Financial RegTech Newsletter, April 2022

(1)

Financial RegTech Newsletter

April 2022

Click to launch

(2)

Financial RegTech Newsletter - April 2022 2 PwC

RBI’s ‘Discussion Paper on Review of Prudential Norms for Classification, Valuation and Operations of Investment Portfolio of Commercial Banks’

Contact us

The current guidelines pertaining to the classification and valuation of investment portfolios are largely based on the recommendations of ‘Informal Group on Valuation of Banks’ Investment Portfolio’ (Convenor: Dr T C Nair), which was published in October 2000. Though the

Reserve Bank of India (RBI) changed guidelines from time to time to meet the changing scenario, a comprehensive review is yet to be done.

This discussion paper from the RBI aims to review the current framework and suggests changes to align commercial banks with global standards and developments in the financial markets.

The major changes proposed in the framework are as follows:

Classification

It is proposed that banks’ investment portfolios be divided into three groups – held to maturity (HTM), available for sale (AFS), and fair value through profit and loss (FVTPL).

At the time of acquisition of securities, banks will have to decide on the investment category, which will be reflected in the investment proposals/deal slips.

HTM: Securities that are acquired with the purpose of retaining them until maturity and have contractual terms (which will result in cash flows) and are solely payments of principal and interest on principal outstanding (SPPI criteria) will be categorised as HTM. These will have fixed or determinable payments and fixed maturity.

AFS: Securities that match the SPPI criteria outlined above and are purchased with the goal of collecting contractual cash flows and selling are classified as AFS.

FVTPL: All securities that do not qualify as HTM or AFS will be categorised under FVTPL. A sub-category – held for trading (HFT) – will be formed to represent the Basel III- compliant trading book, for compliance pertaining to Basel III criteria on capital requirements for market risk.

This newsletter focuses on the monetary, liquidity and regulatory policies and recent developments in a pandemic-affected changing environment.

Banks’ investment portfolios to be classified into three categories: HTM, AFS and FTVPL

(3)

RBI’s ‘Discussion Paper on Review of Prudential Norms for Classification, Valuation and Operations of Investment Portfolio of Commercial Banks’

Contact us

• Securities under HTM will be carried at cost as compared to marked to market earlier.

• The investments classified under AFS will be marked to market – at least on a quarterly basis.

• All securities categorised as FVTPL will be marked to market – securities sub-categorised as HFT will be marked to market daily, while other securities will be marked to market at least quarterly.

AFS: The investments classified under AFS will be marked to market at least on a quarterly basis, and gains or losses will be credited or debited to a reserve called AFS Reserve directly. The AFS Reserve will be used to calculate the Common Equity Tier (CET) 1. However, the unrealised gains transferred to the AFS Reserve will not be eligible for dividend distribution.

FVTPL: All securities categorised as FVTPL will be marked to market, with gains and losses credited or debited to the P&L account directly. Securities in FVTPL that are sub-categorised as HFT will be marked to market daily, while other securities will be marked to market at least quarterly.

These subsequent measurement guidelines will enable the symmetric handling of gains and losses in cash and derivatives portfolio, as per global standards. Furthermore, these will encourage banks to employ derivatives more actively in order to manage underlying risks in their investment portfolios.

RBI’s ‘Discussion Paper on Review of Prudential Norms for Classification, Valuation and Operations of Investment Portfolio of Commercial Banks’

Subsequent measurement

Apart from the initial measurement, there are changes suggested in the subsequent measurement of securities as well.

HTM: Securities held in HTM will be carried at acquisition cost, as opposed to marked to market previously. Banks will assess any permanent decline in value (i.e. an impairment test) at least quarterly, and will charge any impairment loss to the profit and loss (P&L) account.

Initial recognition and measurement

Currently, all investments are initially recorded at their acquisition cost. This method of recognising assets could overvalue the investment, causing distortions in the value of assets and equity, as well as the regulatory capital of reporting companies that invested in such instruments.

To mitigate these issues and align the norms with the global standards, it is proposed that all investments and derivatives are measured at fair value initially.

• All investments and derivatives will be measured at fair value initially.

(4)

RBI’s ‘Discussion Paper on Review of Prudential Norms for Classification, Valuation and Operations of Investment Portfolio of Commercial Banks’

Contact us

Reclassifications between measurement categories

The periodic reclassification of securities across categories by banks results in inefficient price discovery in the

Government securities (G-Sec) market. It also results in an ineffective market discipline on the G-Sec issuer.

Furthermore, the premise underlying the accounting treatment is flawed if the intent – based on which the securities are classified and measured initially – changes often as per the will of the entities.

Therefore, it is proposed to prohibit re-classification between measurement categories. Banks will be given a one-time chance to reclassify their financial instruments at the time of transition, after which no further reclassification or shifting will be permitted. The net gains or losses from such a transition will have to be accounted for in the reserves.

This will be in line with the global practices and allow the banks to develop systems to manage interest rate risk, while also providing market depth for interest rate hedging instruments.

Limit in holdings in HTM

The limit on HTM investments as a percentage to total investments/statutory liquidity ratio (SLR) investments in HTM will be removed.

To address the concern that basic principles and tenets for classification of investments as HTM and valuing them at cost are not invalidated in the absence of a limit, control mechanisms have been put on the sale of HTM. For such sales, banks must have a board-approved policy. This policy dictates that the total sales out of HTM in any given financial year must not exceed 5% of the HTM portfolio’s initial carrying value, beyond which it will require prior RBI supervisory approval – excluding certain pre-existing exemptions.

Any gains from the sale of securities outside of the HTM category will be transferred to a ‘capital reserve’, which will not be accessible for dividend payment.

• Reclassification between measurement categories will be prohibited.

• Banks will be given only one chance for reclassification, at the time of transition.

• The limit on HTM investments as a percentage of total and SLR investments in HTM is

removed.

• A board-approved policy is required for sales out of HTM.

• The total sales out of HTM in a FY are capped at 5% of the HTM portfolio’s initial carrying value.

(5)

RBI’s ‘Discussion Paper on Review of Prudential Norms for Classification, Valuation and Operations of Investment Portfolio of Commercial Banks’

Contact us

Non-SLR investments in HTM

Non-SLR securities may be kept in HTM if they meet all the other requirements for HTM classification. This was earlier prohibited and the change has been proposed to ensure that the accounting of securities is in line with the global standards.

• The earlier prohibition of non-SLR securities to be kept in HTM has been removed.

Valuation

To avoid the recognition of unrealised returns derived from unquoted instruments (which were valued without market- corroborated inputs qualifying for CET 1), it is proposed that, wherever available, banks should use quoted prices and market-based inputs for valuation. Further, the investments should be categorised into three fair-value hierarchies:

Level 1: The topmost rating where investments are valued using quoted prices (unadjusted) in bank-accessible active markets.

Level 2: All investments that are valued using observable inputs such as yield curves and credit spreads will fall under this category.

Level 3: The lowermost rating where investments that are valued using unobservable inputs are categorised.

Banks will have to disclose the fair values of AFS and FTVPL assets in the valuation categories (levels 1, 2 and 3) in the notes to accounts.

Moreover, banks will not be allowed to pay dividends out of gross gains recognised in the P&L account due to any change in the fair valuation of level 3 assets that remain on their balance sheet. These unrealised gains on level 3 assets will be removed from the net profits available for distribution and regulatory capital.

(6)

RBI’s ‘Discussion Paper on Review of Prudential Norms for Classification, Valuation and Operations of Investment Portfolio of Commercial Banks’

Contact us

• Investments have to be categorised into three fair-value hierarchies based on the inputs used for valuation.

• The fair values of AFS and FTVPL assets in the valuation categories have to be disclosed in notes to accounts by the banks.

• IRA has to be completely phased down, while IFR has to be recalibrated to a particular percentage of the AFS and FVTPL portfolio over a period of around three years.

Investment reserve account (IRA) and investment fluctuation reserve (IFR)

Currently, excess provisions for depreciation in the AFS or HFT categories need to be appropriated to an IRA. Also, banks are required to create an IFR to absorb the impacts of any sharp increase in yields in Government securities.

Both IRA and IFR currently qualify for Tier 2 capital.

With changes such as prohibition on distribution of unrealised gains on fair valuation of securities, removal of unrealised gains for level 3 assets in regulatory capital, along with anticipated capital charge for market risk in Basel III, IRA and IFR become less important.

Therefore, it is proposed that IRA be totally phased down. IFR will be continued and recalibrated to a certain percentage of the AFS and FVTPL portfolio over a period of around three years. Tier 2 capital will be authorised for IFR. Any balance in the IRA that is reckoned for CET 1 shall be moved to any reserve under ‘revenue and other reserves’.

RBI’s ‘Discussion Paper on Review of Prudential Norms for Classification, Valuation and Operations of Investment Portfolio of Commercial Banks’

Disclosures

Banks will have to include the following information in the financial statements’ notes to accounts:

a. the carrying amounts and fair values in category-wise and class-wise bifurcation

b. gain or loss for each investment category, recognised in the P&L statement or AFS reserve

c. disclosures for fair-value measurements in accordance with the fair-value hierarchy:

i. Levels 2 and 3 – valuation methodology, inputs and relevant input assumptions and changes in the valuation technique with reasons for change

(7)

RBI’s ‘Discussion Paper on Review of Prudential Norms for Classification, Valuation and Operations of Investment Portfolio of Commercial Banks’

Contact us

ii. Level 3 – relevant quantitative information for unobservable inputs

d. disclosure, if fair value cannot be determined.

Derivatives

It is proposed that the Institute of Chartered Accountants of India (ICAI) may consider updating its Guidance Notes to ensure their consistency with the bank presentation frameworks.

Limits on investments in unlisted securities

Investments that were previously listed but are now unlisted will be exempt from being included in the calculation of the 10% ceiling on unlisted non-SLR investments. This is because such breaches are

unavoidable, and banks will have difficulties in disposing of such investments. Moreover, banks will be required to track these investments separately and develop a strategy for disposing of them, which will need to be reviewed by the Board of Directors annually.

Withdrawal of outdated instructions

Instructions for the engagement of brokers have now become obsolete with the emergence of new technologies like electronic anonymous order matching systems – for example, negotiated dealing system-order matching (NDS- OM). Therefore, the relevance of these should be reviewed considering the recent technological advancements and financial market developments.

• Banks need to include the following in their notes to accounts: the carrying amounts and fair values of instruments, gain or loss for each investment category, disclosures for fair value measurements as per fair value hierarchy and disclosure if fair value cannot be determined.

• It is proposed that the ICAI update its

Guidance Notes for consistency with the bank presentation frameworks.

• Investments that were previously listed but are now unlisted have to be exempted from being included in the calculation of the 10% ceiling on unlisted non-SLR investments.

• The instructions for the engagement of brokers have to be revaluated for relevance.

RBI’s ‘Discussion Paper on Review of Prudential Norms

for Classification, Valuation and Operations of Investment

Portfolio of Commercial Banks’

(8)

Contact us

Technology implications of the proposed changes for commercial banks

To meet the requirements of the new framework, banks would need to effect several changes to their current systems for ensuring compliance. Some of the key changes have been listed below:

a. sub-ledger reconfiguration to capture the proposed changes for supporting improved granularity of the investment portfolio

b. changes in the underlying investments data model to capture improved granularity for investment categorisation and disclosures

c. design and implementation of built-in logic for automated initial classification and valuation of investment securities as per the revised investment categories (addition of the FVTPL category)

d. modifications in the accounting rules to address changes like fair valuation of investment securities.

RBI’s ‘Discussion Paper on Review of Prudential Norms for Classification, Valuation and Operations of Investment Portfolio of Commercial Banks’

Conclusion

It is proposed that the new framework shall be applicable with effect from 1 April 2023. It is expected that the framework will help Indian scheduled commercial banks to align with global standards and meet the needs of the current environment with respect to the classification, valuation and operations of the investment portfolios of commercial banks.

Source: Discussion Paper on Review of Prudential Norms for Classification, Valuation and Operations of Investment Portfolio of Commercial Banks’ by Reserve Bank of India, January 2022

(9)

Contact us

Mukesh Deshpande

Partner, Technology Consulting PwC India

[email protected] +91 – 98450 95391

Hardik Gandhi

Director, Technology Consulting PwC India

[email protected] +91 – 9819379703 Arvind Raj

Principal Consultant, Technology Consulting PwC India

[email protected] +91 – 9969358788 Umang Agrawal

Associate Director, Technology Consulting PwC India

[email protected] +91 – 9769195355

Anurag Gupta

Principal Consultant, Technology Consulting PwC India

[email protected] +91 – 7760314901

Contact us

This newsletter has been researched and authored by Keerti Gogna and Sushant Jadhav.

Acknowledgements

(10)

About PwC

At PwC, our purpose is to build trust in society and solve important problems. We’re a network of firms in 156 countries with over 295,000 people who are committed to delivering quality in assurance, advisory and tax services. Find out more and tell us what matters to you by visiting us at www.pwc.com.

PwC refers to the PwC network and/or one or more of its member firms, each of which is a separate legal entity. Please see www.pwc.com/

structure for further details.

pwc.in

Data Classification: DC0 (Public)

In this document, PwC refers to PricewaterhouseCoopers Private Limited (a limited liability company in India having Corporate Identity Number or CIN : U74140WB1983PTC036093), which is a member firm of PricewaterhouseCoopers International Limited (PwCIL), each member firm of which is a separate legal entity.

This document does not constitute professional advice. The information in this document has been obtained or derived from sources believed by PricewaterhouseCoopers Private Limited (PwCPL) to be reliable but PwCPL does not represent that this information is accurate or complete. Any opinions or estimates contained in this document represent the judgment of PwCPL at this time and are subject to change without notice. Readers of this publication are advised to seek their own professional advice before taking any course of action or decision, for which they are entirely responsible, based on the contents of this publication. PwCPL neither accepts or assumes any responsibility or liability to any reader of this publication in respect of the information contained within it or for any decisions readers may take or decide not to or fail to take.

KS/May 2022-M&C 19084