RBI Rules on State Bond Valuations

Why in news?

• RBI has announced major changes to how banks will have to value state government bonds.
• It will have far-reaching implications for the bond market and for state and central finances.

What is the present mechanism?

• A government bond is a debt security issued by a government to support government spending.

• Currently, state government bonds are accounted for on banks’ books.
• This is done using a straightforward yield-to-maturity approach.
• Investors are allowed to value these holdings at a fixed markup of 25 basis points above the corresponding central government security.
• This is irrespective of which state has issued it.
• This approach largely enforced uniformity.

What are the proposed changes?

• A valuation that is more closely tied to observed market prices is announced.
• This is relatively easy to do for those state government securities that are regularly traded.
• For those that are not regularly traded, the valuation shall be based on the state-specific weighted average.
• The average is for the spread over the yield of the central government securities of equivalent maturity.

What is the rationale?

• There has been an over-supply of state, central and quasi-government paper.
• The simple 25-basis-point rule allowed states to raise money easily from the markets.
• This was used even for extravagant and populist purposes.
• The market was not allowed to discipline poorly run states.
• The RBI was concerned about the general government deficit.
• It cannot change a state government’s fiscal incentives directly.
• It has thus done this indirectly by altering the bond valuation mechanism.

What are the benefits?

• Bond markets treat a debt-ridden state identically to states with better fiscal position.
• The move could thus introduce greater transparency to banks' books.
• It will also allow greater transparency in public finance.
• It could make states reform their expenditure and revenue.

What are the implications?

• The move is a blow to state-run banks already reeling under bad loans and large trading losses.
• The earlier mechanism allowed banks, to an extent, to mask actual trading losses.
• Changing the earlier fixed premium rule would mean that banks' path to easy profits is closed.
• Also, there is possibility of additional losses depending on the future direction of the government bond market.
• The RBI has permitted the banks to spread out their treasury losses in the current June quarter over the next four quarters.
• However, this may not be enough of a compensation from banks’ point of view.
• Banks may no longer buy these state bonds.
• This could push up yields, even for central government securities and corporate bonds

Source: Economic Times, Business Standard