Indian banks were expecting a helping hand from the Reserve Bank of India (RBI) but got a punch in the nose instead. Lenders are staring at huge losses on their bond portfolio owing to rising yields. They were hoping that the central bank might step in to relieve some of that pain. On Monday night, central bank deputy governor Viral Acharya dashed those hopes. He told banks to fend for themselves.

That is good advice. It signals that the central bank is no longer inclined toward regulatory forbearance and rightly so. Such forbearance on bad loans is one reason for the huge pile up in stressed assets now. Indeed, earlier in June, Acharya had also said that interest rate policy cannot be set keeping bank balance sheets in mind.

Having said that, RBI (and the government) should follow through by implementing some reforms. It should further curtail the proportion of bonds banks can hold in the hold-to-maturity category. This portion is not marked to market and enables banks to park illiquid securities. The regulator should do away with the practice of allowing state development loans to be valued at a fixed mark-up over central government bonds. That doesn’t take into account the different risks for each state.

Most importantly, RBI should push for the formation of the public debt management office, which will free it from conflict of interests. Wearing its hat as a banking regulator, the central bank advises lenders to manage duration risk and points to the increasing maturity of their portfolios. As the government’s merchant banker, RBI is probably advising New Delhi to increase the maturity profile of its borrowings.

Acharya’s statement is a wake-up call to banks. But it could not have come at a more inopportune moment. Bond yields have been volatile over the past year. Since August, there has been an accelerated increase because of rising crude prices, a pick-up in inflation and concerns over the government’s ability to manage its finances. A rise in yield means losses for banks in treasury books when bond holdings are marked to market.

At this time, the losses pinch all the more for a couple of reasons. Large banks, especially state-owned lenders, have had to make provisions for bad loan accounts referred to bankruptcy court. Several state-owned lenders are under the so-called prompt corrective action, which means their operations are curtailed. Their bond holdings are also more than what is required under the statutory liquidity ratio.

According to Bloomberg, Indian lenders hold as much as Rs12.5 trillion more government securities than required. That translates into 11.25% of their net demand and time liabilities.

This is partly owing to poor credit growth, which had fallen to as low as 5% in mid-2017, and because banks had surplus liquidity as deposits piled up after demonetisation. But where banks could have done better is in managing risks. Seasoned bankers would know that government bond yields have cycles of moving up and down sharply.

Instead of preparing for that, they have gone to RBI asking to spread their mark to market losses over a couple of quarters. They also requested RBI to postpone its decision to reduce the amount of bonds held in the hold-to-maturity category.

But unlike during the taper tantrum of 2013, when RBI did allow losses to spread, it is no mood to oblige now. What banks got instead was a lesson in risk management basics.

“It appears that for most banks investment activity essentially consists of two steps -- buying and hoping for the best. But hope should not be a treasury desk’s primary trading strategy," said Acharya in his Monday night speech.

He pointed out that state-owned lenders, especially, don’t participate enough in hedging markets. Public sector banks account of one-third of government bond trading, but their share of hedging activity is just 4.6% in the interest rate swap and 13.4% in the interest rate futures segment.

There is poor bank participation in the overnight indexed swaps (OIS) markets which have been around for 15 years.

Acharya is not the only RBI official who has called for better risk management practices. On Thursday, N.S. Viswanathan pointed out that better risk pricing by India’s banks would have avoided the non-performing assets problem.

There can never be a right time for implementing reforms. If it is the sharp rise in yields today, tomorrow it will be the implementation of new accounting standards that have different norms for bond valuations and so on. Banks would do well to recognize losses and move on.

But as mentioned earlier, the regulator and the government should tackle the elephant in the room, or as a bond market expert described off-the-record, the “original sin" of Indian banking: government ownership of banks. Only when banks are free from the clutches of state and finance ministry mandarins will their incentive systems reward things such as risk management.

Ravi Krishnan is assistant managing editor, Mint.

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