Context: RBI’s Economic Capital Framework (ECF) and its significance
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- The Reserve Bank of India, in consultation with the Government of India, had constituted an expert committee, under chairmanship of Bimal Jalan, to review whether the central bank was holding on to too much of its reserves.
What is economic capital framework?
- The Reserve Bank of India (RBI) has developed an Economic Capital Framework (ECF) in 2014-15 to provide an objective, rule-based, transparent methodology for determining the appropriate level of risk provisions to be made under Section 47 of the Reserve Bank of India Act, 1934.
- Economic capital framework refers to the risk capital required by the central bank while taking into account different risks. The economic capital framework reflects the capital that an institution requires or needs to hold as a counter against unforeseen risks or events or losses in the future.
What risks faces by RBI?
- Market risk: which captures the risk arising out of changes in valuation of the assets of the RBI, including foreign reserves, gold and Government securities
- Credit risk: in the form of losses arising due to default by counterparties.
- Operational risk: which arises from losses incurred from inadequate or failed internal processes, people and systems; or from external events (including legal risk)
- Contingent risk: which arises from
- The RBI’s Emergency Liquidity Assistance (ELA) operations and their impact on the balance sheet size and structure (for example, losses on collateral obtained when injecting emergency liquidity into troubled banks);
- Inflation management operations
- Currency stabilization operations.
Components of ECF:
- The Economic Capital Framework consists of two components of RBI’s economic capital – realized equity and revaluation balances.
- Realized equity: The component of RBI’s economic capital comprising its Capital, Reserve Fund and risk provisions (CF and ADF)
- Revaluation balances are highly volatile, and whose levels move autonomously depending on RBI’s discharge of its public policy objectives of maintaining price, financial and external stability, coupled with international market developments reflected in movements in the price of foreign assets, exchange rate, interest rate and gold price.
Recommendations of Bimal Jalan Committee:
- RBI’s economic capital: The Committee reviewed the status, need and justification of the various reserves, risk provisions and risk buffers maintained by the RBI and recommended their continuance.
- A clearer distinction between the two components of economic capital (realized equity and revaluation balances) was also recommended by the Committee.
- As realized equity could be used for meeting all risks/ losses as they were primarily built up from retained earnings, while revaluation balances could be reckoned only as risk buffers against market risks as they represented unrealized valuation gains and hence were not distributable.
- Risk provisioning for market risk: The Committee has recommended the adoption of Expected Shortfall (ES) methodology under stressed conditions (in place of the extant Stressed-Value at Risk) for measuring the RBI’s market risk
- While central banks are seen to be adopting ES at 99 per cent confidence level (CL), the Committee has recommended the adoption of a target of ES 99.5 per cent CL keeping in view the macroeconomic stability requirements.
- Size of Realized Equity: Realized equity is also required to cover credit risk and operational risk. This risk provisioning made primarily from retained earnings is cumulatively referred to as the Contingent Risk Buffer (CRB) and has been recommended to be maintained within a range of 6.5 per cent to 5.5 per cent of the RBI’s balance sheet.
- Surplus Distribution Policy: The Committee has recommended a surplus distribution policy which targets the level of realized equity to be maintained by the RBI. Only if realized equity is above its requirement, will the entire net income be transferable to the Government. If it is below the lower bound of requirement, risk provisioning will be made to the extent necessary and only the residual net income (if any) transferred to the Government.
Past Recommendations of Size of Reserves/Buffer:
- I. Usha Thorat Committee:
- Assuming that total assets consist of Foreign Currency Assets (FCA) and gold, Committee (2004) the CGRA + CR (Contingency Reserve) can together be 12.26% of total assets
- CR requirements for interest rate risk may be taken as 2% of total assets
- Provision of 3.5% towards other risks such as monetary and exchange market operations, investments in subsidiaries and associates, operational risks, etc
- II. Subrahmanyam Committee (1997):
- Internal reserves for absorbing shocks in external assets should be at least 25% of FCA and gold
- 5% of total assets should be set aside towards losses which cannot be absorbed by current earnings
- There should be a reserve of 2% of total assets towards systemic risks
What ways this surplus transfers helps the Government:
- Tax revenue shortfall: With the economy slowing down and the Goods and Services Tax (GST) not kicking in the expected buoyancy, the shortfall may even be higher. The infusion of additional funds, thus, will help the government to substantially overcome this shortfall
- Fiscal deficit: governmenthas a control on its expenditure through Fiscal Deficit target. With transfer of surplus of RBIs reserves, target will be within range of government
- If, on the other hand, the tax revenue growth picks up, then the government can use the additional money to clear the dues of the Food Corporation of India and fertilizer companies to minimize spillover of deficits to the next year
Way forward: The decision of the RBI Board must be welcomed as it has not come a day sooner and should help the government in combating the economic slowdown and to conform to the fiscal targets. It is hoped that the government will be prudent in using these funds.