Issues with functioning of RBI

What is the issue?

There are unresolved issues revolving around the capital base, performance and autonomy of the RBI in recent times.

Is the RBI’s capital base too large?

• Central banks need to be adequately capitalised in order to perform their core functions which include being the lender of last resort for the banking system.
• As per the latest available figures, total RBI capital is around 27% of its total assets.
• This is more than in most central banks in the world.
• However, the problem with this conclusion is the composition of the RBI capital base.
• Only a third of RBI capital is actually contingency funds that can be deployed when needed.
• The remaining two-thirds of its capital is primarily revaluation funds.
• Revaluation funds is an accounting entry which rises and falls as the value of the assets of the RBI rises and falls.
• Thus, over the past quarter, the depreciation of the rupee has led to an increase in the rupee value of RBI dollar assets by almost Rs 1.6 trillion.
• But this is accounting income, not an earned income.
• If one had reported the RBI balance sheet in dollars, then there would have been no change on either side of the balance sheet at all.
• The deployable capital base of the RBI is just about 7% of total assets.
• This makes the RBI one of the most under-capitalised central banks in the world.
• The Economic Survey of 2016 focus on the overall rupee size of the RBI capital base as opposed to its deployable capital base.
• This projects the capital base of RBI higher than its deployable potential and hence are deliberately misleading.
• These factors also bring us to the issue of RBI performance.

What are the concerns put forward against RBI?

• The government criticised the Prompt Corrective Action (PCA) norms and the liquidity management of the RBI on the backdrop of the IL&FS crisis recently.
• On PCA framework - The PCA norms were introduced as a way of getting scheduled commercial banks to begin a prompt recognition and clean-up of their asset base before they acquired any new risky assets.
• This came on the back of a continued worsening of the balance sheets of a number of banks, especially public sector banks, with rising NPAs.
• Banks are supposed to allocate the saving of households towards borrowers who are able to offer the highest returns at the lowest risk.
• Hence, regulators devise measures to ensure that the lending process does not get compromised and PCA norms are one such measure.
• A simple examination of credit growth in the Indian economy this year would suggest that the measures taken under PCA norms most certainly have worked.
• Credit has been consistently growing at double digit rates since December 2017, including in September 2018 when it grew at 12.4%.
• Crucially, this turnaround in credit growth has come after the low single digit rates of the last couple of years.
• Greater lending is being undertaken by better capitalised banks that have weaker incentives to ever-green their stressed assets.
• But the measure taken by RBI in forcing under-capitalised banks to stop lending until they clean up under PCA norms has been criticised heavily by the government.
• The government also claimed that the PCA norms have failed to resolve the NPA crisis in the country.
• These arguments are not based on facts but rather on political expediency and corporate rent-seeking.
• On IL&FS crisis - The other criticism of the RBI is with regards to its post-IL&FS liquidity management, especially for NBFCs.
• NBFCs had typically been funding their investments with debt and bank loans with an increasing reliance on shorter and shorter commercial paper (CP) over the past year.
• Commercial Papers are issued by companies with high-quality debt ratings for raising money to meet their short-term liabilities.
• Corporations, financial institutions, wealthy individuals and money market funds are usually buyers of commercial paper.
• It is usually issued at a discount from face value and reflects prevailing market interest rates.
• Maturities on commercial paper are usually no longer than 9 months.
• Unlike banks, NBFC do not have access to low-cost public deposits and have to heavily rely upon commercial paper and commercial debt markets.
• Banks and Mutual Funds are the main source of funding through commercial papers to NBFCs and housing finance companies.
• While large MFIs have access to bank finance, the mid-sized and smaller ones depend on funds from NBFCs.
• Small and mid-size NBFCs and Micro Finance Institutions (MFI) are going to face the liquidity crunch due to redemption of commercial papers due in November-March.
• Anticipating liquidity crunch, the RBI has announced Rs. 40,000-crore liquidity infusion in November through open market operations recently.
• However, the supposed liquidity crunch in the NBFC segment finds no supporting evidence in the CP rates which have only moved to the extent that the policy rates have moved.
• Thus, there is no sustained independent effect of the IL&FS crisis on market rates.
• However, the government pointing at the fall in new CP issuance in recent months as an effect of IL&FS crisis.
• This is grossly misleading, as it is an attempt at drawing systemic conclusions from only one data point.
• CP issues are a volatile series, wherein their growth rates (year- on - year) were negative in February, March and April of 2018 as well.
• Hence, there is certainly no evidence of any aggregate liquidity crunch.

What should be done?

• These criticisms bring us to the question of RBI independence.
• A sovereign government finances itself from two sources such as taxes on its citizens and printing of money.
• The taxes go directly to the government while revenues from money printing accrue to the central bank.
• Governments face various political constraints that may induce them to take actions that create economic uncertainty.
• One way for citizens to exercise control over the government is to hand over part of the revenues to the central bank and make it institutionally independent of the government.
• Hence, the prevailing argument that independence of RBI is earned through its performance is misleading.
• The performance of the central bank is in itself depends on the independence granted to it and not the other way around.

Source: Indian Express