In recent weeks, there has been a rift between the Central government and the Reserve Bank of India (RBI). Given the mounting non-performing assets, capital crunch in public sector banks and stressed assets in micro, small and medium enterprises (MSMEs), the government expects leniency from the RBI, which is more focused on long-term systemic solutions.
That the government and RBI were not on the same page became clear when Deputy Governor Viral Acharya openly attacked the government stating that “governments that don’t respect the independence of the central bank have to face the wrath of markets,” while illustrating that “a government’s horizon of decision-making is rendered short, like the duration of a T20 match by several considerations. There are always upcoming elections of some sort – national, State and mid-term. In contrast, a central bank plays a Test match, trying to win each session, but importantly also survive it, so as to have a chance to win the next session, and so on… To protect the economy from such short-termism, the central bank is designed to be at a safe distance from the executive branch of the government.”
This led to speculation that the government would not shy away from using the never-used Section 7 to achieve its target and that Governor Urjit Patel may put in his papers. It’s against this backdrop of trust deficit that the RBI Board met on November 19. The meeting, which went on for an unusually long nine-plus hours, seems to have calmed the situation, even though it may be temporary with the next Board meet scheduled on December 14. The marathon meeting agreed on finding a way forward on four key issues:
• Implementation of the Basel regulatory capital framework for addressing capital crunch in the banking sector
• Restructuring scheme for stressed assets in MSMEs
• Bank’s health under Prompt Corrective Action framework
• Economic capital framework of the RBI
Basel Regulatory Capital Framework
The government is continuously pushing the RBI to ease the norms on the MSME sector as well as on public sector banks in line with the internationally accepted Basel III norms. The government believes that Basel norms require only the application of minimal capital norms to internationally active banks but the RBI has applied these norms to all commercial banks, ignoring their global presence.
As per the Basel III norms, banks have to maintain a minimum total Capital to Risk (weighted) Asset Ratio (CRAR) of 8%, whereas the RBI has stipulated 9% and within that Tier I capital (indicates a bank’s financial health and is used when a bank must absorb losses without ceasing business operations) around 6%.
In fact, Acharya has reiterated that Basel III norms are the floor and after the financial crisis, banks do have to maintain high capital reserves. The government, on the other hand, argues that a higher capital norm restricts lending ability and income generation by banks. This also leads to other contentious questions like:
• How much costs will the banks incur in order to maintain high capital?
• Should government retain majority of ownership of public sector banks?
• Do banks actually pass on the burden of raising more capital in the form of higher interest rates to borrowers and depositors?
• How to meet the higher liquidity requirements? Though these are yet to be discussed, it’s clear that the twain have differing views.
Prompt Corrective Action
Another critical issue that has triggered unease is the government’s concerns on the Prompt Corrective Action (PCA) framework of the RBI. This is a policy guideline when a commercial bank’s condition worsens below a mark. At present, any of the three circumstances — banks having net NPA level of 6%, two consecutive years of negative returns on assets or capital adequacy ratio falling below the requirement — can cause the RBI to put a bank under PCA.
As banks are not allowed to fail, PCA is the helping tool in ‘too big to fail’ issue. Last month, Acharya clarified that the aim of PCA is “to intervene early and take corrective measures in a timely manner so as to restore the financial health of the banks that are at risk by limiting deterioration in their health and preserving their capital levels”.
But the government thinks that higher restrictions lead to halting of branch expansion, thereby reducing financial penetration. The PCA could stop a bank’s lending limit to one entity or sector, thus affecting growth. The RBI can also supercede such a bank’s board.
While the RBI has freed up loans up to Rs 25 crore to the MSME sector to ensure financial stability and the move could ease liquidity and accessibility of credit, the concern is that RBI must also address issues of NBFCs so that liquidity crunch doesn’t spill over to MSMEs.
Economic Capital Framework
Economic capital is required to pump liquidity in the economy, buy securities and expand balance sheets of commercial banks to boost confidence in the financial system. This gained importance after the 2008 financial crisis where central banks such as Federal Reserve, Bank of England and European Bank, besides governments, had to rely on reserves to maintain financial stability.
The RBI gets its reserves mainly through two channels:
• Currency & Gold Revaluation Account (CGRA)
• Contingency Fund (CF)
The CGRA is the value of gold and foreign currency the RBI holds on behalf of the government. In 2017-18, this stood at Rs 6.9 lakh crore, while CF was around Rs 2.3 lakh crore. The CGRA is subject to market fluctuations and hence affects the surplus reserves.
The RBI’s capital reserves at present stand at 28% of its total assets, making it one of the highly capitalised central banks in the world. The global average is around 16%. Former Governor Raghuram Rajan had pointed out that the “RBI should transfer to the government the entire surplus, retaining just enough buffers that are consistent with good central bank risk management practice”.
The government wants the RBI to maintain its reserves in line with the global average. Though the RBI managed to protect its reserves this time – the government had sought that one-third of its reserves be pumped into the system – it agreed to set up an expert panel to decide how the future reserves should be utilised.
There are other issues too where the RBI and government’s views do not converge. While the RBI wants the proposed Payment Regulatory Board (PRB) to remain within it, the government wants it as an independent entity.
On October 19, the RBI issued a dissent note on the recommendations of the Inter-Ministerial Committee for finalisation of amendments to the Payment & Settlement Systems Act clearly stating that the PRB must remain with the RBI and be headed by the Governor, RBI.
The RBI is among India’s most respected institutions. There have, of course, been disagreements between the RBI and the government earlier too but they have mostly been resolved amicably.
This time around, many fear that the truce is only temporary. The statements of the government nominees on the RBI Board back this possibility. This belief is also strengthened by developments in many key institutions.
Former President Pranab Mukherjee too flagged such concerns this Friday. “Our Constitution provides a delicate balance of power between various institutions of the state. This balance has to be maintained. In the recent past, these institutions have come under severe strain and their credibility is being questioned.”
Important institutions such as the Supreme Court, Election Commission, Central Vigilance Commission, Central Information Commission and the Central Bureau of Investigation have been caught in the crosshairs in recent times.
Duvvuri Subbarao, in his last public lecture as RBI Governor, said: “I do hope Finance Minister Chidambaram will one day say, ‘I am often frustrated by the Reserve Bank, so frustrated that I want to go for a walk, even if I have to walk alone. But thank God, the Reserve Bank exists.” Wouldn’t it be a good culmination this time too?
(The author is an alumna of London School of Economics)