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There is increasing friction between the government and the Reserve Bank of India. The government is asking the RBI to review its policies in several areas where the central bank should be allowed to operate without interference. This is not an entirely new fight.
Successive RBI governors after Bimal Jalan have had to fight for operational independence with the finance ministry. But the current set of disagreements comes at a bad time.
Emerging markets in general are under pressure. India is still some time away from achieving financial stability by solving the twin balance sheet problem – bad assets at banks and corporates hamstrung from raising credit. Riding roughshod over the central bank could easily lead to heavy capital outflows and delay the rehabilitation of the banking system.
In its latest demand, the government wants RBI to dilute its prompt corrective action (PCA) framework. This set of norms impose sanctions on lenders preventing them from expanding their business if a set of yardsticks aren’t met. RBI tightened these norms last year. Currently, half the state-owned banks, accounting for at least one-fourth of system bad loans and one-fifth of advances, are under this framework.
Watering down PCA is a bad idea. The first-quarter results of public sector banks show that they are not out of the woods yet. The bad loan clean-up that is taking place still has miles to go. The power sector itself has the potential to add a further Rs 1.75 lakh crore of bad loans.
The fact that PSU banks are still struggling is the purported reason why the government has declined RBI’s request to withdraw its nominees from state-owned bank boards. RBI wants greater power to regulate the state-owned banks rather than placing its people on their boards – a situation that in fact places the bank in a position of conflict of interest. Both Urjit Patel and Raghuram Rajan have commented publicly on it.
In other instances, the government wants to have its cake and eat it too. Take RBI’s 12 February circular, which withdrew a bunch of restructuring schemes and set a strict 180-day deadline for banks to deal with loans that are overdue by even a single day. On the one hand, the government is using this to ask RBI to relax the capital adequacy ratios for banks. On the other hand, it wants RBI to relax the new bad loan recognition and resolution framework for the benefit of power producers.
RBI would do well to ignore both these demands. In 2012, while announcing the new framework, the central bank had insisted on higher capital limits to “address any judgmental errors like wrong application of risk weights, misclassification of asset quality, etc.” It pointed out that even under earlier frameworks, RBI norms were more conservative. In any case, despite this India’s banking system has one of the poorest capital to risk-weighted assets ratio of 13.3 percent, according to IMF data.
Higher capital norms are also required because while the stock of bad loans is being addressed, there are no indications that the credit culture in India is improving. If banks continue to ‘extend and pretend’, it is better that they maintain a higher capital buffer. In that context, the 12 February circular is important because it tries to address this very problem of a corrupt credit culture. If RBI caves in to government or Supreme Court diktats and relaxes these norms for the power sector, what’s to prevent a different industry tomorrow from seeking such handouts? That will undermine the sanctity of the debt contract and also the insolvency and bankruptcy code, one of the biggest reforms in recent times.
All these demands smack of adhocism. They are driven by the need to meet the fiscal deficit target. Diluting the capital adequacy norms will free up some Rs 60,000 crore in capital. The government is on the hook for a promised Rs 2.11 lakh crore capital infusion in PSU banks over two years, a large part of which is to be raised from the market. Getting banks out of PCA would help some of them in actually raising these funds from the markets at decent valuations. Similarly, a relaxation for the power sector means that PSU banks won’t have to set aside large provisions which will eat into their capital base. They will be able to show better bad loan numbers too.
That’s on the government spending side. On the revenue side, it expects more dividend from RBI. The government wants RBI to review its dividend policy, perhaps setting aside a fixed portion of its surplus. The government also seems to believe that RBI is being more prudent than necessary by transferring part of the surplus to its contingency reserve and asset development fund over and above what’s needed. However, with RBI being responsible for financial stability, these reserves are an important part of its arsenal to absorb financial shocks. If the government amends the RBI Act to force the central bank to cough up more dividend, it will set a dangerous precedent.
This is not to say that there is no need for debate about the effectiveness of RBI’s regulation over the banking system. RBI should be set to high standards and taken to task if it fails. But the correct way to change policy would be set clear goals and objectives – the flexible inflation targeting framework is a great example – and allow RBI the operational room to do its job. Policy changes that seek to compensate for laxity on the government’s part are retrograde.