Last weekend, Subhash Garg, Secretary, Economic Affairs, and a member on the board of the Reserve Bank of India, tweeted that reports of the government seeking a huge transfer of surplus funds were not true. His tweet came amid conflict between the government and the RBI on several issues, which has seen a public spat and led to the government initiating discussions with the RBI Governor by formally using a provision in the RBI Act that has not been used in the past. What the government and the RBI were engaged in, Garg tweeted, was fixing an appropriate economic capital framework for the central bank. What is this framework, and how does this differ from capital adequacy?
What it means
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 — besides 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. 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 – maintaining confidence in the external value of the currency, of course, is a key mandate.
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. But 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.
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The potential risks
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. These include stress tests to evaluate worst-case scenarios such as collapse of banks, value at risk and so on.
The RBI proposal
In 2015, the RBI discussed this and put in place a draft Economic Capital Framework, or ECF. What it sought then was to cover not only the risk in its balance sheet — foreign exchange risks, or the valuation of the foreign securities it holds against a huge pile of foreign exchange reserves, and as the lender of last resort — but also what it described 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.
What it pointed out was 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. Central banks may not put it explicitly, but a compelling reason for them to build such large capital buffers is to try and preempt a situation where they have to approach their governments for beefing their capital or for recapitalisation. That is seen by them as an erosion of their operational independence. What the RBI also pointed out then was that such requests could come at a time when the sovereigns or governments themselves are under fiscal strain. As it put it, it 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. Arriving at this figure is, therefore, a challenge.
This has 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. In a letter to Chancellor of the Exchequer Philip Hammond on June 21, Bank of England Governor Mark Carney wrote that the new capital framework would 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. As Carney explained, at 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 plausible stress scenarios, which are to be reviewed annually and discussed with the Treasury.
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, the Governor wrote. 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. The current capital of the Bank of England is £2.3 billion.
The challenge 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 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.
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. The dividend policy of the RBI then becomes a technical matter of how much residual surplus is available each year after bolstering equity. Frameworks thus reduce the space for differences, he said. But what governments here also have to be mindful of is that 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.