The current global financial turmoil has underlined the importance of the size of a central bank’s balance sheet. Normally, this aspect of modern-day banking gets scant attention, but in times of crises, like the current one, it rightfully comes in for a sharp rethink.
This is because no central bank has to live up to its role of lender of the last resort everyday. But it cannot afford to fail to do this when a crisis demands the fulfillment of that role.
This is crucial to maintain faith of the financial players in its ability to support the market.
It is little wonder then that when the US Treasury Department decided to bolster the Federal Reserve’s balance sheet by issuing debt, attention was drawn to the Fed’s health as reflected in its account books.
In recent times when the US authorities infused funds into the country’s financial system to avoid market disruptions that would have happened if large-scale bankruptcies of banking institutions were allowed, Federal Reserve and New York Fed took a hit on their balance sheets.
According to an estimate, the Fed had close to $800 billion of treasury bills at the beginning of 2008. By mid-September, this could have come down to around $200 billion, largely because of its rescue operations. This amount was so low that the Treasury had no option but to refurbish Fed’s balance sheet.
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As the current crisis unfolds, it is likely that not only the Fed but also other central banks such as the Bank of England and the European Central Bank may have to take on their books significant amounts of illiquid assets. This would necessitate a booster dose for their balance sheet.
When a central bank is asked to perform its role as lender of the last resort, this kind of situation becomes unavoidable. Some experts were of the view that if the Fed has to play a role as an intermediary in financial markets, it needs to grow on a massive scale.
For Indian financial markets, fortunately, the situation has not yet become so bad that it calls for the Reserve Bank of India to act as lender of the last resort on a wide scale.
Of course, the RBI keeps intervening in foreign exchange and debt markets on a frequent basis, but that is in a different league.
A look at RBI data shows that the Indian central bank has consciously tried to build its balance sheet over the years.
In 2007-08, the size of RBI’s balance sheet rose significantly — by 46 per cent — to Rs 14.6 trillion. Interestingly, the size of the RBI’s 2007-08 balance sheet is equivalent to 34 per cent of India’s gross domestic product (at market prices) as compared with 26 per cent a year earlier.
Over the past years, the RBI has been contributing a relatively larger part of its surpluses to its contingency and other reserves.
In 2004-05, it had transferred 41.6 per cent of its surplus to this account, which went up to 49.9 per cent in 2006-07 and further to 57.9 per cent in 2007-08.
At Rs 33,430 crore, the transfer to contingency reserve in 2007-08 marked a rise of 63 per cent over the previous year.
At the same time, the RBI reduced its contribution to government budget. It transferred Rs 15,011 crore to the government from its surplus fund at the end of 2007-08, a rise of 31.5 per cent from the previous year.
However, in proportion of its gross income, such transfers to government have been declining. The figure declined from 31.9 per cent at the end of 2005-06 to 27.8 per cent at the end of 2006-07 and further to 26 per cent at the end of 2007-08.
It is true that India has yet not seen the kind of financial turmoil that developed world is currently witnessing.
So, it is too early to say if its balance sheet management has been good enough for it to play the role of lender of the last resort, if situation demands.
However, often in such crises, confidence plays a crucial role in deciding survival of the system. On that account, the RBI should score a clear point.