Unit 4: Bank investments

Banks hold investments as the second-largest earning asset after loans, deploying surplus funds into government and corporate securities to earn income while meeting legal obligations and preserving liquidity. In India this activity is governed by the Banking Regulation Act 1949 and Reserve Bank of India (RBI) prudential guidelines, which treat the investment book as a managed portfolio balancing return, safety and liquidity.

• Legal basis: Section 24 of the Banking Regulation Act mandates the Statutory Liquidity Ratio (SLR); the RBI Act 1934 governs the Cash Reserve Ratio (CRR).
• Three competing objectives: income (yield), safety (capital protection) and liquidity (ready convertibility to cash) — every policy choice trades these off.
• SLR vs non-SLR split: investments fall into SLR-eligible securities (government and approved) and non-SLR securities (corporate bonds, commercial paper, mutual funds).
• Portfolio classification: every security sits in one of three buckets — Held to Maturity, Available for Sale, Held for Trading — fixing how it is valued.
• Risk spectrum: credit, concentration, liquidity and off-balance-sheet exposures are monitored against capital under Basel norms.

II. Investment Policy — The Governing Framework

Investment policy is the board-approved document that defines how a bank selects, holds and disposes of securities within regulatory limits.

A. Purpose and principle

• Objective: to maximise return consistent with safety and liquidity, not to chase yield alone.
• Board accountability: the policy is reviewed annually and sets authority limits, counterparty exposure ceilings and permitted instruments.

B. Investment policy

• Scope defined: specifies eligible instruments (G-Secs, T-Bills, state development loans, PSU bonds), rating floors (e.g. minimum investment-grade for corporate paper) and maturity bands.
• Delegation of powers: dealing room authority tiers — a dealer transacts up to a notional cap, larger deals escalate to the treasurer or Investment Committee.
• Trading vs banking book: the policy fixes which desk may buy for trading (short-term gains) and which for structural holding.
• Internal controls: mandates front-office/back-office separation, mark-to-market frequency and stop-loss triggers.

III. Statutory Reserve Requirements — The Compulsory Holdings

Statutory reserves are the minimum balances every bank must maintain, forming the floor of the investment and cash structure.

A. Definition and conditions

• Dual requirement: banks keep a cash reserve with the RBI (CRR) and a liquid-asset reserve in approved securities (SLR), both computed on Net Demand and Time Liabilities (NDTL).

B. Statutory reserve requirements

1. Cash Reserve Ratio (CRR):
   • Nature: a percentage of NDTL kept as cash balance with the RBI, earning no interest.
   • Purpose: monetary control — raising CRR drains lendable funds from the system.
   • Computation example:
     
     TEXT

          NDTL = ₹10,000 crore, CRR = 4.5%
          CRR balance = 10,000 × 0.045 = ₹450 crore

2. Statutory Liquidity Ratio (SLR):
   • Nature: a percentage of NDTL held in cash, gold or approved (chiefly government) securities.
   • Purpose: ensures solvency and a captive market for government borrowing.
   • Illustration: at an 18% SLR, the same ₹10,000 crore NDTL requires ₹1,800 crore in SLR-eligible assets.
   • Penalty: shortfalls attract penal interest above the Bank Rate; persistent default invites regulatory action.

IV. Non-SLR Investments — Beyond the Mandatory Floor

Non-SLR investments are securities held over and above SLR requirements, undertaken purely for yield and portfolio diversification.

A. Definition and conditions

• Instruments covered: corporate bonds and debentures, commercial paper (CP), certificates of deposit (CD), units of mutual funds, equity shares and preference shares.
• Regulatory caution: these carry credit and liquidity risk absent in sovereign paper, so RBI prescribes rating and listing conditions.

B. Non-SLR investments

• Rating requirement: fresh investment in non-SLR debt generally requires a public issue rating at or above investment grade from an approved agency.
• Listing and disclosure: preference for listed instruments to ensure a secondary market and transparent pricing.
• Prudential ceilings: internal and regulatory caps on unrated and unlisted paper limit concentration in riskier assets.
• Example use: parking surplus in a 90-day CP yielding above the comparable T-Bill rate boosts return but adds issuer credit risk.

V. Bank's Investment Classification — The Three Portfolios

Classification determines accounting treatment, so each purchase is tagged by intent at acquisition.

A. Principle of intent-based bucketing

• Rule: the entire portfolio is split into three categories; shifting between them is restricted and done at the lower of cost or market value.

B. Bank's investment classification

1. Held to Maturity (HTM):
   • Intent: securities the bank intends to hold till redemption.
   • Treatment: carried at acquisition cost, not marked to market; premium over face value amortised over remaining life.
2. Available for Sale (AFS):
   • Intent: neither pure trading nor permanent holding — managed flexibly.
   • Treatment: marked to market at prescribed intervals; net depreciation provided for, net appreciation ignored.
3. Held for Trading (HFT):
   • Intent: bought to profit from short-term price movements, typically sold within 90 days.
   • Treatment: marked to market at shorter intervals (often monthly or more frequent); valuation changes taken to profit and loss.
   • Shifting rule: transfers between HTM and the other categories are allowed only with board approval, usually once a year, at the lower of book or market value.

VI. Bank's Investment Valuation Norms — Pricing the Book

Valuation norms translate category into a periodic rupee carrying value, exposing unrealised losses while deferring unrealised gains conservatively.

A. Principle of prudent valuation

• Conservatism: depreciation (loss) is always recognised; appreciation (gain) is recognised only on sale, protecting against overstated capital.

B. Bank's investment valuation norms

• HTM valuation: at cost; any premium amortised, so carrying value trends toward face value by maturity.
• AFS and HFT valuation — mark to market:
  • Quoted securities: valued at market price from the stock exchange or dealer quotes.
  • Unquoted government securities: valued using the yield-to-maturity (YTM) curve published by an approved agency (FBIL).
  • Unquoted non-SLR bonds: valued on YTM with a mark-up over the comparable G-Sec yield to reflect credit spread.
• Price computation: the present value of a bond discounts future coupons and face value:
  
  TEXT

    P = Σ [ C / (1 + y)^t ] + F / (1 + y)^n
    P = price,  C = periodic coupon,  F = face value
    y = yield to maturity per period,  n = number of periods, t = 1…n

• Provisioning: within AFS/HFT, scrips are grouped; net depreciation in each group is provided for while net appreciation in another group is not set off against it.
• Non-performing investments: if interest or principal is overdue beyond 90 days, income is recognised only on receipt and provisioning is made.

VII. Investment Risks — Credit, Concentration, Liquidity and Off-Balance-Sheet

The investment book carries distinct risks measured against capital under Basel capital-adequacy norms, each managed through limits and provisioning.

A. Framework

• Common thread: each risk type is quantified, limited by policy and backed by capital or provisions so that losses do not threaten solvency.

B. Credit risk

• Definition: the risk that an issuer defaults on coupon or principal, causing loss on a non-sovereign holding.
• Measurement: proxied by external credit rating and the credit spread over the risk-free G-Sec yield.
• Mitigation: rating floors, issuer exposure caps and provisioning on downgraded or impaired securities.
• Note: sovereign G-Secs are treated as near zero credit risk, which is why SLR rests on them.

C. Concentration risk

• Definition: the risk from excessive exposure to a single issuer, group, sector or instrument type.
• Measurement: exposure to one counterparty as a percentage of capital funds; sectoral exposure as a percentage of the portfolio.
• Mitigation: single-borrower and group-borrower ceilings (prescribed as percentages of capital), plus diversification across sectors and maturities.
• Example: holding 40% of the non-SLR book in one infrastructure group concentrates risk even if each bond is individually rated.

D. Liquidity risk

• Definition: the risk of being unable to sell a security quickly without a sharp price concession when cash is needed.
• Measurement: bid-ask spreads, trading volumes and the HTM share of the portfolio (illiquid by design).
• Mitigation: holding a buffer of liquid G-Secs eligible for repo, and matching maturities to expected funding needs.
• Link to SLR: SLR securities double as a liquidity reserve because they can be pledged for borrowing from the RBI.

E. Off-balance sheet risk

• Definition: the risk from commitments and derivative positions not recorded as assets or liabilities but carrying real exposure.
• Instruments: interest-rate swaps, forward rate agreements, currency forwards, guarantees and letters of credit.
• Measurement: converted to a credit-equivalent amount using notional value times a conversion factor, then weighted for capital.
• Mitigation: netting agreements, collateral/margining and counterparty limits.
• Example: a ₹100 crore notional interest-rate swap carries no principal exposure, but an adverse rate move creates a replacement-cost loss captured off balance sheet.