ICICI Bank: Is it flirting with danger again? - Views on News from Equitymaster

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ICICI Bank: Is it flirting with danger again?

Dec 12, 2011

ICICI Bank, India's largest banking entity in the private sector, has been a trendsetter in more ways than one. It will not be wrong to call it the pioneer in introducing India's banking sector to the miracles of technology. Besides, a lot of other achievements sit rather lightly on the bank's shoulders.

Its meteoric rise though has not been without its fair share of problems. At times, the chutzpah of its aggressive management has spilled over onto the banking side of things. In other words, the business of lending does not require a ruthless streak. Here, conservatism and an ability to look at the downside more than the upside are the qualities that matter the most in the long run.

ICICI Bank's lending practices at times however did not give this impression. Take the case of 2008-09 crisis. When the crisis did end, it left a gaping hole in the balance sheet of the bank. So much so that it had to undergo a restructuring exercise and go slow on new loans in order to atone for its past sins.

As an aside, the person who can be given a large part of the blame for putting the bank in trouble in the first place was later awarded the businessperson of the year for managing to turnaround the very same business. Quite an irony indeed.

Barely has the firm come out of one hole, we believe that it seems to be flirting with danger yet again. This time the bone of contention seems to be an instrument called as CDS (Credit Default Swap). Those familiar with the sub prime crisis would know that it were indeed the CDSs that were held as one of the key reasons behind the US financial system coming on the brink of a collapse.

And now, these very same instruments have made their entry into India. There are reports doing the rounds that ICICI Bank along with another bank, IDBI Bank, entered into a transaction that marked the formal introduction of local currency CDS market in India.

Why is CDS assumed to be such a potent threat? Well, it is because the way the instrument is structured. It should be noted that in stocks, going long or buying involves limited downside in the form of price going to zero and unlimited upside. While going short involves limited upside and unlimited downside. Thus, shorting is less common than going long.

In the case of CDS though, the case is exactly the opposite. Here, going short by buying a CDS carries unlimited reward and only limited risk. Whereas going long by selling a CDS carries unlimited risk and only a limited reward. Hence, shorting becomes more attractive than going long. And this is where the whole problem lies. As going short carries more rewards, speculation is encouraged here, thus putting the price under a great deal of downward pressure. This then carries the risk of wiping out years of gains in just a handful of transactions. AIG, the US insurance giant got singed just because of this. As George Soros puts it elegantly, it expected to make a fortune in the long run but it was destroyed in a short order.

We do not know what regulations have the Reserve Bank Of India (RBI) put in place for the Indian CDS market, but the very nature of the product does make it risky as we just saw. Furthermore, ICICI Bank is the party that carries limited downside risk in the event of a default and the onus of unlimited losses does fall in IDBI Bank in the first ever transaction that has happened. But, it may not take long for the shoe to be in the other foot and there could be transactions in the future where ICICI Bank is the one selling the CDS and thus carrying limited reward and unlimited risk. This coupled with the bank's history of being a little too aggressive with respect to its lending business does call for a little more due diligence with respect to its transactions.

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4 Responses to "ICICI Bank: Is it flirting with danger again?"

Narasimha Murthy

Dec 21, 2011

Rather than on CDS , the bank may face problems on its loan book exposure to airlines and power cos. CDS were recently introduced in the Indian market and the scope is restricted by RBI. The article is a bit premature and bit too judgemental on the bank.

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murty

Dec 18, 2011

But its been written all over that CDS and other CDOs are the primary cause of the recent melt down!. May be that being the down side is less or limited, they are enouraged to enter in to a large number of such deals and finally seeing danger in its face ?!.

I dont remeber exactly how, but the CDS were reson for problems for many of the former soviet block countries. As there were CDS written, these coutries were denied any forther loans and forced them a default and then the CDO buyrs had a smile. Over all these financial over engineered tools are not to be enouraged, particulrly in a country like India where regulation is not stringent and regulators themselves are not educated enough on these new gen tools of mass distuction.

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ADS

Dec 14, 2011

Disagree with the comment on CDS. CDS is not like selling an option, with unlimited downside. The risk upon selling a CDS is capped to the amount of CDS one has sold. It works exactly like an insurance contract, and the liability of the CDS SELLER, cannot exceed the notional (equivalent to the insured amount). Of course, risk/ reward ratio is skewed in the favour of CDS buyer.

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insider

Dec 14, 2011

spot on!!

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