The depreciation trap

The sharp rise in bond yields over the last few weeks has unnerved banks, who now have to budget for a large depreciation in the market values of their investments.

The markets have begun echoing this concern, and bank stocks have underperformed the Sensex in the past few months. The public sector banks, who have large investment portfolios, have been the worst hit.

Little wonder there is a move to request the Reserve Bank of India to relax the mark-to-market norms on gilts. Under current norms, banks have to mark-to-market all securities in their portfolios barring those in the "held-to-maturity" category.

Any diminution in value for the rest has to be provided for in the P&L account. Banks are afraid that this rule will erode their profits substantially.The banks do have some sort of a case""but only just.

The losses will be largely notional if they decide to hold securities to maturity. But they can put a maximum of only 25 per cent of their investments in the "held-to-maturity" category.

For some banks, the mark-to-market losses on the balance 75 per cent may be substantial enough to wipe out all their profits""leading to some loss of market confidence in these banks. In the case of some weak banks, this could also trigger negative reactions among the general public against the backdrop of some recent high-profile bank failures.

Under the circumstances, the RBI could well consider a relaxation of norms. One area to look at may be the Investment Fluctuation Reserve (IFR), which has been created precisely for the purpose of offsetting depreciation losses in a rising interest rate scenario.

It may not be a bad idea to allow writebacks from the IFR to the P&L account (instead of doing this adjustment below-the-line as per current rules).

While this may sound like tinkering with the rules just to make banks' balance-sheets look better, discretion is often the better part of valour.

Especially in the context of the peculiarities of the Indian situation, where the RBI forces banks to invest a high proportion of their liabilities in gilts as part of the statutory liquidity ratio (SLR).

Another option would be to allow banks to classify the compulsory part of the SLR as "held-to-maturity" with only the excess being marked to market.

But even if the RBI opts for some sort of relaxation, it must prescribe a timeframe for a return to international best practices. Rules that keep changing according to circumstances are not worth the paper they are printed on.

There are, however, several ways banks can combat the hit on their bottom lines even without a relaxation in norms. One is to reduce the duration of investments.

As interest rates go up, long-dated securities are the worst hit, so it makes sense to increase the proportion of short-duration securities in the portfolio.

The RBI could help these efforts by offering more short-dated paper at auctions. But the most important lesson banks need to learn is that it's time to diversify from government lending.

With investment in gilts attracting zero risk weightage, banks preferred to lend to the government rather than other, maybe more needy, borrowers.

It is time to change tack. Banks have to pull out all the stops to increase net interest income and fee income to pull themselves out of the SLR depreciation trap.