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RBI board can advise and persuade the Governor, it cannot direct the Governor on substantive issues, says YH Malegam

RBI board can advise and persuade the Governor, it cannot direct the Governor on substantive issues, says YH Malegam

RBI board can advise and persuade the Governor, it cannot direct the Governor on substantive issues, says YH Malegam
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By CNBC-TV18 Nov 18, 2018 2:23:12 PM IST (Updated)

Veteran chartered accountant YH Malegam, who has also served as the RBI board member for 21 years, spoke to CNBC-TV18 about the recent clash between the government and the central bank. He pointed towards the need for amending the RBI Act, if the government wants to transfer the surplus amount of the previous years.

YH Malegam, a veteran chartered accountant has also served as RBI board member for 21 years. While talking about the recent clash between the government and the RBI, he pointed towards the need of amending the RBI Act if the government wants to transfer the surplus amount of the previous years.

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"The Act provides that all the surplus of the Reserve Bank in any particular year has to be transferred to the government. But there is no provision, which says that any part of reserves can be paid to the centre and therefore at the maximum, which can be distributed, is the surplus for the year without making any transfer to provisions,” he said.
Here is the detailed transcript of the interview.
Q: The first question is on RBI’s capital. Can the government ask for the Reserve’s bank capital?
A: As I understand the act provides that all this surplus of the Reserve Bank in any particular year surplus profits after making provisions for those matters for which central banks make provisions has to be transferred to the government. But there is no provision, which says that any part of reserves can be paid to the government and therefore at the most the maximum, which can be distributed, is the surplus for the year without making any transfer to provisions.
Q: Therefore if something has to be transferred from yesteryears reserves as it were, retained profits, you will have to amend the act?
A: I think so.
Q: You yourself were involved in once advising the Reserve Bank and the government on how much reserves the Reserve Bank should have. Can you take us through the argument?
A: I can’t tell you the details of that report because that has not be made public. I can tell you the broad approach which was taken. The question is that the Reserve Bank as has been made in the public, there was a report made earlier which said that the bank should build up reserves equivalent to 12 percent of its net worth. Gradually, the Reserve Bank has been transferring these amounts to the reserves. What we had to look at was, are the reserves adequate for the risks, which are attached to the bank in its operations.
We came to the conclusion after identifying various risks that the reserves at that point of time were adequate and even maybe a little more than adequate and therefore we suggested that for the next three years you don’t add to the reserves and distribute all the profits which are there and then at the end of three years review the position again.
Q: Which is what Raghuram Rajan did in the three years he was governor, I think he transferred all the surplus which was about Rs 65,000 crore each.
A: I don’t have the figures.
Q: I remember the numbers very well. It was between Rs 60,000 crore and Rs 65,000 crore. We can find it in the RBI annual report. Now after the three years when Dr. Urjit Patel became governor, that was the year of demonetization and therefore the bank made lesser surpluses than previous years. But from whatever surplus of about Rs 30,000 crore, he kept aside about Rs 13,000 crore for contingency. Now do you think he was right, after all he was following the Malegam recommendation? For three years the entire surplus has to be given. In the fourth year he was right in keeping the reserves?
A: As I said the situation does not remain constant so what is right or wrong will depend from the circumstances at a particular point of time. One of the most important things to remember is that a substantial portion of the surplus, which a Reserve Bank makes arises because of the revaluation of its foreign currency reserves. Now these reserves are held in foreign currencies. So, what would happen is that if the rupee depreciates then to that extent, the value of that foreign investment goes up and it gets added to the profits. These are unrealized gains. They could get reversed at some time in the future and therefore this gain is not in fact retained as the surplus but is transferred to reserves so that if and when the currency reverses the position and the rupee appreciates then that amount of reserves can be utilised.
Q: When I looked at the last Reserve Bank balance sheet and accounts it said that there are about 10 lakh crore of reserves of which a little over Rs 7 lakh crore is revaluation reserves and about 2.5 lakh crore are contingency fund and asset development fund. Now would it sound accounting standards not to touch the revaluation reserve when one is calculating the strength of the bank?
A: Obviously, because you cannot distribute unrealized gains and that is a practice, which most central banks follow.
In fact, some years ago the Central Bank of Israel is reputed to have distributed these unrealized gains and subsequently the currency reversed and they had a problem because then the gains, which they had realized had to be reversed but the money had already been paid out.
Q: So, negative reserves actually?
A: That is right.
Q: So we ought not to go down that path. There are others who have suggested that when you transfer the surplus in a particular year to the government it would be better to keep a little amount to smoothen out the dividend payments. I mean there are various suggestions that come in terms of surpluses. Do you think what is called for today would be to appoint a committee with people like you to take a view for the next few years or for all time a dividend policy?
A: I don’t think one can have a set percentage of profits, which must be transferred to reserves because as I said whether the reserves are adequate or not at a point of time depends upon the risks, which are identified at that particular point of time. You can appoint a committee but internally also the Reserve Bank can make an assessment and say to what extent the reserves are adequate. That is opposed to the other proposition that you determine that for all points of time, 12 percent would be an adequate margin that sort of a thing.
Q: You think that is a good idea?
A: I personally prefer that in a volatile situation in which the Reserve Bank operates with currencies fluctuating quite a bit, it is much better to periodically review the position, look at what is available in terms of reserves and then decide whether going forward you should add to those reserves or just eat into those reserves in the future.
Q: The trouble appears to be that the government and the Reserve Bank have a different view on how much capital should be kept. After all Arvind Subramanian said that Reserve Bank was the most over capitalized bank at 27 percent, he said the international average is 14 percent.
A: There are so many risks, which cannot be identified in that particular fashion. For example, apart from this question of the exchange risk, there is the question of the risk that the Reserve Bank ultimately is the lender of the last resort and a strong balance sheet also conveys a strong impression about the bank and in a way of the currency itself. So it is very difficult to decide.
Q: Dr Reddy in this autobiography ‘Advice and Dissent: My Life in Public Service’ and Raghuram Rajan more recently have said that India’s sovereign rating is not AAA. So we ought to have an entity like the central bank with near AAA rating so that when we have a problem this entity can have swap lines or borrow, is that a fair argument you think?
A: It is a question of what is the probability factor which were assigned to a risk. In an AAA rating you might say that you want to cover a risk whereby you ensure that the risk will not materialize the 99.9 percent and you might say well 95 percent is alright. But that is a matter of opinion. But the fact still remains that whatever you do, the law doesn’t permit you to distribute past reserves.
Q: The last question on capital before I come to the board itself can the board direct the Reserve Bank governor to transfer more surplus than he is prepared to, if in his assessment he thinks a part of it needs to be held back?
A: I don’t think the board can do that because the board has to act in accordance with the law. If the act does not permit something how can the board say you can do it.
Q: On that point let me come to the powers of the board itself.  Reports suggest that the board will perhaps try to tell the Governor that the Prompt Corrective Action (PCA) filters to correct weak banks are too severe. Can the board tell the Governor to dilute these norms, does it have the powers?
A: We have to first look at the Reserve Bank Act itself. The board of the Reserve Bank is slightly different from the board of another company. Under the Companies Act, the Managing Director is appointed by the board, the powers of the Managing Director are given by the board and the Managing Director acts under the direction of the board. So the board has the responsibility to direct and control the management. That is the concept of corporate governance.
Under the Reserve Bank Act, in Section 7, as I understand it, there are two sub-sections. One sub-section says that the board has the responsibility to superintend and generally look after the affairs of the bank. There is a second sub-section which says that subject to regulations which the board may provide, the Governor or in his absence any Deputy Governor which he nominates as the same powers. So, in effect therefore both have the powers to superintend and look after the affairs of the bank.
Q: The statements are almost identical.
A: Exactly the same wording. Therefore really they are concurrent powers. Now if the board has to give some directions to the Governor, it can only do so on the basis of the first part of that sub-section which says subject to the regulations which the board makes in accordance with the act.
Q: So subject to the regulations the board makes in accordance with the act the Governor has all powers.
A: That is right. Now, those regulations which are there in Section 58 of the act, have a process. It says that the board can make regulations with the prior approval of the government by notification in the official gazette and then after this notification is done, within 30 days or so, that notification has to be placed before parliament and both houses of the parliament have to approve that or can modify that. So this is the whole process which has been laid down. Therefore, the board cannot suo motu direct the Governor to do something. If it wants to do it, it would have to go through this whole process.
Q: Article 58(2) as you say says that the board can make regulations on the manner and conduct of business of the board, powers to be delegated to local boards, delegation of powers of the board to the Governor and DGs, running of the Reserve Banks staff affairs, manner of balance sheet presentation, etc. Now under these, they may have already made regulations. These existing regulations do not give them the power?
A: At the moment I am not aware of any regulation which says that they can direct the Governor to do something which is concerned with monetary policy.
Q: That they cannot.
A: In fact in a broad sense, the Governor is accountable. He is accountable to parliament, he is accountable to the public, in a way he is accountable to the board, but this is within the provisions of the act. You also got to realize that there are instruments of accountability which are provided for. For example, there is the monetary policy committee (MPC). MPC in a sense holds the Governor accountable. However, even there, the Governor has the veto (the casting vote) so the policy may say something, they may advise him, but he still has the final say.   Then we have the financial stability committee which is headed by the Finance Minister. There is therefore another instrument by which he is accountable.
Now with these accountabilities which are there, if you want him to be accountable to the board on policy matters, a lot of disruption would be created. You have also got to understand that in the case of a company, the board is there to protect the interest of the shareholders; here the board is there to protect the interest of the depositors. If there are policy matters, while in the Companies Act you have various provisions, like a provision which says that certain matters can only be done with a board resolution, certain matters can only be done with a shareholders resolution, and there are provisions for the related party transactions, there are no such provisions in the Reserve Bank Act.
Therefore, if you take a situation in which the board directs the Governor to do something connected with policy matters, then all the directors or some of the directors at least who represent industry, who represent other interests, they would have an interest in that decision making.
How can you expect the Governor to take a prior approval for a policy from the board when the impact of that policy would affect those directors?
Q: Even for that matter, for instance there is a demand from the financial sector players that a line of credit be given by the Reserve Bank to NBFCs, now there are two members of the board at the moment, N Chandrasekaran, Chairman of Tata Sons, they have Tata Capital, an NBFC and Bharat Doshi of Mahindra and Mahindra (M&M), they have MMFSL, it would be conflicting isn’t it to allow a board like this to tell the Governor that you do this for NBFCs?
A: That is one part. As I said, one is question of interest. The other thing you have got to remember is that the Reserve Bank has multiple objectives. You have monetary policy, you have inflation, you have exchange rate, amongst many other things and in fact there is this well-known impossible trinity. If you do something in the monetary policy for affecting inflation, it has an impact on growth. If you do something for growth, it may have an impact on foreign exchange. So there is a very difficult balancing act which has to be done and it can only be done by professionals who understand these things.
In fact, if you look at the financial sector legislative reforms commission, it examines this whole issue of why do you need an independent regulator and it has given four reasons or advantages of having an independent regulator of which two are, in my opinion, very important. The first one says you need the regulator because the regulator has specialized officers staff who have domain knowledge of that field on which regulation has to be done.
So here you have in the Reserve Bank central bankers who understand these things. Board members do not have that sort of expertise. The second and very important, they have said that this provides for a stability in policy because otherwise if that policy was made by the government it would be subject to any political changes which take place in the government.
These are all the reasons why ever since the RBI was formed or nationalized from 1939 till now, I am not aware of any situation where the board of the RBI gave directions to the government. They make a very important contribution by giving advice. They are a sounding board for the Governors and the Governors actually use that without revealing what they intent to do, they discuss various options with the board, they get their advice on matters but the final decision still remains with the Governor.
Q: But still the act would have expected some voting to happen after all it says that the two government nominees are non-voting members, it says that the deputy governors are non-voting members. So voting is envisaged under the act.
A: I agree but it is not as if the board does have powers on certain matters. All I am saying is traditionally and a tradition is also as important as actual provisions of the act.Traditionally, board members have not made any directions on policy but they can make directions on administration, they can make directions upon other matters which are concerned with internal management - that is where the question of voting may come in.
Q: God forbid if it were to happen on November 19th because some board members have strong views on some issues; they vote and pass a resolution asking the Governor to do something, either loosen the controls on banks or give a special line of credit to SMEs. What can the Governor do? Can the Governor say that go back and make regulations and come? This is outside the purview of current regulations?
A: I cannot tell you what the Governor will do but theoretically he could ask for a legal advice as to whether this is within the competence of the board or not.
Q: Do you think that the Reserve Bank of India board in November 19th meeting or in any subsequent meeting passes a vote to influence any of the policies of the Governor. Can the board's advice be set-aside by the Governor?
A: The correct position is like this - the members of the board are knowledgeable people about the industry, about the social problems etc., so they can give valuable inputs to the Governor and the management as to what they feel should be the right policy, what they feel would be the consequence of their policy. They can pursue it, the management in a particular line but they have to stop at the point of persuasion. They cannot direct and that's the point I am making.
 
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