RBIs RESERVE AND RISKS – CURRENT AFFAIRS BY EDEN IAS

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RBIs RESERVE AND RISKS – CURRENT AFFAIRS BY EDEN IAS

Recently the central board of the Reserve Bank of India (RBI) decided to transfer a surplus of Rs 1.76 lakh crore to the government-its highest transfer ever-sparking a fierce debate. The government was, it must be noted, acting on the recommendations of a committee chaired by former RBI governor Bimal Jalan, on capital transfer.

Some economists have welcomed the move as it will help the government counter the shortfall in revenue and tax collection. Since inflationary pressure is low, economists believe that the move will not have a negative impact in the long run. Another group of economists which include the likes of Raghuram Rajan and former RBI governor Urjit Patel said earlier that the move could put RBI in a vulnerable position apart from diminishing its autonomy.

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 are the Risks faced by the 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.

 

What are the sources, RBI generate money?

A significant part comes from RBI’s operations in financial markets, when

  • It intervenes for instance to buy or sell foreign exchange;
  • Open Market operations, when it attempts to prevent the rupee from appreciating;
  • As income from government securities it holds;
  • As returns from its foreign currency assets that are investments in the bonds of foreign central banks or top-rated securities;
  • From deposits with other central banks or the Bank for International Settlement or BIS;
  • Besides lending to banks for very short tenures and management commission on handling the borrowings of state governments and the central government.
  • RBI buys these financial assets against its fixed liabilities such as currency held by the public and deposits issued to commercial banks on which it does not pay interest.

Expenditure for RBI

The RBI’s expenditure is mainly on printing of currency notes, on staff, besides commission to banks for undertaking transactions on behalf of the government and to primary dealers that include banks for underwriting some of these borrowings.

Every year RBI transfers the surplus to government:

RBI is not a commercial organisation like banks and other companies owned or controlled by the government to pay a dividend to the owner out of the profit generated. What the RBI does is transfer the surplus excess of income over expenditure to the government.

Under Section 47 of the RBI Act, “after making provision for bad and doubtful debts, depreciation in assets, contributions to staff and superannuation funds and for all other matters for which provision is to be made by or under this Act or which are usually provided for by bankers, the balance of the profits shall be paid to the Central government”.

 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

Usha Thorat Committee:

Assuming that total assets consist of Foreign Currency Assets (FCA) and gold, Committee recommended that the GRA + 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

Subrahmanyam Committee:

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 is special about the pay out this time?

The RBI does transfer its surplus annually to the government, the owner of the institution, after making adequate provisions for contingencies or potential losses. The profit that is distributed has varied, averaging over Rs 50,000 crore over the last few years.

Now, the RBI Board accepted the recommendations of a committee headed by former Governor Bimal Jalan on transfer of excess capital. This is the first time the RBI will be paying out such a huge amount, a one-off transfer. Earlier, the government had budgeted for Rs 90,000 crore from the RBI as dividend for this fiscal year.

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: government has 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.

Conclusion

Especially after the global financial crisis when central banks had to resort to unconventional means to revive their economies, the approach has been to build adequate buffers in the form of higher capital, reserves and other funds as a potential insurance against future risks or losses.

A higher buffer enhances the credibility of a central bank during a crisis and helps avoid approaching the government for fresh capital and thus maintain financial autonomy.

The decision of the RBI Board must be welcomed as it 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.

 

 

 

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