A long-standing priority for RBI has been to align the banking regulations to global benchmarks. Recent developments in the international accounting standards, primarily IFRS, meant that the accounting requirements for Indian banks had become outdated. In response to this, RBI mandated use of Indian Accounting Standards (Ind AS) by banks from April 1, 2018. However, various complexities, level of preparedness of banks, and the volatile economic environment meant that RBI had to defer adoption of Ind AS. This created uncertainty on RBI’s approach and timeline for achieving alignment.
On 14 January 2022, by publishing a discussion paper, RBI has cleared the air to some extent. The discussion paper proposes several big changes to accounting, valuation and operations of Investment Portfolio of Commercial banks. The changes are intended to achieve maximum possible alignment with IFRS (the accounting standards followed by most of the developed world), with only limited carve outs done for the domestic context. Subject to feedback, the proposals are planned for implementation from 1 April 2023. In this article, we discuss the 5 big impacts for banks due to the proposed changes.
- Revamped classification for investments, thus impacting which securities need to be carried at fair value or MTM – For the 5 largest private sector banks, HTM constituted over 62% of their investment portfolio as on 31 March 2021. All investments except those classified in HTM are required to be fair valued. Therefore, classifying investments in HTM avoids volatility in P&L and capital. Banks would be keenly interested in knowing whether the quantum on investments eligible for HTM classification goes up or down.
On the one hand, ceiling on how much investments can be in HTM category is proposed to be removed. However, on the other hand, it may become a lot more difficult for banks to keep investments in HTM.
The proposed regulations provide that aggregate sales out of HTM shall not exceed 5% of the opening carrying value of the HTM portfolio in any financial year, unless approved by RBI. Currently, transfers beyond 5% are allowed after approval of the board of directors. For many banks this might mean that there is less than can be classified in HTM, or that they will have to significantly change their business model for investments.
The proposals also provide that any gain on sale of HTM securities shall not be available for dividends, further discouraging classification of any securities that may be sold before maturity under HTM.
The potentially larger quantum of investments at MTM exposes capital to interest rate risk, and might also encourage interest rate hedging (which seems to be one of the objectives of RBI). Would also mean that maintaining capital requires more effort and consideration.
- Change in valuation methodology for unquoted equity – The proposed regulations provide that all equity investments (other than those in subsidiaries, joint ventures and associates) shall be carried at fair value. Currently, unquoted equity shares are valued at break-up value based on the latest balance sheet. While this aims to provide better information to stakeholders, it would be quite difficult for banks to implement. Banks currently hold equity investments in various unlisted companies (and not necessarily for profit making purposes). Doing quarterly fair valuation for all of them shall be challenging, and beset with subjectivity.
Exemption to allow cost accounting (but with disclosure of fair value) in cases where equity valuation is not feasible may be considered. Such exemption (while a divergence from IFRS) would be in line with US GAAP.
- Unrealised gains on AFS to get recognised in P&L – In line with IFRS, and the global standards, the proposed regulations allow for unrealised gains to also be considered. Currently net depreciation in value is recognised, while net appreciation, if any, is ignored. Accordingly, banks who are sitting on significant unrealised gains on their AFS portfolio shall get benefit in capital on April 1, 2023.
- Unrealised gains/losses on AFS category shall no longer impact the P&L – Currently, MTM movements of both AFS and HFT categories affect the P&L. This results in significant volatility in net profit/loss, and situations where market movements in interest rates overshadow overall performance of the banks. Under the proposed regulations, MTM changes in AFS securities would get directly recognised in equity. This is a welcome change reducing volatility in the P&L.
For equity investments, banks shall have a choice to classify them either in AFS, or in the Fair Value through Profit and Loss (“FVTPL”) category. This can be done at instrument level. While AFS classification will reduce P&L volatility, banks will need to carefully consider their decision of placing an equity instrument in AFS, because even the realised gains on AFS equity investments shall not be recognised to the profit and loss account (remaining forever in equity).
- Accounting for HTM securities – The current regulations require amortisation of any premium on acquisition of a security, but any discount is not amortised. The proposed regulations require amortisation of both premium and discount. This helps achieve consistency and therefore is appreciated. However, the method to use for amortisation is not provided. Global standards require amortisation based on the effective interest rate (or IRR) or the security. It would be a significant challenge, requiring system changes for banks.
The discussion paper also doesn’t talk about whether premium or discount on AFS securities should be amortised in the P&L, like it is done under IFRS.
This is RBI’s call to action for treasury, finance, and technology teams of Banks. The large-scale changes, and possible impacts in store, means that the time to 1 April 2023 needs to be effectively utilised. However, the fact that it would be a giant leap towards alignment with international standards should be celebrated. How alignment is achieved on loan accounting and provisioning for credit losses is in spotlight now.