Blog: The Impossible Trinity of The Reserve Bank Of India – Time To Break The Bank? – Moneylife

We are all familiar with the impossible trinity posited by Robert Mundell and Marcus Fleming, which states that in its economic policy, a country can choose any two of the following, but not all three, a fixed exchange rate; an independent monetary policy and free flow of capital. Thus:

 

If a country opts for a fixed exchange rate and an independent monetary policy, then it must keep control over capital inflows and outflows. Otherwise, uncontrolled capital flows will force a change in the fixed exchange rate and/or the ability to maintain an independent monetary policy;

 

If a country opts for a fixed exchange rate and free flow of capital, then it surrenders its ability to have an independent monetary policy since the interest rates will be determined by the capital flows, and exchange rate arbitrage will occur;

 

If a country opts for a free flow of capital and an independent monetary policy, then it is compelled to allow the exchange rate to fluctuate.

The Reserve Bank of India (RBI) has an impossible trinity of its very own, driven by fundamental conflicts of interest. Among its roles and objectives, the RBI serves as :

 

The determiner of monetary policy via the monetary policy committee (MPC); 

 

Banking regulator for the banks, financial institutions and non-bank financial intermediaries;

 

Manager of the public debt of the Union and state governments.

 

There are others, but for now, we will focus on these three.

 

The Reserve Bank is charged under the RBI Act with the responsibility of conducting monetary policy. It has three nominees on the six-member MPC that makes the decisions. We can already see three obvious conflicts of interest arising from the above. 

 

First, in a rising inflation scenario, the natural response of the MPC would be to tighten liquidity and hike interest rates. This, however would militate against the RBI’s role as manager of the debt, where the RBI would like to keep the cost of borrowing as low as possible, for which it needs to ensure ample liquidity and low-interest rates! 

 

The RBI is also aware that the hardening of interest rates would depress bond prices, weakening the profitability of the banks, which would need to provide for depreciation. 

 

The RBI also has to be conscious that higher rupee interest rates would also draw in volatile capital flows that pursue arbitrage. So how does the RBI resolve this conflict or prioritise its conflicting objectives?  

 

Supervising PSBs 

 

Similarly, as the banking regulator, the RBI is responsible for the stability of the banking and financial system. It is empowered to require compliance with prescribed norms for capital adequacy, income recognition, asset classification, provisioning etc. 

 

While its word is the law for the private sector and foreign banks (well, in theory at least!), the RBI’s writ over the public sector banks (PSBs) is limited. While it has a voice in the selection of whole-time directors, it is a very limited voice. Nor can the RBI remove PSB bank directors as it can private sector or foreign bank directors. 

 

It may yell itself hoarse about capital adequacy and prudential norms but in practice, the PSBs answer to the department of financial services (DFS) in the ministry of finance (MOF) and only nominally to the RBI. 

 

We have seen examples of such dissonance repeatedly. The RBI has been a silent witness to the MOF urging PSBs to fulfil objectives that may make eminent sense to politicians but bear little relation to sound banking practices. The numerous loan melas, Mudra loans and their ilk are too many to cite. 

 

Even more ridiculous is the presence of a senior RBI officer on the boards of PSBs and financial institutions. The issue is not that these worthies have little experience of banking beyond theory textbooks – that point could apply to most of the board. 

 

The conflict arises when RBI, the banking regulator, conducts annual financial inspections and highlights various lapses to be remedied. What is the responsibility of the RBI itself for these lapses, considering the presence of its nominee director on the board? 

 

In fact, there have been highly embarrassing situations on occasions where the RBI director has to face the RBI inspection team during the board meeting and be confronted with comments on poor attendance or participation! 

 

Way back in the 1990s, the Narasimham committee on banking sector reforms had recommended that the RBI should give up its seats on PSBs. In 2014, the PJ Nayak committee, on the governance of bank boards, also advocated the withdrawal of RBI nominees from PSBs. 

 

In fairness to the RBI, it has sought to remove its nominees from the boards but has been stymied by the MOF, which also has nominee directors and whose bureaucrats consider a board seat as a perk and effectively act as super directors.

 

Last but not least, as the public debt manager, the RBI would want the debt securities of the centre and states to be placed at the lowest cost, for which it often leans on the PSBs to soak up the issues. In so doing, the RBI is effectively encouraging financial indiscipline of the centre and states, as evidenced by the never-ending revenue deficits and imperilling the financial position of the holders of these debt securities. 

 

This impossible trinity of the RBI is well known; however, any action to resolve the conflicts has been notable for its absence. The best-known and commented upon conflict role is that of the public debt manager. 

 

Even Dr Raghuram Rajan, who as a chief economic advisor (CEA) excoriated the conflict of interest and advised that debt management be shifted to the finance ministry, underwent a mysterious conversion as soon as he assumed the role of the RBI governor, and thereafter said no more on the subject!

 

Is the conflict at all amenable to resolution? 

 

No, the individual roles and logic are incompatible and the conflict cannot be resolved. Till date the only workaround has been to prioritise the roles dynamically based on the prevailing situation from time to time. Not only is this an unsatisfactory tactic, fraught with inconsistency, it also perpetuates the conflict without resolving it. The only feasible solution then is to break up the RBI into some select component parts.

 

Debt Management 

 

There would certainly, at one point of time, have been ample merit in housing the debt management function in the RBI, given the fledgling status of the Republic of India and the undoubted skills of the RBI officers. The location of the RBI in Bombay (now Mumbai), in the heart of the money and capital markets, would also have been an important consideration in the days of telexes and telegrams. 

 

Today with the electronic revolution, location is hardly material. It has long been the proud boast of the Indian Administrative Services (IAS) that their skilled generalists can handle any job. While they are undoubtedly convinced of this point, true professionals would chortle at the thought. 

 

Perhaps it may be beneficial to transfer some skilled and experienced RBI officials laterally into the IAS cadre to manage the debt. One way or the other, it is long overdue that the role and responsibility be shifted from the RBI to its rightful place in the Ministry. 

 

The question of banking supervision plus monetary policy also has a history. Internationally, some countries have allowed commercial banks to issue currency and a couple of them still do. Under licence from the Hong Kong Monetary Authority (HKMA), three commercial banks in Hong Kong issue their banknotes for general circulation in the region, in addition to notes issued by the HKMA. 

 

Though unusual, this is not unique, for example, in the UK, seven commercial banks issue banknotes (three in Scotland and four in Northern Ireland) and in Macau, two banks issue banknotes. 

 

Historically with banks being the main engines of credit creation and channels of money supply, it made sense for the institution operating monetary policy also to supervise and regulate the banks. 

 

The size and influence of capital markets dwarfing the banks in today’s world is vastly different. Given that monetary policy operations affect only one or two aspects of banking, it is hard to understand why the conjunction of the two in the same authority should continue. 

 

Importantly, the skills and experience required for monetary policy have little or no overlap with the skills needed for supervising and regulating banks. To his credit, the present RBI governor Shaktikanta Das has drawn attention to this and proposed the creation of a specialist officer cadre for bank regulation with the RBI. 

 

Regrettably, the idea seems not to have been pursued, perhaps due to resistance from RBI staff, who are famously resistant to change.

 

If one accepts, reasonably, that specialised skills and experience are needed for effective bank regulation and supervision, one needs to ask why these skills need to reside in the RBI? It is hard to think of any synergy or benefits that arise from this co-location. 

 

It is high time a specialised banking regulation board (BRB) be set up, staffed by skilled, trained and experienced officers from within the RBI and also drawn on secondment or deputation from banks, to focus sans distraction on the banking sector exclusively. 

 

(Artha Shastry is a banker who wishes to remain anonymous.)

 

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