Prudential Norms for Investment Portfolio Management by AIFIs – Basel III

Prudential Norms for Investment Portfolio Management by AIFIs – Basel III

The Reserve Bank provides guidelines for All India Financial Institutions (AIFIs) regarding their investment portfolios. These guidelines reflect the latest developments in financial markets and align with international practices. This chapter brings together various instructions issued by the Reserve Bank on how AIFIs should classify, value, and manage their investment portfolios.

Investment Policy Framework

  • AIFIs are required to have a comprehensive investment policy, approved by their Board of Directors. This policy should include:
  • Clear investment objectives for transactions made both independently and on behalf of clients.
  • Definitions of permissible securities and derivatives for investment.
  • Authority delegation for executing deals and the required approval processes.
  • Adherence to prudential exposure limits and policies for broker interactions.
  • Risk management systems, portfolio valuation guidelines, and reporting procedures.
  • The policy should ensure that all transactions are conducted ethically and responsibly.
  • It should set prudential limits for investments in various types of securities, including private placements, to avoid systemic risks and manage liquidity.
  • Minimum standards for ratings and limits based on industry, maturity, duration, and issuer should be established to mitigate concentration and liquidity risks.
  • Detailed procedures for equity investments and associated risk management should be included. AIFIs should develop expertise in equity research, potentially through a dedicated department.
  • An Investment Committee, accountable for investment decisions, should be established by the AIFI’s Board.
  • Investment proposals should undergo rigorous credit appraisal, similar to loan proposals.
  • AIFIs should consult defaulters lists from Credit Information Companies and the Central Repository of Information on Large Credits (CRILC) when making investment decisions.
  • Internal credit analysis and ratings should be conducted for externally rated issues, ensuring continuous monitoring and tracking of the financial status of issuers.
  • Transactions in securities and derivatives should be settled as per the relevant regulatory guidelines.
  • Investments, whether privately placed or otherwise, should be held in dematerialized form.

Classification of Investments by AIFIs

All India Financial Institutions (AIFIs) must categorize their investment portfolio into three types: ‘Held to Maturity’ (HTM), ‘Available for Sale’ (AFS), and ‘Held for Trading’ (HFT). They should decide the category when they acquire the investment and record this decision in the investment documents.

Held to Maturity (HTM)

The HTM category should not exceed 25% of the AIFI’s total investments. This category can include:

  • Debt securities.
  • Equity in subsidiaries and joint ventures.
  • Recapitalization bonds from the Government of India for the AIFI’s own recapitalization, held as investments. However, recapitalization bonds from other banks or AIFIs bought for investment are not included in HTM.
  • Unquoted shares, bonds, or units of Category I and II Alternative Investment Funds (AIFs) for an initial period of three years. This three-year period is counted separately for each disbursement to these AIFs.

Investments in subsidiaries, joint ventures, and certain government bonds are not counted towards the 25% HTM limit. Profits from selling HTM investments go to the Profit & Loss Account and then to the Capital Reserve Account, after taxes and statutory reserve transfers. Losses are recognized in the Profit & Loss Account.

Available for Sale (AFS) & Held for Trading (HFT)

Securities bought with the intention of short-term trading are classified as HFT and should be sold within 90 days. Securities that don’t fit into HTM or HFT are categorized as AFS. This includes quoted equity shares, bonds, units of Category I and II AIFs, and financial instruments obtained through conversion of outstanding amounts. These must always be in the AFS category.

AIFIs have the flexibility to decide how much they hold in AFS and HFT, considering factors like intent, trading strategies, risk management, tax planning, skills, and capital.

Profits or losses from selling investments in both AFS and HFT are recorded in the Profit & Loss Account.

Shifting Among Categories for AIFIs

  • All India Financial Institutions (AIFIs) can shift investments between categories, but there are specific rules to follow:
  • AIFIs can move investments to or from the Held to Maturity (HTM) category once a year, with the Board of Directors’ approval. This is usually done at the start of the accounting year. Any additional shifts during the year need explicit permission from the Reserve Bank.
  • Investments in unquoted units, shares, or bonds of Category I and II Alternative Investment Funds (AIFs) that have been in HTM for three years should be moved to Available for Sale (AFS) at the next accounting year’s start.
  • When transferring securities from AFS or Held for Trading (HFT) to HTM, they should be valued at the lower of book or market value. If the market value is higher, it’s ignored, and the transfer is at book value. If the market value is lower, the book value is adjusted down to market value after accounting for any depreciation.
  • Moving securities from HTM to AFS or HFT involves specific conditions:
  • Securities bought at a discount are transferred at acquisition price or book value.
  • Securities bought at a premium are transferred at amortized cost.
  • These securities must be re-valued immediately after transfer, and any depreciation is accounted for.
  • AIFIs can shift investments from AFS to HFT with approval from their Board, Asset Liability Committee (ALCO), or Investment Committee. In urgent situations, the Chief Executive or Head of ALCO can approve the shift, but it must be ratified later.
  • Moving investments from HFT to AFS is generally not allowed, except under exceptional circumstances like tight liquidity or extreme market conditions, and requires approval from the Board, ALCO, or Investment Committee.
  • When transferring securities between AFS and HFT, re-valuation on the transfer date isn’t necessary. Any existing depreciation provisions are transferred accordingly.
  • If sales or transfers from the HTM category exceed 5% of its beginning-of-year book value, AIFIs must disclose in their financial statements the market value of HTM investments and any excess book value over market value not provided for.
  • The 5% regulatory limit doesn’t apply in certain cases, like one-time transfers at the year’s start, sales to the Reserve Bank under liquidity operations, repurchases by the Government of India or state governments, and additional shifts permitted by the Reserve Bank.

Valuation of Investments for AIFIs

Held to Maturity (HTM)

Investments in the HTM category are not marked to market. They are carried at acquisition cost, except when purchased above face value, in which case the premium is amortized over the remaining maturity period. This amortized amount is deducted from ‘Income on Investments’ in the financial statements. The book value of these securities is reduced by the amortized amount each accounting period.

AIFIs must recognize and provide for any significant, lasting reduction in the value of their investments in subsidiaries or joint ventures under HTM. The need to assess impairment is ongoing and arises in situations like default in debt repayment, loan restructuring, or credit rating downgrade to below investment grade. It also arises when a company has continuous losses over three years, reducing its net worth by 25% or more, or when a new company or project fails to reach its break-even point within the original timeframe.

For significant investments, AIFIs should get a valuation from a qualified valuer and make provisions for any impairment. Special securities received from the Government of India for recapitalization will be recognized at fair or market value from FY 2024-25 onwards.

Available for Sale (AFS)

Securities in the AFS category are marked to market quarterly or more frequently. The book value remains unchanged after this marking. Securities are valued individually, and net depreciation across each classification must be provided for, without offsetting against net appreciation in other classifications.

Held for Trading (HFT)

Securities in the HFT category are marked to market monthly or more frequently, similar to AFS securities. The book value remains unchanged after marking to market.

Market Value

For AFS and HFT securities, ‘market value’ is determined as follows:

  • Quoted Securities: Market value is based on prices declared by Financial Benchmarks India Pvt. Ltd. (FBIL) or as available from authorized stock exchanges and trading platforms.
  • Unquoted Securities: These include government securities, special securities, state government securities, debentures/bonds, UDAY bonds, bonds issued by state distribution companies, zero-coupon bonds, preference shares, equity shares, mutual fund units, commercial paper, and securities issued by Asset Reconstruction Companies (ARCs). Each of these is valued based on specific guidelines, often involving yields or prices published by FBIL or FIMMDA, and considering factors like credit ratings, market transactions, and the nature of the security.

Investments in equity, debt, or other financial instruments acquired by converting outstanding advances are valued according to the AIFI’s investment portfolio valuation guidelines. Equity classified as standard or non-performing assets (NPAs) is valued based on market value if quoted, or at a nominal value if not quoted. Depreciation on these instruments, whether standard or NPA, cannot be offset against appreciation in other AFS securities.

Investments in Government Securities by AIFIs

When All India Financial Institutions (AIFIs) engage in transactions involving government securities, they need to follow specific guidelines in addition to the general ones already mentioned:

  • Transactions through SGL Account: All transactions in government securities should be conducted through an SGL/CSGL account. These transactions must follow the Delivery Versus Payment System as per the Reserve Bank’s guidelines.
  • Government Securities on ‘When Issued’ Basis: Transactions on a ‘When Issued’ basis in government securities must adhere to the guidelines outlined in the When Issued Transactions (Reserve Bank) Directions, 2018 and any subsequent amendments.
  • Value Free Transfer of Government Securities: For value free transfers in government securities, AIFIs should follow the guidelines issued in October 2021, which are subject to amendments over time.
  • STRIPS: Stripping or reconstitution of government securities must comply with the conditions in the guidelines issued in March 2010. Accounting and valuation of these transactions should align with the instructions in Annex 22.
  • Repo in Government Securities: Repo transactions, including reverse repo, by AIFIs are governed by the guidelines specified in the Directions issued in July 2018, as amended periodically.
  • Settlement of Transactions in Government Securities: The settlement of these transactions is regulated by the Reserve Bank’s guidelines. AIFIs must record all transactions, whether repo or outright, on the same day in their investment account. They should use ‘Settlement Date’ accounting for recording purchases and sales of government securities transactions.

Investments in Non-Government Securities by AIFIs

All India Financial Institutions (AIFIs) must follow specific instructions when investing in non-government debt securities, both in primary and secondary markets:

  • Listed Non-Government Debt Securities: AIFIs should invest only in listed non-government debt securities that comply with SEBI requirements, except in certain cases as mentioned later.
  • Investment in Unlisted Non-Government Securities: The total investment in unlisted non-government securities should not exceed 10% of the AIFI’s total non-government investment as of the end of the previous fiscal year. These investments must meet SEBI’s disclosure requirements for listed companies. Investments intended to be listed are considered as listed at the time of investment. If they are not listed within the specified time, they count towards the 10% limit for unlisted securities.
  • Additional Investment in Unlisted Securities: AIFIs can invest an additional 10% in unlisted non-government securities, specifically in securitization papers for infrastructure projects and bonds/debentures issued by Securitization Companies and Reconstruction Companies registered with the Reserve Bank.
  • Mutual Fund Investments: Investments in mutual fund schemes with less than 10% exposure to unlisted securities are treated as listed securities for prudential limit compliance.
  • Exclusions from Unlisted Non-Government Securities: Certain securities are not considered as ‘unlisted non-government securities’ for prudential limit purposes, including government-issued securities, equity shares, certain mutual fund units, commercial paper, certificates of deposit, and specific debentures and bonds.
  • Restrictions on Investment Maturity: AIFIs should not invest in non-government securities with an original maturity of less than one year, except for certain types of commercial papers, certificates of deposit, and non-convertible debentures.
  • Prohibitions on Certain Investments: AIFIs are prohibited from investing in zero-coupon bonds issued by corporates and low coupon bonds with substantial premiums at maturity, unless specific conditions are met. They are also restricted from investing in unrated debt securities, with certain exceptions.
  • Repo in Corporate Bonds: AIFIs can undertake repo transactions in corporate bonds as per specific guidelines.
  • OTC Transactions: Investments in commercial papers, certificates of deposit, and short-term non-convertible debentures must follow specific guidelines.
  • Trading and Settlement in Corporate Bonds: Trades in listed corporate bonds should comply with SEBI guidelines. OTC trades in corporate bonds and securitized debt instruments must be reported and cleared through specified clearing corporations.
  • Other Requirements: AIFIs must conduct due diligence for non-government securities investments and ensure compliance with Reserve Bank regulations. Investments in debt securities should have a minimum investment-grade credit rating. AIFIs are also required to disclose details of issuer composition and non-performing non-government investments in their financial statements.
  • These guidelines ensure that AIFIs manage their non-government securities investments prudently, considering risk, compliance, and market practices.

Role of Boards in AIFIs

The Board of an All India Financial Institution (AIFI) has a crucial role in ensuring effective risk management systems for investments in debt securities. They must take timely actions to address any risks identified. The Board should review various aspects of these investments every quarter, including:

  • The total investment and divestment turnover during the period.
  • Adherence to the prudential limits set by the Board for such investments.
  • Compliance with the Reserve Bank’s prudential guidelines.
  • Changes in the credit ratings of issuers and the impact on portfolio quality.
  • Effectiveness of systems and procedures for investing in privately placed instruments.
  • The proportion of non-performing investments.

Internal Control System

AIFIs must establish a robust internal control system for investment transactions, which includes:

  • Clear functional separation of trading, settlement, monitoring and control, and accounting.
  • Distinct roles for trading and back-office functions for the AIFI’s own investment accounts and those of other constituents, including brokers.
  • For each transaction, the trading desk should prepare a detailed deal slip, which is then processed by the back office. This slip should include all essential details of the deal. AIFIs must have checks and balances in place, such as regular reconciliation of investment books, proper voucher recording and verification, contract verification, portfolio valuation, monitoring of limits, and compliance with legal and regulatory reporting requirements.
  • AIFIs should follow the FIMMDA code of conduct for trades in government securities and adhere to Reserve Bank instructions for transactions in various financial instruments.
  • Reconciliation of government securities balances with PDOs should be done quarterly, or more frequently if needed. The internal audit department should periodically review this reconciliation.
  • AIFIs must ensure that stockbrokers, whether as directors or in any other capacity, do not influence the Investment Committee or decisions related to investments in shares or advances against shares.
  • A system should be in place for reporting investment transaction details to top management weekly, including information on bounced SGL transactions and a review of investment activities.

Engagement of Brokers by AIFIs

All India Financial Institutions (AIFIs) must follow specific guidelines when engaging brokers for their transactions:

  • Role of Brokers: Brokers are primarily involved in connecting two parties for a deal. However, transactions between an AIFI and a bank or another AIFI should not go through a broker’s account. This restriction doesn’t apply to securities transactions conducted with banks or non-bank clients through members of the National Stock Exchange (NSE), BSE, and MCX Stock Exchange (MCX-SX). Brokers are not required to reveal the identity of the counterparty before finalizing the deal.
  • Brokerage Details: If a broker is used, the brokerage fee must be clearly stated in the documents submitted for management approval.
  • Deal Confirmation: After concluding a deal, the broker’s note should clearly mention the counterparty’s name and the exact time of the deal. AIFIs need to ensure that the time on the broker note matches the deal ticket. Concurrent auditors should review this aspect.
  • Broker’s Role in Settlement: Brokers should not be involved in the settlement process of deals. Settlement, including fund transfer and security delivery, should occur directly between the counterparties.
  • Government Securities: AIFIs are not allowed to transact in physical form government securities with any broker.
  • Panel of Approved Brokers: AIFIs should create and annually review a panel of approved brokers, with top management approval. Criteria for empanelment should include experience, creditworthiness, market reputation, and any regulatory actions. AIFIs should keep records of transactions and brokerage fees for each broker.
  • Prudential Limits: AIFIs should avoid concentrating a large part of their business with just one or a few brokers. They should set aggregate contract limits for each broker, typically not exceeding 5% of the total transactions through all brokers in a year. This limit is based on the previous year’s turnover and expected business volume for the current year. If this limit is exceeded, AIFIs must document the reasons and inform the Board post-facto. This excess and its justification should be included in the half-yearly Board review. The 5% limit does not apply to dealings through Primary Dealers (PDs).
  • Application to Subsidiaries: These instructions also apply to subsidiaries of AIFIs.

Audit, Review, and Reporting in AIFIs

All India Financial Institutions (AIFIs) need to follow these guidelines for auditing, reviewing, and reporting their investment transactions:

  • Half-Yearly Review: AIFIs should conduct a review of their investment portfolio every six months, as of March 31 and September 30. This review, which includes operational aspects, policy amendments, audit irregularities, and compliance, should be presented to their Boards by the end of May and November. It should confirm adherence to internal policies and Reserve Bank guidelines.
  • Reporting to the Reserve Bank: A copy of the review report presented to the Board should be sent to the Department of Supervision of the Reserve Bank by June 15 and December 15 each year (October 15 and March 15 for the National Housing Bank).
  • Concurrent Audit of Treasury Transactions: Internal auditors should conduct a concurrent audit of treasury transactions monthly. The results of these audits must be reported to the Chairman or Managing Director of the AIFI.
  • Broker Transactions Audit: The same auditors responsible for treasury operations should audit transactions done through brokers. Their findings should be included in the monthly report to the Chairman or Managing Director.
  • Internal Audit: This should continuously cover security transactions, monitor compliance with management policies and procedures, and report any deficiencies directly to the management.
  • Audit Committee of the Board (ACB) Review: In every meeting, the ACB should review the AIFI’s total capital market exposure (both fund-based and non-fund based), compliance with Reserve Bank guidelines, and the effectiveness of risk management and internal control systems. The ACB is also responsible for surveillance and monitoring of investments in shares.
  • Board Reporting: The ACB should keep the Board informed about the overall capital market exposure, compliance with guidelines, and the adequacy of risk management and internal controls
  • Compliance Monitoring: AIFIs should regularly monitor compliance with Reserve Bank guidelines. Compliance in key areas should be certified by statutory auditors and submitted to the Reserve Bank’s Regional Office of Department of Supervision.
  • Reconciliation of Government Securities: AIFIs must provide a certified statement of reconciliation of their investments at the end of each financial year. This statement should be submitted to the Reserve Bank’s Regional Office within a month after the financial year ends. The requirement for this reconciliation should be included in the appointment letters of external auditors. The format and instructions for this statement are detailed in Annex 24.