The RBI (Reserve Bank Of India) Fracas

Authored by jain and govil - astute political observers

Modinomics is yet to deliver – was the Op-ed written by the Editorial Board of Financial Times published from London -(https://twitter.com/ft/status/1069894756929585152. They have raised the following issues in the article.

• Modinomics yet to deliver to many (https://steemit.com/financialtimes/@ajain/ft-rebuttal-part-1-assessing-how-modinomics-has-reached-the-poor)
• Failed infrastructure overhaul (https://steemit.com/india/@ajain/ft-rebuttal-part-2-assessing-failed-infrastructure-overhaul)
• Failed attempt to turn country into a manufacturing powerhouse (https://steemit.com/india/@ajain/ft-rebuttal-part-3-assessing-make-in-india)
• Demonetization ineffective (https://steemit.com/india/@ajain/ft-rebuttal-part-4-demonitization)
• Economic growth squandered away on symbolic projects (Statue of Unity) (https://steemit.com/india/@ajain/ft-rebuttal-part-5-economic-growth-squandered-away-on-symbolic-projects)
• Fudging statistics (https://steemit.com/india/@ajain/ft-rebuttal-part-6-fudging-statistics)
• NPA’s (Non-Performing Assets of Banks)
• RBI Fracas (Reserve Bank of India)

We have initiated a series of eight articles where each issue raised in the Financial Times Op-ed as listed above, will be taken up and put under the microscope of facts and data to critically test the validity of the statements made.

“You have laid stress on the autonomy of the Reserve Bank. Certainly it is autonomous, but it is also subject to the Central Government's directions.”

“It would be completely absurd if the Reserve Bank followed a different policy because it did not agree with those objectives or with the methods of achieving them.”

“Obviously the Bank also has a high status and responsibility. It has to advise the government, but it also has to keep in line with the government.”

Source – RBI History Vol ll page 1150 - https://rbidocs.rbi.org.in/rdocs/content/PDFs/90010.pdf

Who is making the above statements? The above statements are from the letters written on 2nd December 1956 and 1st January 1957, by the then Prime Minister (PM) of India Pt. Jawaharlal Nehru, to the then Reserve Bank of India (RBI) Governor Sir Benegal Rama Rau. Reason – the RBI Governor had serious differences with the then Finance Minister Mr. T T Krishnamachari over financial matters. If you read the full letters (Source URL given above), they contain some very disparaging remarks which are not included here as it would be a digression. And mind you the letters under reference are being written by the PM to a person, who not only was the RBI Governor, but was appointed a Companion of the Order of the Indian Empire (CIE) in 1930, and, was knighted in 1939. Back then, this honor was something similar to what ‘Bharat Ratna’ is in India today.

Was this the only incidence when RBI governors resigned, or worse, were asked to go? Certainly not. Over the last more than 75 years since India’s independence, there have been many instances when such a thing has happened. In fact, the relationship between the Central Bank of a country and the political bosses often tends to get into turbulent waters, and for good reasons. Both are trying to do their jobs. Oftentimes they suffer from a difference of opinions or assessments leading to a potential conflict. This is true not only for India but across the globe for all countries. Who can forget US President Ronald Reagan summoning the US Fed Chairman Paul Volcker to his office in 1984 (when Reagan was in the midst of his re-election campaign)? And, Reagan had a message delivered to Mr. Volcker by the Chief of Staff Mr. James Baker, in his presence. The message was blunt - not to increase interest rates. While all this is not desirable, it is inevitable in the real world. So what happened in case of Urjit Patel (He was the RBI Governor who resigned recently – Dec. 2018) was no surprise. Having said all this, it is very important to analyze and understand what prompted Urjit Patel to put in his papers, that too in a huff.

As it happens in such situations, the rumor mill was rife with all sorts of reasons and explanations as to the cause of resignation. True to the DNA of the species called ‘rumor mills’, everyone seemed to be having insider information on the real cause. Most of the so-called ‘insider information' was nothing more than a figment of fertile imagination, or, hearsay, or, reasons that vested political interests would have wanted to be true. No surprises here. We should not forget this is an election year and rival political parties could not have asked for better fodder against the incumbent government. Such situations are the perfect times to settle scores internally and externally. Urjit Patel’s resignation was no exception. Within no time, the knives were out baying for blood. But, ‘Truth is stranger than fiction’ –so says Mark Twain. Let's, therefore, get to the bottom of it all and see where the truth lies.

There were many points on which RBI and Ministry of Finance had differing viewpoints. However, sifting the wheat from the chaff, a difference of opinion on two points comes up as serious and one which in all probability was the real issue leading to the parting of ways culminating in the resignation of RBI Governor Mr. Urjit Patel. The two points are -

• Prompt Corrective Action Framework
• Capital Framework
  
  Let's look at these points in greater details.

1. Prompt Corrective Action Framework

Let us first understand what this means. In simple language, Prompt Corrective Action Framework (PCA – as it is commonly known) is a mechanism that was developed to define the ‘Capital Adequacy’ of a bank. The framework was introduced in India way back in 2002 by the Vajpayee government. Under the PCA three key elements are monitored for concerned banks to determine whether a particular bank is healthy and robust, or not. These three elements are as below:

• (i) Capital Adequacy
• (ii) Asset Quality
• (iii) Profitability

Restrictive conditions including ‘Lending restrictions’ are put on the operations of a bank if the performance of the bank does not measure up to the norms specified for each of the above performance factors. The kind of restrictions applied to depend upon the level to which a particular bank is in default on the performance front. We examine in details what these three points mean and what the critical levels are failing which restrictive conditions are imposed on a Bank.

i. Capital Adequacy

Capital adequacy ratio (CAR) is the ratio which determines the bank's capacity to meet its liabilities. In simple terms, a bank's capital is the "cushion" for potential losses and protects the bank's depositors and other lenders. Banking regulators in most countries define and monitor CAR to protect depositors, thereby maintaining confidence in the banking system.
The adequacy of Capital is measured in terms of ‘Capital to Risk-weighted Assets Ratio’ (CRAR as referred to in Banking World). The RBI, vide its circular of April 2017, changed the norms for CRAR. The norm specified by RBI in 2017 is 9%. This norm was 6% as per RBI circular released in 2002. So what is the big deal? Surely RBI is entitled to increase the CRAR by 3% points given all that has transpired in the world during the financial turmoil starting 2008 (towards the last months of Bush administration). Where is then the catch? The catch is that the change in norms comes almost a decade after the event. And, even more important, the CRAR specified by RBI was a good 1% above the BASEL III norms. It would be in order to mention that the BASEL lll norms have been evolved in response to the 2008 financial crisis in the world.

(The ‘Bank For International Settlements’ formed a committee – ‘Committee on Banking Regulations and Supervisory Practices’ – in 1974 with an objective to enhance financial stability by improving the quality of banking supervision worldwide. This committee operates from the Bank’s headquarters located at Basel. It has thus come to be commonly known as the Basel Committee in the banking world. The norms specified by them are commonly referred to as Basel norms. The third version of the Basel norms – BASEL lll – are in operation as on date and the same were evolved in the aftermath of the 2008 financial crisis).

ii. Asset Quality

The asset quality of a bank is measured in terms of Net Non Performing Assets to Advances ratio (NNPA - as it is commonly called in Banking World). This ratio is a measure as to what percentage of total loans and advances of a bank are in default or ‘Non Performing Assets’ as it is called in banking parley. Here again, the norms were changed vide the RBI circular of April 2017 quoted above. The breach limit of the NPA was reduced from 10% in 2002 to 6% in the April 2017 circular. This means that if the nonperforming assets of a bank exceed 6% of the advances instead of 10 % as per 2002 norms then the PCA will get triggered and restrictive action will be taken against the bank.

iii. Profitability

The profitability is measured in terms of Return On Assets (ROA) employed. Prior to April 2017 circular, the ROA threshold for PCA was 0.25%. It was changed to negative ROA for two consecutive years.
It is very clear from the above that the PCA norms were made significantly more stringent in 2017 vis a vis 2002. But then, why was this a bone of contention between the RBI and the Government? After all, it was a well-known fact that there had been indiscriminate lending done by banks, they were saddled with huge NPAs, the defaulters were fleeing abroad rather than paying up (examples - Vijay Mallya, Nirav Modi, Mehul Choksi, Sandesara family, and so on many more). In such an environment isn’t it fair on part of the Regulator (RBI) to tighten the screws?

Prima facie there is merit in the above argument. However, when one goes deeper into the real world dynamics, and analyses the impact of the above on Banking operations, one finds that what RBI did was highly retrograde and detrimental to the banks. In turn, it was also detrimental to the businesses dependent on loans from the banks for their legitimate business operations. Why do we say that? The reason we say that is because the reasons for ballooning growth of NPAs had nothing to with the PCA norms being lax. In fact, the Indian banking system withstood the World financial crisis from 2008 onwards very well with the same norms. On many a forum internationally at that time, the then RBI Governor was complimented for deft management of Indian monetary world. The reason for ballooning NPA’s was the profligacy that took place in the banks while lending. This happened during the decade preceding 2014, more specifically in the second term of UPA – 2009 onwards. During this period there was rank indiscipline in following the banking norms for lending and rampant political interference from the highest levels. There was connivance – corruption – collusion between bank executives, bureaucrats, politicians and businesses. The malpractice of zombie lending, evergreening of delinquent loans etc. was very common (Even Viral Acharya acknowledges the same in his A D Shroff memorial lecture quoted above). All of this not only lead to sharp increases in NPAs but even more dangerous kept the real picture of NPAs hidden from the outside world (brushed under the carpet). That was the order of the day. No wonder when the Modi government got to the bottom of it all, to their horror they realized that the NPA’s were far greater than what was reported in 2014 (read the full story on NPA’s in our next article in the rebuttal series). The Modi government took cognizance of the situation in right earnest.

Meetings and confabulations with senior management teams of the banks started immediately wasting no time. In December 2014, PM Modi himself attended the annual conclave of the head honchos of the public sector banks held in Pune. Broad contours of fighting the battle of NPAs was arrived at. It is common wisdom that if you want to tackle any problem then the first step is to acknowledge the problem and to honestly assess the dimensions of the problem. Accordingly, the Government started forcing the banks to start declaring these NPAs on their balance sheets leading to deteriorating balance sheets across the banking spectrum in India. This was India’s 2008 moment (or ‘Lehman moment’ if one were to give it a name) of a financial crisis. No wonder most of the banks started to go on to the wrong side of PCA norms. In such a scenario, instead of nursing the banks and hand holding them in their effort to claw back into healthy operations through strict and prudent lending, RBI almost sounded a death knell for them by making the norms more stringent.

The question before the Government was how to set the things right and get the banking system moving. In a way the government and RBI, both were working on the same end objective. Achieve a robust, clean and progressive banking system with appropriate checks and balances. But their approaches differed. While the RBI approach stopped at just that, the government’s approach had a wider vision – to achieve the objective along with economic growth. As a result, RBI’s approach to making the norms more stringent was seen as an extremely regressive measure by the government as it lead to throttling the banks by putting restrictions on their lending capabilities. This was inconsistent with the growth objective. By throttling the banks you are only pushing towards their failure. Lending is the fundamental business of the banks. If you throttle them and disallow them to lend, then how do they survive. They are saddled with heavy NPA's. They are undercapitalized. On top of it, you make norms more stringent. It is kind of a final push to their grave. No wonder the government and RBI had a strong difference of opinion.

The way forward was to allow the Bank’s to continue with the same norms but to introduce watchdog measures on their operations and processes. The need was to see that corruption, collusion, connivance is not able to subvert the established banking norms and operational procedures while Banks are not hampered from pursuing their legitimate business and legitimate risks. Where required the RBI could have supplemented the procedures to plug the lacunae. And of course, ensure extremely tight oversight at the operations level. This way the Banks will move forward and extend loans which will result in good quality assets for them and also make them grow their earnings and portfolio of good assets. In due course, they will start to stand on their feet and move. The Government was cajoling RBI towards this approach

In a sense, the government's approach was vindicated and it has been reported in the press that five of the banks which were put on PCA list are likely to come out of it by 31st March 2019 by virtue of some prudent Management efforts. The RBI could have worked in tandem with the Government towards alleviating the NPA crisis rather than taking a purely regulatory approach. Such an approach would also not have been without any precedent. Back in 2009 in wake of the global financial crisis of 2008, a collaborative working did take place between RBI and Government to effectively handle the crisis. This was revealed by none other than Mr. D Subbarao, the then RBI Governor, while reminiscing about the handling of the post-2008 financial collapse worldwide and how India was successful in largely isolating itself unlike many other countries especially the western world. He said - ‘Looking back, it had a significant impact and synergistic impact on calming financial markets. I would say that acting together was a deliberate thing and it did have a positive impact.’

It is a pity that India handled the ‘Lehman moment' of world financial crisis with aplomb in 2008-09 but when faced with its own internal ‘Lehman moment' post-2014, the RBI Governor failed to rise up to the occasion. Be in no doubt, the big NPA’s are being tackled separately through bringing in some stringent laws for non-payment of loans, and some stringent watchdog actions on operations. This is precisely what Modi government’s approach has been. And frankly, this is the right approach also. The approach is starting to pay good dividends as the recovery of NPAs under Insolvency and Bankruptcy Code 2016 is gaining momentum. It is sad that RBI, in their overzeal to be ‘The Regulatory Body’, failed to appreciate this finer point.

2. Capital Framework

What should be the capital framework for RBI? In particular, what should be the reserves and surplus that should be available to RBI? This question has been eluding answer for RBI and Government for last more than two to three decades. Despite three committees having looked into the question. The V Subrahmanyam Committee looked into the issue in 1997 and came up with a recommendation of 12% of total assets as contingency reserves. In 2004 another committee - Usha Thorat Committee – was set up to look into the matter again. The Thorat Committee came up with a recommendation of 5.5% of total assets as Contingency reserves. This was not acceptable to RBI and was promptly rejected. In 2013, yet another committee was set up – Y H Malegam Committee. This was done when Mr. Raghuram Rajan was the Governor of RBI. This committee examined and advised that the existing reserves were in excess of the needed buffer. What was the contingency reserve at that time, FY 13-14. It was 8.44%. Accordingly, Mr. Rajan did not transfer any surplus to the contingency reserves of RBI and paid out the entire surplus to the Government.

Given the above set of data points, it is clear that there is absolutely no clarity on the issue what is the appropriate level of ‘Contingency Reserve Fund’ of RBI. Whether a figure of 12% is required, or 5.5% is required, or 8.5% is required, or any other figure is required. The answer is anybody’s guess. In such a situation it is but natural that different norms and figures will be tossed around by different people based on their own understanding of the situation, the precedents at RBI, and the knowledge of the experience of other central banks across the globe available with individuals associated with RBI or Finance Ministry. It is a sort of ‘free for all’ among the experts, many of who were ‘so-called'. This is exactly what happened. And, it lead to a situation of conflict and heartburn between RBI and Government. The press and rival political parties had a field day.

To put a lid to all this, the RBI has once again appointed an expert committee to be headed by Mr. Bimal Jalan.

This committee will examine the Economic Capital Framework for RBI and come up with specific recommendations on the same. The terms of reference for this committee have been mutually worked out between RBI and Ministry of Finance. It includes the question – what should be the appropriate levels of reserves the RBI should hold. Whatever be the outcome of the deliberations and study by the committee, there would at least be no controversy about the person heading the same. Mr. Jalan has been an RBI Governor himself (November 2000 to November 2004) and has also been in different positions in the highest echelons of the Finance Ministry as well as the Prime Minister’s Office (PMO).

While all this was going on, this being an election year, all sorts of politics was being played by the different political parties. Misinformation, half-truth, pure canard and all sorts of insinuations were being put in the public discourse. None of them was however true. And some of them – like the government is missing the deficit financing target and hence needs the money to bolster the budget numbers – were refuted categorically by the Finance Minister on the floor of the House.

We have analyzed and examined the issues leading to the two sides having a difference of opinion on two critical issues – PCA and Capital Adequacy. And there is no doubt that the way RBI went about its task as a regulatory body leaves a large room for improvement (to say it mildly and respectfully). It is now time to also have a look at some of the softer issues that are very important.

The cat was set among the pigeons by none other than the Deputy Governor of RBI, Mr. Viral V Acharya. He was invited by the Forum of Free Enterprise to deliver the annual A D Shroff Memorial lecture in Oct 2018. The topic chosen by him – ‘On the Importance of Independent Regulatory Institutions – The Case of the Central Bank’
(https://www.rbi.org.in/Scripts/BS_SpeechesView.aspx?Id=1066).

One has to just go through the opening part of his lecture where he cites the example of Mr. Martin Redrado, Chief of Central Bank of Argentina, and the circumstances under which he parted company with the Bank in 2010. It would take a man to be blind to miss the similarity – trampling of independence and utilization of the reserves. And therein the message Mr. Viral was trying to convey. The speech betrays the harsh feelings of RBI. One is further left in absolutely no doubt when one scroll to the bottom of the lecture. In the footnotes (footnote 1) Viral Acharya acknowledges that the topic was taken up by him on the suggestion of none other than Mr. Urjit Patel. Mind you, Urjit Patel was at that time the sitting RBI Governor (He resigned only in December 2018). And he was thick into the difference of opinion with the Ministry of Finance at that time. It is a pity that Mr. Patel chose to hit out at the government by getting his deputy to air the grievances on a public platform though trying to give it the cover of academic talk. In the lecture there was also a veiled threat of turmoil in the stock markets – ‘Kiss of death, incurring the wrath of markets' – as Mr. Viral put it. It would be too charitable to say that Urjit Patel would not have assessed the repercussions that would follow pursuant to the delivery of the lecture, especially given the fact that this is an election year. As things unfolded the ‘Kiss of death or wrath of markets’ never happened. The markets went through a downslide momentarily and saw a rebound with a vengeance. The government on its part handled the whole affair gracefully. The government went public acknowledging that there exists a professional difference of opinion with the RBI Governor and that they look forward to resolving the same through discussions under appropriate provisions of mutual rights. They also proposed an expert committee to look into the issue afresh and come up with recommendations in a time bound manner. This committee has since then been appointed also (as also mentioned above in the article).

Whether it was a disgruntled RBI Governor, or, an individual who was unable to control his frustration, one would probably never know. But it was certainly not a person fighting for a ‘Cause’. Let there be no mistaking the bitterness bottled up as reflected in the lecture. One is left wondering though as to why this bitterness? The government was not asking for any waivers or concessions on PCA. All they were saying was, neither this is the time, nor is there a justification to make the norms more stringent. Similarly, on the contingency reserve. The government was not seeking higher payout for budgetary support or more specifically to fund the shortfall of deficit financing targets, should that happen.

So where does all this leave the nation? Disappointed and saddened by the turn of events. And, the lack of maturity displayed by the RBI specifically its Governor. In their regulatory zeal, the RBI failed to grasp and take cognizance of the overall economic situation. The Lehman moment of India. It failed to work with the government in a positive direction and support the gigantic efforts being put in by the government for development all around and with good results. They could have done this without compromising on their regulatory role. It was a purely economic situation. But sadly, the RBI politicized it. The RBI got cocooned into a bureaucratic mindset and got entangled into turf battles.

The article would not be complete before assessing how way off the mark has the FT Op-ed has been in stating - ‘Clashes with RBI arising out of defaults in the performance of finance and infrastructure groups’. Once again for a financial daily of the repute of FT to miss out on all the data points mentioned above and to make a sweeping conclusion as reflected in the statement quoted above, is nothing short of blasphemy and hara-kiri with their own readers.

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