To explain the issue at hand, let me borrow the definition of banking as it stands in the statute book. According to the Banking Regulation Act, 1949, banking is defined as 'accepting deposit of money from public for the purpose of lending or investment.'

In short, banking is simply taking money from one as deposit and lending to other.

But this definition was drafted during innocent times. And times have changed, perhaps drastically, so much so that 'modern banking' is beyond comprehension of even qualified finance professionals.

For an outsider it would seem that most of these modern, second-generation and private sector banks in India are behaving like casinos.

In fact, should they not carry out these titillating activities they can never add the appellation 'modern' or for that matter 'second-generation' to their brand equity. Such is the imperial demand of the modern times. Moreover, anyone who has a contrary view is instantly labelled as primordial by the beneficiaries of this system.

I hope that readers realise that like drug peddlers encouraging users of drug by providing easy and cheap drugs, some of these banks have lured corporates in India to enter into what is popularly called 'exotic derivative contracts.'

As I understand from corporate India and my fellow professionals, the bait was first to 'allow' these corporates to make easy money in the first few transactions entered by the banks with the corporates.

Corporates, emboldened by such initial success, recklessly began to take bigger bets. And when their bets went awry, they were stuck with massive losses. However, it may be interesting to note that banks may not end up with the concomitant profits. And that is the crux of the issue.

This piece essentially seeks to explain the latest threat by our baking sector to our corporates and by our corporates to our banks.

How these exotic derivatives work

Let me illustrate the situation through a hypothetical contract entered into by a corporate and a bank. Let us further assume that these contracts are entered on January 1, 2007 for a year when the corporate 'notionally' agrees to sell Euro for purchasing US $5 million, that is, without any compelling need for the corporate to purchase US dollar. Nor does it have any Euros to sell. Yet the contract is entered into.

Further, we assume that the Euro was equal to $1.30 in the spot market on the day of the contract.

These contacts usually have a 'knock out' clause. That is, if the US dollar appreciates to say 1.27 against the Euro, the bank would pay the Indian corporate, say, a sum of $10,000 and the contract would come to an end.

Similarly, if the US dollar depreciated to 1.33 against the Euro, the corporate in turn would pay the bank a sum of say US $15,000. But this is with a crucial distinction -- the contract would not come to an end and it would continue even as the US dollar depreciates against the Euro.

Now to the third part of the contract -- this is the killer -- and this is called 'knock in.' Should the US dollar depreciate against the Euro to 1.40, the corporate would have to pay $5 million multiplied by 1.40 less a predetermined rate of say 1.20. (why 1.20 is again a story in itself -- but to put it briefly, it is an arbitrary figure).

Readers may note that, in the above instance, the corporate would have to pay twenty cents for every one US dollar contracted, which works out to $ 1million. And that is not all. Should the US dollar appreciate to above 1.40 and once again depreciate, the corporate would have to pay the above sum every time the dollar breaches the 1.40 mark!

And on January 1, 2008, this notional contract is reversed at the prevailing rates between US dollar and Euro. It may be noted that the above is merely illustrative of the financial engineering attempted by both parties. Needless to emphasise it does have numerous variations and attendant complexities.

Even Shylock would not have made such a skewed contract. And if one is still unable to comprehend this issue, let me remind one of the childhood board games, 'Monopoly.' Modern banking is merely an adult version of the same with two important variations -- the players need to have formal qualifications and the net impact runs into several million rupees, or dollars.

Crucially, this is merely a sample of what goes on in the arcane world of finance. It is indeed a sorry state of affairs to note that the best of minds in India are engaged in surpassing Shylock. Don't all these look farcical especially after the players have cleared tough competitive professional examinations?

Isn't all this an attempt to make money out of thin air?

Where are the regulators?

It may be noted that the Reserve Bank of India [Get Quote] had brought out a circular stating inter alia that such contracts can be entered into by banks only if there is an underlying foreign exchange transaction. This means that only genuine exporters and importers can enter into such transactions based on their legitimate requirement of foreign exchange.

What is being increasingly witnessed is that both the corporates and banks have thrown caution to the winds as banks have not insisted on any underlying contracts. And that has provided a window of opportunity to corporates.

What is interesting to note here is that the outstanding value of all these contracts reported to the RBI by all banks aggregates to approximately $3 trillion as at December 2007. Such a huge amount is inexplicable simply because the total foreign exchange hedging requirement (aggregate of both imports and exports) of the country cannot exceed $500 billion in a year.

And even assuming that all of these are hedged and outstanding on that date (which is unlikely), the figure of approximately $3 trillion suggests that a substantial number of such contracts have been entered into between banks and corporates without any underlying requirement, perhaps merely as a wager.

Since RBI is in the know of these figures, one is not certain whether some of the banks have effectively hoodwinked the RBI or have they taken advantage of some loophole.

Another dimension that requires RBI's immediate attention is that many banks have converted their treasury departments into profit centres and fixed profit targets for the same. This is similar to fixing profit targets for cashiers. And when that happens, it is natural for cashiers to pay you Rs 900 for every Rs 1,000 withdrawn.

No wonder, when such targets were fixed, treasury managers went on an overdrive selling such products to corporates. And this is a serious ethical and corporate governance issue and, to me, remains at the root of the problem.

What has added fuel to the fire is that the US dollar has been consistently weakening against all major currencies across the world in 2007. And banks with foreign exchange experts on their panels have invariably ensured that corporates 'notionally' end up purchasing the US dollar and banks end up purchasing other global currencies.

When the US dollar depreciated against other currencies, corporates found themselves holding the wrong end of the stick. How could banks provide such advice to clients when they were in the know of an impending depreciation of the US dollar?

Naturally, corporates are visited by huge losses. As and when losses are actually booked, in some cases it could wipe out the net worth of corporates several times over. And that is why the banks are worried -- they may not be the beneficiaries of such transactions.

Corporates no less guilty

As events unfold, corporates, especially public companies, (some with independent directors on their boards) are no less guilty. Managements claim that they were completely unaware of these transactions entered into by their own employees. In an astonishing case of self indictment, the management of a public company has even gone on record in an affidavit before a court stating that it was not at all aware of these contracts.

And when pointed out to the fact that they enjoyed the profits from such transactions for the year ending March 31, 2007 (which was taken into account and also audited when the affidavit was filed before the courts), they have claimed complete ignorance -- yes, ignorance coupled with injured innocence -- on the matter.

As the stench from this imbroglio overwhelms us, it is increasingly clear that RBI, the Securities Exchange Board of India, and the Registrar of Companies have lots to answer for.

Playing with other people's money

It does not matter who should be the beneficiary of such transactions: banks or corporates. Either way, it is the common man who is the loser. In case of banks, we lose (as depositors and shareholders). If corporates lose, we (as shareholders) lose.

It is time to realise that both corporates and banks are playing with other people's money. And RBI has to intervene in the matter decisively and at once. It needs to set up a high power committee comprising eminent bankers, lawyers, media personnel, finance and foreign exchange experts to set right the matter.

Allowing the issue to fester any longer would irreparably harm the Indian economy. In any emerging economy, banks cannot turn into casinos or corporates into gamblers.

PS: It is indeed inexplicable that many such contracts have been reported from the southern part of the country, where corporates are supposedly conservative.

The author is a Chennai-based chartered accountant. He can be contacted at mrv1000@rediffmail.com