Urjit Patel, governor of the Reserve Bank of India, speaks during a news conference in Mumbai. (Photographer: Dhiraj Singh/Bloomberg)

Why RBI’s Capital Standard Must Remain Very High

BloombergQuintOpinion

One of the major contentious points in the ongoing tussle between the government and the Reserve Bank of India is the amount of reserves RBI holds on its balance sheet. The government thinks that it is much higher than required and the excess should be given back. RBI obviously doesn’t agree with it. While the government seems to have softened its stance by asking for transparent methodology and a truce may have been bought by agreeing to form an expert panel to look into it, the question, however, remains.

What should be the right level of capital for a bank like RBI which doesn’t do normal banking functions and wears multiple hats such as issuer of currency notes, banker to the government, exchange rate management authority holding nation’s foreign exchange reserves and counterparty for international institutions?

For normal banks, there exists an internationally agreed capital standard, the Basel Accord. That standard, however, doesn’t apply to the RBI. In fact, there is no such international standard for the capital of a central bank. Each central bank is different, and its capital needs are driven by its balance sheet structure and the role it performs in the economy. Therefore, to arrive at a meaningful conclusion about the adequacy of its capital, we need to understand the drivers of RBI’s balance sheet and income account.

Also read: In Government-RBI Spat, Reserve Bank Escapes With A Few Burns And Bruises

A Tax That The Government Doesn’t Get

RBI’s income is primarily interest earnings on its assets which are, largely, investments in rupee government bonds and foreign currency securities. It doesn’t pay any interest on its liabilities, the majority of which are notes issued to the public, and deposits by banks and the government. Its expenditure is mainly administrative and small compared to its income. Therefore, a significantly large proportion of its income is net surplus.

This is a major point of differentiation between RBI and a normal commercial bank. It is a monopoly institution for issuing currency notes and a banking regulator. Its income statement reflects this unique advantage. Economists call this ‘monetary seignorage’ and it is nothing but a tax on the rest of the economy.

However, unlike other taxes, the value of this tax is not determined by the government.

It is determined by the demand for currency notes and the level of interest rates. As both are driven by inflation in the economy, monetary seignorage is, effectively, an inflation tax. If this was any other tax, it would have been directly collected by the government and used for funding its expenditure. However, in this case, it is generated as income of the RBI which is transferred back to the government after deducting expenses and making certain provisions as per Section 47 of the RBI Act.

Some of these are contingency provisions held as a Contingency Fund on the RBI’s balance sheet and is counted towards its capital. As of June 30, 2018, the CF was around 6.4 percent of its balance sheet. One major part of the current debate is, therefore, the amount of provisions that it needs to make, and the balance of profits it should transfer to the government on an ongoing basis.

Also read: This Truce Is a Defeat for India’s Central Bank

Revaluation Gains From Foreign Assets

There is another aspect of RBI’s balance sheet, which significantly complicates this story. RBI has been accumulating foreign currency reserves due to its intervention in the forex market. Since India has been a balance of payments-surplus economy for the last several years, its holding of foreign currency securities has been steadily going up. RBI has been holding an average of 73 percent of its balance sheet as foreign currency assets during the past decade. As interest rates on foreign currency assets are much lower than the interest rates on domestic bonds, this has resulted in lowering its interest income significantly.

On the flip side, as the rupee has depreciated by about 44 percent during this period, the rupee value of these foreign currency securities has been steadily going up. These revaluation gains, to the extent not realised, are not passed through its income statement but are directly added to the Currency and Gold Revaluation Reserve Account which accounts for about 19.1 percent of RBI’s balance sheet.

The notable thing is that CGRRA has gone up from 15.4 percent to 26.25 percent of its outstanding foreign currency assets over the past decade, whereas its gross interest income has gone down from 4.31 percent to 2.16 percent as a percentage of its total assets.

It is also noteworthy that CGRRA as a percentage of its total assets has remained steady at around 20 percent during this period. Besides these two, there are a few other reserves on RBI’s balance sheet but they are relatively small.

The accumulation of CGRRA over time is partly due to monetary seignorage and partly because of exchange rate volatility. The question is how much is each? To answer this, we need to answer how much of the rupee’s past depreciation is a result of India’s higher inflation and therefore higher interest rates. According to the Uncovered Interest Rate Parity Theory, the expected change in exchange rate between two currencies should be equal to the interest rate differential between them. For example, if the rupee interest rate is 8 percent and the dollar interest rate is 3 percent, the rupee should depreciate by about 5 percent against the dollar in a year’s time. However, in real-life, this theory doesn’t hold very well.

There are long periods of time when the exchange rate movements don’t reflect interest rate differentials.

The government seems to be suggesting that there is a fairly large amount of monetary seignorage which RBI has been hoarding as a part of its CGRRA over the years and wants it returned.

Also read: RBI And Government Find Some Common Ground, Experts Say

Unique Risks

The problem with this line of argument is that the notion of capital for financial institutions has undergone a dramatic change over the last two decades. It is no longer an accumulated reserve-based concept where you could look at net worth-to-gross balance sheet ratio and decide the riskiness of an institution. Financial institutions hold capital as protection against unforeseen future losses. Determining an appropriate level of capital requires a statistical estimation of these potential losses.

Capital adequacy, from an economic standpoint, is a forward-looking concept and it depends not only upon the size of the risk (like the amount of foreign currency assets) but also on the volatility of the variables, such as exchange rates and interest rates. Therefore, and it is an important point if suddenly markets become highly volatile, the capital requirement goes up even if the size of the balance sheet doesn’t change.

As with any other bank, RBI has multiple risks embedded in its balance sheet. Where RBI’s balance sheet differs from other banks is that it holds a large proportion of its assets as foreign currency securities. These securities could suffer large losses if the global yields were to go up. A much larger source of risk is the rupee’s exchange rate, which if it were to appreciate sharply, would cause significant losses for RBI. Under such a scenario, a normal bank would be reducing the size of its risky assets to make sure its capital is adequate.

RBI, on the other the hand, will most likely be required to intervene in the market to stem rupee appreciation and in the process will end up buying more foreign currency assets.

This brings us to the other major point of differentiation. If the capital level of a normal bank were to go below regulatory minimum, it will be required to either reduce its balance sheet or get more capital from its shareholders. RBI, clearly, wouldn’t want to go back to the government. Shrinking its balance sheet is not an option as that would result in a severe monetary shock to the economy. Hence, it needs to make sure that its capital is determined on a very conservative basis, taking into account all possible externalities.

Ideally, in an economy, the central bank should be its best-capitalised institution and particularly so if it is also performing the role of international counterparty for sovereign’s transactions such as management of its foreign exchange reserves.

In the aftermath of the global financial crisis, the capital requirements of financial institutions have been steadily going up, as successive Basel standards have been mandating increasingly higher levels of minimum regulatory capital. For global systemically important banks, the Basel III standard prescribes a minimum regulatory capital of 15.5 percent of its risk-weighted assets. Bear in mind that this is the regulatory minimum, and banks are expected to maintain a fair amount of capital buffer over and above it. For a central bank, the capital requirement would be much more given the special roles that it performs in the economy.

To conclude, the concept of adequate economic capital is a forward-looking one and its value is determined by the size of the risk on the balance sheet and the volatility of the underlying risk factors. It is a statistically-estimated dynamic concept and is dependent on evolving market conditions. For an institution like the RBI, whose flexibility in modulating its own balance sheet is minimal, the capital standard needs to be fairly high. If that means there is less pass-back of monetary seignorage to the government for deficit financing, then so be it. Hopefully, the proposed expert panel will take into account these aspects while arriving at its conclusions.

Neeraj Gambhir is an independent financial market expert.

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.