IndusInd Bank shares recovered on Wednesday after falling to its lowest level in one year as investors were reassured by statements made by its promoter Ashok Hinduja and CEO Sumant Kathpalia. The shares of the private sector lender had crashed by 27% on Tuesday after the bank disclosed discrepancies in accounting for foreign currency derivative trades over a period of five to seven years.
The private sector lender expects to take the impact of these discrepancies–about 2.35% of its net worth–in the fourth quarter results, yet report a small profit. The bank has estimated the loss on derivatives trade at ₹1,520 crore net of taxes and ₹1,970 crore at the gross level.
The discrepancy in accounting for derivatives was not the only setback for IndusInd Bank investors in recent days. The Reserve Bank of India approved only a one-year extension of the term of its CEO against three sought by the board.
Mint explains what led to the discrepancy in accounting and corrective measures taken by the bank.
What was the genesis of the problem?
What was the genesis of the problem?
Like all banks, IndusInd Bank receives deposits in foreign currency. These include remittances and receipts such as borrowings by institutions. They also offer loans denominated in foreign currencies. As the bank management has explained in various interactions since it revealed the accounting discrepancy, when a deposit is received, the bank has to take a decision on whether it will hold the receipt in foreign currency such as US dollar or convert it into Indian rupees. If the foreign currency is converted into Indian rupees, it is hedged for the entire tenor of the deposit.
Some of these deposits will be withdrawn at a later date for repayment of loans, investments, etc. As the foreign exchange market is volatile and value of currencies fluctuate with changes in the global economy, banks usually enter into hedging contracts for these deposits and borrowings to ensure that they do not make a loss when withdrawals and repayments are due. Hedging is done using derivative products such as currency swaps.
Most banks, as a practice, use external agencies for hedging but that was not always been the case at IndusInd Bank. It used internal trades for instruments that had low liquidity in the external market such as 3-5 year yen deposit or an 8-10 year dollar borrowing from a multilateral agencies. The bank was following this process since the inception of its derivatives desk about seven years ago.
When the bank had to convert such foreign currency deposits into Indian rupees, it internally hedged the amount by entering into derivative contracts with its trading desk. The trading desk then hedged this exposure externally in the market.
How did the discrepancy arise and how was it detected?
External trades and internal trades are valued differently. The external trades are marked to market, and internal trades are at swap valuation. The management explained that these two legs would vary during the period of the contract but converge on the maturity of the instrument. The problem arose when there was an early termination of a contract due to repayment obligation as the bank accounted for profits on external derivative contracts, but losses on internal trades were not considered. This boosted the bank’s net interest income over the years while suppressing losses on derivative trades. The bank’s management disclosed that there were several borrowings which were repaid for which internal trades were unwound but not recorded appropriately.
This discrepancy in recording profits and losses from currency derivative trade continued until April 2024, when a September 2023 circular of the Reserve Bank of India prohibiting internal trades came into effect. All internal trades have since been unwound.
The discrepancy was detected when IndusInd launched an internal review of its derivatives books to ensure compliance with RBI requirements. The estimated loss ( ₹1,520 crore net of taxes) pertains to transactions carried out over seven years until April 2024.
What action has the bank taken so far?
Soon after the bank detected this discrepancy in September-October 2024, it appointed an external agency to review its derivative accounting process, validate its estimate of losses, and get assistance in adopting processes that are in compliance with all the regulations. The board of the company and investors were informed on 10 March as is required under the Securities and Exchange Board of India’s listing regulations. It has also submitted two reports on its findings to the RBI.
Further, after unwinding internal trades, it entered into hedging contracts with external agencies for all transactions where foreign currency is converted into Indian rupees.
Should investors be worried?
The management has tried to reassure investors over the past couple of days. The CEO has said the bank will take a one-time hit from these losses, which most likely will be seen in the fourth quarter results of the current financial year. He has also said that the bank will continue to be profitable and it will be back to business as usual in the coming financial year. The promoters have pledged support, including additional capital infusion if required. The CEO claimed that the management does not see a need for fresh capital infusion for the next four quarters.
“If there is a sharp improvement in financials, particularly with better asset-quality performance in the MFI portfolio, it could help mitigate the current concerns,” said analysts from Kotak Institutional Equities. “In addition, if there are fewer worries on deposit growth and adequate liquidity available for growth, investors might eventually view this event as a less significant error,” the report added.
Meanwhile, RBI is reviewing the derivatives exposures of some private and state-run banks, seeking details on their overseas borrowings, deposits, and forex hedge positions, following IndusInd Bank’s disclosure, sources told Reuters.
