Mains Paper 3: Economy | Mobilization of resources
From UPSC perspective, the following things are important:
Prelims level: Economic Capital of RBI
Mains level: Debate regarding the independence of RBI and Fiscal Strain on Govt.
- The government and the RBI are engaged in fixing an appropriate economic capital framework for the central bank.
- The central government is expecting from RBI to re-distribute its surplus for recapitalization process to counter NPA crisis.
What is Economic Capital?
- Banks and financial institutions are faced with long-term future uncertainties that they intend to account for.
- Economic capital (EC) is the amount of risk capital that a bank estimates in order to remain solvent at a given confidence level and time horizon.
- The concept of economic capital has gained significance especially after the global financial crisis in 2008.
- The crisis exposed many central banks in the world to multiple risks, which forced many of them US Federal Reserve, Bank of England and European Central Bank to pump in liquidity.
- They tempted to buy securities and expand their balance sheets to boost confidence in the financial system and to ensure that critical institutions did not collapse.
What drives balance sheet of Central Banks?
- The balance sheet of central banks is unlike that of the institutions that it regulates or supervises.
- They are not driven by the aim of boosting profits given their public policy or public interest role.
- Their aim is primarily ensuring monetary and financial stability and maintaining confidence in the external value of the currency.
- Central banks do make money or the profits earned by issuing currency which is passed on to the owner of the central bank, the government.
- But they are typically conservative and the crisis prompted a review of the capital buffers that central banks and commercial banks needed.
Potential Risks to Central Banks
- Traditionally, central banks have been factoring in risks such as credit risk when there could be a potential default by an entity in which there has been an investment or exposure.
- There is also interest rate risk when interest rates either move up or slide, depending on the price of which securities or bonds held by a central bank or banks can be impacted.
- Besides, there is operational risk when there is a failure of internal processes.
- To measure these risks, both quantitative and qualitative methods are typically used.
The RBI proposal
- RBI holds a huge pile of foreign exchange reserves, and as the lender of last resort it described as contingent risks arising from its public policy role in fostering monetary and financial stability.
- In 2015, the RBI discussed this and put in place a draft Economic Capital Framework, or ECF.
- The rationale for such a capital framework was that there were increased risks to its balance sheet.
- RBI sought for an adequate capital buffer, critical not only to achieving its objectives, but also to ensuring the credibility of the central bank.
Concerns of RBI
- RBI pointed out that a weak balance sheet could force the central bank to rely more on excessive seigniorage (profit made by issuing currency) income, which would run in conflict to its price stability mandate.
- A compelling reason for RBI to build large capital buffers is to try and preempt a situation where they have to approach their governments for putting up their capital for recapitalization.
- That is seen by them as an erosion of their operational independence.
- The sovereign governments themselves are under fiscal strain.
- This strengthens the case for ex-ante capitalization (based on forecasts) than ex-post capitalization i.e. better to build a capital framework way ahead of a crisis.
Capital Buffer: A Case in England
- In June this year, the Bank of signed a MoU on a capital framework and on distributing its surplus.
- This new capital framework would ensure that the bank’s policy work is fully funded.
- The bank is to be equipped with capital resources consistent with monetary and financial stability remits given by Parliament.
- It provides a robust and transparent system that ensures the credibility of the bank’s policy action in even the most stressed environment, and reflects the new way in which the bank provides liquidity.
How it works
- The Bank of England’s capital will be capped by a ceiling above which all net profits are transferred to the treasury as dividend.
- It also ensures that there is a floor below which a rapid recap to the target is triggered.
- When the cap is below the target, no dividend is paid; when the cap is between the ceiling and the target, 50% of net profits is paid as dividend.
- These parameters are to be reviewed every five years.
Challenges in India
- The Bank of England has said that its capital framework takes into account its wide remit.
- That’s an argument the RBI can easily take, for its mandate too is wider than many central banks.
- There is also the fact that in India, the government that owns a large number of banks is itself struggling to recapitalize
- The govt. is under fiscal strain to meet fiscal targets and to spend adequately on infrastructure and on social welfare schemes.
- The heart of the capital framework is a risk-based capital target reflecting forward-looking risks to the balance sheet over the next five years.
- Its level is determined by evaluating the loss impact of severe stress scenarios.
- In September 2016, then outgoing RBI Governor said the RBI board has adopted a risk-management framework which indicates the level of equity the RBI needs citing potential risks it faces.
- The dividend policy of the RBI is a technical matter of how much residual surplus is available each year after bolstering equity.
- Such frameworks thus reduce the space for differences.