February 5, 2013
(Written for Pragati, December 2012)
The Reserve Bank of India has been a regulator of acclaim, and as regulators all over the world have become more significant to their economies, their role has come under greater scrutiny. In general, the RBI sounds like a bank regulator, but it performs many functions that are at odds with being a bank regulator. It is time now to separate those functions into independent bodies, which need to be just as transparent, or in many cases, even more transparent. Let me suggest what functions we need to spin off into separate bodies.
Liquidity and Monetary Authority
The RBI controls the money supply of the country by being the only authority that can print currency notes. However banks, by virtue of their ability to take deposits and lend money, create more money. Imagine that you had just one bank and I deposited Rs. 100 in it, of which it lends you Rs. 90, and you deposit that Rs. 90 back into the same bank; and then another Rs. 80 of that money is lent to person C who, again deposits it back. There was just Rs. 100 to begin with, but now I think I own Rs. 100 (my deposit in the bank), you think you own Rs. 90 (your deposit) and person C has Rs. 80, for a total “money” in the system of Rs. 270 – essentially with just a 100 rupees, the money has “multiplied”. A central bank must regulate this money supply, printing more when required, and removing excess liquidity when needed.
The RBI needs to continue this function, since this is really the function of a central bank. It will then need to track inflation and growth to see how to regulate the flow of money (and the money “multiplier” effect). The tools to do this include RBI’s bond purchases (currently managed through Open Market Operations (OMO) auctions), managing Cash Reserve Ratios (a percentage of deposits that banks must place with the regulator) and maintaining interest rates.
However the tools that must go out of the RBI basket are direct market based dollar purchases by the RBI, and purchases of other items such as gold or IMF deposits (explained later).
Bank Regulator and Deposit Insurer
The RBI tracks how banks lend and borrow, and maintains requirements such as priority sector lending, sector concentration, group lending limits, ownership of certain types of instruments, and so on. The RBI also provides“insurance” for all deposits up to Rs. 100,000 in any bank.
Moving this out of the ambit of the RBI and into a separate bank regulator is a good step. A bank regulator will also be the ombudsman, dictate bank regulatory reporting, set risk and capital ratios and perform a macro-level validation of banking functions.
This regulator can be separate from the monetary authority and work closely with the RBI to ensure that banks are properly regulated. In fact, given the way systems work today it would be useful to merge the regulation of banks with markets (SEBI) to make a single larger regulatory body.
Merchant Banker for the government
The RBI currently helps the government – both centre and states – borrow money through government securities auctions, which are conducted nearly every week. The RBI appoints and monitors “Primary Dealers”, who will find customers like banks, mutual funds or insurers to buy the bonds being auctioned and also underwrite the auctions (that is, buy those securities that others will not bid enough for).
There needs to be a separate debt management office, because of the obvious conflict of interest between the RBI as a regulator, the RBI that sets monetary policy and the RBI that sells you government securities. The debt management office will need to be created out of RBI resources to reduce friction, and run as an independent, transparent institution (that is, with no political interference). It will have to work closely with the central bank.
One of the reasons that banks are required to have a high Statutory Liquidity Ratio (SLR) is that this provides an automatic subscriber to government bond auctions, thus crowding out private borrowing. With a separate debt management office, debt issuances could be provided to different layers of participants – such as foreign players (who currently have to beg and plead to buy Indian government bonds) or even retail public (who can’t directly buy from the RBI without jumping through many hoops). This can reduce borrowing costs, open up rupee bonds to overseas investors (a step the RBI has been reluctant to do due to other considerations), and allow technology improvements such as Inflation linked bonds, annuities and tax-free state bonds (the very steps the RBI takes years to bring to fruition).
Additionally, the government bond trading platform will need to be set up as a separate entity. It currently runs as a part of the RBI, which again, has no business running the platform, being the merchant bank, and also the regulator.
Currency Trader and Forex Reserve Manager
The RBI openly trades in the currency market. In the process, it might print more rupees to buy dollars, or sell dollars and “extinguish” rupees from the system. This impacts monetary balance, and is a very non-transparent measure. (The RBI doesn’t reveal its activities until a few months have passed, and the impact to the country’s economy can be substantial as it prints rupees to buy dollars. It has done so in the last decade, and in my opinion is partly responsible for the sustained inflation we see today) Additionally this distorts that market for all players – for instance, the RBI places large OTC orders to a bank at 5 pm, thus causing massive movements in the market by a regulator; such moves by someone who can print currency are an abuse of power.
A different agency to manage the country’s foreign exchange reserves would be a more prudent measure. As the Indian rupee gets freer, it may not be necessary to maintain large foreign exchange reserves, and indeed setting up swaps with other countries with the INR as one currency, through a Forex Reserve manager will serve any short term imbalances. The Reserve Manager will be a public body that issues bonds regularly, and RBI will buy its bonds in an auction where every other participant will be able to buy as well, including retail players. A transparent auction will ensure that any additions to money supply (due to the RBI’s purchase of such bonds) will be visible immediately.
This agency can buy gold as well, backed by bonds auctioned on a regular basis.
While the RBI has been lauded for holding India up through the times when the west has faltered, its size, reach and power have also stymied some of our growth, because of considerations that indicate an inherent conflict of interest. With onerous KYC requirements that only hurt the poor, unnecessary restrictions on payment systems, a lax attitude towards opening new markets or freeing the rupee and a reluctance to magnify the banking field by giving more licenses, we have an entity with, if I may say so, too much power and too little action. Cutting up the RBI into more sensible, independent parts is likely to result in better regulation and more transparency. However, care must be taken that such independence remains so and is not misused by governments to push their own agenda.
Original Source: http://capitalmind.in