This Selected Issues paper paints a picture of the Indian economy that has made great strides, but has more to do to accelerate growth and reduce poverty. The paper assesses empirically whether India has entered a new phase of higher trend growth. Two alternative methodologies are used to disentangle underlying structural growth trends from shorter-term cyclical fluctuations around this trend. The paper focuses on a number of the reforms required to ensure that needed high growth can be achieved on a sustained basis.


This Selected Issues paper paints a picture of the Indian economy that has made great strides, but has more to do to accelerate growth and reduce poverty. The paper assesses empirically whether India has entered a new phase of higher trend growth. Two alternative methodologies are used to disentangle underlying structural growth trends from shorter-term cyclical fluctuations around this trend. The paper focuses on a number of the reforms required to ensure that needed high growth can be achieved on a sustained basis.

V. The Interest Rate Risk Management of Banks’ Government Securities Holdings in India1

The large holdings of government securities by banks entail some risk as interest rates are at historical low levels. This paper first measures the interest rate risk associated with such holdings and then assesses its management by banks. Finally, it identifies key issues that could mitigate banks’ vulnerability to interest rate risk.

A. Banks’ Government Securities Holdings as a Source of Risk

1. Banks in India invest heavily in government securities, compared with other countries (Table V.1). Such investments grew by 25 percent in 2003-04 to reach Rs. 6.4 trillion, or 24 percent of GDP at end March 2004.2 They represented one third of total banking system assets at end-March 2004. As a result, Indian banks have some of the highest holdings of government securities relative to their assets when compared to other countries. Furthermore, government securities holdings are well in excess of the statutory reserve requirements. The ratio of statutory liquid securities (SLR)—mainly government securities—reached 41 percent of net demand and time liabilities by end-March 2004, well above the required 25 percent.

Table V.1.

International Comparison of Banks’ Holdings of Government Securities, 2003 1/

(In percentage)

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Sources: Bankscope; FDIC; RBI; and staff calculations.

Data for commercial banks for Germany, Spain, and Japan and for public sector banks for India.

2. With declining interest rates in recent years, banks have earned substantial profits through interest and trading income on government securities. Interest income on these investments represented 35.8 percent of banking system interest income at end-March 2004. Similarly, trading income accounted for 49 percent of the banking system noninterest income at end-2004. Trading income has become one of the main drivers of banking system profitability, accounting for 37 percent of operating profit at end-March 2004.

3. However, the holdings of government securities by the banking system entail risk as interest rates have reached their historical low levels. Most government securities held by banks are long-term fixed-rate government bonds which are sensitive to changes in interest rates. Fixed-rate government securities with a 5–30 year tenor account for 58.2 percent of banks’ total investment portfolios. In contrast, investments with a maturity less than one year represent only 10.4 percent of total as of end-March 2004. At the same time, inflationary pressures have prompted the RBI to raise interest rates in 2004. Further increases in the yields of government securities are a significant risk to the profitability and capital adequacy of the banking system.

B. Measuring the Risk from Government Securities Holdings

4. Given their significant share in the assets of commercial banks in India, it is important to measure the risk of government securities holdings. Gauging the likely reduction in the market value of banks’ government securities holdings and the associated reduction in capital adequacy and profitability can guide banks in managing these risks. In addition, identifying banks most vulnerable to the risks can be useful to supervisors.

Duration Method

5. First, we use a duration/convexity method to estimate the government securities portfolio interest rate risk. From the price-yield relationship for bonds, this method estimates bond price changes for a change in yields. The duration of a bond is a linear approximation of a bond price change. The longer the duration of a bond—measured in years—the more interest rate sensitive it is. Since the price-yield relationship for bonds is not linear but convex, a measure of convexity is also used to account for small changes in yields. Convexity is a second order effect that describes how duration changes as yields change. Mathematically, the duration/convexity method uses a Taylor expansion to approximate the relative change in government securities price, dG/G, following a small change in the yields of government securities dy. D* and C denote the government securities modified duration and convexity, respectively (Jorion, 1997).


6. The interest rate risk sensitivity of banks’ government securities portfolio has increased over time, with public sector banks (PSBs) and old private sector banks the most exposed to a rise in yields. Our estimates (Table V.2) are that, as of end-March 2004, the average duration of the government securities portfolio of scheduled commercial banks (SCBs) was 5.8 years. Public sector banks (PSBs), which account for about 75 percent

Table V.2.

India: Interest Rate Risk of Banking System’s Government Securities Holding

(In billions of rupees as of end-March 2004, unless otherwise indicated)

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Sources: Reserve Bank of India; National Stock Exchange; and staff estimates.

Value-at-risk for a one-month holding period and a 99 percent confidence interval using a variance-covariance (or normal) method.

Scenario Analysis

7. In order to approximate interest rate risk to the banking system, we consider both the direct effect on banks’ securities portfolio as well as how banks can manage such a shock to attenuate its effects. As a base case we consider a one percentage point rise in the benchmark government bond rate. This is similar to the increase experienced between mid-April and mid-July 2004, when the benchmark 10-year bond rose from 5.07 percent to 6.26 percent. This scenario can also be seen in the context of the worst-case increase in Government securities yields over 90 days.3 4

Portfolio Losses

8. In the absence of any interest rate risk management by banks, potential portfolio losses from a hike in interest rates would be significant. A one percentage point increase in interest rates would result in losses worth 133 percent of net profit (Table V.2). The market value of banks’ government securities holdings would be reduced by about Rs. 300 billion or 6 percent of portfolio.5 Some public sector and old private banks would be the most exposed with average portfolio losses worth 153 percent and 123 percent of net profit, respectively, as of end-March 2004. Foreign banks and new private sector banks would be the least vulnerable to such a shock, with losses worth 39 percent and 76 percent of net profit, respectively. However, as discussed below, any such losses would be cushioned by gains previously earned, but not booked under India’s conservative accounting rules, and by an investment fluctuation reserve, and could also be offset by higher income from other sources.

Capital Adequacy

9. Such losses would represent about 26 percent of total capital and a drop in the capital adequacy ratio (CAR) to 9.6 percent from 13 percent (Table V.2). A similar exercise using 1999 data finds that banks would have lost 18.3 percent of total capital and their CAR would have fallen by 2 percent in 1999, suggesting that the exposure to interest rate risk has increased over the years. The capital adequacy of public sector banks would be the most exposed, with their average CAR falling to about the level of the 9 percent regulatory minimum (from 13.2 percent).

10. Our results are consistent with previous findings. For instance, Sarkar (2003) estimates the worst-case loss at end-2002 (for a 90 days horizon and a 99 percent confidence level) for a sample of 51 Indian banks at around Rs. 265 billion or almost 5 percent of their holdings of government securities. Similarly, private banks are found to be the least exposed to interest rate risk and public sector banks the most exposed. No foreign banks (out of 9 banks) would erode more than 25 percent of net worth while, among private banks, the proportion with such risk was around 47 percent (out of 15 banks) and, among public sector banks, 85 percent (out of 27 banks). Sarkar (2003) finds that Indian banks are not uniform in their interest rate risk exposure and there is no clear relationship between their capital adequacy ratio and the market risk they take.

Value-at-Risk (VAR) Approach

11. The duration/convexity approach has well-known limitations, as it measures exposures only for parallel shifts of the yield curve. The Value at Risk (VAR) approach offers a complementary method to measure the interest rate risk of bond portfolios. VAR is the measure of the maximum (worst case) market loss for a given portfolio, for a certain holding period, and for a given confidence interval (see also Patnaik and Shah, 2004). VAR is a measure of the rupee loss on the government securities portfolio that will be exceeded by the end of the chosen time period with the specified confidence level. Duration is directly linked to value at risk and the worst case rupee loss calculations in Scenario 3 can be seen as a VAR estimation at a 99 percent level of significance for a one-year horizon.

Value-at-Risk Estimation Results

12. Using a variance-covariance (or normal) method, we find results that are comparable to the duration method’s estimates.6 We find that the maximum (worst case)market loss for scheduled commercial banks’ portfolio for a one month holding period, and for a 99 percent confidence interval is Rs. 320 billion (Table V.2). This figure is close to the portfolio loss resulting from a 100 basis points increase in the yield curve obtained using the duration approach (Rs. 300 billion). We also use alternative value-at-risk methods, including historical simulation methods together with weighted normal, weighted historical simulation and extreme value methods. Although the results—not reported here—are sensitive to the choice of methods, policy conclusions are qualitatively similar.

C. Interest Rate Risk Management

13. While rising interest rates makes banks vulnerable to treasury losses, banks in India have a number of lines of defense. First, banks have, in recent years, realized substantial profits from their holdings of government securities, thanks to the soft interest rate environment. Banks are required to follow conservative accounting practices in respect of unrealized capital gains on their investment portfolio and have constituted latent reserves.7 Moreover, banks in India have been encouraged to build up investment fluctuation reserves as a cushion against interest rate risk (Gangadhar, 2001). Finally, banks can adjust their behavior to offset treasury losses by adequately managing their asset-liability mismatch.

Basel Core Principles

14. The Basel Committee on Banking Supervision (BCBS) has issued principles regarding the supervision of the interest rate risk management of banks, which can be used as a benchmark for the Reserve Bank of India (RBI). Investment portfolios are bifurcated into a banking book, which includes securities that banks intend to hold to maturity, and a trading book. Since 1996, Basel I regulation requires banks to set aside capital to cover their market risks, where the latter includes the interest rate risk in the trading book, but not the banking book (BIS, 1996). Pillar II of Basel II advises bank regulators to control the level of the interest rate risk in the banking book. It urges supervisors to identify banks that are “outliers,” i.e., those that would lose more than 20 percent of their Tier l and Tier 2 capital due to a specific stress scenario (see BIS, 2003).

15. The RBI is moving gradually towards Basel I principles for managing interestrate risk. In 1995, the RBI introduced asset liability management guidelines and in 1999 guidelines for risk management. To measure liquidity risk, banks are required to submit periodic reports to the RBI. More recently, the RBI is phasing in the implementation of Basel norm for capital charge for market risk over a two year period.8 In addition, since 2000, banks are required to use a 2.5 percent risk weight for their portfolio of government securities in order to determine their capital adequacy ratio, as compared to zero under Basel I. The RBI also advised banks advised to examine the soundness of their risk-management systems and draw up a road map by end-December 2004 for migration to Basel II. In addition the RBI has initiated in 2004 pilot program for risk-based supervision.

Investment Fluctuation Reserves (IFR)

16. As an alternative to Basel I, the RBI currently uses the investment fluctuation reserve (IFR) as the main line of defense against a potential reversal of the interest rate environment. Given, the large holdings of government securities, the IFR can be seen as a reserve to guard against possible reversal of interest rate environment. In 2002, banks were advised to build up an IFR of a minimum of 5 percent of the investment in HFT and AFS categories within a period of five years. Banks were also advised to achieve the goal earlier and are encouraged to reach a 10 percent ratio. Transfer to IFR is as an appropriation of net profit after appropriation to statutory reserve.

17. Basel I can be viewed as a more efficient approach to interest rate risk. This is because it recommends capital charges commensurate with the risk exposure of banks, whereas IFR requirements are uniformly applied to banks with no consideration as to the level of interest rate risk and its associated management. As a result, banks with low exposure to interest rate risk bear a regulatory cost if they comply with the advised IFR level. In contrast, the advised uniform level of IFR may not be sufficient to protect some banks from their high exposure to interest rate risk. Furthermore, a number of banks may not have sufficient profitability and capital to build the advised level of IFR. As the RBI moves to international standards, it is expected that the current system will be replaced by Basel I principles.

18. The current aggregate level of IFR is about half that needed to absorb market losses resulting from a one percentage increase in government bonds yields. The aggregate banking system’s IFR stood at 3.0 percent of eligible government securities at end-March 2004, just over half the 5.8 percent needed to absorb a one percentage increase in the benchmark 10-year government bond (Table V.2). The shortfall would be from public sector banks and old private sector banks. In contrast, new private banks and foreign banks have IFR levels sufficient to absorb the shock.

19. Moreover, the required IFR level would not be short of adequate for public sector and old private banks but too high for new private and foreign banks. In contrast to the advised 5 percent, PSBs and old private banks would require IFR levels of about 6.3 percent and 6.1 percent of eligible securities. However, foreign and new private banks would need only about 2.9 percent and 3.3 percent of eligible securities to absorb a one percentage point shock.

20. Individual bank data show a wide dispersion of IFR suggesting that the RBI should scrutinize closely the most exposed banks, as their IFR could be insufficient to cushion them against large interest rate increases and they could need capital injections. The IFR level of public sector banks ranges from zero percent for two small PSBs to 5.21 percent of eligible securities, with a median of 3.13 percent. All public sector banks have an IFR level below the minimum needed to absorb the average 6.3 percentage-point reduction in the value of government securities holdings following a one percentage point increase in interest rates. After using their existing IFR as a cushion to absorb their portfolio losses, the average CAR of PSBs would fall to 10.4 percent from 13.1 percent, and six out of the 27 PSBs would require capital injection as their CAR would fall below the minimum regulatory level of 9 percent.

Mark-to-Market Requirements

21. The RBI has introduced conservative mark-to-market requirements. Since 2000, banks are required to classify their investment portfolios into three categories with progressively mark-to-market norms: (i) Held to Maturity (HTM); (ii) Available for Sale (AFS); and (iii) Held for Trading (HFT). While investments under the HTM category are not marked-to-market, those under AFS and HFT are to be marked-to-market at year-end and monthly, respectively or at more frequent intervals. Guidelines were also issued for the classification of investments, shifting of investments among the three categories, valuation of the investments, and a conservative methodology for booking profits and losses on sale of investments as well as providing for depreciation. In particular, while net depreciations are recognized and fully provided for, net appreciations are ignored.

22. As a one-time measure in September 2004, the RBI allowed banks to shift securities to HTM, after immediately providing for transfer losses. Prior to September 2004, banks were allowed to classify a maximum of 25 percent of their total investments in government securities in the held-to-maturity category (HTM) category when calculating their IFR. Since September 2004, banks are allowed to hold up to 25 percent of their demand and time liabilities (DTL) in the held-to-maturity category (HTM). However, upon shifting additional securities to HTM, a bank would incur accounting losses equal to the difference between their prevailing market value and acquisition cost or book value. Under both regulations, the advised IFR is worth 5 percent of banks’ government securities in the AFS and HFT categories.

23. The RBI explains the measure—which is consistent with international standards that do not place limits on HTM category—as a regulatory response to concerns about the impact of the rising interest rates on banks’ investment portfolios.9 Banks that choose to apply this measure will reduce their exposure to interest rate risk but will have to incur the cost upfront of transferring more securities to the HTM category. In contrast, banks that decide not to hold more securities to maturity will be exposed to potential future mark-to-market losses if interest rates increase further. Such banks would be particularly at risk if they currently lack the capital to absorb the cost of shifting securities to the HTM category, should interest rates rise in the future. Market participants note that very few banks have chosen to shift more securities to the HTM category in part due to concerns about the immediate impact on their net profits.

Other Aspects of Bank Asset Liability Management

24. Off setting potential treasury losses, higher interest rates on loans can positively affect the net interest rate income of banks. Banks can take advantage of rising short-term rates as loans re-price quicker than deposits, hence widening spreads in an environment of increasing loan-to-deposit ratios. Such higher spreads may attenuate the effect of holding fixed rate government securities in a rising interest rate environment. However, the volatility of deposits needs to be considered as well, as they could be withdrawn in case of a significant interest rate shock. The RBI conducts periodic sensitivity analyses of banks’ balance sheets and found a 4.9 percent positive impact on net interest income (NII) following a 200 basis points increase in interest rates at end-March 2003. This analysis does not, however, incorporate the depreciation of banks’ holdings of government securities.

25. Banks could also manage interest rate risk through a number of measures. Banks could (i) reduce the duration of their assets by selling long-dated government securities; (ii) reduce their holdings of government securities and increase their loan books building on the recent high growth in consumer credit and infrastructure; and (iii) increase the contribution of fee-based income to operating income.

Government Policies to Limit Interest Risk

26. Over the medium-term, a stronger fiscal policy and enhanced opportunities for lending would reduce banks’ reliance on government paper. A reduction of the fiscal deficit would reduce the supply of government securities to the banking system. At the same time, continued structural reforms will make lending to domestic enterprises more attractive, allowing banks to bring their government securities holdings down to the legally required level.

27. Increasing the issuance of short-dated or floating rate government securities—in line with sound debt management practices—would also help banks manage their interest rate risk. The Indian authorities have initiated the sale of floating rate government securities and as of 2003, 3 percent of the total stock of outstanding Government securities was in the form of floating rate instruments. Increasing this proportion could provide banks with an additional tool to manage their interest rate risk. Capital market development could also ensure a better functioning of markets for hedging instruments such as interest rate swaps and forward rate agreements (FRAs), and interest rate futures (see Sarkar, 2003).

28. Widening the investor base for government securities could also help reduce the reliance on banks as the main investors in this market. Commercial banks held 61 percent of the outstanding stock of government securities at end-March 2002. The next most important investor was the state-owned Life Insurance Corporation of India (LIC). Other investors included provident funds, mutual funds, other financial institutions, and retail investors. In order to widen the investor base for government securities, the authorities have allowed FIIs to purchase government securities since February 2004 (see also Arvai and Heenan, 2004). From a systemic perspective, the transfer of long-dated government securities from the banking system to institutional investors would shift the interest rate risk outside the banking system. However, given the long-dated nature of their obligations, non-banks may well be better armed to manage their interest rate exposure than banks.

D. Conclusion

29. This paper measures and assesses the management of, the interest rate risk of banks’ government securities portfolios in India, which it identifies as a key risk for the banking system. We find that the current aggregate level of investment fluctuation reserves (IFR) in the banking system would be insufficient to compensate from market losses resulting from a one percentage point parallel shift in the yield curve. However, while some public sector banks and old private banks are vulnerable, foreign banks and new private banks have built an adequate cushion. Moreover, opportunities exist to offset these losses with higher earnings from lending to the private sector and higher fee-base income. A key priority for the Indian authorities is to scrutinize the risk management practices of individual banks. Given the potential for interest shocks higher than the one percentage increase studied in the paper, an accelerating convergence towards Basel I risk-weighted capital charges and the adoption of the Basel II, Pillar II approach for interest rate risk supervision, especially for those banks most vulnerable to a reversal of the interest rate cycle, could help ensure the stability of the financial system.


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Prepared by Amadou Sy.


Based on a nominal GDP of US$603 billion and an exchange rate of Rs. 43.6/U.S. dollar at end 2003/04.


Using five years of monthly data on government securities yields, Sarkar (2003) estimates the 99 percent confidence level to range from 103 bps to 127 bps for maturities of 1–10 years.


We also consider two additional scenarios. Scenario 2 simply assumes a shock double the size of that in Scenario 1. Scenario 3 assumes a 320 basis points increase, the worst-case increase in government securities yields over one year with a 1 percent probability, assuming that yields are normally distributed (the standardized interest rate shock recommended by the BIS (2003)). Given the strong linearity of equation (1), portfolio losses under these scenarios would be approximately proportional to losses obtained under the base scenario.


A similar approach finds market losses in Japanese banks’ portfolio of Japanese government bonds equivalent to 208 percent of net profit or 14 percent of Tier 1 capital (see Nemoto, 2004).


We use a duration mapping method with linear interpolation using information from zero-coupon government securities (ZCYC) from NSE. Since the NSE database does not provide the correlation of zero-coupon bonds for different maturities, our estimates measure the undiversified portfolio VAR of Indian banks. As a result, our estimates assume perfect correlation across all zero-coupon bonds and ignore possible diversification benefits, which may overestimate the diversified VAR.


The RBI conducts periodic sensitivity analyses of banks’ investments portfolio and estimates the cushion available in terms of unrealized gains on banks’ investment portfolio.


The RBI announced in 2004 that banks would be required to maintain capital charge for market risk in respect of the securities included under the Held For Trading (HFT) and Available for Sale (AFS) category by 2005 and 2006, respectively.


See RBI (2004a), page 171. The RBI has also noted that banks are required to hold 25 percent of their DTL in the form of approved securities—mostly government securities—as statutory reserves and argued that at least this level should be eligible as HTM.