Indian banks' holdings of government securities - measured in rupees - have fallen for the first time in almost 40 years and are now close to the statutory minimum. Such holdings remain, however, large and draw attention to their risk as interest rates are increasing. This paper reviews the reasons why such holdings are so large and measures their interest rate risk using duration/convexity and value-at-risk methods. The first key finding is that, at end-March 2004, some public sector and old private banks were vulnerable to a reversal of the interest rate cycle, while foreign and new private banks had built adequate defences. The second key finding is that recent changes in regulation such as the move to Basel I and the road map to Basel II are important as they make Indian banks' capital more sensitive to interest rate risk.
