Rajan, RBI's cash pile and bank recapitalisation

Reserve Bank of India (RBI) governor Raghuram Rajan has finally made his stance clear on the issue of using RBI’s capital reserve to recapitalise banks. Rajan on Wednesday said that using RBI’s surplus fund to take stake in banks may be a bad idea.

The idea of government using RBI’s cash pile was first muted in the Economic Survey 2016. The survey suggested the Reserve Bank of India (RBI) could use its own equity to recapitalise public sector banks (PSBs), given the high share of capital the central bank holds and the tight fiscal condition of the government.

The government has over the past few years used the proceeds of divestment to recapitalise banks. But with the markets remaining subdued, raising money through divestment became increasingly difficult.

The other option was to allow banks to sell stakes in their non-core businesses. The survey argued that while public sector banks can recapitalise themselves through their own balance sheet by letting the government sell off assets in nonfinancial companies. "What is less appreciated is that RBI could do the same. That is to say it could redeploy its capital as well," the survey said.

 

What the survey is hinting at is that the central bank, like any other bank has a capital which acts as a buffer against the risks they take, that can arise through fluctuations in the value of the foreign exchange reserves due to exchange rate fluctuation and change in the value of government securities due to interest rate movement.

The survey highlighted the fact that RBI’s equity holding, which is capital plus reserves and revaluation of contingency accounts, is the second highest in the world. At 32 per cent of the balance sheet, the capital holding is second only to Norway. In comparison, the capital buffers of US Federal Reserve and Bank of England are less than two per cent. Even the conservative nations like Sweden and Hong Kong have capital of only 20 per cent.

Rough calculation done by Business Standard showed that even if RBI were to bring its equity holding down to the median 16 per cent level, it would free up Rs 5 lakh crore, which is roughly the same amount that is needed to recapitalise the banks as per Basel III norms.

But Rajan feels that RBI should not be picking up bank’s equity. He has been quotes as saying, "This seems a non-transparent way of proceeding, getting the banking regulator once again into the business of owning banks, with attendant conflicts of interest." 

Rajan is right in saying that for RBI it would be mean owning a bank and at the same time monitoring it, a clear case of conflict of interest. But at the same time Rajan seems to agree with the survey’s argument that the capital can be put to good use.

Rajan said that it is ‘better that the RBI pay the government the maximum dividend that it can, retaining just enough surplus buffers that are consistent with good central bank risk management practice. Separately, the government can infuse capital into the banks. The two decisions need not be linked.’ 

This way government takes a bigger bite from RBI’s cash pile by way of dividend and can reuse the fund the way it wants.

Given the amount of cash that RBI is holding in its book, government could use the dividend route to shore up its holding in the banks and recapitalise them enough so that these banks can start lending again. Apparently bank lending is now at a decade low and needs desperate measures by the government and bank to bring it back to respectable levels. The path suggested by Rajan on the direction of the Economic Survey is as good as any to get the ball rolling.