The design of RBI limits its abilities

The Reserve Bank of India (RBI), India’s central bank, performs vital functions that are essential for keeping the Indian economy in robust health. The oversight it exercises on both mainstream commercial banks and cooperative banks is supposed to instil and bolster both confidence and faith of the people in the banking sector.

Recently, the RBI has found itself lurching from one crisis to another as financial institutions such as non-banking financial corporations (NBFCs), cooperative banks and commercial banks collapsed like dominos one after the other. While there might be different reasons that have led to this ugly situation, however, the root cause is essentially the flawed design of the regulator — the RBI — whose architecture is as antiquated as the act that governs it. While it was the asset-liability mismatch that consumed IL&FS and NPAs that led to the fall of Punjab and Maharashtra Bank (PMB), Guru Raghavendra Sahakara (Cooperative) Bank and, now Yes Bank, the buck really stops at the door of the RBI as it failed to exercise oversight effectively.

The construction of the regulator is flawed due to two key reasons, namely, conflicting duties that the RBI is expected to perform, and the dual supervision scenario in the case of cooperative banks.

The RBI draws its powers from several Indian statutes, the most significant of them being the Reserve Bank of India Act, 1934 and others such as the Indian Coinage Act, 1906, the Banking Regulation Act, 1949, the Securities Contract (Regulation) Act, 1956, the Foreign Exchange Management Act, 1999, the Government Securities Act, 2006, the Payment & Settlement Systems Act, 2007, the Credit Information Companies (Regulation) Act, 2005, etc. These statutes mandate the RBI to perform various functions which include monetary management of the country; management of foreign exchange and domestic debt of the government; regulation and supervision of banks, financial institutions, non-banking finance companies, credit information companies, etc. Some of these roles of the RBI are contradictory and directly in conflict with each other. Ideally, they should be managed by different agencies so that they can be discharged effectively. The design of the regulator itself limits its ability to succeed.

In 2010, the then finance minister correctly diagnosed that the RBI is conflicted. However, the prescription that was applied was flawed. Rather than reforming the RBI, an omnibus Financial Stability and Development Council (FSDC) was constituted to co-ordinate the functions of different regulators in the financial sector — RBI for commercial banks and NBFCs, the Securities and Exchange Board of India (SEBI) for capital markets. The Insurance Regulatory Development Authority of India (IRDAI) for the insurance sector, the Forward Market Commission of India (FMC) and the Pension Fund Regulatory and Development Authority (PFRDA) to name but a few.

The Reserve Bank of India’s role in determining monetary policy is fraught with contradictions. These contradictions emanate from the fact that the RBI is the government’s investment banker and at the same time is expected to frame and implement India’s monetary policy. Other than bonds, most of the government’s other debt too is routed through the RBI, and only last year almost 80 per cent of the government’s debt was raised through the RBI.

Herein lies the inherent conflict in its design. To perform its investment banking functions properly, the RBI needs to keep interest rates low, so that savings are channelised towards government debt (which will then offer a comparatively higher rate of interest as compared to bank deposits). However, the RBI is also responsible for monetary policy adjustments, such as keeping the headline inflation rate in check.

To keep the headline inflation rate low, the RBI periodically reviews the repo rate, which is the rate at which the RBI lends to commercial banks, who are then too expected to temper the interest rate they charge their customers. Now to keep a check on inflation, the RBI tries to set a high repo rate so as to signal a scarcity of savings. However, since the RBI performs investment banking functions for the government and also handles its debt, the RBI faces incongruities that handicap it’s efficacious functioning.

It also suffers due to the dual regulation structure that exists for cooperative banks. The RBI is only responsible for regulating banking aspects of cooperative banks, namely, the granting of the licence, maintaining cash reserves, statutory liquidity and capital adequacy ratios, and inspection of these banks. State governments, however, oversee management related issues such as elections, auditing and administrative issues. The dual supervision over these cooperative banks has also played a role in financial misconduct going unnoticed. While in the case of a private bank, the RBI can supersede the board and remove directors, that isn’t the case with cooperative banks. However, the Central government has shown no inclination to reform the cooperative bank regulatory structure despite the lack of effective oversight imperilling the hard earned savings of millions of people.

In recent years, the institutional credibility of the RBI has taken a huge hit due to the frequent change of governors. Both Raghuram Rajan and Urjit Patel were compelled to leave for entirely extraneous reasons. The demonetisation saga was an especially low point in the trajectory of the RBI. Even after three-and-a-half years, it is still not clear whether demonetisation was a considered decision or a command performance. However, the most disturbing was the RBI’s inability to resist the Rs 1.76 lakh crore raid on the reserves of the Central bank by the NDA/BJP government in August 2019. After initially seeking a third of the RBI reserves i.e. at Rs 3.6 lakh crores the government still extracted almost half the amount.

All this has extremely serious ramifications on India’s banking sector. The familiar sight of distraught depositors lining up in front of banks has become all too common in the last couple of years. As public trust in the banking system evaporates, the time has come to unscramble this egg called the RBI by repealing its antiquated 1934 legal architecture and replacing it with a set of structures and institutions that can navigate a 21st century economy.