A vital functionality of central banking is to revive and 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 healty is the most difficulty responsibilty 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 liqudity 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 instiutions? Sometimes peopoe holds a misunderstanding that central banks have enough newly printed currency to help the faliing 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 instiutions.
The central bank is exactly like a commercial bank. The balance sheet and behaviour of the central bank is a replica of that of commercial banks. Central banks also get profit from their day to day operations like providing short term loans (VRR, MSF) to other financial instiutions 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 and 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 financail system, the acticity of providing funds to CF and ADF is called risk provisioning.
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 (ECF) was appointed at a time when several observers opined that the RBI is having surplus capital as it is one of the highest capitalized central banks in the world. Similarly, the volume of surplus transfer to the government also came under review from several quarters. The Committee was appointed in November 19 and its report was published on August 28th, 2019. Though the immediate factor contributed to the appointment of the Committee was the issue of surplus transfer to the government, the Committee’s has a long term relevance as it has to determine the amount of funds to be kept by the RBI to meet the contingency needs. This contingency needs mainly comes from the financial stability and other risk to be solved by the RBI when they happens. After setting apart the funds to meet the risks, the RBI can transfer the remaining amount to the government.
Following are the main recommendations of the Committee on ECF.
The RBI is the primary wall of defence for monetary, financial and external stability, and hence the financial resilience of the RBI needs to be maintained above the level of peer central banks, as it is the central bank of one of the fastest growing economies of the world. The Committee highlighted that the composition and size of RBI’s balance sheet is determined by public policy considerations and generates positive externalities of fostering monetary and financial stability.
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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.”
(a) The size of the Contingency Risk Buffer to be kept by the RBI to meet the most important risk of financial stability risk
While determining the size of funds to be kept by the RBI objectively determine the Contingency Risk Buffer by considering various risks. After meeting this buffer funds, the RBI can transfer the remaining funds as surplus to the government. This means that once the CRB is determined, the transfer amount is to the government is automatically determined.
| 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.
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. |
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). The contingent risks of central banks (arising from their role as the monetary authorities and LoLR) are central bank-specific risks and scenario analyses are used to assess such risks. The LoLR is the central bank facility of helping banks when the banks faces severe liquidity problems.
Meeting financial stability risks need more funds: the size of Contingency Reserve Buffer
The financial stability risks like the Global Financial Crisis is the rarest of the rarest. Here, the Committee recommended that the Contingency 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.
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 meagre. It is from the contingency Fund that the RBI is allocating funds to strengthen the revaluation accounts.
(b) 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.”
(c) 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.
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.
| What is the level of financial stability risk that the RBI should address?
Ensuring financial stability is now become a core function of central banks. Here, financial stability means banks and other regulated entities remains healthy and solvent. Now, in the Indian context, the size of the contingency fund (expressed as a proportion of capital or like that) to be kept by the RBI critically depends upon the financial stability challenge or risk the central bank confronts. Here, the Committee made the following observations while gauging the extent of the financial stability risk “In India, the position of law is such that the RBI is not only the monetary authority, but also the regulator and supervisor, inter alia, of commercial banks, NBFCs and payment systems, and the debt manager of the Government. The Committee agreed that the RBI has one of the widest financial stability mandates deeply entrenched in the RBI’s statute and it is also bound by Section 47 of the RBI Act, 1934 to maintain the financial resources commensurate with the task.” This observation indicate that compared to other central banks, the RBI’s responsivity and the need for funds are greater. |
- d) The surplus distribution policy
An important component of the recommendation was the surplus distribution policy to be followed by the RBI.
Regarding surplus distribution, the Committee recommends that the RBI move away from the 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 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 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.
(e) 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.
The report financial stability risk in the following words: “The financial stability risks are those rarest of rare fat tail risks which, if they do occur, can potentially devastate the economy. Central banks across the world are seen as key custodians of financial stability. Notwithstanding the formal position, as micro-prudential authority (regulator and supervisor of banks) and regulator of payment systems, the responsibility of financial stability overwhelmingly falls on the central bank. In times of stress, central banks are seen to be the LoLR (as well as MMLR), roles which are seen to be quite distinct from that of the Government’s role of ‘Recapitalizer of Last Resort’.”
| Risk from interconnectedness between banks and NBFCs
The report of the Committee point out the growing interconnectedness between banks and NBFCs as a risk factor in the current context. another critical aspect in financial stability consideration is the interconnectedness between banks and non-bank financial entities. Such interconnectedness in Indian markets is enlarging rapidly, thus increasing the risk of contagion in a financial crisis. |
(f) 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.
(g) Alignment of Years
The Committee recommends the alignment of the financial year of RBI with the fiscal year of the Government for greater cohesiveness in various projections and publications brought out by RBI.
Other observations of the Committee
The Committee also made several other recommendations related to its terms of reference. Following are the important ones.
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).
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Following are the five components of the RBI’s capital reserve.
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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.
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.
