Is Contingency Fund of RBI adequate

 

Is Contingency Fund of RBI Adequate?

Surplus Transfer:

Reserve Bank of India (RBI) has transferred Rs.99,122 cr. to the Government of India (GoI), being the surplus amount from its financial results for the year 2020-21. This was 74% increase over the surplus transferred last year (relating to 2019-20) (Rs.57128 cr.) and more than double the amount indicated as ‘dividend estimates from RBI’ in the fiscal budget for 2021-22. It surprised many, as RBI launched a slew of measures in 2020-21, which were aimed at reviving the economy (impacted by the COVID Pandemic, resultant lock downs and significantly less economic activity) but were expected to have a definite bearing to the bottom line of its financial results. Some of the measures initiated by RBI includ. 

1. Its interest free deposits came down by Rs.1.37 lac cr. as CRR was reduced from 4% to 3%.

2. Due to healthy deposit accretion and the scope for credit growth being subdued, there was a huge surplus left out in the banking system even after meeting the increased government borrowings through G-Sec/T-Bills. This surplus was parked with RBI on a daily basis in the reverse repo, which is bound to have had a negative impact in the interest earnings of RBI through LAF.

3.  Operation Twists (simultaneous purchase and sale of government securities) introduced apart from regular purchase of securities through OMO.

4. In order to maintain the exchange rate of rupee with dollars, RBI was in the market constantly to purchase dollars and release liquidity into the system.  

5. It offered money at the reduced repo rate of 4.0% to the banks, FIs and NBFCs through LTRO, TLTRO and on-tap TLTRO for investing/on lending to identified sectors.

Moreover, the accounting year of RBI was changed from ‘July-June’ to ‘April-March’ and since this change is effective from this year only, the operating results is of nine months only (July 2020-March 2021)

Accounts of RBI

In the above backdrop, I perused the annual accounts of RBI

I did not attempt to annualise the results of 2020-21 (9 months extrapolated to 12 months) for comparison, as the regulator’s role is to fulfil its objectives relating to  currency issue, monetary policy and reserve management functions. The income earned is incidental to these objectives and that is why the operating results are even now christened ‘income and expenditure statement’ and not ‘profit and loss statement’

Ø  Income for 2020-21 had come down from Rs.149,672 cr. to Rs.133,273 cr. mainly on account of negative interest on LAF operations going up (interest paid on reverse repo to be precise), decline in interest income from foreign deposits, rupee and foreign securities, partially compensated from the  profit on foreign exchange transactions, which increased substantially by more than Rs.20,000 cr.

Ø  Expenditure came down from Rs.92541 cr. to Rs.34147 cr. mainly on account of reduced employee cost and reduced provision towards contingency fund (CF) (Rs.20710 cr. provided this year as against Rs.73615 cr. provided last year.)

Ø  Though total income has come down by 11%, reduction of provision expenses by Rs.52905 cr. (73615-20710) enabled RBI to post a surplus of Rs.99,122 cr.

Adequacy of Provision:

As the surplus transfer was made possible due to the huge reduction in provision requirements, the question arises - whether RBI has made adequate provision towards CF.

In this regard, RBI accepted all the recommendations of Dr. Bimal Jalan Committee on Economic Captial Framework (ECF) in August 2019, which contained the following major recommendations on surplus distribution to the government every year.

(i)    Target the ‘required realized equity’ (provision requirements) for covering: (i) monetary and financial stability risks (ii) credit risk (iii) operational risk (iv) a shortfall, if any, in revaluation balances vis-à-vis market risk.

(ii) The minimum level of ‘available realized equity’ (ARE)*, (also known as Contingency Risk Buffer (CRB)), should be the sum of the monetary and financial stability risks, credit risk and operational risk and should be maintained within a range of 5.5-6.5% of the RBI’s balance sheet (4.5-5.5% for monetary and financial stability risk and 1% for credit and operational risks).

(iii)           Entire net income be transferred to the Government, if the RBI’s ARE is equal to or greater than upper bound of the ‘requirement’ (6.5%)

(iv)           Subject to ARE lying within the range of ‘requirement’ (5.5 to 6.5 per cent) the Central Board may consider risk provisioning in a manner so as to maintain the RBI’s ‘ARE’ within the range of ‘requirement’ till the next periodic review.

(v)  If the ARE falls short of lower bound of ‘requirement’(5.5%), appropriate risk provisioning should be made by the RBI to augment realized equity to the lower bound of ‘requirement’ and only the residual net income (if any) should be transferred to the Government.

(vi)           There shall be no distribution of unrealized revaluation balance

RBI maintained ARE at the lower bound of the requirement (5.5%) for the last three years, as per details given below:

(Rs. in cr.)

Year	Total Assets	Upper bound (6.5% of total assets	Lower bound (5.5% of total assets	ARE*maintained By RBI
2018-19	4102905	266689	225660	225724
2019-20	5334793	346761	293413	293413
2020-21	5707669	370998	313921	313921

* ARE = Equity+Reserve Fund+CF+ADF

It appears that RBI Central Board relied on (iv) and (v) of the committee’s recommendations for transferring the entire net income to the government after ensuring ARE is maintained at 5.5% of the total balance sheet, though (iii) of the recommendation creates an impression that the entire net income for the current year should be transferred to the government, only when ARE is maintained at the upper bound of the requirement (6.5%).

Leaving the above technical issue, the less provision for the current year (Rs.20710 cr.) in relation to the provision for the previous year(Rs.73615 cr.) is explained by the fact that the balance sheet expanded by 6.99% (Rs.3.73 lac cr.) during 2020-21 as compared to the balance sheet expansion of  30% (Rs.12.32 lac cr.) witnessed during 2019-20. Hence RBI cannot be faulted on having made any less provision for the current year.

Why ARE or Contingency Fund (CF) should have been scaled up?

Though maintaining the ARE at 5.5% of the balance sheet is with the range of 5.5-6.5% accepted for implementation, one wonders how the monetary and financial stability risk provision can be kept at a constant level 4.5% during both normal and abrnormal times. While 2018-19 had only the normal shocks as is common for any economy, the years 2019-20 and 2020-21, clouded by COVID, throws open uncertainties for the future that are difficult even to visualise. In this regard, RBI Governor told in the press meet held on 4^th June 2021, immediately after announcing the decision of MPC, that the surplus transfer is only an accounting issue. And the Deputy Governor Shri T.Rabi Shankar gave exactly the reasons that I have enumerated in the previous paragraph for the lower provision during the current year.  But the question is whether the issue is as simple as an accounting issue only? Is not the central board of RBI obligated to discuss at what level the  provisions for the current year shall be kept,  within the defined range of 5.5-6.5%?

In my opinion, RBI should have scaled up the provision at least up to 6.0 per cent during the current year for the following reasons:

(i)                Banking System is expected to be the most stressed sector at least for the next two years. RBI was not required to play the role of lender of last resort (LoLR), when banks like IDBI Bank, Yes Bank and LVB were stressed as it could find investors to change ownership, board and management and thereby prevented a run on the banks. Small Finance Banks occupy an important space and co-operative banks are also huge in number. Even now, the depositors of PMC are unable to withdraw more than Rs.1 lac from the bank as investors could not be found.  If the stressed banks go up in number, RBI has to act as the LoLR in true sense of the term to pump in liquidity and avoid systemic risks.  For that adequate financial stability risk provisions are required.

(ii)             NBFCs, referred to as shadow banks, have entered all areas of lending more so on the retail side. They have a significant share in the lending portfolio of the finance sector to the economy. Even banks are encouraged to lend to NBFCs for on-lending to identified priority sectors. The systemic risk to the financial sector arising out of NBFCs is more pronounced now than ever before. IL&FS & DHFL failure episodes are only of recent origin.

(iii)           DICGC is a subsidiary of RBI and the risk coverage to depositors of the banks has been recently raised from Rs.1 lac to Rs.5 lacs. The risk arising out of the increased coverage should be factored by the parent in its risk calculations.

(iv)           With the second wave  of COVID on going, RBI has to continue its accommodative policy stance and liquidity measures during the current FY at least, which is likely have an impact on its earnings and provision towards CF.

(v)              Had RBI chose to keep the ARE at 6%, additional provision needed would have been Rs.28539 cr. Still it could have transferred Rs.70583 cr. to the government, much more than the amount transferred last year and what has been budgeted by the government in the current fiscal. 

(vi)           RBI financial stability risk provisions need to be viewed as the country’s savings for a rainy day and has to be demonstrably credible with the requisite financial strength.

Regards

 V.Viswanathan

 Coimbatore

05.06.2021