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
