Basics of Bank Investments

8/8/2019 Basics of Bank Investments

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Bank Investments



Bank Investments

y In addition to loans and advances, banks deploy a part of theirresources in the form of investment in securities/ financialinstruments. The bulk of a bank's assets are held either in the form of (a) loans and advances and (b) investments.

y Investments form a significant portion of a bank's assets, next only toloans and advances, and are an important source of overall income.Commercial banks' investments are of three broad types: (a)Government securities, (b) other approved securities and (c) othersecurities.

y These three are also categorised into SLR (Statutory Liquidity Ratio)

investment and non-SLR investments. SLR investments compriseGovernment and other approved securities, while non-SLRinvestments consist of 'other securities' which comprise commercialpapers, shares, bonds and debentures issued by the corporate sector.





Bank Investments

y Under the SLR requirement, banks are required to invest aprescribed minimum of their net demand and time liabilities(NDTL) in Government- and other approved securities under theBR act, 1949. (Note that SLR is prescribed in terms of banks'liabilities and not assets). This provision amounts to 'directed

investment', as the law directs banks to invest a certain minimumpart of their NDTL in specific securities.

y While the SLR provision reduces a bank's flexibility to determineits asset mix, it helps the Government finance its fiscal deficit. It isthe RBI that lays down guidelines regarding investments in SLR

and non-SLR securities.y Bank investments are handled by banks through their respective

Treasury Department.



Investment Policy

y Each bank is responsible for framing its own Internal InvestmentPolicy Guidelines. The Asset Liability Committee (ALCO) of a bank,comprising senior bank officials and headed in most cases by the CEO,plays a key role in drafting the investment policy of the bank. Theinvestment policy and the changes made therein from time to time

have to obtain the bank Board's approval for it. The aim of anInvestment Policy of a bank is to create a broad framework withinwhich investment decisions of the Bank could be taken.

y The Investment Policy outlines general instructions and safeguardsnecessary to ensure that operations in securities are conducted inaccordance with sound and acceptable business practices. Theparameters on which the policy is based are return (target return asdetermined in individual cases), duration (target duration of theportfolio), liquidity consideration and risk.



Investment Policy

y The Investment Policy provides guidelines with respect toinvestment instruments, maturity mix of investment portfolio,exposure ceilings, minimum rating of bonds/ debentures, tradingpolicy, accounting standards, valuation of securities and income

recognition norms, audit review and reporting and provisions forNon-Performing Investments (NPI).

y It also outlines functions of front office/ back office/ mid office,delegation of financial powers as a part of expeditious decision-making process in treasury operations, handling of asset liability

management (ALM) issues, etc.



Maintenance of SLR

y Banks' investments in Central and State Government dated securitiesincluding treasury bills are governed by the RBI guidelines regardingmaintenance of minimum level of SLR securities as well as their ownapproved policy.

y As stated earlier, under the Banking Regulation Act, 1949, the RBIprescribes the minimum SLR level for Scheduled Commercial Banks(SCBs) in India in specified assets as a percentage of the bank's NDTL. The

actual percentage (that is, the value of such assets of an SCB as apercentage of its NDTL) must not be less than such stipulated percentage.The RBI may change the stipulated percentage from time to time.

y Over the years, this ratio (SLR ratio) has changed a lot, but has broadlymoved on a downward trajectory, from the of 38.5% of NDTL in the early90's (September 1990) to 25% by October 1997, with the financial sectorreforms giving banks greater flexibility to determine their respective assetmix. The SLR was further reduced to 24 percent of NDTL in November2008, but has been raised back to 25 percent level since October 2009.Currently, it is at 25 percent level.

y Banks can and do invest more than the legally prescribed minimum in SLR.



Maintenance of SLR

y The RBI has prescribed that all SCBs should maintain their SLR inthe following instruments which will be referred to as "statutoryliquidity ratio (SLR) securities":

y i. Dated securities as notified by RBI;

y

ii. Treasury Bills of the Government of India;y iii. Dated securities of the Government of India issued from time

to time under the market borrowing programme and the MarketStabilisation Scheme;

y iv. State Development Loans (SDLs) of the State Governmentsissued from time to time under their market borrowingprogramme; and

y Any other instrument as may be notified by RBI.

y These investments must be unencumbered.



Investments by Commercial Banks



Penalties

y If a banking company fails to maintain the required amount of SLRsecurities on any given day, it shall be liable to pay to the RBI penalinterest for that day at the rate of 3 per cent per annum above theBank Rate on the shortfall and, if the default continues on the nextsucceeding working day, the penal interest may be increased to a

rate of 5 per cent per annum above the Bank Rate for theconcerned days of default on the shortfall.

y The Bank Rate is determined by the RBI from time to time. It isthe rate at which the RBI lends to the banks, and should not beconfused with the repo rate, which is the lending rate the RBI uses

in the daily repo (repurchase) markets.



Non-SLR Investments

y If there is any proposal to invest or disinvest in non-SLR securities, theconcerned officials must refer these proposals to the Investment Committee of the bank.Upon vetting and clearance by the Investment Committee, financialsanction should be obtained from the appropriate authority in terms of theScheme of Delegation of Financial Powers.

y Non-SLR Investments can include:

y Investments in Associates/ Subsidiaries and Regional Rural Banks

y Strategic Investments

y Venture Capital Investments

y PSU Bonds

y Corporate Investments

y Mutual Fundsy Bonds/debentures issued by Securitisation Companies (SCs) and

Reconstruction Companies (RCs)



Non-SLR Investments

y However, as per RBI guidelines, the investments (SLR as well asNon-SLR) will be disclosed in the balance sheet of the Bank as perthe six-category classification listed below:

y a. Government securities,

y b. Other approved securities,y c. Shares,

y d. Debentures & Bonds,

y e. Investment in subsidiaries/ joint ventures in the form of shares,

debentures, bonds etc, andy f. Others (Commercial Paper, Mutual Fund Units, etc.).



RBI·s uidelines or investments in other

than Government Securities

y According to the RBI, banks desirous of investing in equity shares/debentures should observe the following guidelines:

y i. Build up adequate expertise in equity research by establishing adedicated equity research department, as warranted by their scaleof operations;

y ii. Formulate a transparent policy and procedure for investment inshares, etc., with the approval of the Board; and

y iii. The decision in regard to direct investment in shares,convertible bonds and debentures should be taken by theInvestment Committee set up by the bank's Board. The Investment

Committee should also be held accountable for the investmentsmade by the bank.



Investment Policyy Further, with the approval of respective Boards, banks should clearly lay down the

broad investment objectives to be followed while undertaking transactions insecurities on their own investment account and on behalf of clients, clearly definethe authority to put through deals, procedure to be followed for obtaining thesanction of the appropriate authority, procedure to be followed while puttingthrough deals, various prudential exposure limits and the reporting system.

y

Investment proposals should be subjected to the same degree of credit risk analysis asany loan proposal. Banks should have their own internal credit analysis and ratingseven in respect of issues rated by external agencies and should not entirely rely onthe ratings of external agencies. The appraisal should be more stringent in respect of investments in instruments issued by non-borrower customers.

y As a matter of prudence, banks should stipulate entry-level minimum ratings/quality standards and industry-wise, maturity-wise, duration-wise and issuer-wise

limits to mitigate the adverse impacts of concentration of investment and the risk of illiquidity.



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Valuation Norms

y The key features of RBI guidelines on categorization and valuationof banks' investment portfolio are given below.

y The investment portfolio of a bank normally consists of both"approved securities´ (predominantly Government securities) and"others" (shares, debentures and bonds). The Bank should classify

their entire investment portfolio under three categories viz. 'Heldto Maturity' (HTM), 'Held for Trading' (HFT), and 'Available forSale' (AFS).

y HTM includes securities acquired with the intention of being heldup to maturity;HFT includes securities acquired with the

intention of being traded to take advantage of the short-termHTM must not be more than 25% of the portfolio. AFS refers tothose securities not included in HTM and HFT.



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Valuation Norms

y Banks should decide the category of investment at the time of acquisition. Profit or loss on the sale of investments in both HFT andAFS categories is taken in the income statement. Shifting of investments from / to HTM may be done with the approval of theBoard of Directors once a year, normally at the beginning of the

accounting year. Similarly, shifting of investments from AFS to HFTmay be done with the approval of the Board of Directors, the ALCOor the Investment Committee.

y Shifting from HFT to AFS is generally not permitted. However, it will be permitted only under exceptional circumstances like not being ableto sell the security within 90 days due to tight liquidity conditions, orextreme volatility, or market becoming unidirectional. Such transfer ispermitted only with the approval of the Board of Directors/ ALCO/Investment Committee.



Banks' Investment lassi ication and

Valuation Norms

y HTM securities are not marked to market and are carried at acquisition cost or at anamortised cost if acquired at a premium over the face value. (In the case of HTMsecurities, if the acquisition cost is more than the face value, premium should beamortised or written off over the period remaining to maturity.) AFS and HFTsecurities are valued at market or fair value as at the balance sheet date.

y Valuation of investments is to be done as per guidelines issued by RBI from time to

time.However, banks may adopt a more conservative approach as a measure of prudence.

y The 'market value' for the purpose of periodic valuation of investments included in theAFS and HFT would be the market price of the scrip as available from the trades/quotes on the stock exchanges, price list of RBI and prices declared by Primary DealersAssociation of India (PDAI) jointly with the Fixed Income Money Market and

Derivatives Association of India (FIMMDA) periodically. In respect of unquotedsecurities, RBI has laid down the detailed procedure to be adopted. For example, banksshould value the unquoted Central Government securities on the basis of the prices/yield to maturity (YTM) rates put out by the PDAI/ FIMMDA at periodic intervals.



Treasury Management

y Investment transactions are undertaken as per the approvedinvestment policy of the bank and in accordance with the tradingpolicy and Manual of Instructions. With a view to synergisingstrengths, a bank usually operates an integrated treasury

department under which both domestic and forex treasuries are brought under a unified command structure.

y The task of domestic treasury operations is predominantly tomake investments on their own account, while the task of forextreasury is to predominantly conduct operations on behalf of

clients. The discussions so far on SLR and non-SLR operations fallunder domestic treasury management.



Forex Treasury Management

y The Forex department of a bank does the following:

y administers and monitors merchant or client transactionsemanating from branches,

y undertakes cover operation for merchant transactions, trades ininter-bank forex market, manages foreign currency funds likeForeign Currency Non Resident (FCNR) Accounts, ExchangeEarners Foreign Currency (EEFC) Accounts, etc. and maintainsNostro Accounts.

y While bulk of the forex treasury operations are on behalf of theclients, the banks also handle proprietary trading, i.e., forex

trading on the banks' own account.y One important safeguard that banks are required to take is to

make a clear separation between their transactions on their ownaccount and those on behalf of their clients.



Structure of Integrated Treasury

y The treasury department is manned by the front office, mid-office, back office and audit group.

y The dealers and traders constitute the front office. While buyingand selling, they are the first point of interface with other

participants in the market (dealers of other banks, brokers andcustomers).

y The mid-office set-up, independent of the treasury unit, acts as aunit responsible for risk monitoring, measurement and analysisand reports directly to top management for control. This unit

provides risk assessment to Asset Liability Committee (ALCO)and is responsible for daily tracking of risk exposures, individuallyas well as collectively.



Structure of Integrated Treasury

y The back office undertakes accounting, settlement and

reconciliation operations.

y The audit group independently inspects / audits daily

operations in the treasury department to ensureadherence to internal/ regulatory systems and

procedures.



Integrated Treasury Structure

Top Management

Audit Head Risk Mng. HeadTreasury Head

Mid-office Audit Group Head - Forex Head-Money

Currency Traders Corporate FX Dealers Secondary Dealers Money Market Dealers

Money Back OfficeForex Back Office

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Basics of Bank Investments

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