Saturday, October 10, 2020

Central bank independence: Response to a reader's comment

In response to my post on central bank independence, a reader comments:

Aren't you using the pandemic-induced exceptional circumstance to rubbish Acharya's thesis? Granted that exceptional situations require a less doctrinaire approach but that apart i think there is merit in the view that a restructured standard asset is an oxymoron. I am one with you on accountability though. Take the issue of bank supervision. Musn't the RBI be held accountable for sleeping at the wheel and waking up too late to the crisis, the more so given its nominees were on the Boards of PSU banks? There cannot be independence without accountability.  

First, my basic problem is with Viral Acharya's thesis that fiscal dominance is the root cause of our banking woes. If that were so, how does one explain recurrent banking crises in economies where there has been no fiscal dominance? 

Adair Turner, former Chairman of UK's Financial Services Authority, explains in his book, Between Debt and the Devil, that money creation happens either by government or through the banking system. He argues that both can be equally irresponsible in the creation of money. The financial crisis was the result, not of fiat money created by government, but excess loan creation by private bankers. So, the idea that if government practises fiscal prudence, banking crises will somehow disappear seems rather misplaced.

Secondly, about loan restructuring or 'kicking the can down the road'. At the risk of sounding heretical, I make bold to say that without some kicking of the can down the road, it's impossible to practise banking. The question is one of proportion. If, say, 5 per cent of loans are restructured, it is not an issue; if the proportion of 25 per cent, there is certainly an issue. Next, restructuring must be based on sound financial considerations, it should not happen for mala fide reasons. Subject to these to two caveats, one should not have an issue with loan restructuring. 

Especially in the case of infrastructure projects and SMEs, where cash flows can be uncertain for reasons beyond the control of firm management, one cannot rigidly apply NPA norms and despatch the firm to IBC. Bankers need to exercise their judgement in handling such cases. That they refuse to in today's fraught environment is a different matter.

Thirdly, about the accountability of RBI. Not all of the bad loan problem is the result of irresponsible lending. The Economic Survey of 2016 argued persuasively that much of the NPA problem was the result of factors extraneous to management: 

Without doubt, there are cases where debt repayment problems have been caused by diversion of funds. But the vast bulk of the problem has been caused by unexpected changes in the economic environment: timetables, exchange rates, and growth rate assumptions going wrong.

So the idea that there was a colossal management failure at PSBs to which the RBI nominees were party is suspect, to say the least.
Where the RBI, perhaps, went wrong was in its over-zealous approach to NPA recognition under the Asset Quality Review. In one year, 2016, the ratio of gross NPAs to advances jumped to 7.48 per cent from 4.27 per cent in 2015. This led to a severe capital crunch, which affected credit growth, which affected borrowers and led on to more NPAs.
One could argue that it was not lack of central bank independence but the assertion of independence through an extremely stringent AQR that led on to major problems for the banking sector and the economy at large. The issue was not so much lack of supervision as the RBI's response to the NPA issue when it surfaced. This also was the reason for the tensions that emerged between the RBI and the government. 

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