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Economic capital framework: Fixing something that ain't broke

The government has announced another committee to look at the economic capital framework for the Reserve Bank of India (RBI). This looks like an unnecessary step, given that only a few years back in 2013-14 RBI had referred the matter to a technical committee headed by Mr. YH Malegam.

The terms given to the technical committee in 2013-14 included "to review the level and adequacy of internal reserves and surplus distribution policy of the RBI." The current committee headed by Bimal Jalan is also charged with similar terms of reference. The current government made an unreasonable demand to dip in to the accumulated surpluses and reserves of the RBI and much controversy and a resignation later, had to find a face-saving measure to wriggle out of the situation by referring the brazen act to a committee. Let me explain why it is brazen.

Even before Raghuram Rajan took over as the Governor, in 2012-13 a technical committee with Mr. YH Malegam as the Chair was appointed to look at the aspects of how the RBI balance sheet should be presented. Soon after in 2013-14 a follow up technical committee was appointed to examine the level and adequacy of internal reserves and the surplus distribution policy. Based on the report it was decided that RBI at that time held excess reserves. The committee recommended that till such time the reserves were considered "excess" the complete surpluses should be transferred to the government as dividends.

Following the recommendations of the committee in the year 2013-14 RBI transferred its entire surplus to the Government of India. This was a record amount of Rs.526.79 billion. In the four years preceding RBI had transferred around 52% of its total surplus to the government. During 2013-14 it transferred 99.99% of its surplus. It remained at 98% of the profits all the way for two more years and has been above 70% ever since (See table below).

Following the report of the technical committee that was chaired by Malegam, in 2014-15 a draft Economic Capital Framework was formulated. This document highlighted the reasons why the RBI needs resources. The needs included (a) market intervention operations (b) carrying out the functioning of the lender of last resort (c) to derisk the financial system. It also highlighted the fact that if the central banks suffer losses and do not have adequate buffers they would have to depend on the Sovereign for recapitalization. The dependence on the Sovereign had implications on the autonomy of the Central Bank as well as the concern that the Sovereign might not have the fiscal space in a crisis situation where the fiscal situation would in itself be under stress.

In November 2016 the Central Bank Risk Managers Conference held under the aegis of the Bank of International Settlements had the Economic Capital Framework as a central theme. Risk managers from Central Banks of 31 nations participated. RBI was also a part of the steering group to look at these aspects on an ongoing basis. The Annual Report deals with this matter: "As regards the measurement of risk exposures of the bank, the Economic Capital Framework already in place, provides an ongoing balance sheet wide monitoring mechanism therefor and enables an informed decision on building up requisite level of financial buffers against such exposures" (p.158 of RBI Annual Report 2016-17).

Given that RBI was pro-actively engaged in this aspect and dealing with the aspects of risk and adequacy of reserves, and pro-actively transferring the surpluses to the Government at a higher level this aggression of the Government can only be construed as its need to raid the reserves. Unlike the past

terms of reference, the current terms of reference is also somewhat aggressive in its tone and tenor and somewhat specific about "excess" and "deficit" reserves.

The only saving grace in this face-saving exercise is that the committee appointed by the Government. It has people with known integrity and objectivity. Bimal Jalan is known for his fairly open and conciliatory approach without compromising on the fundamentals. Therefore, it is safe to assume that the RBI's capital is in safe hands and the controversy will be played down. Most likely the committee is unlikely to make fundamental changes to the existing framework or allow the Government to dip into the past reserves. That would eventually prove that this was a fishing expedition of the Government and a rather needless exercise.

The writer is an expert on finance and professor at the Indian Institute of Management, Bangalore (IIMB).