Is the RBI over capitalised? Only if you compare apples with oranges

Comparisons being drawn with central banks in USA or Europe are flawed and careful analysis gives lie to such assertions

According to the official press release of the Reserve Bank of India (RBI), the Central Board of the RBI, at its meeting held in Mumbai on 19 November 2018, decided to constitute an expert committee to examine the Economic Capital Framework (ECF) of the RBI, the membership and the terms of reference of which will be jointly determined by the Government of India and the RBI. 

Contextually, the issue of the RBI being excessively/over capitalised was first broached in the Economic Surveys of 2015-16 and 2016-17, citing the examples, inter alia, of the central banks of the USA and the UK which had capital-to-assets ratio of below 2%. But such comparisons need to be on apples-to-apples, or oranges-to-oranges, and not apples-to-oranges, basis as implied in the Economic Surveys. Specifically, it needs to be noted that the balance sheets of the central banks that issue international reserve currencies need to be distinguished from the balance sheets of those that do not. The central banks of the former category carry comparatively far too less foreign currency assets as a percentage of their total assets in their balance sheets and this asymmetry between the two exposes the former category to far less exchange rate risk than the latter. Significantly, the exchange rate risk has historically been far more serious than the interest rate risk globally. 

Illustratively, the European Central Bank’s foreign currency assets (gold being a very insignificant component in the balance sheets of nearly all the central banks) and revaluation reserves constitute about 16% and 8%, respectively, of its balance sheet in comparison to RBI’s 78% and 20%. However, this apple-to-orange comparison can be transformed to apple-to-apple, or orange-to-orange, one by simply adjusting the revaluation reserves of either the ECB (apple) or the RBI (orange). Specifically, the adjusted, orange-to-orange, revaluation reserves of the ECB comparable to the RBI’s 20% will be 78%/16%*8%, that is, 39% versus 20% of the RBI, and not 8%, which is apple-to-orange comparison! It simply means that if the ECB has 8% revaluation reserves to cover the forex risk of 16% of foreign currency assets, it will, ceteris paribus, have 39% worth of revaluation reserves to cover the forex risk of 78% worth of forex assets on its balance sheet for which the RBI has only 20%. Alternatively, the adjusted, apple-to-apple, revaluation reserves of the RBI will be 16%/78%*20%, that is, 4.10% versus 8% of the ECB and not 20%, which is apple-to-orange comparison! This analytical framework can be extended to include equity and retained earnings component of the capital as well, which in the case of the ECB and the RBI are 2.3% and 7%, respectively, thus giving total capital-to-assets ratio of 10.3% and 27%, respectively. Doing this gives the ECB’s adjusted capital-to-assets ratio of 78%/16%*10.3%, that is, 50.2% and the RBI’s adjusted capital-to-assets ratio of 16%/78%*27%, that is, 5.5%. 

Thus, from the above analytical framework, it turns out, ceteris paribus, that rather than, and far from, being about  2.5 times the revaluation reserves (20%/8%) and total capital (27%/10.3% ), both the  revaluation reserves and the total capital of the RBI, as a percentage of its balance sheet, are about  half (20%/39% or 4.10%/8%) and (27%/50% or 5.5%/10.3%) the revaluation reserves and the total capital, respectively, of the ECB! Based on the same analysis, ceteris paribus, compared to the RBI’s capital-to-assets ratio of 27%, the adjusted, orange-to-orange, capital-to-assets ratios of the US Federal Reserve, the Bank of England, the Bank of Japan and the Bank of Russia come out as 10%, 18%, 43% and 28%, respectively, and, therefore, the RBI is no way excessively/over capitalised as concluded by the Economic Surveys! The Committee on RBI’s Economic Capital Framework may like, therefore, to apply this analytical framework to compare the RBI’s revaluation reserves and capital with those of the other central banks mentioned in the Economic Surveys, to reach a meaningful conclusion as to whether the RBI is excessively/over capitalised at all! 

As regards an appropriate level of the RBI’s economic capital , it must be noted that all the revaluation reserves serve, as quasi-capital, the purpose of true economic capital as its first line of defence against unrealised marked-to-market net losses, obviating any impact on its contingency fund except that credit balances in these accounts cannot be transferred to the government for the reasons clearly explained in the article. It is only when there is debit balance in any of these revaluation accounts is the contingency fund debited. According to the current accounting policy of the RBI, such negative balances, if any, are debited to the contingency fund on 30 June every year and reversed on the first working day of the following year. However, without in any way detracting from the integrity and the robustness of the accounting practices, it will be logically consistent and more appropriate to first adjust such debit/negative balances against the credit balances available in the other revaluation accounts and debit the contingency fund only as a last resort because unlike the contingency fund, which is ‘net realised gains-based’, all revaluation accounts are ‘net unrealised gains-based’. This will obviate the need for reversal of the debit entries unless they are from the contingency fund as done now and, significantly, avoid reporting lower credit balance in the contingency fund as on 30 June unless it is because of net debit balance of all the revaluation accounts. 

Finally, to ensure that there is nearly always a minimum-sized contingency fund (equity capital) which more than absorbs the effect of the net erosion of the credit balances in the revaluation accounts, the minimum credit balances in the revaluation accounts can be modelled using historical time series of these balances (technically referred to as the Value-at-Risk ( VaR) model with very conservative 95% to 99% Confidence Intervals) such that any balances lower than these minima will trigger retention of so much higher realised net gains and so much lower surplus transfer to the government. Equally, in the opposite case, there will be so much higher surplus transfer to government.

The author is a former Executive Director of RBI. He tweets @vksharma52