RBI Initiates Industry-Wide Review of Derivative Positions Following IndusInd Bank Debacle

The Reserve Bank of India (RBI) has initiated a review of the derivative portfolios of both private and public sector banks following discrepancies in forex derivatives accounting reported by IndusInd Bank, sources informed Moneycontrol.

The central bank is closely examining the hedging positions taken by various banks and gathering comprehensive details regarding these trades.

“The RBI has reached out to banks to evaluate their hedging positions in light of the IndusInd Bank issue,” said one of the sources, who requested anonymity. As of now, the RBI has not responded to Moneycontrol’s email inquiries. This article will be updated once a response is received.

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Objectives of the Review

According to sources, this review serves two main objectives. First, the RBI aims to determine whether other banks have violated the new regulations on derivative trading. Second, the regulator seeks to use this opportunity to assess banks' internal compliance with treasury operations.

With derivatives playing a crucial role in risk management for banks and corporations, ensuring proper accounting practices and compliance is vital. The RBI’s probe is expected to bring greater transparency to how banks account for their derivative positions, particularly in the wake of heightened scrutiny over financial reporting standards.

RBI's Regulations on Derivative Accounting

Under the RBI's Master Direction on Classification, Valuation, and Operation of Investment Portfolio of Commercial Banks (Directions), 2023, banks must classify their derivatives portfolio into three fair value hierarchy levels—Level 1, Level 2, and Level 3—and disclose this in their financial statements.

Additionally, banks are prohibited from distributing dividends from net unrealized gains recorded in their profit and loss statements due to fair valuation of Level 3 derivative assets and liabilities. Such net unrealized gains must also be deducted from Common Equity Tier 1 (CET 1) capital, as per RBI guidelines.

These regulations aim to enhance the corporate bond market, promote the use of derivatives for hedging, and strengthen banks' overall risk management frameworks.

Impact on the Currency Derivatives Market

Regarding currency derivatives, the RBI issued a circular on January 5, 2024, mandating that investors maintain a valid underlying contracted exposure, which should not have been hedged using any other derivative contract. Investors must also be able to verify such exposure if required.

Following this directive, the open interest contracts in the currency derivatives market on the National Stock Exchange saw a decline.

Market participants noted that this move was aimed at curbing speculative trading in the derivatives segment and ensuring that only genuine hedging transactions take place. However, some traders expressed concerns that the regulation could reduce liquidity in the forex derivatives market, making it more challenging for businesses to hedge their currency exposure efficiently.

IndusInd Bank’s Disclosure and Market Reaction

On March 10, IndusInd Bank disclosed in an exchange filing that an internal review of its derivatives portfolio revealed a potential impact of 2.35% on its net worth, which was approximately ₹62,000 crore as of March 31, 2024. The review of banks’ investment portfolios was conducted as per RBI directions issued in September 2023.

IndusInd Bank CEO Sumant Kathpalia, during a late-evening conference call, acknowledged certain discrepancies in account balances but did not specify the process through which these gaps were identified.

A day after this disclosure, IndusInd Bank’s stock plunged over 27%. However, Chairman Ashok Hinduja reassured investors that the bank would receive full support if any capital requirement arose. By the afternoon of March 12, the stock was trading at ₹680 on the National Stock Exchange, marking a 3.7% increase and breaking a five-day losing streak.

The Broader Implications of RBI’s Review

The RBI's review is expected to have far-reaching implications for the Indian banking sector, particularly in terms of risk management and regulatory compliance. Experts believe that the central bank could introduce stricter reporting requirements to ensure greater transparency in derivative transactions.

Additionally, some analysts suggest that banks might become more cautious in their forex and derivative dealings, leading to reduced market volatility in the long run. However, short-term disruptions could arise as institutions adjust to the regulator’s heightened scrutiny.

This development underscores the growing importance of regulatory oversight in India's evolving financial landscape. The RBI’s proactive approach highlights the need for banks to maintain robust risk management systems to safeguard their financial stability and investor confidence.

With the review still underway, the banking sector will be closely watching for any additional regulatory changes that may arise from this exercise.