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Economy

Banks and Corporates fight it out over derivatives. Banks will lose either way.

From Bloomberg:

Jasmin Mehta says that when he told salesmen from ICICI Bank Ltd. he didn’t understand currency derivatives, they chauffeured him to a hotel and bombarded him with charts showing how his company could make a profit with zero investment.

Jasmin Mehta says that when he told salesmen from ICICI Bank Ltd. he didn’t understand currency derivatives, they chauffeured him to a hotel and bombarded him with charts showing how his company could make a profit with zero investment.

Three months later, Mehta, then chief finance officer of Sundaram Multi Pap Ltd., told his chairman that two of the contracts had turned sour, incurring losses of 60 million rupees ($1.5 million). ICICI has served a bankruptcy notice to collect the money, Sundaram says.

“I was made to believe these bets don’t go wrong,” says Mehta, 33, a commerce graduate from Mumbai’s Dalmia College. “It was all about making profit, no mention of losses.” ICICI, India’s second-biggest bank, denies misleading its customers.

Indian companies may lose $4 billion on derivatives, according to Hong Kong-based brokerage CLSA Ltd. Sundaram is among a dozen firms that have filed lawsuits against banks including ICICI, Kotak Mahindra Bank Ltd. and Axis Bank Ltd., accusing them of hiding risks to lure small businesses into contracts they didn’t understand. No rulings have been issued.

“There’s a lack of transparency at banks,” says Gautam Rao, director of Business Risk & Hedge Management, a Chennai- based consulting firm. “They don’t explain the various legs of the transaction. The companies have no clue what they’re doing.”

Looks like the companies are claiming they weren’t advised right.

The banks say clients were fully aware of the risks.

“We maintain records to show that companies knew what they were getting into,” says Madhabi Puri Buch, an executive director at ICICI who declined to comment on specific cases. “There were no complaints when they were making profits.”

In Sundaram’s case, ICICI has a signed contract and the recording of an Oct. 24 phone call in which Mehta says, “Yes, yes, yes, I agree,” according to papers filed at Bombay High Court.

Indian banks may lose 16 billion rupees if they can’t enforce the contracts with smaller companies, according to CLSA, the Asian brokerage arm of French investment bank Calyon. The estimate is based on the assumption that 10 percent of companies may renege on the agreements.

ICICI declined to comment on potential losses for its clients on April 26, when the bank reported earnings. Axis Bank, India’s fourth-largest by market value, set aside 719.7 million rupees for possible losses April 21.

Two things work in favour of the corporates. One, that they may be able to prove that the banks sold them products they did not understand. The usual statement is “caveat emptor” – buyer beware – which means if a buyer agrees to buy a product he is responsible for the risk. But in banking circles, a new term – caveat venditor, or seller beware – is doing the rounds. Given that financial derivatives are horrendously complex, understanding them can sometimes be beyond the ability of small companies. And then, some products are disguised lose-lose situations for the corporates, because the banks have access to far more information that the corporates. When this comes out, it is likely that an authority – either the RBI or the courts – may rule in favour of the corporate. (They have done so many a time, telling brokers to return clients money even after having a power-of-attorney to trade)

Second, ICICI bank can’t sell them a derivative if it’s a speculatory hedge – because the RBI bans those if not traded on an exchange. Most of these contracts are OTC – over the counter – products, which are ok for a hedge, but not really for the kind of contracts that have been taken which are simply speculation. If the corporates prove that the contract was illegal, they cannot be enforced and the banks are left holding the loss.

So two things work against banks – that the contract may be deemed invalid because it’s illegal, or that they missold the product. If the court ruling is for Sundaram, expect a huge number of cases against the banks.

What are the other options? Out of court settlement. This will necessarily be in favour of the corporate – as obviously the payment will be much lesser than the demand (why settle otherwise?) Even there, there will be more such cases by other corporates who know they can get away with paying less.

Lastly, what if ICICI wins? They may not get the full money – in this case, the company may be bankrupt and only part of the money may be recovered. But after this, no one will deal with ICICI for derivatives; that means a huge reduction in fee and treasury income. With credit growth slowing and now fee/treasury income also impacted, the net impact on banks is negative.

This is very bad for the big P/E banks. If anything it is good for the traditional, conservative banks, who are likely to get the business. They’re all at P/Es of 6 and 7 and such, and growing reasonably – like Corporation Bank. (But these PSUs suffer on account of the government’s policies so risk isn’t small)

(Note: Canara Bank just announced bad results. Will cover that separately.)

  • Manish says:

    >poor Jasmin, he should have read Traders, Guns and Money or simply head to Vegas!

  • Anonymous says:

    >This may only be tip of the iceberg. It is well known that plenty of personal incentives gets passed around both inside and outside India on such deals.

    Corporate CEOs and CFOs may have milked the system and laughing all the way to Swiss Banks.

  • Anonymous says:

    >Hi,
    Offtopic comment: Your moneyoga.com site is good,but too slow.
    – mahesh

  • Anonymous says:

    >How the Axis Bank can do out of court settlement with Rajshree Sugars and Chemicals Ltd., which proves that Axis was also equally wrong in mis-selling derivatives to RSCL. All others who lost the cases should reopen it for further inquiry through CBI probe alleged mis-selling of these products, violation of foreign currency laws and offences of cheating, criminal conspiracy and fraud

    Shadow on the Axis Culture Ref Business India 25/07/2010 Axis Bank has grown by acquiring business by aggressive pressure on the branches and ignored fundamental aspects of banking such as operational efficiency, staff accountability, audit & compliance and hence the bank is facing a serious issues with a high NPAs, serious frauds through senior branch officials due to business pressure and also unethical HR practices like withdrawal of ESOPs up to the level of AVPs and frequent changes in PMS & Promotion policies has increased staff attrition rate. Its a time to re look into those issues seriously and grow clean & green in order to bring the permanent light from shadow. Sanjay Prabhu – Pune Ex Employee & Share Holder of Axis Bank