The proposed regulations are a significant improvement over the extant regulations and address many of the inadequacies and incongruities present in the latter. One of the proposed changes, which is the requirement for improved granularity in categorising and disclosing information related to investments would help in improving the transparency of the banks’ standing in terms of both risk exposure and financial position. These proposed changes are in accordance with the recommendations in our paper on the transparency of banks’ disclosure regime where we proposed, among other recommendations, that banks should disclose the amounts of investments in the various categories – Held-to-Maturity (HTM), Available-for-Sale (AFS), Held-for-Trade (HFT), and the assumptions and methodologies used in the valuation of securities in their investment book[1].
The Discussion Paper also enables banks to hold non-SLR securities, such as corporate bonds, in their HTM portfolio. Earlier, banks wanting to diversify had to necessarily hold such instruments in their trading book, either as AFS or HFT. This approach subjected them to market price volatility, irrespective of whether the intent of the bank was to hold such instruments to maturity, or not. This approach thus disincentivised banks from diversifying their exposures using debt instruments. The proposed regulation allows them to move away from an exclusive “originate-and-hold-to-maturity” strategy, thereby improving their ability to manage concentration risks better[2]. Moreover, it would also allow them to improve the liquidity of their balance sheets.
We also commend the RBI’s approach of outlining the background, rationale, and guiding principles of the regulations before detailing the regulations themselves. However, we point out certain inconsistencies and omissions in the proposed regulations that could undermine the achievement of its objective.
We present detailed feedback on the Discussion Paper in the form of answers to the ten questions posed within the Discussion Paper. For concerns that fall outside the scope of the first nine questions, we include specific comments in the tenth answer.
Question 1: Are there any important issues pertaining to the investment portfolio that should be taken up for consideration?
The proposed changes in the classification and valuation norms for instruments in banks’ investment portfolio seek to bring the regulatory framework closer to the standards prescribed in the Indian Accounting Standards (Ind-AS) and the International Financial Reporting Standards (IFRS)[3]. Additionally, the proposed regulations also make the classification of instruments stringent in comparison to the extant instructions, which allow for a laxer classification of instruments at initial recognition and also allow for relative ease in their reclassification later[4].
As the Discussion Paper states in paragraph 5.3, one of the reasons to review the extant norms is due to the blurred distinction between the categories – AFS and HFT – of what is viewed as the trading book[5]. The lack of a distinct separation between the two categories has led to most trading being conducted out of AFS portfolio rather than HFT, thus distorting the trading book[6]. The proposed regulations seek to remedy this by allowing only those financial instruments that satisfy the Solely Payments of Principal and Interest on Principal Outstanding (SPPI) criterion to be held in the AFS portfolio[7]. Also, the securities held in the AFS portfolio can be held to maturity or sold without any restriction[8]. The intent appears to be, therefore, to allow banks to hold, or sell, securities for Asset Liability Management (ALM) purposes without having to subject them to a greater valuation frequency, as is applicable for the HFT portfolio. (Per the extant instructions, securities held in the AFS portfolio are required to be marked-to-market (MTM) on a quarterly basis, whereas for those in the HFT category, the MTM requirement is daily[9]). However, without any explicit restriction on the sale of securities in the AFS portfolio, the arbitrage present in the extant guidelines would continue to persist, albeit for a smaller subset of securities.
For instance, those instruments which are held by the bank with the intent of trading[10], but which also meet the SPPI criterion, can still be traded out of the proposed AFS portfolio, which has a lower valuation frequency requirement. Essentially, in this case, while the bank is subject to market risk – in the form of short-term price volatility – the full extent of risk is not captured when instruments are placed in the AFS portfolio, instead of HFT. This, in turn, obfuscates the true levels of risk which the bank is exposed to, and can potentially limit the effectiveness of the bank’s overall risk management strategy. Therefore, to ensure that instruments held for trading are not misclassified as AFS, it is important that the RBI include explicit limitations on the sale of securities in the AFS portfolio so that it can better achieve its stated objective and prevent the distortion of the trading book.
Question 2: Are there any other overarching principles that the RBI should consider while updating the current framework?
The guiding principles outlined for updating the current framework of regulations are an important aspect of the Discussion Paper as they form the basis for the current as well any potential future revision(s)/amendment(s) to the norms. While the proposed principles are largely relevant for the effective regulation of the investment portfolio, we share below a concern regarding the framing of one of the principles.
Guiding Principle (e) reads – ‘The issues specific to the Indian context should be addressed and given due weightage in the revised framework[11].’ As clarity on the meaning and interpretation of the term ‘Indian context’ is not provided in the guiding principle itself, there is scope for ambiguity in the interpretation of this principle. Moreover, it may be apt to consider Guiding Principle e) as an implicit principle that guides the framing of not just the proposed norms in this Discussion Paper, but of all of RBI’s regulations. The RBI could instead provide the rationale for any context-specific norms which may have been drafted, why there was a need to deviate from global standards, and an analysis laying out the costs and benefits of such norms to financial service providers. Such an articulation of contextual elements (if any) would reduce the potential ambiguity in the interpretation of the principle while also preserving economic substance.
Question 3: Should banks be given the irrevocable option at initial recognition (or on transition to this framework) to classify their investments in equity shares of their subsidiaries, associates, and joint ventures under FVTPL or AFS like any other equity instrument instead of the mandatory classification as HTM proposed above?
Equity investments in such ventures are likely to be long-term and strategic in nature, without any objective of trading for capital appreciation. Therefore, it would appear appropriate to shield bank balance sheets from short term fluctuations of the investment’s market price. Thus, a classification of most such investments as HTM is valid.
However, if a bank were to use a portion of these investments for the purpose of trading, even with the exemption of such securities from the sale threshold limits under the HTM category[12], the accounting norms on gains arising from sales out of HTM[13] preclude the bank from fully taking advantage of changes in fair value of these investments. Therefore, the proposal of mandatory classification of a bank’s investments in equity shares of their subsidiaries, associates, and joint ventures as HTM may be restrictive and even seen as impinging on the bank’s freedom to pursue its business strategy.
Further, it is important that these shares be regularly assessed to check for any permanent diminution of value. Therefore, it is beneficial that the proposed guidelines handle this aspect through the quarterly assessment of HTM securities for impairment. We elaborate, in the answer to Question 5, how these impairment tests can be improved to provide a fair presentation of the banks’ financial statements.
Question 5: Clause 9(a) of the Reserve Bank of India (Classification, Valuation and Operation of Investment Portfolio of Commercial Banks) Directions, 2021 (i.e., the Master Direction) provides certain tests for impairment. Is there a need for specifying more indicators of potential impairment?
The extant instructions pertaining to the prudential norms on the classification and valuation of investment portfolio give a prescribed set of circumstances under which impairment is determined. Per the extant instructions, the need to determine whether impairment has occurred shall arise in the following circumstances[14]:
- On the happening of an event which suggests that impairment has occurred which, at the minimum, shall include:
- the company has defaulted in repayment of its debt obligations.
- the loan amount of the company with any bank has been restructured.
- the credit rating of the company has been downgraded to below investment grade.
- The company has incurred losses for a continuous period of three years and the networth has consequently been reduced by 25 percent or more.c.
- In the case of a new company or a new project when the originally projected date of achieving the breakeven point has been extended i.e., the company or the project has not achieved break-even within the gestation period as originally envisaged.
Given that, under Indian Generally Accepted Accounting Principles, impairment itself is based on incurred loss and not expected loss (as in Ind-AS), the relevance of the impairment exercise is further reduced when there is only a limited set of circumstances under which impairment is assessed. Also, many of these prescribed circumstances – such as when the company has defaulted in repayment of its debt obligations, and when the loan amount of the company has been restructured – are those that are triggered after the event of default.
The relevance and usability of the impairment test can be further improved if these impairment tests are forward-looking. While the extant instructions mention that these are the ‘minimum’ features that need to be considered, it would be prudent to include additional tests that better evaluate impairment or a significant increase in credit risk like those laid out in Ind-AS standards[15]. Some of these are:
a) Significant changes in external market indicators of credit risk such as the credit spread and market information related to the borrower, such as adverse changes in the prices of a borrower’s debt and equity instruments.
b) Significant changes in facets of the borrower’s operating results that go beyond just networth, such as declining revenues or margins, increased balance sheet leverage, management problems, or other factors that significantly affect the borrower’s ability to service their debt obligations.
c) Significant changes in the value of the collateral supporting the asset or in the quality of third-party guarantees or credit enhancements which might reduce the borrower’s incentive to make the scheduled contractual payment.
Question 6: Is the definition of ‘active market’ as given above with illustrative examples adequate? Are there any other markets that could be considered as ‘active markets’? Comments may be provided with rationale.
While the definition of ‘active markets’ as specified in paragraph 7.29 is adequate at a principle level, there is a lack of clarity in the given illustrative examples. For instance, it is unclear what is meant by ‘recognised stock exchanges for SENSEX/NIFTY shares.’ It is not clear whether all recognised stock exchanges, and the shares traded in them, should be considered as active markets or that only shares of entities that are part of SENSEX/NIFTY that are traded in recognised stock exchanges be considered as active markets? In the case of the latter, the definition of an ‘active market’ would be rather restrictive as equity shares not included in the benchmark indices could also have adequate liquidity. For instance, the 1-month average trading volume of Vodafone Idea’s stocks is 42 Crore number of shares, while the equivalent figure for Reliance Industries, which is part of the SENSEX (BSE 30), is 68 Lakh number of shares[16]. We propose that, in addition to illustrative examples, there also be an indicative list of features (such as a low bid-ask spread or daily trading volumes above a threshold) that an ‘active market’ for an asset or a liability might possess.
Question 7: Is the definition of ‘unobservable inputs’ as given above with the illustrative examples adequate?
In paragraph 7.30, the illustrative example for the investments whose valuation is presumed to be based on unobservable inputs includes mutual funds that invest more than 10% of their corpus in unquoted instruments[17]. This is unduly restrictive as the regulation treats the valuation of unquoted instruments on par with that of mutual funds, whose units are listed, and yet have 10% or more of their corpus in unquoted instruments. The liquidity of the mutual fund unit is more pertinent than the valuation of the underlying securities themselves.
Question 8: Should the IFR continue? If so, at what level should it be set and how much time should be given to banks to achieve that level?
As the Discussion Paper mentions, the rationale for the Investment Fluctuation Reserve (IFR) is to protect banks from interest cycles. Historically, RBI has given special dispensation to banks on occasions when the interest rate cycle turned adverse. For instance, during times of sustained rises in G-sec yields, banks were allowed to, in 2005, shift securities from other categories into HTM, and in 2013, defer recognition of valuation losses by six months[18]. Protecting its portfolio against adverse market movements is prudent risk management for a bank and all banks should employ appropriate risk management strategies to achieve the same. It is not the regulator’s remit to design and enforce operational risk management strategies for banks nor should it provide special dispensations going forward. Thus, both the IFR and any related regulatory forbearance should be discontinued.
Question 10: Are there any proposals you do not agree with? If yes, please provide separate comments for each proposal you do not fully agree with mentioning the proposal number, the specific paragraph number and reasons for disagreement. Comments would be useful, if they clearly articulate implementation difficulties or conceptual issues along with alternative proposals.
The following points list our concerns regarding specific points in the proposal.
- Paragraph 7.4 details the type of securities that can be classified as HTM. The list does not include debt instruments with floating rate coupons linked to a market-determined interest rate. These instruments meet the SPPI criterion and if the bank were to have an intent to hold such instruments to maturity, they should be allowed to be classified as HTM. However, as such instruments are not included in the illustrative examples in paragraph 7.4, it is unclear whether these instruments qualify to be classified as HTM.
- In paragraph 7.6, in the illustrative list of instruments that need to be categorised as FVTPL, only investments in pass-through certificates (PTCs) representing the equity tranche of a securitisation transaction are included. The paragraph also states that investments in other senior and mezzanine tranches shall need to be reviewed for their compliance with the SPPI criterion[19]. However, it is unclear whether such investments (PTCs of senior or mezzanine tranches) can be held in HTM, if the intent is to hold them to maturity. The lack of a clear directive regarding PTCs would act as a barrier for banks to expand their (HTM) investments in PTCs. This in turn can potentially block liquidity sources for those institutions which directly originate assets, especially in the priority sector[20].
- Paragraph 7.6 which gives the illustrative list of instruments that need to be categorised as FVTPL lists ‘Securitisation receipts’ as one of the instruments[21]. The regulations need to explicitly specify that securitisation receipts are from the sale of non-standard assets, and not that of standard assets.
- Paragraph 5.3 mentions that the asymmetric treatment of the AFS/HFT portfolios in the current framework is one of the reasons for revising it. However, the guidelines then stipulate that the initial valuation of instruments that are not quoted and cannot be valued through market variables, will be done in an asymmetric manner. The rationale given (in paragraph 7.10) for the asymmetric treatment is that the BR Act (Banking Regulation Act, 1949) requires banks to recognise all losses and expenses before paying out dividends[22]. However, that still does not explain why gains need to be amortised over the period of the asset’s lifetime and not recognised instantly. If the RBI’s rationale behind continuing the asymmetric treatment is a matter of following the principle of prudence, it must explicitly state so. Also, a clear distinction needs to be made between unrealised and realised losses/gains.
Concluding Remarks
The proposed regulations, if and when implemented, would succeed in addressing several major and long-standing issues with the current framework on banks’ investment portfolio. We wholeheartedly welcome several significant changes in the guidelines pertaining to a) the eligibility of non-SLR securities to be held in HTM b) the categorisation of investments into fair value hierarchies and c) the increased requirement for disclosures in the notes to accounts. However, there are still some issues, if left unaddressed, would diminish the significance and efficiency of the proposed measures. For instance, the norms on the hierarchy of valuation methods are held back by the lack of clarity on the interpretation and application of the definition of active markets. The permitting of non-SLR securities to be classified as HTM must also be bolstered by robust impairment tests, and clarity on the eligibility of specific instruments such as PTCs of senior and mezzanine tranches. Moreover, the distinction between the trading book categories needs to be clear enough to address the trading book distortions.
Nonetheless, it is laudable that the proposed guidelines would bring the Reserve Bank’s guidelines on valuation of the investment portfolio closer in line with that of global standards of accounting and risk management[23]. This would also ease the process of future implementation of Ind-AS for banks. In addition to improving the regulation and disclosure regime at the entity level, the proposed changes would have a positive effect from a systemic risk point of view as well. With the proposed changes on eligibility of non-SLR securities to be classified as HTM, banks can better manage their concentration risks and also improve the liquidity of their balance sheets. Further, as banks are significant participants in the investor market, this proposed change could also aid in the development of the bond market, which in turn would have far-reaching positive effects on systemic stability and financial market resilience.
[1] Srinivas, Madhu, et al. ” Assessing Transparency of Indian Banking System’s Public Risk Disclosure Regime – A Regulation Based Approach.” 2021. Dvara Research.
[2] Risk management strategy for large branch-based banks to deliver credit more effectively to low-income households and small businesses. Source – Chapter 4.2, Committee on Comprehensive Financial Services for Small Businesses and Low-Income Households. 2014. RBI Publications. Retrieved from: https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/CFS070114RFL.pdf
[3] Paragraph 5.2, Ibid.
[4] Section 5, Ibid
[5] Paragraph 5.3 point (e), Ibid.
[6] Ibid
[7] Section 7, Ibid
[8] Ibid
[9] Paragraphs 7.12 and 7.15, Ibid.
[10] That is, holding the securities for short term resale or to benefit from short-term price movements, or to lock in arbitrage profits.
[11] Section 6, Discussion Paper on Review of Prudential Norms for Classification, Valuation and Operations of Investment Portfolio of Commercial Banks. January 2022. RBI Publications. Retrieved from: https://rbidocs.rbi.org.in/rdocs/Publications/PDFs/DISCUSSIONPAPER9604DB243FA84169847AC576EBEB593B.PDF
[12] Per Paragraph 7.20 in the Discussion Paper, if a bank were to choose to sell or disinvest from the investments in subsidiaries, associates and joint ventures, it is free to do so as the sale of such securities is exempt from the threshold limit (five percent of the opening carrying value of the HTM portfolio) of aggregate sales out of HTM.
[13] Paragraph 7.20, Ibid.
[14] 9 (a) (v), Master Direction – Classification, Valuation and Operation of Investment Portfolio of Commercial Banks, 2021. August 2021. RBI Master Directions. Retrieved from: https://rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=12153
[15] B5.5.17, Indian Accounting Standard (Ind AS) 109 – Financial Instruments. Retrieved from: https://www.mca.gov.in/Ministry/pdf/INDAS109.pdf
[16] As on Feb 9, 2022. Retrieved from: https://www.moneycontrol.com/india/stockpricequote/telecommunications-service/vodafoneidealimited/IC8;
https://www.moneycontrol.com/india/stockpricequote/refineries/relianceindustries/RI;
[17] Paragraph 7.30 point (a), Discussion Paper on Review of Prudential Norms for Classification, Valuation and Operations of Investment Portfolio of Commercial Banks. January 2022. RBI Publications. Retrieved from: https://rbidocs.rbi.org.in/rdocs/Publications/PDFs/DISCUSSIONPAPER9604DB243FA84169847AC576EBEB593B.PDF
[18] Heads I Win, Tails the Regulator Dispenses, Understanding and Managing Interest Rate Risk at Banks – Speech by Viral V Acharya, Deputy Governor. January 2018. RBI Speeches and Interview. Retrieved from: https://www.rbi.org.in/Scripts/BS_SpeechesView.aspx?Id=1053
[19] Paragraph 7.6 point (a), Discussion Paper on Review of Prudential Norms for Classification, Valuation and Operations of Investment Portfolio of Commercial Banks. January 2022. RBI Publications. Retrieved from: https://rbidocs.rbi.org.in/rdocs/Publications/PDFs/DISCUSSIONPAPER9604DB243FA84169847AC576EBEB593B.PDF
[20] Recommendation 4.10, Committee on Comprehensive Financial Services for Small Businesses and Low-Income Households. 2014. RBI Publications. Retrieved from: https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/CFS070114RFL.pdf
[21] Paragraph 7.6 point (b), Discussion Paper on Review of Prudential Norms for Classification, Valuation and Operations of Investment Portfolio of Commercial Banks. January 2022. RBI Publications. Retrieved from: https://rbidocs.rbi.org.in/rdocs/Publications/PDFs/DISCUSSIONPAPER9604DB243FA84169847AC576EBEB593B.PDF
[22] Paragraph 7.10, Discussion Paper on Review of Prudential Norms for Classification, Valuation and Operations of Investment Portfolio of Commercial Banks. January 2022. RBI Publications. Retrieved from: https://rbidocs.rbi.org.in/rdocs/Publications/PDFs/DISCUSSIONPAPER9604DB243FA84169847AC576EBEB593B.PDF
[23] Section 4, Ibid.
Cite this Item:
APA
Neelam, A., & Srinivas, M. (2022). Feedback on the Reserve Bank of India’s Discussion Paper on Review of Prudential Norms for Classification, Valuation and Operations of Investment Portfolio of Commercial Banks dated 14 January 2022. Retrieved from Dvara Research.
MLA
Neelam, Amulya and Madhu Srinivas. “Feedback on the Reserve Bank of India’s Discussion Paper on Review of Prudential Norms for Classification, Valuation and Operations of Investment Portfolio of Commercial Banks dated 14 January 2022.” 2022. Dvara Research.
Chicago
Neelam, Amulya, and Madhu Srinivas. 2022. “Feedback on the Reserve Bank of India’s Discussion Paper on Review of Prudential Norms for Classification, Valuation and Operations of Investment Portfolio of Commercial Banks dated 14 January 2022.” Dvara Research.
