In a strategic move to safeguard banking institutions from potential capital market volatilities, the Reserve Bank of India (RBI) has introduced revised norms pertaining to the issuance of Irrevocable Payment Commitments (IPCs) by banks. This latest development aims at reducing the financial risks that banks might incur due to their engagements in capital markets.
On a recent Friday, the RBI unveiled a circular which mandates that only those custodian banks that include a particular clause in their agreements with clients will be authorized to issue IPCs. This crucial clause ensures that banks retain an undeniable right over the securities that are slated for receipt as part of any settlement payout.
The central bank has, however, provided an exemption from this clause in instances where transactions are pre-funded. This means the clause will not be necessary when clear Indian Rupee (INR) funds are present in the customer’s account or, for foreign exchange transactions, when the bank’s nostro account is sufficiently credited before the IPC is issued.
A notable aspect of the updated regulations includes the calculation of the maximum intraday risk to custodian banks that issue IPCs. The RBI has declared that this risk shall be considered as Capital Market Exposure (CME) at the rate of 30 percent of the settlement amount. This determination is grounded on an assumed equity price drop of 20 percent on the next trading day (T+1), along with an additional margin of 10 percent to account for a further potential decline in price.
In scenarios where margin payments are made in cash, banks will be able to reduce their exposure by an amount equivalent to the margin paid. Conversely, if margins are paid with permitted securities to Mutual Funds or Foreign Portfolio Investors, banks can reduce their exposure by the same amount post-adjustment for a ‘haircut’. The ‘haircut’ refers to a risk mitigation measure set by the Exchange for the accepted securities being used as a margin.
The regulations further elaborate on situations under the T+1 settlement cycle, where the exposure is normally limited to intraday. However, if exposure remains outstanding at the conclusion of T+1 Indian Standard Time, banks must maintain capital on the remaining capital market exposure as directed by the Master Circular – Basel III Capital Regulations, issued on April 1, 2024, subject to periodic amendments.
Moreover, the RBI has clarified the implications of banks’ underlying exposures to their counterparties, resulting from intraday CME. Such exposures are to be regulated by limits established under the Large Exposure Framework dating back to June 3, 2019, with subsequent amendments considered. The RBI emphasized that these revised instructions are effective immediately.
Accompanying these stipulations, the RBI elaborated on the context of these changes. The risk mitigation measures outlined in the previous circular were predicated upon a T+2 rolling settlement cycle for equities (where ‘T’ signifies the trading day). However, with stock exchanges introducing a T+1 rolling settlement system, the existing guidelines for IPC issuance by banks needed an overhaul.
Henceforth, all IPCs issued by custodian banks as part of the T+1 settlement cycle will align with new instructions. The commitment towards regulatory adaptability reflects the RBI’s insistence on prudence, ensuring that risk management within the banking sector remains responsive to the ever-evolving financial landscape. This proactive approach underlines the continuous regulation of the banking system by the RBI, which seeks to uphold the stability of the financial sector even as it navigates through the complexities of market operations.
