January 16, 2018 5:22:14 am
With banks staring at huge losses on their investment portfolios due to a surge in the yield on the benchmark 10-Year Government Security (G-Sec), Reserve Bank Deputy Governor Viral Acharya on Monday pulled up the banks saying that risk management “leaves a lot to be desired” and asked them to modernise their treasury functions and adopt robust risk controls. He also made it clear that interest rate risk of banks “cannot be managed over and over again by their regulator”.
“The efficiency with which this risk is currently managed leaves a lot to be desired. While duration risk management is constrained by the G-Secs issuer’s choice of maturity structure and liquidity in the secondary bond market, the risk can be managed more nimbly by also availing of hedging markets,” Acharya said.
“My point in showing this time-series and episodic phases of G-Sec yield movements is that banks should not be surprised repeatedly when government bond yields rise sharply and their investment profits drop,” Acharya said. The RBI’s Financial Stability Reports (FSR) have regularly pointed out the impact of such large interest rate moves on capital and profitability of banks. 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, Acharya said while addressing a function organised by the Fixed Income Money Markets and Derivatives Association (FIIMDA).
He said the treasury functions at banks need to be modernised with urgency, subjected to careful scrutiny by boards, overlaid with prudent risk management practices, and trained to employ hedging instruments specifically targeted at managing interest rate risk.
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, he said. Rating agency ICRA had said banks may face mark-to-market (MTM) losses aggregating about Rs 15,500 crore on their investment portfolios in the October-December 2017 quarter due to surge in the yield on the benchmark 10-Year G-Sec by 67 basis points in the said quarter. Acharya said interest rate risk of banks cannot be managed over and over again by their regulator.
He said banks should conduct reverse stress tests, i.e., ask the question as to what kind of G-Sec yield movements, parallel shift at a minimum but ideally also yield-curve steepening, would wipe out the allocated capital? “Indeed, such reverse stress tests have been recommended by the Reserve Bank and could become part of Board-level risk discussions,” he said. However, no stress test is perfect; and, no risk measure such as value at risk or expected losses which use historical distributions can anticipate fully the nature of future yield movements. “Hence, banks also need to adopt robust risk controls for resilience. This can involve concentration limits, so banks do not exceed their exposure to G-Secs beyond an internally agreed total proportion of assets; or the excess SLR should be commensurate in risk terms with the bank’s capital allocation for investments,” Acharya said.
“There is usually an uninspiring chatter every time G-Sec yields show a sustained rise that the market is irrational in its movements. Not only is it not difficult to separate rational market movements from irrational ones at high frequency, such proclamations are a sign that those betting on government bonds while chatting such are clueless about the drivers of market movements. Isn’t that a good time for the bank senior management to rein in their Treasury portfolio risks?” he asked.
On hedging the risk, he said PSBs account for about 70.6 per cent of the banking sector assets. However, their participation in such hedging markets is limited or negligible.
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