What is Investment Fluctuation Reserves ?

Introduction to Investment Fluctuation Reserves

Investment fluctuation reserves are the reserves built up within many accumulation-style superannuation funds. The main purpose is smoothening the year-to-year returns credited to member accounts. These reserves are established by not distributing some of the investment income when fund earnings are high. When the earnings are low, the investment reserves are then used to top up the rates credited to member accounts. Thus, the rate credited to members on a year-to-year basis is not absolutely dependent on the market cycle. The Superannuation Industry (Supervision) legislation permits the Investment fluctuation reserves to be maintained, only if trustees establish and follow a strategy for their prudential management. Banks should build their Investment fluctuation reserve quickly in order to be in a better position to tackle interest rate volatility.

Why Investment Fluctuation Reserves are needed ?

• Banks were advised to build up IFR (Investment Fluctuation Reserve) of a minimum 5 per cent of the investment portfolio within a period of 5 years.
• The purpose was building up of adequate reserves to guard against any possible reversal of interest rate environment in future due to unexpected developments.
• In June 24, 2004, banks were advised to maintain capital charge for market risk in a phased manner over a two year period, for ensuring smooth transition to Basel II norms,as under:
• With respect of securities included in HFT (Held for Trading) category, open foreign exchange position limit, open gold position limit, trading positions in derivatives and derivatives entered into for hedging trading book exposures as recorded by March 31, 2005, and
• With respect of securities included in the AFS (available for sale) category by March 31, 2006.

• For encouraging banks for early compliance with the guidelines for maintenance of capital charge for market risks, it was advised in April 2005 that banks which have maintained capital of at least 9 per cent of the risk weighted assets for both credit risk and market risks for both HFT (items as indicated at (a) above) and AFS category may treat the balance in excess of 5 per cent of securities included under HFT and AFS categories, in the IFR, as Tier I capital.
• Banks which satisfied the above were allowed to transfer the amount in excess of the said 5 per cent in the IFR to Statutory Reserve.
• In October 2005, banks were advised that if they have maintained capital of at least 9 per cent of the risk weighted assets for both credit risk and market risks for both HFT and AFS category by March 31, 2006, they would be granted to treat the entire balance in the Investment Fluctuation Reserves as Tier I capital. In order to meet the purpose, banks may move the balance in the Investment Fluctuation Reserve ‘below the line’ in the Profit and Loss Appropriation Account to General Reserve , Statutory Reserve or balance of Profit & Loss Account.

Status of Investment Fluctuation Reserve under consideration in Indian Banks

• In April 2002, banks got sops for creating IFR (Investment Fluctuation Reserves). Some leeway was provided by the Reserve Bank of India to the banks in setting aside funds to create an investment fluctuation reserve (IFR) to manage risks related to interest rate. At the same time, the central bank had ignored a strong demand from banks for treating Investment Fluctuation Reserves as Tier-I capital.
• By excluding HTM (Held to Maturity) category of securities for computation of IFR, bankers felt, the central bank had straightened an anomaly in its initial norms. In January, investment portfolio within a period of 5 years.
• In August 2003, the Investment fluctuation Reserve norms were revised. The Reserve Bank of India had planned to revise the IFR requirement norm for banks. Before August ‘03, banks were required to build up an IFR of 5% of their investment portfolio to mostly take care of interest rate risks. Certain modifications in IFR requirements started with changes based on duration. Considerable examination and thinking was under way for introduction of standard methods for measurement and management of risks related to market, such as the duration method or the value-at-risk method.
• In September 2003, UCBs were told to set up Investment fluctuation Reserve. This directive had been issued so that all those banks adequately hedged themselves against any adverse movements in interest rates. UCBs were required to build up IFR out of realised gains on sale of investments, subject to availability of net profit. For the smaller UCBs, however, IFR build up was optional.
• The minimum IFR requirement of five per cent was to be computed with reference to investments in two categories – HFT (held for trading) and AFS (available for sale) category. Investments under the HTM (held to maturity) category, however, were not to be reckoned for the purpose.
• The IFR, so built-up, was eligible for inclusion of Tier-II capital. Banks utilized the amount contained/parked in IFR to meet the depreciation requirement on investment in securities, in future, as per the guidelines issued by the central bank. The UCBs had been given the freedom to build up a higher percentage of IFR, up to 10 per cent of their investment portfolio, with the approval of their board of directors. Banks were required to transfer maximum amount of the gains realized on sale of investment in securities to the IFR. Transfer to the IFR was to be as an appropriation of net profit after appropriation to the Statutory Reserve.
• In January 2005, Reserve Bank of India planned for a hike in the Investment fluctuation Reserve. Public sector banks had been quietly sounded about a possible increase in the investment fluctuation reserve (IFR) from the current level. Most of the banks had already reached the prescribed IFR threshold of 5 per cent of their respective investments. The deadline for complying with IFR guideline was April 2006. But all the banks, including the weak ones, were expected to reach the 5 per cent IFR well before the deadline, as reported by the banking sources.
• The sources explained that the Reserve Bank of India (RBI) proposal stemmed from worries about the possibility of a steep depreciation in Government securities values in the coming months. Already the 10-year yield-to- maturity had dropped by over 1.7 per cent since April in 2005. It was poised to top 7 per cent by the end of that fiscal year. Therefore, the sources said, the RBI preferred an increase in the IFR to help banks overcome any sharp volatility in the securities markets. Few bankers were against this proposal of raising the IFR, though most of them wanted it to be treated as part of the funds they owned. The reason was because the bankers felt that the reserves could be created out of their recoveries of non-performing assets.
• The sources also added that the RBI was also prepared to consider upgradation of the IFR to tier one capital. At that time, banks were asked to treat IFR (investment fluctuation reserve) only as tier two capital though most of them had repeatedly demanded that it should be treated as tier one capital. Tier I capital comprised the owned funds of the banks and tier two of subordinated debt with maturities in excess of five years and revaluation reserves. The original IFR guidelines were issued when yields were softening. The actual reason for treatment of IFR as tier two was that it was only a revaluation of investments and therefore technically not part of owned funds. When the securities began to depreciate, this reason no longer applied. Bankers said that the RBI had accepted the contention of the banks, since the IFR was treated as a charge on the banks’ profits. So far the RBI had declined bankers demands for drawing on the IFR for meeting the depreciation provision or amortising the depreciation over predetermined time frame. Although banks were making profits in core operations, the rise in the YTM had resulted in steep losses due to depreciation and impacting their net profits. The losses were despite the change in the nomenclature for valuation of securities during the second quarter of the current fiscal. The changed nomenclature implied that the banks would be allowed to treat up to 25 per cent of their demand and time liabilities as part of the held-to-maturity securities. But most banks are already well over this figure, since their investment-deposit ratio is about 44 per cent.
• Banks mentioned that treatment of the IFR had then allowed them to obtain a better pricing for their planned equity issues. It was partly because the book value of the banking shares had automatically risen. Besides, the treatment of IFR (investment fluctuation reserve) has also resulted in the banks improving their capital-to-risk- weighted asset ratio from the current figures. This again also allowed them to expand their risk-weighted assets.
• In July, 2005, PSBs (Public Sector banks) pressed demand with Reserve Bank of India to include their Investment fluctuation Reserves in Tier I capital. Public sector banks had again approached the Reserve Bank of India for conversion of their investment fluctuation reserve to Tier I capital. Bankers said this move was really necessary since all banks were expected to shift to the operational risk and market risk guidelines prescribed under the Basel II guidelines. Volatility of banks’ investment was referred to as market related risks. Operational risks were attributed to the internal systems, people associated, all processes involved and the external factors. Bankers mentioned that such a transition would need greater Tier I capital equity plus reserves.
• Till mid 2005, only IFR (investment fluctuation reserve) in excess of the 5 per cent of the investment portfolio was treated as Tier 1 capital. IFR was considered as a below-the-line item and was a charge on net profit. Bankers had raised the issue of treating the IFR as part of Tier I in the past also, though the RBI had turned down the proposal since it was created as a revaluation reserve. But bankers said that the IFR, however, was now becoming redundant. One reason for the Investment Fluctuation reserve – IFR’s redundancy was the fact that most banks have completed de-risking of their investment portfolios – the HFT (held-for-trading) and AFS (available-for-sale) categories.
• De-risking implied that banks had shrunk the average maturities of both AFS and HFT to under two years. For some of the larger private banks, the average tenure was about one year even after including the HTM (held to maturity) categories; few were interested in long-dated securities at a time when the interest rate outlook was bearish. Moreover, bankers last year had shifted substantial chunks of their securities portfolios to the held-to-maturity (HTM) category, reaching the IFR targets well before the deadline of 2006. Most banks were able to breach the 5 per cent target partly on account of the Reserve Bank of India respite. This was because under the then current guidelines, there was no IFR (investment fluctuation reserve) requirement for securities categorized as HTM.
• But the bankers said that once Basel II operational risk and market risk guidelines became effective, even HTM securities would have come within its purview. Consequently, bankers said, that if the then present trend in yields continued, they would be required to make large capital allocations for even HTM securities, which at that time comprised about 25 per cent of the demand and time liabilities. Bankers also mentioned that it was the fear that was preventing bankers from becoming active in the debt markets. Most banks were just selling their securities and bringing them down to the barest statutory requirement ahead of the new norms.
• Above all, bankers were also worried about the impact of the depreciation on their portfolios with the 10-year yield-to-maturity (YTM) dipping to 7.2 per cent down from 6.75 per cent from the last day of the first quarter. Although most banks had brought down their average tenors, they still used the 10-year YTM for reference. Besides, what also worried bankers was that even for shorter-dated securities, between one and five years, YTMs had hardened. This meant that they would still end up with large depreciation provisions if the then current trend continued.