Market reforms: The unfinished agenda

It's time to address the root cause of the 1992 stock market scandal - a conflict of interest in RBI's many roles

The release of a recent Sony LIV series on the Harshad Mehta financial markets scandals that rocked India in the early 1990s has triggered chintanam on an event that perhaps led to some of the biggest reforms in the Indian financial sector. The “securities scam” was in essence, a diversion of funds, estimated at between Rs 3,500 crore and Rs 5,000 crore during 1991-92, from the inter-bank government securities (G-Sec) market to stock market manipulators. These diverted funds were used to artificially create a giant rise in stock prices.

The Government of India and the Indian Parliament mounted a capable response to these events in three phases. In the first phase, we got the Securities and Exchange Board of India (Sebi), a modern effective regulator for securities market, and two new securities infrastructure institutions — the National Stock Exchange and National Securities Depository Limited  — which featured novel governance arrangements. In the second phase, we got a modern derivatives market enabling risk mitigation and improved price discovery. The third phase saw the convergence of Sebi and the Forward Markets Commission, a step towards unifying all organised financial trading in India into one unified set of exchange and regulatory institutions.

Somewhere in this journey, we lost focus on the root cause of the 1992 scandal. The heart of the problem in 1992 was the inter-bank G-Sec market. At that point in time, the Reserve Bank of India (RBI) through its Public Debt Office Department (PDOD) managed public debt. As the Joint Parliamentary Committee (JPC) on the subject noted, the failure of the PDOD to discharge its responsibilities provided scope for irregularities in transactions in government securities. The malfunctioning of PDOD led to the misuse of “Bankers Receipts (BRs)”. The JPC concluded that “the misuse of BRs could be traced to the inefficient functioning of the PDOD and the lack of effective supervision by the RBI”. It further said that “the supervisory mechanism in the RBI was only in form and lacked substance and effectiveness.” Quite a strong indictment!

Having the central bank manage public debt generates a series of conflicts, which have negative effects on economic and financial policy. There is a conflict of interest between setting the short-term interest rate (i.e. the task of monetary policy) and selling bonds on behalf of the government. If the central bank tries to be an effective debt manager, it would lean towards selling bonds at high prices, i.e. keeping interest rates low. This leads to an inflationary bias in monetary policy. Half of this conflict has been solved by legislatively mandating an inflation-targeting RBI. But the other half of the problem, namely the RBI as the debt manager of the government, remains.

There is a further conflict of interest in bank regulation by an RBI which is also handling public debt. When the RBI tries to do a good job of discharging its responsibility of selling bonds, it may veer towards using its regulatory power over banks to force banks to hold more government bonds. Having a pool of captive buyers undermines the growth of a deep, liquid market in G-secs, with vibrant trading and speculative price discovery. It is too easy for the RBI to sell government bonds to captive buyers in normal times, but then in exceptional times (such as 2020), the lack of a diversified pool of voluntary buyers of bonds hampers an expansion of the deficit.

Illustration: Binay Sinha

The failures of achieving a liquid and efficient government bond market have hampered the development of the corporate bond market, which requires the foundation of a tradeable and hedgeable government bond yield curve. When the central bank controls the market infrastructure for the G-Sec markets, as the RBI currently does, this creates another conflict, where the owner/administrator of these systems is also a participant in the market.

 Separating debt management from the RBI is key to addressing these conflicts. In this framework, the RBI focuses on monetary policy, i.e. on the task of modifying the short-term interest rate so as to stabilise the domestic business cycle. The debt management office works as the “investment banker” for the government, selling bonds and engaging in other portfolio management tasks in close coordination with its client, the budget division of the Ministry of Finance. Each of these agencies then has a clear focus, specialised professional skills are built up (in monetary policy at the central bank and in investment banking at the debt management office), and conflicts of interest are minimised.

This is hardly a novel set of ideas; this intellectual clarity has been present from the early 1990s onwards. The Narasimham I Committee on Financial Sector Reform (1991) clearly identified the conflicts that result when the same institution manages debt and regulates banks. The Working Group on Separation of Debt Management from Monetary Management, which submitted its report to the RBI in December 1997, recommended the separation of the two functions and establishment of a company to take over debt management. The RBI Annual Report for 2000-01 recommended the separation of the functions of debt and monetary management in the medium-term, and the explicit removal of the debt management function from the RBI.

The first significant move on debt market reforms was taken by the present government in 2015, when it brought a draft law to Parliament, but later withdrew it. Mainstream thinking on this question seems to have shifted since then. There is greater clarity at the RBI that it must only pursue the 4 per cent inflation target and divest other responsibilities. For example, Professor Amartya Lahiri, who used to head the Centre for Advanced Financial Research and Learning, recently wrote that redesign of India’s financial architecture requires three reforms, of which one is “the RBI needs to be relieved of its public debt management role”. He draws extensively on the recent books by Urjit Patel and Viral Acharya. In the present RBI governor, we have a person who has actually handled each of the conflicts discussed above and lived through the difficult task of reconciling them.

This confluence of factors, not least of which is the bulging public debt, suggests that this is a good time to get back to focusing on and solving this problem.

The writer retired as a secretary to GoI and is  now a professor at the National Council of Applied Economic Research. Views are personal