In today’s Finshots, we break down how derivatives mismanagement can have massive negative repercussions, as we saw with IndusInd Bank, and why the RBI is investigating other banks for their forex derivatives exposure.

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The Story

Barings, the UK’s oldest merchant bank, appointed Nick Leeson as a derivatives trader for its Singapore office.

Leeson’s job was to make low-risk profits through arbitrage. Now it’s a fancy way of saying buy low in one market, sell high in another simultaneously, and pocket the difference. Specifically, Leeson’s job was to profit from minor price differences in Nikkei 225 futures contracts between the Osaka Securities Exchange in Japan and the Singapore International Monetary Exchange (SIMEX).

For the uninitiated, futures contracts are a type of derivative or simply financial contracts that derive their value from the underlying assets (here, the Nikkei 225).

Pretty straightforward, right? 

However, Leeson didn’t just stick to arbitrage. Instead, he retained the futures contracts for longer periods, hoping to make much larger profits by betting on the rise of the Nikkei 225 Index. And his crafty strategy bore fruit, too. He made massive sums for the London bank, sometimes to the tune of 10% of the bank’s overall profit. 

However, his speculative trades were unhedged, meaning he was betting only on the rising index without any protection if it fell. Thus, he had no safety net. Soon enough, his bets started going downhill with the decline of the Nikkei Index, and his losses began accumulating.

What he did next was even more glaring, to say the least.

Rather than reporting the losses, Leeson hid them in a secret account, initially meant for tracking trading errors. 

But that wasn’t his only trick.

Since he was trading futures contracts, which settle at a later date, he didn’t immediately have to book losses. Further, instead of closing bad trades and accounting for losses, he doubled down, placing even bigger bets in hopes of recovering what he had lost. 

Essentially, he was gambling on the market bouncing back in his favour. This allowed him to push losses into the future, never booking them in the present. Meanwhile, he recorded any small profits that he made immediately. Thus, this accounting mismatch created a financial illusion that Barings Bank was making money when, in reality, it was drowning in losses, ballooning to twice the bank’s capital. And when the truth finally surfaced, Barings Bank collapsed overnight in 1995!

But why are we talking about it today?

Because just a few days ago, IndusInd Bank disclosed lapses in its derivatives accounting.

Now, we’re not drawing exact parallels because the Barings case was an outright fraud by a single trader that went rogue. Rather, we are emphasising the accounting mismatches in the banks’ derivatives exposure. The news sent IndusInd’s stock nosediving over 27%, wiping out ₹19,000 crores in market value. While there’s no rogue trader here, unlike the infamous Barings Bank collapse, it still raises concerns about how banks handle complex financial instruments.

For more context, let’s unwrap what exactly happened at IndusInd Bank.

IndusInd had a large forex derivatives exposure. The problem was that it didn’t account for losses properly. While other banks followed RBI’s instructions and accounted for mark-to-market (MTM) losses on their forex derivative books, IndusInd didn’t. Worse, it didn’t hedge its forex positions either.

Now, MTM simply means valuing assets at their current market price, not the price at which they were initially bought. So if a bank holds forex derivatives and their value drops, it must immediately record the loss in its books. IndusInd, however, chose not to do this.

Then there’s hedging. When a bank takes on foreign currency exposure, it’s exposed to fluctuations in exchange rates. To avoid surprises, it can hedge the risk, where the bank pays a small fee upfront to lock in exchange rates and shield itself from future losses. And when these forex trades are settled, the bank either books a gain or a loss.

But IndusInd had massive unhedged forex positions, and when things went south, it racked up huge losses. Worse, instead of booking them outright, the bank disguised them as “receivables” and even classified them as intangible assets on its balance sheet. 

Now, they would have accounted for these losses gradually, but the RBI’s 2023 rule came their way. Now they had to classify their derivatives portfolio and disclose this information in their financial statements. It was then that Indusind’s major gaps in managing its risks got exposed.

But why do banks even deal with derivatives, in the first place?

Look, banks are constantly trading. Currencies, bonds, stocks, interest rates, commodities, you name it. But they don’t just buy and sell these assets outright. They often use derivatives to hedge risks, speculate, or enhance returns. 

For instance, say a bank lends money in dollars but collects payments in rupees. If the rupee weakens, it loses money. To avoid this, it can lock in exchange rates using a forex swap or forward contract, shielding itself from currency swings. 

Second, managing interest rate risks. Banks borrow and lend at different interest rates. If rates suddenly spike, their cost of borrowing rises, squeezing margins. To protect themselves, they use interest rate swaps, where they agree to exchange fixed-rate payments for floating-rate ones or vice versa to balance risks.

Last but not least, derivatives are speculation for profit. Not all derivative trades are for risk management. Banks also actively bet on movements in interest rates, commodities, or currencies to make quick gains. But if these bets go wrong, the losses can quickly spiral out of control.

That’s where mismanagement comes in.

Look, derivatives can be potent tools, no doubt. However, they can be double-edged swords, too. If a bank doesn’t track its derivative positions correctly due to accounting lapses, poor risk controls, or aggressive bets, the losses can quietly snowball.

That’s why the RBI is now cracking down harder on how banks manage their derivative books. It has asked other banks with significant forex derivative exposures to disclose their risk positions to ensure a bigger problem isn’t lurking beneath the surface.

While IndusInd’s case isn’t a scandal, it reminds us of the importance of confidence in the banking system. Folks like you and me place our trust in banks. And if their internal systems aren’t in place or their accounting isn’t done correctly, they might incur losses, eroding our trust.

That’s exactly what happened to IndusInd, which lost a whopping market value in a matter of a few hours.

Needless to say, banks can’t afford to be careless with their risk management. One slip-up, and public trust goes out of the window and winning it back is an arduous climb back.

Until next time...

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