Govt. invokes Sec 7: Will RBI stop functioning independently?

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Govt. invokes Sec 7: Will RBI stop functioning independently?

The news that the government has invoked Section 7 of the RBI Act is making rounds and raising eyebrows today. Here are some basic things you should know about this matter:

What is Sec 7 of the RBI Act? | Govt. invokes Sec 7: Will RBI stop functioning independently?

Section 7 of the RBI Act allows the government to direct/instruct and advise RBI in consultation with the governor. By invoking this section the government is empowered to consult and give instructions to RBI especially when the government feels that certain issues are serious and are in the public interest.

Section 7 of the RBI Act for reference

 

In the history of free India, this is the first incidence of government invoking sec 7 and taking the role to advise RBI on matters of public interest.

By invoking this section the tussle that was going on between the RBI and the government has taken an authoritative turn.

What are these “matters of Public Interest?”

Growing NPAs and deteriorating health of State-owned Public Banks

RBI being a central bank is responsible to manage the health of the banks including public sector banks. Growing NPAs is a matter of concern and RBI has laid norms to tackle them. In February 2018 the RBI banned all loan restructuring schemes and notified new norms. RBI directed the banks to set a 180 days deadline for declaring a loan as NPA. After 180 days, the stressed account will be addressed in the bankruptcy court for settlement.

After the Nirav Modi fraud, the PNB bank faced more than Rs 14,000 crore loss only in this case. Many other frauds by many banks came to light around the same time.

RBI feels the Prompt Corrective Action (PCA) framework is best suited to tackle the deteriorating health of the State-owned Public sector banks. Read more about this in our earlier post  PCA framework: RBI’s tool to tackle financial stability

The government feels that the new regulations are very harsh on the public sector banks. The government also blamed RBI for failing to detect Nirav Modi – PNB scam. On the other hand, RBI feels that it does not have the same powers as those of supervising the private banks.

PCA framework and dividend distribution

RBI has put 12 banks i.e. 11 public sector banks and 1 private sector bank under the prompt corrective action framework. Apart from lending restrictions as mentioned above, PCA norms also restrict branch expansions, dividend distribution etc.

This year RBI transferred only Rs 30,000 crores as a dividend against the budget of Rs 66,000 crores. This has left the Finance Ministry in surprise. The government wants these PCA norms to be relaxed which according to RBI will not serve as an effective mechanism to tackle financial stability and adds that PCA framework prevented banks from adding more NPAs.

Policy interest rates

The government wanted RBI to increase the interest rates. In October the RBI kept its rates unchanged. Moreover, the Monetary Policy Committee (MPC) led by the governor refused to meet the chief economic advisor of the country before the decision of interest rate hike and the rift widened.

Read more on What happens when RBI increases rates.

NBFCs and Liquidity issue

With the default by IL& FS and subsequent liquidity crisis in the market, corrective action was necessary. The Government wanted RBI to replicate its course of action taken in 2008 to infuse the liquidity. RBI denied this and the rift increased. Finally, the government had to fall back on public sector banks to buy assets from NBFCs instead of using a special purpose vehicle.

In 2014, when the earlier Governer Mr. Raghuram Rajan retired, the grapevine mentioned the differences between the governor and the government. After the demonetization announcement in 2016 along with the current governor, it was convincing that the government and RBI are in a sink. However, over the last few years, the tensions between them rose and led to this ultimate action by the government which was never done in the history of the Central Bank.

To quote RBI deputy governor  ” Governments that do not respect central bank’s independence will sooner or later incur the wrath of financial markets, ignite economic fire..” (Reference: TOI)

Will this jeopardize the freedom of the central bank or is this the right decision? Only time will tell that. But, hopefully, the financial health of the economy should not be at the stake.



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CA Janhavi Phadnis
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