The Reserve Bank of India (RBI) has recently issued updated guidelines regarding the investment portfolios of commercial banks. These guidelines, effective from the accounting period after April 2024, are aimed at aligning Indian banking practices with international standards. This comprehensive article breaks down the key aspects of these guidelines, making them accessible to a broader audience.
Reserve bank of India to meet international standards of classification, valuation, and operation of portfolio of commercial banks has revised its guidelines vide its communication dated 12th September 2023. It is time to understand these extant instructions in simple terms.
Spread in 14 chapters, these instructions match up to international standards and expectations of vast number of stakeholders of commercial banks. Narrated below is the list of chapters.
1. Preliminary
2. General guidelines
3. Classification of investments by banks
4. Initial recognition
5. Subsequent measurement
6. Reclassifications between categories
7. Sale of investments from HTM
8. Fair value of investments
9. Operational guidelines
10. Income recognition, asset classification and provisioning
11. Small finance banks and payments banks
12. Derivatives
13. Penal consequences for non-compliance
14. Transition and repeal provisions
I intend to explain the instructions in the form of question and answer for easy reference and understanding.
1. Let us have some introduction. These master directions will take place from accounting period after April 2024, which indicates some time available for the banks to understand, prepare processes and implement on time. All commercial banks and State bank are covered.
2. Some of the meaning for words like carrying cost, corporate bonds and debentures, current and valid credit rating, fair value, government security, level 1, 2, and 3, short sale, statutory liquidity ratio, statutory reserve, financial asset and financial instrument attract my attention.
3. Well, nearly 40 words are chosen for explanation
For better understand ory notification, RBI has maintained a legal parlance over these words and others. But we are aware of the frequent usage of these words recently in various financial instances.
4. How do the banks maintain investment frame work. The banks have to get their investment policy duly approved by their board of directors and being communicated to RBI in normal channel.
5. What does the investment policy of the any bank contain?
“The investment policy shall, at the minimum, include:
i. The investment criteria and objectives to be achieved while undertaking investment transactions on their own investment account and on behalf of clients.
ii. Securities in which investments can be made by the bank.
iii. Derivatives in which the bank shall deal.
iv. The authority to put through deals.
v. Procedure for obtaining the sanction of the appropriate authority and putting through deals.
vi. Adherence to various prudential exposure limits.
vii. Policy regarding dealings through brokers, systems for management of various risks, guidelines for valuation of the portfolio and the reporting systems.”
Banks must have Prudential limits for investment in securities, adequate risk management systems, the procedure for investment in equities, and the policy for associated risks. Like any loan proposal, investments undergo the same credit risk analysis. Banks have been advised to have even their own credit analysis and credit rating even in respect of rated issues and pure reliance on external rating of agencies. This is obvious in view of massive failure of banks depending upon the credit rating agencies for housing bubble, failure of countries which fancy a better rating system by historical reasons. Recent financial world including India is a witness to frequent failure of financial institutions.
6. Let’s learn the categorization of investments.
The banks shall classify their entire investment portfolio as Held to Maturity (HTM), Available for Sale (AFS), Fair value through Profit and Loss (FVTPL) .Obviously, the categorization of investment is done before and at the time of acquisition and the decision shall be definitely documented.
How shall these investments be presented in their Balance Sheet?
It shall be as under:
i. Government securities
ii. Other approved securities
iii. Shares
iv. Debentures & Bonds
v. Subsidiaries and / or joint ventures
vi. Others (to be specified)
Time to learn the basics of HTM, AFS, and HFT.
HTM
To quote from the text:
i. 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
ii. the contractual terms of the security give rise to cash flows that are solely payments of principal7and interest on principal outstanding (‘SPPI criterion’) on specified dates.
More details can be obtained from the direct communication.
AFS
What about AFS?
i. “The security is acquired with an objective that is achieved by both collecting contractual cash flows and selling securities; and
ii. the contractual terms of the security meet the ‘SPPI criterion’ as given in paragraph 6.1(a)(ii) above.
Provided that on initial recognition, a bank may make an irrevocable election to classify an equity instrument that is not held with the objective of trading (i.e., not held for any of the purposes listed in paragraph 4 of Annex I) under AFS.
(b) AFS securities shall inter-alia include debt securities held for asset liability management (ALM) purposes that meet the SPPI criterion where the bank’s intent is flexible with respect to holding to maturity or selling before maturity.”
What are FVTPL and can we know their names?
Securities that fail to fall under HTM or SFS find their place under this category. It can be mentioned as under:
i. “Equity shares, other than (a) equity shares of subsidiaries, associates or joint ventures and (b) equity shares where, at initial recognition, the irrevocable option to classify at AFS has been exercised.
ii. Investments in Mutual Funds, Alternative Investment Funds, Real Estate Investment Trusts, Infrastructure Investment Trusts, etc.
iii. Investment in securitisation notes which represent the equity tranche of a securitisation transaction. Investments in senior and other subordinate tranches shall need to be reviewed for their compliance with SPPI criterion explained in clause 6.1(c) above.
iv. Bonds, debentures, etc. where the payment is linked to the movement in a particular index such as an equity index rather than an interest rate benchmark.”
It is essential to learn how initially these securities are recognized for value?
All investments are measured at fair value which turns out to be acquisition cost.
Chapter 4 under initial recognition, under para 8-10 details with government securities, any day 1 gains/losses for the purpose of Profit and loss account.
What about subsequent measurement which may take place depending upon the financial position of the bank or policy changes on investment.
HTM
(a) 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.
AFS
As per its name, these are available for sale. Then what?
The securities held in AFS 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 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’..
However, the net appreciation or depreciation11 shall be directly credited or debited to a reserve named AFS-Reserve without routing through the Profit & Loss Account.
The securities held in FVTPL shall be fair valued and the net gain or loss arising on such valuation shall be directly credited or debited to the Profit and Loss Account. Securities that are classified under the HFT sub-category within FVTPL shall be fair valued on a daily basis, whereas other securities in FVTPL shall be fair valued at least on a quarterly, if not on a more frequent basis.
Accounting adjustments?
(b) Any discount or premium on the acquisition of debt12 securities under 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’.
(c) Proper recognition of gains or loss require adequate recognition and placement of the securities as per approved norms of the banks.
In a business, banks do work on day-to-day basis and may be required to reclassify between categories. Clear examples with actual declaration of treatment can be summarized as under.
From to accounting treatment
HTM – AFS: Fair value on reclassification date shall be revised carrying value. Gain or loss to be under AFS Reserve.
HTM – FVTPL: Fair value on reclassification date shall be the carrying value. Gain or loss to be duly accounted in the Profit and Loss Account under Item (III): ‘Profit on revaluation of investments’ under Schedule 14: ‘Other Income’.
AFS To HTM: The investments to be reclassified at its fair value. An interesting treatment. Of account. However, the cumulative gain/loss previously recognised in the AFS-Reserve shall be withdrawn therefrom and adjusted against the fair value of the investments at the reclassification date to arrive at the revised carrying value. Thus, the revised carrying value shall be the same as if the bank had classified the investment in HTM ab initio itself.
Similar transfer of AFS To FVTPL or FVTPL To HTM/AFS are given in the master circular. One can refer for detailed analysis.
Further information on fair value calculation.
- Quoted Securities
- The fair value for the quoted securities shall be the prices declared by the Financial Benchmarks India Private Ltd. (FBIL) in accordance with RBI circular FMRD.DIRD.7/14.03.025/2017-18 dated March 31, 2018, as amended from time to time.
- Unquoted securities: Treasury bills to be valued at carrying cost. Use of FBIL with its perodical valuation may assist in case of unquoted central/state government securities.
Unquoted Non-SLR securities: Unquoted debentures and bonds shall be valued by applying the appropriate mark-up over the YTM rates for Central Government Securities as put out by FBIL/FIMMDA, subject to the following:
(i) The mark-up applied shall be determined based on the ratings assigned to the debentures/ bonds by the credit rating agencies and shall be subject to the following:
a. The mark- up shall be at least 50 basis points above the rate applicable to a Central Government security of equivalent maturity for rated debentures/ bonds.
b. The mark-up for unrated debentures or bonds shall not be less than the mark-up applicable to rated debentures or bonds of equivalent maturity.
Provided that the mark-up for the unrated debentures or bonds should appropriately reflect the credit risk borne by the bank. For other complicated operational issues, one can easily go to chapter 9 for guidance.
One is tempted to know the role of the Board of Directors. What is it?
On quarterly basis, the board to review the following aspects of non-SLR investments.
Total business of investment/divestment during the reporting period, compliance with prudential norms of board/RBI, rating migration of the issuers/issues held in bank’s books, adequacy of the risk management systems/processes prescribed by the board, and finally non-performing investments.
Many financial institutions around the world lost financially heavy amounts sometimes resulting in their own non-existence.
What internal control measures have been prescribed by RBI to the banks for investment purposes?
- a clear functional separation of (a) trading, (b) settlement, (c) monitoring and control, and (d) accounting.
- Preparation of deal slips with full particular activity like HTM, AFS, FVTPL or HFT which will be audited later for accounting purposes. With total computerization, much easier to contain full information and supervision, revision or review at various levels.
- Board’s prescribed control measures should be strictly adhered to by all persons involved who are qualified to handle and also various measures like internal auditing, external auditing or RBI auditing etc. to be followed.
- FIMMDA Code of conduct must be adhered to during trading operations in government securities, NDS-OM and in the OTC market.
- Monthly tallying of books with Public Debt Office is a must on monthly basis.
- Non- performing investment activities to be reviewed periodically and put up to Board.
Under item no.37 investment fluctuation reserve, it has been emphasized that Banks shall create an Investment Fluctuation Reserve (IFR32) until the amount of IFR is at least two per cent of the AFS and FVTPL (including HFT) portfolio, on a continuing basis, by transferring to the IFR an amount not less than the lower of the following:
i. Net profit on sale of investments during the year.
ii. Net profit for the year, less mandatory appropriations.
Conclusion: The RBI’s updated guidelines regarding commercial banks’ investment portfolios in 2023 are a significant step toward aligning Indian banking practices with international standards. These guidelines are designed to enhance transparency, risk management, and governance within the banking sector. By understanding and implementing these guidelines effectively, banks can mitigate risks and contribute to financial stability and growth.
This article serves as an informative guide, but it is imperative that banking professionals adhere to rigorous governance standards and due supervision at all levels when making investment decisions. For the complete guidelines, readers can refer to the official RBI website here.
This article is for informatory purposes and it is expected that all professional decisions will obviously involve adequate governance standards and due supervision at all levels.
Author Bio
