Revising the norms for valuing the investments of financial institutions (FIs) is long overdue. FIs have a very different investment portfolio from banks; their exposure to equity is far higher. And equity, as everyone knows, is more exposed to market risks than debt for the simple reason that while debt can be held to maturity, there is no maturity for equity.
Marking the value of an equity portfolio to market therefore is an obvious measure of prudence. As a result of the new norms introduced, FIs will now have to make additional provisions, and their bottomlines will consequently suffer.
How big the impact will be depends on the state of the markets. According to their latest balance sheets, the value of the investment portfolios of IDBI and ICICI was significantly higher than book value on March 31.
Since then, however, both the equity and debt markets have moved adversely, and the gap between market and book value will have significantly narrowed, if not turned negative. The exact details will be impossible to ascertain from publicly available information because the RBI has said that FIs will not be required to mark to market their equity exposures in project finance upto two years from the date of commencement of commercial production or upto five years from the date of acquisition, whichever is earlier.
Some idea of the scale of the provisions required can be had from the provisioning done by ICICI quarterly under its US GAAP requirements. For IFCI, the market value of investments was lower than investments even in end-March, when the Sensex was at 5,000. And what must be the condition of the state level DFIs?
The RBI has ruled that while depreciations are to be passed through the profit and loss account, the reverse -- taking the benefit of appreciation in investment values -- will not be allowed. This is typical financial conservatism but consider the consequences.
Why, for example, will a bank or financial institution invest in company debentures if they have to provide for market risk, while plain vanilla term loans or deferred payment guarantees, which are almost matching credit substitutes, do not have this requirement?
In that case, what happens to the development of the corporate bond market? It is theoretically possible that a mark-to-market requirement may spur trading, but that
