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RBI cautions on the perils of regulatory encroachment

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Mr.Dhananjay Sinha

Head of Research and strategist

01 Nov 2018


The lecture by RBI Deputy Governor Dr. Viral Acharya last week, pertaining to the RBI’s independence from state interventions, underpins the lingering and enlarging problems faced by India’s banking and financial services industry. The topic is important because it is not just about a turf war between the central bank and the state, but is also against the backdrop of nearly three-fourth of the constituents of India’s Rs100tn lending industry, including public and private sector banks and NBFCs, facing impairment or liquidity issues.

While Acharya’s speech revolves mostly around the generality of the independence of the RBI, which has been well-researched, its importance lies in the timing of his speech as it warns against the looming perils of heightened government interventions in the functioning of the central bank. He assiduously tries to articulate that coercive state interventions can lead to economic instability. His speech is a critical commentary on the recent developments — both global and domestic.

The recent meltdown in the emerging markets is seen as a fallout of the attempts by heads of states undermining monetary policy decisions of the central banks. Hints are also toward US President Donald Trump’s recent public tirade against the US Federal Reserve decision to raise rates at a time of rising inflation and fiscal deficit. His warning is explicit, compromising the Fed can undermine the US dollar’s status of being a reserve currency. The Wrath of the Market — “Kiss of Death” — eventually prevails over governments that do not respect their central banks’ independence.

That threat from Acharya veils his observations over the ongoing challenges that the RBI currently faces. It closely follows the RBI Governor’s speech in March 2018 on the regulatory disparity between the central bank’s supervisory powers over public and private sector banks, making Acharya’s speech hugely important.

In my view, the discords between central banks and governments have intensified in the past two years. Back in Feb-Apr 2014, the debate was on the RBI’s power to constitute members of the monetary policy committee, which was settled amicably. But the scale of the current discord is at a much different plane and is emerging on multiple fronts.

First, the government’s decision to go ahead with demonetization, overruling former RBI Governor Raghuram Rajan’s reservations, is a monumental example where the currency replacement process, which is essentially within the ambit of RBI’s role, was superseded, thereby causing severe economic damages. While Acharya has refrained from touching upon this encroachment, the damages, especially for the informal sector, small businesses, and farming sectors, are still lingering and snowballing into the many ongoing concerns he has touched upon.

Second, the appointment of government-affiliated officials to key central bank positions is cited as a means to influence the decision-making process at the institution. This can possibly be construed as an oblique reference to the political appointments on the RBI’s board of individuals who have earlier advocated the demonetization decision and were critical of the earlier governor’s management of the RBI.

This bears significance amid the strong differences reported within the RBI’s central board on a host of issues, including allowing forbearance for MSME lending, relaxation of the Prompt Corrective Action (PCA) Framework for severely ailing banks, and response to the ongoing problems in the NBFC sector.

Third, the demand for MSME forbearances, i.e., a relaxation of non-performing asset recognition norms by banks, is ironically justified by non-official directors, who have earlier supported demonetization, as a counterbalance to the damage caused by it.

Experiences, since 2008, amply show that such forbearances impede long-term growth and eventually lead to mounting impairment of loans, translating into bigger burden on the tax payers — the PSU bank recapitalization package is an apt example.

In contrast, the RBI’s recent measures to subsume all forbearances like S4A, 5/25, and other restructuring into gross NPA and forcing banks to provide for them clearly indicate its stand that it is aggressively working toward creating a stable and sustainable banking industry.

Fourth, the demand for the relaxation of the PCA framework goes against the rule-based approach of RBI that is aimed at preventing the infestation of NPA problems of severely ailing banks into a cascading systemic issue. The eleven public-sector banks that are put under PCA are subject to curtailments in normal business of new loans and deposits. The discord over this issue again encompasses the differences over the short- and long horizon hinted by Acharya.

Fifth, the problem faced by NBFCs are rooted in the decisions they made on business and risk appetite, especially in the real-estate and developer-financing businesses. The decision to run significant asset-liability mismatch and borrow short-term money to fund long-term assets — especially during the demonetization phase when interest rates were low — to make disproportionate margins were also business decisions of NBFCs. Hence, it is unreasonable to expect the RBI to respond beyond providing liquidity support, now that the tide has turned against the past excesses of the sector. However, it is imperative that the losses from poor underwriting and rate hardening will need to be absorbed by these commercial entities.

Sixth, Dr. Patel’s March 2018 lecture on the non-neutral regulatory power of the RBI on PSU banks, which outlines the central bank’s statutory limits in undertaking the full scope of actions against the irregularities in PSU banks’ operations, can be seen in the backdrop of the Nirav Modi scam. This was also a clear case of discord between the government and the RBI over the regulatory accountability between the two. 

With the RBI being challenged over the efficacy of its regulatory supervision, it proactively responded by taking measures, especially in the private banking space, where it claims to have greater regulatory power. These include things like dilution of promoter holding, forced changes in leadership wherever required, directives to convert new banks into a holding company structure, etc. Contrastingly, the regulatory actions pertaining to PSU banks by the government has been less than proportionate.

Seventh, the usurping of the RBI’s forex reserves as mooted by the government earlier for the purpose of fiscal needs, such as the recapitalization of PSU banks, is an ongoing thorny issue that compromises the financial strength and credibility of the RBI. This proposal was deftly opposed by Raghuram Rajan and recently addressed comprehensively by Rakesh Mohan, an earlier deputy governor.

Eighth, the RBI has published its dissent note (October 2018) against the recommendation of setting up a separate payment regulator outside of the RBI as it will set a precedence for the attrition and erosion of the statutory powers of the central bank.

Overall, the course of conduct of government actions, particularly in the aftermath of demonetization, the PNB-Nirav Modi scam, the functioning of PSU banks, and the prevailing NBFC crisis, is impacting the functioning of the RBI. The successive commentaries by senior officials of the RBI are revealing the depth of the discords even more. Acharya rightly points out that the coercion of the RBI will undermine its regulatory powers and encourage unhealthy lobbying by banking and non-banking firms, instead of working toward the common good. The hope is that the government sees the merit in the voice coming from the RBI’s technocrats. The risk is that political expediency ahead of the upcoming elections may weigh in on government priorities.