Banks should not be surprised when there is a sharp rise in bond yields. Rather, they should “know and understand this risk rather well,” said Reserve Bank of India (RBI) Deputy Governor Viral Acharya (pictured) to the association of bond investors, most of them being from banks. “Interest rate risk of banks cannot be managed over and over again by their regulator,” Acharya said on Monday, delivering a stern message to banks. “The regulator, in the interest of financial stability, is caught in such situations, between a rock and a hard place, and often obliges.” However, by taking advantage of the dispensation regularly, efficient price discovery in the government securities (G-Sec) market and effective market discipline on the G-Sec issuer was not happening. “Nor does it augur well for developing a sound risk management culture at banks.” The comment comes at a time when banks have been lobbying with the central bank to allow spreading their treasury losses over a few quarters, instead of booking it right away. Yields moved about 70 basis points in the third quarter, which may have resulted in Rs 150 billion to Rs 250 billion of nominal losses for banks. In a speech at the annual dinner of the Fixed Income Money Markets and Derivatives Association (FIMMDA), the RBI deputy governor indicated that this was not the first time when bond yields have risen.
But banks have not been much wiser; rather, they tend to ignore the risk. “… banks should not be surprised repeatedly when government bond yields rise sharply and their investment profits drop. RBI’s Financial Stability Reports (FSR) have regularly pointed out the impact of such large interest rate moves on capital and profitability of banks,” said Acharya. “Banks should know and understand this risk rather well. Perhaps they do, and the issue is really one of incentives that lead to their ignoring this risk.” And the incentive was to line up to the regulator to give regulatory compensation, which, Acharya described as “heads I win, tails the regulator dispenses.” The share of commercial banks in outstanding G-Secs was around 40 per cent as on June 2017, while investment of banks in G-Secs as a percentage of their total investment was around 82 per cent for FY 2016-17. The corresponding figure for public sector banks for 2016-17 was slightly higher at 84 per cent. In spite of the relative stability of the consolidated debt to gross domestic product (GDP) ratio of the government, the investor base for G-Secs in India was primarily limited to domestic institutions, which often resulted in oversupply of bonds in the market, Acharya observed. The excess liquidity in the banking system did not get absorbed through the RBI’s liquidity operation, and capital-starved banks parked the funds in bonds, at the expense of duration risk. “As a result, the size of banking sector’s balance-sheet exposure to G-Secs, and hence, its interest rate risk, is high in an absolute sense, and is relatively elevated, when measured in proportion to total assets, for public sector banks relative to private banks,” Acharya added.