Risks loom for state owned banks relying on sovereign bonds

With credit growth at multi-year lows, Indian lenders have been binging on sovereign debt. With the government set to borrow more, the move is fraught with risk. Bond holdings as a proportion of aggregate deposits stood at about 29% in the two weeks ended Dec. 20, way higher than the 18.25% mandated by the central bank, according to calculations based on data from the Reserve Bank of India. That leaves banks exposed to losses if yields climb on higher federal borrowings.

A flight into the safest fixed-income asset follows a drop in loan disbursals to a two-year low in December, as businesses cut output and consumer spending eased. “A somewhat robust deposit growth vis-à-vis a relatively lukewarm credit growth leaves a lot of liquidity chasing interest rate risks,” the RBI said in its Financial Stability Report released last month.

While yields have dropped recently, thanks to the RBI’s unconventional policy action, they may still rebound as market watchers expect the government to add to its record borrowings.

“Short-term mismatches are resulting in excess liquidity, which finds its way into government securities,” said R.K. Gurumurthy, treasurer with Lakshmi Vilas Bank Ltd. in Mumbai. Treasury incomes at lenders may come under strain later this year, he said.

State-owned lenders are carrying significant interest rate positions on their books, especially in debt maturing in more than five years, the central bank said in the report.

PV01, a gauge of how much the price of a security changes if the interest rate moves by one basis point, was higher in September from June for the so-called available-for-sale portfolio of state-run and foreign banks, the RBI noted.