North Block vs Mint Rd

The finance ministry and Reserve Bank are at loggerheads. The decision by nominee directors of the RBI to stay away from meetings of bank boards, called at the instance of the finance ministry to discuss interest rate hikes, signals this loud and clear. At issue is the proper intersection of the roles of the owner of a bank (for most of the big banks, this is the government) and its regulator. The latter is supposedly autonomous, but historically has been given to close coordination with the finance ministry. But it is clear that, far from there being any coordination, the two are now pulling in different directions. It hardly needs emphasising that this is an unhealthy development.

Monetary policy, signalled and mediated principally through interest rates, is the function of the central bank. Individual banks take their commercial decisions on deposit and lending rates within the framework set by the central bank, on the basis of their best commercial judgment. It becomes a matter of regulatory concern only if a bank mismanages its affairs. In short, bank managements attend to individual decisions, while the regulator looks at systemic health.

This fairly simple equation gets complicated when most of the big banks, which account for more than three-quarters of total banking, are owned by the government. For the finance ministry, acting as the shareholder, decided within three days of the RBI raising short-term interest rates in the last week of July, to write to public sector bank managements, asking them to take board approval for any downstream interest rate hikes that they proposed to announce. The ministry's justification is that it was merely insisting on corporate governance norms, and asking banks to look at efficiency parameters when considering interest rate hikes. The message in such a communication that most people would read is disapproval of any hikes""the opposite of what the RBI was signalling.

Unimpressed, some bank managements went ahead and announced the hikes anyway. The managements argue privately that decisions on interest rates are not policy decisions that go to their boards, but commercial decisions taken by asset-liability committees""which have met and therefore satisfied corporate governance norms. But this provoked a second communication from the ministry, the boards were asked to meet, and the majority have now approved the rate hikes (with representatives from the finance ministry taking part, and those from the RBI staying away). The RBI can argue, legitimately, that if the finance ministry is trying to get three-quarters of the banking system to follow a contrary line on interest rates, it is running its own monetary policy.

Mint Road is in fact known to have been unhappy even earlier, with the government moving away from market-determined interest rates by directing that farm credit be given at 7 per cent interest, with similar demands now building up for handloom credit. In short, there are substantive differences between the ministry and the central bank. It is best if these are sorted out quickly and privately, without further public spats. And it would be best if the finance ministry avoided giving the impression that it is countering steps announced by the RBI.

What about the ministry's concerns about the efficiency parameters of the public sector banks? These banks (as also their private sector counterparts in the country) have a large spread between their average cost of deposits and the average lending rate. This spread (which is what helps the banks pay their costs and earn a profit) is usually more than 3 percentage points, which is twice the global norm, and should rightly be considered a systemic weakness. However, the principal cause of this is high wage costs, which total 1.4 per cent for the state-owned banks-compared to 0.6 per cent for the private banks in India. This appears to be the principal differentiator in terms of operating efficiencies. While the finance ministry, acting as shareholder, is right to express its concern over this, the solutions are long-term ones; so it is hardly appropriate to make this an issue in the context of short-term responses to market developments.