The Reserve Bank of India’s (RBI’s) balance sheet should be strong enough to support banks if there is a need to recapitalise them during a financial crisis, said the report of the committee to review the economic capital framework (ECF) of the central bank.
India, with one the lowest sovereign ratings, and not having a reserve currency to boot, should not think that risky actions by the government would still be as safe as advanced economies, said the panel headed by former RBI governor Bimal Jalan.
“The fact that ELA (emergency liquidity assistance) operations by the AE (advanced economy) central banks did not result in losses for them should not draw the central banking community into any false sense of complacency about the riskiness of such actions,” the report, released on the RBI website on Tuesday, said. “Had the AEs, which are ‘issuers of reserve currencies’, not followed up their ‘qualitative easing’ programmes with the very significant ‘quantitative easing’, it is possible that their ELA operations could have ended very differently.”
As a stark warning to the government, which now seems to be depending upon the RBI transfers to bridge the fiscal deficit, the committee said the centre’s manoeuvrability on recapitalisation of commercial banks or of the RBI could be constrained during a financial stability crisis.
“The committee recognised the need for the RBI to maintain its realised equity at an appropriate level to ensure that the country is not battling a financial stability crisis with a level of financial resources that is not perceived as credible by the market,” it said. “The committee, therefore, recognised that the RBI’s financial stability risk provisions need to be viewed for what they truly are, i.e. the country’s savings for a rainy day (a financial stability crisis), built up over decades and maintained with the RBI in view of its role as the LoLR (lender of last resort). Its balance sheet, therefore, has to be demonstrably credible to discharge this function with the requisite financial strength.”
To maintain resilience, the committee suggested a relatively smaller transfer than what was anticipated. The RBI board accepted the recommendations and transferred the maximum amount of Rs 52,637 crore as excess provisions that the committee gave leeway to.
Contrary to expectations, the committee overturned the RBI board’s previous decision of maintaining capital buffer of 3 per cent with medium-to-long term target of 4 per cent. Instead, the committee said the buffer should be between 2-6.5 per cent, and finally suggested that ‘realised equity’, or roughly the contingency fund, should be maintained between 5.5 per cent and 6.5 per cent of the assets, including 1 per cent buffer.
Finance Secretary Rajiv Kumar, the government’s nominee on the committee, objected to this, stating that the provision for monetary and financial stability risk should be maintained at 3 per cent. However, the committee maintained that won’t be adequate, considering central banks were increasingly providing for financial and monetary stability risks. The committee also categorically denied transfer of “unrealised valuation buffers”, instead, suggesting it to be used as “risk buffers against market risks”.
This unrealised valuation buffers, in the form of revaluation reserves, constituted 73 per cent of the RBI’s economic capital as on June 2018.
According to the committee, a higher transfer is not possible when banks in India are at a vulnerable position. “While large public sector ownership has been seen as a positive in preventing bank runs in the past, the NPA crisis has thrown light on the challenges that arise if a sizable majority of the banking sector looks at the government for recapitalisation,” the committee said. “Herein lies the challenge of assessing the risk provisioning requirements of the RBI. The RBI would theoretically not be exposed to ELA (emergency liquidity assistance) losses if the government recapitalises these banks. However, the European debt crisis has demonstrated that private sector debt crises can transform into a Sovereign debt crisis if the government over-stretches itself in recapitalising the distressed banks,” the report said.
This position, in case of India, is “even more severe” considering the Sovereign’s rating is at the lowest investment grade. “Any downgrade, due to fiscal slippages caused by recapitalisation, could exacerbate the capital flight caused by the financial crisis.” Add to it, the rupee not being a reserve currency will greatly limit India’s capability to manage financial crises, the report warned.
“The potential losses of the RBI range from 4.6 per cent of RBI’s balance sheet to 8.2 per cent if India’s top 10 banks get into a liquidity problem. If the crisis is bigger, widening the scenario to 55 banks, the potential losses to RBI’s balance sheet could be in the range of 6.6 per cent to 11.8 per cent.”
“If the recovery rate is assumed lower at 60 per cent, the losses could range from 9.3 per cent to 16.4 per cent for top 10 banks and from 13.1 per cent to 23.5 per cent for 55 banks,” the committee said.
The committee on ECF was guided by the principle that the alignment of the objectives of the government and the RBI is important. “As a central bank is a part of the Sovereign, ensuring the credibility of the RBI is as important, if not more, to the government as it is to the RBI itself,” the report said, adding that difference of view notwithstanding, it was important that the objectives of the government and RBI are in harmony.
Overall, the financial strength of the RBI was not bad. The RBI had an overall fifth rank in 2018 at 26.8 per cent of its balance sheet with respect to central banking economic capital, largely emanating from revaluation balances accumulated by rupee depreciation. Among the EMs, the RBI’s position was fourth in 2018.
Importantly, the committee suggested that the surplus distribution policy should move away from targeting total economic capital alone, to one where it has a dual set of targets — the total economic capital of the RBI; and the level at which realised equity is to be maintained.