Rupee interest derivatives for SFBs may boost liquidity in OIS market, balance sheet resilience: Experts

Interest Rate Derivative

The Reserve Bank of India’s decision to allow small finance banks to deal in rupee interest derivative products is likely to increase liquidity in the overnight interest swap (OIS) market and boost balance sheet resilience, experts said.

Interest rate derivatives are financial contracts whose value is linked to the movement of interest rates. They are often used by financial institutions and banks, among others, as a hedge against interest rate variations.

The central bank, in its monetary policy announcement on April 5, said it has decided to allow small finance banks (SFBs) to deal in permissible rupee interest derivative products in terms of the Rupee Interest Rate Derivatives (Reserve Bank) Directions, 2019. The RBI will issue the circular regarding this shortly.

“It will enhance liquidity in the OIS market with the introduction of a new segment of participants,” said Rajeev Pawar, head of treasury at Ujjivan Small Finance Bank.

Sanjay Agarwal, founder of AU Small Finance Bank, said it will impart greater flexibility for hedging operations and help boost balance sheet resilience.

Until now, SFBs were allowed to deal only in interest rate futures for proprietary hedging, the RBI said.

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How do interest rate derivatives work?

Interest rate derivatives operate on the principle of swapping or hedging interest-rate cash flows.

The institutions or parties involved agree on the terms, including the notional amount, fixed or floating interest rate, and duration. The value of the derivative fluctuates with changes in interest rates, offering opportunities for both profit and risk mitigation.

Ajay Kanwal, managing director of Jana SFB, explained that if a bank with a requirement of a two-year fund expects rates to head lower, it will raise the deposit rates and receive fixed two-year swap so that when the rates move lower the banks will not hit by higher deposit cost as lower swaps will give it a profit.

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Small finance bank tag

During the post-policy press conference, the RBI turned down a request from SFBs to drop the “small finance” tag from their names, saying it is a key differentiator.

“SFBs actually have been conceptualised as a differentiated bank with a specific objective. And the tag of having an SFB after the name is a key part of the differentiator. So, I don't think there's any requirement to modify that,” said RBI deputy governor M Rajeshwar Rao.

He said the objective of SFBs is to widen financial inclusion among the underserved and unserved population through high-tech and low-cost operations.

“And meeting priority sector norms is a key part of this entire process. So, I think the norms continue to be at that level,” Rao said.