From UPSC perspective, the following things are important :
Prelims level : Economic Capital of RBI
Mains level : Issue over transfer of surplus funds of RBI
- A committee under former RBI governor Bimal Jalan considering guidelines for transfer of the central bank’s surplus funds to the government delayed submitting its report after lack of consensus.
Bimal Jalan Committee
- The committee was appointed in December 2018 to review the Economic Capital Framework (ECF) for the RBI after the Finance Ministry advised the central bank to transfer surplus funds to the government.
- The RBI has over Rs 9.6 lakh crore surplus capitals.
- The panel has been entrusted with the task of reviewing the best practices followed by central banks worldwide in making assessment and provisions for risks.
Issue over surplus transfers
- The government and the RBI under its previous governor Urjit Patel had been at loggerheads over the Rs 9.6 lakh crore surplus capital with the central bank.
- The finance ministry was of the view that the buffer of 28 per cent of gross assets maintained by the central bank is well above the global norm of around 14 per cent.
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.
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.