• FEBRUARY 19, 2003

Banks: How well protected?

A soft interest rate scenario advocated by the RBI coupled with low credit off take has seen interest rates fall to historically low levels. Low credit off take has prompted many banks to invest in G-Secs at levels more than that required for purposes of SLR. While the threat of falling G-Sec prices may be a short term concern for now, the reality is that in the long term there will be an improvement in credit off take and at that time G-Sec prices are likely to further witness a decline.

In our earlier article Banks: Prudence warranted we had highlighted the fact that small banks that do not have a large net worth are in a situation where a considerable part of their net worth could be eroded due to falling G-Sec prices. In this article we look at the stipulations of the RBI regarding this matter and the position of public sector banks (PSB) and private sector banks regarding the same.

The RBI has stipulated that in order to protect the banks against drastic movements in interest rates, banks have to create an investment fluctuation reserve (IFR). This IFR must be created by transferring maximum amount of gains that the bank makes from the sale of investments in securities like G-Secs. Banks have to achieve an IFR at a minimum of 5% of all investments in ‘held for trading’ (HFT) and ‘available for sale’ (AFS) categories, within a period of 5 years. For example if a bank has Rs 50 in HFT and Rs 50 in AFS he has to have an IFR of a minimum of Rs 5.

Banks: IFR status
(Rs bn) Total
(Rs m)
Net worth 1% of investments
(Rs m)
Net impact
(Rs m)*
Erosion in
net worth*
HDFC Bank 120 2401 20 1,200 1,200 -
ICICI Bank 359 273 66 3,589 (3,316) 5.0%
IDBI Bank 24 100 3 242 (142) 4.7%
UTI Bank 66 708 6 663 45 -
SBI 1451 6712 152 14,514 (7,803) 5.1%
BOB 238 2568 36 2,383 185 -
BOI 221 2418 28 2,208 209 -
Corporation Bank 81 898 20 806 92 -
Oriental Bank 137 1205 16 1,372 (167) 1.0%
PNB 282 3101 29 2,821 280 -
* If there is a 1% fall in the value of investment portfolio
Investments include government securities and other securities like equity and debentures. It also includes investments in subsidiaries
All FY02 figures

The table above shows the position of various banks with respect to the provision they have made for the investment fluctuation reserve and the effect a 1% fall in investments on the net worth of these banks. Among the private sector banks in the study HDFC Bank is clearly the best-protected bank, while among the PSBs Corporation Bank has this distinction. We would like to point out here that while the IFR is for protection of the G-Sec portfolio our study includes all investments of the bank.

As we do not possess the exact figures of the investments in ‘held for trading’ (HFT) and ‘available for sale’ (AFS) categories of these banks we are not in a position to comment on whether the provisioning carried out by these banks is in line with the RBI guidelines. But we assume that the IFR of these banks is still short of stipulations. The table illustrates the fact that for some banks like ICICI Bank, IDBI Bank and SBI the IFR is not enough to prevent the erosion of the net worth in case of a 1% fall in their investment portfolio. The level of IFR is even more important currently as the RBI has further stipulated that banks are to ‘mark-to-market’ the individual scrips held under the AFS category, at least at quarterly intervals instead of annual intervals.

Banks have aggressively provided for the IFR in FY02 and this trend is likely to be followed in FY03 also. Erosion in the equity capital of the banks limits the expansion plans of banks, as the capital adequacy ratio of banks is dependent on the net worth. Banks may witness lower earnings growth as they aggressively provide for NPAs and the IFR, but in the long run it is going to protect the banks against adverse changes in interest rates that threaten to adversely impact the equity capital of the bank. Better-managed banks have shown the will to protect the capital of shareholders. IFR may well turnout out to be a tool to judge the quality of the management in the future especially in a scenario of volatile interest rates that the country could witness in the future. Investors may want to keep this aspect in mind when they are looking to invest in banks.

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