The Bimal Jalan Committee is reported to be finalising the framework to calculate the surpluses and reserves the Reserve Bank of India (RBI) should transfer to the government. The present legal framework allows the RBI to choose what proportion of reserves it transfers. As a consequence, it has built up reserves higher than what most other central banks hold.

The role of a central bank is different from that of a commercial bank. It issues money on behalf of the sovereign. The differences in the role played by a central bank also translate into differences in how we measure their ‘surpluses’ and estimate requirements for whether they need to hold risk capital.

At 28 per cent, the RBI is one of the largest holders of capital and retained earnings amongst emerging economies. RBI’s capital and retained earnings, as a percentage of balance-sheet, are higher than those of its emerging economy peers, such as Brazil (0.85 per cent), Chile (-16.21 per cent), Indonesia (3.50 per cent), Korea (2.20 per cent), Malaysia (3.43 per cent), South Africa (0.89 per cent) and Turkey (3.16 per cent).

Four models

In general, central banks have four ways of choosing how much money to transfer to the government.

  • All the earnings are transferred to the government, and then, based on the budget approved for the central bank, the government transfers it money.
  • A certain amount of reserves, expressed as a percentage of profits, are held by the central bank depending on its needs and functions, decided by the law, and any earnings over and above that are transferred to the government.
  • There are laws duly enacted that lay down what percentage of central bank earnings should be held and what should be transferred. This is not contingent on the capital position of the central bank. The law provides for a joint decision-making arrangement for the transfer of profits.
  • In a handful of countries, the proportion of profits to be transferred as dividends is at the central bank’s discretion.

The arrangement between the RBI and government of India falls into the fourth model. The RBI Act allows the central bank to choose what amount it transfers to the government, which is why it has built up reserves higher than most central banks. The annual transfer, called dividend in this case, has been a matter of contention between the government and the RBI.

Do central banks need to hold capital?

Some economists argue that central banks can have negative capital, as they do not face the same liquidity challenge as commercial banks. The authority to issue legal tender gives central banks a financial buffer in the form of seigniorage income. They also argue that a central bank is really a part of the government, and its balance sheet should be thought of as part of the consolidated balance sheet of the government.

Others believe that a central bank needs to hold capital. First, it has operating costs such as payment of wages, salaries, the cost of premises and the cost of printing banknotes and minting coins.

Second, if the assets of a central bank fall in value, its balance sheet is at risk, for which it should hold capital. If the value of $1 falls from Rs 70 to Rs 50, we might feel the currency has strengthened and it is good news for the economy, but the RBI’s balance sheet faces a loss as it holds its assets in dollars and its liabilities are in rupees.

Central bank assets are typically government bonds and foreign currency assets. Small open economies tend to have greater risk of currency appreciation, as most of their central bank assets are denominated in foreign exchange. These countries therefore have large capital requirements in order to address the risk of central bank losses due to appreciation in the exchange rate.

Third, a central bank may hold capital for bailing out banks. When banks are private and it is politically difficult for the government to do so, it may ask the central bank to bail out banks. Since banks are privately owned, governments avoid the political fallout of a bail-out by having central banks take on the responsibility of assuming financial obligations and non-performing assets of banks.

Finally, there are last-resort functions in the form of capital support, liquidity provision or market-making that may involve sufficient financial exposure. The scale of last-resort interventions by central banks could also serve as a reason for holding seigniorage income. During times of crisis, collateral policies are relaxed to ensure supply of credit lines. The capital requirements are expected to be larger for banks entrusted with lender-of-last-resort functions.

The road ahead

The Bimal Jalan Committee report is likely to recommend, first, a mechanism for how the existing stock of excess capital with RBI may be transferred to the government, and, second, a framework for the flow of surplus from the RBI to the government on an annual basis.

Reports suggest that the first may be done over a three-to-five-year period. Since the creation of this surplus had led to an increase in government borrowing, resulting in higher public debt, it should be used to retire government debt. That way, it will also not flow into the budget in one year, but its benefit, of a lower interest bill of government, will be spread out over the years to come.

The framework for the flow of annual surplus to the government should involve an amendment to the RBI Act so as to do away with the ambiguity that exists today — the act allows the RBI board to decide how much it wants to tuck away as contingency or other reserves.

A provision for a realistic level of revaluation reserves, such as what may be needed if the rupee appreciates by 10 per cent or so, should be made. An MoU should be signed with the government, whereby it should promise to make up for any losses beyond the amount held by the RBI.

In addition, the RBI’s budget should be placed in its board and audited by the Comptroller and Auditor General to bring greater transparency to its expenditure.