We shouldn’t exaggerate our NPA problems: former RBI governor YV Reddy
Former RBI governor YV Reddy on Indian banking’s bad loan problems, RBI autonomy, and the conflict of interest for the government in its role as sovereign and owner of banks
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Mumbai: While Indian banking faces a bad loan problem, it should not be exaggerated, says Y.V. Reddy, former Reserve Bank of India (RBI) governor. The Indian banking system is still strong and there is no crisis of liability not being discharged; just efficiency issues and some past mistakes, he says in a freewheeling chat on the eve of the release of his book Advice and Dissent: My Life in Public Service. Edited excerpts from the interview:
Dr Reddy, it’s not a tell-all book…
The purpose of the book isn’t to tickle, it’s to inform. There is no villain in the book. When I wrote my Telugu autobiography, they told me they’d heard about the many quarrels with the ministers and there was nothing much about it in the book. I told them that when the husband and wife make love, the neighbourhood doesn’t know but when they quarrel, everybody knows. Ninety per cent of the time we did a lot of good things, and the purpose of this book is to inform about that 90% when we did complex things in difficult situations and we worked hard. Actually, if you read carefully, between the lines, and behind the lines, you would find clues and hints to the untold tales. They could be the tales that may tell all.
In the book, you write that when you started in 1996, the challenge was to wrest autonomy for RBI by restraining fiscal dominance. Aren’t we still talking of fiscal dominance now? Has the wheel turned full circle now?
Yes and no. No, because at that point of time, nobody knew what fiscal dominance or repression was. There was no proper accounting of the relationship between the Reserve Bank, the government and the market. Over time, the market system has developed. The government has ceded ground to the RBI and the market. There is proper accounting of the relationships. The government cannot simply go on printing money. Substantively, the level of fiscal dominance is sort of continuing but now there are fiscal rules. Even if they are not strictly followed, it is more transparent now. Therefore, there are built-in checks and balances.
But, 70% of the banking system is owned by the government, so aren’t there a lot of conflicts there?
Yes, there is a problem in the way it is structured. Let us take this NPA (non-performing assets) problem. What happens in a standard bank? The regulator would be able to tell the bank as the trouble starts that it needs to bring more capital. So, it is the owner’s responsibility to bring more capital. If the owner doesn’t bring more capital, the regulator would take necessary action to ensure that its operations are restricted or whatever might be necessary. In this case, the government—which is the owner—is saying in the Economic Survey that the regulator should bail out the regulated entity with the regulator’s money. That’s odd, there’s a confusion there.
Who has to collect the money from the borrowers? It is the bank, its management, its owners. Now, you have a situation in which the Banking Regulation Act is amended and the government, as an owner, is telling the Reserve Bank to ensure that the banks collect it. So, there is a mix-up in the roles of sovereign, bank owner and the regulator. That is the structural problem. When you have banks under a statutory provision, not under company law and not with limited liability, etc., there is disconnect.
Let me put this another way: we have all these regulations for a bank, what is the assumption? The regulator regulates on the assumption that the bank will try to maximize profit. If the bank isn’t interested in maximizing profit or has other objectives or compulsions, the policy itself is blunted. That’s number one. Second, the bank is supposed to have limited liability, and hence the importance of capital adequacy.
Is it possible to have a public sector bank (PSB) with limited liability? So, if you look at the deposit insurance, it arises on the assumption that the bank is subject to liquidation. Is it possible for PSBs to be liquidated?
That’ll be a question about the sovereign itself.
Yes. That is exactly my point. You have a banking system in which the sovereign is the owner; so the sovereign cannot say I have limited liability. The law is prescribed by the sovereign. And therefore, the CBI (Central Bureau of Investigation) and the CVC (Central Vigilance Commission) have jurisdiction. You cannot say they can’t get in. In PSBs, the government is in partnership with private shareholders. So it is a hybrid. This institutional structure is outdated and we haven’t been able to change it for the past 25 years. There is no political consensus to change it.
So what should be done?
As a first step, PSBs should be incorporated under the Companies Act. I personally feel that financial sector reform in India should lean towards more efficiency. That is possible only with a significant change in governance, and institutional and legal structures of PSBs. I can’t imagine any significant progress in the financial sector without sorting out this problem.
How do you view the government directing RBI to directly resolve NPA accounts?
As you will notice from the book, we had also taken unconventional measures in certain matters. Since there is an extraordinary problem of high NPAs, extraordinary measures are warranted. But it should be clear that this is taking care of an extraordinary problem of clearing the NPA stock. It doesn’t take care of the problem of the flow. It doesn’t take care of the problem of the system. That will keep recurring unless addressed. Secondly, it has to be made clear that the amendment which empowers the RBI is temporary. If these measures are permanent, they will destroy the system.
You’ve written that the seeds of NPAs are sown in good times. With the benefit of hindsight, would you have done more to curb crazy lending, a term you’ve used in the book?
That we should have tightened more is a possibility. I believe that we did the right thing, for a variety of reasons. As I explained in BIS (Bank for International Settlements) in 2010, when we are undergoing a structural transformation, we require deepening. So credit growth has to be high since the medium-term objective is to increase the base of credit. The challenge for policymakers is to encourage structural growth in credit to facilitate growth and also to contain the cyclical upward and downward movements in the desired secular growth in credit. Therefore, the extent to which I can lean against the wind is constrained.
But having said that, it will be useful to make a disaggregated analysis of whether the NPAs originated at that point of time or later because of post-crisis policies or economic conditions from time to time. There are fundamental issues. Was it that infrastructure agreements were unequal? Is it possible that there were problems in governance practices in the infrastructure companies? Is it possible that banks are not fully equipped to lend to infrastructure companies? Was it related to specific industry cycles?
You were one of the first governors to push for more disclosures such as revealing penalties for banks. Now, RBI has taken a step further with the divergences that some of the banks have disclosed between their reported NPA numbers and what RBI audits show. Are there any lessons from that?
I can say from my experience that when it comes to banking systems, it is based on trust. Therefore, I insisted on disclosure of penalties for the first time. Punishment is not an end in itself. It should be set such that it prevents something undesirable from happening. And the question is that, even if you want to take certain actions, sometimes it may be better to take action rather than talk of action before the action.
Our banking system is still strong. Private sector banks’ capital is adequate to take care of the NPAs. The public sector banks are government banks; so where is the question of solvency? So, there is no crisis of liability not being discharged; just efficiency issues and some past mistakes.
If you go to Latin America, to an East Asian country, to an African country, some people keep their savings outside the country. In fact, in some other countries, even the central bank governors and deputy governors keep their money outside (laughs).
India is one of the few countries in which the average citizen has full faith in the banking system. We should not exaggerate our NPA problems.
Yes, there has been fraud, systemic failure, inefficiencies and governance failure. That should be sorted out. In fact, we should emphasize that efficiency should be improved and that is very important for the health of the banking and financial systems, and the health of the Indian economy at large.
So are you saying more disclosures are bad?
No. How much, when, what, how and why you disclose matters is important. Disclosure is not an end in itself; that is my point. You must disclose to ensure that such things don’t happen in the future. You must disclose at a proper time so you can take action. The problem will get exacerbated if you disclose but cannot take action. Your own capacity to solve the problem becomes difficult. So it is not instant disclosure. The fundamental fact, I believe, is that the purpose of the central bank is, at all times, to ensure trust and faith in the system. And you can point out the flaws in the system in a way that you are also assuring people that you are fixing it.
So, in the book, what came across even in your role as a central banker was that you seemed more focused on regulation rather than just monetary policy.
Yes, that is very true. I believed that, particularly in India, the effectiveness of monetary policy will depend on two things: the markets and the institutions. One of the first things we wanted to do was improve transmission. We brought about a full-fledged and reasonable development of the money market and the government securities market. Institutions such as primary dealer systems and infrastructure such as the clearing corporation had to be developed. The monetary policy has to be coordinated with elements that contain structural transformation as well as policies, in the context of the cycle.
You’ve written that the job of RBI is to save the economy from the government. I don’t know if you meant it as a joke or half-seriously.
I meant it half-seriously. A central bank is created essentially to take a long term and apolitical view in the interest of maintaining trust and confidence in the monetary and financial system. Therefore, it is the job of the RBI to assure that it is taking an independent view of the risks to the system.
RBI’s credibility and autonomy have come under fire post-demonetization. What is autonomy according to you?
The limits of autonomy of central banks was recognized at the time of the global crisis. The autonomous central banks could not prevent the crisis and required government support to manage the crisis. In some ways, their credibility has taken a hit. However, the major development is the recognition of the importance of coordination. So, the autonomy is tempered with appropriate coordination, which I always believed in.
What do you think about the invitation to the MPC (monetary policy committee) members by the government?
In this particular case, I don’t know the facts. As an academic, I can say that the MPC is an arrangement, which is consistent with the theoretical proposition about the monetary policy. It is a construct, which is common to many other countries. We have said that the members take decisions and that the government can give communication in writing to the committee.
My impression is that the government’s view was quite clear in the public domain. I don’t know if there was more information that had to be communicated. If this is true, that could’ve as well been in writing. So, an analyst would ask if there is certain information that cannot be communicated in the public domain or in writing and what it could be. So this is the confusion. So we should have a system that elucidates what channel of communication is being used for what kind of information.
But this kind of confusion used to prevail at your time as well.
But that was part of the system. From my point of view, I must have the government on my side, or at least not on the opposite side, to ensure my monetary policy is effective for the simple reason that it owns the PSBs and transmission is not possible without them. Secondly, the prices of many commodities are controlled, so in my view, my monetary policy will succeed only if I have the government on my side so I have to convince them. There is nothing wrong with consultation because they have the benefit of advice. I strengthened my hand in my discussion with the government by way of the TAC (technical advisory committee) because I got technical advice from them.
I still believe that there is considerable merit in coordination. We cannot separate the conduct of monetary policy of today from structural transformation over the medium term. Can you separate SLR (Statutory liquidity ratio) from monetary policy and fiscal dominance? When SLR had to be reduced significantly, the law had to be amended. Should I not go to the minister to amend the law? So we have to recognize that in our country, when there is a combination of structural transformation and policy, coordination is extremely important.