New revised investment rules for banking sector welcome

- The new framework will improve disclosures and bring more stability to the banking system

A stable banking system is essential for financial stability. In such a situation, it is essential that banks are properly regulated and that they do not take unnecessary risks. Credit quality and bad loan levels in the banking sector often attract public attention. It is important for the regulator to keep a close eye on the investment portfolio. The Reserve Bank of India has recently issued revised investment norms for the banking sector. It is worth noting that the recent banking troubles in the US were partly the result of inadequate investment regulation. In Silicon Valley-like banks, concentration on both the asset and liability fronts was very high. Although there is no such threat facing Indian banks, reforms in the regulatory framework based on experience and evidence will help strengthen the regulatory framework.

As far as the existing regulatory guidelines on investment appraisal are concerned, they are largely based on the framework issued in October 2000. The new norms are based on the discussion paper released by the Reserve Bank in 2022. According to the banking regulator, the revised framework is in line with global norms and best practices. Banks will have a clearly marked trading book. The new norms will also remove the hold-to-maturity component from the existing investment book and enhance disclosure. The framework will be effective from the next financial year and it places more responsibility on bank boards. It requires banks to adopt a comprehensive investment policy which is duly approved by the board of directors.

In terms of details, banks have to classify the entire investment portfolio into three categories – held to maturity, available for sale and fair value through profit and loss. However, this will not include investments made in joint ventures and subsidiaries. Removing the hold-to-maturity category limit will give banks the freedom to structure their investment book. This will increase the demand for corporate bonds. Apart from this, there will be stability in income. However, banks have to carefully restructure their books because, for example, they cannot easily move securities in and out of held-to-maturity.

Reclassification will require not only the board's approval but also the Reserve Bank's prior approval, which will be granted only in rare circumstances. Securities sold from the held-to-maturity category in any financial year should not exceed 5 percent of the initial value of the portfolio. Any sale beyond this would require the approval of the Reserve Bank.

The framework also provides detailed rules for audit situations that arise when securities are transferred from one category to another. There are also clear rules on which types of securities are to be kept in which category and how their value will be determined.

Banks also need to create reserves for investment fluctuations. While this would be eligible for inclusion in Tier 2 capital, it would also increase the loss tolerance of the banking system. The overall expectation is that the new framework will improve disclosures and bring more stability to the banking system.