Inflation and interest rates dropped sharply in the last five years. Many banks have traditionally financed themselves using current accounts and savings accounts, and used this money to buy long dated government bonds.

These banks have profited handsomely in the last five years. However, there are important concerns about what will happen to these banks in the event that interest rates go up.

A few months ago, Ajay Shah and I worked on the question of measuring the interest rate risk of banks in India  (http://icrier.res.in /publications /wp92).

Balance sheets of 42 banks were analysed to measure the risk faced by these banks as of March 3, 2002.

We found that the two largest banks, State Bank of India and ICICI Bank, carried relatively little risk.

However, we found that many other banks carried substantial risk. While most banks stood to gain if interest rates went down, this was not true for all banks.

Therefore, as of March 31, 2002 there were a number of banks such as Centurion, Global Trust Bank, Canara Bank, Bank of Maharashtra and State Bank of Mysore that stood to lose if interest rates went down during the year.

Even though the full impact of the fall in interest rates that took place during the year on their balance sheets is yet to be known, the composition of their assets and liabilities suggested that these banks were not hedged.

The most interesting feature of these results was the fact that while some banks carried an exposure whereby they stood to lose money if interest rates went up, there were also those banks that had the opposite exposure.

This raises the possibility of interest rate derivatives transactions, where a bank like Bank of Baroda would sell the long bond futures, a bank like Canara Bank would buy long bond futures.

Both banks would be better off after doing this transaction, by having reduced their risk.

There now appears to be some movement towards allowing banks to hedge their risks using interest rate derivatives.

The Securities and Exchange Board of India recently came out with a document defining the risk management procedures required for trading of options and futures on the long interest rate and the short interest rate.

It now appears that trading in these four groups of products will commence fairly soon.

This offers fresh opportunities for banks to hedge their risks. Without the option of using derivatives banks would need to make sure that their assets and liabilities are hedged.

This (in turn) requires that banks have to adjust the duration of their asset and liability products, in order to ensure that they do not carry interest rate risk.

The international norm is for banks to first establish a product portfolio on assets and liabilities focusing purely on profitability.

Once a portfolio is chosen, the bank would measure the interest rate risk, and then use the interest rate derivatives market to hedge it off.

This frees the bank's decision making process with regard to its borrowing and lending from concerns about interest rate risk and allows it to focus on improving its profitability.

In the light of the above argument it is clear that the current move by Sebi to offer trading in interest rate derivatives on exchanges creates an opportunity to make Indian banks safer.

The typical bank, which borrows using savings bank accounts and lends to companies, will short sell notional bond futures.

Banks will be more comfortable entering into long-term credit with companies, if they can lay off their interest rate risk using the interest rate futures and options.

But for banks to be able to utilise this opportunity, the Reserve Bank of India needs to make considerable progress on the regulation of banks, to bring about a sound framework for thinking about interest rate risk on the part of managers, board of directors and supervisors.

The first confusion that needs to be eliminated is the accounting treatment of securities. RBI's Asset and Liability Management guidelines do not allow full mark to market by banks.

When the value of its investment portfolio goes down, a bank has to show it in its balance sheet but when the value of this portfolio goes up, the bank can show its profits only to the extent that they offset the losses it has made in this portfolio.

Also, this is done only for the securities that are 'held for trading.' It is not done for securities that are 'held for maturity.'

These rules add non-transparency and generate confusion. It is important for bank managers, the board, shareholders, and regulators to have accurate data about where the bank stands.

To impute a historical book value to a financial asset, when that differs from its market value, whether it is higher or lower, may seem to be cautious in the eyes of the regulator.

It does not allow banks to show big profits and distribute them away, but it raises more questions than it answers about the impact of interest rate movements on the balance sheet of banks.

Banks claim to have 'hidden reserves,' suggesting that they are healthier than what their balance sheets (according to RBI's ALM guidelines) suggest. The value of these 'hidden reserves' are not obvious and clear.

The system would be much more transparent if RBI were to modify their rules so that all banks do marking to market for their investment portfolio.

Further, RBI could emulate the high quality disclosure framework that exists for mutual funds requiring daily disclosure of the value of the securities portfolio of every bank.

The second element that RBI needs to put into place is a proper framework for the measurement of interest rate risk. Measuring risk is the first step towards hedging it. This should be accompanied by a requirement for banks to provide full information of their positions on the interest rate derivatives market.

The paper mentioned above focuses upon the profit/loss experienced by a bank, after taking into account full marking to market of assets and liabilities, in the event of a change in interest rates over a one-year horizon.

This framework should be extended to include the positions of banks on the interest rate futures and options market. Banks should be required to disclose daily reports showing their exposure, measured in this fashion.

The ball is now in the RBI's court. It can use the current opportunity to make bank managers and boards use the interest rate derivatives market to make banks both safer and more profitable.

Alternatively, it can sit back and let the tax payer pay for the risks taken by 'lazy' public sector bankers who are secure in the knowledge of bail-outs and  neither care to measure nor hedge their risks. Hopefully, Dr Jalan will do the right thing.

The author is at Indian Council for Research on International Economic Relations. These are her personal views.

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