In August last year, Mark Carney, Governor of the Bank of England told Bloomberg about fixing common errors that happen over history and the attempt by the central bank he heads to ensure a change in thinking to make the system as resilient as possible to “unknown unknowns”.
The questions on the minds of central bankers like him are: “What’s the shock that could happen? Do I have enough capital? If somebody fails, can I clean up the mess in an orderly way?”
A few days ago, the chief of the world’s most powerful central bank, the US Federal Reserve, Jeremy Powell, said at the annual meeting in Jackson Hole, Wyoming, that the Fed was examining the monetary policy tools it has used both in calm times and in (a) crisis.
Powell, who has come under a savage attack from the US President Donald Trump, said that the Fed is now assessing whether it should expand its toolkit. All these indicate the fraught times for the world’s central banks, in the backdrop of fears of a possible recession, the effectiveness of monetary policy and growing political assaults on these banks in the face of a global slowdown.
Like some of its peers, the Reserve Bank of India, too, should be fortifying itself considering the risks on the horizon. But it may have been partly blinded because of a controversy that erupted late last year on the level of reserves which it maintains, and the quantum of profits or surplus that it should distribute to the government — the owner of the bank.
There has been a possible closure to that with the RBI board approving the recommendations of a committee headed by Bimal Jalan, based on which, the central bank will transfer Rs 1.76 lakh crore to the government, including the surplus and excess provisions. The committee has also outlined a clear and transparent policy for the distribution of RBI’s profits over the next few years, which should lead to less conflict.
More importantly, it has also set new benchmarks for building capital buffers to equip a central bank which dons multiple hats — that of a monetary policy authority, a regulator of the financial sector and the payments system, debt manager for both the Centre and state governments and the issuer of currency. Such a wide mandate for a central bank, including fostering financial stability, will in the normal course call for bullet-proofing against multiple risks relating to credit, operations, contingent risks, financial stability and revaluation of assets.
Wiser, after the balance of payments crisis in 1991, the RBI started building adequate buffers in the form of a few reserve funds. But, over the past decade, successive governments, desperate to raise revenues, have sought hefty payouts from the central bank, arguing that it was far more capitalised than not just its emerging market peers but also in comparison to some of the leading global central banks. Such comparisons may be meaningless considering that quite a few of them have fully convertible currencies.
The first major pitch for large transfers of surplus profits from the RBI came during the tenure of Raghuram Rajan as Chief Economic Advisor, a thread which was picked up by his successor, Arvind Subramanian.
The Jalan committee’s review, however, shows that the RBI’s realised risk provisions have dropped below levels equivalent to 1988-89,with progressively higher transfer of surpluses to the government over the last few years. This has been pronounced in recent years with such transfers as a proportion of the bank’s net income averaging 90 per cent between 2014-18 — a sharp spike compared to the average of a little over 50 per cent in the years up to 2004.
Explained | How and why RBI transfers to government
The committee’s analysis shows that 90 per cent of the net income was transferred to the government when risk provisioning was 10 per cent over the past few years. All this coincides with the period when the government was struggling to meet its mandated deficit targets. The committee’s report also says that close to 73 per cent of the RBI’s economic capital is in the form of unrealised revaluation balances, which reflect changes in the market movements of domestic and foreign securities and gold. Those balances, which may have led many to seek higher payouts, can’t be tapped into, the committee has recommended — a sensible practice.
A bilateral agreement on the distribution of surplus or profits and a flexible approach may have worked in India until the blow up last year. But, what makes it easier in the case of many other central banks is that the quantum to be paid out is built into the law — either as a fixed percentage of the current net profit or based on clearly defined criteria.
There may not be an optimal model for this but a beginning has been made which should lead to less conflict, a more transparent process, smoothening of profit flows over the next few years and building up of adequate capital for a modern central bank. The UK has already done that with the Bank of England and the Treasury, having signed an MoU last year on their financial relationship which lays the ground rules for determining the bank’s capital, dividend payments, among others.
As Adair Turner, former head of the UK Financial Services Authority wrote in the Financial Times recently, central bank watching is a preoccupation for many professional economists as minor rate changes matter a lot to asset managers, macro hedge funds, investment banks and their clients, but not as much for consumers and businesses.
The issue of the independence of the Indian central bank is now threatening to degenerate into a spectator sport with personalities looming larger than institutions or the sovereign. Even in such a scenario, if both sides have agreed to adopt a new approach to determine the economic capital of the central bank and on future distribution of its profits, it may have to do largely with the fact that two senior members of the committee, Bimal Jalan and Rakesh Mohan, have been on both sides of the divide — in the finance ministry and the RBI.
The dousing of fires for now opens up a window of opportunity to unveil a calibrated public spending programme or to set aside sufficient capital for a new institution to finance long term projects. And if policymakers on both sides can shut out the noise, it could be an opportune time to repair ties between the government and the RBI and to forge a respectful relationship.
This article first appeared in the print edition on August 29, 2019 under the title ‘In mutual interest’. The writer is consulting editor, The Indian Express.