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India Private Banks' Contingent Liabilities: Losing the Balance?

A recent RBI (Reserve Bank of India) Report shows that India private banks continued to expand their contingent liabilities, or off-balance sheet exposures, in line with the trend seen in recent years. Contingent liabilities of banks in India increased nearly 88.44% to Rs. 144.3 trillion in 2007-08 as more companies rushed to hedge their foreign exchange contracts to tide over the volatility in currency markets. This is over and above the 80.2% growth in off-balance sheet exposures seen in 2006-07.

As a consequence of this significant rise in contingent liabilities, the total off-balance sheet exposure of private banks in India at the end of March 2008 was more than three times the size of their consolidated balance sheet. At the end of March 2007, contingent liabilities stood at double the size of their consolidated balance sheet. Leveraged positions in derivatives as a means of diversifying income and increasing use of derivatives as tools for risk mitigation appear to have contributed to the growth in contingent liability exposures, said the RBI.

Contingent liabilities or off-balance sheet exposures include forward exchange contracts, derivatives for currency swaps and interest rate swaps, currency options and interest rate futures, letters of credit and guarantees. These are called off-balance sheet exposures because they are not directly funded by banks and do not appear on their balance sheets. However, these remain as liabilities on the books of banks, and the commitment needs to be honoured if the client companies fail to do so. Contingent liabilities often do not ever become actual liabilities. However, if they are large they may pose enough of a risk, and could be expected to have a significant impact on valuation.

The level of contingent liability exposure of India private banks has seen significant rise in the last few years, as mentioned before. Just how large an exposure it is for individual private banks, can be seen from the graphic below. HDFC Bank, one of the most reputed and admired private banks in India, leads the pack with an exposure of 445% of total assets, followed closely by Yes Bank, one of the smallest private banks at 405% of total assets. In contrast, the largest bank, the PSU State Bank of India, has been the most conservative with its contingent liability exposure at 92% of total assets.

Looking at this picture, its apparent that contingent liability impact on valuation has been largely ignored for HDFC Bank, probably due to its impeccable and conservative record so far, coupled with its high growth and earning power. But one of the smallest private banks Yes Bank is still suffering on the valuation front probably due in part to the high contingent liability exposure. It must be said in Yes Banks defence, that even if there was an additional provision made for Rs. 100 crores say in FY 2009, given its great NPA levels, its asset quality levels do not deteriorate much and will remain on par with the best NPA levels in the industry. Yes Bank may thus be a price-mismatch bargain again! And on that coin, so would State Bank of India given that its off-balance sheet exposure is the lowest, being less than its total assets. ICICI Bank (IBN) has managed well on this front, but we have seen ICICI Bank's valuation suffer for big concerns on several other important metrics.

Having said all that, just how much of a risk have these huge exposures actually been? What is the quantum of losses that private banks have had to book and/or make provisions for?

Is it possible to derive some measure of the adequacy/inadequacy of derivatives exposure risk management by private banks in India?

Let's see what we have on the derivative losses disclosures front until now, from leading private banks. From the disclosures, it appears that the range of losses and/or provisions for private banks is from 0.02 to 0.05 percent of Total Contingent Liabilities. However, for the PSU State Bank of India it's only about 0.004 percent of Total Contingent Liabilities. Is that a further indication of prudent derivatives risk management by the PSU bank? Read on!

Defaults on contingent liabilities by private banks' clients in India have been common in 2007 and 2008 as companies had rushed to hedge their foreign exchange contracts to tide over the huge volatility in currency markets. Losses for Indian firms mounted in the year to March as their currency derivatives bets soured because of the unexpected appreciation of the Swiss franc and Japanese yen against the US dollar. Many companies had taken bets in these low-interest currencies to protect themselves from the rupee’s gains, which climbed the most in more than three decades against the dollar in 2007. The rupee appreciated by over 12% in 2007, and in 2008-09 has depreciated by over 20%! Under RBI guidelines, any such outstanding contract would be classified as an NPA, 90 days after a default in payment to the bank.

However the level of disclosures with respect to such defaults by clients is not as common. Axis Bank is perhaps the most prominent private bank that was the first to explicitly disclose the quantum of defaults and the provisioning cover made. According to Axis Bank, at the end of March ’08 it had structured 188 outstanding derivatives transactions in which the banks clients had aggregate MTM losses of $168 million or Rs 674 crore (70 transactions in which bank's clients had aggregate MTM profits of Rs 8.67 crore). Explaining the details of the provisioning, the bank said, of the 188 transactions with MTM losses, 6 have been repudiated by two clients, involving an MTM loss to the clients of $18 million or Rs 72 crore. The two companies have gone to court over these cases. Axis Bank had made full provision of Rs. 72 crore for these losses. That amounts to 0.03 percent of Total Contingent Liabilities for FY 2008 standing at Rs 258,895.66 crore.

ICICI Bank made additional provisions of around $45 million (Rs 180 crore) for mark-to-market losses (MTM) on its credit derivative obligations (CDOs) and credit-linked note (CLN) portfolio during February and March 2008. This takes the bank's total provision for these instruments to $170 million (Rs 680 crore) during the year, which amounts to 0.05 percent of Total Contingent Liabilities for FY 2008 standing at Rs 1,250,595.22 crore. Asked about the cases filed by the bank's clients related to the derivative deals, Chanda Kochar, joint-MD said,

Corporates take derivative products to hedge their exposure. Some corporate clients have taken a mark-to-market loss. The bank does not disclose any profits or losses incurred by its clients. There are a few cases which are under dispute and the bank has made adequate provisions for it.

The nation’s largest bank, State Bank of India (SBI), said its customers may have lost as much as $175 million or Rs700 crore because of currency derivatives trading in the year ended 31 March. “We have been in derivatives and have done deals for our own customers with underlying assets,” chairman O.P. Bhatt said on Wednesday. “They made profits a year back. This year, they may make a loss of Rs7 billion.” Bhatt said the bank doesn’t face any court cases from companies on derivative transactions and it won’t set aside funds to cover losses in its earnings for the year ended March. However the bank may also set aside about $10 million (Rs 40 crore) for potential losses because of the meltdown in the credit markets after the US subprime crisis began last year, amounting to 0.004 percent of Total Contingent Liabilities for FY 2008 standing at Rs 945,770.21.

Another private bank, Kotak Mahindra Bank said it had made a provisioning of $21.5 million or Rs 86 crore to cover the mark-to-market (MTM) losses of its clients on account of forex derivative transactions. The bank has around 45 clients, having exposure to forex derivatives, who have suffered MTM losses of $153 million or Rs 612 crore on account of forex transactions as on May 8, 2008. “We carry a provision of Rs 86 crore toward stressed assets. In this regard (exposure to forex derivatives), the bank has no exposure to SME clients,” Uday Kotak, the bank’s vice-chairman and managing director, told reporters.

And what is the position of HDFC Bank (HDB), the most reputed and admired private bank in India? HDFC Bank made a provision of around Rs 100 crore on currency derivative trades. “We have made a provisioning of Rs 172.7 crore for multiple contingencies, including around Rs 100 crore for a possible hit on account of domestic derivatives exposure. We have no exposure in any instruments like collateralised debt obligations and credit linked notes,” said a bank official. The bank, which has been dragged to court by a few customers over derivatives, also set aside a small sum for litigation. “The amount is very small,” said Paresh Sukhtankar, executive director of HDFC Bank. Unlike other banks like Axis Bank and State Bank of India, HDFC Bank has not revealed any mark-to-market losses of its clients. The Rs 100 crore provision on domestic derivatives exposure amounts to 0.02 percent of Total Contingent Liabilities for FY 2008 standing at Rs 593,008.08 crore.

One of the smallest private banks, Yes Bank said that one of its clients had gone to court over a dispute involving a derivatives transaction. Yes Bank has around 130 foreign exchange clients. Most of them are large companies and emerging corporates companies with a turnover in the range of Rs 150 crore to Rs 750 crore. Nearly 70 per cent of the bank’s derivatives exposure is to large companies.The bank said its clients were meeting obligations (for derivatives) as and when the contracts fell due. “The bank has made contingent credit provision of Rs 17 crore reflecting the market environment (due to rising risk) in which it is operating. This provision is not for any specific client, but for future without any actual loss incurred by the bank,” MD Rana Kapoor reiterated. The Rs 17 crore provision amounts to 0.02 percent of Total Contingent Liabilities for FY 2008 standing at 68,899.54 crore.

Disclosure: Long HDB, Short IBN

Source: Donald Francis, Seeking Alpha

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