Persuade, do not direct

How to deal with RBI

During the reform period till 2013, the government took several steps to strengthen the balance sheet of the Reserve Bank of India and added to the reserves. For instance, the excessive cost of sterilisation, which normally is borne by the central bank, was shared by the government to keep the central bank strong to be able to serve it better in times of difficulties. In recent years, the government has reviewed this approach. Further, by taking recourse to the unprecedented practice of interim dividend, the spirit of limit on the Ways and Means arrangement under the fiscal management legislation has been compromised. Immediate fiscal needs seem to take precedence over a renewed assessment of the capital needs of RBI.

In 2018, the government took the stand that the RBI has excessive reserves, and the excess could be legitimately claimed by the government. It was laying claim to stock and not merely flow.

There is no doubt that in the ultimate analysis, the government as the owner has a claim over the reserves, but the way it exercises this claim gives signals to the market and influences public opinion. In law, the RBI Board will have to decide on this, and the Board members are nominated by the government. There are two substantive issues. One is the determination of excess reserves and whether this should only be confined to realised gains or can apply to revaluation gains as well; the second issue is the immediate use of excess reserves, as determined.

There are different approaches to the level of capital of a central bank. One view is that government will provide support to it when needed and hence the issue of adequacy does not arise. All income over expenditure every year could get transferred to the government. Alternatively, the government may like to assure the markets that its central bank has the capital to meet contingencies that may arise without depending on governments. There is merit in keeping at least the central bank’s balance sheet strong if the government’s fiscal balance sheet is weak. But substantively, it is the judgement of the government that prevails on the adequacy issues, though procedurally it is that of the Board.

Use of reserves accumulated in the past will have to consider four factors: one, the macroeconomic implications of such transfers, in particular, the monetary implications, which are likely to be expansive; two, the issues of inter-generational equity, since the reserves have been accumulated as an insurance for the future; three, the constitutional propriety of using the reserves directly to fund capital of the banks, instead of crediting it to the Consolidated Fund of India and then using it as considered necessary by the government; and four, the incongruity of the banking regulator being asked to use its resources to fund banks that are in need of capital. A committee has been appointed to advise the RBI on the capital framework and related matters.

Second, the government demands that the RBI should relax the norms of Prompt Corrective Action. The government’s contention is that growth is affected by such stringent measures. This is certainly an operational matter and a matter on which government-owned institutions could make representations to the RBI for consideration. There can be genuine concerns of the government, but governments generally persuade, not direct, the regulator in such matters. Obviously, the government is tilting in favour of its own regulated entities who failed to convince the regulator in the matter, though RBI is the agent of the government and fully equipped to take a view on the matter. In a manner, this dilutes both the autonomy and accountability of the RBI.

Third, the government is also seeking the dilution of the Basel III norms for India on the ground that these are more stringent than the global standards. In general, the Basel III norms assume a particular level of realisable value of the assets in case it becomes non-performing. In India, the transactions cost and the liquidity in relevant markets, in particular in real estate, make the realisable value generally far less than the declared value. There is, thus, a case for the Indian norms to be more stringent than global ones. But the scope, coverage and deviation from global standards are a regulatory and operational matter.

Fourth, the extent of the RBI’s response to the liquidity conditions being faced by non-banking financial companies is another point of friction between the government and RBI. If IL&FS faced a liquidity problem, it would have been the responsibility of RBI. Obviously, it is an insolvency issue since the government intervened. Perhaps the government intervened since both LIC and SBI, owned by it, are large stakeholders in IL&FS, and also because many infrastructure projects are involved. In any case, RBI should be concerned at the risk assessment capabilities of public sector giants like LIC and SBI that allowed this to happen while having a large stake in IL&FS.

Fifth, the government seeks a policy and a procedure from RBI to facilitate lending liberally, primarily to small and medium industries. The SMEs’ problem is not new, nor is it unique to India. However, any extraordinary push will jeopardise depositors’ interest or induce systemic instability. This is a matter again in which the government and industry could raise the issue and convince RBI but should ideally respect its judgement. To implement any support beyond what RBI considers prudent, government should ideally draw upon its budgetary resources, as is being done to waive farm loans.

Finally, the issue of governance and the role of the RBI Board have been raised. This certainly is a matter that requires consideration keeping in view both global practices and changing domestic circumstances. In any case, if the role of the Board is being reviewed, it should encompass its composition, its relations with the government and with the RBI Governor. The current composition of the Board in India is unique and appropriate to a full-service central bank. Currently, the Board focuses on house-keeping and renders advice and guidance on policy and is active in committees of the Board, constituted on the advice of the Governor and which provide fora for detailed scrutiny and guidance by the Board members.

The issues relating to the regulatory relaxations, capital framework and the role and composition of the Board will have a lasting impact on RBI.

(The writer is a former RBI Governor. The article is excerpted from the Kale Memorial Lecture, 2018, which he delivered at the Gokhale Institute of Politics and Economics, Pune, on February 8, 2019) (The Billion Press)