Don't run to the RBI: Banks should manage treasury portfolios by themselves

Over the past six months, the Indian bond market has seen a great deal of action. In the quarter ending December 2017 the 10-year government security (the G-sec) yield, which is generally used as a benchmark, has gone up by 67 basis points. The yield curve has steepened sharply; and banks fear the spike in bond yields has caused profits to decline equally sharply. This has, predictably, led to demands for relief from banks. The banking regulator, the Reserve Bank of India, is the first port of call under such circumstances. Recently, RBI Deputy Governor Viral Acharya revealed that banks had requested a special dispensation from the central bank, while noting that the RBI was not inclined at the moment to give in to these demands. Essentially, the banks wish to allow their treasury losses to be spread out over a few quarters. Most of the banks hit the hardest are state-controlled ones; one ratings agency estimating that they will endure four-fifths of the impact of higher yields — the total hit might be over Rs 150 billion. 

In addressing this issue, Mr Acharya correctly pointed out that the fear was that perverse incentives were being set up for banks. In particular, banks make profits from the bond market when the going is good, but rush to the regulator for help when the bond market turns adverse. This is neither sustainable nor desirable. As the deputy governor suggested, the only realistic way to deal with this situation is not to give in again — as the RBI has several times in the past — but instead for the banks to beef up their in-house capacity and capability to deal with interest rate risk. Intervention from the regulator cannot be the banks’ first and only method of interest rate risk management. There should also be clear accountability for those in bank management who have taken the bets on the bond market that caused losses. This requires not only a build-up of capacity at the managerial level but also a more detailed scrutiny by bank boards. It is worth asking, once again, exactly what the Banks Board Bureau is doing to fix the governance of public sector banks and the scrutiny of these banks by their boards. 

The problem runs deeper, of course. The bond market is not deep enough, which means that the demand and supply dynamics of G-secs from public sector banks is sufficient for very volatile price dynamics. This needs to be addressed going forward. But, more generally, it is time for the government to examine exactly how its own fiscal misbehaviour combines with its unwillingness to ensure accountability in the state-controlled banking sector to create poor incentives and to hobble the bond market. Bond yields spiked because it appeared the government borrowing programme would expand, and the government’s own banks took a hit as a result, and went running to the regulator for help. Once again, it is clear that there is no replacement for genuine reform of the state-controlled banking sector, and the accountability and investment in risk-management capacity that will happen as a result of that reform.