Because the Little Indian Securities Scam may have been caused by the central bank's inefficient systems.

By Gautam Chakravorthy

It was a terse, late-evening telephone call from the Reserve Bank of India's (RBI) Public Debt Office (PDO) on June 12, 1998, that curtly warned the Treasury Department of Credit Agricole Indosuez (Credit Agricole) that it had erred in its dealings in government securities. Although the startled managers of the French bank immediately began working the phones to defuse the crisis, at 8:45 p.m., when the call came, most offices had called it a day. So, Credit Agricole (1996-97 deposit-base: Rs 771 crore), for the first time, failed to convince the central bank that its transactions had actually been above board.

The next morning, the RBI summoned the senior managers of the bank (BT Best Banks 97 Rank: 59) to inform them that the bank had been suspended from participating in any transactions in government securities. Naturally, this order put the bank's other dealings under a cloud too. Four days later, fearing that the government securities market could turn jittery, the RBI, on June 16, 1998, quietly placed the suspension "in abeyance." And, a fortnight later, the central bank revoked its order. Confirms William Roberts, 43, coo, Credit Agricole: "There was a suspension letter issued by the RBI, which was later withdrawn."

Who was the culprit in this Little Indian Securities Scam? Credit Agricole? Or the RBI? BT investigates the episode to pinpoint why the central bank went back on its suspension-order, and allowed Credit Agricole to wriggle out of a tight situation.

THE DEAL. It all began on June 9, 1998, when Credit Agricole entered into a repurchase (repo) transaction of Rs 40 crore with the Securities Trading Corporation Of India (STCI), a primary dealer in government securities. This deal envisaged the foreign bank buying back the securities it had sold on June 9, 1998, at a pre-determined price on June 12, 1998. Since Credit Agricole expected to receive the securities that day, it entered into another repo deal on June 12, 1998, with the Discount Finance House of India (DFHI).

Technically, there is nothing wrong with such back-to-back deals. Every bank aggressively churns its holdings in government securities to earn extra profits. After all, it does not make business sense to block 35 per cent of your funds in government securities--as statutorily required to maintain the Statutory Liquidity Ratio (SLR, 25 per cent) and Cash Reserve Ratio (CRR, 10 per cent) requirements--whose yields range between 4 per cent and 11 per cent per annum. Not surprisingly, in 1996-97, repo deals constituted 23.60 per cent of the total transactions (Rs 1,22,942 crore) in government securities and treasury bills. And many banks use their portfolios to arbitrage between the foreign exchange and money markets too.

In the recent past, while the call money rates have remained depressed, at 5-6 per cent, the forward premia on the dollar has been hovering at 10 per cent. Thus, it makes sense for a bank to enter into a repo deal--in which the repurchase price of the securities sold is linked to the call money rate--to access liquid cash. And use that money to buy dollars at spot prices, and sell them at a higher price in the forward market. Consequently, the difference between the call money rate--at which the bank borrows--and the forward premia in the foreign exchange market--the bank's gains--is booked as profits.

On its part, the RBI allows such deals as long as the banks maintain their SLR and CRR requirements at the end of every day, and it does not lead to speculation in the foreign exchange market. Thus, Credit Agricole's repo deals were struck purely to take advantage of the arbitrage potential. But the problem arose during the transfer of the securities by the DFHI in its account at the RBI's PDO, which maintains a record of transactions in government securities as also the balance in each bank's account.

On June 12, 1998, the PDO discovered that Credit Agricole did not have enough securities of the same nomenclature in its account to sell to the DFHI. Obviously, the bank had failed to transfer the securities it had sold to the STCI on June 9, 1998, to its account. That resulted in a violation of the rules on 2 counts. One, the RBI guidelines outline that no bank can sell securities unless it has a balance in its account. And two, no bank can sell securities which have not been transferred to its name. This is frowned on by the central bank since it is tantamount to the short-selling of securities by a bank.

THE RESCUE. Given the nature of the violations, the RBI, probably, had no option but to suspend Credit Agricole from dealing in government securities. This, however, led to complications. First, the DFHI could default if it had entered into another deal to sell the same securities to a third party. Fortunately, that was not the case. Second, Credit Agricole could default on its CRR requirements as on June 12, 1998, if the DFHI failed to pay the bank. And third, the STCI was likely to default if it did not receive the dues from Credit Agricole. Indeed, the STCI was forced to borrow from the call money market to fulfil its commitment to 2 other parties that day.

The day was partly saved by the DFHI's decision to extend notice money--credit given to a party for over 2 days without receipt of the corresponding securities--to Credit Agricole. Explains a senior dealer with the DFHI: "We gave the notice money since the rate was good, and we wanted to bail out Credit Agricole." But that still did not solve the STCI's problem since the RBI's order did not allow the second leg of the repo transaction--the repurchase of the securities--between Credit Agricole and the STCI to be concluded. As the deal never took place, there was no way Credit Agricole could pay the STCI for buying back the securities on June 12, 1998.

Not surprisingly, it was the RBI which had to resolve the issue. Its abeyance order allowed Credit Agricole to resume its dealings, and enabled the STCI to enter into a fresh transaction, extending the earlier 3-day repo deal to 7 days.

THE CULPRIT. Did the RBI issue the abeyance order to protect the DFHI--an innocent victim--or to cover up its own deficiencies? Quite simply, the latter. Ever since the Rs 5,000-crore Great Indian Securities Scam in 1992, the RBI has changed its system of manually settling transactions in government securities. Three years ago, the Delivery Versus Payment system was introduced, whereby the banks and the primary dealers must submit a form to the RBI detailing their purchases every day. Based on that, the PDO debits or credits the Securities General Ledger (SGL) account of each bank.

Although this new system is years ahead of the old manual one, it still has several lacunae. First, the forms have to be deposited every day with the PDO. This entails each player spending hours filling it up, detailing each transaction, and then standing in a queue at the PDO to submit it. Second, all transactions have to be submitted before 2:30 p.m. each day. Finally, the forms are vetted, and the SGL accounts are debited and credited on a first-come, first-served basis.

Clearly, there are chances of the forms detailing a bank's--or a dealer's--sale transactions being presented before another set of forms comprising its purchase transactions. In such cases, unless the bank has a surplus in its account, it is likely to register a default. Many banks have regularly defaulted in the past on this count. Even the RBI allows them some leeway, and resorts to punitive measures only if a player has defaulted more than 3 times in the last 6 months.

On June 12, 1998, Credit Agricole was on the rack only because the DFHI's form to buy securities from the bank was presented before Credit Agricole's form detailing its purchases from the STCI. To avoid the RBI's charges of violations, most banks maintain a gap of at least 1 day before reselling the securities they have purchased to a third party. That was where Credit Agricole went wrong since it sold the securities on the same day to the DFHI.

However, the RBI obviously needs to upgrade its system to tackle these transactions. Indeed, the central bank plans to introduce a Real-Time Gross Settlement System, in which the PDO can instantly monitor the balance in each SGL account as transactions are concluded. Until that happens, however, the banks will have to be more careful in their dealings in government securities if they are to feel secure. Thankfully, Harshad Mehta hasn't forged a French connection.

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