Is the RBI Over Capitalised?

Only if You
Compare Apples With Oranges
Comparisons being drawn with central banks in the US or Europe are flawed and careful analysis
gives lie to such assertions.

According to the official press release of the Reserve Bank of India (RBI), the Central Board of
the RBI, at its meeting held in Mumbai on November 19, 2018, decided to constitute an expert
committee to examine the Economic Capital Framework (ECF) of the RBI, the membership and
the terms of reference of which will be jointly determined by the government of India and
the RBI.

Contextually, the issue of the RBI being excessively/over capitalised was first broached in
the Economic Surveys of 2015-16 and 2016-17, citing the examples, inter alia, of the central
banks of the US and the UK which had a capital-to-assets ratio of below 2%. But such
comparisons need to be on apples-to-apples, or oranges-to-oranges, and not apples-to-oranges,
basis as implied in the Economic Surveys.

Specifically, it needs to be noted that the balance sheets of the central banks that issue
international reserve currencies need to be distinguished from the balance sheets of those that do
not. The central banks of the former category carry comparatively far too less foreign currency
assets as a percentage of their total assets in their balance sheets and this asymmetry between the
two exposes the former category to far less exchange rate risk than the latter. Significantly, the
exchange rate risk has historically been far more serious than the interest rate risk globally.

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Illustratively, the European Central Bank’s foreign currency assets (gold being a very
insignificant component in the balance sheets of nearly all the central banks) and revaluation
reserves constitute about 16% and 8%, respectively, of its balance sheet in comparison to RBI’s
78% and 20%. However, this apple-to-orange comparison can be transformed to apple-to-apple,
or orange-to-orange, one by simply adjusting the revaluation reserves of either the ECB (apple)
or the RBI (orange).

Specifically, the adjusted, orange-to-orange, revaluation reserves of the ECB comparable to the
RBI’s 20% will be 78%/16%*8%, that is, 39% versus 20% of the RBI, and not 8%, which is
apple-to-orange comparison. It simply means that if the ECB has 8% revaluation reserves to
cover the forex risk of 16% of foreign currency assets, it will, ceteris paribus, have 39% worth of
revaluation reserves to cover the forex risk of 78% worth of forex assets on its balance sheet for
which the RBI has only 20%. Alternatively, the adjusted, apple-to-apple, revaluation reserves of
the RBI will be 16%/78%*20%, that is, 4.10% versus 8% of the ECB and not 20%, which is
apple-to-orange comparison. This analytical framework can be extended to include equity and
retained earnings component of the capital as well, which in the case of the ECB and the RBI are
2.3% and 7%, respectively, thus giving total capital-to-assets ratio of 10.3% and 27%,
respectively. Doing this gives the ECB’s adjusted capital-to-assets ratio of 78%/16%*10.3%, that
is, 50.2% and the RBI’s adjusted capital-to-assets ratio of 16%/78%*27%, that is, 5.5%.

Thus, from the above analytical framework, it turns out, ceteris paribus, that rather than, and far
from, being about 2.5 times the revaluation reserves (20%/8%) and total capital (27%/10.3% ),
both the revaluation reserves and the total capital of the RBI, as a percentage of its balance sheet,
are about half (20%/39% or 4.10%/8%) and (27%/50% or 5.5%/10.3%) the revaluation reserves
and the total capital, respectively, of the ECB. Based on the same analysis, ceteris paribus,
compared to the RBI’s capital-to-assets ratio of 27%, the adjusted, orange-to-orange, capital-to-
assets ratios of the US Federal Reserve, the Bank of England, the Bank of Japan and the Bank of
Russia come out as 10%, 18%, 43% and 28%, respectively, and, therefore, the RBI is no way
excessively/over capitalised as concluded by the Economic Surveys. The Committee on
RBI’s Economic Capital Framework may like, therefore, to apply this analytical framework to
compare the RBI’s revaluation reserves and capital with those of the other central banks
mentioned in the Economic Surveys, to reach a meaningful conclusion as to whether the RBI is
excessively/over capitalised at all.

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As regards an appropriate level of the RBI’s economic capital , it must be noted that all the
revaluation reserves serve, as quasi-capital, the purpose of true economic capital as its first line
of defence against unrealised marked-to-market net losses, obviating any impact on its
contingency fund except that credit balances in these accounts cannot be transferred to the
government for the reasons clearly explained in the article.

It is only when there is debit balance in any of these revaluation accounts is the contingency fund
debited. According to the current accounting policy of the RBI, such negative balances, if any,
are debited to the contingency fund on June 30 every year and reversed on the first working day
of the following year. However, without in any way detracting from the integrity and the
robustness of the accounting practices, it will be logically consistent and more appropriate to first
adjust such debit/negative balances against the credit balances available in the other revaluation
accounts and debit the contingency fund only as a last resort because unlike the contingency
fund, which is ‘net realised gains-based’, all revaluation accounts are ‘net unrealised gains-
based’. This will obviate the need for reversal of the debit entries unless they are from the
contingency fund as done now and, significantly, avoid reporting lower credit balance in the
contingency fund as on June 30 unless it is because of net debit balance of all the revaluation
accounts.

Finally, to ensure that there is nearly always a minimum-sized contingency fund (equity capital)
which more than absorbs the effect of the net erosion of the credit balances in the revaluation
accounts, the minimum credit balances in the revaluation accounts can be modelled using
historical time series of these balances (technically referred to as the Value-at-Risk (VaR) model
with very conservative 95% to 99% Confidence Intervals) such that any balances lower than
these minima will trigger retention of so much higher realised net gains and so much lower
surplus transfer to the government. Equally, in the opposite case, there will be so much higher
surplus transfer to government.