On Wednesday, 7 August, the monetary policy committee of the Reserve Bank of India (RBI) will announce its monetary policy decision. RBI is widely expected to cut rates. It does not matter what the magnitude is. The question of transmission is a big one. Interest rate cuts take much longer to be passed on, if at all they are passed on. Moreover, it is not even clear if interest rates matter in the current uncertain environment. There is much that the government needs to do to dispel the uncertainty for it has had quite a substantial role in its creation. That is the subject of another column, however. Here, we shall focus on what the central bank should do.

According to data published by the Bank for International Settlements (BIS), India’s credit-to-gross domestic product (GDP) gap has been negative since 2013 and is now running well below trend. That is not a surprise. Banks are unwilling to lend and businesses are not keen to borrow either. There is not much confidence that non-performing assets will not see further accretion. The understandable caution of banks should not starve creditworthy borrowers of credit. Both the government and the central bank must do all that is within their powers to ease the situation.

The country’s central bank, in the credit boom years up to 2007, had proactively adjusted risk weights to dissuade banks from lending excessively to certain sectors and businesses. Is there a case for doing so in reverse now? I think so, and that would be less risky than opening up external commercial borrowings to purely domestic players. That would be the first step.

In the post-2008 phase, regulators around the world have embraced counter-cyclical capital buffers and macroprudential norms to better regulate credit creation while interest rates plumbed new lows. RBI could use the mechanism of countercyclical capital buffers to ease credit conditions. Counter-cyclical capital buffers mean exactly that. They have to counter the cycle and not exacerbate it. It is possible to do this with clear expiration dates. Extraordinary measures must be withdrawn when times become ordinary. There should be other safeguards lest the bond market react badly to such a move.

The central bank must apply the many regulatory lessons that it must have learnt from the recent and ongoing episode of bad debts. Second, it must act in concert with owners of banks in enforcing lending discipline. Third, I had also written earlier on the incongruity of the central bank prescribing the marginal cost of funds-based lending rate as the floor in a so-called liberalized interest rate environment. Fourth, the government, on its part, must use the crisis to legally enshrine non-interference in the operational decisions of banks. Fifth, the government must incentivize banks to augment their assessment of credit worthiness and risk assessment of loans on a continuous basis. More specifically, capitalization support and operational autonomy must be made contingent on skill upgradation and other quantifiable performance measures. Finally, both the government and the central bank must be clear that as economic conditions normalize, countercyclical capital buffers must and will move in the opposite direction.

It is not widely known that the page relating to Basel III norms in the website of BIS states rather clearly: “Like all Basel Committee standards, Basel III standards are minimum requirements which apply to internationally active banks." A substantial number of banks in India, especially government-owned banks, are not internationally active banks. Their predominant shareholder is the government and the deposits are protected by the government in more ways than one, both formally and through an implicit understanding that the government would not allow the failure of banks owned by it, let alone cause depositors to lose money.

The bigger question, therefore, is whether the capital adequacy norms prescribed under Basel III should be made uniformly applicable to all banks in India or only to internationally active banks. A lower capital ratio for other banks will not only reduce the capitalization burden on the government but will also free up lending capacity.

The problem is that the discourse has become so puritanical that such a move would be seen as a dilution of prudence and credit discipline and interpreted as another sign of the central bank caving into pressure from North Block or South Block or both. Therefore, the government and the central bank must approach this in a calibrated manner and communicate clearly so that it is not painted as another attack on institutions by the government.

To begin the process, the government and the central bank could consider appointing a committee to re-examine the relevance of capital adequacy norms prescribed for internationally active banks in the Indian context. The terms of reference for such a committee should be formulated in a manner that strikes a balance between India’s economic growth and employment imperatives and maintaining a sound banking system. India should not prioritize one at the cost of the other.

These are the author’s personal views

V. Anantha Nageswaran is the dean of IFMR Graduate School of Business, Krea University

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