REVALUATION OF INVESTMENT PORTFOLIOS OF BANKS

The SBP has stepped in as a savior to bring the banks out of the bond market blood bath

By SHABBIR H. KAZMI
Oct 04 - 10, 2004

The State Bank of Pakistan (SBP) has issued the circular regarding amendments in the revaluation of banks' investment portfolios. The amendments that have been made relate to the held to maturity investments where a) unrealized losses on securities would be carried at amortized cost and shall not be required to be revalued and losses do not have to be booked on their balance sheets and b) reclassification within classes for held to maturity investments would be disallowed once a security has been classified as held to maturity.

The circular BSD-14 is a follow up to an earlier circular BSD-10 on the classification of investment portfolios of banks. According to BSD-14 banks no longer need to revalue their holdings of the government securities and bonds that have been categorized as 'held to maturity'. In order to bring the investment portfolios under International Accounting Standards, banks were supposed to classify their securities in three categories: 1) held for trading, 2) available for sale and 3) held for maturity.

According to Ali Farid of AKD Securities, "The SBP has stepped in as a savior to bring the banks out of the bond market blood bath. As interest rates climbed up, bonds prices fell and banks, which has previously made huge gains from the rising bond prices, were caught on the wrong foot. The combined impact on falling bond prices, along with thin spread, placed the banking sector's profitability in peril. Although, the rise in interest rates is expected to improve the spread, the impact would still be marginal, as high competition in the sector would be a constraint. "

These amendments are expected to bode well for banks as it would prevent them from reporting losses on their balance sheets. However, banks would have to make a strategic decision regarding which investments would have to be classified under held to maturity before 30th September. Although, most banks have disposed off part of their PIB holdings during the current year, PIB holdings are still a matter of concern.

The amendments in the circular focus on held to maturity investments. According to the previous circular, unrealized gains and losses on securities under this category would be charged to equity and could be transferred to the other two classes, namely held for trading and available for sale within two months of a new accounting year. Both of these points have been modified where now unrealized gains and losses on securities held to maturity would be carried at amortized cost and shall not be required to be revalued. In addition, reclassification within classes for held to maturity investments cannot be made and once a security has been classified as held to maturity it cannot be reclassified.

The amendments should bode well for banks as they would not have to book unrealized losses on their equity with respect to bond investments. During the recent past, banks have been facing a major threat as increasing PIB rates have resulted in huge unrealized losses on their investment portfolios. Since these investments do not have to be revalued and can be carried at cost, a major hit on bank's balance sheet is avoided. However, banks would have to re-examine and finalize their investment categories by 30th September 2004 after which reclassification of investments amongst the three categories would be difficult to make. Therefore, banks would have to make a strategic decision on how much investments would be classified as "held to maturity". It is expected that banks would transfer majority of their PIB holdings depending on their ability to maintain a large PIB holding.

With respect to specific banks, larger banks are expected to benefit the most as they have the capacity to transfer most of their PIB holdings as held to maturity and carry their large portfolio for a long period of time.

THE KEY CATEGORIES

Held for Trading investments are valued at fair market value and listed on current assets on the balance sheet. Any unrealized and realized gains or losses on these securities are reported in the income statement.

Available for Sale securities are valued at market value and carried on the balance sheet. The unrealized gains and losses on this category are not included in income statement and reported as a separate component of shareholders' equity.

Held to Maturity securities are valued at amortized c