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Reserve Bank of India Deputy Governor Viral Acharya’s observation about the size of the banking sector’s balance-sheet exposure to Government Securities spooked the bond markets on Tuesday.
Addressing the annual dinner of the Fixed Income Money Market And Derivatives Association Of India, on Monday night, Acharya noted that the interest rate risk on government securities is high in an absolute sense, and that this risk cannot be managed over and over again by the regulator.
Yields on Government Securities (G-Secs) jumped in response: the yield on the benchmark 6.79 per cent Government Security (G-Sec) maturing in 2027 touched 7.58 per cent, a two-year high, during intra-day trades. The price at this yield was ₹94.74.
This G-Sec was last traded at a yield of 7.55 per cent (against Monday’s closing yield of 7.44 per cent) and its last traded price was ₹94.94 (₹95.65).
Bond prices and yields are inversely correlated.
“The regulator, in the interest of financial stability, is caught in such situations (of episodic phases of sustained rise in G-Sec) between a rock and a hard place, and often obliges,” said Acharya. “However, the trend of regular use of ex-post regulatory dispensation to ease the interest rate risk of banks is not desirable from the point of view of efficient price discovery in the G-Sec market and effective market discipline on the G-Sec issuer. Nor does it augur well for developing a sound risk management culture at banks.”
He observed that recourse to such asymmetric options – “heads I win, tails the regulator dispenses” – is akin to the use of steroids.
“They get addictive and have long-term adverse effects in the form of frequent relapse even though their use may be justified to relieve occasional intense pain,” he said, stretching the metaphor.
Referring to G-Sec yields in India undergoing episodic phases of sustained rise of close to 200 basis points at regular intervals, Acharya said banks should not be surprised repeatedly when government bond yields rise sharply and their investment profits drop. RBI’s Financial Stability Reports (FSR) have regularly pointed out the impact of such large interest rate moves on capital and profitability of banks.
“Banks should know and understand this risk rather well. Perhaps they do, and the issue is really one of incentives that lead to their ignoring this risk…,” said Acharya.
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