Economics

The reserves in Reserve Bank


Context

  • Economic Capital Framework (ECF) for the central bank-explained.

Background

  • The 2008 global financial crisis exposed many central banks in the world to multiple risks, which forced many of the banks and sovereign governments to pump in liquidity, buy securities and expand their balance sheets to boost confidence in the financial system and to ensure that critical institutions did not collapse.
  • In this context, the concept of economic capital framework gained significance.
  • In 2015, the RBI discussed this and put in place a draft Economic Capital Framework, or ECF. 
  • This has also been done in many countries, such as New Zealand and England.
  • In June this year, the Bank of England and Her Majesty’s Treasury or HM Treasury (the equivalent of India’s Finance Ministry) signed a MoU on a capital framework and on distributing its surplus. 

Recent developments on Economic Capital Framework (ECF) in India

  • In 2015, the RBI put in place a draft Economic Capital Framework, or ECF. 
  • In a speech in September 2016, then outgoing RBI Governor Raghuram Rajan said the RBI board has adopted a risk-management framework which indicates the level of equity the RBI needs, given the risks it faces.
  • Last weekend, Subhash Garg, Secretary, Economic Affairs, and a member on the board of the Reserve Bank of India, tweeted that the government and the RBI were engaged in fixing an appropriate economic capital framework for the central bank of India.
  • His tweet came amid conflict between the government and the RBI on several issues.

About Economic Capital Framework (ECF)

  • 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 but their aim is primarily ensuring monetary and financial stability – maintaining confidence in the external value of the currency.
  • Central banks do make money thanks to seigniorage, or the profits earned by issuing currency which is passed on to the owner of the central bank, the government.
  • However, they are typically conservative and the crisis prompted a review of the capital buffers that central banks and commercial banks needed.
  • Essentially, 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.

Example of working of ECF in England

  • 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.
  • The floor now for the bank is £500 million, the target £3.5 billion and ceiling £5.5 billion.
  • These parameters are to be reviewed every five years.

Need of Economic Capital Framework (ECF)

  • 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.
  • 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.
  • Operational risk: when there is a failure of internal processes.
  • Operational independence: Central banks want to build such large capital buffers because of preempting a situation where they have to approach their governments for beefing their capital or recapitalization, which is seen by them as an erosion of their operational independence.
  • To measure these risks, both quantitative and qualitative methods are typically used.
  • These include stress tests to evaluate worst-case scenarios such as collapse of banks, value at risk and so on.

Need of Economic Capital Framework (ECF) in India

  • In 2015, the RBI discussed this and put in place a draft Economic Capital Framework, or ECF.
  • It then sought to cover in the ECF was the risk in its balance sheet (foreign exchange risks, or the valuation of the foreign securities) as well as contingent risks arising from its public policy role in fostering monetary and financial stability.
  • The rationale for such a capital framework was that there were increased risks to its balance sheet, and an adequate capital buffer was critical not only to achieving its objectives, but also to ensuring the credibility of the central bank.
  • It was pointed out that a weak balance sheet could force the central bank to rely more on excessive seigniorage income, which would run in conflict to its price stability mandate.
  • RBI also pointed out that requests for recapitalization could also come at a time when the sovereigns or governments themselves are under fiscal strain.
  • RBI argued that the ECF strengthens the case for ex-ante capitalisation than ex-post capitalisation – meaning that it would be better to build a capital framework way ahead of a crisis.
  • 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 recapitalise these banks, given the fiscal strain and the need to meet fiscal targets and to spend adequately on infrastructure and on social welfare schemes.

Significance of Economic Capital Framework (ECF)

  • An appropriate capital framework could ensure that the bank’s policy work is fully funded and that the bank is 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.
  • At the heart of the capital framework is a risk-based capital target reflecting forward-looking risks to the balance sheet.
  • Its level is determined by evaluating the loss impact of severe plausible stress scenarios, which are to be reviewed and discussed with the Treasury.

Challenges for Economic Capital Framework (ECF) in India

  • The dividend policy is a technical matter of how much residual surplus is available each year after bolstering equity.
  • Unlike in the past when much of the crisis had its origins in fiscal stress, over the past years, it is originating in the financial sector with its growing and influential role and the contagion effect flowing from that is difficult to contain.
  • It is better to build a capital framework way ahead of a crisis but arriving at an appropriate figure for ex-ante capitalisation than ex-post capitalisation is a challenge.

Way forward

  • The government and the RBI should come together to prepare an appropriate Economic Capital Framework (ECF) for India.
  • For an appropriate ECF a team of experts from RBI and the government should be given a task of framing it.
  • A well-researched and tested framework is the need of the hour.

Leave a Reply

Please log in using one of these methods to post your comment:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: