The Hindu Business Line : Banking regulation, supervision and Monetary Policy

So long as the conflict of interest of supervisors and regulators does not turn into a serious moral hazard problem and there are transparent institutional mechanisms that allow an arm's length relationship between the supervisory and regulatory wings, the justification for separating supervision from regulation in economies where markets are not fully integrated is weak, says A. VASUDEVAN

Central banking is often regarded by many students of economics and business management as equivalent to Monetary Policy and the regulations that go with it. This view, however, is only partially correct. For, there are many regulations that, per se, are not directly related to Monetary Policy but integral to the complex and interactive processes of central banking. Reporting requirements and the principles of banking supervision are cases in point. The former can be critical to the pursuit of announced Monetary Policy. On the latter, however, the view, both in India and elsewhere, is not unequivocal. Some consider banking supervision as an activity that can easily be separated from central banking and entrusted to a separate agency or a super body for supervision of the entire financial sector, as was done in the UK.

Separation vs supervision

The advocates of separation emphasise two points. First, the moral hazard that could arise partly from the expectations of depositors and creditors that they would be treated equally in the event of bank failure and partly from lack of clarity in the rules about the treatment of bank failure. And, second, central banks often face a dilemma while taking Monetary Policy action based on supervisory information because they know that as their actions would affect banks divergently, banks would tend to set right the anomalies.

The advocates of central bank supervision put their faith in five arguments:

The enormous database with central banks helps them to be objective with regard to market expectations and take necessary actions when required.

Most central banks provide payment and settlement services and are able to monitor payment failures and identify pressure situations in different markets and banks.

Central banks as lenders of last resort get prior intimation about the borrowing requirement of any bank and so can take prompt action to obviate any liquidity or systemic crisis.

Even where separation exists, central banks would have to study issues relating to financial stability as is done at the Bank of England.

Cooperation among central banks helps avoid spill-over or contagion effects through concerted action on the basis of the superior information at their disposal on markets and financial institutions.

In India, a case for a separate super body for financial supervision or hiving off banking supervision from the Reserve Bank of India has not as yet been made convincingly. Though there has been no bank failures since 1960, the RBI on the basis of its supervisory information turned weak banks (Global Trust Bank, for instance) into stronger ones through mergers. This was done not merely to preserve financial stability, as most observers tend to argue, but also for better effectiveness of Monetary Policy.

So long as the conflict of interests of supervisors and regulators does not turn into a serious moral hazard problem and there are transparent institutional mechanisms that allow an arm's length relationship between the supervision and regulatory wings, the justification for separating supervision from regulation in economies where markets are not fully integrated is weak.

Supervision and regulation are critical for the effectiveness of the Monetary Policy. Both are sustained by the very stance of the policy. And, in turn, they influence the Monetary Policy. This interactive process needs to be viewed from the angles of supply of and demand for credit.

Monetary Policy instruments such as interest rates, open market operations and cash reserve ratio, to cite a few, influence bank reserves which, in turn, have a bearing on the supply of bank credit. And credit supply would affect the overall liquidity in the economy.

Banking regulation and supervision have two effects: One, they influence the behaviour of borrowers and lenders. Two, they affect the monetary base or bank reserves. The behaviour of borrowers and lenders, in turn, influences the demand for credit and through it the overall liquidity.

This is undoubtedly a simplified view of Monetary Policy's influence on liquidity. But it is essentially through its assessment of liquidity the RBI or, as a matter of fact, any central bank pursues the objectives of Monetary Policy, namely, price stability and economic growth.

Regulatory changes that follow monetary policy initiatives and supervisory concerns do impact the economy. To illustrate, the changes in areas such as interest rates , reserve ratios, measures to improve competition through permission for foreign investor presence, prudential norms and risk management systems. We shall discuss a few of these.

Effect of regulatory changes

The recent legislative action on removal of minimum limit for CRR would in theory help the RBI release the requisite liquidity, should there be a large demand for credit and investments. However, as supply of investment outlets cannot expand sharply, banks with the help of improved bank reserves would lend more than before, thereby enabling in some cases, increased economic activity.

However, excess liquidity with banks could jeopardise price stability and could, as the international debt experience has shown, create a larger pool of non-performing assets. The monetary policy action would, in such a case, necessitate heightening of supervisory concerns about the quality of loans and the eventual risks.

Take another example. Changes in interest rates would affect the behaviour of borrowers and lenders. A rate increase would lead to disinclination on the part of borrowers to take loans while lenders would, given the liquidity and cost of funds, be inclined to lend more.

The implications for growth and price stability in this case are evident. But where there is information asymmetry, lenders would suffer. The regulatory framework has to, therefore, be complemented by institutional mechanisms for good loan recovery and credible credit information system.

The relaxations in regulations relating to entry of foreign investment and to banks to raise equity capital from the market up to 49 per cent of paid-up capital can expand the asset generating capacity of banks, giving rise to expectations about acceleration of activities but , at the same time, raising the concerns of supervisors and inflation watchers among policymakers.

The main question is: Will the credit expansion happen on its own in the context of the projected 8.5 per cent growth during the Eleventh Plan period? The answer to this is crucial, as there are many global and domestic uncertainties.

Among them, the one not adequately discussed is the effects of migration to stringent Basle II norms by end-March 2007.

The emphasis of the norms on risk management and risk-based supervision could dampen bankers' enthusiasm to expand credit, notwithstanding the claims that there exists a risk management framework in all banks.

These claims have not yet been tested in times of sustained buoyant credit demand. It would be unfortunate if the implementation of Basle II leads to more bureaucratic procedures in loan making and crowd out the small borrowers.

How the Monetary Policy and the regulatory and supervisory concerns interact and generate a framework that would be conducive to growth with both price and financial stability would be interesting to watch.

(The author, a former Executive Director of the Reserve Bank of India, can be contacted at asurivasudevan@hotmail.com)