Banks must not be surprised but understand the risks in the bond markets well and that central bank will not intervene to bail out banks from adverse interest rate movements, Reserve Bank of India (RBI) Deputy Governor Viral Acharya said.
Banks must not be surprised, but understand the risks in the bond markets well, said Reserve Bank of India (RBI) Deputy Governor Viral Acharya, even as he noted the central bank will not intervene to bail out banks from adverse interest rate movements.
Banks are set to witness heavy treasury losses amounting to anywhere between Rs 15,000 - 25,000 crore in the third quarter results after the bond yields collapsed about 67 basis points in the December quarter.
However, in a strong message, Acharya said “Interest rate risk of banks cannot be managed over and over again by their regulator."
In a speech at the annual dinner of the Fixed Income Money Markets and Derivatives Association (FIMMDA), the RBI deputy governor indicated this was not the first time when bond yields have risen. But banks have not been much wiser; rather, they tend to ignore the risk. “… banks should not be surprised repeatedly when government bond yields rise sharply and their investment profits drop."
Having started reporting the results this month, banks have asked RBI to allow spreading of the provisions on the losses to avoid taking an immediate hit on their profitability.
It has been a common practice among Indian banks to seek relaxation whenever they were in losses, and the regulator in the past has largely obliged.
However this time, Acharya threw the ball in the treasury departments' courts speaking to the association of bond investors, most of them being from banks, saying instead of praying for regulatory relaxations they should equip themselves with derivative products.
“The regulator, in the interest of financial stability, is caught in such situations, between a rock and a hard place, and often obliges,” Acharya said.
However, he added, "By taking advantage of the dispensation regularly, efficient price discovery in the government securities (G-Sec) market and effective market discipline on the G-Sec issuer was not happening. “Nor does it augur well for developing a sound risk management culture at banks.”
According to him, the excess liquidity in the banking system did not get absorbed through the RBI’s liquidity operation, and capital-starved banks parked the funds in bonds, at the expense of duration risk.
He said, "With relatively high duration and concentration of G-Secs in investment portfolio, bank earnings and capital remain exposed to adverse yield moves."
As a result, the size of banking sector's balance-sheet exposure to G-Secs, and hence, its interest rate risk, is high in an absolute sense, and is relatively elevated, when measured in proportion to total assets, for public sector banks relative to private banks.
RBI’s Financial Stability Reports (FSR) have regularly pointed out the impact of such large interest rate moves on capital and profitability of banks, said Acharya. "Banks should know and understand this risk rather well. Perhaps they do, and the issue is really one of incentives that lead to their ignoring this risk.”
And the incentive was to line up to the regulator to give regulatory compensation, which, Acharya described as “heads I win, tails the regulator dispenses.”
The share of commercial banks in outstanding Government Securities (G-Secs) was around 40 percent as on June 2017, while investment of banks in G-Secs as a percentage of their total investment was around 82 percent for FY 2016-17.
The corresponding figure for public sector banks for 2016-17 was slightly higher at 84 percent.
In spite of the relative stability of the consolidated debt to gross domestic product (GDP) ratio of the government, the investor base for G-Secs in India was primarily limited to domestic institutions, which often resulted in oversupply of bonds in the market, Acharya pointed out.
