The BoB request follows the emergence of negative spread on its FCNR(B) funds. Spread on FCNR(B) funds have turned negative for banks following the drying up of domestic demand for FCNR(B) loans as well as the interest rate cut in the United Sates. While the average cost of FCNR(B) funds for banks is in the region of 5.5 per cent, the interest rate on US treasuries and six-month Libor, the major avenue for deployment of FCNR(B) funds, is around 5 per cent. On the other hand, blue-chip Indian papers are available at attractive spreads of over 400 basis points above Libor.

Many Indian banks have already routed their FCNR(B) funds to the lucrative Indian overseas corporate paper market by taking advantage of a loop-hole in the Reserve Bank rule on FCNR(B) funds investment. They have skirted the RBI rule by lending to their overseas branches-- which in turn-- invest the borrowed fund in Indian papers abroad.

The overseas branches of Indian banks are free to invest their funds in Indian corporate paper and need to adhere only to banking rules of the host countries. This way, even though the bank will have to book a loss on its FCNR(B) funds, it gains ultimately on a net basis by higher profits from its foreign operations.

Even large banks like State Bank of India (SBI) and Bank of India (BoI) have reportedly routed their FCNR(B) funds to Indian corporate papers through their overseas branches. BoB has sought the RBI permission in order to get clarity on the issue as investment in corporate papers via overseas branches goes against the spirit of FCNR(B) investment rules.

The maximum maturity of FCNR(B) deposits with banks is three years, while the investments in Indian corporate paper is highly illiquid and of longer maturity. Investment of FCNR(B) funds in Indian corporate paper would require high level of asset liability management skills. Balancesheet size of Indian banks' international operations will have to be really big for them to service any large scale redemption calls of FCNR(B) deposits, said a banker. This may restrict the size of FCNR(B) funds that banks may invest in corporate paper, he said.

The total size of FCNR(B) funds with banks is $8.46 billion as on March, 1998. Since then the FCNR(B) corpus has not grown much further. In fact, it had fallen a little due to the shift to Resurgent Indian Bond issue in August. SBI has the largest FCNR(B) corpus amounting to more than $3 billion followed by BoB and BoI.

State Bank of India had been picking up Indian papers abroad at spreads of over 400 basis points since the beginning of 1998. The spread on Indian paper is still very high due to the low interest on emerging market papers as well as the desperate sales by Japanese banks following trouble at home. Japanese banks were one of the biggest lenders to Indian companies till a year back.