Explainer: IndusInd Bank derivative loss – what happened and what it means

IndusInd Bank recently disclosed a significant issue in its derivatives portfolio, leading to an estimated adverse impact of 2.35% on its net worth as of December 2024. This disclosure has raised questions about the Bank’s risk management practices and the potential implications for its financial health. Here’s a detailed explainer on what happened, why it happened, and what it means for the Bank and its stakeholders.

What is the Derivative Loss?

IndusInd Bank identified discrepancies in its derivatives portfolio, specifically related to hedging instruments used by its Balance Sheet Management Desk (also known as the Asset Liability Management or ALM desk). These derivatives were primarily used to manage foreign currency deposits and borrowings, converting them into Indian Rupees (INR). The Bank estimates that the cumulative impact of these discrepancies will reduce its net worth by 2.35%.

The loss stems from accounting mismatches in the valuation of internal trades conducted over the past 5 to 7 years. These trades were used to hedge foreign currency exposures, but due to a process flaw, the accounting treatment of these trades led to a material discrepancy.

How Did This Happen?

1. Internal Trades and Accounting Mismatch:
   • The Bank used internal trades to hedge foreign currency exposures, particularly for long-tenor transactions (e.g., 3-5 years yen deposits or 8-10 year dollar borrowings).
   • These internal trades were entered into when there was limited liquidity in the external market. The Bank would take market quotes from multiple sources before executing these trades.
   • However, the accounting treatment of these trades was flawed. While the external trades (used to hedge the internal trades) were marked-to-market, the internal trades were accounted for using swap cost accounting. This led to a mismatch in how gains and losses were recorded over time.
2. Unwinding of Trades:
   • When the Bank repaid some of its foreign currency borrowings, it had to unwind these internal trades. During this process, discrepancies emerged because one leg of the trade was hitting the P&L (Profit and Loss) statement, while the other was affecting the asset book.
   • Over time, these mismatches accumulated, leading to the significant impact on the Bank’s net worth.
3. Regulatory Changes:
   • The issue came to light during a review of the Bank’s derivatives book in alignment with the Reserve Bank of India’s (RBI) Master Direction issued in September 2023. Effective April 1, 2024, the Bank had to discontinue internal trades as per new guidelines.
   • During this review, the Bank identified discrepancies in the accounting of some trades, which were flagged by September-October 2024. An external agency was then appointed to conduct a thorough review.

What is the Financial Impact?

• The estimated impact of 2.35% on net worth translates to approximately INR 2,100 crores in absolute terms.
• The loss will be reflected in the Bank’s P&L statement, primarily through the net interest income (NII) line, as the income from these trades was mostly booked under NII.
• The Bank has stated that its profitability and capital adequacy remain healthy enough to absorb this one-time impact. However, the exact financial impact will be confirmed once the external agency completes its review by the end of the fourth quarter.

How is the Bank Addressing the Issue?

1. External Review:
   • IndusInd Bank has appointed an external agency to review the processes and ascertain the root cause of the discrepancies. The final report is expected by the end of the fourth quarter (March 2025).
   • The Bank has assured stakeholders that the external review will validate the current estimate and provide a clearer picture of the financial impact.
2. Regulatory Communication:
   • The Bank has kept the RBI informed about the issue. A preliminary update was shared with the regulator last week, and a final update was provided after the Board meeting.
3. Process Changes:
   • Effective April 1, 2024, the Bank has discontinued all internal trades and now only conducts external trades with market counterparties for hedging its foreign currency exposures.
   • The Bank has also implemented stricter controls and processes to prevent similar issues in the future.

What Does This Mean for IndusInd Bank?

1. One-Time Impact:
   • The derivative loss is a one-time impact and is not expected to affect the Bank’s ongoing business operations or growth trajectory. The Bank has sufficient reserves and capital to absorb the loss.
2. Reputation and Trust:
   • While the Bank has been transparent in disclosing the issue, the incident raises questions about its risk management practices and internal controls. The Bank will need to reassure investors and stakeholders about the robustness of its processes going forward.
3. Regulatory Scrutiny:
   • The RBI is already aware of the issue, and the Bank has been proactive in communicating with the regulator. However, this incident could lead to increased regulatory scrutiny in the future, particularly around treasury operations and derivative transactions.
4. Leadership and Governance:
   • The Bank’s CEO, Sumant Kathpalia, has been given a one-year extension instead of the usual three-year term. While he has stated that this is unrelated to the derivative loss, the incident could have influenced the regulator’s decision.
   • The Bank’s Board will evaluate both internal and external candidates for the CEO position as part of its succession planning.

Key Takeaways

• What Happened: IndusInd Bank identified discrepancies in its derivatives portfolio, leading to a 2.35% impact on its net worth. The issue stems from accounting mismatches in internal trades used for hedging foreign currency exposures.
• Why It Happened: A flawed accounting process for internal trades, combined with regulatory changes, led to the accumulation of discrepancies over 5-7 years.
• Financial Impact: The estimated loss is INR 2,100 crores, which will be reflected in the P&L statement. The Bank has sufficient capital to absorb this one-time impact.
• Next Steps: The Bank is conducting an external review, has discontinued internal trades, and is working to strengthen its risk management processes.

Conclusion

While the derivative loss is a significant setback for IndusInd Bank, the Bank’s proactive disclosure and commitment to transparency are positive steps. The focus now will be on completing the external review, implementing stronger controls, and reassuring stakeholders about the Bank’s financial health and governance practices. The incident serves as a reminder of the complexities involved in managing derivatives and the importance of robust risk management frameworks in banking operations.

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