Economic Survey: RBI's Capital and Reserves

RBI must redeploy its capital in state-owned banks: With the government under pressure to meet its fiscal deficit target over the medium term, the economic survey, released by the finance ministry, on Friday said the Reserve Bank of India (RBI) should

My VIEW:

Copied below is Box 1.6 from  Economic Survey 2016 (Chapter 1 Economic Outlook, Prospects, and Policy Challenges)

Box 1.6: Addressing the Twin Balance Sheet Challenge

One of the most critical short-term challenges confronting the Indian economy is the twin balance sheet (TBS) problem—the impaired financial positions of the Public Sector Banks (PSBs) and some large corporate houses— what we have hitherto characterized as the ‘Balance Sheet Syndrome with Indian characteristics’. By now, it is clear that the TBS problem is the major impediment to private investment, and thereby to a full-fledged economic recovery. The problems in the banking system have been growing for some time. Stressed assets (nonperforming loans plus restructured assets) have been rising ever since 2010, impinging on capital positions, even as the strictures of Basel III loom ever closer on the horizon. Banks have responded by limiting the flow of credit to the real economy so as to conserve capital, while investors have responded by pushing down bank valuations, especially over the past year. The shares of many banks now trade well below their book value. This balance sheet vulnerability is in some ways a mirror and derivative of similar frailties in the corporate sector, especially the large business houses that borrowed heavily during the boom years to invest in infrastructure and commodity-related businesses, such as steel. Corporate profits are low while debts are rising, forcing firms to cut investment to preserve cashflow. This situation is not sustainable; a decisive solution is needed. But finding one is difficult. For a start, given the intertwining set of problems, solutions must strengthen both sets of balance sheets. Some steps have already been taken. In August last year, the government launched the Indradhanush scheme, which includes a phased program for bank recapitalization. Meanwhile, the RBI initiated the 5:25 and SDR schemes, which create incentives for the banks to come together with their borrowers to rehabilitate stressed assets. These are good initial steps which might require follow-up. Resolving the TBS challenge comprehensively would require 4 Rs : Recognition, Recapitalization, Resolution,

and Reform. Banks must value their assets as far as posible close to true value (recognition) as the RBI has been emphasizing; once they do so, their capital position must be safeguarded via infusions of equity (recapitalization) as the banks have been demanding; the underlying stressed assets in the corporate sector must be sold or rehabilitated (resolution) as the government has been desiring; and future incentives for the private sector and corporates must be set right (reform) to avoid a repetition of the problem, as everyone has been clamouring.

But there is a needed sequence to these 4 Rs: Recognition must come first, but it must be accompanied by an adequate supply of resources; otherwise, banks will be vulnerable. Given the tight fiscal position, where might the resources to recapitalise PSB’s come from? One possible source is the public sector’s own balance sheet. For example, the government could sell off assets that it no longer wants to hold, such as certain nonfinancial companies, and use the proceeds to make additional investments in the PSBs. This option is reasonably well understood. What is less appreciated is that RBI could do the same. That is to say it could redeploy its capital as well. Like all financial firms, central banks hold capital to provide a buffer against the risks they take. In the case of central banks, risks arise because the value of the foreign exchange reserves in terms of domestic currency fluctuates along with the exchange rate, while the value of the government securities they own changes as interest rates move. Measuring these risks and calculating how much buffer should be provided against them is difficult. For that reason, central bank capital holdings vary widely. The figure above* depicts the ratio of shareholder equity to assets for various central banks. Shareholder equity is defined to include capital plus reserves (built through undistributed retained earnings) plus revaluation and contingency accounts. The chart shows that RBI is an outlier with an equity share of about 32 per cent, second only to Norway and well above that of the U.S. Federal Reserve Bank and the Bank of England, whose ratios are less than 2 per cent. The conservative European Central Bank (ECB) and some EM central banks have much higher ratios, but even they do not approach the level of the RBI. If the RBI were to move even to the median of the sample (16 per cent), this would free up a substantial amount of capital to be deployed for recapitalizing the PSBs. Of course, there are wider considerations that need to be taken into account. Most important, any such move would need to be initiated jointly and cooperatively between the government and the RBI. It will also be critical to ensure that any redeployment of capital would preserve the RBI’s independence, integrity, and financial soundness—and be seen to do so. At this stage, what is important is the broader point: that funds for recapitalization can be found, at least to a certain extent, by reallocating capital that already exists on the public sector’s balance sheet. Once the resources to back recognition are identified, the remaining 2 Rs (Resolution and Reform) can be pursued with vigour. There are many options here, including creating “bad banks” to implement the four Rs.

*A bar graph. Not copied here.

My comments:

Long back, RBI had taken a conscious decision to augment its reserves (Contingency Reserves + Assets Development Reserves) to a level of 12 per cent of the Bank’s balance sheet total. The Bank almost managed to almost touch this level in 2009. The following table indicates the progressive deterioration in the reserves position, since then:

Balances in Contingency Fund (CF) and Asset Development Fund (ADF)(Crore)

June 30	CF	ADF	CF+ADF	As%to total assets
2009	153392	14082	167474	11.9
2010	158561	14632	173192	11.3
2011	170728	15866	186594	10.3
2012	195405	18214	213619	9.7
2013	221652	20761	242413	10.1
2014	221652	20761	242413	9.2
2015	221614	21761	243375	8.4

Source: RBI Annual Reports

RBI’s capital since inception has remained at Rs 5 crore. There is no clarity about the components reckoned for computing the RBI’s capital and capital-like reserves at 32 per cent of balance sheet total.

M G Warrier