The Reserve Bank of India (RBI) has announced the constitution of a six-member panel to look into its economic capital framework. A reference to economic capital framework had come up in the context of adequacy of capitalisation and reserves at the central bank. Various stakeholders have been involved and each has its own viewpoint on the extent of capital and reserves at the bank. In determining the RBI’s capital adequacy, the perceptions of the government, private sector and RBI differ vastly, driven by the interests they individually serve. As beauty lies in the eye of the beholder, the definition of capital lies in the eyes of the stakeholder. By way of background, S&P Global Ratings has viewed recent developments concerning RBI as credit negative.
Economic capital tailored to a central bank’s specific risk profile is unique in the context of a country’s financial and banking system. Evidently, RBI has applied a unique lens in determining its economic capital. Terms such as economic capital, subscribed capital, regulatory capital, and book capital are not similar. Rather, a framework is required for creation of a system that can distinguish risk by a risk rating against the practice of “one size fits all” policy. The RBI needs a capital cushion based on its own risk profile. Regulatory capital is the capital required to meet minimum regulatory standards, defined as the capital required to achieve an investment-grade rating (generally BBB or equivalent). Economic capital, unlike regulatory capital, explicitly accounts for diversification and is directly linked to default probability on its portfolio and exposure.
Financial counterparties to the RBI’s commercial operations have either implemented the framework or are increasingly moving towards adopting it. The central bank needs to initiate the process at the earliest. This will help align its internal risk ratings with those of its counterparties and rating agencies. MFIs, the World Bank, Asian Development Bank, and the like are understood to have implemented their own economic capital framework. The RBI regularly undertakes market operations for buying and selling securities and currencies. Allocation of economic capital will allow it to align these activities with better risk-adjusted returns.
Economic capital takes into account both expected and unexpected losses. While expected loss is considered a cost of doing business, it’s the potential for any unexpected loss that drives capital assignments. The economic capital required depends on both the nature of business and risk tolerance of the institution linked to its desired target rating. Economic capital represents risk-based capital allocated on account of credit, market, liquidity, operations, business and country risks. The framework creates a common currency for measuring risks and in the context of a central bank is more evolutionary than revolutionary.
The RBI is a risk keeper for the nation and not just a risk keeper of its balance sheet. Its task is to manage systemic risk and the financial system as a whole. It could also face situations where it must act as lender of last resort. The central bank is exposed to sizeable short-term adverse impacts, if a major credit event takes place either onshore or offshore. The question then comes up as to what is the best defence? And the best defense is having adequate bank capital, reserves and liquidity, apart from ample foreign exchange reserves. For the RBI, any failure to take timely action could result in enormous costs. The lower the targeted default probability, the higher the capital cushion required. As the size of a country’s economy and GDP grows, so does the need for economic capital at its central bank.
The RBI holds a significant amount of foreign currency assets. Such assets are exposed to both currency depreciation and appreciation events. The associated volatility and impact could result in the bank reporting either gains or losses on its foreign currency assets. These are unrealised as long as foreign currency holdings remain on its books. Simply put, the revaluation gains or losses are mark-to-market positions that reflect the true value of the asset on a particular date and not realised gains or losses. The RBI has experienced both revaluation losses and gains in the past several decades. These losses and gains have been significant, if counted as a percentage of GDP. The RBI needs a cushion in its balance sheet to absorb adverse risk events. In the past, it had to rely on government support through the market stabilisation scheme for lack of a capital cushion when faced with currency appreciation events.
The economic capital required by RBI will be based on its risk tolerance and its targeted risk rating. The RBI’s board has opted for a target implied rating of AAA. Naturally, the capital required at a target rating of AAA will be significantly higher than that required at BBB. The markets are aware that associated benefits of AAA rating of a central bank outweigh the costs associated with holding extra capital to achieve AAA rating. The constitution of an expert panel will let the RBI remain independent, facilitating an informed decision-making process. The RBI needs to perform its key role as the nation’s risk-keeper. Perhaps extra capital in this context is a necessary evil.
The writer is a former Senior Advisor, Asian Development Bank. The views are personal
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