It would appear that the time hasn't come for fair value in Indian finance if some recent decisions of India's key financial regulators regarding asset valuation are any indication. Those decisions are also well understandable in both the historical and prevailing global and Indian environment.

It is pertinent to note here that fair value or mark-to-market (MTM) accounting has been accused, rather unjustifiably, of accentuating (if not triggering) the yet to subside global financial market crisis. This is quite like missing the wood for the trees. For, the marking down of asset values in the balance sheets of global financial institutions such as a Citigroup or Bank of America or an AIG did not spring out of nowhere but was a logical consequence of the underlying (residential mortgages) loans getting into the non-performing category. The cart did follow the horse. With the fundamentals weakening on their own, there was no way that avoiding MTM accounting was going to result in their improvement. In fact, any artificial support to asset values in that scenario could have aggravated the market crisis even more.

Indian situation different

While fair value accounting, therefore, was quite appropriate in the global market place, the situation facing Indian financial institutions and regulators has been qualitatively different.

In the case of banks, while the level of securitised market investments on their balance sheets (a minimum of 24 per cent of their deposit liabilities) is quite sizeable, these investments are almost completely free of credit risk - since they are predominantly government bonds. As for interest rate risk, that has become secondary in the current environment where credit risk has assumed critical significance as it affects the very solvency of the financial institution. (Fair value losses for global banks have actually increased even as central banks have furiously cut interest rates - a clear proof of the dominant credit risk concerns which have been driving asset values in recent times. Even for Indian banks, investments other than government bonds have suffered market value losses in the falling interest rate environment and have been duly recognised).

There is also a moral obligation for government/ the regulator to exempt commercial banks from recognising interest rate risk on their government securities portfolio since the 24 per cent investment is mandated and not by free choice.

Therefore, it is only reasonable that banks which are compelled to invest in government securities (and long duration ones at that) even during the up turn in the interest rates cycle are exempt from recognising (adverse) changes in their value due to interest rates movements. This was the principle behind the Reserve Bank of India's decision in September 2004 to exempt commercial banks from recognising fair value changes (on account of adverse interest rate moves) on their government bonds portfolio up to 25 per cent of their deposit liabilities.

One can note the difference here between the Indian and global situations. Globally, it was actual deterioration in credit quality which drove fair value changes. No such deterioration in credit quality - at least of the government securities portfolio - has happened in India.

Indian government bonds, actually, have gained substantially in value in the past four months on the back of the slide in inflation and the RBI cutting rates. But, the RBI's decision of September 2004 stands and therefore, it is doubtful if many banks were able to capitalise on the recent massive fall in yields - from the 9.50 per cent levels in July-August 2008 to around 5.25 per cent earlier this year - since almost all of them (including some big private sector banks) maintain(ed) their investments portfolio as per the RBI's September 2004 decision. Abiding by that RBI decision meant that value changes in the investments portfolio would be zero or neutral to both rising and falling interest rate scenarios. (Benchmark Indian government bond yields have since firmed up to around six per cent as of mid February).

Banking and insurance regulation

Will the RBI decision of September 2004 to exempt banks from fair value accounting of their government securities continue? Possibly yes.

Indeed, the very fact that the banking regulator has not thought of revising its earlier circular during the last couple of months when interest rates fell quite sharply, tells its own tale. For one, from an interest rates point of view, it shows that the current softness in rates may not be enduring. More importantly, fair value accounting for a portfolio of credit-risk free assets is meaningless as long as those assets can be temporarily liquefied (through Central bank operations such as repos) to meet any liquidity requirement.

This argument appears particularly valid in the current global marketplace. For despite the availability of the instruments and institutions - derivatives exchanges, futures and options markets etc - to hedge against fair value losses, credit losses (both realised and notional) have been so overwhelming that those hedging instruments/ products have not been able to produce adequate offsets. Indeed, those hedging instruments and products are only for normal times.

In India, in the absence of the institutions and products necessary for hedging fair value risk, it is all the more understandable that the regulators do not compel financial intermediaries to practice fair value accounting.

In the case of banks, therefore, given the make up of their securitised assets portfolio (dominated by government securities), fair value accounting does not seem that necessary or important from the regulator's point of view. (From the financial institution's perspective, though, things could be different. But, to have that perspective, the institution should have a superior insight into how interest rates will evolve in the Indian markets!)

Much of the same thinking appears to drive Indian insurance regulation also. The insurance regulator, in recent times, has repeatedly postponed the application of fair value accounting to the (debt securities) investments portfolio of insurance companies for solvency margin purposes. At a conceptual level, the relevance of fair value accounting for life insurance assets has been even questioned given the very long term nature of insurance liabilities.

While the non-adoption of fair value for non-linked business is quite understandable, linked business is a different kind of fish. The daily NAV process in the linked business effectively means adoption of the fair value or the MTM concept. Therefore, the non-application of the fair value concept (to the debt market portfolio) in the overall daily NAV computation could mean that insurance companies were unable to reflect the value gains in the debt market in recent times (referred to earlier) in their published NAVs. Given that high(er) NAVs could be a business booster, the non-adoption of fair value to the debt market portfolio (even in the linked business) could have arguably led to less (linked) business flowing in to insurance companies in recent months. This issue needs to be probed further by the regulator for a fine tuning of the asset valuation norms.

Equity securities, by their very nature, cannot be carried at historical cost. Fair value has to be applied on them. The insurance regulator, IRDA, has recognised this and to mitigate the negative impact on solvency which can be (has already been) caused by weak capital markets, has lowered the "factor" multiples to be applied in the computation of the solvency margin. That is, while nothing much can be done about equity securities held in the investments portfolio on the assets side of the balance sheet, the insurance regulator has tried to ensure that the value loss on the assets side does not erode an insurance company's ability to maintain the required solvency ratios.

Overall, Indian regulators have tried to shield domestic financial institutions from the rigors of fair value accounting given the extraordinary market environment prevailing today and also given some peculiarities in the Indian context. The long term movement, though, should be towards creating the appropriate environment in which Indian finance can apply fair value to its balance sheet.