Banks in talks with SBP to reclassify loss-making bonds

The State Bank of Pakistan (SBP) is actively considering allowing loss-making bonds in the Available For Sale (AFS) portfolio of banks to be reclassified as Held to Maturity (HTM) at cost. If the SBP allows this reclassification, it would be easier for commercial banks to meet capital adequacy.

Loss-making bonds are those whose present value in the secondary market is lower than the book value on the banks’ balance sheet.

For instance, a bank buys a fixed-rate bond yielding 10% when the policy rate is also at 10%. The policy rate, however, rises. This increase in policy rate, and the consequent increase in the market’s required rate of return for that bond will result in the price of that bond to fall. For the sake of more clarity, it can be said that the price of a fixed-rate bond moves inversely to its yield, so when the yield goes up, the price of a fixed-rate bond goes down.  

AFS portfolio instruments are revalued daily at a benchmark published by the Financial Markets Association of Pakistan called PKRV. It is named after the Refinitiv Eikon page on which this benchmark has been published since the practice began. 

The negative deviation from book value is provided for on a bank’s balance sheet from its capital. Losses eat into the Tier 2 Capital ratio of banks and restrict further risk taking activity including making loans or fresh investments in securities. 

The term Tier 2 Capital refers to one of the components of a bank’s required reserves and is designated as the second or supplementary layer of a bank’s capital. It is composed of items such as revaluation reserves, hybrid instruments, and subordinated term debt.

Currently, not only have the bonds fallen in value, the difference between the bond’s yield and the rate at which it is being financed, the carry, is also negative. 

Banks are funding bonds that yield between 9-12% at the Open Market Operations (OMO) rate of 13.75% to 13.85%. 

A negative carry shows up in the Net Interest Income portion of the Income Statement, while the revaluation loss appears as a negative in the capital portion of the balance sheet. 

If banks don’t sell the security, the loss is temporary as the value of security approaches par at maturity. Selling the security, however, means realizing the loss. Banks are reluctant to do that as that impacts their income statement and balance sheet because when earnings go down so does capital.

Sources further divulged that some commercial banks have been lobbying – either directly individually or through the Pakistan Banks Association (PBA) – the SBP to allow a one-time reclassification at the original cost of the bonds so that banks can meet their Capital Adequacy Requirements (CAR).

The CAR is calculated by dividing the Eligible Regulatory Capital by the total Risk Weighted Assets (RWA) as denominator. This indicates the robustness of the bank’s overall capitalization and balance sheet strength. 

Currently, banks/Development Finance Institutions (DFI) are required to maintain a minimum CAR of 10 percent on an ongoing basis at both standalone and consolidated basis.

The SBP allowed reclassification of securities from AFS to HTM when Basel II was adopted. Then, the SBP had instructed banks that they could not use the HTM securities to obtain repo financing and had to fund them from their own capital deposits. 

It is expected that this time around, the SBP will add on stringent conditions to those availing the one time reclassification. 

As per informed sources, it is likely that the SBP may restrict banks from paying dividends to their shareholders for a specific number of years in case a bank chooses to reclassify. This restriction on dividend is however to preserve capital as preserving capital through reclassification and draining through dividend would be counterproductive. 

This cap on dividends may impact the performance of these stocks on the Pakistan Stock Exchange (PSX). 

“The SBP is allowing banks to make losses on bonds and then letting banks brush their losses under the carpet. As a result, banks will never fully learn to fix their risk management,” opines a source.

Another source, however, believes that banks will be able to reverse their losses eventually as they near maturity if they don’t reclassify. 

If the banks keep it at AFS, they will recognize a huge fair value loss at present, but as maturity approaches the loss will start to reverse for banks when the value of security approaches par value. Due to the present impact on the CAR, some banks may not be in the position to wait for reversal. 

The source further adds, that this puts the risk management of banks under question. “Banks are supposed to have robust risk management in place, especially in cases where they simply earn off the safest form of investment – government lending.”

Sources at the SBP, however, seem to be conflicted. While banks need to reclassify in order to reach the required CAR, the practice of letting banks reclassify from AFS to HTM at cost removes the repercussions of bad decision-making.”