Editorial Simplified: Bank and Its Critics | GS – III

Relevance: GS Paper III (Indian Economy)

Why has this issue cropped up?

Recent weeks have seen an explosion of commentary on the RBI by government sources, members of policy advisory groups, academics and others. The issues revolve around the capital base, performance and autonomy of the RBI.

RBI’s capital base

  • 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 per cent of its total assets. This, as some observers have pointed out, is more than in most central banks in the world.
  • 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. This is an accounting entry which rises and falls as the value of the assets of the RBI rises and falls.
  • Thus, the deployable capital base of the RBI is just about 7 per cent of total assets. This makes the RBI one of the most under-capitalised central banks in the world.

RBI’s performance

  • The recent uproar has been over two overlapping concerns — the Prompt Corrective Action (PCA) norms and the liquidity management of the RBI since the IL&FS crisis broke in September 2018.
  • 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.
  • Have the PCA norms worked? A simple examination of credit growth in the Indian economy this year would suggest that the measures most certainly have worked. Credit has been consistently growing at double digit rates since December 2017.
  • The other criticism of the RBI is with regards to its post-IL&FS liquidity management, especially for NBFCs. The available evidence certainly doesn’t suggest an ongoing liquidity crisis. 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. There is no sustained independent effect of the IL&FS crisis on market rates. There is certainly no evidence of any aggregate liquidity crunch.

RBI’s independence

  • A sovereign government finances itself from two sources: 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. Central bank performance depends on independence.