To expand access to credit, the Government of India and the RBI have required lending institutions, especially banks, to lend mechanically and directly to several economic sectors, like agriculture and affordable housing. With interest rates capped, such as for loans to small farmers and enterprises under interest subvention schemes, these lending activities violate the principle of risk-ordinality in credit-risk pricing, which is that borrowers with comparable risk-profiles are priced similarly no matter which segment they represent. This issue of mispricing of credit risks often ends up making the lenders’ balance sheets riskier, and is further aggravated when lenders, particularly banks, are prohibited, from hedging certain types of risks originating from such loans. For instance, when a bank grants a loan to a small farmer growing wheat or rice, it exposes itself to the price risk associated with the commodity, i.e., if the price of wheat or rice falls around the time of harvest, the farmer may be unable to repay whole or part of the loan on time.
There are three avenues to hedge against such commodity price risks on the banks’ loan book. The borrower (farmer) may hedge (her price-risk) by purchasing commodity derivatives. The lenders may offer their borrowers commodity derivative contracts, to indirectly hedge their own price-risk, instead of the borrower independently sourcing it. Finally, the financier may itself take a proprietary position in the market, in order to hedge the commodity price risk on its loan portfolio. In the last scenario, the probability of default (PD) of the borrower (i.e., farmer) remains unchanged, but the loss given default (LGD) reduces for the financier.
Under the first approach, where the farmer must hedge her price risk independently, several hurdles exist due to market-related barriers and complex product design. Further, lenders are, to a large extent, prohibited from offering such derivatives to their clients and from taking proprietary positions. In this post, we discuss the market and regulatory barriers that prevent most farmers, banks and NBFCs from participating in the commodity derivatives market.
The Market Barriers
To participate in the commodity exchanges, a farmer must be able to meet the minimum lot size[1] requirement for the commodity. Continuing with the earlier example of the small farmer cultivating wheat, the minimum lot size requirement (for wheat) is 100 quintals, however, small farmers, representing most farmers in India, will be unable to meet the requirement of lot size out of their own produce. Thus, if such farmers enter into a contract, it leads to over-hedging, and inefficient allocation of capital for the underlying risks. Hence, to overcome the first barrier, farmers desiring to hedge their risk through commodity derivatives must aggregate their produce through intermediaries.
Aggregation of farmers’ produce through intermediaries, like Farmer Producer Organisations (FPOs), are, however, rife with problems. FPOs often find it difficult to access debt to buy and aggregate produce[2]. Additionally, the ability to aggregate produce by FPOs depends on their rapport with farmers rather than on the execution of contractual agreements, which, many a time, farmers are hesitant to enter into. This, however, does not appear to be an insurmountable challenge as there have been cases where the National Commodity & Derivatives Exchange (NCDEX) had entered into a contract with FPOs who then had back-contracts/agreements with farmers[3].
The next barrier emerges in the form of margin requirements, since a smallholder farmer may find it difficult to maintain the variation margin associated with commodity futures. Though this concern was recently eliminated with the introduction of options on goods by SEBI in 2020[4], over-hedging by a single farmer remains a major concern.
The limited geographical reach of exchanges and brokers, restricted to only large trading centres, keeps the ‘distance’ to the smallholder farmer large. The problem persists even in the case of aggregation through FPOs, since capability building remains to be done for many. Also, most FPOs do not engage in post-harvest aggregation needed to overcome the lot size barrier to serve remote smallholder farmers. The prevalence of these issues is apparent since FPOs contribute only a very small fraction of overall agri-futures trading at NCDEX[5].
Given these market-driven barriers and the complex product design, it is difficult for the borrowers (farmers) to hedge their risk independently. Thus, the agricultural sector continues to remain highly risky for lenders. Hence, lenders must be allowed to either offer products designed to hedge the commodity price risk to their borrowers or hedge these risks themselves. Presently, both these avenues are prohibited for the most part.
The Regulatory Barriers
Banks, by themselves, are not allowed to offer commodity derivatives, or take proprietary positions. Banks are, however, permitted to offer broking services, i.e., they can offer commodity derivative contracts to their borrowers, through a subsidiary. However, the regulatory regime prohibits the subsidiary from engaging in proprietary trading[6]. This stands in contrast with other jurisdictions, like Australia, where banks offer commodity swaps to farmers to help mitigate price risk. They do so by entering into bilateral swap contracts[7] that are cash-settled at maturity, circumventing the problems associated with margin requirements and standardised contracts (e.g. lot-size requirements). Similarly, Standard Bank Group in South Africa offers tailored financing and commodity price risk solutions to clients ranging from agri commodities to energy trading.
Since commodity swaps have a commodity price/commodity index as the reference price, a conservative reading of the Banking Regulation Act (1949) suggests that banks in India might not be allowed to offer commodity swaps as it can be viewed as indirectly dealing in commodities[8]. Banks are also currently prohibited from taking proprietary positions in commodity derivatives[9], and are thus unable to hedge their exposure to the price-risks arising from their loan portfolio.
NBFCs, on the other hand, are not explicitly prohibited from either offering commodity derivatives to their borrowers or from taking proprietary positions. Often NBFCs we spoke to register their subsidiaries as sub-brokers/Authorised Persons under any existing broker and offer commodity derivatives to their clients. However, NBFCs are still reluctant to take proprietary positions since they often take their cue from the regulations applicable to banks. Thus, in absence of an explicit directive permitting NBFCs to take proprietary positions, the situation is expected to remain unchanged.
The prohibitory regulations (for banks) and the lack of affirmative provisions (for NBFCs) prevent lenders from hedging their commodity price risk, and thus increase their overall risk. However, one may argue that these restrictions are designed to ensure that lenders do not engage in speculative activities, which can increase systemic risk. While it is feasible that such a scenario may occur, where banks, instead of hedging their price risk, turn to commodity derivatives for speculative purposes, the RBI can restrict banks from taking such speculative positions. Indeed, the RBI Working Group on Commodity Futures and Warehouse Receipts (2005) recommended that banks be allowed to take proprietary positions within prudential limits[10]. The same recommendation is also echoed by the Working Group to Review of the Guidelines for Hedging of Commodity Price Risk by Residents in the Overseas Markets (2016)[11]:
“The Group, therefore, recommends that domestic banks and/or their subsidiaries active in capital markets be allowed to offer commodity hedging facility to their constituents for better risk management in the economy, initially on a back-to-back basis, on both OTC and exchanges, including on domestic exchanges. Later, when necessary risk management capability has been acquired, banks may be allowed to run a book in commodity derivatives within the umbrella limit of 20% of NOF applicable for investment in equities, venture capital funds (VCFs) & equity linked mutual funds.”
Further, the RBI already allows banks, which are authorised to operate the gold deposits scheme to enter into forward contracts on gold with exporters of gold products, jewellery manufacturers, trading houses, etc[12]. Since these contracts are bilaterally settled, and not through exchanges, the RBI appears to not be principally opposed to such design. Hence, the RBI may allow banks to offer commodity swaps to its borrowers (farmers) using the same approach followed in Australia, as discussed earlier.
To conclude, financial products being offered to customers must be designed suitably. To ensure that millions of small and marginal farmers are not left with unserviceable debts due to the price volatility of their produce (underlying agri-commodities), banks and NBFCs must be allowed to offer risk-hedging products, like commodity derivatives. Similarly, it is also imperative to allow lenders to hedge their own exposures to de-risk their balance sheets. To this end, the Union Government and the RBI should consider using the powers vested under Section 6(o) of the Banking Regulation Act (1949)[13] to permit banks to take proprietary positions within prescribed prudential limits. Further, the RBI should also consider encouraging NBFCs to take proprietary positions with appropriate prudential limits, as necessary.
[1] Lot sizes are set differently for different crops by the exchange and decided based on what the smallest quantity of produce could be for which costs such as transportation costs and quality check costs can be incurred in a viable manner.
[2] See: “Linking farmers to futures market in India”. T.Chatterjee, R.Raghunathan, A.Gulati. Working Paper 383, August 2019; accessible at: https://icrier.org/pdf/Working_Paper_383.pdf
[3] See the case titled “Devnarayan Gram Samaj Samiti”, in the report “Success Stories of Farmer Producer Organisations (FPOs)”, NABARD, 2020; accessible at: https://ncdex.com/downloads/fpo/casestudy/Success Stories of FPOs_Aug 2020_compressed.pdf
[4] See: SEBI Circular on Options in Goods – Product Design and Risk Management Framework; accessible at: https://www.sebi.gov.in/legal/circulars/jan-2020/options-in-goods-product-design-and-risk-management-framework_45692.html
[5] Between April 2016 and May 2018 only a tiny fraction (0.004 percent) of overall agri-futures trade at NCDEX was through FPOs. See: “Linking farmers to futures market in India”. T.Chatterjee, R.Raghunathan, A.Gulati. Working Paper 383, August 2019; accessible at: https://icrier.org/pdf/Working_Paper_383.pdf
[6] See Regulations 21 and 22 of RBI Master Direction- Reserve Bank of India (Financial Services provided by Banks) Directions, 2016 (updated till September 25, 2017, https://www.rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=10425
[7] https://www.commbank.com.au/business/managing-risk/managing-commodity-risk.html?ei=managing-commodity-risk
[8] See Section 8 of The Banking Regulation Act, 1949 [Act No. 10 of 1949]; accessible at: https://rbidocs.rbi.org.in/rdocs/Publications/PDFs/BANKI15122014.pdf
[9]See Regulation 21 of the RBI Master Direction- Reserve Bank of India (Financial Services provided by Banks) Directions, 2016 (updated till September 25, 2017) https://www.rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=10425
[10] See recommendation 8.14 of “The Report of the Working Group on Warehouse Receipts & Commodity Futures”; accessible at: https://www.prsindia.org/sites/default/files/bill_files/bill67_2007010167_Report_ofRBI_working_group_on_warehouse_receipts_and_commodity_futures.pdf
[11] See paragraph 5.4 of “The Report of the Working Group to Review of the Guidelines for Hedging of Commodity Price Risk by Residents in the Overseas Markets”; accessible at: https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=880
[12] Section III, https://www.rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=10485#C4
[13] See The Banking Regulation Act, 1949 [Act No. 10 of 1949]; accessible at: https://rbidocs.rbi.org.in/rdocs/Publications/PDFs/BANKI15122014.pdf
