Meaning and Operation of Networth
Networth is required for any fictitious commercial entity to ensure that its operations are not hampered by expected variation in the business variables.
An industrial or commercial entity, when it builds it networth, increases its bank balances held with a commercial bank. It may then spend that increase in networth in an acquisition of business, fixed asset or inventory or patents which can be converted back in cash with varying degrees of difficulty.
Now, when a commercial bank builds its networth, in that instantaneous moment, its reserves with its central bank increases, and then the commercial bank goes on to buy securities or issue loans or to open new branches or ATMs or acquisitions from that increase in networth, which can be converted back to cash in case of need.
Lastly, what happens when a central bank builds it networth? Where does that money goes? Central bank by definition, builds its networth in its local fiat currency. When central bank increases its domestic reserves, it sucks out the equivalent reserve money from domestic economy.
Money Supply and Central Bank Networth
Any domestic economy requires a certain level of and a certain growth in money supply. Sources of reserve money are-
- Currency Printing,
- Central Bank loans to commercial bank, and
- Central Bank loans to its own government and
- Foreign Exchange holdings of the central bank
This reserve money is reduced on day to day basis by any profits that the central bank makes, as any increase in reserves of central bank leads to decrease in money supply.
When viewed in this way, Central Bank Networth is a choice of monetary policy action and (as I will explain later) is not required for safety. If Central Bank keeps too much networth, then for the same level of money supply, it will have to give additional loans to banks or to the government. In other words, Central Bank Networth imposes (as I will show later) unnecessary cost on the money supply in the form of interest charged on loans by the central bank. Meaning central bank networth, is a friction to the operation of domestic economy.
Safety Margin and Networth
It has been stated that central bank needs to hold some networth for safety margin for the asset held by the central bank. Let us unpack this.
What are the assets held by the central bank?
Firstly, loans to its own government and to banks regulated by it (against the security of government bonds). Since, domestic government bond of a sovereign country with a central bank is completely free of default risk, there is no need to hold any capital against such loans. The interest rate led price volatility of such loans is transient phenomenon and for an entity with printing press, are not a cause of worry.
Secondly, central bank holds foreign exchange reserves. When will central bank face losses on its foreign exchange reserves? When the domestic currency will appreciate against foreign currencies. When will domestic currency appreciate? When the domestic inflation is unexpectedly lower? What is the course of action when domestic inflation is unexpectedly lower? Print money. What happens when central bank monetizes its losses on currency holdings? Money supply increases. Presto! Central bank faces no foreign currency risk vs intended course of action dilemma ever!
Operation of Safety Margin
Many experts are wrongly assuming that the networth of central bank is held in some safe box which can be withdrawn at the time of crisis. That is not the truth. Networth of central bank is leakage from domestic money supply. When central bank runs up losses, it is addition to domestic money supply. Hence, instead of looking at Central Bank Networth as safety margin issue, it should be looked up as composition of money supply issue.
Structure of RBI Balance Sheet and Colonial Vestiges
Attention of the readers is drawn to seven magnificent books, namely, The Evolution of State Bank of India Vol I to Vol III and The Reserve Bank of India Vol I to IV.
A detailed reading of these books shows that many structures in Indian banking and central banking regulations and practices are vestiges of British colonial mentality that the brown natives are incapable of handling their own affairs. A tussle between natives and the colonial masters in defining and redefining structure of the banking system is well documented in those books. However, post-independence, somehow Indians stopped breaking down those colonial vestiges. Now, after 72 years, today RBI has decided to break one more such vestige by announcing draw down of networth.
Just to give an example, BOE operates at a leverage of 140x. US Fed operates at leverage of 300x plus. Why should Indian RBI operate operate at 20x only, when as I have shown above, no central bank needs any domestic reserves ever? To couch this question in the form of independence of central bank is intellectual dishonesty at best and continued racism at worst.