Analysis of RBI Master Direction on Banks’ Investment Portfolios

Analysis of Master Direction – Classification, Valuation and Operation of Investment Portfolio of Commercial Banks (Directions), 2023

Introduction

In view of the significant developments in the global standards on classification, measurement and valuation of investments, the linkages with the capital adequacy framework as well as progress in the domestic financial markets, a need was felt to review and update these norms.

The revised framework as detailed in the Reserve Bank of India (Classification, Valuation and Operation of Investment Portfolio of Commercial Banks) Directions, 2023 annexed hereto shall be applicable from April 1, 2024, to all Commercial Banks excluding Regional Rural Banks.

Some Important definitions and key terms

“Corporate bonds and debentures” for the purpose of these Directions mean debt securities which create or acknowledge indebtedness,

“Day 1 Gain” is the difference between the fair value at initial recognition and acquisition cost where such fair value exceeds the acquisition cost.

“Day 1 Loss” is the difference between acquisition cost and the fair value at initial recognition where the acquisition cost exceeds such fair value.

“Level 1” in the context of inputs used for valuation of a financial instrument are those inputs which are quoted prices (unadjusted) in active markets for identical instruments that the bank can access at the measurement date. In reference to the valuation of an instrument, it refers to a valuation that is substantively based on Level 1 inputs and does not have any significant Level 2 or Level 3 inputs.

“Level 2” in the context of inputs used for valuation of a financial instrument are those inputs, other than quoted prices included within Level 1, that are observable for the asset or liability, either directly or indirectly. In reference to the valuation of an instrument, it refers to a valuation that is based on Level 1 and Level 2 inputs and does not have any significant Level 3 inputs.

“Level 3” in the context of inputs used for valuation of a financial instrument are unobservable inputs. In reference to the valuation of an instrument, it refers to a valuation in which there is a significant Level 3 input.

Classification

Banks shall classify their entire investment portfolio (except investments in their own subsidiaries, joint ventures and associates) under three categories, viz., Held to Maturity (HTM), Available for Sale (AFS) and Fair Value through Profit and Loss (FVTPL). Held for Trading (HFT) shall be a separate investment subcategory within FVTPL. The category of the investment shall be decided by the bank before or at the time of acquisition and this decision shall be properly documented.

HTM – The security is acquired with the intention and objective of holding it to maturity, i.e., the financial assets are held with an objective to collect the contractual cash flows; and the contractual terms of the security give rise to cash flows that are solely payments of principal7 and interest on principal outstanding (‘SPPI criterion’) on specified dates.

AFS – The security is acquired with an objective that is achieved by both collecting contractual cash flows and selling securities; and the contractual terms of the security meet the ‘SPPI criterion’

Initial recognition

All investments shall be measured at fair value on initial recognition. Unless facts and circumstances suggest that the fair value is materially different from the acquisition cost, it shall be presumed that the acquisition cost is the fair value.

Where the securities are quoted or the fair value can be determined based on market observable inputs (such as yield curve, credit spread, etc.) any Day 1 gain/ loss shall be recognised in the Profit and Loss Account, under Schedule 14: ‘Other Income’ within the subhead ‘Profit on revaluation of investments’ or ‘Loss on revaluation of investments’, as the case may be.

Subsequent Measurement

HTM – Securities held in HTM shall be carried at cost and shall not be marked to market (MTM) after initial recognition. However, they shall be subject to income recognition, asset classification and provisioning norms as specified in Chapter X of these Directions. Any discount or premium on the securities under HTM shall be amortised over the remaining life of the instrument. The amortised amount shall be reflected in the financial statements under item II ‘Income on Investments’ of Schedule 13: ‘Interest Earned’ with a contra in Schedule 8:’Investments’.

AFS and FVTPL – The securities held in AFS and FVTPL shall be fair valued at least on a quarterly basis, if not more frequently. Any discount or premium on the acquisition of debt securities under AFS or FVTPL shall be amortised over the remaining life of the instrument. The amortised amount shall be reflected in the financial statements under item II ‘Income on Investments’ of Schedule 13: ‘Interest Earned’ with a contra in Schedule 8:’Investments’

The valuation gain and loss shall be aggregated of all securities and the net appreciation or depreciation shall be directly credited or debited to a reserve named AFS Reserve without routing through the Profit & Loss Account. The unrealised gains transferred to AFS-Reserve shall not be available for any distribution such as dividend and coupon on Additional Tier 1.

Upon sale or maturity of a debt instrument in AFS category, the accumulated gain/ loss for that security in the AFS-Reserve shall be transferred from the AFS Reserve and recognized in the Profit and Loss Account under item II Profit on sale of investments under Schedule 14-Other Income. In the case of equity instruments designated under AFS at the time of initial recognition, any gain or loss on sale of such investments shall not be transferred from AFS-Reserve to the Profit and Loss Account. Instead, such gain or loss shall be transferred from AFS-Reserve to the Capital Reserve.

Reclassification

Bank shall not reclassify investments between categories without the approval of BOD (MANCO). Further, reclassification shall also require the prior approval of the Department of Supervision (DoS), RBI.

Accounting treatment for reclassification: –

Transition and repeal provision

At the time of transition to these directions (i.e., on April 1, 2024), banks shall reclassify their investment portfolio as at March 31, 2024, as per the directions laid down in Chapter III of these Directions.

Conclusion

In conclusion, the Reserve bank of India in lieu of this circular brings in sync the reporting guide line of the banks in India with the global standards like IFRS. RBI highlights the valuation of securities and investments made by the bank to be reported in line with global standards as well as it also emphasises on transparent reporting of investment. With the new reporting standards in place no bank would be allowed to give dividends from the AFS reserves. The emphasis on systematic reporting, internal controls, and audit procedures underlines the importance of transparency and accountability in financial transactions. This conclusion states the key points and directives mentioned in the document, emphasizing the importance of compliance, risk management, and operational integrity for commercial banks.

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Authors: Mitansh Shah, Article Assistant, and Mohit Gujar, Senior Manager. For inquiries, email blogs@bilimoriamehta.com or contact +91 9602701969, +91 8928782988.