In Not-So-Subtle Speech, RBI Deputy Governor Flags Risks to Central Bank Independence

"Governments that do not respect central bank independence will sooner or later incur the wrath of the financial markets... and come to rue the day they undermined an important regulatory institution."

New Delhi: In a wide-ranging speech on Friday, Reserve Bank of India (RBI) deputy governor Viral Acharya reiterated the importance of independent central banks around the world, noting that “governments that do not respect central bank independence will sooner or later incur the wrath of the financial markets, ignite economic fire, and come to rue the day they undermined an important regulatory institution”.

Delivering the A D Shroff Memorial Lecture in Mumbai, Acharya started by highlighting examples of where central bank independence had been compromised – from Argentina (Martin Redrado’s exit) to the US (Volcker’s fight with the Reagen adminstration) – to show that in each case, the country’s economy suffered as a result. 

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“This complex interplay of the sovereign’s exercise of its powers, the central banker’s exit, and the market’s revolt, will be at the center of my remarks today on why it is important for a well-functioning economy to have an independent central bank, i.e., a central bank that is independent from the executive branch of the government,” the deputy governor said.

Closer home, the RBI has for the last year been fighting a three-pronged battle with the Narendra Modi government. The issues concern: the role of the central bank in regulating India’s public sector banks (PSBs), specific government decisions such as the appointment of politically-tinged candidates to central bank’s board, the need for a new and independent payments regulator, and the issue of transferring the central bank’s excess capital to the government.

In his speech, Acharya touched indirectly on all issues.

On the matter of greater central bank control over PSBs, the RBI has recently been in a back-and-forth with the Centre over whether the prompt corrective action (PCA) framework should be relaxed as a means of reviving weaker government banks. The central bank naturally feels that it should not, as it could lead to greater bad loan risks, while the Modi government believes that by relaxing PCA rules it will be able to revive credit growth in certain sectors.

The larger debate over the power the RBI has over government banks was first raised in light of the Nirav Modi scam, when governor Urjit Patel indirectly hinted that there was no point in blaming the central bank for the Punjab National Bank controversy, as it had “weaker regulatory powers” when it came to PSBs.

On this point, Acharya reitreated Patel’s arguments and noting that the RBI was limited in “undertaking the full scope of actions against public sector banks”.  Excerpts from his speech:

1) Regulation of Public Sector Banks: One important limitation is that the Reserve Bank is statutorily limited in undertaking the full scope of actions against public sector banks (PSBs) – such as asset divestiture, replacement of management and Board, license revocation, and resolution actions such as mergers or sales –– all of which it can and does deploy effectively in case of private banks. The significant implications of this limitation were highlighted in detail in Governor Patel’s speech in March 2018, Banking Regulatory Powers should be Ownership Neutral. To reiterate from the FSAP (Para 39 in Summing up Responsibilities, Objectives, Powers, Independence, and Accountabilities, the Basel Core Principles Detailed Assessment Report):

“Legislation should be amended to enable the RBI to extend all the powers currently exercised over private sector banks to PSBs; in particular, regarding Board member dismissals, mergers and license revocation. … It should also remove the option of an appeal to the government when the RBI revokes a license. If statutory changes are difficult, the RBI and the government should consider adopting a framework agreement whereby the government would acknowledge the RBI’s full operational authority and independence in supervision and regulation, as they did recently for monetary policy.”

In August 2018, the Modi government appointed chartered accountant S. Gurumurthy and banking industry executive Satish Marathe to the board of the RBI. The decision raised eyebrows in certain circles, as governments in the past have generally inducted industry captains or people without publicly-declared political leanings. Gurumurthy is associated with the right-wing Swadeshi Jagran Manch while Marathe was the treasurer of the Akhil Bharatiya Vidyarthi Parishad during his college days.

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While Acharya didn’t address this under the India-specific section of his speech, he did point out that appointing “government-affiliated officials” to “key central bank positions” could result in short-term gains for a government but would in the end reduce a central bank’s horizon of decision-making.

Excerpts from his speech:

Now, although the central bank is formally organised to be separate from the government, its effective horizon of decision-making can be reduced for short-term gains by the government, if it so desires, through a variety of mechanisms, inter alia,

  1. Appointing government (or government-affiliated) officials rather than technocrats to key central bank positions, such as Governor, and more generally, senior management;
  2. Pursuing steady attrition and erosion of statutory powers of the central bank through piece-meal legislative amendments that directly or indirectly eat at separation of the central bank from the government;
  3. Blocking or opposing rule-based central banking policies, and favoring instead discretionary or joint decision-making with direct government interventions; and,
  4. Setting up parallel regulatory agencies with weaker statutory powers and/or encouraging development of unregulated (or lightly regulated) entities that perform financial intermediation functions outside the purview of the central bank.

If such efforts are successful, they induce policy myopia in the economy that substitutes macroeconomic stability with punctuated arrival of financial crises.

On the issue of whether the RBI should transfer its excess capital or reserves to the Centre in order to be used to recapitalise India’s banks – a debate that has gone on for the last four years and has found favour with former chief economic adviser Arvind Subramanian – the deputy governor emphasised that having “adequate reserves… is considered an important part of the central bank’s independence”.

Excerpts from his speech:

(2) The Reserve Bank’s Balance-sheet Strength: Having adequate reserves to bear any losses that arise from central bank operations and having appropriate rules to allocate profits (including rules that govern the accumulation of capital and reserves) is considered an important part of central bank’s independence from the government (see, for example, Moser-Boehm, 2006). A thorny ongoing issue on this front has been that of the rules for surplus transfer from the Reserve Bank to the government (Cogencis, 2018, “Govt pegs RBI excess capital at 3.6 trln rupees, seeks it as surplus”), an issue that relates closely to the leading Argentine example in my introductory remarks. It has been covered deftly by Rakesh Mohan (2018) in the last of his three-part series of recent articles on the Reserve Bank, titled Protect the RBI’s balance-sheet; therein, he elucidates why a central bank needs a strong balance-sheet to perform its full range of critical functions for the economy. I quote his main points below:

“First, … The longer-term fiscal consequences would be the same if the government issued new securities today to fund the expenditure. [R]aiding the RBI’s capital creates no new government revenue on a net basis over time, and only provides an illusion of free money in the short term.”

“Second, … The use of such a transfer would erode whatever confidence that exists in the government’s intention to practice fiscal prudence.”

“Third, … In theory, a central bank can implement monetary policy appropriately with a wide range of capital levels, including levels below zero. In practice, the danger is that it may lose credibility with the financial markets and public at large, and may then be unable to attain its objective if it has substantial losses and is seen as having insufficient capital.

Are fears with regard to possible central bank losses illusory? According to the Bank for International Settlements (BIS), 43 out of 108 central banks reported losses for at least one year between 1984 and 2005.

It is also argued by some that the government can always recapitalise a central bank when necessary. This is certainly true in principle but is practically difficult when the government itself suffers from fiscal pressures and maintains a relatively high debt-GDP ratio, as is the case in India. What is also important is the erosion of central bank independence both in reality and perhaps, even more importantly, in optics. …

Once again, better sense has prevailed and the government has not raided the RBI’s balance sheet.”

Acharya ended his speech by re-emphasising the need for greater executive respect for the independence of central banks.

“As many parts of the world today await greater government respect for central bank independence, independent central bankers will remain undeterred. Governments that do not respect central bank independence will sooner or later incur the wrath of financial markets, ignite economic fire, and come to rue the day they undermined an important regulatory institution; their wiser counterparts who invest in central bank independence will enjoy lower costs of borrowing, the love of international investors, and longer life spans,” he said.