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Bank G-Sec fears: How real?

Jun 11, 2004

There has been a persistent fear among the investment fraternity of a possible erosion of the value of investment portfolio of banks if there is a rise in interest rates. These fears have been compounded due to the fact that public sector banks, which are bound by regulatory requirements to maintain G-Sec investment portfolios, have in the last 2-3 years increased their exposure to this segment. According to the Indian Banks' Association (IBA), Government Securities (G-Sec) holding of Indian banks stands at around 35%-40% of aggregate deposits (summation of demand deposits and time deposits), as compared to only 4.6% in banks of US, a negligible 0.3% in banks of UK and around 6.9% in banks of the Euro zone. However, one needs to keep in mind the fact that Indian banks have to hold a minimum of 25% of their deposits in the form of G-Secs. This requirement is called the SLR.

In this article, we will discuss the complexity of this problem and the remedial measures that need to be taken to mitigate the impact of any adverse change in interest rates in the future. The table below indicates the duration of the G-Sec portfolios of the banking sector. The sector has been classified on the basis of foreign banks, private sector banks and public sector banks. The table indicates that the duration is the highest for the public sector banks and this means that they have a high sensitivity to any change in interest rates. Consequently, they are likely to witness higher erosion in the value of G-Sec portfolio compared to foreign and private sector banks if the interest rates rise.

Category G-Sec portfolio* (Rs bn) Duration (years)
Foreign banks 324 2.2
Private sector banks 852 3.1
Public sector banks 4,468 4.7
Total 5,644 4.3
* 2001-02 data
Source: IBA and RBI

The IBA has indicated that an interest rate shock (where rates rise significantly in a short span) would erode more than 25% of the networth of foreign banks. Among private sector banks, this proportion was around 54%, and among nationalized banks, it was as high as 89%. These figures indicate the susceptibility of various segments of the banking sector to adverse changes in interest rates. The RBI has already instituted a mechanism in place to protect banks against any adverse shocks due to interest rate changes. The Investment Fluctuation Reserve is such a mechanism that mandates banks to keep a reserve that will protect them against an interest rate shock in the future. The limit for this reserve has been kept at 5% of the investment portfolio. While most banks have already created these reserves, they are still some time away before the statutory limit is reached.

Apart from this measure, there are other instruments that could help banks mitigate interest rate risk in the future. Interest rate swaps and interest rate futures are such instruments that are essentially derivative products which can help the sector hedge its G-Sec portfolio against interest rate shocks. Floating rate G-Secs are another instrument that can be used to mitigate the risk. However, the proportion of floating rate G-Secs to total G-Sec portfolio only stands at 3% currently. A conscious increase in the same by the Reserve Bank of India (RBI) may go a long way in insulating the banking sector from the interest rate risk.

While the Indian banking sector has managed to take advantage of the falling interest rate regime, it remains to be seen how they manage a rising rate scenario. In particular, public sector banks will be under scrutiny due to their relatively higher risk in this regard. We would like to maintain that a rapid rise in interest rates will be very adverse for the sector. However, a measured rise may be well handled (which seems more likely at the current juncture). Investors need to focus on banks, which have lower dependence on profit from sale of investments as far as their other income is concerned. Since other income forms a large part of profit before tax for the sector, this aspect is of importance. Performance in the core business of lending will be a key determinant of valuations from here on.

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