CLSA: Private Banks Will See A Compression in FY09 Earnings by 4 to 6 per cent

CLSA: Which Banks Are At Risk?HDFC Bank, ICICI Bank, Bank Of Rajasthan, Karur Vysya, City UnionSince our first note highlighting risks of exotic forex trades for corporates (Exotic Show – Caveat Emptor; 28th November 2007); both Yen and Swissy have appreciated ~11% vis-à-vis USD. Based on our sensitivity a 15% default (of total MTM losses) would lead to a 2-4% reduction in net-worth (10-15% of earnings) for private banks. Fee income from these exotic products has grown significantly in last 2 years for some private sector banks. In our view, a cautious stance by corporates and potential restrictions by RBI can lead to lower growth over a high base / decline in fee income from these products in FY09, earnings impact could be 4-6%.JPY and CHF have appreciated c12% YTDq Since our first note highlighting risks of exotic forex trades for corporates (Exotic Show – Caveat Emptor; 28th November 2007); both Yen and Swissy have appreciated ~11% vis-à-vis USD.q In addition to losses accumulating on earlier contracts (which knocked-out at 110 levels), a lot more contracts have been knocked out at various levels such as 105, 102, 100 etc. q The problem is much more severe than what it was when we first highlighted it 3 months ago. For e.g. a $100m underlying contract with initial rate at 115JPY/USD and knock-out at 100JPY/USD would now have marked-to-market losses of c$15m (15% of contract value)Risks for corporates – One time hit + Loss of other income/higher interest costsq Entry into these contracts (at time of entering into the contracts, losses were considered a remote possibility) helped corporates boost other income or significantly reduce interest costs.q One can consider writing these contracts (details of contracts in our earlier research) similar to selling insurance policies for a low probability catastrophic event ( which in this case happens to be sharp appreciation of JPY/Swissy)q Not only will the corporates have to take large losses (Marked-to-market, but probability of crystallisation also very high given the sharp appreciation) on existing trades leading to one-time losses; but future option writing activity will shrink significantly reducing avenues for boosting profits. This can impact recurring profit growth in some cases.Multiple efforts to address the problemq Conversion of MTM losses to loans by banks given the inability of clients to pay-up or desire of clients to postpone losses from being reported in P&L immediately.q Rolling over losses on existing contracts by entering into new contracts with some upfront profits.q Based on our discussion with a few market participants, a number of corporates have taken large bets on flattening/steepeni ng of yield curve in US to generate upfront profits to payoff losses on forex contracts. (we will discuss some of these interest-rate linked exotic products in subsequent research)Risks for banks – Default risk + Loss of fee income in futureq Some corporates have challenged the validity of these contracts claiming “mis-selling by banks”. A number of SMEs are unlikely to pay-up the losses leading to NPAs and one-time provisions by banks.q Some corporate have asked banks to crystallise losses and convert them into loans q Based on our sensitivity a 15% default (of total MTM losses) would lead to a 2-4% reduction in net-worth (10-15% of earnings) for private banks q Fee income from these exotic products has grown significantly in last 2 years for some private sector banks. In our view, a cautious stance by corporates and potential restrictions by RBI can lead to lower growth over a high base / decline in fee income from these products in FY09, earnings impact could be 4-6%.Safe Harbor Statement:Some forward looking statements on projections, estimates, expectations & outlook are included to enable a better comprehension of the Company prospects. Actual results may, however, differ materially from those stated on account of factors such as changes in government regulations, tax regimes, economic developments within India and the countries within which the Company conducts its business, exchange rate and interest rate movements, impact of competing products and their pricing, product demand and supply constraints.