The Reserve Bank of India (RBI) Versus Government of India (GOI) Kabaddi

The GOI-RBI spat evokes images from the competitive Indian sport of “Kabaddi” where a lone offensive player, called “raider”, enters the opposing team’s half of the court to tag “defenders”, thereby scoring points. The unprecedented invocation, by the Ministry of Finance (MoF),  of section 7 of the RBI ACT, of 1935 - that allows the Finance Ministry to issue a diktat to the RBI in “public interest”  - led to the RBI’s  “open mouth operation” – borrowing liberally from the former Governor of RBI YV Reddy’s pun on the “Open Market Operation”  – by the current Deputy Governor, of RBI, Viral Acharya. "Acharya" means "Teacher" in sanskrit & his erudite speech delivered, at the AD Shroff memorial lecture, last week, that went viral, raised 4 main issues

·         Governments’ encroach on the autonomy of their central banks at the peril of inviting the wrath of the financial markets. Ex Argentina in 2010

·         Regulation should be ownership neutral: Govt. should allow RBI to regulate Public Sector banks (PSB) on par with Pvt. Sector Banks

·         GOI’s should not dilute RBI’s regulatory scope by appointing a separate regulator for the payments sector 

·         GOI should not raid RBI’s reserves to fund its fiscal deficit.

GOI seems to have a separate set of grouses

·         RBI lax in managing the Liquidity issues in the market

·         Prompt corrective Action(PCA) that debars 11 of the 27 PSBs (Public Sector Banks including subsidiaries of SBI & Bharatiya Mahila Bank)  from lending needs to be revised & lending to MSME sector encouraged

·         Exempt the power sector companies from the 12^th Feb’18  circular on bad debts

·         Reduce Tier 1 capital norms from the stringent 5.5% to Basel 3 norms of 4.5%

Obviously, both sides have legitimate arguments & had debate rather than confrontation marked their relationship, public fracas could have been avoided. It is also prudent to note that governors' before Rajan had been associated, for a decade or two, with the govt., & hence could carry their concerns to the Finance Ministry, with nuance & subtlety. 

That does not absolve the govt. though of its missteps. Unless subject matter experts, rather than generalist bureaucrats, man the Ministry of Finance (MoF), they might not be able to have a competent debate with the technocrats of the RBI. Furthermore, GOI's lackadaisical  handling of the Election Commission (EC), Chief Vigilance Commission (CVC), Supreme Court (SC) & now the Central Bureau of investigation (CBI), forces one to believe the argument of critics that the Govt. treated the RBI in a cavalier fashion; riding roughshod on the RBI during demonetization, in 2016 & beyond was especially distressing since the latter was left holding the can for the former’s actions. RBI’s employee union coming out in support of Viral Acharya’s speech is indicative of an institution up in arms & not any specific individual or cabal protesting under the impression of being under seize. The RBI angst is thus palpable & has been accentuated with Deputy Governor, Nachiket Mor’s resignation - considering the conflict of interest inherent in his employment with the Bill & Melinda Gates Foundation - & the appointment of independent directors like S Gurumurty, peddling the government's line, during the board meetings.

RBI is right in demanding greater powers to manage PSBs

The RBI is right in demanding parity of powers in dealing with all banks – Public or Private.  RBI’s control over the PSBs is weakened as a consequence of the Banking Regulation Act; clause 51 of the said Act does not allow RBI to remove the Chairman, Directors or the management who are beholden to the govt. unlike the “fit & proper” criteria applied, by the RBI, to the Pvt sector banks that helped influence issuance of marching orders to the Chiefs of Yes Bank, Axis Bank & ICICI . RBI cannot call for a meeting of the PSB’s board, supersede the board or appoint observers nor can it force mergers between PSBs or trigger their liquidation.

RBI guidelines on 15% ceiling on promoter group shareholding & 10% on non-promoters brings in various counterbalancing forces, into banks, that protect minority rights better than PSBs where the govt. holds more than 51% shareholding. The Pvt sector banks have lower NPA’s vis a vis their PSB brethren , perhaps, as a consequence of better regulation & better credit appraisal - courtesy need to approach markets regularly for fund raising, unlike PSBs beholden to the govt. Conversely, lax project appraisal & nepotism led to huge credit outflows of Rs 52 lakh crores, largely from PSU banks, during the period 2008-14 as against 18 lakh crores during the previous 6 years, which PM, Modi mocked as “phone banking”.

Critics have lambasted the RBI, for their inability to detect or prevent scams despite having a nominee on all the PSB boards & more than one where banks are troubled or raise special concerns. To be fair, RBI Governor Urijit Patel, like his predecessor Rajan, have argued for withdrawal of their nominees citing conflict of interest as a regulator cannot be a party to bank’s management decisions. The PJ Nayak committee report, though, has submitted that the bank boards, as they exist now, are not cohesive & the RBI nominees carry weight with the independent directors, acting as a stabilizing advocacy; the committee suggested a 3 phase reform process starting with the formation of a Bank Boards Bureau to be taken over by a holding company of PSBs to be followed by empowering PSB boards & RBI nominees stepping down in phase 3. Unfortunately, we haven't seen substantial action by the govt. on this  issue.

The job of the regulator should be to force timely recognition & disclosure of NPA’s followed by adequate capitalization of PSBs & issue marching orders in case of violations. The RBI, is thus legitimate in demanding more powers to handle PSBs but that alone is useless unless Chinese walls are installed between the MoF & the PSBs - to prevent the recurrence of "phone Banking" - & the reforms advocated by the PJ Nayak committee are completely implemented; no Govt., though, would concede the same, unless it is preceded by electoral funding reform, a prerequisite to eliminate crony capitalism & that appears unlikely in the short term.

"No" to a separate Payments Regulator

The confrontationist stance of the govt. in advocating a separate Payments Regulatory Board (PRB) – with powers to nominate its chairman, in consultation with the RBI, was opposed, rightly, by the latter arguing, instead, for the RBI Governor to be the chairman with 3 members, each, nominated by the RBI & the Govt. with the Governor having a casting vote. Payments are a subset of currency under RBI regulation & dual regulation of instruments like cards or wallets is undesirable. Perhaps, it is time to have a super financial regulator considering the complementarity of jurisdictions between the RBI, SEBI & IRDA & to avoid their turf battles thereoff.

Fixed Formula to share RBI reserves with Govt to avoid annual tussle

The govt. wants RBI to transfer about Rs 3.6 lakh crores of reserves. While admitting that the govt. is under pressure to achieve its fiscal deficit target, since indirect taxes are trending below budget, it is irrational to force RBI to fill the gap, instead of resorting to expenditure rationalization & raising of resources. RBI believes that the balance sheet of the institution would be damaged by such  an action. A fixed formula, to avoid this annual bickering exercise would be in order which would maintain the strength of the RBI balance sheet & transfer the surplus to the govt. – not to manage its fiscal deficit but into an SPV to be used for building infrastructure alone to put a lid on fiscal profligacy.


Need for Liquidity to manage tight market conditions

The govt. does have a point, though, on some of the issues raised. Courtesy the rise in oil prices & US interest rates, capital outflows have increased during the recent months worsening the Current Account Deficit (CAD); capital outflows, RBI’s intervention to prop the rupee, the delay in GST refunds to exporters, the IL&FS crisis & the NBFC tailspin there-off & the advance tax payments made in Sept by corporates, followed by the busy festive season have accentuated the liquidity crisis. The govt. has nudged for RBI action, perhaps, to also account for the liquidity needs, during the impending elections, to 5 state assemblies, by Dec'18.

The 2008 financial crisis has shown that infusion of liquidity is a necessary strategy to manage systemic risk likely to be caused by the fall of institutions too big to fail; IL&FS conundrum had a domino effect of Mutual Funds & Banks not subscribing to securities issues by NBFCs facing further heat post real estate player, Supertech’s defaults.

Open Market Operations (OMO) planned for Nov, of Rs 40000 crores, in addition to the Rs 36000 crores, in Oct, seems to be the compromise worked out between the warring factions of the RBI & the executive.

Case for refining PCA

Prompt Corrective Action (PCA), that imposed lending restrictions on 11 PSU banks, considering their low Capital Adequacy Ratio CAR), NPAs greater than 6%, negative ROA for 2 consecutive years or leverage crossing 25 times their Tier 1 Capital, while theoretically elegant, is liable to lead to loss of good customers & fee income weakening their balance sheets further.  Livemint report, on 31^st Oct 2018, cites Capital Line data from June 2017 to June 2018 to conclude that during the said period Net Interest Income of these 11 banks rose by 114% but NPA’s rose between 195 basis points for Corporation bank to 667 basis points for IDBI bank - which is now being acquired by LIC. Allowing them leeway lend to “good customers” even while strengthening their “risk assessment & project approval teams” would any day be a better alternative to making a strong bank acquire a weak one, wreaking the balance sheet of the former. The govt. wanting these banks too, to be part of their MSME “Support & Outreach Initiative” that promises approval of “loan under Rs I crore in 59 minutes” is unsound as it caters to their election needs alone, especially when most of the MSME loans are unsecured.

Unsound to offer Lifeline to stresses assets in Power sector

It is to the govt. credit that they rolled out the Insolvency & Bankruptcy code (IBC), in 2016, that has led to a fantastic resolution of the stressed assets in the steel sector. RBI has tightened the bad loan recognition norms vide its 12^th Feb'18 circular: a firm lands up into the Special Mention Accounts(SMA) if it defaults on the interest or principal payment even by a day, NPA on the 91^st day & IBC on the 181^st day, if no resolution plan (RP) has been implemented within the timeline. The Private Power Producers with about 1.5 lakh crores in stressed assets & next in line for IBC resolution, moved the Allahabad High Court which lobbed the ball into the govt. court suggesting that they could use section 7 of the RBI act to initiate consultation. Perhaps, the govt. wants to tackle the stressed assets in the power sector after the general elections in 2019 & is seeking a reprieve. The RBI’s policy prescription is neat, in eliminating ad-hocism & discretion in decision making - that provides scope for corruption & nepotism - thereby sending across an unambiguous signal to the defaulters not take the lenders for granted. Perhaps, prior discussion between the RBI & the govt. before announcing the policy would have been more prudent.

Reduction of Stringent Tier 1 Capital norms

Western financial institutions follow stringent provisioning of NPA norms unlike kicking the can down the road phenomena in India, due to political pressure. The RBI seems to have ordered for 5.5% tier 1 capital against 4.5% as per Basel 3 to counter the malady of sweeping NPA's under the carpet. Perhaps, correct provisioning of NPAs should precede reduction of capital norms

Conclusion

GOI is wrong if it sees the RBI actions as the tyranny of the unelected while the RBI is wrong in assuming complete unencumbered autonomy.  The government’s horizon is short term: its elected term of 5 years while that of RBI is long term: to manage financial stability. Governments wish to drive growth & keep various lobbies happy while RBI is focussed on inflation control & price stability & hence clashes are inevitable.  Since a country is more important than a party, it is prudent for the govt. to elicit the RBI’s views & formulate a policy based on consensus; this needs MoF to staff itself with subject matter experts capable of having an informed dialogue with the technocrats of Mint Street. Similarly, RBI should respond to the MoF, even if it disagrees, & conduct Board meetings more regularly, to dispense with the impression of hubris & arrogance. YV Reddy's simple stratagem on how RBI can adroitly manage the relationship with the executive: complete freedom in operational issues, prior discussion with the govt. on policy issues & working in close coordination with the govt. on structural reforms.  Perhaps, a compromise by GOI & RBI, to arrive at a win-win policy framework is the way forward.