OpEd Analysis – RBI concedes vital principle

OpEd Analysis - RBI concedes vital principle

Recent RBI & Centre Meeting :-

In a recent meeting between Centre & RBI Officials on November 19. Every one of the four decisions taken, including three decisions related to regulation, was assigned to the board. It also mentions that the constitution of a committee to examine the economic capital framework of the RBI, which was one of the decisions taken, will be jointly determined by the RBI and the Government of India.

The government and some of the current nominee directors on the RBI board have contended that all policy decisions must be deliberated by the board.

These announcements constitute a significant departure from what has appeared to be the position of the RBI thus far: policy decisions, especially those relating to regulation, are the exclusive province of RBI management. Any departure from this position amounts to an infringement of the RBI’s autonomy.

Debate on RBI Board :-

Various experts have made the point that the RBI Act vests all powers in the board and, concurrently, it vests those very powers in the RBI Governor. Whether the board can issue directions to the RBI Governor in the event of a difference of opinion between the two is not clear, some experts reject the suggestion outright.

Many contend that the RBI board has played an advisory role in the past and should continue to do so. RBI board must play a largely advisory role. Even so, it is legitimate to expect that all policy matters would be deliberated by the board. The RBI management may or may not accept the inputs of the board. But the board must have its say.

Debate regarding RBI reserves – How much capital the RBI needs has been hotly contested in recent years ?

  • The government’s position is that the RBI’s reserves are in excess of reserves typically held by central banks elsewhere
  • Some commentators have described the government’s position as an attempt to ‘raid the reserves’ of the RBI to fund its fiscal deficit
  • This is a crude mischaracterization of the position. Reducing reserves enables the government to spend — but not by stealing the RBI’s cash

How do reducing reserves favour the government?

The RBI’s reserves fall into two categories: revaluation reserves (which have mostly to do with the change in the rupee value of the RBI’s holdings of gold and foreign currencies) and contingent reserves (which represent plough back of a portion of the surplus earned by the RBI every year, the remaining portion being transferred to government as dividend)

Contingent reserves are intended for risks related to the RBI’s balance sheet. Now Let us suppose that these should not be touched. Revaluation reserves are an accounting entry.

The RBI can reduce some of the revaluation reserves on the liability side and extinguish an equivalent value of government securities on the asset side. The latter step would lower the stock of debt owed by the government. This would provide headroom for the government to raise debt for meeting its future expenditure (including recapitalisation of public sector banks)

Ensuring credit flow :- The other outcomes at the RBI board meeting have to do with increasing the flow of bank credit and easing the problems of borrowers, especially small and medium enterprises (SMEs)

  • Banks are subject to capital adequacy requirements — that is, they have to hold a minimum of capital against every rupee of loans they make
  • The RBI’s requirement of capital adequacy is one percentage point higher than that of the internationally accepted Basel norms laid down by the Bank for International Settlements
  • The government would like to align Indian banks’ requirements with the Basel norms as that would reduce the demands for capital made on it by public sector banks (PSBs)
  • The RBI did not yield on this point at the recent meeting. However, it has agreed to defer an increase in the capital requirement of banks of 0.625% under another head by one year

Easing PCA framework :- The RBI has also agreed to consider the government’s suggestion for easing the norms for Prompt Corrective Action (PCA) for banks

What is PCA ?

The PCA imposes restrictions of various kinds on banks, including restrictions on lending for the weakest banks

What’s the idea behind easing norms for PCA ?

The idea is that banks that are very weak should not create problems for themselves by making more loans. They should focus on getting their balance sheet right by reducing costs, selling some of their non-core assets and the like

A PCA regime has significant negative externalities. If many banks face lending restrictions for a prolonged period, it could create serious problems for the economy. Large corporates could get into distress because of their linkages with distressed SMEs. So can the healthier banks that are exposed to these corporates

A relaxation in PCA norms, by translating into higher credit flows, could relieve stress in the broader economy

Way forward

As a public institution whose actions have enormous welfare implications, the RBI management cannot rule by fiat.  Its actions must flow from a consultative process. It must explain and justify its actions. It must be seen to be accountable. The RBI board could be an important mechanism for ensuring that these conditions are met

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