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Informist, Thursday, Mar. 20, 2025

 

By Aaryan Khanna

 

NEW DELHI – The accounting "discrepancies" recently disclosed by IndusInd Bank had many, including the Reserve Bank of India, asking the same question: how prevalent are the practices that landed the private lender in the soup? Turns out, they are rather unusual and the probe into the derivative operations of all banks is unlikely to see the central bank unearth widespread reporting defects, officials from eight banks told Informist on the condition of anonymity.

 

IndusInd Bank last week said an internal review had uncovered certain discrepancies in the accounting of its derivative portfolio against foreign currency borrowings. These errors, the bank's management explained, were due to internal trades between the balance sheet management desk--which manages assets and liabilities--and the trading desk, which managed the aforementioned exposure by striking external trades. Both desks followed two separate accounting methodologies. According to IndusInd Bank, the issue came to light when the internal trades had to be unwound because of the RBI's derivative guidelines that came into effect from April 2024.

 

The problem sounds like one that could occur at any Indian bank. But it is not, with bankers pointing out two key factors specific to IndusInd Bank and the discrepancies: the use of internal trades and their accounting treatment.

 

INTERNAL TRADES

IndusInd Bank's management told analysts late on Mar. 10 that internal trades between the asset-liability management and trading desks were a regular practice ever since the bank started its derivatives operations. But this is typically not the case across the industry. Officials from several private and foreign banks, particularly those of IndusInd Bank's size, said they had internal controls on trades between the two desks. Instead of passing on positions to traders, dealers tasked with asset-liability management themselves approach the market for hedging transactions, circumventing the need for internal trades.

 

"95% of mid- and large-size banks will either have an outright ban on internal trades or will heavily restrict them," a senior treasury official at a private bank said. "It is only smaller banks, where the merchant and trading desks are combined, which would still show a lot of internal trades and have a natural overlap."

 

Banks that permit internal trades follow a cardinal rule: the sum of two internal trades must always be zero. IndusInd Bank just couldn't follow this rule because the two desks followed different accounting systems. While the internal trade was subject to swap accounting under which trades are typically accounted on an accrual basis, the hedge was marked to market. Only if a trade is held to maturity would the two systems result in the value of the transaction converging with no hit to the bank, officials said. But if the hedge was unwound due to a tenure mismatch with the underlying liability, or if there was a margin call, it would either lead to an unaccounted-for gain or loss on the bank's portfolio.

 

These internal trades are typically on the foreign exchange side, where clients ask for quotes and the asset-liability management desk executes a back-to-back trade to pass on the client order trading desk to 'cover'--or hedge. All eight bankers said different accounting systems between the liability and its hedge was unheard of at their banks. Two bankers from mid-sized state-owned banks said ever since they began hedging their foreign exchange portfolios in earnest a few years ago, all Mumbai Interbank Forward Outright Rate swaps--the most widely used derivative instrument to hedge foreign exchange liabilities--have been marked to market.

 

With the RBI's new accounting guidelines in place since Apr. 1, such trades have largely been marked to market and are only accounted on an accrual basis when the trade is perfectly hedged. That 'perfect hedge' would include the underlying matched exactly with the hedge and the maturity would match to the day and would be signed off by the bank's control functions, including internal risk and accounting departments, treasury officials said.

 

WHY INTERNAL?

According to IndusInd Bank's management, the internal trades were struck only in cases where the trade had little liquidity in the secondary market, such as a three-five-year yen deposit or a 10-year dollar loan. While officials from other banks agreed with the logic--in cases where such trades were allowed, the trading desk would be quicker and more efficient in finding a hedge--the specific trades cited by IndusInd Bank drew conflicting responses.

 

Some treasury officials acknowledged the paucity of liquidity in the MIFOR swap market, which is the first port of call for asset-liability managers. Vanilla MIFOR swaps are useful in hedging dollar liabilities maturing in two, three, and five years--the most widely-traded contracts--and not much beyond. But other bankers said their asset-liability management desks have solved these problems by conducting a simple swap with any bank having an exposure to the offshore foreign currency market, with both the dollar and yen among the most traded currencies in the world and quotes for such positions plentiful.

 

"The positions that IndusInd reported that required internal trades to hedge, those have massive amounts of liquidity in the offshore market and one can easily get a quote from a foreign bank," said the treasury head at a private bank.

 

REVERBERATIONS?

Bankers said the RBI had stepped up its scrutiny on their foreign exchange liabilities and accompanying hedges, but they do not expect much dirt to be unearthed either from their own books or at the systemic level. Instead, they said, the issues was likely a perfect storm that occurred due to IndusInd Bank's accounting practices between 2017 and March 2024.

 

Most banks conducted an internal review of their entire investment portfolio, both cash-settled and derivatives, in Jul-Sept--a little over three months after the new RBI accounting guidelines kicked in. The bankers Informist spoke to said any flaws in their accounting would have popped up then, especially with public sector banks having overhauled their practices in the run-up to and following the new RBI norms. With IndusInd Bank also initially finding the faulty trades in September and October, treasury officials speculated the accounting issue popped up due to the volatility in the foreign exchange market at the time that led to the value of the hedge fluctuating, while the liability was constant.

 

"Our accounting on this issue is clean, and to be honest, I don't think banks have had a problem with forex hedging at all," a senior treasury official at a state-owned bank said. "If at all there is going to be an issue somewhere, it may be for a short period of time, that has been reviewed and rectified a long time ago."

 

Perhaps IndusInd Bank will somehow manage to explain away its problems to the RBI. But the astonishment in the industry over the last week suggests this may not be the case. As such, although the fallout could be limited to IndusInd Bank, it may go beyond a hit to the bottomline and heads could roll.  End

 

US$1 = INR 86.21

 

Edited by Avishek Dutta

 

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