As gilt yields rise, an RBI step from 2018 could be a blessing for banks’ capital position

While most analysts continue to retain their confidence in the banking space, a development since the Union Budget on February 1 could pose risks to the profitability of Indian lenders – an abrupt rise in yields on government securities.

With the Budget announcing a larger-than-expected fiscal deficit and gross borrowing programme for the next financial year, sovereign bond yields have shot up, with yield on the 10-year benchmark paper registering a rise of 22 basis points so far in the quarter.

The Indian 10-year bond yield was last at 6.68 per cent. Bond yields and prices move inversely and when prices decline, banks suffer marked-to-market losses which eat into capital and profitability.

Specifically, the government securities that are held in two categories – the available-for-sale portfolio and the held-for-trade portfolio require banks to provide for marked-to-market losses in the event of a rise in gilt yields.

Domestic banks are said to be holding government securities well in excess of the 18 per cent of net demand and time liabilities (a proxy for deposits) stipulated under the Statutory Liquidity Ratio.

This is primarily owing to the deluge of surplus liquidity infused by the RBI into the banking system – much of which has been parked in government bonds amid low credit off-take due to the coronavirus pandemic.

While surging crude oil prices and the likelihood of the US Federal Reserve suggest that sovereign bond yields are set to harden further by the end of the quarter, analysts say that a step taken by the RBI in 2018 could cushion the losses for Indian banks and more crucially, prevent core capital from taking a hit.

In April 2018, the central bank, which was then helmed by Urjit Patel, had issued a circular which advised banks to create an Investment Fluctuation Reserve in order to build up an adequate buffer to protect against episodes of rising yields.

The investment fluctuation reserve (IFR) which would come into effect from 2018-19 should be at least 2 per cent of the available-for-sale (AFS) and held-for-trade (HFT) portfolios and would be eligible for inclusion in tier-2 capital, the RBI had said.

“A bank may, at its discretion, draw down the balance available in IFR in excess of 2 percent of its HFT and AFS portfolio, for credit to the balance of profit/loss as disclosed in the profit and loss account at the end of any accounting year,” the circular read.

This move by the RBI, which at the time had been viewed by some segments of the market as a conservative step, will now provide banks with a much stronger footing to navigate treasury losses than they had in the past.

““What will happen is that because the banks would have credited this amount on their reserves and surpluses over the last three or four years; though there will be an marked-to-maturity (MTM) loss, banks can utilize this IFR against the loss,” ICRA, Vice-President and Co-Group Head Anil Gupta said.

“There will be a loss in the P&L, no doubt. But it will not impact the core capital of a bank because the IFR is included is included in the tier-2 capital,” he said.

Over the last few years, on several occasions, banks have been compelled to seek regulatory dispensation from the RBI in order to soften the blow of treasury losses on their books when bond yields hardened. This approach was criticized by former Deputy Governor Viral Acharya.

Given that the Indian banking system is burdened with a legacy of asset quality problems, lenders could hardly afford a fresh erosion of capital emanating from interest rate risks on bond portfolios.

“Any hardening of interest rates would depress investment income under the AFS and HFT categories (direct impact). It is assessed that a parallel upward shift of 2.5 percentage points in the yield curve would lower the system level capital to risk-weighted assets (CRAR) by 77 bps and system level capital would decline by 5.6 per cent,” the RBI observed in its Financial Stability Report for December 2021.

Based on the PV01 (present value formula) figures provided by the RBI in its report, Gupta provided a back-of-the envelope calculation for the degree of MTM losses banks could incur in the event of a 40-basis-point rise in bond yields.

PV01 describes the actual change in price of a bond if the yield changes by one basis point. Higher the PV01, the higher would be the volatility.

“…You can say based on a PV01 of around Rs 200 crore, there would be an MTM loss of roughly Rs 8,000 crore for public sector banks. For private banks it is mentioned at Rs 44.6 crores. Which means that one basis point is roughly Rs 45 crore and 40 basis points would be somewhere a little less than Rs 2,000 crore.

“For foreign banks the situation is that they are heavily loaded on government securities because their credit-deposit ratio is typically low and they end up parking surplus liquidity into g-secs so their number is higher at Rs 121 crore PV01. So for forty basis points you can say that maybe Rs 4,800 to Rs 5,000 crore.“

As yields inevitably head higher once the Centre’s gigantic borrowing programme for the next financial year commences in April, it is also possible that the RBI could provide dispensation to banks such as provision to spread out losses over successive quarters or by extending the existing leeway given on keeping securities in the held-to-maturity portfolio.

Securities kept in the held-to-maturity portfolio are exempt from being marked-to market.

The central bank had earlier increased limits under the held-to-maturity (HTM) category to 22 percent from 19.5 percent of total deposits. The dispensation was then extended by another year to 2023.

Fresh regulatory leeway notwithstanding, Indian banks and those investing in them, can breathe a lot easier because of the step taken by the country’s central bank four years ago, sector specialists believe.