Banks well placed to withstand trading losses due to hardening yields: RBI

While banks are endowed to face effects of rising yields, they need to strengthen risk management practices and internal controls by banks remains of paramount importance, it emphasised

Banks in India are well placed to withstand headwinds from the current phase of hardening of yields. The timely creation of investment fluctuation reserve (IFR) provides them adequate buffers to withstand trading losses, according to a Reserve Bank of India (RBI) study.

While banks are endowed to face effects of rising yields, the need to strengthen risk management practices and internal controls remains of paramount importance, the study emphasised.

The RBI study on the impact of rising yields on government bonds, covering the period Q1FY16 to Q1FY23, attempted to estimate its impact on bank profitability. The short-term yields and the slope of the yield curve had a negative impact on trading income for the period. The views expressed in the article appearing in the October 2023 Bulletin are those of the authors and do not represent the views of the Reserve Bank of India.

The Mark to Market (MTM) losses have been a major source of concern for both banks and regulators in light of the systemic impact of interest rates on financial markets. The macro-prudential measures such as the creation of IFR have provided a cushion to the banking sector against the current episode of hardening of yields.

The investment fluctuation reserve (IFR) is created by transferring the gains realised on the sale of investments. It enables banks to maintain an adequate reserve to protect against an increase in yields on their balance sheet in the future. In the wake of the guidelines and with falling yields, resultant higher trading profits led to a higher transfer of funds to IFR.

The IFR reached 2.2 per cent of the Held for Trading (HFT) and Available for Sale (AFS) portfolio by end-March 2022 at the system level. However, with a sharp rise in G-Sec yields and a fall in bond prices in Q1FY23, banks recorded treasury losses in their trading book to the tune of 4.9 per cent of their operating profit. Yet, at the system level, banks managed to maintain their IFR above 2 per cent, which reached 2.7 per cent by March 2023, the study added.