Better management of market risk

With increased role of non-banks in financial intermediation, the statutory liquidity ratios (the portion of funds to be invested by banks in government securities) are gradually coming down.

Banks in the business of mobilizing deposit resources have to deploy funds in (i) Central bank mandated form – cash with central bank and subscribing government securities (ii) dissemination of credit in the market (iii) remaining funds to be deployed in investments to earn profits using the synergy of market movements of interest rates/yields. As part of business strategy banks are increasingly diversifying into market driven investments to improve the bottom-line.

Corporate sector earlier depending on bank finance have begun to access funds from other sources such as equity, bonds, debentures, external borrowings and seeking investments from private equity. As a result, the investment markets are deepening. The financial sector too is fast expanding its reach to even move towards peer-to-peer lending. In the process, banks earlier concentrating exposure to credit risk is getting exposed to market risk.

Basel Committee on banking supervision defines market risk as the risk of losses in on or off balance sheet positions that arise from movement in market prices. It is also known as ‘systemic risk’ that cannot be eliminated through diversification though it can be hedged against. Sources of market risk, among many include losses arising out of recessions, political turmoil, changes in interest rates, bond yields, natural disasters and cyber attacks.

Investment policy of banks

In order to enable banks to follow a standard procedure in managing investment portfolio of the banks, a board approved investment policy is institutionalized taking cue from the central bank guidance and bank’s own resource position. In order to suggest best practices in managing investments of banks, Basel Committee on Banking Supervision (BCBS) guidelines apply to all forms of investments – equity, hedge funds, managed funds, investment funds, debentures and bonds.

It is based on the principle that banks should apply a look – through approach to identify the underlying assets whenever investing funds. The risk-weighting framework built into it enables the application of consistent risk – sensitive capital framework that provides incentives for improved market risk management practices. It is desired that the investment policy of banks should integrate best practices to insulate or mitigate the market risk. The policy should rest on three pillars. (i) Look Through approach (LTA) (ii) Mandate based approach (MBA) and finally (iii) fall back approach (FBA).

Classification of securities

Based on this philosophy, banks institutionalize investment policy with three distinct classifications. It may differ from country to country depending upon its market practices and central bank direction. (a) Held to maturity (HTM) – these are non-marketable fixed income securities not generally influenced by the market volatility. Investments in such instruments will mature on a fixed future date. These securities are not meant for trading and are therefore not subject to ‘mark to market’ depreciation of values. (b) Available for Sale (AFS) – These securities do not necessarily have ready marketability but can be sold by banks within a duration of one year.

They are semi marketable but whenever banks have liquidity crunch, they can be sold instead of resorting to market borrowings at higher interest rates. But since they are under AFS category, they are to be ‘market to market’. (c) Held for Trading (HFT) - the most liquid securities that have ongoing market quotations are placed in it. The trading profit is targeted from this portfolio that has to be most vibrant and market connected. Since the values of securities under this category is susceptible to market volatility, they are marked to market. Normally, as per investment policy, the classifications of securities are shuffled once in a year to up date trading capabilities and to ease their valuation.

Mark to Market (MTM)

The securities held by banks as part of investment portfolio are susceptible to market volatility. Their valuations are subject to downside risks as bond yields dip with interest rate curve changing. Mark to Market (MTM) is to calculate the value of a financial instrument or portfolio of such instruments at current market rates or prices of underlying securities compared to its acquisition value. For example, if a security (bond/equity) is acquired by a bank at US $ 100 on say, April 1, 2017, as part of investment portfolio and if its quotation in the market is down to US $ 87.43 on December 31, 2017. It has diminished in its value by US $ 12.57. Then the MTM loss is said to be US $ 12.57.

Under the prudential standards, bank has to re-price the security in its investment book at market rate at US $ 87.43 and debit MTM loss to profit and loss account of the bank absorbing the potential fall in value. Instead, if the price is quoted at US $ 102.33 there is MTM gain which cannot be taken as profit unless the security is actually sold and value is realized. MTM is an international prudential standard meant to ring fence banks against loss of value in securities from time to time.

Thus MTM is a process of marking the price of securities to the current market value at which it can be sold. Though an MTM on a daily basis is often desired but is done as per bank’s own policy in order to crystallize MTM losses and absorb them well in time to prevent their accumulation. The periodicity of assessing MTM losses and its absorption policy is defined in investment policy to make investment portfolio shock proof.

Risk weighted assets

Like loans, the securities have risk weights to on the basis of their inherent risks. Government securities having sovereign guarantee are assigned zero risk weight. All other instruments carry risk weights as per their perceived risk. The intention of assigning risk weight is to arrive at risk weighted assets of the portfolio so that capital adequacy ratios can be worked out. The risk weights are also linked to the credit rating of issuing organization. In a scale of say, ratings accorded from AAA to BBB, AAA is considered the safest instrument and BBB may be the risky one. Basel III provides for assigning risk weight on securities ranging from zero to 150 depending upon the perceived risk. Basel III accord clearly a spell out that capital adequacy is to be calculated on the basis of risk-weighted assets.

Banks have to keep in mind the risk weights and likely MTM losses in selecting an instrument for investing bank funds. Even non-funded facilities carry MTM risk and risk weighted assets are reckoned for the purpose of arriving at potential market risk.

Way forward

As banks move towards more market driven investments as part of business strategy, it is necessary to fine tune market risk management process and internal systemic controls so that trading profits are kept as safe from market volatility as possible. Classification of investments, assessing MTM losses, perceiving impact of risk weights on capital adequacy, working out risk mitigation strategies, adapting better prudential norms in pursuing trading systems, reinforcing internal controls and keeping a scrupulous check on operational aspects can enhance quality of market risk management.

The team engaged in market risk management has to be well trained and exposed to non-bank treasuries and overseas treasuries to help expand span of employee knowledge so that risk mitigation and timely prevention of potential losses can be ensured in market risks.

(The author is Director, National Institute of Banking Studies and Corporate Management – NIBSCOM, Noida, National Capital Region – NCR, Delhi, India. The views are his own)