Draft Guidelines for Banks' investment in Non-SLR securities Letter to all Scheduled Commercial Banks Reserve Bank of India Department of Banking Supervision Central Office, Centre I, Cuffe Parade Colaba Mumbai 400005 DBS CO PP / 11.01.005 / 1999-2000 April 4, 2000 All Scheduled Commercial Banks Banks' investment in Non-SLR securities Consequent to the exclusion of investments in preference shares, debentures and bonds of private corporates from the annual ceiling of 5% of incremental deposits of previous year for investments in the above mentioned securities and equities in terms of Monetary and Credit Policy announced in April 1997 RBI undertook a study of the non-slr investment of banks. The study caused concerns about the non-slr portfolio of banks, as a substantial portion was composed of privately placed unquoted securities. To suggest appropriate measures for regulating such investments and bringing in more transparency, accountability and risk perception, a technical group with officials drawn from the Treasury Departments of banks and experts on corporate finance was constituted by RBI in August 1998. 2. The Report of the group was discussed by the Board for Financial Supervision and proposals in this regard were subsequently discussed with a few banks and All India Financial Institutions on 2/3 occasions and their comments were also obtained. Keeping in view banks and FIs' responses, draft guidelines have been prepared, which are enclosed to this letter. You are requested to furnish your comments/suggestions within 10 days from the date of this letter. The draft guidelines are also being put on the RBI website for comments from any quarters within the above mentioned period of 10 days. Yours faithfully, (A.Q. Siddiqi) Chief General Manager-in-Charge Reserve Bank of India Letter to all India Term Lending and Refinancing Institutions
Department of Banking Supervision Central Office, Centre I, Cuffe Parade Colaba Mumbai 400005 DBS CO PP BC 31 / 11.01.005 / 1999-2000 April 4, 2000 All India Term Lending and Refinancing Institutions Banks' investment in Non-SLR securities Consequent to the exclusion of investments in preference shares, debentures and bonds of private corporates from the annual ceiling of 5% of incremental deposits of previous year for investments in the above mentioned securities and equities in terms of Monetary and Credit Policy announced in April 1997 RBI undertook a study of the non-slr investment of banks. The study caused concerns about the non-slr portfolio of banks, as a substantial portion was composed of privately placed unquoted securities. To suggest appropriate measures for regulating such investments and bringing in more transparency, accountability and risk perception, a technical group with officials drawn from the Treasury Departments of banks and experts on corporate finance was constituted by RBI in August 1998. 2. The Report of the group was discussed by the Board for Financial Supervision and proposals in this regard were subsequently discussed with a few banks and All India Financial Institutions on 2/3 occasions and their comments were also obtained. Keeping in view banks and FIs' responses, draft guidelines have been prepared, which are enclosed to this letter. You are requested to furnish your comments/suggestions within 10 days from t he date of this letter. The draft guidelines are also being put on the RBI website for comments from any quarters within the above mentioned period of 10 days. Yours faithfully, (A.Q. Siddiqi) Chief General Manager-in-Charge Draft Guidelines for banks Non-SLR investments As you may be aware the RBI has been concerned for quite some time about the quality of the Non-SLR Portfolio of banks as studies have shown that a substantial portion of it is composed of privately placed unquoted securities. Though banks have not reported any significant losses on their holding of unquoted debt, the absence of a secondary market for unquoted paper raises concerns about the valuation of the portfolio also.
2. With a view to ensuring that Non-SLR investments are made on the basis of sound prudential considerations and more transparency, accountability and risk perception is brought to bear on decision making, the following guidelines are issued relating to i. classification of debentures as advances or investments ii. limits on nature and extent of advance or investment and iii. Valuation basis 3. Classification of debentures i. The Accounting standard on " Disclosure of Accounting Policies ( AS-1) " as well as the Framework for the preparation and presentation of financial statements issued by the International Accounting Standards Committee have stipulated that the accounting treatment and presentation in financial statements of transactions and events should be in accordance with their substance and economic reality and not merely the legal form ( details of relevant accounting standards are given in Annexure I ). Therefore, In deciding upon the classification, it is important to consider the intention behind the deployment of funds. The factors which could indicate the intention are :- a. the tenure of the debenture b. the purpose for which the proceeds will be used c. the share of the investor in the total issue d. whether the borrower approached the lender or whether the borrower issued an invitation to which the lender responded (ii) Having regard to the above, debentures must be treated in the nature of an advance when : a. the debenture is issued as part of the proposal for project finance b. the tenure of the debenture is of 5 years and above, i.e. long-term c. the investor has a significant stake in the issue say 10% or more d. the issue is part of a private placement, that is, the borrower has approached the investor and not part of a public issue where the investor has subscribed in response to an invitation (iii) Since it may be difficult in all cases to identify debentures which in substance are advances, the debentures need not be shown as advances if any of the following features exist. (The reasons are stated thereagainst). Feature (a) Tenure is less than 5 years. (b) Stake is less than 10% of issue Reason Project finance is normally 5 years and more. Advance implies a lender/borrower
(c) Debenture is not privately placed relationship which suggests one or a consortium of lenders. When the stake is below 10% it may suggest the relationship of an investor. When the institution subscribes to a public issue of debentures or buys the debentures in the secondary market, it is acting as an investor and not as a lender. 4. Limit on the extent of advance or investment 4.1 Where the debenture is treated as advance there need not be any limit on the extent of holding since the advance will be subject to the usual prudential norms applicable to advances. 4.2 Where the debenture is treated as investment, such investment should be within a limit of 15% of total investments considering the fact that the debentures are generally illiquid. There is a similar limit in respect of thinly traded or non-traded investments of mutual funds. 5. Valuation : i. Debentures : Because of their illiquidity, all debentures falling within the category of investments should be valued on the YTM basis. Since the debentures may be of different companies having different ratings, the basis of valuation may be decided by the institutions subject to the following:- a. The rate used for the YTM should be at least 0.5% above the rate applicable to a Government of India loan of equal maturity. b. Where the debenture is quoted and there have been transactions within 15 days prior to the valuation date, the value adopted should not be higher than the rate at which the transaction is recorded on the stock exchange. ii. Preference Shares : The basis of valuation of preference shares should be on YTM basis. Since the preference shares will be issued by companies with different ratings, the basis of valuation may be decided by the institutions subject to the following (for the reasons stated thereagainst). Stipulation Reason a. The rate used for YTM Should:- i. Dividends on preference shares are taxfree. i. in the case of a bank must not be lower than the coupon rate for a GOI loan of equal Maturity ii. The effective tax rate for a bank is 38.5% and for an FI is 23.1% considering 40% deduction under Section 36(1) (viii).
ii. in the case of an FI must not be lower than 1.5% above the coupon rate for a GOI loan of equal maturity iii. Therefore the after-tax return on a GOI loan with a coupon rate of 10.75% would be 6.61% for a bank and 8.27% for an FI. iv. Considering a risk factor of 4%, the expected return should be 10.61% for a bank and 12.27% for an FI. a. Where preference dividends are in arrears, When preference dividends are in arrears, the no credit should be taken for accrued share is a on-performing asset. dividends and the value determined on YTM should be discounted by at least 15% if arrears are for one year and more if the arrears are for more than one year. * The share should not be valued at above its This is the maximum amount which will be redemption value. received on redemption. * When a preference share has been traded on the stock exchange within 15 days prior to the valuation date, the value should not be higher than the price at which the share is traded. Annexure I 1.1 Accounting Standard on "Disclosure of Accounting Policies" (AS-1) states as under :- "Considerations in the Selection of Accounting Policies" 16. The primary consideration in the selection of accounting policies by an enterprise is that the financial statements prepared and presented on the basis of such accounting policies should represent a true and fair view of the state of affairs of the enterprise as at the balance sheet date and of the profit or loss for the period ended on that date. 17. For this purpose, the major considerations governing the selection and application of accounting policies are: - a. Prudence... b.substance over Form The accounting treatment and presentation in financial statements of transactions and events should be governed by their substance and not merely by the legal form.
c. Materiality..." 2. Framework for the preparation and presentation of financial statements issued by the International Accounting Standards Committee states under "Qualitative Characteristics of Financial Statements". "Qualitative characteristics are the attributes that make the information provided in financial statements useful to users. The four principal qualitative characteristics are understandability, relevance, reliability comparability". Under reliability there is a paragraph (No.35) headed "Substance over Form" which states: - "35. If information is to represent faithfully the transactions and other events that it purports to represent, it is necessary that they are accounted for and presented in accordance with their substances and economic reality and not merely their legal form. The substance of transactions or other events is not always consistent with that which is apparent from their legal or contrived form. For example, an enterprise may dispose of an asset to another party in such a way that the documentation purports to pass legal ownership to that party; nevertheless, agreements may exist that ensure that the enterprise continues to enjoy the future economic benefits embodied in the asset. In such circumstances, the reporting of a sale would not represent faithfully the transaction entered into (if indeed there was a transaction)."