Risk (Un)Ltd.

Another bank fraud, New tool to tackle inflation, & Options trading trends 🛑 💸 📈

Long weekends for the win! Unpopular opinion - the day before the long weekend is more fun than the actual off-days. So many plans, so much to look forward to. The long-awaited road trip, a fancy dinner, a movie, and probably some laundry too. Well, cheers to all of that!

Before you go take off though, let us catch you up with the news this week ⬇️

Estimated reading time: 5 min

Gaming the IBC  

Photo by Olya Kobruseva from Pexels

Another bank fraud?

Bouncers restricting entry are a familiar sight at clubs. But bouncers keeping bank officials from accessing financial documents? Also, the bouncer is disguised as a company secretary? It seems like quite a curious method to keep some documents hidden. And if this seems stranger than fiction, that's probably because this is all real. So, here is the story of how a group of companies gamed the Insolvency and Bankruptcy Code (IBC) to con some of India’s biggest banks. 

The insolvency resolution process

Before we begin, here’s a quick explainer of the IBC. It’s the legal process that banks can initiate on companies that have defaulted on their loan repayments. Once under insolvency proceedings, promoters of a defaulting have to give up their control and the firm is auctioned off to the highest bidder or liquidated. Decisions are made by the committee of creditors (CoC) which is made up of banks and other firms that are owed money.  

Committee out of control

With that out of the way, let’s talk about KG Corp, formerly known as Tayal Energy and part of the Tayal Group, controlled by Pravin Kumar Tayal. This firm owed Punjab National Bank, UCO Bank and Bank of India a total of ₹614 crores. But it was a group of five little-known firms that initiated insolvency proceedings against KG Corp. These firms, along with a few others, claimed they were owed ₹1800 crore, giving them a majority say in the decisions of the CoC. 

Bad haircut

Here’s where things take a murky turn. All these firms put together were worth just about ₹3 crores so how were they owed ₹1800 crore? Turns out they were all related parties of the Tayal Group. And when banks wanted to verify the documents that showed the amounts owed, they got the bouncer treatment. With their majority in the CoC, the related firms approved a resolution plan for KG Corp worth ₹34 crores, forcing the banks to take a 97% haircut on what they were owed. 

Low and Behold

Photo by Edvin Richardson

Floored

Okay, this is a meal and a half to digest, so let’s take it super slow. During the pandemic, the RBI pumped a lot of money into the economy to support it. Now, the Russia and Ukraine situation has launched the world oil prices, and therefore inflation, to the stars. Long story short the RBI now has to tackle the inflationary trends in India - and it plans to do this by mopping the excess liquidity in the economy.

Normally the central bank does this by increasing the reverse repo rate - i.e the rate at which the RBI borrows from commercial banks. The higher the rate the more willing commercial banks will be to park their excess reserves with the RBI. This will automatically decrease liquidity in the economy, therefore taming inflation. 

New kids on the block

So, did the RBI increase reverse repo rates? Well, yes and no. It didn’t increase the actual rate but effectively substituted it with something called the standing deposit facility (SDF). Now, what is SDF? It is effectively the same thing as the reverse repo rate but with one big difference. Whenever you take a loan you need to give collateral for it. Similarly, when the commercial banks lend money to the RBI at the reverse repo rate, the RBI gives them collateral of bonds. But providing bonds at a large scale can be challenging as was seen during demonetisation. This is where SDFs help. They are a collateral-free arrangement that allows the RBI to borrow from commercial banks.

Tough Love

What the RBI did indicates that global inflation, and inflation in India, is a concern that it wants to tackle. In line with this, it has even reduced the growth forecast to 7.2% for FY23, from a previous 7.8%. More importantly, it has increased the inflation forecast to realistic figures and therefore made provisions like the SDF to control it. It even said the deposits against SDF will be counted as part of the statutory liquidity ratio (a portion of a bank’s deposits that it needs to keep liquid). This shows a shift in the stance of the RBI from accommodative and growth-oriented, to cautious when it comes to inflationary pressures.

Risky Traders And Concerned Regulators

Photo by Mikhail Nilov

Trendy investors

The average trend from a first-time investor to an expert is a gradual process. This can be measured not just by time and amount invested but also by the financial instruments being used. Typically, one would dip their feet into capital market waters through mutual funds. Then move on to stocks. And once armed with enough financial and market know-how, venture into equity derivatives. Another way to look at this trajectory is the increasing risk investors take on with more complex instruments. 

Losses unlimited

But like many past trends, the pandemic has upended this one too. We saw investors jumping head-first into cryptocurrencies even though these are considered riskier than stocks. Similarly, the Securities and Exchange Board of India (Sebi), is concerned about the influx of new investors in equity derivatives, mainly in options. The reason is that investors can face unlimited losses in such markets. 

Let’s take a quick example to understand this. A ‘call option’ is a derivative contract that gives an investor who buys this contract (for a premium amount, say ₹5000) the option to buy the underlying asset (say 100 LIC shares) at a strike price (say ₹10,000) on a specified date. A contract has to be between two parties (say you and me). 

If I’m selling a call option with a strike price of ₹10,000, it means I think the value of 100 LIC shares will fall below that amount and I’ll make a profit of ₹5000, or the premium, when you do not exercise the call option. But if the price of LIC shares go up, then you (having bought the option to buy 100 LIC shares from me) will exercise the call option on the specified date. Now, I can either sell my own LIC shares to you for a loss or I have to buy 100 LIC shares at the higher market price and sell them to you for ₹10,000. In this case, my loss keeps on increasing as the price of LIC shares goes up, meaning my loss is unlimited.         

Invisible hand of the market (regulator)

If this was a bit difficult to understand, that’s exactly the point. Investors ideally should not get into the derivatives market without adequate knowledge and financial resources. Recent discussions on this topic between the National Stock Exchange and the country's top brokerages sparked off speculations that Sebi had something to do with it. This brought back memories for brokerages about the regulator’s previous attempts at a ‘product suitability framework’. It entailed brokerages selling products to investors based on their net worth and risk profile. Brokerages had opposed the move claiming they did not have the capability to certify all their clients’ net worth.