Economic Capital Framework

Economic Capital Framework

News:

Reserve Bank of India (RBI) has formed a six-member expert committee to study its economic capital framework headed by Former RBI Governor.

Important Facts:

Need of the Panel.

• The government felt that the RBI’s reserves exceeded its requirements and these could be used for productive purposes such as recapitalizing public sector banks.
• The issue of reserves had generated tension, with former governor Patel strongly opposed to any transfer of surplus funds. The RBI had transferred Rs 50,000 crore to the government in June.

Functions of the Panel

• The Expert Committee on Economic Capital Framework will suggest adequate level of provisions, reserves and buffers to be held by the RBI, and determine whether they are held in surplus or deficit by the central bank.
• To suggest an adequate level of risk provisioning that the RBI needs to maintain.
• To determine whether the RBI is holding provisions, reserves and buffers in surplus / deficit of the required level of such provisions, reserves and buffers.
• To propose a suitable profits distribution policy taking into account all the likely situations of the RBI, including the situations of holding more provisions than required and the RBI holding less provisions than required;
• Any other related matter including treatment of surplus reserves, created out of realized gains, if determined to be held.
• The Expert Committee will submit its report within a period of 90 days from the date of its first meeting

Six-Member Panel:

• The six-member expert panel will be headed by former RBI Governor Bimal Jalan. Former Deputy Governor Rakesh Mohan has been named the vice chairman of the committee.
• This will be the first time a panel on RBI’s economic capital framework will have government representatives
• The previous three were headed by YH Malegam, Usha Thorat and V Subrahmanyam.

Government Demand

• The government felt that the RBI’s reserves exceeded its requirements and these could be used for productive purposes such as recapitalizing public sector banks.
• The reserves are meant for unforeseen contingencies, including depreciation in the value of securities, risks arising from exchange rate operations and other systemic challenges.

How does RBI build its reserves?

• The reserves with the RBI accumulate due to several factors.
  • First is its income from three sources: interest on government bonds held for conducting open market operations; fees from government market borrowing programme; and income from investment in foreign currency assets.
  • Second source is earnings retained after giving dividends to government.
  • Third source is revaluation of foreign assets and gold.
  • The RBI needs adequate capital reserves for monetary policy operations, currency fluctuation, possible fall in value of bonds, sterilization costs related to open-market operations, credit risks arising from the lender of last resort function and other risks from unexpected increase in its expenditure.

Is there a right level of reserves?

• The RBI Act does not specify the amount to be transferred to the government. There is no consensus on the right level of capital for a central bank. Unlike a private bank, a central bank can work with a negative net worth too.
• RBI transfers the surplus to the government after keeping all provisions and contingency buffers, according to its statutory mandate under Section 47 of the RBI Act

How government could gain

• If the RBI agrees its reserves are in excess or adequate, the government can gain in two ways.
  • If the RBI does not set aside more in funds, the government going ahead will get more from RBI every year as dividend.
  • In case RBI liquidates reserves deemed excess, the current government gets one-time big cash inflow from the RBI as it sells some of its assets. However, the legality of this liquidation is not clear yet.

Global Practice:

• Every country has its own way of handling the issue of central bank capital. For example, the Bank of Korea is not only legally bound to transfer 30% of its annual profits to statutory reserves but also has a right to call for more capital from the South Korean government when it feels the need to bolster its balance sheet.
• The Singapore constitution says that the Monetary Authority of Singapore has the responsibility to safeguard accumulated reserves which were not added during the term of the current government.
• Like in India, central banks in both the UK and US decide after consultations with the government. But in Japan, it is the government that decides. By and large, with a few exceptions, the quantum of surplus transfer averages around 0.5% of the GDP.