The Indian banking sector can breathe a sigh of relief as the Reserve Bank of India's (RBI) financial stability report, released barely three months ago, dismisses the possibility of a Silicon Valley Bank-type crisis in the Indian banking system.
Like in India, the yields on US government securities have increased significantly when the Federal Reserve increased interest rates by a whopping 450 basis points. This, in turn, has been causing losses for bond investors as prices dropped with the increase in yields. In fact, this drop in prices was the reason which drove Silicon Valley Bank to collapse, primarily because the bank had invested the deposit money, which it received from start-ups and venture capital firms, in long-term US government securities. The mark-to-market losses on its investment portfolio and the subsequent withdrawal of deposits compelled the bank to liquidate its investment portfolio at a loss.
Coming to the Indian scenario, the RBI's report, which covered an 8-year period until the first quarter of 2022-23, has found that Indian banks' interest income and other non-interest income, such as, fee and commission, underwriting, and income from forex operations, could partly offset treasury losses in a rising interest rate scenario. Since May last year, the RBI has hiked the benchmark repo rate by 250 basis points to 6.50 per cent. There is another 25-basis point increase expected in the April monetary policy. This sudden hike in interest rates in India is little over half of what the US has done.
Whenever monetary policy gets tighter, rising yields on securities have a negative effect on trading income because the prices of existing securities drop in the market, which lowers their value. Additionally, the new securities are priced at a much higher rate reflecting the new interest rates in the economy.
There are rules for mark-to-market for any change in the value of securities both globally and in India's banking system. As per the RBI rule, investments classified under the 'held to maturity' (HTM ) category need not be marked-to-market. The securities in Available for Sale (AFS) category will be marked-to-market generally at quarterly intervals. The securities in the Held for Trading (HFT) category are marked-to-market at monthly basis.
Indian banks investment portfolio of short-term securities (up to 1 year), which are generally kept for sale and trading purposes, is around 37 per cent, whereas a large portion with a maturity profile of more than a 1 is parked in the HTM category.
In a recent analyst meeting, private sector ICICI Bank stated that they generally carry a very low duration portfolio in the AFS category. "So, whatever mark-to-market, if at all, would have been there in third quarter, it would have been negligible. We would have had some small gains on the equity side. So, that has led to this small net positive. But even adjusted for that, we would not have had any material mark-to-market at all because of the low duration of our AFS portfolio," the bank had said.
Over a 5-year period, Indian banks' trading income has indeed shown high volatility because of changes in interest rates, but banks also have interest rate hedging mechanisms. In fact, the private sector and foreign banks are better in terms of hedging and containing losses.
In its report, the RBI said that countercyclical macroprudential tools, such as the investment fluctuation reserve (IFR), created by transferring the gains realised on sale of investments during an easing interest rate cycle, act as shock absorbers in a tightening phase.
It may be remembered that the IFR guidelines were revised in April 2018 under which banks were advised to transfer net profit on sale of investments to the IFR, until it reaches at least two per cent of the Held for Trading (HFT) and Available for Sale (AFS) portfolios.
According to RBI, the banking system’s IFR reached 2.2 per cent of HFT plus AFS portfolios in March 2022. "This has helped banks absorb the losses associated with the rise in G-sec yields in the first quarter of 2022-23 and resultant treasury losses, to the tune of 4.9 per cent of their operating profit," the central bank had noted in its report. It further added that the banks have reported positive trading income to the tune of 2.1 per cent of operating profit as G-sec yield plateaued in the second quarter of 2022-23.
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