The Reserve Bank of India (RBI) has developed an Economic Capital Framework (ECF) for determining the allocation of funds to its capital reserves so that any risk contingency can be met and as well as to transfer the profit of the RBI to the government.
There are two clear objectives for the ECF. First, the RBI as a macroeconomic institution has the responsibility to fight any disorder especially a crisis in the financial system. Here, to meet such a crisis, the RBI should have adequate funds attached under the capital reserve.
Second is transferring the remaining part of the net income to the government.
The process of adding funds to the capital reserve is a yearly one where the RBI allots money out of its net income to the capital reserve. How much funds shall be added to the capital reserve each year depends upon the risky situation in the financial system and the economy. The process of allocation of funds is technically called as provisioning (risk provisioning etc.,) to the reserves.
After allotting money to the capital reserve, the remaining net income of the RBI is transferred to the government as profit. Since the government is the shareholder of the RBI, the latter’s’ income (means profit) should be transferred to the Government (Section 47 of the RBI Act).
Here, the determinaton of the amount of money to be provisioned or allocated to the capital reserve (out of the RBI income) is a difficult task. The risk scenario in the economy, the size of the current capital reserve with the RBI including the contingency fund etc are critical in deciding the size of provisioning to the capital reserve. For adjusing or determining the central banks’ capital reserve in accordance with its needs, central banks have a methodology called Economic Capital Framework.
What is Economic Capital Framework?
The ECF is an objective, rule-based, transparent methodology for determining the appropriate level of risk provisions (fund allocation to capital reserve) that is to be made under Section 47 of the Reserve Bank of India Act.
Previously, there were several attempts to frame an ECF for the RBI. But under the changed circumstances, the RBI central board constituted a new committee (under Bimal Jalan) to design an ECF in 2018.
Expert Committee on Economic Capital Framework
The Central Board of the RBI in its meeting held on November 19, 2018, in consultation with the Government of India (Government), constituted an Expert Committee to review the extant ECF of the RBI. The Committee was chaired by former Governor Bimal Jalan. RBI has a sophisticated practice of upgrading capital framework. In the past the Subramanyam Group (1997), Malegam Committee (2014), ECF (2015) and the Usha Thorat Committee (2004) were appointed to make recommendations on the ECF.
Recommendations of the Bimal Jalan Committee on ECF for the RBI
The Expert Committee to Review the Extant Economic Capital Framework was appointed at a time when the transfer of RBI’s net income to the RBI touched 99% for several years. Similarly, several observers opined that the RBI is having surplus capital as it is one of the highest capitalized central banks in the world. The Committee was appointed in November 19 and its report was published on August 28th, 2019.
Following are the main recommendations of the Committee on ECF.
There should be harmony between the interests of the government and the RBI on the design of the ECF.
In its report, the committee stressed the need for aligning the interests of the government and the RBI. The Committee opines that “there always needs to be harmony in the objectives of the Government and the RBI.”
The financial resilience of the RBI should be kept as one of the central banks of the emerging world: “the Committee was of the view that the financial resilience of the RBI needs to be maintained above the level of peer central banks, as would be expected of the central bank of one of the fastest growing economies of the world.”
Whether the RBI’s capital reserve is enough or whether there is a surplus capital reserve with the RBI?
Here, after devising a new methodology, the Committee on ECF found that the available risk buffers (capital available with the RBI) is around 26.8% of the assets. What is required is 20. 8% to 25.4%. Hence, there is a surplus capital reserve with the RBI.
The Committee identified that there is excess realized equity and it ranges from Rs 26280 crores to Rs 62456 cores, as on June 30, 2018.
Figure: RBI’s surplus distribution vis a vis risks provisioning –last 5 years
Role of the CF: Contingency Fund is the real reserve to manage any financial crisis
RBI’s capital reserve has five components. The most important one is the Contingency Fund that is holding bulk of the yearly addition of money from the RBI through provisions. Other three components are just revaluation accounts whereas the remaining asset development fund is meager. It is from the contingency Fund that the RBI is allocating funds to strengthen the revaluation accounts.
The Jalan Committee report recognizes that the Contingency Risk Buffer is the country’s savings for a ‘rainy day’ (a financial stability crisis) which has been consciously maintained with RBI in view of its role as Lender of Last Resort (LoLR).
Following are the five components of the RBI’s capital reserve.
Meeting financial stability risks need more money
The financial stability risks like the Global Financial Crisis is the rarest of the rarest. Here, the Committee recommended that the risk buffer in the range of 5.5 per cent to 6.5 per cent of the RBI’s balance sheet for meeting this risk. But at present, the available level is 2.4 per cent of balance sheet as on June 30, 2018.
RBI’s capital reserves seems to be bigger, because of the revaluation gains of gold, foreign currency etc., and not due to fund allocation to capital reserves from its own profit.
Even if the RBI’s economic capital could appear to be relatively higher, it is largely on account of the revaluation balances which are determined by exogenous factors such as market prices. Nearly 73% of the capital reserves are from revaluation gains and only the rest from equity injection from the government. This is a weak feature of the seemingly high capital reserves of the RBI.
Figure: Components of RBI’s capital reserve
There should be separate treatment for revaluation balances vis a vis equity contribution (realized equity) from the government.
Out of the RBI’s total buffer or capital reserves, nearly 73% comes from the high revaluation of its assets like foreign currency, gold etc. This valuation can fluctuate. On the other hand, the equity contribution from the government (this is actually, the provision of net income of the RBI to liquidity Contingency Fund and Asset Development Fund of the RBI) is the one that really matters (that is just around 27% of the total capital reserves).
The Committee votes for inclusion of the unreliable revaluation accounts as part of risk buffer that can be used to meet contingency situations.
The Committee recommended the inclusion of the revaluation balances (from valuation gains of gold holdings of the RBI etc.) as a part of RBI’s overall risk buffers. At the same time, due recognition should be given to their volatility, limited usability, significant strategic and operational constraints on their monetization.
The revaluation balances can’t be used in an emergency situation since, the gold, foreign currency assets etc can’t be sold overnight or their selling has strategic issues. Hence, the only component of the capital reserve is the Contingency Fund.
Measures to address the volatility of the revaluation accounts should be designed.
What are the types of risks which the RBI should consider while determining the size of capital reserves?
The Committee identified different types of risks for the RBI:
- Currency risks (since the RBI keeps huge volume of foreign currency assets),
- Gold Price Risk (RBI has gold reserves)
- Interest rate risk (RBI holds government securities)
- Credit risk (bonds and loans to the commercial banks)
- Operational risks (due to any potential operational problems)
- Monetary and Financial stability risks (due to weaknesses of the financial institutions like banks, liquidity problems
The Committee observed that there are no significant threats from some of the risks. Hence the Committee suggested keeping reserves to meet the following type of risks.
(i) Monetary and financial stability risks
(ii) Credit risk
(iii) Operational risk
(iv) A shortfall, if any, in revaluation balances vis-à-vis market risk.
Methodology of finding the risk level and thus to determine the amount of capital reserves
To keep the financial resilience of the RBI regarding the maintenance of capital reserves, the RBI adopts Expected Shortfall (ES) Methodology to measure the market risk (and thus to decide the amount to be kept as capital reserves).
- ADF can be used as risk provision: Asset Development Fund should also be considered as a risk provision if needed.
- Balance sheet of the RBI to be reformatted: The Committee recommended for the reformatting of the balance sheet of the RBI slightly.
Emergency Liquidity Assistance (ELA) will be riskier if there is high level of NPAs
The Committee observed that providing emergency money to banks will be riskier if banking sector has higher level of non-performing asset (NPA).
ELA is a crisis time financing given by a central bank to financial institutions including banks who need temporary liquidity needs.
On ELA, significant credit risk can arise from ELA operations during periods of stress. RBI can face ELA losses, even when though major part of the banking sector is in the public sector. Losses can occur when ELA support is provided to private sector banks.
Government ownership has prevented runs in the banks; still recapitalisation is burdensome.
According to the report, large public sector ownership was a positive factor preventing bank runs in the past. But the rise of NPAs has increased recapitalisation by the government.