Table 3: Interest Rate Risk of Banks’ G-Sec Holding (Duration Method)

(in billions of rupees as of end-March 2004, unless otherwise indicated)

Source: Reserve Bank of India and author’s estimates.

Economic and Political Weekly March 31, 2007 (Table 3). The market value of banks’ government securities holdings would be reduced by about Rs 300 billion or 6 per cent of the portfolio.5 PSBs and old private banks would be the most exposed with portfolio losses of 153 per cent and 123 per cent of net profit, respectively, as of end-March 2004. Foreign banks and new private sector banks would be the least vulnerable to such a shock, with losses of 39 per cent and 76 per cent of net profit, respectively. Capital adequacy: Such losses would represent about 26 per cent of total capital and a drop in the capital adequacy ratio (CAR) to 9.6 per cent from 13 per cent (Table 3). A similar exercise using 1999 data finds that banks would lose 18.3 per cent of total capital and their CAR would fall by 2 per cent in 1999, suggesting that the exposure to interest rate risk has increased over the years. The capital adequacy of PSBs would be the most exposed, with their average CAR falling to about the level of the 9 per cent regulatory minimum (from 13.2 per cent).

Our results are consistent with previous findings. For instance, Sarkar (2003) estimates the worst-case loss at end-2002 (for a 90-day horizon and a 99 per cent confidence level) for a sample of 51 Indian banks at around Rs 265 billion or almost 5 per cent of their holdings of government securities. Similarly, private banks are found to be the least exposed to interest rate risk and PSBs the most exposed. No foreign banks (out of 9 banks) would erode more than 25 per cent of networth while, among private banks, the proportion with such risk was around 47 per cent (out of 15 banks) and, among public sector banks, 85 per cent (out of 27 banks). Sarkar (2003) finds that Indian banks are not uniform in their interest rate risk exposure and there is no clear relationship between their capital adequacy ratio and the market risk they take.

Value-at-Risk (VaR) Approach

International Best Practices: Basel Core Principles

Table 4: Interest Rate Risk of Banks’ G-Sec Holding(Value-at-Risk Method)

Figure 3: Public Sector Banks – Capital Adequacy Ratiosand IFR, India

0

20

8

18

6

16

144

122

100

88

Sources: RBI and author’s calculations.

would benefit from lower regulatory capital requirements. In contrast, banks with poor risk management would be penalised by higher capital requirements.

The IMF (jointly with the World Bank), as part of its financial sector assessment programmes, has reviewed countries’ compliance with Basel Core Principles (BCP). In the course of 71 confidential assessments covering 12 advanced, 15 transition, and 44 developing economies, it has been found that all advanced economies under consideration have complied with the Basel I core principles regarding market risk and risk management. In contrast, 66 per cent of developing economies and 53 per cent of transition economies did not comply with such principles.

In India, the RBI has moved gradually towards Basel I principles for managing interest rate risk with the use of specific regulatory measures in the interim period.8 In 2000, banks were required to use a 2.5 per cent risk weight for their portfolio of government securities in order to determine their capital adequacy ratio, as compared to zero under Basel I.

As an alternative to Basel I, the RBI also relied on the IFR as the main line of defence against a potential reversal of the interest rate environment. As per RBI’s guidelines, Indian banks’ trading books include securities under the HFT and AFS categories. In 2002, banks were advised to build up an IFR of a minimum of 5 per cent of the investment in HFT and AFS categories within a period of five years. Banks were also advised to achieve the goal earlier and are encouraged to reach a 10 per cent ratio. Transfer to IFR was as an appropriation of net profit after appropriation to statutory reserve.

In 2004, the RBI announced that implementation of the Basel norm for capital charge for market risk would be phased in over a two-year period. In particular, banks were required to maintain capital for market risks on securities included in the HFT and AFS categories, by March 2005 and March 2006, respectively.

In 2005, the RBI advised that those banks with a capital adequacy ratio of at least 9 per cent of the risk weighted assets (for both credit risk and market risk, and for both the HFT and AFS categories) as of March 31 2006, would be permitted to treat the entire balance in the IFR as Tier I capital (rather than Tier II capital). The RBI noted that several public and new private sector banks benefited from this measure and the IFR ratio for SCBs dropped sharply to below 0.1 per cent from 4.4 per cent at end-March 2005 [RBI 2006]. According to Gupta and Batra (2006), the inclusion of the IFR will increase Tier I capital by about 20 per cent over the March 2005 levels and provide more room for banks to raise Tier II capital.

IFR (in per cent of eligible securities) CAR (in per cent)

0 1 2 3 4 5 6

The road map to Basel II should also provide Indian banks a strong incentive to strengthen their risk management practice.9 Banks are required to manage the market risk in their books on an ongoing basis and comply with the capital requirement for such risk on a daily basis. Intra-daily exposures have to be monitored and controlled using strict risk management systems. To measure interest rate risk, banks will have to use a duration method.

Although the convergence to Basel I is under way, it is useful to review the limitations with using the IFR as a buffer against changes in interest rates. In fact, Basel I and II can be viewed as more efficient approaches to manage interest rate risk. This is because it recommends capital charges commensurate with the risk exposure of banks, whereas IFR requirements were uniformly applied to banks with no consideration as to the level of interest rate risk and its associated management. As a result, banks with low exposure to interest rate risk paid a regulatory cost if they complied with the advised IFR level. In contrast, the advised uniform level of IFR may not have been sufficient to protect some banks from their high exposure to interest rate risk. Furthermore, a number of banks may not have been able to generate sufficient profitability and capital to build the advised level of IFR.

In fact, the aggregate level of IFR at end-March 2004 was about half that needed to absorb market losses resulting from a one percentage point increase in government bonds yields. The aggregate banking system’s IFR stood at 3.0 per cent of eligible government securities at end-March 2004, just over half of the

5.8 per cent needed to absorb a one percentage point increase in the benchmark 10-year government bond (Table 5). The shortfall would have been from public sector banks and old private sector banks. In contrast, new private banks and foreign banks had IFR levels sufficient to absorb the shock.

Moreover, the required IFR level would have not only been short of adequate for PSBs and old private banks but too high for new private and foreign banks. In contrast to the advised 5 per cent, PSBs and old private banks would have required IFR levels of about 6.3 per cent and 6.1 per cent, respectively, of eligible securities. However, foreign and new private banks would have needed only about 2.9 per cent and 3.3 per cent, respectively, of eligible securities to absorb a one percentage point shock. This result suggests that an IFR level which would have taken into account the level of interest rate risk in individual banks would have been better suited as a risk management tool than a uniform level of IFR.

Individual bank data show a wide dispersion of IFR, suggesting that close scrutiny of the most exposed banks would have been needed, as their IFR could have been insufficient to cushion them against large interest rate increases and they could have needed capital injections. The IFR level of PSBs ranged from zero per cent for two small PSBs to 5.21 per cent of eligible

Economic and Political Weekly March 31, 2007 securities, with a median of 3.13 per cent. All PSBs had an IFR level below the minimum needed to absorb the average

6.3 percentage-point reduction in the value of government securities holdings following a one percentage point increase in interest rates. After using their existing IFR as a cushion to absorb their portfolio losses, the average CAR of PSBs would have fallen to 10.4 per cent from 13.1 per cent, and six out of the 27 PSBs would have required capital injection as their CAR would have fallen below the minimum regulatory level of 9 per cent (Figure 3).

To address the interest rate risk of government securities, the RBI also fine-tuned its regulation to provide more “breathing space” to Indian banks. Since 2000, banks are required to classify their investment portfolios into three categories with progressively mark-to-market norms: (i) held to maturity; (ii) available for sale; and (iii) held for trading. While investments under the HTM category need not be marked-to-market, those under AFS and HFT are to be marked-to-market at year-end and monthly, respectively or at more frequent intervals. Guidelines were also issued for the classification of investments, shifting of investments among the three categories, valuation of the investments, and a conservative methodology for booking profits and losses on sale of investments as well as providing for depreciation. In particular, while net depreciations are recognised and fully provided for, net appreciations are ignored.

As a one-time measure in September 2004, the RBI allowed banks to shift securities to the HTM category, which needs not be marked-to-market. Prior to September 2004, banks were allowed to classify a maximum of 25 per cent of their total investments in government securities in the HTM category when calculating their IFR. Since September 2004, banks are allowed to hold up to 25 per cent of their demand and time liabilities (DTL) in the HTM category. However, upon shifting additional securities to HTM, a bank would incur accounting losses due to differences between their prevailing market value and acquisition cost or book value.

The RBI explained the measure – which was consistent with international standards that do not place limits on HTM category

– as a regulatory response to concerns about the impact of the rising interest rates on banks’ investment portfolios.10 Banks that chose to apply this measure reduced their exposure to interest rate risk but had to incur the cost upfront of transferring more securities to the HTM category. In contrast, banks that decided not to hold more securities to maturity were exposed to potential future mark-to-market losses when interest rates increased further. Such banks would have been particularly at risk if they lacked the capital to absorb the cost of shifting securities to the HTM category following interest rates rises.

Other Aspects of Bank Asset Liability Management

It is important to note that conservative accounting rules in India were such that banks held an additional cushion against interest rate risk. Indeed, valuation norms require that while net depreciation of investments is taken on the profit and loss account, appreciation is not accounted for and the book value remains unchanged. The accumulated provision for depreciation is meant to reflect the diminution in the book value and requires to be added to the cushion of unrealised gains and IFR to better estimate the amount of cushion available to absorb interest rate shocks. Data limitations are however such that we cannot estimate this figure for individual banks, but unrealised gains would be positively related to duration.

In addition, offsetting potential treasury losses, higher interest rates on loans can positively affect the net interest rate income of banks. Banks can take advantage of rising short-term rates as loans re-price quicker than deposits, hence widening spreads in an environment of increasing loan-to-deposit ratios. Such higher spreads may attenuate the effect of holding fixed rate government securities in a rising interest rate environment. However, the volatility of deposits needs to be considered as well, as some could be withdrawn in case of a significant interest rate shock. As mentioned earlier, the RBI (2003) found a 4.9 per cent positive impact on net interest income following a 200 basis point increase in interest rate at end-March 2003.

Banks could also manage interest rate risk through a number of measures. Banks could (i) reduce the duration of their assets by selling long-dated government securities; (ii) reduce their holdings of government securities and increase their loan books by building on the recent high growth in consumer credit and infrastructure; and (iii) increase the contribution of fee-based income to operating income.

Over the medium term, a stronger fiscal policy and enhanced opportunities for lending would reduce banks’ reliance on government paper. A reduction of the fiscal deficit would reduce the supply of government securities to the banking system. At the same time, continued structural reforms will make lending to domestic enterprises and consumers11 more attractive, allowing banks to bring their government securities holdings down to the legally required level.

Increasing the issuance of short-dated or floating rate government securities – subject to sound debt management practices

– would also help banks manage their interest rate risk. The Indian authorities have initiated the sale of floating rate government securities and in 2003-04, the government raised 16 per cent of its gross market borrowings in the form of floating rate bonds (FRBs). In 2004-05, this proportion increased to about 29 per cent of gross issuance.12 Capital market development could also ensure a better functioning of markets for hedging instruments such as interest rate swaps and forward rate agreements (FRAs), and interest rate futures [Sarkar 2003].

Widening the investor base for government securities could also help reduce the reliance on banks as the main investors in this market. Commercial banks held 61 per cent of the outstanding stock of government securities at end-March 2002. The next most important investor was the state-owned Life Insurance Corporation of India (LIC). Other investors included provident

This paper measures and assesses the management of interest rate risk of banks’ government securities portfolios in India. In particular, it finds that the current aggregate level of IFR at end-March 2004 in the banking system would have been insufficient to compensate for market losses resulting from a one percentage point parallel shift in the yield curve. However, while some PSBs and old private banks were the most vulnerable, foreign and new private banks had built in an adequate cushion. As a result, a key priority for the Indian authorities would have been to scrutinise the risk management practices of individual banks to identify the most exposed institutions.

Given interest rate shocks higher than the one percentage point increase studied in the paper, accelerating convergence towards Basel I risk-weighted capital charges, and the adoption of the Basel II, Pillar II approach for interest rate risk supervision, especially for those banks most vulnerable to a reversal of the interest rate cycle, are useful measures to strengthen the stability of the financial system. In addition, a move to Basel II, Pillar III relative to enhanced transparency on risk management may be warranted.

[An earlier version of this paper was published as an IMF working paper. The views expressed in this paper are those of the author and do not necessarily represent those of the IMF or IMF policy. The author wishes to thank an anonymous referee, and Aditya Narain for their useful comments.]

1 Indian banks are required to hold a minimum of 25 per cent of their net demand and time liabilities in the form of government securities and other approved securities.

2 In recognition of the transfer of risks associated with government securities to the banking system through open market operations (OMO), the Reserve Bank of India did not conduct OMO auctions in 2004-05 and is using its portfolio of government securities for the conduct of reverse repos under the liquidity adjustment facility (LAF). In contrast, OMO amounting to Rs 407 billion and Rs 527 billion (face value) were conducted in 2002-03 and 2003-04, respectively.

3 Deputy governor Mohan noted in a speech that “the predominance of government securities in the fixed income securities market of India mainly reflects the captive nature of this market as most financial intermediaries need to invest a sizeable portion of funds mobilised by them in such securities. While such norms were originally devised as a prudential measure, during certain periods, such statutory norms pre-empted increasing proportions of financial resources from intermediaries to finance high government borrowings” (Reserve Bank of India Bulletin, October 2004, p 851.)

4 Using five years of monthly data on government securities yields, Sarkar (2003) estimates the 99 percent confidence level to range from 103 basis points to 127 basis points for maturities of one to 10 years. We also consider two additional scenarios. Scenario 2 simply assumes a shock double the size of that in Scenario 1. Scenario 3 assumes a 320 basis point increase, the worst-case increase in government securities yields over one year with a 1 per cent probability, assuming that yields are normally distributed (the standardised interest rate shock recommended by the Bank for International Settlements [BIS 2003]. Given the strong linearity of

Economic and Political Weekly March 31, 2007

equation (1), portfolio losses under these scenarios would be approximately proportional to losses obtained under the base scenario.

5 A similar approach finds market losses in Japanese banks’ portfolio of Japanese government bonds equivalent to 208 per cent of net profit or 14 per cent of tier 1 capital [Nemoto 2004].

7 The RBI conducts periodic sensitivity analyses of banks’ investment portfolio and estimates the cushion available in terms of unrealised gains on banks’ investment portfolio.

9 So far, the RBI has announced a road map to Basel II for the treatment of credit and operational risks. Foreign banks operating in India and Indian banks with a presence outside the country are to migrate to the standardised approach for credit risk and the basic indicator approach for operational risk, with effect from March 31, 2008. All other scheduled commercial banks are encouraged to migrate to these approaches no later than March 31, 2009.

10 See RBI (2004, p 171), The RBI has also noted that banks are required to hold 25 per cent of their DTL in the form of approved securities – mostly government securities – as statutory reserves and argued that at least this level should be eligible as HTM.

11 Government securities to some extent compete with loans. As their attractiveness decreases, some banks may increase their lending. However, if credit risk assessment is not appropriate, the overall credit risk of the system could increase, although its interest rate risk has decreased. Banks could also increase the contribution of fee-based income to operating income which could mitigate their overall riskiness.

12 Including 364-day treasury bills, gross issuance of securities for the purpose of market borrowings having a duration of less than one year amounted to 45 per cent of the total. In addition, absorption of liquidity under the Market Stabilisation Scheme using 9-day and 364-day treasury bills is helping lower the duration of banks’ holdings of government securities. The authorities have also constituted a Sub-Group of the Technical Advisory Committee on Money, Forex, and Government Securities Markets to address the issue of the low liquidity of FRBs.

13 The offloading of government securities may lead to an increase in interest rates as bond prices fall. As banks move to shorter-duration bonds, a selloff in the long bonds segment can occur, thereby drastically steepening the yield curve. In addition, interest rate derivatives are vulnerable to convexity and can be adversely affected.

BIS (1996): ‘Amendment to the Capital Accord’, Basel Committee on Banking Supervision.

– (2003): ‘Principles for the Management and Supervision of Interest Rate Risk’, Basel Committee on Banking Supervision.

Darbha, Gangadhar (2001): ‘Value-at-Risk for Fixed Income Portfolios – A Comparison of Alternative Models’, National Stock Exchange, Mumbai, India.

Gupta, Vineet and Vibha Batra (2006): ‘Introduction of New Capital Instruments: Indian Banks Get Greater Latitude to Raise Capital’, ICRA, February, www.icra.in

Jorion, Philippe (1997): ‘Value at Risk: The New Benchmark for Controlling Market Risk’, Irwin Professional.

Mohan, Rakesh (2004): ‘Financial Sector Reforms in India: Policies and Performance Analysis’, Reserve Bank of India Bulletin, www.rbi.org.in

Nemoto, Naoko (2004): ‘‘Rising Long-Term Interest Rates Highlight Importance of Japanese Banks’ Asset-Liability Management’, Standard & Poor’s.

Patnaik, Ila, Ajay Shah (2004): ‘Interest Rate Volatility and Risk in Indian

Banking’, IMF Working Paper, WP/04/17, Washington DC. RBI (2003): Reports on Trends and Progress of Banking in India, 2002-03, Reserve Bank of India, www.rbi.org.in

Sarkar, Soumya (2003): ‘Interest Rate Risk in the Investment Portfolios of the Indian Banking System’, Treasury Research Group, ICICI Bank.