ANALYSIS OF HELD TO MATURITY SECURITIES INVESTMENT UPWARD TREND

RELATED TO BASEL III REGULATION IN INDONESIA

Ari Kuncara Widagdo and Agil Ilman Rezadi

Faculty of Economics and Business, Universitas Sebelas Maret, Indonesia

Abstract

Purpose – The purpose of this paper is to find the cause of Held To Maturity (HTM) securities

investment upward trend phenomenon in Indonesia at the moment of Basel III regulation began to

be applied.

Methodology – We analyze the trend by making HTM securities graph of Indonesian banks. The

trend then compared with the graph from United States that happened earlier. The result then

confirmed through interview with the regulator dan bank.

Findings – The result showed that there may be a relationship between the HTM securities upward

trend and Basel III regulation. The bank said that the relevan aspect related to the upward trend

should be liquidity coverage ratio (LCR) rules. However, the regulator declare a doubt because of

two things. Firstly, the capital adequacy ratio of Indonesian banks is more than enough so the

impact will be minimum. Secondly, the respond from banks toward Basel III regulation should be

premature because the application of Basel III regulation related to OCI rule had just applied in

September 2016.

Keywords : HTM Securities, Regulatory Capital Requirement

Management, Basel III Regulation, OCI, LCR

JEL Classification : G11, M41

Introduction

The hot topics discussed in media such as Bloomberg, CFA Institute, Reuters and Wall

Street recently are the increasing use of held to maturity (HTM) securities in United States banks.

Here is a graph of HTM securities investment trend per year 2000-2016 that comes from the US

central bank:

As seen in the graph, the global economic crisis in 2008 is very influential on the investment

market that appears to occur turmoil in the period 2007-2009. On the other hand, it turns out that

this period is the beginning of the upward trend of HTM securities. Perhaps in terms of percentage

is still quite small from the position of 1% of total assets, now become 4%, but this value is jumped

many times over the previous years.

In times of crisis, interest rates on securities tend to rise so that securities will lose their

value. This situation makes investment into HTM securities become more attractive because it can

avoids the recognition of losses. For banks, this is more enticing because under the Basel III

regulation, this impairment loss affect not only the other comprehensive income (OCI) but also

reduce the regulatory capital.

Unfortunately, the research of Barth, Gomez-Biscarri, Kasznik, & Lopez-Espinosa (2014)

didn’t conduct on HTM securities and only stated that HTM securities may be used as regulatory

capital management tools by selling them prior to maturity although could broke against accounting

rules as stated in FASB accounting standard codifications topic 320. In Indonesia is ruled by

tainting rule in PSAK 55. The sale itself is very rare. Barth et al. (2014) only focus on AFS

securities that used as a tool for regulatory capital management.

In fact, the sales of HTM securities in the era of the Basel regulation occurred, namely when

Citigroup reclassified its HTM securities in 2011. The sale of HTM securities should not be easy

and must meet many requirements. Surprisingly this sale is approved by the regulator. This incident

will provide foothold for other banks that selling HTM securities isn’t as complicated as the rules

(Alloway, 2011).

Many observers of capital markets such as Wire (2014), Levine (2014), Vickery, Deng, &

Sullivan (2015), Shenn (2014), Alloway (2011), Rapoport (2015), Rudegeair (2013), Henry (2012),

and Papa (2015) analyzing the upward trend. Their analysis stated that this trend can be defined as

accounting twist, accounting switch, capital avoiding, or regulatory arbitrage. No one has said that

this trend is a regulatory capital management technique yet because there is not any practice of

selling HTM securities that violate accounting principles. They also argue that it is very difficult to

prove the intention of investing in HTM securities. Banks may intend to hold it into maturity,

intending to avoid possible losses, or may be also intended as a securities buffer that can be traded

in an emergency to meet Basel III regulatory requirements.

This paper focuses on the increasing trend of Indonesian banking HTM securities which

may be affected by the OCI rules in Basel III regulations. Basel III regulation itself has been

enacted in all G20 member countries including Indonesia. Although the implementation is slower

than other countries such as the United States, researcher feels that the Basel III regulation will have

the same impact on banks in Indonesia.

Literature Review

Regulatory Capital Management

Management regulatory capital is a form of earning management by recognizing, avoiding,

or neglecting a transaction that may affect the value of regulatory capital. It is not always in the

form of cheating and violation, but also in a positive way that is more on the opportunities that

appear in alternative rules in accounting and regulation. According to Rahmawati, Suparno, &

Qomariyah (2006) earnings management can be defined as an effort of manager flexibility to

protect themselves and company in anticipation of unexpected events.

In this paper, the management of regulatory capital is defined as a manager effort to avoid

the risk of unrealized loss on AFS securities. The regulator asks banks to increase regulatory capital

and some buffers but managers prefer to fulfill it by investing in secure HTM securities. However,

according to Zack (2009) the use of HTM securities with the intention of not holding it into

maturity is classified as fraud risk related to fair value.

Basel Regulation

Basel Regulations are prepared by Basel Committee on Bank Supervision (BCBS). BCBS

can be regarded as the world's central bank, especially in the G20 countries. Established in 1974 in

Basel, Switzerland, BCBS is responsible for strengthening bank regulation, supervision and practice

with the goal of improving financial stabilization. BCBS then issued several regulatory packages

namely Basel I, Basel II, and the last Basel III. This regulation provides banking recommendations

for capital risks, market risks, and operational risks. The goal is to ensure banks have sufficient

capital to meet all obligations and absorb unexpected losses that may arise (Caturini, 2016).

Basel III Regulation

Since the global financial crisis in 2008, banking industry and regulators underwent

considerable pressure. It is began by the fall of several major banks such as Lehman Brothers.

Finally, BCBS decided to renew Basel regulation in 2010. This regulation provides additional

requirements to financial institutions that have a systemic influence on the world banking industry

in form of capital structure change, capital conservation buffer, countercyclical capital buffers, and

liquidity management in form of Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio

(NSFR). Increasing the minimum tier I capital ratio from 4% to 6% and requirement of the

minimum common equity from 2% to 4.5%. One that distinguishes Basel III from the previous

rules (Basel II) is the elimination of capital filters so that the value of Accumulated of Other

Comprehensive Income (AOCI) affects the value of regulatory capital. The implementation of

Basel III in Indonesia has started gradually since 2013, and expected to be fully implemented by

2019.

Regulatory capital is the minimum capital requirement that must be met by banks based on

Basel regulations. Regulatory capital consists of tier I and tier II. Tier I is a major capital

component consisting of common stock, retained earnings, AOCI, and noncontrollable interest. Tier

II is a complementary capital (OJK, 2016). For banks, keeping the regulatory capital value healthy

is as important as keeping the value of profit. Regulatory capital is the basis for regulators to

oversee the health of banks and standard in providing some incentives to the bank.

A simple calculation of capital in accounting is to calculate the difference between assets

and liabilities. However, the calculation of regulatory capital based on Basel III regulation is

different. The difference is seen by not recognizing some account that ultimately reduce the value of

regulatory capital. The components are goodwill, intangible assets, deferred tax assets, investments,

allowance for uncollectible assets on non-earning assets, some allowance for impairment losses, and

others.

High Quality Liquid Asset (HQLA)

A liquid asset can be classified as high quality if the ability to generate cash, either through

sales or repurchase agreement (REPO), will remain intact even in the idiosyncratic and market

stress periods (OJK, 2014). Low quality assets usually fail to meet this test. Under stressful

conditions, low quality assets are easy to lose in value quickly.

Some of the fundamental characteristics of HQLA include:

a. low risk (low duration, low legal risk, low inflation risk, and low exchange rate risk);

b. have an easy and sure assessment method;

c. has a low correlation with risky assets;

d. listed on a recognized exchange;

e. has an active market;

f. low volatility.

In the Basel III regulation, HTM securities is included in HQLA. Though HTM securities

cannot be said to have a low duration. Instead HTM securities should be intended to be held to

maturity, but in the business view such rigid rules are so unfavorable so that the existence of REPO

transactions and the inclusion of HTM securities into the HQLA category greatly facilitates the

business process but can taint accounting principles.

Buffer in the Basel III regulation means an additional reserve of capital that is intended to

address possible financial risks in the banking industry. Banks treating HTM securities as buffers

may also potentially taint accounting. Like REPO transactions, treating HTM securities as buffers is

not appropriate because since the beginning, HTM securities should be intended not to be traded

until maturity and emergency tools. If banks want to use it as buffer and keep an eye on uncertain

market conditions then the most appropriate choice in accounting is investing in AFS securities.

Previous Research

Research on HTM securities is very rare due to its unflattering characteristics and

accounting treatment. However, at the time of the Basel III regulation rolled out, there was a

significant increase as if Basel III regulation greatly influenced managers' decisions to choose

investing in HTM securities.

Unfortunately, there is not a single research that examined this phenomenon. Researchers

only found qualitative research from Black (2015), the source documents from the Department of

Treasury USA (2013), and many opinions from economic observers.

Research Method

The research method used is qualitative research. The preliminary study is derived from

secondary data of banking financial statements in Indonesia for period 2007-2016. The result can

provide an early picture that the phenomenon occurred in the United States was also happening in

Indonesia, but the data cannot be interpreted exactly whether the cause of the increasing trend is

Basel III regulations as alleged by many economic observers.

Furthermore, researchers collect official documents, literatures, and additional data

contained in the internet. Subsequently, information obtained through secondary data and written

documents is drawn conclusively and clarified through interviews with the OJK as regulator and

bank as the user.

Result and Discussion

Analysis the trend

Graph 2. Comparison of HTM Securities Trends in America and Indonesia

2007 2008 2009 2010 2011 2012 2013 2014 2015 20160

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10

12

14

16

INDOUSA

As a preliminary analysis, researchers compared the trend from USA and Indonesia. The

result can be seen in Graph 2. The graph shows HTM security value based on the percentage with

total assets owned by banking. If the graphs are analyzed there are some similarities. In the United

States, the upward trend began in 2011 at 1% percentage of total assets and then increased to 4% in

2016, while in Indonesia, the upward trend began in 2012 at 2% percentage of total assets and then

increased to 6% in 2016. Then if it is associated, in year 2011-2013 is the period of application

Basel III regulation. It can be interpreted that the trend of increasing HTM securities has

relationship with the implementation of Basel III regulations.

A trend can be caused by various factors. This graph is also inseparable from various

reasons. The causes are include HTM securities market interest rates that may be favorable, the

fulfillment of bank liquidity strategies or management practices to achieve the minimum regulatory

capital requirements. However, researchers have not found convincing answer to this phenomenon.

A tentative conclusion that can be taken that there is relationship between HTM securities upward

trend and Basel III regulation being applied in Indonesia. Additionally, this trend could mean

regulatory capital management to avoid fluctuations in interest rate changes that could interfere the

achievement of minimum regulatory capital requirements.

Analysis from written document

Based on source documents and additional data obtained, the researcher concludes that this

phenomenon is inseparable from the influence of Basel III regulation. OCI that affect the

calculation of regulatory capital are perceived to have unfavorable risks for banks. Unrealized

losses on the OCI is just loss on paper that have not really realized. This value also does not really

reduce the profit. However, this value represents the company's current economy.

The rules of OCI in the Basel III regulation have the potential to have an impact that

complained by banks. Based on data from the Department of Treasury USA (2013: 82059)

mentioned that:

“To address the potential impact of incorporating the volatility associated with AOCI into regulatory capital, banking organizations also noted that they could increase their overall capital levels to create a buffer above regulatory minimums, hedge or reduce the maturities of their AFS debt securities, or shift more debt securities into their HTM portfolio. However, commenters asserted that these strategies would be complicated and costly, especially for smaller banking organizations, and could lead to a significant decrease in lending activity”.

The document states that the rules of OCI in the Basel III regulation will make the bank

invest in securities with lower volatility because the OCI component is highly vulnerable to changes

in market interest rates. This condition is very unfavorable since the unpredictable situation during

the global crisis in 2008. The relationship of this trend with Basel III regulation is clarified by a

statement from Wall Street Journalist Rapoport (2015), who stated that:

“The trend is likely to continue, analysts said, partly because Basel III requirements encouraging banks to hold more liquid securities still are being phased in”.

Similarly, the opinion of Wire (2014) which states that:

“The greatest shift has been at US banks as new Basel III rules on unrealized gains and losses on AFS flowing through regulatory capital. They are likely transferring securities from AFS to HTM to avoid a build-up of unrealized losses in accumulated other comprehensive income (AOCI), which will be included in the common equity tier 1 calculation starting in 2015”.

This conclusion is reinforced by Vickery et al. (2015) stating that:

“Finally, a notable recent market trend is the shift in bank portfolios toward HTM securities, What explains this trend? A key difference between HTM and AFS is the accounting treatment of gains and losses. Gains and losses in the value of HTM securities that result from movements in market prices aren’t recognized unless the asset is sold. For AFS securities, however, such shifts in value, while not affecting accounting income, do affect the measurement of regulatory capital adequacy under the Basel III framework”.

Bloomberg economic analyst Levine (2014) explains that banking intention of investing in

HTM securities may not violate the rules of Basel III, but posing the risk of tainting the principles

in accounting. As he said:

“So why not classify your liquidity buffer as held-to-maturity, that is, as bonds that you plan to hold on to forever? You tell your accountants "we never plan to sell these bonds," and you tell your regulators "well we can always sell these bonds in an emergency." You treat the same thing in opposite ways”.

The sale of HTM securities without violating the principles in accounting has been

facilitated through REPO transaction to accommodate when banks require funds in an emergency.

However, this does not mean that the intention of investing in HTM securities from the start

becomes a tradable or in-REPO purposes in times of emergency. If banks indeed intend to do such a

thing, banks should invest in AFS securities. Zack (2009) in his book Fair Value Accounting Fraud:

New Global Risks and Detection Techniques even stated that this kind of action is a fraud risk

because it meets one of the criteria he mentioned:

“A debt security being misclassified as held-to-maturity when in fact management no longer intends to hold the security to maturity or considers it to be available for sale in response to changes in market conditions”.

REPO transaction itself has a notable record because this transaction has a high fraud risk.

One example is the collapse of Lehman Brothers. Within the company there is a high asset mark-up

because the securities that have been sold by REPO are not recorded by the seller's obligation to

buy it back.

Difference Trend in Types of Banking

The increasing trend of HTM securities may have different patterns among different types of

banks. Banks with small capital are expected to have the most significant impact.

Graph 3. Securities Trends of Indonesian Small Capital Banks Period of 2007 -2016

AFS HTM TRD0

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Sum of 2007Sum of 2008Sum of 2009Sum of 2010Sum of 2011Sum of 2012Sum of 2013Sum of 2014Sum of 2015Sum of 2016

If analyzed, according to Graph 3. above, the increasing trend of HTM securities investment

looks significant and began to emerge in 2012. This is different from the graph of large banks in

Indonesia which has total assets above 100 trillion rupiah. In accordance with Graph 4. the trends

that occur in large banks are not very visible. Even the value of HTM securities can be said to be

relatively stable over time. Large banks are also seen to have larger AFS securities. This provides

widespread space in the securities business stratefy and is less affected by the Basel III regulations.

Graph 4. Trend of Large Bank Capital Securities Period of 2007 -2016

AFS HTM TRD0

1

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5

6

7

8

9

10

Sum of 2007Sum of 2008Sum of 2010Sum of 2009Sum of 2011Sum of 2012Sum of 2013Sum of 2014Sum of 2015Sum of 2016

Analysis data from the Regulator

The temporary conclusion then clarified to the regulator. It turns out that the conclusions

drawn by researcher is different, although regulator do not deny that there is likely to be any effect

of the Basel III regulation on the trend of HTM securities. However, this conclusion requires further

research. Based on the results from interviews, researcher gets the information that it seems that the

trend is not likely caused by the Basel III regulation as the phenomenon that occurs abroad. The

regulator expressed his doubts because of two things. Firstly, the regulator believes that the capital

adequacy ratio of Indonesian banks is very high, causing the impact related to capital would be

minimum. Secondly, the concrete response from the bank should not be occured because Basel III

regulation related to the new OCI rules had just applied in September 2016. Generally, banks in

Indonesia focus more on their own business. When a new regulation is implemented, banks just

start to respond. They do not look at trends that occur overseas.

Additionally, the comparison of trends that occurs between large and small banks are also

confirmed to the OJK. The result turned out that this grouping data is considered to have a large

disparity so it cannot be used as a guide in concluding a certain trend. As Faisal M. Issom, as

Deputy Commissioner of OJK Banking Supervisory stated that:

"Smaller banks have limited capital and capabilities. They do not have enough human resource and tools to manage AFS securities that have a greater risk. Then if we compare the small banks, private banks, and government banks, they have quite big disparity".

Analysis data Clarification from Banks

The temporary conclusions of the researcher also clarified to the banks through interviews.

The results are quite different compared with the statements from the regulator. In general, the bank

stated that the possible cause of this HTM securities upward trend is not caused by the rules of OCI

in Basel III regulation. In addition, inspite of the OCI rules there is another aspect in the Basel III

regulation that is likely to cause this trend.

The banks declared conclusively that there is no significant influence between the rules of

OCI in the Basel III regulation and the increasing trend of HTM securities because the OCI rules in

the calculation of regulatory capital tier I can be offset against retained earnings components that

also included the regulatory capital tier I calculation. Although there is a risk of unrealized loss on

OCI, but securities also generate interest income that will calculated through retained earnings that

will compensate for the unrealized losses incurred. A more influential factor is the rules of LCR in

the Basel III regulation. As Albert Alberami said that:

"Actually, in the Basel III regulation, there are many aspects. In addition to OCI rules there are rules of LCR, NSFR, buffer and others. In my personal opinion, the rules of OCI are not solely influential. The more influential factor to this trend is the LCR rules because the HTM securities are included in the LCR calculation, making it more secure as a buffer. The classification of HTM securities as HQLA on LCR calculations may be causing this upward trend not because of OCI rules".

Albert Alberami, as Head of Banking Asset Management of Bank Negara Indonesia also

confirmed that the rules of the LCR in the Basel III regulation that include HTM securities as one of

the HQLA component in the LCR calculations may oppose the accounting. HTM securities cannot

be said to be liquid in accounting point of view, but based on Basel III regulations this securities

can be said to be liquid because it meets its definition that can be converted through REPO

transaction. In accordance with his statement:

"Yes, liquid does not mean always sold. Liquid means easily converted into cash. The mechanism can be sold, REPO, and collaterized ".

Then, the comparison of trend that occured between big and small bank also confirmed to

the bank. As a result, smaller banks with high HTM securities trend are suspected to be affected

also by the LCR rules on Basel III regulations.

Conclusion

Based on graph analysis, written documents, and interviews, researcher unable to conclude

whether the upward trend of HTM securities in Indonesia is related to Basel III regulation or not.

Based on confirmation from OJK, the influence of Basel III regulation related to OCI rules is still

premature.

Based on the confirmation from the bank, if the trend of HTM securities increase is indeed

happening then the relevant rules of Basel III Regulation that may be related are the rules of the

LCR not the OCI rules. LCR rules require banks to create buffers by holding certain assets

classified into HQLA to meet the cash outflow risk over the next 30 days. HTM securities that

belonging to HQLA are considered to be an attractive option because they are safer in market to

market, while OCI rule is considered to be less relevant as it can be compensated with retained

earnings component which is also component of regulatory capital tier I.

Although researcher cannot conclude the effort of regulatory capital management in this

trend, Levine (2014) says that this trend contains the aspect of regulatory capital management.

Banking can choose what accounting alternative will be used as his opinion that said:

“The economic loss is the economic loss, but the accounting treatment varies from "recognize the economic loss immediately" through "recognize it for some purposes but not for others" all the way to "ignore it in all ways forever." And you get some choice about what accounting treatment you'll use”.

Additionally, banking representative Albert Alberami confirmed that there is a difference in

the treatment of HTM securities between accounting and HQLA in the LCR rule of Basel III

regulations. Based on accounting, HTM securities cannot be said to be liquid, but based on Basel III

regulations, HTM securities are included as liquid assets because they can be converted through

REPO transactions. This difference in treatment makes HTM securities an attractive option because

these securities are no longer intended to be held up to maturity, but to be intended to comply with

LCR rules, secure from fair value assessment, and liquidity purposes through REPO transactions.

Regulatory capital management efforts also appear to be vary according to the bank type.

Small banks appear to be more significant to do this trend and the bigger bank seems less affected

by this change of regulation.

In this paper, researcher focused on matching the upward trend of HTM securities in

Indonesia with the OCI rules in Basel III regulation. The rules in the Basel III regulation itself have

many aspects. Based on the results of interviews with banks, this study should be more relevant by

matching the upward trend of HTM securities and LCR rules in Basel III regulation. Researcher

expect that the future research need to focus more on this trend relationship with the rules of the

LCR in the Basel III regulation.

In accordance with a statement from Black (2015) that this phenomenon is interesting to

investigate. Differences in accounting treatment in general compared with the Basel III regulation in

calculating the value of capital will likely create many new forms of business strategy. Differences

in recognition of OCI, intangible assets, deferred tax assets, and so on make the practice of

regulatory capital management more creative. Capital market observers Levine (2014) have even

predicted the practice of selling deferred tax assets to cash in order to increase the value of

regulatory capital.

Lastly, the researcher want to give advice to the regulator related to the trend. Although

regulators have doubts as to whether or not there is a correlation between HTM's securities upward

trend and Basel III regulation, regulators should take a closer look at this phenomenon. Regulators

should not be careless although the banking capital adequacy ratio in Indonesia shows very good

value. Regulators should consider and observe that similar trends are taking place abroad in

response to the Basel III regulation so that the regulator becomes ready and prudent in

implementing Basel III regulations.

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