India's Central Bank : Challenges Galore

The Global ANALYST, November 2018

(Published by ICFAI, Hyderabad)

India’s Central Bank: Challenges Galore*

M G Warrier

The idea of an independent central bank was conceived in the 1920’s and the Reserve Bank of India came into being on April 1, 1935, after enactment of the Reserve Bank of India Act, 1934.

Even while giving shape to a reasonably strong central bank for India in the situations prevailing during the early 1930’s, the need for comprehensive changes in the Reserve Bank of India Act, 1934 at a later date had been foreseen by the writers of the Act who included the following clauses in the Preamble of the RBI Act:

“And Whereas in the present disorganization of the monetary systems of the world it is not possible to determine what is suitable as a permanent basis for the Indian monetary system;

But Whereas it is expedient to make temporary provision on the basis of the existing monetary system, and to leave the question of the monetary standard best suited to India to be considered when the international monetary position has become sufficiently clear and stable to make it possible to frame permanent measures;”

But, even the authors of the original RBI Act would not have anticipated the kind of assault on RBI that is happening during the current decade, with tacit approval from the owners.

The unfolding story of the humiliation India’s central bank is being subjected to, and which, so far, has been taken in its stride by RBI, has been brilliantly narrated by Dr Rakesh Mohan in a three-part series on RBI, published in the Business Standard recently (October 3-5, 2018). Expressing anguish about the destabilization efforts by vested interests faced by RBI, he concludes that the amendment to the Preamble of the Reserve Bank of India Act, 1934 carried out in 2016 was intended to implement various recommendations of Committees like Percy Mistry Committee (2007), Raghuram Rajan Committee (2009), and Financial Sector Legislative Reforms Committee (2013,Chairman: B N Srikrishna). In effect, deviating from the purported mandate of considering Financial Sector Reforms FSLRC made several recommendations, if implemented, would have truncated and destabilized RBI in one stroke. Though some acts and omissions on the part of Raghuram Rajan during his three-year tenure at Mint Road were controversial, his short-duration presence in India helped in diluting the adverse impact of FSLRC on RBI and two consecutive Economic Surveys on the National Balance Sheet. Once he understood the negatives, Rajan used his teaching skills to make the powers that be understand his point of view, when necessary, by making a PowerPoint presentation himself.

The amended Preamble of the RBI Act now reads as under:

“PREAMBLE

An Act to constitute a Reserve Bank of India.

Whereas it is expedient to constitute a Reserve Bank for India to regulate the issue of Bank notes and the keeping of reserves with a view to securing monetary stability in 2 [India] and generally to operate the currency and credit system of the country to its advantage; 3 [AND WHEREAS it is essential to have a modern monetary policy framework to meet the challenge of an increasingly complex economy; AND WHEREAS the primary objective of the monetary policy is to maintain price stability while keeping in mind the objective of growth; AND WHEREAS the monetary policy framework in India shall be operated by the Reserve Bank of India;] It is hereby enacted as follows:-”

Dr Rakesh Mohan’s observation that “The RBI has been a full-service central bank since its inception in 1935, encompassing its role, inter alia, as a monetary authority, a banking regulator, the lender of last resort, a foreign exchange and exchange rate manager, and a sovereign debt manager, apart from other  functions such as currency issuer and payment system regulator and facilitator.” need to receive the serious attention it deserves from the policymakers. RBI has also played its role excellently well at appropriate times in reorganizing the institutional system in the financial sector to meet the country’s economic development needs. Establishment of SBI, IDBI, NABARD, Exim Bank, SIDBI, and RRBs, timely interventions to avoid bank failures and the developmental role played by it to ensure successful implementation of government programmes aimed at alleviation of poverty and providing infrastructure for economic development are initiatives from RBI for which there may not be any parallel in the history of central banks.

All these and more leads to the question as to why efforts are being made to weaken RBI. Beyond direct threats of weakening the central bank by legislative procedure, there are constant efforts at making RBI subservient to certain vested interests. These are in the form of weakening RBI’s board (On November 8, 2016, the day of demonetization, out of 14 positions on the RBI Central board, 8 were vacant, according to a source) and top management. By design, all Governors and most of the Deputy Governors, of late, are getting a tenure of 3 years and the position at Executive Directors’ level is also not much better. Ideally, the tenure at these levels should be 5 years and above.  

Regulation and Supervision

Chapter VI of RBI Annual Report 2017-18 (See Box 1) dwells in detail about the work in progress in the areas of Regulation, Supervision, and Financial Stability. In addition to commercial banks in public and private sectors, there are a host of other institutions in Indian Financial Sector many of which carry on banking and ‘quasi-banking’ functions which are also gradually being brought under the regulatory discipline of RBI. These include cooperatives including cooperative banks and NBFCs (some of which are government-owned). The multiplicity of ownership and applicability of several laws in addition to the Banking Regulation Act and RBI Act pose a variety of practical problems for RBI in enforcing prudential business norms and regulatory discipline over such institutions.

Add to all these the constraints, like the not very supportive approach from the owner (GOI) faced by RBI expressed through the constant threats of dilution of powers and the demand for transfer of more funds resulting in depletion of RBI’s reserves and so on. We have covered some of the issues relating to the inadequacy of powers vested in RBI to handle recalcitrant PSBs highlighted in a speech by RBI Governor Urjit Patel during March 2018, in the April 2018 issue of The Global ANALYST (Strengthen the Regulators).

*Submitted version

Box 1

RBI Annual Report 2018

Chapter VI Regulation, Supervision and Financial Stability

Introductory

During 2017-18, the banking sector continued to grapple with the problems of deteriorating asset quality and declining profitability. In order to align the resolution process with the Insolvency and Bankruptcy Code (IBC), 2016, the framework for the resolution of stressed assets was revised and the previous schemes were withdrawn. Customer rights were strengthened by limiting liability of customers in unauthorized electronic banking transactions. Further, given the increasing popularity of digital payments medium, data protection and cyber security norms were strengthened. For effective and timely redressal of grievances of customers of Non-Banking Financial Companies (NBFCs), an Ombudsman Scheme for deposit taking NBFCs was initiated. Regulatory policies for cooperative banks were further harmonized with those of scheduled commercial banks (SCBs). In order to bring about ownership-neutral regulations, government-owned NBFCs will be required to adhere to the Bank’s prudential regulations in a phased manner.

Some HR issues

In Chapter I (Assessment and Prospects) of last year’s Annual Report, RBI has observed:

“The stage is set for the intensification of structural reforms that will unlock new growth energies and place the Indian economy on a sustainable trajectory of higher growth. Resolute progress in repairing and resolving the acute stress in the banking system and in shoring up corporate debt will re-intermediate financial flows for productive purposes, which are essential for sustaining an acceleration in growth with macroeconomic and financial stability.”

For preparing the ground for this and constant monitoring of compliance with regulatory requirements by banks and other institutions RBI needs to strengthen its workforce numerically and from the angle of skill-development factoring in the needs of expanding work areas. RBI’s position is similar to Fire Force and Air Force, as regards maintenance and upkeep of manpower and ‘tools’ ready to act any time. Complacency can be suicidal and outsourcing work is no option. These observations are in the context of RBI’s staff strength remaining static (around 7000 officers and 4000 clerks) during the two years 2016 and 2017 when workload had increased considerably, compared to, say that existed at the beginning of the decade.  

Protecting the RBI’s Balance Sheet

I have been writing in the media about the need to ensure a strong capital and reserves adequacy position for RBI since the beginning of this decade. Dr Rakesh Mohan in the concluding part of the three-part series of articles published in the Business Standard which I recalled at the beginning, has used stronger language (reminiscent of late S S Tarapore) to defend the need to protect RBI’s Balance Sheet. He says:

“The most disturbing developments in recent years have been formal suggestions emanating from the government’s official statutory Economic Survey proposing a raid on the RBI’s balance sheet, with the purpose of funding the recapitalization of public sector banks. The proposal was to transfer a portion of the stock of securities held in the RBI’s balance sheet to public sector banks. It was argued that the RBI has excess capital in its balance sheet.”

Dr Rakesh Mohan has argued the case for a strong RBI balance sheet basing his arguments on the functional responsibilities like monetary policy operations, shouldered by RBI which can’t wait for budget funding. Asserting that fears with regard to possible central bank losses are not illusory, he mentions that according to the BIS 43 out of 108 central banks reported losses for at least one year between 1984 and 2005. One can imagine a political response, like “So what? The owner (GOI) can always make good the losses!” The answer to that is, the financial stability of the country is important to attract investments from within the country and abroad and a weak central bank doesn’t send out positive signals in this regard.

In a carefully worded statement, RBI Annual Report takes cognizance of the need to augment capital and reserves to a reasonably high level in Chapter XI (see Box 2). RBI’s capital since inception remains static at Rs 5 crore. Bank’s reserves (Contingency Fund + Asset Development Fund) depleted from a self-set target of 12 percent of total assets (which RBI almost touched in 2009) to a low of 7.05 percent of total assets as on June 30, 2018. The percentage was 9.2 in 2014 from which year RBI continuously transferred its entire surplus income to GOI till 2016 resulting in depletion of this percentage every year since then. Earlier GOI listens to the alarm, the better for the Indian economy.

Box 2

Box XI.1(RBI Annual Report 2017-18)

Surplus Distribution Policy in Central Banks:

An Overview

It is in the public interest that a central bank should continue to perform its public policy functions effectively even during times of  extreme stress. A central bank, therefore, requires a minimum level of confidence regarding its financial strength and the resources at its disposal which will allow it to effectively discharge its functions even during crises. The surplus distribution policy adopted by a central bank is one of the key elements that can determine its financial strength.

Major factors determining surplus distribution

The same approach for surplus distribution cannot be applied across central banks considering the varied political and economic environment under which they operate. Other considerations which necessitate different distribution policies are the varying levels of risk exposures of the central banks as well as the availability of risk transfer mechanisms between the central banks and their stakeholders. The risk transfer mechanism may also not be effective if a particular stakeholder’s finances are also under stress during a crisis.

Various approaches adopted for surplus transfer

A cross country analysis of the surplus distribution policy of central banks by scrutinising publicly available information reveals that central banks can be classified predominantly into the following categories of surplus distribution:

a) Surplus retention is based on a target level of provisions to be achieved. A few central banks also follow accelerated surplus retention based on a target level of provisions in case where the target is not met.

b) Retention of surplus is based on a numerical rule linked to the surplus of the current year.

c) Surplus smoothening wherein it is ensured that regular surplus may be transferred to the government and that the surplus transfer is not affected by the cyclicality of the provisions of the central bank.

Desirable characteristics of a Surplus Distribution Policy

The provisioning requirements of a central bank should be linked to a target level of financial resilience to be achieved/ maintained. In the case of central banks where the distribution arrangements result in continuous substantial transfers without considering the overall level of provisions and risk transfer mechanisms, the financial strength of the central bank may progressively weaken. Further, if a central bank maintains unrealised valuation gains on its balance sheet, these are predominantly taken as non-distributable.

The distribution policy should also bring about smoothening of surplus transfer to the government.