Are more bank stocks at risk of a meltdown like IndusInd Bank?

medium119148028When IndusInd Bank reported discrepancies in its derivatives portfolio, resulting in a 2.35% hit to its net worth, the fundamental question was how such an event could occur. After all, the bank has been doing these trades for the past eight years. So, what went wrong?The answer lies in a trade that has existed for the past two decades, which has benefited from low interest rates. For the longest time, Japanese and Swiss interest rates have remained low, helping derivative labs across the world create exotic products that would benefit from the simple underlying fact that interest rates in Japan and Switzerland do not change. But that has not been the case.In March 2024, the Bank of Japan (BoJ) ended its negative interest rate policy, adjusting the benchmark rate from -0.1% to a range of 0% to 0.1%. In July 2024, the BoJ further increased the policy rate to around 0.25%. This simple act ended the “yen carry trade” that was around for around 17 years.The yen carry trade allowed investors to borrow money at a lower interest cost and use it to invest in assets or currencies that offer higher yields. The estimated size of the trade is around $350bn in terms of loans by Japanese banks, but the actual size could be higher due to leverage used by long-short funds.The trade has been directly responsible for the creation of exotic derivatives, pricing of debt markets and even the valuation of equities. It has helped Japanese housewives become ace derivative traders and make money on every trade. medium119147652IndusInd’s yen storyIndian banks have been huge beneficiaries of this trade; they have borrowed in low-cost yen to hedge their NRI deposits. But while doing so, they have also got into trades that, for the longest time, have given them huge profits. But a little upward moment in Japanese interest rates has created big problems for these banks.IndusInd Bank used 3-5-year yen deposits as part of its internal trades where interest rates were very low. It was using the same to swap with 10-year US dollar borrowings. According to a Motilal Oswal report, these trades were on swap contracts and not on mark-to-market (MTM) basis.But in April 2024, the bank had to discontinue its internal trades and follow the Reserve Bank of India’s (RBI’s) guidelines issued in September 2023 to align its books with market prices. Experts say that the losses actually started to happen after the BoJ increased interest rates for the first time in March 2024.Clearly, whoever created these instruments had a hardline belief that no matter what happens, there is no way that Japanese interest rates will go up and disrupt the bank’s income profile.The estimated impact of losses works out to 2.35% on the bank’s net worth or ₹2,100 crore. Now the RBI wants to do an audit and find out if there are other banks that used the yen-dollar swap in their derivatives trading. medium119147685The backgroundThis is not the first time that derivatives have blown up due to a minor increase in interest rates. In 2006 and 2007, the Swiss franc was considered to be the ultimate stable currency where interest rates had not moved and many exotic derivatives were created with the Swiss franc as the base currency.The Swiss National Bank (SNB) raised policy rates in five quarterly steps of 25 basis points (bps) each to 2.25% by March 2007. In the March policy statement, the SNB leaned towards continuing lifting interest rates, partly based on the high level of capacity utilisation and the weak exchange rate, but noted the need to remain flexible. Market participants on average price in a slight rate increase for June 2007.It was a time when many Indian companies announced to the stock exchanges that they were sitting on notional losses because of their exposure to foreign exchange derivatives. Amtek Auto announced that the company was sitting on ₹72 crore loss, which amounted to 30% of net profits of ₹236 crore during the year ended May 2007. Interestingly, the company had earned ₹36 crore in terms of forex revenues on account of derivative profits in the previous year.According to news website Rediff, software company Hexaware declared that it had made an ₹80 crore loss for the quarter ended December 2007 and had taken a huge hit of ₹103 crore on account of forex derivatives that went bust. Similar has been the case with Sundaram Multi Pap, which had actually sued ICICI Bank for its losses on forex derivatives that the company said was sold to them by the bank.It was not that these banks were creating these derivatives in the Indian market. They were mostly third-party products that the bank was using to sell them to exporters who wanted to hedge their currency risks and at the same time yield additional fee income. The banks were hedging their forex deposits separately.Indian banks had assumed that the Swiss franc would never move and there were no signals in the Swiss economy to show that the SNB will raise interest rates. But that is the beauty of pricing financial products. They are based on a fundamental assumption that all things being equal, the derivative product should ideally give a high return with almost no risk. But interest rates, which have a huge bearing on currencies, have a way of moving up. Very few investors are in a position to understand that what is stable can turn volatile without any prior warning.The smartest person in the room, as usual, turned out to be Warren Buffett who issued low-cost yen-denominated bonds to fund his acquisition of five Japanese companies. In 2024, the yen had appreciated 11% against the dollar and this helped Berkshire Hathaway to report $850mn in after-tax gains in its Japanese bonds. This is despite the rise in interest rates. medium nocaptionhttp://youtu.be/sXwWymg2eXA?si=IeKtkmqD1sXu0ziyWhy did interest rates in Japan rise?In a speech on March 5, BoJ deputy governor Uchida Shinichi acknowledged the volatility in exchange rate and stock prices resulting from the yen carry trade unwind.“The unwinding of these yen carry positions when the bank raised its policy interest rate in July (2024) was one of the factors behind the large fluctuations in exchange rates and stock prices,” Shinichi said. This carry trade market is estimated to be around $4tn.After the 1990s, Japan got mired in a vicious cycle of stagnation and deflation, crashing its share in world stock market capitalisation to 6% in 2023 — a mighty fall from its peak of 45% in December 1989. It wasn’t until the then Prime Minister Shinzo Abe’s expansionary fiscal policies in 2013 — better known as the Abenomics programme — that Japan managed to battle deflation and started a gradual recovery.Things changed markedly in recent years as growth came back accompanied with inflation. Market participants expect the BoJ policy rate to rise to 1% over the next 18 months from 0.5% at present. Rising rates in Japan combined with a falling dollar are leading the yen to appreciate. Since the start of this year, the dollar index (DXY) has fallen nearly 6%, whereas the yen (USD/JPY) has strengthened around 6.3% against the dollar during the same period.There are expectations that rates will turn lower in the US whereas they will go up in Japan. This means the persistent challenge of higher rates and yen appreciation will continue to create dislocations in the market. A carry trade that made sense at zero rates may not be viable when rates are positive, and the host currency is rising.Pressure from US President Donald Trump could also be a factor behind the yen’s recent strength, as he has accused China and Japan of keeping their currencies depressed. “I have called President Xi, I have called the leaders of Japan to say you can’t continue to reduce and break down your currency,” Trump said on March 4.“You can’t do it because it’s unfair to us. It’s very hard for us to make tractors, Caterpillar here, when Japan, China and other places are killing their currency, meaning driving it down,” he said.Responding to Trump’s comments the following day, Japanese finance minister Katsunobu Kato said, “Tokyo was not taking policies directly aimed at weakening the yen, as per a Reuters report. Rising rates and geopolitical factors, alongside a falling dollar, means investors' yen may continue to rise going ahead.”The final cutOn the face of it, it might appear that the Japanese interest rate has moved from 0.1% to 0.5%. which appears to be very low when compared to the US interest rate at 4.2%. But it simply means that those who have borrowed in yen will now have to churn out five times more in terms of costs and the yields are lower.Now the RBI wants to investigate other banks to see if they have traded in similar kinds of derivatives that involve yen transactions. But the stock market is resilient. Since February 27, the IndusInd Bank stock is down by 35% and trades at ₹676; the Nifty Bank Index is down 2% for the same period. In general, there is a feeling that this is more of an IndusInd Bank-related issue, while other banks do not have such kind of unhedged derivative positions on their balance sheets.