A Rs. 1,580 crore “oopsie”
Welcome to this week’s edition of TOPICAL WEDNESDAY! This week, we will try to understand the recent mess that came out of Induslnd bank. I think some you were already expecting it. So here we go…
IndusInd Bank, the fifth-largest private bank in India, somehow managed to “misplace” ~Rs. 1,580 crore through accounting discrepancies in its derivatives portfolio! That’s right, a bank that handles billions in transactions daily somehow couldn’t properly track its own money!
This news broke on Monday, and by Tuesday morning, the market delivered its swift and merciless verdict: IndusInd’s stock plummeted a jaw-dropping 27%, hitting a 52-week low of Rs. 656 per share and wiping out more than Rs. 18,000-19,000 crore in market value faster than you can say “accounting error.” Investors are now asking the million-dollar question: “How could the brilliant minds of such a large bank miss this, and how can an investor even safeguard him/herself against such an event?“
If you learn how this actually happened, you’ll be left equally stunned. It’s like discovering your financial advisor has been using a Magic 8-Ball to manage your retirement fund! And the timing couldn’t be worse – just when banks are scrambling to attract deposits in the busy March quarter!
So, dear readers, today we’ll try to understand how this derivatives disaster unfolded…
All these banking functions involve a lot of jargon like swaps, MTM, derivatives, liquidity stress, etc. (which might sound highly technical but aren’t really). Let’s break it down in simple terms.
What Actually Happened?
Imagine you’re running a household budget, and suddenly you realize you’ve been miscalculating your savings for years. That awkward moment just happened to IndusInd Bank, except their miscalculation involved a cool Rs. 1,500-2,000 crore.
So, what happened was that the bank made a mistake in how it tracked some of its “financial safety nets” (derivatives). These safety nets are like contracts that lock in prices or interest rates to protect against future risks. For example, if you take a loan with a floating interest rate, you might buy a “safety net” to fix your payments, so they don’t go up if rates rise. Pretty smart!
But IndusInd Bank used two different methods to track these safety nets:
1. External Safety Nets (Managed by Other Banks/Companies)
Updated Daily: These safety nets were part of trades with other financial institutions. They were updated daily to reflect current market prices, which means their values were adjusted daily.
Real-World Prices: This daily update ensured that the bank’s financial reports accurately reflected the current market situation. It’s like checking your stock portfolio every day to see how much it’s worth.
2. Internal Safety Nets (Managed by Indusind Bank)
Not Updated Regularly: These were internal trades or hedges that the bank used to manage its own risks. However, unlike the external safety nets, these were not updated regularly to reflect changing market conditions.
Stale Valuations: This meant that the bank’s internal safety nets were valued based on outdated prices, leading to discrepancies between what was reported and the actual economic reality. It’s like still using last year’s stock prices to calculate your portfolio’s value today.
Over time, the values of these two types of safety nets drifted apart, like two clocks showing different times. The bank didn’t notice this mismatch for years, leading to a Rs. 1,500–2,000 crore error (2.35% of its net worth).
Why Did This Happen?
Outdated Rules for Tracking Safety Nets – The RBI updated its rules in April 2024 to ensure banks handle their financial safety nets (derivatives) more transparently. These rules require:
- Equal Treatment of Gains and Losses: Banks must report both profits and losses from derivatives equally, without hiding losses.
- Same Valuation Method: Banks must use the same method to value both internal and external derivatives.
Why IndusInd Struggled:
Problem 1 – They used long-term contracts (like 8–10 year USD swaps) that are hard to value because they’re not commonly traded. It’s like trying to price a rare painting, there’s no clear market value.
Problem 2 – They didn’t update the value of these contracts regularly (no “mark-to-market”), so losses accumulated without being reported.
Confusing Safety Net Designs
IndusInd Bank’s internal safety nets didn’t match their external ones. This is because the bank’s internal safety nets were designed differently from their external ones. This mismatch meant that some risks were not fully covered, leading to unexpected losses.
Example: Imagine buying insurance for your car that only covers accidents for the first 8 years of a 10-year loan. If you have an accident in the last 2 years, you’re not protected. IndusInd faced a similar situation with its derivatives.
Weak Checks and Balances
This error went unnoticed for 7–8 years because:
- Audits Missed It: Regular audits failed to catch the discrepancy between internal and external derivatives.
- Outdated Systems: The bank’s systems were not advanced enough to detect these issues. It’s like trying to solve complex math problems with a basic calculator instead of a excel.
Why This Was a Problem – The lack of strong internal controls meant that the discrepancy wasn’t caught until much later, allowing it to grow into a significant issue.
Real-World Example – Summarising the Situation
Let’s say you borrow Rs. 1 lakh at a floating interest rate (which changes yearly). To protect yourself, you buy a “safety net” (derivative) that fixes your rate at 8% for 5 years.
Good Scenario: If rates rise to 10%, your safety net saves you ₹2,000/year.
IndusInd’s Mistake:
- They used two safety nets: one external (tracked daily) and one internal (not tracked).
- Over time, the external safety net showed losses (due to rate changes), but the internal one stayed unchanged.
- The bank ignored the losses on the internal safety net, making their profits look higher than they were.
This means that due to such a management mistake, the bank’s net worth was higher by Rs. 1,577 crore. This will be corrected in the future, which will affect its performance temporarily in Q4FY25.
This means that due to such a management mistake, the bank’s net worth was higher by Rs. 1,577 crore. This will be corrected in the future, which will affect its performance temporarily in Q4FY25.
What’s Next?
The bank is fixing this by:
Stopping Internal Safety Nets: They’ll only use external ones that are updated daily.
Regular Checkups: Hiring external auditors to avoid future errors.
Simplifying Contracts: Using shorter, simpler safety nets (e.g., 2–3 years instead of 10) that are easier to value.
Closing Thoughts
This was like a shopkeeper forgetting to track half their inventory—eventually, the mismatch catches up. For IndusInd Bank, better rules, simpler tools, and stricter checks will prevent this from happening again. But the lost of confidence in the bank will be a bigger blow to the investors of the company.
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Disclaimer: This newsletter is for educational purposes only and is not intended to provide any kind of investment advice. Please conduct your own research and consult your financial advisor before making any investment decisions based on the information shared in this newsletter.
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