Banking investments

New norms will impart stability

A stable banking system is an absolute necessity for maintaining financial stability. It is thus important that banks are properly regulated and do not take unnecessary risks. While the quality of lending in the banking system and the level of bad loans often attract public attention, it is also important for the regulator to keep a close eye on the investment portfolio. The Reserve Bank of India (RBI) on Tuesday in this context released revised investment norms for the banking sector. It is worth noting that the recent run on banks in the US was partly a consequence of inadequate regulation of investments. Both the asset and liability sides of banks, such as the Silicon Valley Bank, were extremely concentrated. Although Indian banks do not face any such threat, revision in the regulatory framework, built on experience and evidence, should help further strengthen the regulatory architecture.

The current regulatory instructions on the valuation of investment are broadly based on the framework introduced in October 2000. The new norms are founded on a discussion paper issued by the RBI in 2022 as well as the inputs received. The revised framework, according to the banking regulator, is in line with global standards and best practices. It will introduce a “symmetric treatment of fair value gains and losses”. The banks will have a clearly identified trading book. The new norms will also remove the existing ceiling on the held-to-maturity (HTM) part of the investment book while increasing disclosures. The framework, which would come into effect next financial year, puts more responsibility on bank boards. It expects banks to adopt a comprehensive investment policy, duly approved by the board of directors, encompassing various elements as defined.

In terms of detail, banks will have to classify the entire investment portfolio under three categories — HTM, available for sale, and fair value through profit and loss (FVTPL). This will, however, not include their investments in joint ventures and subsidiaries. Securities held for trading will be a subcategory of FVTPL. The removal of the ceiling in the HTM category should provide banks some freedom to structure their investment books, depending on the broader economic environment. This will also increase demand for corporate bonds. Besides, it would give more stability to earnings. However, banks will have to structure their books carefully because they will not be able to move securities freely in and out of HTM, for instance. After the transition period, banks will not be able to reclassify investments easily. Reclassification will not only require the board’s approval but also prior approval from the RBI, which will be given only in rare circumstances. Further, in any financial year, the securities sold from the HTM category should not exceed 5 per cent of the opening value of the portfolio. Further sales will need the RBI’s approval.

The framework has also provided elaborate rules for the accounting treatment if securities are moved from one category to another. It also has clear rules in terms of what kind of securities are to be kept in which category and how they are valued and accounted for. Banks are also required to create an investment fluctuation reserve. While it will be eligible for inclusion in Tier-II capital, it would increase the banking system’s ability to absorb losses. Overall, the new framework should be expected to improve disclosure and impart more stability to the banking system.