derivatives.
    - RBI now regulates the interest rate and foreign exchange OTC derivatives market and has set up an internal group to formulate new comprehensive guidelines to replace existing instrument-specific ones.
- Selected Risk Management Initiatives (Table 1; RBI sources):
  - Risk Management:
    - Market Risk Management Guidance Note (2002)
    - Credit Risk Management Guidance Notes (2001, 2002)
    - Risk Management Systems in Banks Notes (1999)
  - Risk-Based Supervision:
    - Risk Based Supervision Discussion Paper (2001)
  - Asset-Liability Management (ALM):
    - Guidelines on ALM Draft Amendments (2007)
    - Improvements to ALM framework, including duration gap approach (DGA) and granular approach to liquidity risk measurement (2006)
    - ALM Guidelines (1999)
  - Operational Risk:
    - Operational Risk Guidance Note (2005)
  - Stress Testing:
    - Stress Testing Guidelines (2006)
  - Derivatives Instruments:
    - Draft Guidelines on Credit Default Swaps (2007)
    - Amendment to the RBI Act (2006) establishing legality of OTC derivatives, empowering RBI to regulate the interest rate and foreign exchange OTC derivatives market
    - Derivative/Hedge Accounting Discussion Paper (2006)
    - Prudential norms for classification, valuation, and operation of investment portfolio by banks (2006)
    - Fair value accounting in line with IAS 39
  - Government Securities:
    - Government Securities Bill enacted (2006), allows strips, hypothecation, pledge, and lien of Government securities, maintenance of records in electronic form
    - Short-selling in Government securities introduced (2006)
- Closing note in the section:
  - The RBI has taken a number of regulatory measures to address the risks associated with derivatives instruments.

### IV. Conclusions
- Regulatory and supervisory initiatives have advanced but are insufficient on their own.
- Necessary complementary actions:
  - Further improvements in banks’ internal risk management practices and human resources capacity.
  - Continued development of domestic capital markets to provide liquidity, infrastructure, and risk management instruments.
- Emphasis on integrated approach:
  - Strengthened prudential regulation and supervision, improved bank risk management, and deeper capital markets are all required to manage the risks arising from Fuller Capital Account Convertibility in India.

*Source: _wp07251 - Section 1 (IMF Working Paper WP/07/251, October 2007) — Capital Account Convertibility and Risk Management in India by Amadou N. R. Sy*

### Section 2

### _wp07251 - Section 2

### Prudential measures, derivatives accounting, and market practices
- Regulatory measures include holding of minimum defined regulatory capital for all OBS exposures, collection of periodic supervisory data, and transparency and disclosure requirements.
- RBI emphasis:
  - due diligence regarding customer appropriateness and suitability of products;
  - use of risk mitigation techniques such as collateral and netting arrangements.
- Prior gap: lack of prudential accounting guidelines for derivatives.
- RBI actions in 2006:
  - issued guidelines for the valuation and accounting of derivatives and more generally banks’ investment portfolio (both 2006) to introduce fair value accounting norms for derivatives broadly in line with international accounting norms (IAS 39) with the objective of bringing all derivative transactions “on-balance sheet” as against “off-balance sheet” as being done currently.
  - commercial banks and primary dealers are now allowed to begin transacting in single-entity credit default swaps.

### Stress testing
- RBI issued draft guidelines on stress testing (2006) covering major risk areas.
- Banks are required to conduct stress tests to estimate the resources needed to reduce the risk identified and meet the minimum capital adequacy requirement.
- Frequency guidance:
  - Banks advised to apply stress tests at varying frequencies dictated by business requirements, relevance, and cost.
  - Exposures to sensitive sectors and high risk category assets would have to be subjected to more frequent stress tests.

### Financial sector stability and development self-assessment
- A forthcoming self assessment of financial sector stability and development will assess preparedness of the Indian financial system for fuller capital account convertibility.
- This exercise follows the 2001 FSAP and a number of self-assessments of international standards and codes.
- The self-assessment will partly rely on the IMF-World Bank Handbook on Financial Sector Assessment (2005).

### Basel II implementation
- Basel II objectives:
  - make banks’ regulatory capital more sensitive to risk;
  - recognize developments in risk measurement and risk management techniques (e.g., Internal Rating Based (IRB) Approach);
  - align regulatory capital closer to economic capital.
- Implications:
  - Indian banks with stronger risk management practices would benefit from lower regulatory capital requirements.
  - Banks with poor risk management—e.g., reliance on external ratings—would be penalized by higher capital requirements.
- Credit risk treatment changes:
  - Current risk weights set by asset class and range from 0 percent to 100 percent.
  - Under Basel II standardized approach, risk weights will depend on the individual risk rating of each counterparty and the ceiling risk weight increases to 150 percent.
  - Capital requirements for credit exposures, including cross-border portfolios, will depend on the risk weights of individual counterparties and could potentially increase depending on portfolio quality.
- Roadmap and migration deadlines:
  - Foreign banks operating in India and Indian banks having presence outside India are to migrate to the standardized approach for credit risk and the basic indicator approach for operational risk, with effect from March 31, 2008.
  - All other scheduled commercial banks are encouraged to migrate to these approaches no later than March 31, 2009.

### Conclusions: market development, infrastructure, and policy priorities
- Determinants of institutions’ risk management capacity include availability of instruments to manage risk, liquidity of financial markets, quality of market infrastructure, and level of market discipline (as recognized in the Tarapore Committee Report).
- Key market shortcomings:
  - Term money market is limited.
  - Domestic yield curve for government securities exists up to 30 years but depth and liquidity are limited.
  - Corporate bond market is relatively small and illiquid.
  - Market for securitized assets has fallen short of expectations.
  - OTC derivatives market is growing rapidly but its prudential and regulatory framework has just been laid out.
- Authorities’ actions to address gaps:
  - RBI Working Group on Screen Based Trading in Government Securities (2004);
  - RBI Internal Technical Groups on Money Market and on Central Government Securities Market (2005);
  - Government Securities Act allows stripping of bonds into separately-tradable principal and interest payments;
  - High Level Expert Committee on Corporate Bonds and Securitization (appointed 2006) produced recommendations helpful for better risk management.
- Recommendation:
  - Revisit what needs to be done to prepare India’s financial system to manage risks from FCAC by taking a closer look at measures—and the pace of their implementation—needed to develop domestic capital markets accordingly.

*Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2007/_wp07251.pdf*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2007/_wp07251.pdf_