Preserving the independence of the RBI

If proposals to set up an appellate body to review RBI's regulatory and supervisory decisions were to be implemented, the whole supervisory process would get mired in constant litigation

The last decade has witnessed an almost constant attack on the Reserve Bank of India (RBI), emanating sometimes from within the government, sometimes from expert committees appointed by the government, and otherwise from independent analysts, researchers, commentators and economists. That this has happened is quite curious, particularly since the RBI is generally acknowledged to have negotiated very well the vicissitudes of financial markets, both global and domestic, resulting from the Asian financial crisis 1996-97, the north Atlantic financial crisis (NAFC) of 2008-09, and the taper tantrum of 2013. Its otherwise consistent performance has, however, been marred in recent years by the high inflation of 2010-13, the current ongoing emergence of some large frauds and excessive non-performing assets in the banking and non-banking financial sectors, and a couple of episodes of excessive volatility in the exchange rate.

 
The saving grace has been that wiser counsel seems to have prevailed most of the time, and most of the recommendations that would have adversely affected the functions of the RBI were eventually not implemented. 
 
RBI performance pre-NAFC
 

During the period before the eruption of the NAFC in 2008-09, the RBI suffered substantial criticism for being excessively conservative in its approach to the regulation and supervision of the banking and non-banking financial sectors, and in being excessively cautious in permitting introduction of then-popular financial innovations. Similarly, there was withering criticism of its monetary policy-making, which did not conform to the internationally popular inflation targeting framework often characterised as the gold standard in monetary policy-making. There was also a view that its approach to external sector management, consisting of forex intervention to achieve a managed float of the exchange rate, accumulation of foreign exchange reserves, combined with capital account management, was too cautious and inimical to Indian financial market development. Such views were then reflected in the observations of various committees such as the High Powered Expert Committee on Making Mumbai an International Financial Centre (HPEC, 2007; Chairman Percy Mistry), Committee for Financial Sector Reforms (CFSR, 2009; Chairman: Raghuram Rajan), and the Financial Sector Legislative Reforms Commission (FSLRC, 2013; Chairman B N Srikrishna).

 
Although there were differences in the specific recommendations of these committees, there were broad commonalities, which essentially proposed the dilution of RBI functions as a full-service central bank. On the monetary policy side, even though the RBI had practiced a multiple indicators approach, its inflation management record between the mid-1990s and the late 2000s had been exemplary and not different from other central banks that did practice inflation targeting. The average inflation between 1995 and 2008 was around 5.5 per cent. It is, therefore, surprising that each of these committees proposed a simpler single-objective, single-instrument market policy framework centered on inflation targeting.

 
Similarly, between the early 2000s and 2008, the RBI had successfully managed the external sector and maintained financial stability despite consistent and excessive capital inflows that reached a peak of almost 10 per cent of GDP in 2007-08. The capital account had been opened incrementally and the exchange rate allowed to fluctuate in response to market fundamentals while curbing excessive unwarranted fluctuation. A whole range of instruments had to be used to accomplish relatively successful sterilisation, which involved the introduction of the market stabilisation scheme (MSS), changes in the cash reserve ratio (CRR), the use of open market operations (OMO), and the judicious operation of the liquidity adjustment facility (LAF), along with corresponding monetary policy changes. Foreign exchange reserves were augmented substantially through consistent forex intervention, thereby providing a significant degree of forex buffers to cope with the high degree of volatility that characterises international capital flows. The utility of such reserves was demonstrated in the aftermath of the NAFC and the taper tantrum. Yet the general recommendations from these committees (and the IMF) proposed much greater capital account opening towards a liberalisation of both inflows and outflows, a reduction in forex intervention, greater participation of foreign investors in both the domestic bond and stock markets, and the elimination of restrictions on both sovereign and corporate foreign borrowing. It is ironic that these recommendations were being made just when international financial markets, particularly in advanced economies, were demonstrating the severe problems that can arise from excessive financial innovation, excessive global capital flows, and lack of capital account management. In effect, these recommendations amounted to a significant reduction in RBI roles related to the pursuit of financial stability through external management.

 
A full-service central bank
 
The RBI has been a full-service central bank since its inception in 1935, encompassing its role, inter alia, as a monetary authority, a banking regulator, the lender of last resort, a foreign exchange and exchange rate manager, and a sovereign debt manager, apart from other functions such as currency issuer and payment system regulator and facilitator. The 1990s and 2000s had seen a general movement in some countries towards making the central bank a pure monetary authority, while separating out its related functions to a separate agency. This movement was led by the UK when it made the Bank of England (BoE) a pure monetary authority, set up a separate debt management office (DMO), and shifted all financial sector regulation to the newly created Financial Services Authority (FSA) in the late 1990s. In India, the various committees recommended similar action, proposing the shifting of some of these roles from the RBI, though they did shy away (reluctantly) from taking away the banking regulation function. Once again, some of these recommendations were being made just when global expert opinion had begun to change after the NAFC.

 
Ironically, the FSA in the UK has been abolished since, and its financial regulatory and supervisory functions have been brought back to the BoE. In addition, a financial stability objective has been added explicitly to the functions of the BoE, with a formal Financial Policy Committee established within the BoE. Similarly, while the European Central Bank (ECB) was originally established as a pure monetary authority, in the wake of the NAFC, it is now entrusted with bank supervisory responsibilities as well.
 
That having been said, new questions have arisen with regard to the RBI’s functioning in regulation and supervision of both banks and non-bank financial institutions. After continuous and substantial improvement in the performance of public sector banks in the 2000s, they have exhibited significant deterioration with the emergence of large non-performing assets in recent years. Governance issues have arisen in some private sector banks as well. Most recently, one of the most significant non-bank financial institutions has suddenly begun to default on its debt obligations.

 
The collective impact of each of the developments is serious for the Indian financial sector. In view of the increasing size, complexity and interconnectivity in India’s financial sector, the RBI’s regulatory and supervisory apparatus clearly needs to be re-examined and modernised, along with technical strengthening and expansion of its personnel. That would include an organised programme for greater lateral entry into the RBI. Separating out this function from the RBI would not be a solution. One approach would be greater formalisation and strengthening of the existing Board of Financial Supervision  within the RBI, which already meets on a monthly basis. There also needs to be a greater clarity on the supervision of systemically important financial institutions as the inter-linkages between different segments of the financial sector become more complex. This includes arrangements for regulatory cooperation where there are overlapping regulatory responsibilities. Indeed, central banks, as

monetary and regulatory authorities and lenders of last resort, are almost universally seen as critical to the maintenance of financial stability.
 
In the wake of the NAFC, in other countries, the financial stability and macro-prudential regulatory function has now been specifically entrusted to the central bank. By contrast, in India the Financial Stability and Development Council (FSDC) was established in 2010 with this explicit responsibility. In fact, when the FSDC was first proposed to be created, the RBI governor was placed on par with the other regulators on the board of the FSDC. Good sense, however, prevailed and the governor is now designated as the vice-chair of this committee, consistent with the key role of the central bank in financial stability and macro prudential policy.

 
There have also been puzzling proposals to set up an appellate body to review the RBI’s regulatory and supervisory decisions, as there are for other regulatory authorities. There seems to be little understanding of the continuous process that characterises regulation and supervision of banks and other financial institutions. If such decisions could be appealed, the whole supervisory process would get mired in constant litigation with resultant chaos in the system. This is the reason why such provisions for appeals against banking regulation and supervision do not exist in any other major jurisdictions either. There have been other more recent developments that have also been somewhat disturbing.

 
(Tomorrow: Responsibility fulfilled)
 
The author is senior fellow, Jackson Institute for Global Affairs, Yale University, and distinguished fellow, Brookings India