ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846

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Paranoia or Prudence?

How Much Capital Is Enough for the RBI?

To assess whether the Reserve Bank of India is overcapitalised, two approaches are employed. First, the methodology and risk tolerance parameters used by major central banks are applied to the RBI’s balance sheet. Second, a simple cross-country econometric framework relating optimal capital to its possible determinants is used. Both suggest (conservatively) that the RBI has substantial excess capital—in excess of ₹4.5 lakh crore—which could be profitably deployed elsewhere, not for financing general government operations or the deficit but, for example, to recapitalise the public sector banks conditional on them being reformed. 

The authors worked in or were associated with the Ministry of Finance when the bulk of this paper was written. This paper is an elaboration of the ideas first presented in the Economic Survey, 2015–16. Without implicating anyone in the views expressed in the paper, the authors would like to gratefully acknowledge discussions with and inputs (and criticisms) from Viral Acharya, Rajiv Mehrishi, Rakesh Mohan, Michael Patra, Raghuram Rajan, YV Reddy, and especially Subhash Garg and Vijay Kelkar.

The Reserve Bank of India (RBI), like other central banks, must ensure the credibility, autonomy, and effectiveness of its policy actions. The RBI is a counterparty in many financial transactions and is expected to deliver on its obligations even in the worst possible market conditions and times for the country. As a consequence, the RBI needs to have a very resilient balance sheet. That is, the RBI needs adequate capital reserves and other buffers that it can use to stabilise the economy during times of distress.

But how much capital should a central bank hold?1 This is a question that has no clear answer either in theory or practice. In theory, there is a spectrum of views. At one end is the view that central bank capital holdings do not matter, for three reasons. First, central banks can always deliver on their domestic obligations regardless of their net worth because they can always issue liabilities (“print money”). Second, central banks are part of the government and it is the broader government balance sheet that matters, not that of any of its constituents. Third, as long as overall conditions are reasonable, central banks’ stream of profits will eventually make up for any capital shortfalls because of their unique ability to generate income or “seigniorage” (Ernhagen et al 2002). As monopoly providers of a zero-interest liability, namely currency, which the public will always demand (at least, until the world becomes cashless), central banks will always generate net income as long as the assets they hold provide some returns (Buiter 2008). As shown here, this has certainly been true for the RBI. For these reasons, a number of central banks such as those of Israel, Chile, the Czech Republic and Mexico have continued to operate quite successfully for long periods with negative capital.

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Updated On : 20th Dec, 2018
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