On 12 February 2018, the Reserve Bank of India (RBI) had released a circular to counter the banking sector’s non-performing assets (NPAs) and defaults. The instructions issued by RBI created much discomfort among a large number of Indian businesses.

On 2 April 2019, the Supreme Court declared this circular “ultra vires", which means it was beyond RBI’s legal authority. The apex court declared that the central bank could not apply a blanket rule on non-repayment of loans to all bank borrowers and that it could only issue such rulings on a case-by-case basis.

This pushed RBI into fire-fighting mode. In comments after RBI’s April monetary policy statement, its governor Shaktikanta Das stated that the ruling did not imply that RBI’s powers were “under doubt".

What is interesting, though, is that RBI is not the lone regulator caught in this legal trap. A similar set of events have confronted the European Central Bank (ECB) as well. In a speech on 22 March 2019, Ignazio Angeloni, a member of the supervisory board of ECB, addressed the issue of how legal hurdles can impede banking supervision. He said supervision rests on legal acts that are often “challenged in court, becoming invalid and even turning into a liability for the supervisor". Thus, ECB may have supervisory powers, but it does not mean it can always use these powers.

He used a recent case to illustrate this hurdle. ECB had asked banks under its oversight to maintain provisions for deteriorating assets over a certain period, but the European Parliament got in the way. As Angeloni said, “The ECB’s power to set provisioning calendars for deteriorated exposures was challenged by the European Parliament on the ground that calendars, being akin to rules, invade the prerogatives of the legislator. Prudential provisions could only be applied case by case, not across the board."

These words are similar to those used by India’s apex court. Angeloni further stated that “this combination of law and interpretation severely limits the supervisor’s scope to independently set prudential provisions".

Angeloni’s speech discussed the wider topic of supervisory independence. Historically, there has been a lot of emphasis and research on monetary policy independence, but barely anything on supervisory independence. The speech pointed out that the first research study on the subject was done by a lawyer, Rosa Lostra, who vouched for banking supervision independence. The issue of time inconsistency, which is often used to argue in favour of monetary policy independence, applies to banking supervision as well. After all, if a regulator promises tough regulatory norms but does not walk the talk, then expectations of a lax regulatory regime will set in, resulting in banks taking higher risks. Expectations of lax banking regulation are as harmful as inflationary expectations, and some would argue that the former is even more, given how most financial crises start with lapses in banking regulation.

In his speech, the ECB regulator mentioned two more hurdles for supervisory independence, apart from the legal ones—its analytical and the political dimensions. As for the first, he pointed to the difficulty of measuring banking risks, as most of the discussion is on defining price stability and rather less attention is paid to credit risks. The political dimensions go back to the issue of whether giving independence to supervisory bodies leads to concentration of power with unelected technocrats. If yes, what is the best way to organize the task of banking supervision? This is the same question that monetary policy experts are asking.

Why are so many battle lines being drawn with central banks across the world? Earlier, these were mostly drawn with governments, but are now being drawn with legislative bodies as well. This is because central banks have gained power since the 2008 financial crisis, unlike what happened during the 1930s Great Depression, when central bank authority was significantly curtailed.

Take the case of ECB, which started with just monetary policy but is now responsible for bank supervision and systemic risk as well. Likewise, most central banks now have overall financial stability, which includes banking supervision, as an explicit goal. Most of them are also dealing with high-NPA levels left behind by the crisis. Countries such as New Zealand have added ensuring optimum employment to their central bank’s goals. These add-ons resulted in several pushes and pulls with respect to the actions of central banks. Note that some economists had warned that additional powers would end up reversing their so-called independence. This is what appears to be happening.

That is not necessarily wrong, however. Whoever said that central bankers could do no wrong? Their decisions and actions need to be questioned as vigorously as those of any other institution. The 2008 crisis was a result of several lapses by central banks that were defended in the name of “independence". A recent book by Paul Tucker speaks of the “unelected power" of central banks and discusses how central bankers can emulate the best of judicial self-restraint and become models of dispersed power.

So, even while much of the discussion and criticism revolves around whether RBI has enough independence on its monetary policy and interest rate decisions, the same should apply to banking supervision as well. Or else, we could have more ultra vires notifications to grapple with.

Amol Agrawal is professor of economics at Ahmedabad University.

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