RBI Notification

RBI Issues Draft Guidelines for Minimum Capital Requirements for Market Risk

The RBI recently released draft guidelines for minimum capital requirements for market risk, which will come into effect from April 1, 2024. The rules are meant to bring RBI regulations in line with Basel III standards. They apply to all commercial banks except for local area banks, payments banks, regional rural banks, small finance banks^[1], and all types of cooperative banks. Some of the key highlights from the guidelines are:

Differentiation between Trading Book and Banking book

• Trading book refers to the portion of a bank’s assets that are held with the intention of trading or reselling them in the short term to make a profit. These assets are generally highly liquid and can include securities, derivatives, and currencies. The trading book is marked-to-market daily, meaning the value of the assets is revalued daily to reflect current market prices.
• On the other hand, the banking book refers to the portion of a bank’s assets that are held for the long-term with the intention of earning interest income or for strategic reasons. These assets are generally less liquid and can include loans, mortgages, and other fixed-income securities. The banking book is marked-to-market periodically, which means the value of the assets is revalued at regular intervals, such as quarterly or annually.
• The new rules set a line between the banking book and the trading book. They list the instruments that are subject to capital requirements for market risk and those that are subject to capital requirements for credit risk. RBI defines a trading book as all instruments that meet the specifications for trading book instruments such as financial instruments and foreign exchange.

Capital Requirements

• Under the new norms, banks will be required to maintain a certain level of capital to cover the risks associated with their assets and liabilities. Specifically, the capital requirement for specific risk and general market risk will be 9% each of the bank’s core capital and the exposure to the specified instruments.
• Specific risk refers to the risk associated with individual assets or exposures, while general market risk refers to the risk associated with overall market movements. These capital charges will also apply to all trading book exposures, which are investments that banks make for trading purposes.
• It is worth noting that trading book exposures are typically exempted from capital market exposure ceilings for direct investments, which means that banks can invest a larger portion of their capital in these types of investments without being subject to additional capital charges.

Fair Valuation and Designation of Instruments

• Fair value is the price at which a financial instrument would be traded between two parties who knew each other well and were both willing to do so. It is a market-based measure that reflects the current market conditions and the risks associated with the financial instrument.
• For trading book instruments, banks are required to value them at fair value on a daily basis. This is because these instruments are held for short-term trading purposes and are expected to be sold in the near future. Fair value accounting allows banks to reflect the changes in the value of these instruments in their financial statements in a timely manner.
• The rules say that banks have to put a fair value on any trading book instrument every day and also say that any instrument a bank holds when it is first recorded on its books is considered a trading book instrument, unless it is specifically set aside for short-term resale, profiting from short-term price changes, locking in arbitrage profits, or hedging risks that come from instruments meeting.

Instruments Assigned to the Banking Book

• Instruments assigned to the banking book refer to financial assets held by a bank for the purpose of generating income from interest or dividend payments, as well as to manage the bank’s liquidity and risk. These assets are typically held to maturity, and are not traded frequently in the market.
• Unlisted equities and equity investments in subsidiaries and associates, instruments designated for securitization warehouse, securities with real estate as underlying as well as derivatives thereof, securities with retail and micro, MSME exposure as underlying, and equity investments in funds are all assigned to the banking book under the new guidelines.

Ban on Short Positions and Underwriting

• A short position is a trading strategy where an investor borrows shares of a stock, sells them at the current market price, and then buys them back later at a lower price to return the borrowed shares. The investor profits from the difference between the sale price and the buyback price. Short selling is commonly used by hedge funds, speculators, and other investors to bet against a stock’s price or hedge their portfolios.
• Underwriting refers to the process of raising capital for a company by issuing stocks or bonds. Underwriters are financial institutions that purchase securities from the issuing company and then sell them to investors at a higher price to make a profit. Underwriting is a crucial function in the capital markets, as it enables companies to raise funds and investors to access new investment opportunities.
• The new regulations prohibit shorting any instrument, with the exception of derivatives and Central Government Securities. The sale of stocks, bonds, and debentures may be underwritten by banks.

Deviation from the Presumptive List

After prior RBI and board approval, banks will have the option to depart from the presumptive list. The instrument must be designated in the trading book if this approval is not given.

Shifting of Instruments

After the initial designation, banks are not free to move instruments between the trading book and the banking book at will, and they are not allowed to do so for the purpose of regulatory arbitrage.

Management Continuous Compliance and Risk Systems

Banks must continuously satisfy all market risk capital requirements by the end of each business day, and they must also maintain stringent risk management programs to track and manage intraday exposures to market risks.

Conclusion

The RBI’s draft guidelines for minimum capital requirements for market risk aim to ensure that banks maintain adequate capital to withstand market volatility. Banks must adhere to these guidelines and have clear policies and documented practices to determine which instruments can be included in or excluded from the trading book for calculating regulatory capital, taking into account their risk management capabilities and practices.

Comments and feedback invited:

The RBI has sought comments from stakeholders and the public until April 15, 2022, after which the final guidelines, with modifications, will be applicable to all commercial banks. The Reserve Bank of India (RBI) is seeking feedback from stakeholders and the public on draft guidelines, which is a great opportunity for interested parties to provide their input and suggestions. It’s important for banks to ensure they are fully compliant with the final guidelines by April 1, 2024, to avoid any penalties or legal issues. If anyone has any questions or concerns regarding the draft guidelines, they should take advantage of this opportunity to submit their feedback to the RBI.

Also Read:
RBI Recent Guidelines on Government Securities Market
Mandatory Norms under RBI Regulations on Digital Lending
RBI’s Retail Direct Scheme to facilitate investment in G-Secs

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