The RBI versus government saga - in search of core solutions

(This article appeared in ET on November 28, 2018, URL below:

https://economictimes.indiatimes.com/news/economy/policy/the-reserve-bank-versus-government-saga-in-search-of-core-solutions/articleshow/66834380.cms?utm_source=ETMyNews&utm_medium=HPMN&utm_campaign=AL1&utm_content=20 )

The RBI versus government saga - in search of core solutions 

The last few months have been busy for our financial ecosystem, for the wrong reasons. 

RBI folk have been busy penning and delivering caustic speeches that leave little to the imagination about what they think of Delhi.

For its part, Delhi has been busy delivering its counter-narrative through tweets, sound bites, and by complaining about Mint Street to whoever cares to listen.   

Commentators like me have been busy gleefully churning articles on what we think is the latest score.

Much of this is quite pointless though – the underlying disagreements and implications are serious and real, but in this melee, we could be skirting the true solutions that stare us in the face. 

The differences

Let’s list the areas of differences between the RBI and the government. 

The government wants the RBI to relax lending restrictions on the notionally weak banks that are under RBI’s Prompt Corrective Action (PCA) framework. It wants RBI to provide forbearance (in other words, to close its eyes) on stressed loans, particularly to the Power and Micro Small and Medium Enterprise (MSME) sectors. It wants to access the capital on RBI’s balance sheet. Finally, it wants the RBI to provide relief to stressed Non-Banking Financial Institutions (NBFIs). 

The solution set

The issues raised by the government are real. Banks need to do more to support the economy. Power, MSME, NBFI and other sectors do need relief. The government could always do with additional funds.

But the real solution is unlikely at the door of the RBI – at best, RBI can offer short-term policy palliatives.

Perhaps the solution instead lies in injecting more capital into government-owned banks, and at the same time, overseeing true reform of the financial sector. 

Bank Capitalization

Even after completing the INR 2.11 lakh crore recapitalization announced in October 2017, banks will be short of capital by Basel standards, constraining their operations. 

Consider this. As of March 2018, 16.7% of Public Sector Bank (PSB) loans were stressed, with only 42% provision for loan losses. One reason for the absence of market trades in distressed debt is this inadequate provisioning. For a more conservative 60% provisioning, PSBs would need INR 1.9 lakh crores of additional capital. 

Some suggest that given the government’s implicit support to PSBs, RBI should relax standards around recognition and treatment of non-performing assets, and lower the minimum amount of capital needed by banks. RBI disagrees. 

There is an alternative – the government could infuse adequate capital into PSBs. This need not be as fiscally draining as it sounds. 

Recapitalization bonds – already issued recently - represents one way of infusing capital into banks with manageable side effects. Banks lend to the government through these bonds, and the government in turn infuses equity into the same banks. This is self-funding both for the banks and the government. 

By reiterating its confidence in the ecosystem with additional equity infusion, the government would help address core issues directly. Banks would then be able to increase provisioning against stressed assets, while increasing lending to deserving NBFI, MSME and other sectors. 

Recapitalization bonds would also reduce the need for any extraordinary fund-raising by the government – one less motivation for it to eye the RBI cookie jar for additional dividends.

However, any recapitalization should necessarily be accompanied by real banking and market reform - else we risk throwing good tax-payer money after bad. 

This is where the 2014 P J Nayak committee recommendations on banking reform come in.

Banking reform - freeing Indian banks

The P J Nayak committee report was released in May 2014 and its recommendations are worth implementing in toto. 

Amongst other recommendations, the committee calls for the creation of a truly independent, professionally managed Bank Investment Company (BIC) to hold the government’s equity stake in PSBs – akin to Temasek Holdings in Singapore.  

The formation of BIC, followed by enabling legislation, would allow PSBs to come under Companies Act rather than under Bank Nationalization Act or State Bank of India Act. This in turn would allow RBI supervision to be bank ownership neutral, and eventually help keep PSBs outside the purview of CAG, CVC and RTI. 

It would also eventually pave the way for PSBs to follow market-linked employee policies. The role of executive chairman of State Bank of India, overseeing a balance sheet of INR 37 lakh crores, needs a better salary than INR 30 lakhs per year. 

Importantly, implementing P J Nayak committee recommendations would create a distance between the government and the day-to-day functioning of PSBs. The genesis of stressed loans has been linked to direct pressure from Delhi on banks to lend. It doesn’t matter how well-intentioned this intervention is. Whether it is to fund much-needed infrastructure or deserving MSME sectors, commercial decisions are best left to independent, accountable banking professionals. 

It will take courage, sacrifice, and – dare I say - patriotism on the part of Delhi to implement these reforms, knowing that by doing so, it would be loosening its grip on banks. 

Until then, we could be condemned to enduring serious battles that beat around the policy bush.