The Reserve Bank’s requirement that banks provide for “diminution in the economic value of restructured advances” appears to be based on questionable premises and should be revisited by the authorities. The relevant rules were originally prescribed in 2003 and expanded in 2009.
On restructuring an advance banks may reschedule principal repayments and reduce interest rate charged. In August 2003, the RBI did not stipulate on rescheduling principal repayments. It, however, specified that if interest rate is reduced, the amount of interest sacrificed, if any, measured in present-value terms, should either be written off or provided for by the banks.
This prescription primarily applied to term loans repayable over a few years. The rationale perhaps was that for each term loan, the bank might have borrowed from a specific source at a particular rate of interest. While the interest payable on the bank’s borrowing remained at the original level, the corresponding term loan given by the bank would have, on restructuring, started earning a lower interest. This difference was sought to be spread over the remaining period of the loan.
The above logic should not apply to banks in India as, unlike their western counterparts, local banks fund their term loans from a pool of deposits with varying maturities and there would be no identified source of borrowing for each loan. The rule did not, however, cause much harm to the system as some clever bankers circumvented the provisioning requirement by extending the period of the loan sufficiently so that there was no sacrifice in present value terms.
‘Fair value’ concept
Since 2009, the RBI enlarged the scope of the rule by bringing in the concept of “fair value” of an advance. According to the RBI, “Reduction in the rate of interest and/or reschedulement of the repayment of principal amount, as part of the restructuring, will result in diminution in the fair value of the advance.
“Such diminution in value is an economic loss for the bank and will have impact on the market value of equity”.
Therefore, the RBI wanted banks to calculate the present value of the stream of principal repayments and interest payments for both the original schedule and the revised schedule using a particular discount rate and provide for the difference between the two. Such provision should be calculated every year for the advance. For advances below Rs 1 crore, the RBI has stated that banks can, instead of going through the cumbersome exercise, provide 5 per cent of the advance.
Many issues arise in the reasoning behind RBI’s stipulation. First, is there a logic in computing “fair” value of an advance?
Banks’ investments in highly liquid bonds/debentures are required to be marked to market, that is, stated at the value which they will fetch in the market (possibly fair value) irrespective of their cost to the banks. Advances are illiquid and there is no market for them.
Does the fair value (or the sum it will fetch if sold to another institution) of an advance depend primarily on the interest paid by the borrower? The answer is no, because a prospective buyer would look at the amount that could be recovered both from the borrower and from the security backing the loan.
Secondly, assets in balance-sheets of corporate entities, including banks, are valued on the basis of triple criteria of recorded facts, accounting conventions and personal judgments and rarely on market-value basis.
‘Marked to market’
The exception made is in respect of marketable securities such as shares and bonds, which are “marked to market”. But then, the RBI has permitted banks to discard this principle even in marketable bonds issued by governments.
For purposes of statutory liquidity requirements, banks should keep such securities to the extent of around 25 per cent of the banks’ deposit liabilities.
These, according to the RBI, could be kept in “held to maturity” category and could be valued at original cost. No market-value concept here. If easily liquid and marketable assets, to the extent of 20-25 per cent of deposits, need not be valued at market value, what is the necessity for valuing a small portion of the highly illiquid advances at the so-called fair value?
Thirdly, if a term loan is prematurely repaid and the bank has perforce to invest the amount in a lower yielding short-term loan, the “fair value” of the total advance portfolio would be reduced. Would that also call for a provision?
Obviously, the RBI has not asked banks to do so. But the principle would apply all the same.
Lastly, if by market value of a bank’s equity, one refers to share prices, it is well known that such prices do not ever reflect the exact fair value of the assets of a company (bank).
For one, no market player ever has any clue regarding fair value of assets, as she/he does not have all the relevant data to appraise fair value.
For another, share prices depend on multiple factors such as book value of assets, earnings per share, company’s reputation in the market, sentiments at the material time and, above all, herd mentality.
If the RBI is really concerned that restructuring erodes the overall quality of the asset portfolio, instead of asking banks to go through such elaborate mathematical calculations that might lead to “precise” incorrect results, it could ask banks to provide an extra percentage, say, 1 or 2 per cent for such advances till the total provision for an advance reaches 100 per cent.
Would the Indian Banks’ Association examine these issues and take up the matter suitably with the RBI?
(The author is a former Deputy Managing Director, SBI.)