Home / Industry / Banking /  Is Reserve Bank of India hoarding too much capital?

Central banking works best when it is boring. So, it is surprising that the very technical issue of whether the Reserve Bank of India (RBI) holds too much capital in its balance sheet has become the vortex of an unexpectedly heated public debate. The government reportedly wants RBI to return some of its capital to its owner. RBI is pushing back. The battle lines have been drawn. The adequate level of central bank capital is expected to be one of the key issues to be discussed when the RBI board meets once again next week.

The battle is being fought at a time when the balance sheet of the Indian central bank has nearly trebled in size over the past decade—from 14.08 trillion in fiscal year 2009 to 36.18 trillion in fiscal year 2018. As a share of the gross domestic product (GDP), the size of RBI’s balance sheet has remained stable over the years, data shows.

Most of the expansion in the RBI’s balance sheet has come from the sharp increase in the rupee value of foreign securities held by RBI, as the Indian central bank, has built up forex reserves for protection against global financial shocks.

The liabilities side of a central bank balance sheet is dominated by equity, reserves and bank notes issued. The logic of balance sheets demands an increase in liabilities to match the increase in assets. Most central banks have rapidly expanded their balance sheets in the past decade and, thus, liabilities as well.

However, the rise in the assets side of the RBI balance sheet because of the purchase of foreign currency bonds is qualitatively different from the rise in the assets held by, say, the US Federal Reserve, which bloated its balance sheet through the purchase of domestic securities for monetary expansion through quantitative easing. A central bank such as RBI that mostly holds foreign securities faces fundamentally different risk management challenges than a central bank such as the US Federal Reserve that mostly owns domestic securities.

Simple global comparisons of central bank capital can be quite misleading for this reason.

Any central bank holds capital as a buffer against losses in its portfolio. In the case of RBI, the total reserves have also trebled in tandem with the size of the balance sheet. Are the 9.23 trillion it currently holds as reserves too much? Not necessarily.

RBI maintains two major types of reserves. It has a revaluation fund, which has to be adjusted depending on the changes in the value of the dollar and gold portfolios. This is a standard accounting requirement. A sharp depreciation of the rupee or a fall in international gold prices will eat into these reserves. Most of the reserves that RBI holds are in the form of revaluation reserves. They have moved in tandem with the increase in foreign exchange plus gold holdings. As a share of the RBI’s forex and gold reserves, revaluation reserves have declined slightly in recent years.

The second category of reserves is the contingency reserves needed for the Indian central bank to conduct its usual functions. As Amartya Lahiri, director of the RBI-funded Centre for Advanced Financial Research and Learning and a professor at the University of British Columbia, pointed out in a recent article in The Indian Express, two-thirds of the reserves in the RBI balance sheet are accounting entries while only one-third is capital that can actually be deployed. He has argued that RBI is one of the most under-capitalized central banks in the world if only contingency reserves are considered.

As the accompanying chart shows, almost all the increase in RBI’s capital base in the post-crisis era is because of revaluation rather than contingency reserves. The latter has been more or less constant over the past six years, a far cry from the view that the Indian central bank has been hoarding capital.

Every country has its own way of handling the issue of central bank capital. For example, the Bank of Korea is not only legally bound to transfer 30% of its annual profits to statutory reserves but also has a right to call for more capital from the South Korean government when it feels the need to bolster its balance sheet. The Singapore constitution says that the Monetary Authority of Singapore has the responsibility to safeguard accumulated reserves which were not added during the term of the current government.

India need not copy any of these specific provisions, but the ongoing debate shows that a more formal framework is desperately needed. The Reserve Bank of India Act, 1934, is vague on what has now become a political flashpoint. It is now time for more legal clarity on central bank capital, which needs an informed debate rather than hasty action.

Niranjan Rajadhyaksha is research director and senior fellow at the Mumbai-based IDFC Institute.

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