Inside IndusInd Bank: Was It Really A Derivatives Disaster?

Around 6:30 p.m. on March 10, private sector lender IndusInd Bank Ltd. told exchanges that it had discovered some discrepancies in its derivatives account balances. The bank said that these were found during a review of its “other asset and other liability” accounts of the derivative portfolio, after the implementation of a central bank circular.According to the bank, the discrepancies would result in a 2.35% impact of IndusInd Bank’s net worth as of Dec. 31, 2024. On a back on the envelope calculation, this number worked out to around Rs 1,500 crore.Shortly after, at 7:15 p.m., the bank hosted an analyst call where it tried to answer analyst queries. The call was hosted by Sumant Kathpalia, chief executive officer and managing director, Arun Khurana, deputy CEO and Indrajit Yadav, head of investor relations and strategy. To be sure, Khurana is also in charge of the bank’s treasury department and the chief financial officer function.Analysts on the call quizzed the management on various aspects of this discrepancy. What part of the balance sheet does this impact? How and when did the bank find this? When will the impact be accounted for? Why did auditors not catch this? Analysts asked these questions and more.The management tried to respond to all, leaving more questions than answers.NDTV Profit's checks with former and existing IndusInd Bank officials, former regulators, senior bankers leading large trading books and experts in the foreign currency operations points to the possibility of an alternative reality. Queries mailed to IndusInd Bank on Thursday did not yield any responses..No, Your IndusInd Bank Deposits Are Not Under Stress.During the conference call on March 10 and a subsequent media interview, CEO Kathpalia and Deputy CEO Khurana tried to explain the issue. To analysts, Khurana explained that whenever the bank contracts foreign currency borrowings or deposits, it may choose to do two things. First is hold the foreign currency deposits as it is, where no hedging against currency risk is required. Under the second option, the bank converts these liabilities into rupees for lending in India. "If it is converted into INR, it is hedged for the underlying tenor. So that way, we were hedged all the time," Khurana explained. In transactions involving long term foreign currency borrowings, the bank would perform something known as an "internal trade". Unwinding this is what led to the large loss, he explained. To understand this better, let’s assume that the bank has contracted borrowings in a foreign currency, e.g. Yen, for five years. The bank could deploy these in foreign currency lending operations, but such options are limited. So, the bank decides to convert its Yen holdings to rupee liabilities and deploy in local lending operations.In such a scenario, the bank has to undertake two levels of transactions. First is the internal trade where the asset-liability desk of the bank swaps the foreign currency for rupees with itself. This is referred to as an internal trade, as the bank is the counterparty on both ends of the swap. .IndusInd Bank Comes Under NSE’s Short-Term ASM Surveillance After Derivatives Loss Disclosure.Once swapped, the bank accrues daily cost on the underlying liability in an interest cost account, over the duration of the liability. This cost is therefore on an accrued basis, not marked to market. The bank also earns interest income on the local lending, which gives it a net positive interest earning. Interest earned on rupee loans is higher than interest paid on foreign borrowings.But, of course the bank has a foreign currency liability to repay at a later date—five years in our example. To protect itself against foreign exchange fluctuation in the interim, the bank asks its trading desk to hedge its position. This leg, or the external trade, is however marked to market and adjusted accordingly. Even though the internal and external costs are different initially, they negate each other by the time the underlying liability matures.The problem occurs when the liability gets redeemed before its planned maturity date. In such a scenario, there is now no underlying liability against the external trade, creating an open position for the bank. The bank is required to unwind the entire transaction and account for whatever loss they have faced. This means you stop daily accrual of interest cost on the borrowing, the accrual of the interest differential earned on the domestic lending and record the swapped cost on a mark-to-market basis..IndusInd Fiasco Impact: RBI Seeks Compliance Reports From Banks On Foreign Currency Borrowings.In IndusInd Bank's case, this is where the bank's systems seem to have failed. According to a person in the know, the bank did not fully unwind the internal trades, continuing to accrue interest differential on a daily basis. Had the transactions been thoroughly unwound, the loss would have been adjusted over time, not adding up to a large number in a single quarter, this person said.This is likely a breach of long standing accounting principles, the person said. The reporting of financial gain or losses from such transactions were not up to code. This is also not a derivatives problem, but one of faulty balance sheet management, this person added..The bank was quick to blame RBI's September 2023 master circular on investment portfolios of banks for the gap to have occurred. This seems like a complete red herring though. According to a former central banker, the master circular is just a combination of existing rules, put together in one document for more clarity for regulated entities. They bring no new rules on accounting standards. In fact, accounting in the trading book or otherwise are governed by various rules set by the Institute of Chartered Accountants of India, the accounting standards of India. These have been in place since the early 2000s. For the bank to say that RBI's master circular forced them to unwind existing internal trades leading to the loss, does not sit right. Most likely, the imbalance in the interest accrual account added up to a large number, which IndusInd Bank could no longer carry forward, the former central banker said. The first person responsible for catching this would be the chief financial officer of the bank. On Jan. 21, 10 days before the bank was set to disclose its third quarter results, IndusInd Bank CFO Gobind Jain resigned from the bank. In his resignation letter, Jain highlighted that he was keen to pursue other opportunities outside the bank or with the promoter group.Jain has told the RBI about these discrepancies and the situation at the bank, a person aware of the developments said. This was done soon after his resignation was accepted by the bank. Typically, the regulator conducts an exit interview with key managerial persons after they resign from a bank or large non-bank.According to IndusInd Bank, Jain's term would end on April 17, after he serves his 90 day notice period. This means that Jain continues to remain in the system, while the disclosures are being made. Khurana was given additional charge of the CFO function in January.So currently, the trading and the finance teams both report to the same person, which is typically avoided in most banks, a senior official at IndusInd Bank said. .In This Economy… IndusInd Bank’s Derivative Discrepancies Shake D-Street.The cohort of auditors are also to blame here. In the March 10 call, Kathpalia explained to analysts that four types of audits are typically conducted. A concurrent audit, an internal audit, a statutory audit and RBI audit.How is it that such a large gap in the balance sheet went unnoticed for so long? All foreign exchange trades and positions on the balance sheet are fully recorded on a central system by the treasury and finance department. It is not possible for a bank to not already know that it holds a risky position at any given time, the official said.It is likely that the bank was aware of the scale of the issue much before they claimed to know it. The disclosure on March 10 was prompted by the RBI, the official quoted above said.The banking regulator on Saturday issued a rare clarification after questions about depositor safety were raised. RBI said that IndusInd Bank depositors need not react to speculative reports about the bank.However, the RBI also clarified that it had advised the board and the management of the bank to make due disclosures and take remedial measures on the accounting issue in the current quarter. .IndusInd Bank Faces Target Price Cuts As Credibility, Earnings Troubles Emerge.Over the analyst call, Kathpalia explained that IndusInd Bank "observed some discrepancies in accounting of some of the trades, which was identified by September and October 2024". This was right before the eight-minute mark on the call. Remember the timing, because it comes into play later.Soon after, the bank started an internal review in the matter and informed the regulator about it. The bank had also appointed an external agency to validate its internal findings. People in the know said this agency is PwC.The report by this external agency would be submitted soon and the bank would disclose the full information along with its January-March quarter results or "maybe prior to results itself", Kathpalia told analysts.Later, analysts asked the bank to clarify why the findings were not made public during the October-December quarter results. To this, the management said that it had no updates available at the time. Third quarter results were announced by the bank on Jan. 31. Surprisingly, Kathpalia, past the 24-minute mark, said something different about the timing of when the discrepancies were found. "We never had a gap and there were so many audits which have gone through. It's just that we realise it now over a period of last one or two months, and I said that once it started coming in."Interestingly, over the March 10 analyst call and later clarifications in media interviews, while the management said that it had decided to come out in public with its findings on its own, the regulator had a different take. "The board and the management have been directed by Reserve Bank to have the remedial action completed fully during the current quarter viz., Q4 FY25, after making required disclosures to all stakeholders," RBI said in a statement on Saturday, while also assuring depositors that their deposits were not at risk..Accounting Discrepancies: ICAI May Review IndusInd Bank's Books.RBI, on its part, has started a review of system-wide foreign currency borrowing positions, by asking lenders to submit a compliance report. The report seeks clarity on whether all banks are following long held accounting principles on such borrowings.The Securities & Exchanges Board of India is reviewing the delay in market disclosures and the curious sale of shares by Kathpalia and Khurana. Last year, both sold nearly 80% of their holdings in the bank when the share price was trending about Rs 1,500 apiece. The bank’s shares have since remained under a cloud owing to disclosures of microfinance losses during this financial year.The ICAI may also look at non-compliance with accounting norms, according to people with knowledge of the matter.Will the bank be forced to recognise any other skeletons in the closet? That will become clear when the bank reports details of the PwC audit report. .Banking Valuations Attractive, IT Growth Still Uncertain, Says Franklin Templeton's Ajay Argal

Inside IndusInd Bank: Was It Really A Derivatives Disaster?

For the bank to say that RBI's master circular forced them to unwind existing internal trades leading to the loss, does not sit right.

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