Investors in Yes Bank Ltd, an Indian lender partly owned by Rabobank Groep NV of the Netherlands, have had a turbulent ride amid an unravelling of Indian firms’ risky, leveraged bets on currency movements.
Yes Bank shares have tumbled 42% this month, making it the worst performer among 18 banking stocks on the Bombay Stock Exchange’s Bankex index. On 19 March, the bank issued a statement rebutting what it said were “unfounded rumours” it was losing money on foreign-currency derivatives exposure, or that customers—similarly affected by losses?on?their?own?contracts—were defaulting on their payables.
Yes Bank has no uncovered positions in its foreign exchange derivatives business and clients are meeting all their maturing financial obligations, the statement said.
What’s important here is to ask why, of all Indian lenders, Yes Bank—rated a “buy” by three brokerages in just the past two weeks—bore the brunt of the sell-off. The reason, as I see it, is simple: Yes Bank specializes in lending money to small- and mid-sized businesses,?which accounted for around two-fifths of the bank’s total loans at the end of last quarter. Since the counterparty credit risk in derivative trades is perceived to be higher for smaller companies that lack the financial strength to meet an unforeseen commitment—especially a derivatives loss magnified by leverage— Yes Bank stock got pummelled.
Risk of defaults
Analysts at Mumbai-based brokerage India Infoline Ltd say the concerns about the bank and its customers are overblown: While Yes Bank’s lending is directed towards smaller businesses, the foreign-currency dealings are with top companies. “The bank clarified to us that none of its clients have defaulted so far, and chances of material defaults are very unlikely since the bank has sold over 90% of derivative products to the Top 200 companies in India,” India Infoline analysts Prabodh Agrawal and Parthapratim Gupta noted in their 19 March report. The fear of defaults is at the core of the current bout of anxiety?in India?with?structured products.?Anecdotal evidence suggests?that?the?market?risk?of currency?derivatives?is?primarily on the balance sheets of Indian firms, and not those of the banks. But it isn’t clear whether the smaller firms would be able, or willing, to meet their obligations to the banks.
Yen and the dollar
Some media reports are already speculating if a contract involving a corporate treasury selling a currency option to a bank is enforceable. After all, exporters and importers in India are only allowed to take forward currency positions to hedge their risk; they’re prohibited from entering into deals where there’s a net inflow of premium to them from selling options. Those, however, are precisely the kind of trades many of them may have done over the past couple of years. For example, the chief finance officer at an exporting firm only needed to buy protection against the rupee rising too much against, for instance, the US dollar. But he decided to be more clever than prudent. So, he bought a structured product that made the same hedge ostensibly very affordable. But this involved the exporter writing an option in the bank’s?favour against the?yen rising beyond 100 to the dollar. The yen rose past 100 on 13 March.
Jamal Mecklai,?chief executive?of Mumbai-based risk management consulting firm Mecklai Financial, said this month that Indian firms may have as much as $5 billion (Rs20,050 crore) in mark-to-market losses on their currency positions.
Even so, as Mecklai noted in an interview posted on the website Moneycontrol.com, Indian accounting norms don’t require firms to mark these positions to market. That means bets which have turned unprofitable because of the dollar’s recent slide—to a record against the euro last week and to a 12-year low against the Japanese yen—may remain hidden from scrutiny until the contracts mature and the losses are realized. That’s making investors in Indian firms jittery.
Shares in Wockhardt Ltd, an Indian drug maker, fell 3% on Monday on a report last week in Mint, citing bankers and risk management experts whom it didn’t identify, that it has chalked up “substantial” paper losses because of positions in cross-currency options and structured products. The firm denied the report on Thursday and said it won’t incur any losses on account of derivatives either in the current quarter or subsequently. Wockhardt shares have slumped almost 25% this month.
A panel appointed by the Reserve Bank of India (RBI) to take stock of the country’s foreign exchange market and recommend regulatory changes had anticipated in 2005 that in the absence of proper accounting standards, there will be “incentive for companies to engage in so-called ‘cost-reduction’ derivative transactions by hiding the associated risk.” That warning shouldn’t have gone unheeded. Equity investors in India don’t know which company managements have been adventurous in assuming currency risk.
RBI has instructed financial institutions to follow aspects of the international accounting standard that stands guard against underreporting of derivative risks. Non-bank firms in India can still get away with inadequate disclosure. However, investors in Indian banks have an additional concern: credit risk. What if the thrill-seeking managements now become completely desperate and ask their counterparties in the mad, bad deals to take a walk?
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