Rethinking investment provisioning: Banking on a loan vulnerability reserve

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Updated: April 24, 2018 4:56:09 AM

The loan vulnerability reserve can be created for special mention accounts, with differing norms for different grades of such accounts

investment provisioning, rbi circular, Investment Fluctuation Reserve, rbi data, AFS categories, SMA accountsRBI data on all banks in Statistical Tables relating to banks in India 2016-17 show outstanding investments in GSecs was Rs 29.24 lakh crore. (Reuters)

The RBI circular relating to valuation of investment portfolio as far back as 2005 says, “With a view to building up of adequate reserves to guard against any possible reversal of interest rate environment in future due to unexpected developments, banks were advised to build up Investment Fluctuation Reserve (IFR) of a minimum 5 per cent of the investment portfolio within a period of 5 years….. Banks were advised in October 2005 that, if they have maintained capital of at least 9 per cent of the risk weighted assets for both credit risk and market risks for both HFT and AFS categories, as on March 31, 2006, they would be permitted to treat the entire balance in the IFR as Tier I capital.”

RBI data on all banks in Statistical Tables relating to banks in India 2016-17 show outstanding investments in GSecs was Rs 29.24 lakh crore. The amount in the investment fluctuation reserve was Rs 2,916 crore, which is 0.1% of the total. Now, RBI has given banks another chance for providing for their marked-to-market (MTM) losses for December 2017 and March 2018 over four quarters from the respective date, which will help their P-&-L look better. With heavy provisioning for NPAs, additional provisions for such losses would make the accounts look even more distressed. But, are we kicking the can again?

Ideally, such allowances should not be made as these lead to the moral hazard of perverse incentives, wherein banks don’t comply with the conditions that were attached when making use of the width provided by the central bank. At present, RBI has put the condition that, “an amount not less than the lower of the following: (a) net profit on sale of investments during the year (b) net profit for the year less mandatory appropriations, shall be transferred to the IFR, until the amount of IFR is at least 2 percent of the HFT and AFS portfolio, on a continuing basis.” These amounts will not be much this year.

Conditions have been placed that the MTM losses need to be disclosed in the annual accounts to maintain transparency. This also means that when bank results are reviewed every quarter till the end of 2018, MTM losses have to be also adjusted for, in order to gauge the true picture. To that extent, it would be more difficult to interpret the accounts properly—considering that the provisioning for NCLT cases is also being cut. However, there are no punitive measures in case banks do not comply with the same.

At an ideological level, it can be argued whether or not the central bank, or the government, should intervene in a big way in the market, to accommodate banks with the MTM regulation that has been imposed by them. The issue of lowering losses on investments has been addressed already in two subtle ways so far. First, the benchmark 10-year-GSec yield was lowered by 20-25 bps. Second, the announcement of a lower quantum of borrowing for the first half of FY19—less than 50% of the total government borrowing projected for the year—has pushed down the yield further by around 30 bps. But given the large volume of securities that are held by banks (`33.5 lakh crore), and in the AFS and HFT categories, valuation becomes critical.

The 10-year paper started the year at 6.75% and ended at 7.40%, and the yield varied from a minimum of 6.41% to a maximum of 7.91%. If the IFR was created as per RBI norms earlier, this would not have been an issue. There is a strong case to argue that these things should not be done as the MTM losses of a commercial transaction undertaken by banks should not be the concern from the point of view of policy.

On the other side, it can also be argued that using such buffers for guarding against volatility in the market is pragmatic and can be stretched to other areas as well, to safeguard the realm. RBI’s Revised Framework for Resolution of NPAs has tackled the bad loans issue by starting from the principle of possible default. It lays stress on the SMA (special mention accounts) in three buckets, based on delays in payments in multiple of 30 days, before the three-month norm kicks in for the account being designated as a NPA. Further, it targets loans of `5 crore and above as the cutoff on exposure that gets included in the common repository.

To lower the provisioning requirement for the NPA, which would result ultimately, it would be interesting to explore the option of creating a special reserve for SMAs called, say, the ‘Loan Vulnerability Reserve’. It can be created for the SMAs with differing norms. For example, aggregate SMA-1 loans can attract a loan vulnerability norm of 1% of outstanding, SMA-2, 2% and SMA-3, 3%. As the size of assets under each bucket increases, the amount that is transferred to the reserve would also increase. Further, as assets move out of these buckets in either the higher or lower category, adjustments would automatically be made.

Hence, when the asset finally becomes a NPA, the provision that has to be made can be transferred from the Reserve. It would then have to be replenished based on the net pressure on the SMAs. A related issue is the treatment of these reserves. In case of the IFR, RBI has stated that it would be considered as Tier II capital, while the earlier notification has spoken of such reserves being treated as Tier I capital. A similar approach can be considered here where the SMA-1, SMA-2, and SMA-3 reserves under the LVR, could get different kinds of recognition.

The idea presently is still amorphous, and in the realm of theory. It would require wider debate on its feasibility. Making special reserves for any purpose imposes a cost on the bank as money gets blocked. Therefore, special dispensation is required from the point of view of including them under ‘capital’ so that the cost is reduced. This problem will intensify in the coming months as banks prefer to hold more GSecs as investment and also recognise the SMA accounts on a monthly basis. If ideology backs the creation of an investment fluctuation reserve, then building any buffers sounds pragmatic as it helps to maintain the sanctity of the system.

The author is Chief economist, CARE Ratings, and author of Economics of India: How to fool all people for all times.

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