What went behind RBI decision to transfer funds?

The Reserve Bank of India (RBI) on Monday announced a record high Rs 1.76 lakh crore dividend to the government. Here is the transfer explained:

The RBI was founded in 1935 and has been operating according to the Reserve Bank of India Act of 1934. The Chapter 4, section 47 of the Act, titled “Allocation of Surplus funds” mandates for any profits made by the RBI from its operations to be sent to the Centre.

According to the original provision, “After making provision for bad and doubtful debts, depreciation in assets, contributions to staff and superannuation funds…the balance of the profits shall be paid to the Central Government.”

How does the RBI earn its profit?

The RBI earns its profits primarily from the interest it gets from the purchase and sale of government securities, the interest earned from lending to banks and an interest earned on bond holdings earned on open market principles. From this amount, the net profit is calculated by subtracting the operation expenditures, and other expenses as stipulated in section 47 of the RBI Act.

What does the RBI reserve consist of?

The RBI’s reserves consist of currency and gold revaluation account (CGRA), the investment revaluation account, the asset development fund (ADF) and the contingency fund (CF). The CGRA makes up the chunk of the reserves and has gone up substantially since 2010---at a compounded annual growth rate (CAGR) of 25 per cent to Rs 6.91 lakh crore in 2017-18. It essentially reflects the unrealised gains or losses on the revaluation of forex and gold.

Next, the CF constitutes over a fourth of the RBI’s reserves. The CF is a specific provision made for meeting unexpected contingencies from exchange rate operations and monetary policy decisions. RBI contributes a sizeable portion of its profit to the CF.

The IRA is sub-divided into IRA-foreign securities and IRA-rupee securities. The former reflects the unrealised gain or loss on the mark-to-market of foreign securities while the latter is on account of marking rupee securities. The ADF has been created to meet internal capital expenditure and make investments in subsidiaries and associated institutions.

What were the recommendations made by the Bimal Jalan Committee on risk provisioning and surplus distribution?

Four basic pillars form the foundation:

RBI’s economic capital

A clear distinction was made between the two components of economic capital i.e. realised equity and revaluation balance. Realised equity could be used for meeting all risks/ losses as they were primarily built up from retained earnings. Revaluation balances could be reckoned only as risk buffers against market risks as they represented unrealised valuation gains and hence were not distributable. Further, there was only a one-way fungibility between them which implies that while a shortfall, if any, in revaluation balances vis-à-vis market risk provisioning requirements could be met through increased risk provisioning from net income, the reverse, i.e., the use of surplus in revaluation balances over market risk provisioning requirements for covering shortfall in provisions for other risks is not permitted.

Risk provisioning for market risk

The committee has recommended the adoption of Expected Shortfall (ES) methodology under stressed conditions in place of the extant Stressed-Value at Risk for measuring the RBI’s market risk. While central banks are seen to be adopting ES at 99 per cent confidence level (CL), the committee has recommended the adoption of a target of ES 99.5 per cent CL keeping in view the macroeconomic stability requirements. In view of the cyclical volatility of the RBI’s revaluation balances, a downward risk tolerance limit (RTL) of 97.5% CL has also been articulated.

Size of Realised Equity

The committee recognised that the RBI’s provisioning for monetary, financial and external stability risks is the country’s savings for a ‘rainy  day’ (a monetary/ financial stability crisis). This risk provisioning made primarily from retained earnings is cumulatively referred to as the Contingent Risk Buffer (CRB) and has been recommended to be maintained within a range of 6.5 per cent to 5.5 per cent of the RBI’s balance sheet, comprising 5.5 to 4.5 per cent for monetary and financial stability risks and one per cent for credit and operational risks.

Surplus Distribution Policy

The committee has recommended a surplus distribution policy, which targets the level of realised equity to be maintained by the RBI, within the overall level of its economic capital vis-à-vis the earlier policy which targeted total economic capital level alone. Only if realised equity is above its requirement, will the entire net income be transferable to the government. If it is below the lower bound of requirement, risk provisioning will be made to the extent necessary and only the residual net income (if any) transferred to the government.

Based on these principles, the following has been worked out:

• Realised Equity: Given that the available realized equity stood at 6.8 per cent of balance sheet, while the requirement recommended by the committee was 6.5 to 5.5 per cent of balance sheet, there was excess of risk provisioning to the extent of Rs 11,608 crore at the upper bound of CRB and Rs 52,637 crore at the lower bound of CRB. The Central Board decided to maintain the realised equity level at 5.5 per cent of balance sheet and the resultant excess risk provisions of Rs 52,637 crore were written back.
• Economic capital levels: While the revised framework technically would allow the RBI’s economic capital levels as on June 30, 2019 to lie within the range of 24.5 to 20 per cent of balance sheet, the economic capital as on June 30, 2019 stood at 23.3 per cent of balance sheet. As financial resilience was within the desired range, the entire net income of Rs 1,23,414 crore for the year 2018-19, of which an amount of Rs 28,000 crore has already been paid as interim dividend, will be transferred to the Government of India.