Investment Portfolio Classification
The Banking Regulation Act of 1949: How it applies to Cooperative Banks
The Banking Regulation Act was introduced in 1949. Before that, only certain clauses of the Companies’ Act of 1913 were applicable to Banking Companies. The Act became necessary when many banks became weak financially, due to the poor management of loan/investment portfolio, and also for not maintaining sufficient liquidity. The situation was further compounded by a surge in the opening of new banks as well as the closure and failure of some old banks.
The key goals of the Banking Regulation Act are:
- to safeguard the interests of investors and depositors
- to strengthen the foundation of banking institutions
- to tailor the financial system to the priorities of the nation.
The Act was made applicable to cooperative banks in 1966 by bringing in Section 56.
According to the chief general manager of RBI, the main issues regarding classification of investment portfolio are:
They have to take into consideration ‘SLR Holdings under Held to Maturity Category’ in terms of which banks are allowed to overshoot the limit of 25 per cent of total investments under the Held to Maturity (HTM) category given that:
- The excess only consists of SLR securities, and
- The total value of SLR securities kept in the HTM category is not greater than 24.5% by end of June 2013, 24% by end of September 2013, 23.5% by end of December 2013, and 23% by the end of March 2014 of their Demand and Time Liabilities (DTL) as on the last Friday of the second preceding fortnight.
According to the RBI governor those guidelines are reviewed as follows:
The main points of the revised guidelines are given below:
- The banks need to classify their entire investment portfolio as on September 30, 2000, under three heads i.e. ‘Held to Maturity’ (HTM), ‘Available for Sale’ (AFS) and ‘Held for Trading’ (HFT).
- In the balance sheet, the investments will still be disclosed as per the existing six categories, i.e. i) Government securities ii) other approved securities iii) Shares iv) Debentures & Bonds v) Subsidiaries/ joint ventures vi) Others (CP, Mutual Fund Units, etc.).
- The investments under the Available for Sale and Held for Trading categories should be marked to market routinely as indicated in the Annexure or a bit more frequently.
- The investments under the Held to Maturity category need not be marked to market as in the case of ‘Permanent’ securities at present.
- Categorization of investments, shifting of investments between the three given categories, valuation of the investments, the approach for booking profit/loss on sale of investments and provisions for depreciation should be in accordance with the guidelines in the Annexure.
- The weight ages assigned to the risk factor involved in various securities at present, including those for ‘market risk’, would remain constant.
The existing investments may be classified into three categories on the basis of the book value of the respective securities as on September 30, 2000. After this, the valuation of the securities slotted under the ‘Held for Trading’ and the ‘Available for Sale’ categories may be carried out as mentioned in the fresh guidelines. The first such revaluation may be done as on September 30, 2000 for the securities under the ‘Held for Trading’ category. If the bank proposes to revalue this category more frequently than once a year, then the securities under the ‘Available for Sale’ category can also be revalued as on that date.
Banks need to formalize an Investment Policy with the approval of their Board of Directors to manage the requirements on shifting, classification and valuation of investments under the renewed guidelines. Besides, the Investment Policy document should thoroughly address risk-management challenges, and make sure that the procedures that are to be adopted by the banks under the revised guidelines are fair, transparent and documented well enough to allow for easy verification by inspectors and auditors.
HOW THE CLASSIFICATION IS DONE:-
The entire investment portfolio of the banks (including SLR securities and non-SLR securities) can be classified under three categories:
- Held to Maturity
- Available for Sale
- Held for Trading
However, in the balance sheet the investments are to be revealed only as per the following six classifications:-
- i) Government securities
- ii) Other approved securities
- iv) Debentures & Bonds
- v) Subsidiaries and/ or joint ventures
- vi) Others (Commercial Papers, Mutual Fund Units etc.)
Held to maturity:
These are those securities which are bought by the banks so as to be held up till the time they mature.
Held for Trading:
These are those securities which are acquired by the banks with the intention to trade by taking advantage of the short-term price/ interest rate movements.
Available for Sale:
These are those securities which do not fall under any of the above two categories.
Some Important Facts:
- Banks should decide the category of investments at the time of acquisition.
- The investments included under “Held to Maturity” should not exceed 25 per cent of the bank’s total investments. The banks may however, at their discretion, include category securities less than 25 per cent of total investment.
Though the following investments are to be classified under “Held to Maturity”, however they will not be accounted for in the calculation of the above mentioned ceiling of 25 %.
- Re-capitalisation bonds that have been received from the Government of India
- Investing in joint ventures and/or subsidiaries (joint ventures are the ones where the bank and its subsidiaries together hold greater than or equal to 25% of the equity).
- The investments in bonds or debentures, which are recognised to be in the form of an advance/loan.
- The banks, which had already marked to market more than 75% of their SLR portfolio, will be given the choice to classify their investments anew, under “Held to Maturity” up to the permissible level.
- Profit on sale of investments in this category should be first taken to the Profit & Loss Account and thereafter be appropriated to the ‘Capital Reserve Account’. Loss on sale will be considered in the income statement
- Under Available for Sale and Held for Trading categories, the banks would be free to decide the extent of their holdings. This will be decided by them after considering aspects such as basis of intent, trading strategies, tax planning and risk management potential.
- The investments under Held for Trading would be those from which the bank could expect a gain by movement of interest rates. The securities had to be sold off within 90 days, and if due to some circumstances the banks was unable to sell them, then these investments would come under ‘’Available for Sale’’
- Profit and loss on sale of these investments falling under any of these two categories would come under profit loss statement.
SHIFTING AMONG CATEGORIES
- Shifting of investment to or from Held to maturity by banks can only done once at the beginning of accounting year with the approval of board of directors
- Investments can be shifted from Available to sale category to Held for trading by banks only with the approval of board of directors/ALCO/Investment committee.
- Investments cannot be shifted from Held for trading to Available to sale unless under some exceptional circumstances with approval from board of directors
- The investments that have been categorised under Held for trading need not be marked to the market. If they are lower than the face value, they are carried at the acquisition cost itself. If they are more than the face value, then they are amortised over the time remaining to maturity.
- Banks should recognise any reduction, other than temporary, in the value of their investments in subsidiaries or joint ventures which are included under the Held to Maturity
- Individual scrips in Available to sale category need to be marked to market at the end of the year, or more frequently.
- Individual scrips in Held for trading need to be revalued monthly, or at equal intervals of time.
- When securities are included in any of the three categories where interest/ principal are in debt, the banks should make suitable provisions for the depreciation in the value of the investment.
- The ‘market value’ used for the valuation of investments included in the Available for Sale and the Held for Trading categories is equal to the market price of the scrip as available from the SGL account transactions, trades/ quotes on the stock exchanges and the price list of RBI.
- Treasury bills need to be valued at the carrying cost itself.
PRUDENTIAL NORMS FOR BANKS TO CLASSIFY THEIR INVESTMENT PORTFOLIO
Short Sale can be defined as the sale of securities that you do not own. Banks carry out the sale of Central Government’s dated securities, only if the short position is covered within a time scale of five trading days, including the day of trade. A bank could also have ‘notional’ short sale where it could sell a security short from Held For Trading even if the security is kept under the HFT/AFS/HTM book. There are certain criteria under which the Banks can undertake the Short Sale transactions.
‘When Issued Market’
‘When, as and if issued’ (commonly referred to as ‘when-issued’ (WI)) security is a security that has been authorized for issuance, but has not yet actually issued. ‘WI’ trading generally occurs in the time lag between a new issue being announced and then it actually getting issued. The procedure of the working of WI is elucidated in the RBI Circular.
Policy and internal control mechanisms (Short Sale/WI)
Banks need to put in place a written policy giving out the guidelines/instructions duly approved by Board before going for short sale/WI transactions. Besides this, the transactions are to be verified by multiple auditors simultaneously in order to comply with the guidelines, as also with internal guidelines and report breaches, if any, to the respective Public Debt Office (PDO) wherein the Subsidiary General Ledger (SGL) maintains its account.
- Banks are required to frame Internal Investment Policy Guidelines with proviso to include Primary Dealer (PD) activities duly approved by respective Boards. The PD business carried out by the bank only involves dealing, underwriting and market-making in Government Securities. Other Investments in corporate/PSUs/FI bonds, CPs, and other such fixed income securities will not be deemed to be part of the PD business. Banks are permitted to undertake investment in equity shares/ debentures subject to have in place adequate expertise in equity research by establishing a dedicated equity research department as warranted by their scale of operations.
- With the approval of respective Boards, banks may clearly lay down the broad investment objectives to be followed while undertaking transactions in securities on their own investment account and on behalf of clients. While formulating the policy’s guidelines, RBI instructions are strictly observed for STRIPS.
- “STRIPS” (Separate Trading of Registered Interest and Principal of Securities) are distinct, independent securities that are developed from a Government security’s cash flows and which comprise:-
- Coupon STRIPS, where a coupon flow of the original security is represented by the single cash flow of the STRIP
- Principal STRIP, where the principal cash flow of the original security is represented by the single cash flow of the STRIP.
Given the fact that there is substantial investment in privately placed unrated bonds, from both borrowers as well as from non-borrowers, and in the absence of standardized mandatory disclosures, including credit rating, Banks do not have the wherewithal to conduct proper due diligence to take an investment decision, which could lead to leading to chinks and flaws, i.e., shortfall in the appraisal.
Hence, to try and diminish the inadequacies in the disclosure offer for private placements, a disclosure format has been designed that contains the minimum disclosure requirement and other conditions also. This document serves as a ‘best practice model’ for the banks. All these banks are supposed to have an Investment Policy document that should be duly approved by the respective Boards.