RBI’s role as apex financial institution

  • Category
    Economy
  • Published
    4th Nov, 2019

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.

Definitions:

Capital Adequacy Ratio (CAR):

CAR is a measurement of a bank's available capital expressed as a percentage of a bank's risk-weighted credit exposures. It foretells a bank’s ability to absorb losses using its own capital.

Shadow banking:

Shadow banking refers to unregulated activities by regulated institutions. The shadow banking system creates credit across the global financial system through a group of financial intermediaries whose members are not subject to regulatory oversight. Examples of intermediaries not subject to regulation include hedge funds, unlisted derivatives, and other unlisted instruments, while examples of unregulated activities by regulated institutions include credit default swaps.

Non-performing loans/Assets (NPAs):

NPA is a loan or advance for which the principal or interest payment remained overdue for a period of 90 days. NPAs can be classified as a ‘substandard asset’, ‘doubtful asset’, or ‘loss asset’, depending on the length of time overdue and probability of repayment.

Cash Reserve Ratio (CRR):

CRR is a specified minimum fraction of the total deposits of customers, which commercial banks have to hold as reserves either in cash or as deposits with the central bank. The aim is to ensure that banks do not run out of cash to meet the payment demands of their depositors. It is a crucial monetary policy tool and is used for controlling money supply in an economy.

Statutory Liquidity Ratio (SLR):

SLR is the ratio of liquid assets to net demand and time liabilities (NDTL). Every bank must have a minimum portion of their NDTL in the form of cash, gold, or other liquid assets by the day’s end. SLR is a monetary policy tool instrumental in ensuring the solvency of the banks and flow of money in the economy. Its increase constricts banks’ ability to inject money into the economy.

Open Market Operations (OMO):

OMO is the sale and purchase of government securities and treasury bills by the central bank (RBI). The objective of OMO is to regulate the money supply in the economy. It’s a monetary policy tool. When RBI wants to increase money supply in the economy it purchases the government securities from the market, and vice versa. OMO is carried out through commercial banks and not public.

Bank rate:

The Bank Rate is the rate at which the Central Bank discounts the bills of commercial banks. In bank rate there is no need for collateral security. The loans are usually short-term loans lasting for just a day, or even just overnight. Lower bank rates can help expand the economy by lowering the cost of funds for borrowers, and higher bank rates help to contain inflation.

Repo rate:

Repo rate is actually a repurchase agreement, and refers to the rate at which a commercial bank sells security to Central Bank to raise money. It promises to buy back the same security from RBI at a predetermined date with an interest at the repo rate. It allows the central bank to control liquidity, money supply, and inflation level in the country. To decrease the money supply in the economy, the RBI will hike up the repo rate to discourage banks from borrowing funds. With fewer funds available with them, they have less to offer to the customers.

Reverse repo rate:

Reverse repo rate is the interest offered by RBI to banks who deposit funds into the treasury. For instance, when banks generate excess funds, they may deposit the money with the central bank. So, the interest earned on the deposited funds is known as the reverse repo rate.

Non-bank financial companies (NBFCs):

In India, NBFC is a company registered under the Companies Act, 1956. They are financial institutions that offer various banking services like lending, making investments, currency exchange, underwriting etc. Their activities are akin to that of banks; but do not have a banking license. Unlike in case of banks, NBFC cannot accept demand deposits; NBFCs do not form part of the payment and settlement system and cannot issue cheques drawn on it; deposit insurance facility of DICGC is not available to depositors of NBFCs. These limitations keep NCFCs outside the scope of conventional oversight from financial regulators.

Gross Domestic Savings Rate:

Gross Domestic Saving is GDP minus final consumption expenditure. This rate is expressed as a percentage of GDP. Gross Domestic Saving consists of savings of household sector, private corporate sector and public sector.  Major reasons for decline in the rate of gross domestic savings include; moderation in profit of the private corporate sector, greater dissaving of public authorities, decline in household savings, in particular, financial savings, largely on account of persistent inflation.

Current Account Deficit (CAD):

CAD is slightly different from Balance of Trade (BoT), which measures only the gap in earnings and expenditure on exports and imports of goods and services. While CAD also factors in the payments from domestic capital deployed overseas. Current Account = Trade gap + Net current transfers + Net income abroad.  A country with rising CAD shows that it has become uncompetitive, and investors are not willing to invest there.

Asset Quality Review (AQR):

Typically, RBI inspectors check bank books every year as part of its annual financial inspection (AFI) process. However, a special inspection was conducted in 2015-16. This was named AQR. In AQR the sample size of loans inspected is much bigger than AFI. These inspections check if asset classification is in line with the loan repayment and given prudential norms. Assets classification requires concerned loans to be identified and classified as non-performing.

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.

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