Did the RBI try to bail out banks last Friday?

Prices of bonds and their yields (or interest rates) move in opposite directions. In other words, when the prices move up, the yields go down. This is textbook knowledge.

In times of high inflation, bond prices should drop and yield rise, otherwise the real return (that is, yield or interest minus inflation) on a bond shrinks. So it is only natural that the inflation rate and yield should move in tandem.

But last Friday the government bond market witnessed a unique phenomenon: bond yields and inflation moved in opposite directions.

While wholesale price-based inflation (wholesale price index, or WPI) shot up from 7.94 per cent to 8.17 per cent, the yield on the most-traded 10-year benchmark government paper (8.07 per cent 2017 gilt) dropped from 6.02 to 5.88 per cent.

In normal circumstances, a bond market rally is the last thing one expects when the inflation rate is inching up and tell-tale signs of a rate hike are written on the wall (Housing Development Finance Corporation and State Bank of India have raised their fixed rate home loans and commercial banks have marginally raised the rates on corporate loans without changing their prime lending rates).

So what happened last Friday? Why did the commercial banks, led by a large public sector intermediary, chase government paper like there was no tomorrow?

One possible explanation could be that inflation has peaked and will come down over the next few weeks. The reason for this optimistic outlook is the base effect. Between September and November last year, the rate of inflation rose sharply. In fact, other things remaining unchanged, the rate can come down.

But that may not be the real reason for the abnormal behaviour of the bond market on that day. The sudden surge in bond prices, which pushed yields down, could be traced to a late evening announcement by the banking regulator the previous day relaxing the investment guidelines of banks' gilts portfolios.

This has widely been perceived as a "bailout" package for banks. What was in that package? Broadly, the regulator fine-tuned the prudential norms on the classification of bank's investment portfolio to "bring them in alignment with international practices" taking into account the requirement of maintaining a large statutory reserve requirement "" 25 per cent of banks' demand and time liabilities (DTL) under Section 24 of the Banking Regulations Act, 1949.

The RBI has allowed banks to exceed the present limit of 25 per cent of total investments under the held-to-maturity (HTM) category provided the excess comprises only statutory liquidity ratio (SLR) securities and the total SLR securities held in this category is not more than 25 per cent of their DTL.

This one "one-time measure" will allow banks to shift their SLR securities to the HTM category any time during the current financial year. Since banks do not need to mark to market the securities held under the HTM category, this segment of the investment portfolio will not take the hit in a rising interest rate scenario.

Bank's investment portfolio has three parts: HTM, available for sale (AFS), and held for trading (HFT). At the beginning of a year, a bank is required to decide on the bunch of securities to be kept under HTM.

This portfolio is not affected by the interest rate movement because the securities are not required to be valued according to the current market prices at the time of finalising the financial statement. In accounting parlance, this is called mark to market.

When the security prices fall "" and interest rates rise "" banks are required to make provisions to make good the fall in prices (the gap between the acquisition price and the market price) of securities kept under AFS and HFT segments. This has a negative impact on the banks' bottomline as the profitability drops to the extent of provisioning requirements.

Prima facie, by allowing the banks to increase their holdings under the HTM, the RBI is trying to help them in protecting their balance sheets. But if one looks at the fine-print of the RBI statement on Thursday, it becomes clear that the case is not that simple.

The regulator has made it clear that while transferring securities from AFS and HFT to HTM, banks must provide for the depreciation "" the gap between the cost of acquisition of such securities and the market value on the date of transfer.

In other words, despite the relaxation, the banks cannot escape the one-time loss arising out of the fall in securities prices. They can, however, cut the losses or minimise the future loss by punting on the future course of interest rates.

For instance, the price of a particular security that was Rs 112 or so in the beginning of April, went down to Rs 104 in the beginning of August. Since then, it has gone up to about Rs 110.

If a bank feels that the price will go down further during the year as the interest rates are set to rise, it may shift the security now to the HTM category by booking a loss of Rs 2. If it does not do so and the price of the security price dips to 102 in future, the loss will be Rs 10.

This is the genesis of the mad chase of government papers by banks on Friday despite the rise in inflation rate. There was a concerted move to push up the price so that the loss is minimal when the portfolio transfer takes place.

As a result of this, the yield on the benchmark 10-year paper dropped to 5.88 per cent, 219 basis points below the inflation rate on Friday. The spread between the yields on the 10-year paper and the five-year paper narrowed to 3 basis points on that day, with the yield on the five-year paper hovering close to 5.85 per cent.

This was not the only anomaly in the bond market. The spreads between two papers of the same maturity also widened to an amazing level. Take a look at the yield on two 10-year papers trading in the market.

The yield on the 7.37 per cent 2014 benchmark paper was 5.88 per cent, while that on another 2014 paper was 6.91 per cent "" a gap of 103 basis points. Similarly, the 7.49 per cent 2017 paper was trading at 7 per cent, while the yield on the 8.07 per cent 2017 paper was 6.3 per cent.

Normally, the spread between 10-year and five-year gilts is 30 to 40 basis points, which gets widened to 50 basis points in a bearish market. Similarly, the difference between the yields on two papers of the same maturity is not more than 50 basis points.

In their over-eagerness to push the prices of the bonds up and cut losses, commercial banks distorted the yields and killed the entire price discovery mechanism. An informal cartel was formed to drive down yields and protect the balance sheets.

Such developments are not rare in the equity market where operators often gang up to drive up the price of a particular scrip even though the stock may not be fundamentally strong to trade at the level.

In this case, instead of stocks, government paper prices were driven up by a concerted move by some banks to a level that is out of sync with the economic fundamentals and interest rate outlook.

Other participants in the debt market such as mutual funds and primary deals cannot escape the interest rate volatility but banks can do so, at least partially, since they have the biggest voice and the regulator is there to bail them out in times of crisis.

To be fair to the RBI, it did not give the banks an open-ended escape route. Despite the changes in investment norms, banks are, in fact, not happy as they are being forced to take the one-time hit on their balance sheets.

There is also possibly nothing wrong in allowing 25 per cent of SLR securities to be protected from interest rate movements since banks have historically been carrying the burden of government borrowing to bridge the fiscal deficit.

Globally, in some other markets too, banks normally carry a banking book of investments, which comprises statutory holdings to support government borrowings that are protected from interest rate volatility, and a trading book.

But the RBI's move seems to be ad hoc and half-hearted. If it wants to follow the global practice, it needs to make other changes too in investment norms.

For instance, under the US GAAP (generally accepted accounting principles) banks are allowed to book both notional profits and losses on securities when it comes to marking them to market.

But the Indian accounting system requires banks only to book losses in case the market price of securities goes down. They are, however, not allowed to book profits when the prices go up.

If the GAAP, in this respect, is favourable to banks, there are other aspects that are more stringent than the Indian accounting system. For instance, GAAP does not allow banks to sell from the HTM book where the securities are held to maturity in letter and spirit.

Indian banks are, however, allowed to sell securities kept under HTM and they can always buy fresh securities and put them under HTM. To that extent, HTM also becomes a trading book. The RBI needs to address all these issues collectively instead of going for soft options.

Finally, neither the commercial banks nor the regulator has done much to prepare the financial system to tackle the shocks of rising interest rates. The CEOs of banks did not make any complaint when rates were falling since they were making money on their treasury operations.

But at the first sign of rate hike, they started begging the regulator for a rescue package. The RBI, on its part, made the banks create an investment fluctuation reserve (IFR) to cushion any rate shock and repeatedly told them to get ready for a possible reversal of interest rate direction.

But it hardly took a look at areas of interest rate derivatives and credit derivatives to create avenues for banks to manage the interest rate risks.

No wonder, at this point the RBI does not seem to want to rock the boat for banks' profitability. Artificially low market rates will also help the government save on its cost of market borrowings.