India’s banks may be able to use part of their assets in their statutory liquidity portfolios to meet Basel III requirements on liquidity ratios, which will make it easier for the country’s financial institutions to meet supervisory requirements but could have adverse effects on the government bond market.
Currently, Indian banks are mandated by the Reserve Bank of India (RBI) to keep 23% of their deposits in government securities, which they must hold until maturity and therefore cannot trade. These assets are thus categorised as “hold to maturity,” or HTM, and do not have to be marked-to-market. This protects banks from incurring losses on their balance sheets from market movements as a result of having to hold the bonds.
Since banks cannot sell these bonds, the assets are not considered liquid and therefore do not comply with Basel III norms.
“If you want to clarify government securities as liquidity investments, it has to be over and above the statutory requirements. So if you hold it to HTM, you can’t trade it, you can’t sell it, so how come it’s liquid?” said a Singapore-based credit analyst.
Basel III rules require banks to hold highly liquid assets that can be sold off to protect from a liquidity crisis. The amount of such securities should be equal to the total net cash flows of the bank in normal conditions. The implementation of the liquidity coverage ratio will be completed through phases from January 1, 2015.
Banks will have to ramp up their holdings of government securities if they are to meet both the RBI’s statutory liquidity ratio (SLR) rules as well as the Basel III liquidity rules. But instead of asking banks to set aside a separate portfolio to meet these Basel III rules on liquidity, local news reports say that the RBI is considering whether to lower the amount of assets that must be held to maturity in a bank’s SLR to prevent a sudden need for banks to stock up on additional securities.
Currently, at least 70% of government securities are held by the country’s banks, according to an estimate by a credit analyst. Banks hold about 27%-28% in bonds to maturity, which exceeds current rules.
However, analysts say this move will hurt demand for government bonds.
“The headlines news is good for liquidity in the system, but not for bonds. The implementation remains a key - a cut in the limits, if not done in a phased manner, could induce a marginal selling of bonds.” said Rohit Arora, a fixed income analyst at Barclays. “However, if the recent interest from foreign investors in Indian government bonds sustains, the net impact on the yields may be negligible.”
Arora says the best way to minimise shocks to the bond market is for the RBI to reduce the level of assets that can be held to maturity in phases by giving the banks six months to reduce the hold-to-maturity amount to half a percent, and continue at that base on a rolling basis.
Banks and primary dealers may also work together to minimise disruptions to the bond market by earmarking bonds that are close to maturity or “in the money” to be liquidated if needed. “In the money” bonds mean securities that have been bought at lower levels than current prices.
But even if the levels are lowered, such a move may do little to induce secondary bond market trading.
“Would that mean actual trading will start happening? My answer with that will be no because they have to hold 23% in any case of their borrowings and deposits, for them to start trading may not be such a big thing,” said the credit analyst.
Arora says the effects from the lowered limits will be visible in the longer term, after the RBI finalises its guidelines on Basel III in March, when India’s financial year ends.
Still, a drop in Indian government bond yields will persuade banks to sell some of their holdings. Aashish Agarwal, a banking analyst at CLSA, says banks will seek to book profits from lower yields.
“Rates are declining so clearly that should help banks rather than go against them,” said Agarwal. “Banks will use this to move some of their portfolio out of HTM to AFS [available for sale] and that should help them to book profits on these names when the interest rates go down.”
Yields on the 10-year government bond have dropped 16 basis points in the past month to 7.91%.
Agarwal suggests that banks will book approximately 5% in profits if they were to sell at current rates.
Indian banks have historically been required to hold government bonds to help fund the government deficit.