The Hindu Business Line : Treasury windfall for banks

As the quarterly results for December 2008 start pouring in, we are going to witness massive trading profits by bank treasuries and near complete elimination of mark-to-market losses.

Ramesh Krishnan

Ramzan Baydan owns the Baydan Shoe Co in Istanbul, Turkey. Model 271 is just another product from his factory. Suddenly he is flooded with orders for 300,000 pairs, forcing him to hire a hundred people. The Iraqi journalist who hurled a shoe at US President George Bush was wearing this brand!

A marshy piece of land, unattended for several years, suddenly is much sought after because a defence project is coming up nearby.

Such instances of unexpected and instant gains in value are sporadic and few to count by. One such recent case of sudden gain in value is the bond portfolios of commercial banks in India. Banks carried huge mark-to-market losses on their bond portfolio up to the half-year ending September 2008. As the quarterly results for December 2008 start pouring in, we are going to witness massive trading profits by bank treasuries and near complete elimination of mark-to-market losses.

Bolstering liquidity

The stimulus package for reviving the economy, put forth by the Government of India, has seen the RBI acting in tandem to bolster liquidity in the system and demonstrate its bias towards lower interest rates.

The series of measures have seen the repo level come down to 5.50 per cent, reverse repo to 4 per cent and Cash Reserve Ratio (CRR) to 5 per cent.

The steep fall in crude oil prices during the same period has led to the progressive decline in inflation, strengthening the hands of the government and the central bank.

Resultantly, the benchmark ten-year sovereign yield has registered a steep decline from around 9 per cent to 4.86 per cent, though currently it has retraced to 5.20 per cent levels. Translated into price movement, the benchmark ten-year bond has gained from Rs 98 to Rs 125 with potential for more rises. This is where the long forgotten bond portfolio of banks has suddenly gained value, similar to the fortunes of Ramzan Baydan.

The market has been witnessing a rising interest rate trend from early 2004. Resultantly, the price of bonds kept falling, necessitating banks to provide for mark-to-market losses or book trading losses on exiting from these bonds. Therefore, banks began pruning their SLR portfolio and pushed maximum of the portfolio into the statutorily mandated SLR level under held to maturity (HTM) category, as this category was exempted from being marked to market.

However, banks were required to amortise the premium on their bonds in the HTM category over the residual tenor of the bond. This amortisation had resulted in bringing down the holding cost of the bonds in the HTM category, thereby increasing the potential for profits in today’s context.

However, banks preferred to run a leaner treasury to avoid mark-to-market losses. This can be observed from the shrinkage in the investment portfolio of banks from the high of 35 per cent plus in 2004 to 26-27 per cent by 2008.

As the bond portfolio did not give an opportunity to exit at profit, in relation to the highs of early 2004, banks began to look at equities for trading gains.

The steep decline in the equity market from January 2008 has left the banks bleeding on their fixed income and equity portfolios. While the fleet footed treasuries cut their equity positions (including mutual fund portfolio), many chose to run them as a fixed income portfolio and the mark-to-market losses kept mounting.

Tinkering with duration

In bond dynamics, ‘duration’ is a first-degree measure of interest rate risk associated with a bond or a portfolio of bonds. The four-year interregnum from 2004 to 2008 did provide innumerable opportunities for banks to constrict and elongate the duration of the portfolio.

When liquidity appeared to be very grim in the market a couple of months back, we did see mutual funds exiting from even a liquid instrument like Treasury Bills at yields close to a score to meet their redemption pressures. This was one such opportunity for reducing the duration by buying into T-Bills.

Auctions of long-dated bonds were seen being picked up more by the primary dealers who had to necessarily underwrite the auctions. Treasuries with a prognosis (mainly based on global cues) that chose to buy into a ten-year bond at a discount to face value would have consciously elongated their duration, thereby increasing their interest rate risk.

The risk-reward trade off being what it is, such banks will be able to book humungous trading gains today.

Beyond the perfect post-mortem and the attendant academics, the reality is different. Banks that chose to maintain only the regulatory SLR level will have to perforce build up their SLR portfolio at the same time while they are exiting from the bonds that have suddenly gained value for booking profits.

Debt-swap scheme

This is where it will do well for banks to take a view on interest rate and position themselves accordingly. One may draw a parallel to the debt-swap scheme introduced by the RBI in 2003.

The RBI bought from banks high coupon government bonds at near market-related prices and swapped them by selling lower coupon government bonds of longer maturity, at a price that was at a premium to the market prices. Essentially, this was the price that banks paid for illiquidity of the high coupon bonds and the larger volume of transactions that could be achieved through the swap with the RBI.

While this enabled banks to book massive profits, their portfolio duration got elongated, adding to the interest rate risk of the portfolio. If any bank chooses to book profit and re-enters into bonds of similar tenor, they may not be adding value to the portfolio.

For those market participants who hold the view that yields may not stretch lower further, it would be prudent to reduce the portfolio duration. T-Bills, floating rate bonds and bond portfolio through market repo and CBLO (Collateralised Borrowing and Lending Obligations) will aid this objective. Moving to floating rates through interest rate swaps will also mitigate the risk of a fixed income portfolio.

For those who hold that yields will lower further, it will be beneficial to run a larger and longer tenor bond portfolio, that will provide more opportunities for booking trading gains from their portfolio subsequently, should the market move as per their views.

For the undecided and fence-sitters, it is speculative trading as usual. However, any attendant strategy may not be able to crystallise profits as much as a portfolio will be able to.

It will be apposite to recall the farsighted approach of the RBI, which stipulated build up of an Investment Fluctuation Reserve when the bank treasuries posted huge profits from early 2001. We have already seen how banks have dipped into these reserves, when such runaway profits evaporated subsequently.

(The author is Deputy General Manager, State Bank of Hyderabad. The views are personal. blfeedback@thehindu.co.in)