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Dvara Analysis Weblog | Suggestions on the Reserve Financial institution of India’s Dialogue Paper on Overview of Prudential Norms for Classification, Valuation and Operations of Funding Portfolio of Industrial Banks dated 14 January 2022

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Authors:

Amulya Neelam
Madhu Srinivas

The proposed laws are a major enchancment over the extant laws and deal with lots of the inadequacies and incongruities current within the latter. One of many proposed modifications, which is the requirement for improved granularity in categorising and disclosing info associated to investments would assist in enhancing the transparency of the banks’ standing when it comes to each danger publicity and monetary place. These proposed modifications are in accordance with the suggestions in our paper on the transparency of banks’ disclosure regime the place we proposed, amongst different suggestions, that banks ought to disclose the quantities of investments within the varied classes – Held-to-Maturity (HTM), Out there-for-Sale (AFS), Held-for-Commerce (HFT), and the assumptions and methodologies used within the valuation of securities of their funding guide[1].

The Dialogue Paper additionally permits banks to carry non-SLR securities, similar to company bonds, of their HTM portfolio. Earlier, banks eager to diversify needed to essentially maintain such devices of their buying and selling guide, both as AFS or HFT. This strategy subjected them to market worth volatility, no matter whether or not the intent of the financial institution was to carry such devices to maturity, or not. This strategy thus disincentivised banks from diversifying their exposures utilizing debt devices. The proposed regulation permits them to maneuver away from an unique “originate-and-hold-to-maturity” technique, thereby enhancing their potential to handle focus dangers higher[2]. Furthermore, it will additionally enable them to enhance the liquidity of their stability sheets.

We additionally commend the RBI’s strategy of outlining the background, rationale, and guiding ideas of the laws earlier than detailing the laws themselves. Nonetheless, we level out sure inconsistencies and omissions within the proposed laws that would undermine the achievement of its goal.

We current detailed suggestions on the Dialogue Paper within the type of solutions to the ten questions posed throughout the Dialogue Paper. For considerations that fall outdoors the scope of the primary 9 questions, we embrace particular feedback within the tenth reply.

Query 1: Are there any vital points pertaining to the funding portfolio that must be taken up for consideration?

The proposed modifications within the classification and valuation norms for devices in banks’ funding portfolio search to carry the regulatory framework nearer to the requirements prescribed within the Indian Accounting Requirements (Ind-AS) and the Worldwide Monetary Reporting Requirements (IFRS)[3]. Moreover, the proposed laws additionally make the classification of devices stringent compared to the extant directions, which permit for a laxer classification of devices at preliminary recognition and likewise enable for relative ease of their reclassification later[4].

Because the Dialogue Paper states in paragraph 5.3, one of many causes to evaluation the extant norms is because of the blurred distinction between the classes – AFS and HFT – of what’s considered because the buying and selling guide[5]. The dearth of a definite separation between the 2 classes has led to most buying and selling being performed out of AFS portfolio reasonably than HFT, thus distorting the buying and selling guide[6]. The proposed laws search to treatment this by permitting solely these monetary devices that fulfill the Solely Funds of Principal and Curiosity on Principal Excellent (SPPI) criterion to be held within the AFS portfolio[7]. Additionally, the securities held within the AFS portfolio will be held to maturity or bought with none restriction[8]. The intent seems to be, due to this fact, to permit banks to carry, or promote, securities for Asset Legal responsibility Administration (ALM) functions with out having to topic them to a better valuation frequency, as is relevant for the HFT portfolio. (Per the extant directions, securities held within the AFS portfolio are required to be marked-to-market (MTM) on a quarterly foundation, whereas for these within the HFT class, the MTM requirement is each day[9]). Nonetheless, with none express restriction on the sale of securities within the AFS portfolio, the arbitrage current within the extant tips would proceed to persist, albeit for a smaller subset of securities.

As an illustration, these devices that are held by the financial institution with the intent of buying and selling[10], however which additionally meet the SPPI criterion, can nonetheless be traded out of the proposed AFS portfolio, which has a decrease valuation frequency requirement. Basically, on this case, whereas the financial institution is topic to market danger – within the type of short-term worth volatility – the total extent of danger is just not captured when devices are positioned within the AFS portfolio, as a substitute of HFT. This, in flip, obfuscates the true ranges of danger which the financial institution is uncovered to, and may probably restrict the effectiveness of the financial institution’s general danger administration technique. Due to this fact, to make sure that devices held for buying and selling should not misclassified as AFS, it is crucial that the RBI embrace express limitations on the sale of securities within the AFS portfolio in order that it could higher obtain its acknowledged goal and stop the distortion of the buying and selling guide.

Query 2: Are there another overarching ideas that the RBI ought to contemplate whereas updating the present framework?

The guiding ideas outlined for updating the present framework of laws are an vital side of the Dialogue Paper as they type the idea for the present as nicely any potential future revision(s)/modification(s) to the norms. Whereas the proposed ideas are largely related for the efficient regulation of the funding portfolio, we share under a priority relating to the framing of one of many ideas.

Guiding Precept (e) reads – ‘The problems particular to the Indian context must be addressed and given due weightage within the revised framework[11].’ As readability on the that means and interpretation of the time period ‘Indian context’ is just not supplied within the guideline itself, there’s scope for ambiguity within the interpretation of this precept. Furthermore, it could be apt to contemplate Guiding Precept e) as an implicit precept that guides the framing of not simply the proposed norms on this Dialogue Paper, however of all of RBI’s laws. The RBI may as a substitute present the rationale for any context-specific norms which can have been drafted, why there was a must deviate from world requirements, and an evaluation laying out the prices and advantages of such norms to monetary service suppliers. Such an articulation of contextual parts (if any) would scale back the potential ambiguity within the interpretation of the precept whereas additionally preserving financial substance.

Query 3: Ought to banks be given the irrevocable choice at preliminary recognition (or on transition to this framework) to categorise their investments in fairness shares of their subsidiaries, associates, and joint ventures underneath FVTPL or AFS like another fairness instrument as a substitute of the necessary classification as HTM proposed above?

Fairness investments in such ventures are prone to be long-term and strategic in nature, with none goal of buying and selling for capital appreciation. Due to this fact, it will seem applicable to defend financial institution stability sheets from quick time period fluctuations of the funding’s market worth. Thus, a classification of most such investments as HTM is legitimate.

Nonetheless, if a financial institution had been to make use of a portion of those investments for the aim of buying and selling, even with the exemption of such securities from the sale threshold limits underneath the HTM class[12], the accounting norms on beneficial properties arising from gross sales out of HTM[13] preclude the financial institution from totally profiting from modifications in honest worth of those investments. Due to this fact, the proposal of necessary classification of a financial institution’s investments in fairness shares of their subsidiaries, associates, and joint ventures as HTM could also be restrictive and even seen as impinging on the financial institution’s freedom to pursue its enterprise technique.

Additional, it is crucial that these shares be usually assessed to examine for any everlasting diminution of worth. Due to this fact, it’s useful that the proposed tips deal with this side by the quarterly evaluation of HTM securities for impairment. We elaborate, within the reply to Query 5, how these impairment checks will be improved to supply a good presentation of the banks’ monetary statements.

Query 5: Clause 9(a) of the Reserve Financial institution of India (Classification, Valuation and Operation of Funding Portfolio of Industrial Banks) Instructions, 2021 (i.e., the Grasp Course) gives sure checks for impairment. Is there a necessity for specifying extra indicators of potential impairment?

The extant directions pertaining to the prudential norms on the classification and valuation of funding portfolio give a prescribed set of circumstances underneath which impairment is set. Per the extant directions, the necessity to decide whether or not impairment has occurred shall come up within the following circumstances[14]:  

  1. On the occurring of an occasion which means that impairment has occurred which, on the minimal, shall embrace:
    • the corporate has defaulted in compensation of its debt obligations.
    • the mortgage quantity of the corporate with any financial institution has been restructured.
    • the credit standing of the corporate has been downgraded to under funding grade.
  2.  The corporate has incurred losses for a steady interval of three years and the networth has consequently been diminished by 25 % or extra.
  1.  Within the case of a brand new firm or a brand new challenge when the initially projected date of attaining the breakeven level has been prolonged i.e., the corporate or the challenge has not achieved break-even throughout the gestation interval as initially envisaged.

Provided that, underneath Indian Usually Accepted Accounting Ideas, impairment itself is predicated on incurred loss and never anticipated loss (as in Ind-AS), the relevance of the impairment train is additional diminished when there’s solely a restricted set of circumstances underneath which impairment is assessed. Additionally, many of those prescribed circumstances – similar to when the corporate has defaulted in compensation of its debt obligations, and when the mortgage quantity of the corporate has been restructured – are these which can be triggered after the occasion of default.

The relevance and usefulness of the impairment check will be additional improved if these impairment checks are forward-looking. Whereas the extant directions point out that these are the ‘minimal’ options that have to be thought of, it will be prudent to incorporate further checks that higher consider impairment or a major enhance in credit score danger like these specified by Ind-AS requirements[15]. A few of these are:

a) Important modifications in exterior market indicators of credit score danger such because the credit score unfold and market info associated to the borrower, similar to antagonistic modifications within the costs of a borrower’s debt and fairness devices.

b) Important modifications in sides of the borrower’s working outcomes that transcend simply networth, similar to declining revenues or margins, elevated stability sheet leverage, administration issues, or different components that considerably have an effect on the borrower’s potential to service their debt obligations.

c) Important modifications within the worth of the collateral supporting the asset or within the high quality of third-party ensures or credit score enhancements which could cut back the borrower’s incentive to make the scheduled contractual fee.

Query 6: Is the definition of ‘energetic market’ as given above with illustrative examples enough? Are there another markets that might be thought of as ‘energetic markets’? Feedback could also be supplied with rationale.

Whereas the definition of ‘energetic markets’ as laid out in paragraph 7.29 is enough at a precept degree, there’s a lack of readability within the given illustrative examples. As an illustration, it’s unclear what is supposed by ‘recognised inventory exchanges for SENSEX/NIFTY shares.’ It’s not clear whether or not all recognised inventory exchanges, and the shares traded in them, must be thought of as energetic markets or that solely shares of entities which can be a part of SENSEX/NIFTY which can be traded in recognised inventory exchanges be thought of as energetic markets? Within the case of the latter, the definition of an ‘energetic market’ could be reasonably restrictive as fairness shares not included within the benchmark indices may even have enough liquidity. As an illustration, the 1-month common buying and selling quantity of Vodafone Concept’s shares is 42 Crore variety of shares, whereas the equal determine for Reliance Industries, which is a part of the SENSEX (BSE 30), is 68 Lakh variety of shares[16]. We suggest that, along with illustrative examples, there even be an indicative checklist of options (similar to a low bid-ask unfold or each day buying and selling volumes above a threshold) that an ‘energetic market’ for an asset or a legal responsibility may possess.

Query 7: Is the definition of ‘unobservable inputs’ as given above with the illustrative examples enough?

In paragraph 7.30, the illustrative instance for the investments whose valuation is presumed to be primarily based on unobservable inputs consists of mutual funds that make investments greater than 10% of their corpus in unquoted devices[17]. That is unduly restrictive because the regulation treats the valuation of unquoted devices on par with that of mutual funds, whose items are listed, and but have 10% or extra of their corpus in unquoted devices. The liquidity of the mutual fund unit is extra pertinent than the valuation of the underlying securities themselves.

Query 8: Ought to the IFR proceed? If that’s the case, at what degree ought to or not it’s set and the way a lot time must be given to banks to realize that degree?

Because the Dialogue Paper mentions, the rationale for the Funding Fluctuation Reserve (IFR) is to guard banks from curiosity cycles. Traditionally, RBI has given particular dispensation to banks on events when the rate of interest cycle turned antagonistic. As an illustration, throughout instances of sustained rises in G-sec yields, banks had been allowed to, in 2005, shift securities from different classes into HTM, and in 2013, defer recognition of valuation losses by six months[18]. Defending its portfolio towards antagonistic market actions is prudent danger administration for a financial institution and all banks ought to make use of applicable danger administration methods to realize the identical. It’s not the regulator’s remit to design and implement operational danger administration methods for banks nor ought to it present particular dispensations going ahead. Thus, each the IFR and any associated regulatory forbearance must be discontinued.

Query 10: Are there any proposals you don’t agree with? If sure, please present separate feedback for every proposal you don’t totally agree with mentioning the proposal quantity, the precise paragraph quantity and causes for disagreement. Feedback could be helpful, in the event that they clearly articulate implementation difficulties or conceptual points together with different proposals.

The next factors checklist our considerations relating to particular factors within the proposal.

  • Paragraph 7.4 particulars the kind of securities that may be labeled as HTM. The checklist doesn’t embrace debt devices with floating charge coupons linked to a market-determined rate of interest. These devices meet the SPPI criterion and if the financial institution had been to have an intent to carry such devices to maturity, they need to be allowed to be labeled as HTM. Nonetheless, as such devices should not included within the illustrative examples in paragraph 7.4, it’s unclear whether or not these devices qualify to be labeled as HTM.
  • In paragraph 7.6, within the illustrative checklist of devices that have to be categorised as FVTPL, solely investments in pass-through certificates (PTCs) representing the fairness tranche of a securitisation transaction are included. The paragraph additionally states that investments in different senior and mezzanine tranches shall have to be reviewed for his or her compliance with the SPPI criterion[19]. Nonetheless, it’s unclear whether or not such investments (PTCs of senior or mezzanine tranches) will be held in HTM, if the intent is to carry them to maturity. The dearth of a transparent directive relating to PTCs would act as a barrier for banks to develop their (HTM) investments in PTCs. This in flip can probably block liquidity sources for these establishments which straight originate property, particularly within the precedence sector[20].
  • Paragraph 7.6 which supplies the illustrative checklist of devices that have to be categorised as FVTPL lists ‘Securitisation receipts’ as one of many devices[21]. The laws must explicitly specify that securitisation receipts are from the sale of non-standard property, and never that of ordinary property.
  • Paragraph 5.3 mentions that the uneven remedy of the AFS/HFT portfolios within the present framework is without doubt one of the causes for revising it. Nonetheless, the rules then stipulate that the preliminary valuation of devices that aren’t quoted and can’t be valued by market variables, will probably be finished in an uneven method. The rationale given (in paragraph 7.10) for the uneven remedy is that the BR Act (Banking Regulation Act, 1949) requires banks to recognise all losses and bills earlier than paying out dividends[22]. Nonetheless, that also doesn’t clarify why beneficial properties have to be amortised over the interval of the asset’s lifetime and never recognised immediately. If the RBI’s rationale behind persevering with the uneven remedy is a matter of following the precept of prudence, it should explicitly state so. Additionally, a transparent distinction must be made between unrealised and realised losses/beneficial properties.

Concluding Remarks

The proposed laws, if and when applied, would reach addressing a number of main and long-standing points with the present framework on banks’ funding portfolio. We wholeheartedly welcome a number of vital modifications within the tips pertaining to a) the eligibility of non-SLR securities to be held in HTM b) the categorisation of investments into honest worth hierarchies and c) the elevated requirement for disclosures within the notes to accounts. Nonetheless, there are nonetheless some points, if left unaddressed, would diminish the importance and effectivity of the proposed measures. As an illustration, the norms on the hierarchy of valuation strategies are held again by the shortage of readability on the interpretation and software of the definition of energetic markets. The allowing of non-SLR securities to be labeled as HTM should even be bolstered by strong impairment checks, and readability on the eligibility of particular devices similar to PTCs of senior and mezzanine tranches. Furthermore, the excellence between the buying and selling guide classes must be clear sufficient to handle the buying and selling guide distortions.

Nonetheless, it’s laudable that the proposed tips would carry the Reserve Financial institution’s tips on valuation of the funding portfolio nearer in keeping with that of worldwide requirements of accounting and danger administration[23]. This may additionally ease the method of future implementation of Ind-AS for banks. Along with enhancing the regulation and disclosure regime on the entity degree, the proposed modifications would have a constructive impact from a systemic danger viewpoint as nicely. With the proposed modifications on eligibility of non-SLR securities to be labeled as HTM, banks can higher handle their focus dangers and likewise enhance the liquidity of their stability sheets. Additional, as banks are vital contributors within the investor market, this proposed change may additionally help within the improvement of the bond market, which in flip would have far-reaching constructive results on systemic stability and monetary market resilience.


[1] Srinivas, Madhu, et al. ” Assessing Transparency of Indian Banking System’s Public Danger Disclosure Regime – A Regulation Based mostly Strategy.” 2021. Dvara Analysis.

[2] Danger administration technique for big branch-based banks to ship credit score extra successfully to low-income households and small companies. Supply – Chapter 4.2, Committee on Complete Monetary Providers for Small Companies and Low-Earnings Households. 2014. RBI Publications. Retrieved from: https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/CFS070114RFL.pdf

[3] Paragraph 5.2, Ibid.

[4] Part 5, Ibid

[5] Paragraph 5.3 level (e), Ibid.

[6] Ibid

[7] Part 7, Ibid

[8] Ibid

[9] Paragraphs 7.12 and seven.15, Ibid.

[10] That’s, holding the securities for brief time period resale or to learn from short-term worth actions, or to lock in arbitrage earnings.

[11] Part 6, Dialogue Paper on Overview of Prudential Norms for Classification, Valuation and Operations of Funding Portfolio of Industrial Banks. January 2022. RBI Publications. Retrieved from: https://rbidocs.rbi.org.in/rdocs/Publications/PDFs/DISCUSSIONPAPER9604DB243FA84169847AC576EBEB593B.PDF

[12]  Per Paragraph 7.20 within the Dialogue Paper, if a financial institution had been to decide on to promote or disinvest from the investments in subsidiaries, associates and joint ventures, it’s free to take action because the sale of such securities is exempt from the edge restrict (5 % of the opening carrying worth of the HTM portfolio) of mixture gross sales out of HTM.

[13] Paragraph 7.20, Ibid.

[14] 9 (a) (v), Grasp Course – Classification, Valuation and Operation of Funding Portfolio of Industrial Banks, 2021. August 2021. RBI Grasp Instructions. Retrieved from: https://rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=12153

[15] B5.5.17, Indian Accounting Commonplace (Ind AS) 109 – Monetary Devices. Retrieved from: https://www.mca.gov.in/Ministry/pdf/INDAS109.pdf

[16] As on Feb 9, 2022. Retrieved from: https://www.moneycontrol.com/india/stockpricequote/telecommunications-service/vodafoneidealimited/IC8;
https://www.moneycontrol.com/india/stockpricequote/refineries/relianceindustries/RI

[17] Paragraph 7.30 level (a), Dialogue Paper on Overview of Prudential Norms for Classification, Valuation and Operations of Funding Portfolio of Industrial Banks. January 2022. RBI Publications. Retrieved from: https://rbidocs.rbi.org.in/rdocs/Publications/PDFs/DISCUSSIONPAPER9604DB243FA84169847AC576EBEB593B.PDF

[18] Heads I Win, Tails the Regulator Dispenses, Understanding and Managing Curiosity Price Danger at Banks – Speech by Viral V Acharya, Deputy Governor. January 2018. RBI Speeches and Interview. Retrieved from: https://www.rbi.org.in/Scripts/BS_SpeechesView.aspx?Id=1053

[19] Paragraph 7.6 level (a), Dialogue Paper on Overview of Prudential Norms for Classification, Valuation and Operations of Funding Portfolio of Industrial Banks. January 2022. RBI Publications. Retrieved from: https://rbidocs.rbi.org.in/rdocs/Publications/PDFs/DISCUSSIONPAPER9604DB243FA84169847AC576EBEB593B.PDF

[20] Suggestion 4.10, Committee on Complete Monetary Providers for Small Companies and Low-Earnings Households. 2014. RBI Publications. Retrieved from: https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/CFS070114RFL.pdf

[21] Paragraph 7.6 level (b), Dialogue Paper on Overview of Prudential Norms for Classification, Valuation and Operations of Funding Portfolio of Industrial Banks. January 2022. RBI Publications. Retrieved from: https://rbidocs.rbi.org.in/rdocs/Publications/PDFs/DISCUSSIONPAPER9604DB243FA84169847AC576EBEB593B.PDF

[22] Paragraph 7.10, Dialogue Paper on Overview of Prudential Norms for Classification, Valuation and Operations of Funding Portfolio of Industrial Banks. January 2022. RBI Publications. Retrieved from: https://rbidocs.rbi.org.in/rdocs/Publications/PDFs/DISCUSSIONPAPER9604DB243FA84169847AC576EBEB593B.PDF

[23] Part 4, Ibid.


Cite this Merchandise:

APA

Neelam, A., & Srinivas, M. (2022). Suggestions on the Reserve Financial institution of India’s Dialogue Paper on Overview of Prudential Norms for Classification, Valuation and Operations of Funding Portfolio of Industrial Banks dated 14 January 2022. Retrieved from Dvara Analysis.

MLA

Neelam, Amulya and Madhu Srinivas. “Suggestions on the Reserve Financial institution of India’s Dialogue Paper on Overview of Prudential Norms for Classification, Valuation and Operations of Funding Portfolio of Industrial Banks dated 14 January 2022.” 2022. Dvara Analysis.

Chicago

Neelam, Amulya, and Madhu Srinivas. 2022. “Suggestions on the Reserve Financial institution of India’s Dialogue Paper on Overview of Prudential Norms for Classification, Valuation and Operations of Funding Portfolio of Industrial Banks dated 14 January 2022.” Dvara Analysis.



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