Failure to manage rate risks could cost banks up to Rs25,000 crore: Viral Acharya

Banks must learn to manage treasury and keep tabs on the bond market to understand the risks of interest rate changes and the central bank cannot intervene to bail out banks from adverse interest rate movements, Reserve Bank of India (RBI) deputy governor Viral Acharya has said.

Banks must not be surprised, but understand the risks in the bond markets well, said Reserve Bank of India (RBI) deputy governor Viral Acharya, even as he noted the central bank will not intervene to bail out banks from adverse interest rate movements.

Banks are expected to lose anywhere between Rs15,000 crore and Rs25,000 crore in treasury write downs in the third quarter after the bond yields collapsed about 67 basis points in the December quarter.

''Interest rate risk of banks cannot be managed over and over again by their regulator," Acharya said in a speech at the annual dinner of the Fixed Income Money Markets and Derivatives Association (FIMMDA).

While indicating that this was not the first time when bond yields have risen, the RBI deputy governor said banks have not been much wiser; rather, they tend to ignore the risk. ''… banks should not be surprised repeatedly when government bond yields rise sharply and their investment profits drop."

A  government bond portfolio of Rs1,00,000 crore size with 10 year maturity, falls in value by Rs1,000 crore upon a 0.1 per cent or 10 basis points (bps) rise in the 10-year G-Sec benchmark yield, Acharya pointed out.

The share of commercial banks in outstanding G-Secs is around 40 per cent (asw of June 2017). Investment of scheduled commercial banks (SCBs) in G-Secs as a percentage of their total investment was around 82 per cent for FY 2016-17, while it is slightly higher at 84 per cent for public sector banks (PSBs).

This exposure has noticeably increased since 2014, Acharya pointed out.

The deputy governor made the comments after banks started reporting the results this month and have sought RBI permission to spread the provisions on the losses to avoid taking an immediate hit on their profitability.

It has been a common practice among Indian banks to seek relaxation whenever they were in losses, and the regulator in the past has largely obliged.

This time, however, RBI wants banks' treasury departments to equip themselves with derivative products rather than praying for regulatory relaxations, Acharya said.

''The regulator, in the interest of financial stability, is caught in such situations, between a rock and a hard place, and often obliges,'' Acharya said.

However, he added, "By taking advantage of the dispensation regularly, efficient price discovery in the government securities (G-Sec) market and effective market discipline on the G-Sec issuer was not happening. ''Nor does it augur well for developing a sound risk management culture at banks.''

According to him, the excess liquidity in the banking system did not get absorbed through the RBI's liquidity operation, and capital-starved banks parked the funds in bonds, at the expense of duration risk.

He said, "With relatively high duration and concentration of G-Secs in investment portfolio, bank earnings and capital remain exposed to adverse yield moves."

As a result, the size of banking sector's balance-sheet exposure to G-Secs, and hence, its interest rate risk, is high in an absolute sense, and is relatively elevated, when measured in proportion to total assets, for public sector banks relative to private banks.

RBI's Financial Stability Reports (FSRs) have regularly pointed out the impact of such large interest rate moves on capital and profitability of banks, said Acharya. "Banks should know and understand this risk rather well. Perhaps they do, and the issue is really one of incentives that lead to their ignoring this risk.''