Banks are not allowed to participate in the Indian commodity derivatives markets. Such non-participation of the most important financial institution of the country – banks – is an important missing link in the evolution of this market in India.

While much has been talked about in various contexts recommending banks’ participations, the latest Report of a Finance Ministry committee suggesting steps to fulfill the objectives of price discovery and risk management in the commodity derivatives market, says: “… One way to reduce the cost of capital for the commodities trader is, to make banks … an integral part of trading in commodity derivatives.”

It is a fact that there are regulatory restrictions on part of banks too that restrict their participations in commodity futures markets. But, the fact remains that their participation in commodity exchanges is a win-win situation for all: it helps the banks, it helps commodity markets,and in the process, it helps the economy as a whole.

Risk management platform While the above-mentioned report recognises that banks’ participations in the commodity derivatives market will contribute to the depth and width of the market, what this process also contributes to is the availability of an unparalleled risk management platform for the banks themselves, as banks also need to manage risks arising from commodity price volatility.

Thanks to globalisation of the Indian economy and business expansion of Indian banks, their exposure to rising commodity price volatility is significantly high – 19 per cent according to some estimates made in 2011-12. Yet, while banks have been allowed to manage other risks in their portfolios, they do not have any mechanism to hedge commodity price risk in an effective and transparent manner, barred as they are from entering the commodity derivatives market.

Intermediation, aggregation Further, banks can act as intermediaries and aggregators, facilitating the risk management actions of farmers and other small players who on their own may find considerable barriers to enter this market. World-over, there are examples galore on banks’ participation in exchange-traded commodity derivatives market on behalf of farmers, enabling the latter manage risk exposure better and increase their incomes.

Mention may be made of Rabobank’s intervention in Tanzania and Nicaragua and Banco do Brasil’s intervention in the Brazilian agricultural market through issue of exchange-traded Cedula Producto Rural contracts. Many of these interventions are made through designing and offering customised hedging solutions fulfilling the requirements of farmers.

Besides, by aggregating small participants, banks enable even small farmers to reap the benefits of hedging. On a similar note, the non-farm sector, especially the small and medium enterprises, too can be a significant beneficiary of the commodity futures market, which can be increased manifold by the facilitative role provided by banks.

Releasing scarce resources At the micro level, with a comprehensive risk management policy that encompasses commodity price risks, banks’ financial and human resources can be freed to cater to more important strategic functions. Under the evolving international regulatory regime where norms on credit and provisioning are increasingly being linked to risk assessment of banks’ portfolios, hedging against commodity price movement will actually contribute to freeing of financial resources – enabling not just achievement of priority sector targets for Indian banks, but also their overall business expansion.

Through focused deployment of appropriate credit products, these developments could, at the macro level, go a long way in smoothening and quickening the credit cycle, thereby enhancing productivity of credit.

Better liquidity, hedging From the commodity market’s perspective, banks’ participation will help in providing the market with the much-needed long-term traction. This will help the long-term hedgers’ participation on the one hand, by reducing the overall costs of transactions (including the impact costs), and will help enhancing the hedging efficiency. There has often been a complaint from large corporates about lack of long-term traction in the Indian comexes, which inhibit their hedging efficacy. Banks’ participation will help ameliorate that concern.

A “Pareto” Improvement Here lies the “Pareto” improvement through banks’ participation in Indian comexes. On the one hand, it will be in the interest of banks’ own sustainable growth.

On the other hand, it will help them achieve the goal of inclusive growth through market inclusion of millions of commodity producers. Thus, banks’ participation in the commodity derivatives market does not stand as a policy option; it is a fundamental economic need of the day that is long overdue.

(The author is Chief Economist of Multi Commodity Exchange of India Limited. Views are personal)