Risk mismanagement

The events related to the Global Trust Bank have brought issues of banking regulation to the forefront. The rise in inflation is going to have a significant impact on another aspect of banks where regulation is particularly weak. This is the impact of inflation figures and the consequent rise in interest rates on balance sheets of banks. This impact is not going to be limited to one bank. It will hit a large number of banks, both public and private.

Bond markets have already been reacting to the rise in inflation. Interest rates have risen and bond prices fallen. All indications are that this trend will continue. For the last three years, many banks have been sitting on huge interest rate risk. The balance sheets of the majority of banks in India have been riddled with huge mismatches. These banks stood to gain when interest rates fell, but they were at the risk of taking big hits if interest rates were to rise. Bank investment in long dated government bonds, whose prices move sharply when there is a change in interest rates, is one of major sources of the interest rate risk of banks in India. The focus of regulation on credit risk and NPAs has encouraged banks to do 8220;lazy banking8221;, where instead of making the effort of giving loans to credit worthy borrowers, banks choose to lend money to the government. In this scenario, a rise in interest rates is going to put a large number of banks in the red. Some banks have already witnessed a sharp drop in profits in 2003-04 because interest rates did not fall, as they had done in the preceding two years.

RBI regulation on interest rate risk has been even weaker than its regulation on credit risk. Instead of assessing the interest rate risk of each bank, the RBI has asked all banks to hold an 8220;investment fluctuation reserve8221; which should be 5 per cent of the value of its government bond holdings, over a period of five years. This reserve is inadequate to cover the risk being taken by banks who have high interest rate risk exposure. The monitoring of interest rate risk by banks is supposed to be done by the RBI on the basis of the Interest Rate Risk Statement that banks submit to the RBI on a quarterly basis. The RBI does not require banks to release this statement to the public. Given the quality of monitoring, it is important that the depositors and shareholders should have the right to make their own judgement and not have to depend on the judgement of the RBI8217;s risk monitoring mechanism. The RBI should take immediate steps to improve public disclosure by banks.