While the Reserve Bank of India has allowed banks to hedge the currency risk of FCNR deposits (deposits in Indian banks in dollars) with a cost of 3.5% versus market rates of 7% or more, this facility was being considered for a great leveraged return.
The concept is:
- If you as a bank want low hedge costs, you must do a back-to-back swap with the RBI for three years or more (the tenure of the FCNR deposit)
- Then you get to borrow INR at 3.5% a year to get back the same number of dollars back. The interest rate is embedded in the swap. So you sell the RBI 1 million dollars at Rs. 62.639 on 23 Sep 2013, and buy back the 1 million dollars at 70.4419 on 9 Feb 2017 (in the above example). The buy-back rate is basically a 3.5% interest per annum, compounded every six months.
- This is awesome for the bank. They offer something like 4.95% per year, for three years; they get the hedge at 3.5%, and the effective cost of the deposit is about 8.5% (lesser if you consider that banks could charge some fee for this).
But if the deposit should want an early withdrawal, then what happens? The bank has to do a reverse transaction for the rest of the time of the swap. Effectively the bank buys dollars from the RBI on the early termination date and does a forward to sell back those dollars at the original maturity date, thus effectively reversing the transaction.
In the above example the inverse cost for the dollar buy is 3.5%+4% penalty for the reverse leg (for the period of the deposit already completed) and then 7.4% as the market rate for the remaining period. This is again embedded in the rupee cost on the buy transaction.
Forget the calculations - they can be complex. In the above example:
- Bank gives RBI $1 million, gets Rs. 62.639 million.
- After 756 days there is an early termination (let’s assume its a single deposit)
- Bank has invested the money at, say, 10% per year. After 756 days, the bank now has Rs. 76.31 million.
- But the bank must pay Rs. 84.361 for a dollar according to the inverse swap shown.
- So the bank gets back only $0.905 million.
That means the early withdrawal not only ate up all the interest, it ate up about 10% of the principal as well!
That’s a fairly high cost, and the bank will pass it on to the borrower.
If a customer sees a 10% prepayment penalty (plus loss of interest), the attractiveness of the product will go away.
But you say, why can’t you just stick with the product for the maturity period, instead of exiting early? Answer: because you may have other options. If US interest rates go up, there might be a great opportunity to invest elsewhere with a similar product, and get 6% or 7%. Or, you might need the money - the lock-in cost is simply too high.
Kotak is already charging for early termination:
This should make the deposits unattractive for the 3 year or higher period. But given that the dollar has now fallen to Rs. 61.77 from the 68 levels, this product will die a quiet death.