Muddled incentives can muddy RBI’s monetary policy objectives | Mint

Muddled incentives can muddy RBI’s monetary policy objectives

Post the 1991 economic reforms, RBI had to re-adjust and deploy a wider range of indirect instruments and incentives, reserving the sledgehammer approach for exceptional circumstances.
Post the 1991 economic reforms, RBI had to re-adjust and deploy a wider range of indirect instruments and incentives, reserving the sledgehammer approach for exceptional circumstances.

Summary

Misaligned liquidity control levers and banks incentivized to write off loans can make it harder for RBI to achieve its goals

In economics, incentives matter a lot. They lie at the heart of policymaking because people respond to them, motivated to act along certain predetermined pathways. The Reserve Bank of India (RBI) also uses a package of explicit and implicit incentives to persuade economic agents to act in a certain fashion so that the central bank can meet its price, economic growth and financial stability mandates. Unfortunately, the incentives embedded in the current version of monetary policy as well as in the banking regulatory framework seem to be sending out mixed signals.

RBI actually uses a mix of incentives, moral suasion and direct intervention if it wants economic agents to translate monetary signals to the real economy. In the earlier era of central banking by fiat, banks had to compulsorily comply with RBI-issued edicts; they had little room for deviant behaviour. But, post the 1991 economic reforms, RBI also had to re-adjust and deploy a wider range of indirect instruments and incentives, reserving the sledgehammer approach for exceptional circumstances. The central bank is today confronted with the consequences of two sets of incentives that are sending out mixed signals, one that was highlighted during the August monetary policy meeting and another which found reference during the post-policy press conference, and was the focus of some recent discussions in Parliament.

Graphic: Mint
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Graphic: Mint

In the first instance, misplaced incentives have seemingly forced the central bank to resort to a battering-ram approach for managing surplus liquidity in the system. The recent surge in systemic liquidity—prompted by withdrawal of the 2,000 note and aided by government spending, RBI’s annual surplus transfer to the government and capital inflows—adds fuel to existing inflationary tendencies currently under pressure from elevated food prices. Consequently, RBI has been trying to suck out additional liquidity through repeated variable rate reverse repo (VRRR) auctions—in which banks deposit funds with RBI for specified periods and rates, against the security of government bonds—but has been facing studied indifference and rejection from banks (see chart). Over nine auctions of varying tenors between 30 June and 28 July, banks submitted bids for only 5.696 trillion against a notified amount of 11.5 trillion, resulting in only 49.5% subscription. Stung by the rejection, RBI has now imposed an incremental cash reserve ratio (CRR) of 10% on the increase in net demand and time liabilities between 19 May and 29 July, which is expected to absorb an additional 1 trillion from the system.

It is somewhat mystifying that banks have been snubbing VRRR auctions and instead investing surpluses in the overnight standing deposit facility (SDF), which offers a lower return than VRRRs: 6.25% against 6.49%. This could probably be viewed as a manifestation of banks’ survival instincts, conserving cash to meet an unforeseen and sudden liquidity deficit. Alternatively, banks may have found RBI’s April 2022 introduction of SDF liberating because they have complete discretion in the use of this window, while the central bank controls VRRR timing, amounts and rates. And then there’s the incentive: RBI probably promoted SDF post the pandemic, when credit demand was low, because it was collateral-free; this allowed the central bank to absorb larger amounts unrestricted by the amount of government bonds in its portfolio. Having promoted SDF as an ideal liquidity management tool, the central bank may now be finding it difficult to turn the dial back.

The second misdirected incentive is the drive to bring down the headline non-performing asset (NPA) ratio at any cost. This has forced banks to write off large chunks of outstanding loans in their books. Replying to a question in Parliament on 7 August, minister of state for finance Bhagwat Karad said that banks had cumulatively written off over 14.5 trillion between April 2014 and March 2023. This has allowed both RBI and the political class to proclaim a decadal low in both gross and net NPAs: 3.9% and 1%, respectively, by March 2023. Ideally, a sharp decline in NPAs should be a welcome development, indicating a robust credit market with healthy borrowers and lenders. However, the aggressive write-off also represents a perverse incentive. When bank officials are incentivized to showcase better headline NPA data by aggressively writing down loan amounts, it weakens their incentive to conduct proper credit appraisal or pursue loan monitoring and recovery.

Technically, written-off loans do not fall off the recovery bandwagon and banks are expected to pursue repayment, even if recovery is partial. But the overall record has been patchy so far. Data placed in Parliament shows the recovery rate from written-off loans between April 2014 and March 2023 at an abysmal 14%. When borrowers, especially Indian corporate borrowers, know that loans will be written off to exhibit low NPAs and banks will be lackadaisical in pursuing recovery, it provides an incentive for wilful defaults. During the monetary policy press conference, deputy governor Swaminathan J said that banks have been exhorted to redouble their recovery efforts. This is easier said than done. Getting banks to change behavioural patterns mid-stream, without spelling out any new incentives, may not help move the needle much.

Rajrishi Singhal is a policy consultant and a senior journalist. His Twitter handle is @rajrishisinghal.

 

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