Independence of the RBI: 50 Shades of Gray

This article follows from an earlier blog post regarding the Reserve Bank of India and excessive regulation. Although this digresses from the blog’s theme, regulation is an important aspect concerning every stakeholder: thus this article. Our gratitude to Mandar Kagade, our guest author, for having chosen our platform.

Recent developments surrounding the withdrawal of legal tender effect for INR 500/- and INR 1000/- (“Demonetization”) have cast a shadow on the autonomy of the Reserve Bank of India. Two former Governors have addressed the erosion of RBI autonomy in public discourse recently generally arguing that RBI autonomy ought to be respected. Economists have weighed in on both sides; Indira Rajaraman, formerly a member of the RBI Board, recently observed that Demonetization differs from previous attempts of divesting RBI of critical functions in that it deeply eroded RBI’s role with respect to issuance of currency. Professor Shah, of the NIPFP, disagrees with the “pro-autonomy” view with a caveat; his view is that RBI should be accountable except to the extent it is gatekeeping (“issuing a license”), enforcing the law (“investigating”) or conducting monetary policy (“setting policy rates”).

However, to say RBI’s autonomy ought to be respected is to beg the question as to what that autonomy means. The question is amplified in the Indian context because to borrow from Dr. Reddy, “RBI is a full-service Central Bank.” In other words, it conducts monetary policy, manages the government debt and regulates the banking and payments sector.

This troika of responsibilities warrants a tailored, rather than binary conception of RBI’s independence. Monetary policy for example, is a counter majoritarian exercise. Elected governments with four-five year horizons would love to see growth fuelled by lower interest rates. But if Central Banks acted as their agents (and kept interest rates low), fairly soon, they (and the people) will have to contend with inflation (or in rare cases, hyperinflation). Economies around the world therefore have moved to secure de jure and/or de facto independence for their Central Banks in the conduct of their monetary policy.  Given the importance that society in preserving the (real) value of money that autonomy in the rate-setting exercise ought to be welcomed.

It is worth pointing out that India retains a de facto (if not de jure) autonomy for the RBI. This means that though the law empowers the Central Govt. to give directions to the Bank in public interest (under Section 7 (1) read with 7(2) of the RBI Act, 1934), these powers appear to be rarely at play leading up to a policy-setting exercise. (Frequently, the Finance Minister will be in the news opining about rate-cuts closer to the scheduled RBI monetary policy meeting to try and “nudge” rate action but that’s that). Recently, India moved to a Monetary Policy Committee structure to set rates and also adopted a Inflation-Targeting framework. The former instrument is a 6-member Committee with the mandate to set rates: Three members of the RBI, three nominated by the Govt. with a casting vote for the Governor. The latter is a mandate to the RBI to maintain inflation (at 4%) in a “comply or explain” framework. In other words, the RBI Governor will owe an explanation if the Central Bank’s actions did not keep inflation in a pre-agreed range.

Unlike monetary policy, in the context of regulation though, academic literature and regulatory practice teaches us to have more accountability rather than less.

Why should regulators be accountable? Research suggests there are several reasons lawmakers, before hand, and the Courts, afterwards, ought to hold the regulators accountable. In an early paper, George Stigler of the Chicago University pointed out that sectoral regulators are “captured” by their regulatees and get gamed by the very stakeholders they are mandated to supervise. This “beholdenness” of the regulators could be a function of repeated interaction between the same set of stakeholders; say, they hang-out at the same parties and go to fishing trips outside of work. Maybe they went to the same Business/Law school. It could also be a function of narrow sectoral expertise that regulators develop overtime in the area they regulate. The latter creates the so-called “revolving door” creating perverse incentives in the extant regulator to “forbear” its regulatees so that he/she may get employed after leaving the Government.

Even when there are no capture concerns, agency theory teaches us, agents would have incentives to shirk and shark at her principal’s expense. A ready example of this is a bare perusal of any RBI notification. More often than otherwise, these delegated rules are issued with “motherhood and apple-pie” prefatory statements, to wit:  “in the interests of depositors”, “in the interest of financial stability” and the regulators assume their political principals will take their word for it. A particularly noteworthy example of this regulatory sloth is the “Concept Paper on Peer-to-Peer Lending” RBI released in May, 2016. The paper advanced the following argument, as one of the reasons for regulating Peer-to-Peer lending:(a new  form of lending that relies on “matching” lenders with borrowers on a platform; a banking-like but non-banking activity fulfilling the same demand as banks). RBI argues: If the sector is left unregulated altogether, there is a risk of unhealthy practices being adopted by one or more players, which may have deleterious consequences.” No footnotes support the claim and no illustrative examples of what these unhealthy practices might be or what deleterious consequences these might lead to are provided. Such alarmism inhibits innovation and lead to financial exclusion of many untold millions without formal access to financial services.

Such examples as above appear to evidence the need to prescribe accountability mechanisms for the regulatory role of the RBI. Unfortunately, Indian lawmakers and Courts rely on the benevolence and wisdom of RBI and other regulators and afford them a “margin of appreciation”. Statutes drafted with wide latitude and plenary powers to draft delegated laws (with little or no oversight of the Parliament) are exhibit 1 in this regard. Moreover, India is hardly an isolated instance of such discretion. The United States for example, follows the “Chevron Doctrine” that affords the regulators and Executive Agencies wide latitude in interpreting their statutes unless the interpretation is “arbitrary and capricious”. The caveat is a difficult barrier to scale for most litigants.

All is not lost however. The recently inaugurated Trump administration and the latest Congress have both taken steps to reign in the long rope thus far afforded to the regulators. In the context of financial sector, the recently promulgated Executive Order provides that, “making regulation efficient, effective and appropriately tailored” and “restoring public accountability of federal financial regulatory agencies” are among its Core Principles. India has also commenced taking steps towards ensuring accountability of RBI through proposals such as cost benefit analysis and the Financial Sector Appellate Tribunal in the Indian Financial Code.

To summarize then, context matters. The answer to the question whether RBI is independent lies is not black or white, but gray. The correct response should be: “In what context?”