Monday, November 19 may be a day of reckoning for the Indian financial sector. The sector's backbone, its regulator, the Reserve Bank of India (RBI) may face its most difficult test ever. If news reports are to be believed, the government may want to make the RBI a board-run central bank.
Section 7 of the RBI uses identical words to describe the powers of the RBI governor and deputy governors on the one hand and the RBI board on the other. Section 7(3) which governs the powers of the governor has one additional phrase. The section reads "Save as otherwise provided in regulations made by the central board, the governor, and in his absence the deputy governor nominated by him in his behalf, shall also have powers of general superintendence and direction of the affairs and the business of the bank."
In an interview with CNBC-TV18, YH Malegam, veteran chartered accountant and one of the longest serving members of the RBI board,
interpreted this to say the governor shall normally run the RBI. The board must restrict itself to areas where it has made regulations- mostly about its own conduct, that of local boards and about RBI staff issues.
News reports now suggest the government is asking the board to make regulations is areas like financial stability, monetary policy transmission and exchange rate management so that the governor runs the affairs of RBI in a manner that the board wants.The trouble with this interpretation is manifold. 1. It is against convention. Traditionally, the board only advises,
as former RBI governor C Rangarajan says. The governor is sensitive to the board's advice. 2. While some legal pundits argue that convention is not equal to law, and that the law permits the board co-equal powers with the governor, in this case convention becomes important because of the nature of the board. Since conventionally the board only advises, it has been customary to have many corporate honchos on the board. Currently the board has N Chandrasekharan, chairman Tata Sons, Bharat Doshi, a former CFO of M&M and even currently employed in the group's trusts, and Dilip Sanghavi, MD, Sun Pharma. All these groups have significant loans and will benefit from say foreign exchange management rules or even from interest rate transmission rules. It cannot have been the intent of the framers of the Act to make the governor subservient to corporates? The other members of the board have conventionally been social workers and scientists. It appears unlikely that any government would want them to design exchange rate policies and bank supervision. Members of the board are not responsible to parliament. The governor is. So what happens if policies misfire? Should the governor face the wrath of parliament for following his board? If indeed the country moves towards a powerful board, ought not the members of the board be selected through a more rigorous process? Finally, a board-run central bank is unheard of world over, says P Chidambaram, former finance minister and eminent lawyer. It would completely militate against the autonomy of the central bank, he adds.
So what else may happen on Monday? It is possible the board may, at the behest of the government, pass resolutions asking the governor to solve a few issues.
One of these could be the curbs placed on weak banks through the prompt and corrective action rules because of low capital or high unprovided bad loans or recurrent losses. The board could prevail upon the RBI to loosen these curbs. This could leave the RBI is piquant position, since many of these 11 PCA banks have posted rather disastrous results in the second quarter. It is also important to note that in the latest report of the IMF-cum-World Bank on India's financial sector, the duo have recommended to the RBI to have stricter and higher provisioning. Which means, in a peer review, the RBI-recommended provisioning is actually below international standards.
The other demands from the board could be to lower the minimum capital requirement from banks. Government officials have clarified that RBI requires 9 percent minimum capital against 8 percent required by Basel rules. Here again, RBI worries that globally banks have much lower loss given default. In India loan recovery is typically low because of the time consuming judicial process and high transaction costs like stamp duty. A meeting ground between the government and RBI looks tough.
The other key issue could be liquidity. The finance minister has publicly urged that the market is facing tight liquidity. The RBI did its bit by infusing Rs 80,000 crore of liquidity through bond purchases. It may offer to do more. Likewise on providing probably forbearance or one-time restructuring facilities for small businesses, some meeting ground may be found.
Behind all the substantive issues, the stand-off may also be personality driven or downright one-upmanship, something which can be bridged by some conciliatory approach, or which may marred irreparably by harsh words.The resignation of the governor can't be good news for the economy, the polity, the financial sector or the central bank itself. Hopefully sense and sensibility will prevail.