Issue

Context
The banking system is crucial in India’s economy, and their poor state of health today, is further exacerbating the slump in economic activity across the country. In this context it is important to assess the role of the Reserve Bank of India (RBI) as the apex financial institution.

Background

• Credit growth has fallen sharply in recent months as banks have become wary of lending; even firms have become reluctant to undertake new projects.
• Capital adequacy for Indian banks is Capital buffers of India’s banking system are among the lowest among the G-20 economies.
• Meanwhile, the troubles in the shadow banking sector threaten the health of the banking system, and may prolong a deep financial slump. It could result in a spike in bad loans for conventional banks which fund the shadow banks.
• The ‘domestic savings rate’ is low. There is sharp decline in the ‘net savings rate of households’, which have borrowed to maintain consumption levels in period of weak income growth. There is growing dependence on foreign capital inflows to fund the Indian commercial sector.

Analysis

RBI as a monetary authority

• RBI’s institutional framework underwent a significant change in the early 1990s after the liberalisation programme was launched. Both Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) were reduced, and more importantly the administered structure of interest rate was abandoned, and the government was forced to go to the market and borrow at market determined rates of interest.
• Switching to market determined interest rates has important implications for the RBI, because now their Open Market Operations (OMO) became an instrument of credit control. Also the ‘bank rate’ and ‘repo rate’ became policy instruments because of this change.
• The foreign exchange market also came into active operation because of the switch. The relationship between the foreign exchange market and the domestic money market became intense, and as a consequence, the monetary policy issues were linked to the rest of the world.
• The new monetary policy framework that came into operation required RBI to maintain price stability and to contain inflation. In 2016, a Monetary Policy Committee (MPC) was set up to bring transparency and accountability in fixing India's Monetary Policy. It set the inflation target at 4% (plus or minus 2%).
• Though it is often argued that with the constitution of MPC, RBI shifted from targeting multiple indicators to just one indicator – inflation; however, matters of inflation are always considered in tandem with economic growth considerations.

RBI as a credit controlling authority

• Bank lending should normally outpace nominal GDP in an emerging economy, but that’s not the case in India right now. The credit gap has been negative since the end of 2013.
• Most of the new deposits that banks have collected since early 2019 have been parked in government securities rather than being lent to enterprises.
• Crisis among non-bank financial companies (NBFCs), and fears about the stability of some banks, has declined bank credit (both bank and non-bank) to the private economy as a whole.
• Despite RBI regularly slashing the repo rate to increase bank credit and boost demand, the economy has not gained growth momentum. The reasons why repeated lowing of interest rates does not work are:
  • monetary policy becomes impotent when interest rates fall near zero;
  • increases in money supply are less than people’s expectations;
  • Individuals don’t borrow if there is low purchasing power.

RBI as a banking regulator

• The ‘board for financial supervision’ enabled RBI to take an integrated view of the problems of the banking system.
• The policy of bank licensing as done in the early 1990s was very successful. Many licences were given at the time, and most top banks of today are the ones which were licensed in the early 1990s. But for some time there was almost no issue of new licenses.
• The sudden crisis of 2008 delayed classification of ‘non-performing loans’ as ‘bad loans’. But the stress on bank and corporate balance sheets only grew, prompting RBI to finally launch a clean-up act in 2015. RBI also put restrictions on fresh lending by some of the worst-affected lenders.
• Governance reforms in state-owned banks proposed by the PJ Nayak committee, which could have otherwise allowed the healthier banks to lend more freely, were put on a halt.
• With constrains of new regulations and weight of bad loans on their books, banks outsourced part of their lending activity to shadow banks. These non-banks played a key role in ensuring credit to risky sectors such as real estate, even while ensuring that banks did not have to bear a direct exposure to such assets.
• Now, the problems in shadow banking industry threaten to spill-over onto the banking system and the responsibility of RBI as a regulator has increased.

RBI as a guardian of exchange rate

• In 1993 RBI shifted from a dual exchange rate system, to a fully market-determined exchange rate system.
• Before 1991, India was dependent on multilateral institutions for support. After the change in foreign trade policy and the change in exchange rate management, the Balance of Payment (BoP) situation has been managed quite well. As on 23 August 2019, India's total foreign exchange (Forex) reserves stand at around US$429 billion.
• Today, the funds crunch in the financial sector would have been worse had not been for foreign capital inflows, through either foreign direct investment (FDI) or external commercial borrowings (ECBs). Though this source of funding provides relief, but it is also a source of risk.
• If there is a domestic investment revival without a matching revival in domestic savings, India could face current account pressures due to increased dependence on foreign capital inflows to fund the Indian commercial sector.
• Though RBI has successfully managed the external sector, there still remains need for the current account deficit to be brought down.
  
  

Conclusion and Way forward

The mess in India’s financial system lies at the heart of India’s slowdown today. The opacity around asset quality has led to a spike in the risk premium, nullifying the effect of RBI’s successive rate cuts. RBI can undertake an ‘asset quality review’ of the banking sector, similar to the one conducted for banks in 2015, to improve the sector and increase its funding. It would also be a good approach for RBI to open, and allow new entities to come into the banking system. This will have a good effect in terms of efficiency and technology induction.