India’s government wants to dilute an important corrective programme for the nation’s struggling lenders — and the central bank is having none of it

• The government has been insistent that the RBI ease the restrictions of its Prompt Corrective Action framework so as to increase the flow of credit to small-and-medium-sized enterprises.
  
• There are currently 11 out of India’s 21 public-sector banks placed under the PCA programme, which imposes limits on the extension of loans, branch expansion and issue of dividends.
  
• At a board meeting last week, the RBI rejected a plan to dilute the framework, saying that the banks would need at least two to three years before reaching an adequate level of financial strength.
  

The Reserve Bank of India (RBI) and the central government are in the midst of a very public confrontation with one another over the autonomy and corrective programmes of the former.

The government has been insistent that the RBI ease the policies of its Prompt Corrective Action Framework, which restricts the operations of struggling banks, so as to give small-and-medium-sized enterprises in stressed sectors easier access to financing.

There are currently 11 out of India’s 21 public-sector banks and one private sector bank that have been placed under the PCA programme. They were put on the watchlist owing to their high level of non-performing loans. As a result, they have not been allowed to extend loans and/or add branches and issue dividends to shareholders for the time being. Furthermore, extending loans to risky sectors could risk derailing the turnaround process. In order to be taken off the list, banks need to effectively provision for their bad loans and turn a profit for two consecutive years.

At a board meeting last week, the RBI rejected a plan to dilute the framework, saying that the banks that had been placed under the programme weren’t in the clear yet and that they would need at least two to three years before reaching an adequate level of financial strength and being able to resume their normal business operations.

However, the government has been adamant that the framework be eased to prevent a liquidity crunch in India’s financial system and stimulate the economy. In response to the government’s proposals, Viral Acharya, the deputy governor of the RBI decried what he felt was the government’s interference in the operations of the central bank.

Speaking in Mumbai on 26 October, Acharya said that the short-term focus of the current Modi administration was at odds with the RBI’s long-term approach to economic growth and financial stability.


This was likely a reference to the government’s proposal to dilute the RBI’s policies and ease the PCA framework, thereby allowing a greater flow of credit to small businesses; which while a stimulus for the economy in the short term, risks exacerbating the bad loan problem in the medium-to-long term. He added that the government’s attempt at curtailing the autonomy of the central bank could come at a “terrible price”.

The move came a few days after the RBI and government publicly butted heads over a proposal for the establishment of an independent payments regulator. The central bank released a “dissent note” wherein it explained that payments systems should be regulated by the central bank, since it was a currency regulator and monetary authority.

The public conflict between the RBI and the central government is a cause for concern and does not bode well for markets in the short-term. However, it is long overdue. In order to effectively regulate the banking sector and ensure the stability of the economy, the RBI needs independent decision-making powers bereft of short-term government targets.

The PCA programme is part of a larger plan to clean up the banking sector. The dilution of the programme would put banks at the risk of a continued build-up in bad loans and undo all the progress that has been made so far in helping them recover.