Relevance: GS Paper III (Indian Economy)
Why does the RBI need sufficient capital?
- The RBI is a counterparty in many financial transactions and is expected to deliver on its obligations even in the worst possible market conditions and times for the country.
- As a consequence, the RBI needs to have a very resilient balance sheet. That is, the RBI needs adequate capital reserves and other buffers that it can use to stabilise the economy during times of distress.
How much capital should a central bank hold?
- At one end is the view that central bank capital holdings do not matter, for three reasons.
- First, central banks can always deliver on their domestic obligations regardless of their net worth because they can always issue liabilities (“print money”).
- Second, central banks are part of the government and it is the broader government balance sheet that matters, not that of any of its constituents.
- Third, as long as overall conditions are reasonable, central banks’ stream of profits will eventually make up for any capital shortfalls because of their unique ability to generate income.
- As shown here, this has certainly been true for the RBI. For these reasons, a number of central banks such as those of Israel, Chile, the Czech Republic and Mexico have continued to operate quite successfully for long periods with negative capital.
- Another view is that if central banks run short of capital, this may bias their monetary policy, leading to higher inflation.
- There is also the concern that if government finances are themselves fragile, central banks cannot rely on the government to recapitalise them in difficult circumstances, and that they should protect themselves by building up their capital .
- Central banks need capital not so much for economic reasons but for political ones. For example, if central banks are short of capital and need to turn to governments, their independence might be compromised.
Capital hold by RBI at present
- It holds about 28% in capital, which is the fifth largest amongst all major central banks.
- If we consider the level of capital needed to deal with the risks the RBI faces, it is found that the RBI is holding about 11 percentage points (₹ 3.6 lakh crore) more capital than it needs.
- There is a basic asymmetry in the balance sheet of a central bank: the vast bulk of the assets accrue interest but many of its liabilities are interest-free. Hence, most of the central banks, including the RBI, generate a large net interest income, or “seigniorage.” Most of this income is transferred to the central government, but a considerable portion is retained.
- Though the RBI is highly profitable and does not undertake any risky lending (like commercial banks), why does it have to make provisions for its assets? Because its main assets are subject to risk, especially market (that is, price) risk.
- To guard against all the potential losses, the RBI maintains internal reserves . In addition to equity and retained earnings, the capital reserves have, over the years, been supplemented by a series of buffers to cushion contingencies. These include: the Currency and Gold Revaluation Account (CGRA), the Investment Revaluation Account (IRA), and the contingency fund (CF). To these, an additional buffer in the form of the Asset Development Fund (ADF) has been added since 1997–98.
How much capital does RBI need to hold?
The Malegam Committee observed that the total capital to cover various risks faced by a central bank like the RBI was in excess of what was required. It recommended the transfer of the entire surplus to the government, over a period of three years starting from 2014.
Why RBI needs to hold high levels of reserve?
It is argued that the RBI needs to be conservative because the government’s fiscal position—and hence its ability to capitalise the RBI in adverse circumstances—is not as robust as other comparator countries.
Arguments against transferring excess capital from RBI to govt?
- First, the underlying assets—foreign exchange reserves or g-secs—would need to be sold to realise the valuation gains.
- And second, such sales would roil financial markets, appreciating the exchange rate, causing interest rates to soar, and reducing the money supply.
- Third, the government would not really gain from transferring capital from the RBI, since the consequent reduction in the central bank’s balance sheet would cause future dividend income to fall.
- Transfers from the RBI reserves should only be used for operations like recapitalising PSU banks and retiring debt.
- Any such transfers should address the valid concerns on risks to the RBI’s balance sheet.
- The government should never allow central bank capital to fall below a jointly agreed threshold.
- Any decision to use excess reserves must be taken cooperatively, not adversarially, to avoid any sense of the government raiding the RBI.
During and after the Global Financial Crisis, major central banks across the world have lent the heft of their balance sheets to pull economies out of dire economic circumstances. More recently, there have been proposals to use central bank capital as “helicopter money”. Against this evolving view of central banking, the suggestion that the RBI’s excess capital should be deployed elsewhere is conservative.