A vital functionality of central banking is to rescue the financial system from any crisis by keeping vigil on regulation, supervision and by extending funds to the needy institutions and sectors. Financial stability -the goal of preserving and maintaining financial institutions including banks safe and healthy is the most difficulty responsibility of central banks. Instances from recent times shows central banks constantly facilitating rescue of banks whenever they faces crisis. This is often done by providing liquidity assistance and in rare cases, the Lender of Last Resort (LoLR) support when a particular bank collapses.

All these indicates that the central bank itself need required level of funds on its own to assist financial institutions. How the central bank gets funds for supporting the financial institutions? Sometimes people holds a misunderstanding that central banks have enough newly printed currency to help the failing financial institutions. But this is not the case. Each rupee printed by the central bank is supplied only in accordance with set policies. Actually, the central banks keeps own funds in the form of capital reserves to assist other institutions.

The central bank is exactly like a commercial bank. The balance sheet and behaviour of the central bank is a replica of commercial banks. Like commercial banks, central banks also get profit from their day to day operations like providing short term loans (VRR, MSF) to other financial institutions and temporary loans to the government. In these operations, the RBI gets sizable profit. These profit over its expenditure is considered as income. A part of this income created is allocated to its reserve fund under Contingency Facility (CF) and Asset Development Fund (ADF) through a process called provisioning. Since the amount allocated to these two funds are done on the bases of the risk factors that is prevailing in the financial system, the activity of providing funds to CF and ADF is called risk provisioning.

Now, the central banks considers and measures several types of risk like financial stability risk, monetary risk, credit risk etc. and determines the amount of funds to be kept aside as reserves to meet such risks. The risk meeting amounts for each type of risk is scientifically estimated suing risk parameters and for this specific committees are formed. In India, such committees are formed historically and the latest one is the Committee on Economic Capital Framework under the Chairmanship of Bimal Jalan.

The Bimal Jalan Committee’s main task was to determine the Economic Capital Framework or the method of estimating the capital or funds to be kept by the central banks to meet contingency situations. Once such amount is estimated and expressed as a percentage of the balance sheet (assets or liability of the central bank), every year, funds are to be provided to the reserves based on risk parameters. This activity is called risk provisioning and the funds are allocated from the yearly income of the central bank to two important contingency funds of the RBI called CF and ADF. The most important point of this determination and allocation is that the remaining part of the income (after allocating to Contingency Reserve Buffer) can be estimated as surplus and can be transferred to the government as the RBI is fully owned by the government. Such a surplus transfer is done on an annual basis, after the recommendations of the RBI’s Central Board.

Now, the job of determining the surplus transfer amount to the government is automatically determined once the provisioning to the as CRB is estimated.

For 2022-23, the RBI Central Board has transferred an amount of Rs 2,10,874 crore. This is a huge amount given the transfer history of recent years. This windfall gain will considerably help the government to manage fiscal deficit as well as augment public expenditure in the next budget.

The surplus distribution policy

The funny and interesting side of the relationship between the RBI and the government is that the government being the owner of the central bank, has the right to get all the surplus (profit) from the RBI. As we mentioned, the surplus should be transferred to the government only after making (risk) provisioning (allocating) funds to the RBI’s capital reserve in the form of a scientificllay determiend pool known as Contingency Reserve Buffer. To understand the full meaning and workign of the buffer components like CF and ADF got to another article.

Historically, the estimation of the allocation of funds were governed by the recommendations of expert committees formed by the RBI. Now, teh latest committee on that was the Bimal Jalan Commitee and the surplus transfer policy is governed by the Recommendations of the Bimal Jalan Committee on Economic Capital Framework.

Regarding surplus distribution, the Committee recommends that the RBI move away from the previous SSDP (Staggered Surplus Distribution Policy), towards one which compares the ‘available realized equity’ (ARE), i.e., Capital, Reserve Fund, CF and ADF, with the ‘requirement’.

The Committee recommends that the surplus distribution policy should move away from targeting total economic capital alone, to one where it has a dual set of targets:

(i) The total economic capital of the RBI.

(ii) The level at which realized equity (Realised equity is comprised of Capital, Reserve Fund, Contingency Fund [CF] and Asset Development Fund [ADF]) is to be maintained.

The Committee’s recommendation here is determination of surplus after making the risk provisioning under Contingency Reserve Provisioning (CRB). Here, the committee suggested that the distribution policy should be guided by the maintenance of available realized equity’ (ARE). Here, the Committee stipulated that the desired ‘ARE’ would be required to lie within the range of ‘requirement’ of 5.5 to 6.5 per cent under CRB. Provisioning should be made to keep this ARE level and the remaining can be forwarded as surplus to the government.

The Committee has recommended a surplus distribution policy which targets not only the total economic capital (as per the extant framework) but also the realized equity level of the RBI’s capital. Realised equity is comprised of Capital, Reserve Fund, Contingency Fund [CF] and Asset Development Fund [ADF]. The Committee, recommended that, in effect, the surplus distribution policy will be required to target the ‘required realized equity’ (requirement) for covering:

(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.

An important component of the Birecommendation was the surplus distribution policy to be followed by the RBI.

What is Contingent Risk Buffer (CRB)? What is the level of CRB to be maintained?

Contingency Risk Buffer is the provisioning of funds for meeting potential risk related to the various risk categories. The Committee recommends that the minimum level of realized equity to be maintained should be the sum of the monetary and financial stability risks, credit risk and operational risk. The required risk buffers for these are shown in the table.

Usually, the CRB is expressed as a percentage of the balance sheet of the RBI. As per the recommendations of the RBI, the CRB should be maintained between 5.5 % to 6.5 % of the balance sheet. Here, the risk provisioning is mainly a cushion for two vital components -both financial stability as well as monetary stability risks. The Committee recommends that the size of the monetary and financial stability risk provisions should be maintained between 4.5 to 5.5 per cent of the balance sheet. The remaining provisioning is for other type of risks. Now, this policy on CRB determines the risk provisioning needed and the amount of surplus transferred to the government. The Committee suggested an average risk provisioning over the five-year period of 2018-19 to 2022-23 for CRB of 5.5 and 6.5 per cent of the balance sheet. It is to be remembered that the committee’s recommendation time period for this is five years.

Type of risk Required risk buffers under the ECF (as a % of the balance sheet)
Market Risk 18.9
Financial and monetary stability risk 4.5 to 5.5
Credit risk 0.6
Operational risk 0.3
Total risks/risk buffers 20.8 to 25.4

As the lowest estimate of RBI’s LoLR (Lender of Last Resort) risk is 4.6 per cent and the sum of credit and operational risk is 0.9 per cent, the lower bound of the CRB is to be maintained at 5.5 per cent with an upper bound of 6.5 per cent. The CRB requirement has been rounded-up from 5.4 – 6.4 per cent to 5.5 – 6.5 per cent, as the lowest estimate of RBI’s LoLR risk is 4.6 per cent and the sum of credit and operational risk is 0.9 per cent. Thus, the lower bound of the CRB is to be maintained at 5.5 per cent with an upper bound of 6.5 per cent.

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