The bank’s Balance (The Indian Express)

Mains Paper 4: Economy
Prelims level: VaR Analysis
Mains level: Indian Economy and issues relating to planning, mobilization of resources, growth, development and employment

Context

•  How much equity should the Reserve Bank of India (RBI) hold?
•  A committee is currently examining this issue.
•  The RBI’s current equity holding is around 27 per cent of its total assets.
•  This overall equity level can be divided into four categories: Paid-up capital, contingency capital, revaluation capital and asset development fund.
•  The two largest components of these are contingency capital (6.6 per cent) and revaluation capital (around 20 per cent).

Rupee valuation

•  The revaluation capital is an accounting entry that offsets changes in the rupee value of the foreign assets and gold holdings of the RBI due to changes in the exchange rate of the rupee and changes in the dollar price of gold, respectively.
•  Arguments have been made that Equity is too high, especially when compared with other countries and that the RBI should transfer a part of this “excess” capital to the government as a one-time payment.
• One way of judging whether or not this level of equity holding is excessive is to use a metric that is typically applied to commercial banks.
•  Under this method, one computes the fraction of the value of the banks’ assets that are at risk due to fluctuations in the market value of the asset.
  About VaR analysis
•  This approach tries to look at the worst “x” per cent changes in the asset value of the bank during the sample period and estimates the associated size of the fall in asset value.
•  If the bank has capital greater than this value then one can say it has enough capital to withstand negative shocks in 1-x per cent of cases.
•  The higher x is, the greater is the safety level that the bank has. Thus, if the chosen x is 1 per cent then the bank has enough capital to absorb 99 per cent of the shocks that typically hit the system.
•  The RBI would require a 30 per cent overall equity to asset ratio to cover 95 per cent of all shocks it faces.
•  Thus, its overall equity level has to be raised from the current 27 per cent level.
•  If, instead, one only focuses on non-exchange rate-related shocks, then the core equity to asset ratio needed by the RBI to cover 95 per cent of all such shocks is around 17 per cent.
  So, why might a central bank hold equity rather than paying it out to the government?
•  There are two important reasons.
•  First, putting a part of the country’s assets in a protected entity like the central bank builds fiscal credibility of the country as long as the central bank is viewed by markets as being independent of the government.
•  This can improve the country’s international credit rating.
•  It also gives the central bank greater credibility in committing to perform its emergency functions without worrying about the fiscal contingencies of the government.
•  Second, mandating payments from the capital of the central bank creates a policy moral hazard.
•  A formal agreement between the government and the RBI :
•  (a) a target band for the equity level of the RBI based VaR computations;
•  (b) the time frame within which the RBI needs to bring its capital level back within the band every time the bounds of the band are breached, and
•  (c) explicitly prohibit any payments to the government that is based on the equity level of the RBI.

Way forward

•  That implies that the RBI’s current core equity level of 6.6 per cent needs to be more than doubled.
•  When the equity of a commercial bank becomes negative, they are bankrupt and their shareholders typically demand liquidation.
•  The central bank of a country, however, is not a commercial bank.
•  Its owner is usually the government, which certainly will not demand liquidation of the central bank in the event its equity turns negative.
•  In the event of an emergency, the central bank would need assets to fight it.

Online Coaching for UPSC PRE Exam

General Studies Pre. Cum Mains Study Materials

Prelims Questions:

Q.1) Consider the following statements with respect to Organization of the Petroleum Exporting Countries (OPEC)
1. All the founding members were from Asia
2. It is headquartered in Baghdad

Select the correct statement(s)
a) Only 1
b) Only 2
c) Both 1 and 2
d) Neither 1 nor 2

Answer: D

Mains Questions:
Q.1) So, why might a central bank hold equity rather than paying it out to the government?