CFA(R) Equity — Change of Strategy: didn’t work A 94-year-old bank, which had been sanctioning loans to small businessmen from textile industries for 9 decades, decided to start sanctioning loans to retail, MSME, and heavy corporate. This change in strategy eventually did help the bank to grow substantially in a very short period of time (2013 onwards to 2018). But the price paid was hefty in the Long run. The majority of loans that were extended were in cyclical industries like Infrastructure and Power which got affected most because of the slowdown of the economy (due to issues of demonetization & GST etc.). This led to default in payment of interest and thus banks started showing losses, NPAs started to increase steadily, Capital Adequacy ratio was declining consistently.

The takeaway to CFA(R) students: Exposure to Cyclical industries is a double-edged sword. It would have worked in favor of LVB if the economy had gone through expansion. But unfortunately, it happened other way around.

CFA(R) Fixed Income: Collateral Missing?? We know that a lender should look at 4 Cs while lending to any borrower:

Capacity Character Covenants & Collateral Loans sanctioned to Cyclical industries had either no collateral or Poor-Quality collaterals. This resulted in significant LGD (Loss given default) as recovery from those collaterals was highly insignificant.

CFA(R) Portfolio Management: Ability to take risk v/s willingness to take risk In 2017, when LVB’s financial position was weakening due to losses it started to make – LVB, in an effort to earn significant interest income, started granting even unsecured loans at an extremely high-interest rate.

Considering the financial situation of the bank – it clearly didn’t have the ability to take the risk but in agreed to recover past losses — it had a significant willingness to take the risk.

Bank chose to go with higher willingness over lower ability which is exactly opposite to what we have learned in CFA(R) Portfolio Management and that probably could be the reason for the current situation of LVB.

CFA(R) Fixed Income: What about Capacity to repay? We now know that to recover from past losses, LVB took the road of extending risky loans. However, these loans were granted to distressed entities and also to individuals with extremely poor CIBIL scores. The capacity of borrowers to repay was completely ignored as the entire focus was on earning higher interest income. And we know what happened because of that.

CFA(R) Economics — Role of Central Banks: Regulation We have learned in CFA(R) Course in Economics that RBI is a regulator of the banking system.

RBI was closely monitoring this issue ever since the company started recording losses. In 2019 RBI kept the bank in Preventive Corrective Action for a year. The plan was to get equity capital infused from either India Bulls or Clix Capital. But as it didn’t work out, RBI had to cap max withdrawal of Rupees 25,000 for a month on 17th November and also declared that DBS India (a subsidiary of DBS Singapore) shall acquire LVB. DBS would bring in Rs 24,000 Crore of capital investment to fuel in a bank and in return gets a network of 560 plus branches across 19 states.

RBI managed to arrange an investor- DBS Bank, thereby protecting the interest of the depositors.

CFA(R) Fixed Income – Debt comes before Equity We have learned in CFA(R) Course that in terms of the ranking system – Debt always comes before Equity and that’s what makes Debt – less risky and Equity – a riskier investment.

In this scheme of DBS taking over LVB, 2 things can be prominently seen:

dues of Debtholders of a bank (deposit holders) are completely being protected. They aren’t losing a single rupee

dues of shareholders are completely being lost as Equity is being wiped down to NIL (Equity holders are losing everything)

Bottom Line: Same company when viewed from the eyes of debtholders looks less risky as compared to when looked at from the eyes of Equity holders.

CFA(R) Ethics Standard V- Investment Analysis: Past Drives Futures. Really?? Equity investors had significant indications from the past 10 quarters that LVB is not performing well. But they were of a belief that it would be able to turn around with the support of equity capital infusion.

They anticipated that RBI would come up for help in case lenders fails to attract equity investors. Precedence was the case of Yes Bank where RBI’s action did help equity holders to a significant extent.

Sadly, this did not happen as RBI decided to write down equity capital to 0. What CFA(R) Candidates can learn from this:

Past returns do not always determine the future returns (assuming LVB would be a copy-paste of Yes Bank turned out to be a blunder.

CFA(R) Ethics Standard 1(D) Misconduct As of now, it hasn’t come to the table that there was any fraud involved in sanctioning of loans. Also, deliberate default from borrowers (called willful default) also hasn’t yet been concluded.

There is one more fact in the tail, the Singh Brothers (who owned Religare Enterprises) were arrested in charge of fraud with a bank with 791 crores. They clarified that the bank has converted 791 Crores of Fixed Deposits and deducted the Principal amount of loan of 750 Crores Rupees by themselves without prior information. The hearing of this case is going in the court as of now. Probably this was a Misconduct on account of the lender or not – Court will take a call soon.