24 May 2024 Economic Capital Framework (ECF)
THIS ARTICLE COVERS ‘DAILY CURRENT AFFAIRS’ AND THE TOPIC DETAILS OF ”Economic Capital Framework (ECF)”. THIS TOPIC IS RELEVANT IN THE “Economy” SECTION OF THE UPSC CSE EXAM.
Why in the News?
The Reserve Bank of India (RBI) recently approved the transfer of Rs 2.11 lakh crore as a dividend to the Government of India for the financial year 2023-24. This is the highest-ever dividend despite the Contingent Buffer Risk being increased to 6.5% for 2023-24. The transferable surplus for the year (2023-24) has been arrived at based on the Economic Capital Framework (ECF).
About Economic Capital Framework(ECF):
- The Economic Capital Framework (ECF) is an extensive risk management mechanism mainly utilised by financial institutions to ascertain the capital required to maintain solvency and protect against assorted risks.
- It offers a systematic approach for calculating the suitable amount of risk provisions and the distribution of profits, as mandated by Section 47 of the RBI Act, 1934.
- According to these provisions, the central bank must transfer its remaining profits to the central government after setting aside funds for potential bad debts, asset depreciation, and staff benefits.
- The old Economic Capital Framework (ECF) was formulated during 2014-15 and became functional in the fiscal year 2015-16. In 2018, the Reserve Bank of India (RBI) established an Expert Committee led by Dr Bimal Jalan to assess the existing ECF and recommend an appropriate policy for surplus distribution.
- On August 26, 2019, the Reserve Bank of India implemented a new Economic Capital Framework (ECF) based on the suggestions from the Bimal Jalan Committee, which is Subject to a review every five years.
- The Economic Capital Framework helps the RBI manage financial risks by determining the surplus reserves it can transfer to the government. The Expert Committee recommended that the Reserve Bank of India’s (RBI) surplus distribution policy should include not just the total economic capital—comprising capital, reserves, risk provisions, and revaluation balances—but also realised equity, including capital, reserve fund, and risk provisions.
- They advised that the RBI’s total economic capital should be between 20.8% and 25.4% of its balance sheet, with the Contingent Risk Buffer (CRB), designed for monetary, fiscal stability, credit, and operation risks, maintained at 5.5-6.5%. The CRB acts as a national financial stability reserve. If realised equity exceeds required levels, all of RBI’s net income goes to the government; if below, risk provisioning is prioritised, and only the remainder is transferred.
Key objectives of the Economic Capital Framework(ECF) include:
- Financial Stability: Ensure the RBI has sufficient capital to manage financial and operational risks, thereby maintaining financial stability.
- Risk Management: Enhance the RBI’s ability to absorb losses from its operations and external shocks.
- Transparent Surplus Distribution: Establish a systematic approach to distributing surplus reserves to the government, balancing the need for the RBI to maintain adequate reserves and the government’s fiscal needs.
- Regulatory Compliance: Align the RBI’s practices with international best practices for central banks, ensuring a robust and transparent financial management framework.
About Bimal Jalan Committee:
In 2018, the Reserve Bank of India established a committee led by Dr Bimal Jalan to evaluate its Economic Capital Framework. The primary goal of this committee was to recommend an appropriate framework for risk provisioning and capital requirements for the RBI. The recommendations of the committee are:
- Realised Equity: The committee recommended that the RBI maintain a Contingent Risk Buffer (CRB) of 5.5% to 6.5% of its balance sheet. This buffer is meant to cover monetary and financial stability risks.
- Revaluation Balances: The committee recommended treating the revaluation balances (gains from currency and gold revaluation) separately and not using them to meet operational losses.
- Surplus Distribution: It proposed a clear distinction between realised and unrealised gains. Only realised gains (net income) should be available for distribution as surplus to the government.
- Periodicity of Review: The ECF should be reviewed periodically (every five years) to ensure it remains relevant and effective.
In August 2019, the RBI adopted most of the Jalan Committee’s recommendations, establishing an updated Economic Capital Framework. This revamped framework introduces a more transparent and systematic approach to defining capital levels and risk provisioning.
Conclusion:
The Economic Capital Framework is pivotal in enabling financial institutions to manage their risk exposure effectively, efficiently allocate capital, and comply with regulatory requirements. It ensures the financial system remains stable and promotes a clear and transparent process for distributing surplus with the government. The framework has evolved under the guidance of the Bimal Jalan Committee’s recommendations to harmonise the RBI’s operations with international norms while catering to the unique needs of domestic financial stability.
Download Yojna daily current affairs eng med 24th May 2024
Mains Practice Questions:
Q. How do regulatory bodies view financial institutions’ use of the Economic Capital Framework, and how does this impact compliance requirements?
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