Size of Contingency Fund: Where govt, RBI disagree: 

Size of Contingency Fund: Where govt, RBI disagree:

Context

• Centre was in talks with the RBI over the transfer of its surplus. The surplus sum transferred from earnings during 2016-17 was Rs 30,659 crore, less than half of the Rs 65,876 crore transferred the previous year. However, the government expected more.
• Part of the reason for the smaller surplus was the RBI’s setting aside Rs 13,140 crore for its Contingency Fund (CF), a provision that was not made last year.

The issue

• The government is of the view that there are no special risks to the central bank and the RBI should transfer the surplus earning to the government instead of setting aside a part of it for its contingency reserve.
• The government is in talks with the RBI for the transfer of the payout over and above the surplus the RBI had already transferred to it.
• The question is, what level of reserves should a central bank keep to tide over extreme financial disruptions?

Government’s view

• The government’s view has been that compared to many other central banks in the world, the RBI has been earmarking amounts far in excess of what is needed to maintain its credit-worthiness.
• Also, the government argues that as the owner of the Indian central bank, the sovereign would infuse more capital (or recapitalise) if at all the RBI’s balance sheet were to be impacted.
• It seems like the Ministry may be working on a benchmark to compare the RBI and other central banks.
• Chief Economic Advisor Arvind Subramanian has in the past made out a case for utilising the RBI’s reserves to provide capital to state-owned banks.

RBI’s view

• The RBI bases its assessment on an economic model — a risk management framework, which it has adopted to calculate the level of reserves that need to be maintained.
• Former RBI Governor Raghuram Rajan has said that based on the results of a sophisticated risk analysis by RBI staff, the board of the central bank had decided over the last three years that an equity position (including reserves) of around Rs 10 lakh crore was adequate.
• Rajan has argued against the transfer of a special dividend to the government over and above the surplus — it just amounts to putting back into the system the money the RBI made from it.

Conclusion

• The RBI’s approach on bolstering its reserves may be guided by a desire to ensure that it does not have to approach the government for capital at any time. Strengthening its balance sheet in preparation for a black swan event could be its way of protecting its independence from the government.
• It will be interesting now to see how the arguments progress, and which view prevails finally. With the accounts for the year having been finalised and adopted, it would be extraordinary if the central bank approves a payout over and above the surplus.

What is a contingency fund?

• A contingencies fund or contingency fund is a fund for emergencies or unexpected outflows, mainly economic crises.

Contingency fund in India

• The Constitution of India authorized the parliament to establish a contingency fund of India. The Contingency Fund of India is established under Article 267(1) of the Indian Constitution. Accordingly, Parliament enacted the contingency fund of India Act 1950.
• However, the contingency fund maintained by the RBI is different from the mentioned above.

Funds maintained by the RBI

• RBI maintains a contingency reserve for meeting unexpected and unforeseen contingencies.
• RBI also maintains Asset Development Reserve, created in 1997-98, to meet the internal capital expenditure and make investments in its subsidiaries and associate institutions.

Why RBI needs to maintain contingency funds:

• The RBI says the CF is meant for unforeseen contingencies including depreciation in the value of securities, exchange guarantees and risks arising out of monetary or exchange rate policy operations.
• It is basically a buffer against valuation losses on bond holdings or foreign exchange assets in the event of a rise in interest rates or appreciation of the rupee.
• The Fund would also be helpful in a “black swan” event — such as the collapse of Lehman Brothers or of local banks that may threaten financial stability.
• RBI has got wide area of responsibilities, and hence it is at greater risks.
• RBI may require recapitalisation, precisely at a time when the fiscal position is under strain, say, due to a financial crisis.
• According to central bankers, since RBI is also the lender of last resort, it needs to maintain a healthy contingency reserve so that it can lend its support in the event of a bank’s failure