Public sector banks absorb more than half of the government’s bond supply every financial year and by default are susceptible to market risks on their bond portfolio.
Yet when it comes to hedging these market risks, they have grossly under-provided for risks. As of March 2017, the investment fluctuation reserve of commercial banks stood at Rs2,916 crore or less than 1% of the total investment portfolio.
In 2005, the Reserve Bank of India (RBI) had asked banks to create an investment fluctuation reserve by transferring bond gains during good times so that it would take care of mark-to-market hit during bad times. In the years that followed, RBI eased its rules to some extent but banks had to maintain this reserve to guard against a hit on their available-for-sale and held-for-trading portfolios. By nature, the held-to-maturity (HTM) portfolio need not be marked to market.
The adjoining chart shows that banks have maintained just the bare minimum and in some cases no reserves. Public sector banks fare the worst while foreign banks have maintained a reasonable level of reserves. Private lenders too kept low reserves.
In the years where the reserve was low, one reason was that profit from sale of investments was low. In fact, some banks faced a mark-to-market hit on their bond portfolios. However, banks didn’t beef up their reserves in the years they made large gains out of bond sales. In the absence of a vibrant market for credit risk hedging instruments, it is important for banks to build adequate reserves, especially when the regulator has mandated them to do so.