Quest for Restoring Financial Stability in India : An Interview with Dr. Viral Acharya (Former Deputy Governor of RBI) ,(C.V. Starr Professor of Economics at NYU)
ABOUT THE AUTHOR
Dr. Viral V. Acharya, the C.V. Starr Professor of Economics at New York University Stern School of Business, emerges as a distinguished economist with a multifaceted career that spans academia, central banking, and financial market regulation. Holding a Bachelor of Technology in Computer Science and Engineering from the prestigious Indian Institute of Technology, Mumbai, and a Ph.D. in Finance from NYU-Stern, Dr. Acharya combines a solid technical foundation with extensive research in the field.
Before joining NYU-Stern, he contributed significantly to the London Business School and held the position of Senior Houblon-Normal Research Fellow at the Bank of England. With a focus on theoretical and empirical analysis of systemic risk in the financial sector, credit risk, liquidity risk, and their regulatory implications, Dr. Acharya's research reflects a deep commitment to understanding and addressing the challenges facing the global financial system.
His academic influence extends beyond research, as he has served in advisory roles to the Federal Reserve Banks of New York, Philadelphia, Chicago, and Cleveland, the Board of Governors, and several other prominent financial institutions and regulatory bodies internationally. As a Director of the National Stock Exchange of India and the NYU-Stern Initiative on the Study of Indian Capital Markets, he has demonstrated a keen interest in both domestic and global financial landscapes.
Notably, Dr. Acharya's tenure as the Deputy Governor of the Reserve Bank of India from January 2017 to July 2019 reflects his practical engagement with monetary policy, financial stability, and market dynamics. This experience positions him uniquely as a bridge between academic theory and real-world policymaking.
ABOUT THE BOOK
Dr. Viral Acharya's "Quest for Restoring Financial Stability in India" emerges as a seminal work that transcends the conventional bounds of economic literature. Within its pages, Acharya weaves a narrative beyond a mere compilation of speeches and minutes, presenting a comprehensive exploration of India's financial landscape.
The book stands as a testament to his commitment to fostering a dialogue on the critical issues surrounding India's economic landscape during his tenure at the Reserve Bank of India (RBI). The collection of sixteen speeches and monetary policy minutes offers a comprehensive view of his insights, providing readers with a nuanced understanding of the challenges and potential solutions.
Acharya's acknowledgments set a poignant tone, portraying the speeches and minutes as more than mere documents but as his "voice, lifeblood, and raison d'être." This underscores the exhaustive effort invested in crafting these pieces, providing readers with a behind-the-scenes glimpse into the intricate workings that often evade the scrutiny of market observers. Dr. Y.V. Reddy's foreword adds a layer of context, linking fiscal accountability with financial stability through a quote from Dr. B.R. Ambedkar, thereby establishing a thematic connection that resonates throughout the book.
The preface, titled "Fiscal Dominance – A Theory of Everything in India," serves as the core of the book. Acharya employs a captivating narrative style, commencing with a reflection on the state of the Indian banking sector in 2017. This serves as a backdrop for a profound exploration of fiscal dominance and its pervasive influence on financial stability.
Divided into six sections, the book systematically addresses critical facets of India's financial challenges. The first section delves into the resolution of Non-Performing Assets (NPAs) and the imperative for bank recapitalization. This diagnosis of the banking sector's ailments leads to a two-pronged prescription: the need for banking reforms and the imperative development of financial markets.
The subsequent sections articulate Acharya's vision for a holistic financial system, each addressing a crucial aspect:
Resolving Non-Performing Assets (NPAs) and Recapitalizing Banks: Acharya's diagnosis of the banking sector's ailments leads to two critical prescriptions – the need for banking reforms and the development of financial markets.
Creating a Public Credit Registry: The call for a Public Credit Registry emerges as an integral component of the quest for financial stability, aiming to enhance credit information sharing and improve credit market efficiency.
Incorporating the Financial Cycle in the Monetary Policy Framework: Dr. Acharya advocates for an expanded approach to monetary policy, calling for the incorporation of considerations of the financial cycle to enhance its effectiveness.
Improving Monetary Policy Transmission: The book sheds light on the challenges faced in transmitting monetary policy effectively, suggesting measures to strengthen this crucial link in the financial system.
Developing Viable Capital Markets and Ensuring External Sector Resilience: Acharya emphasizes the importance of developing robust capital markets and ensuring resilience in the external sector, presenting a vision for a well-rounded financial system.
Striking the Right Balance: Enhancing the Autonomy of the Central Bank, the Markets, and the Real Economy: The final section delves into the delicate balance required between the central bank, markets, and the real economy, advocating for enhanced autonomy and clear rules.
The government debts and deficits exert a profound influence on central bank policies. The repercussions extend across the banking sector, default disclosure norms, monetary policy, market regulations, and reliance on alternative funding sources. Acharya's analogy of T20 cricket (government) versus Test cricket (RBI) succinctly encapsulates the core issue.
The book does not merely diagnose challenges but prescribes a roadmap for the central bank to navigate the complexities posed by fiscal dominance. It attempts to make the complexities of banking and regulatory oversight accessible to readers. The book's core message revolves around the divergent views on economic policies, primarily centered on the independence of the central bank.
The historical context is crucial to understanding the present dynamics. Until the enactment of the Fiscal Responsibility and Budget Management Act of 2003, the RBI had been under close government control. A global trend towards central bank independence was observed from the mid-1990s. With inflation targeting becoming the top priority post-2003, the RBI faced a daunting challenge – the surge in non-performing assets, particularly in public sector banks. The government's reluctance to allow prudent oversight, especially in the last five years, marked a reversal in the earlier trend toward RBI independence. Acharya contends that the central bank should operate autonomously to ensure stability in the financial system, emphasizing the need for stringent rules, good governance, and minimal government interference.
In conclusion, "Quest for Restoring Financial Stability in India" is more than a book; it is a rallying call for a collective effort toward a stable and sustainable financial future. Dr. Viral Acharya's insights, drawn from extensive experience, offer a roadmap for policymakers, regulators, and the public to navigate the complexities of India's financial landscape. The book, with its comprehensive analysis and thought-provoking recommendations, stands as a significant contribution to economic literature and is a must-read for anyone invested in India's economic well-being. Acharya invites all stakeholders to engage in an open discussion, emphasizing the urgency of restoring financial stability for sustainable growth. The book serves as a vital resource for policymakers, economists, and anyone seeking insights into the challenges confronting India's financial sector.
Excerpts from the Interview:-
Q1) The Preface of your book sets the stage with a gripping narrative about the challenges faced by the Indian banking sector. Can you elaborate on the specific incidents or factors that led you to reflect on the state of the banking sector during your journey from New York to Mumbai in January 2017?
Viral Acharya: When I reflected on joining the Reserve Bank of India (RBI), it was around the time Governor Rajan finished his term, and Dr. Patel became the new Governor. This left a vacancy for the Deputy Governor position in charge of monetary policy, research, and markets. In July or August, I anticipated the announcement of this position for applications. Given my banking background and advisory roles in central banks globally, I decided to take on this role for two reasons. First, from a personal standpoint, working in a central bank is ideal for someone researching central banking, financial crises, and macro implications of finance. It allows you to apply your research rigorously and learn on the job. Second, and more importantly, I believe that India needed to address the issues in its banking sector. Drawing from my research and experience, I felt I could make a significant contribution to this effort. It was also a way for me to give back to India, a country that always feels like home to me.Â
The speeches I gave as Deputy Governor were my way of advocating for change. These speeches covered various areas like resolving non-performing assets, setting up a public registry for transparency, improving monetary policy transmission, developing capital markets, and balancing the roles of the government, central bank, markets, and the private sector. These speeches were not just technical; I made an effort to explain complex ideas from basic principles, making them accessible to everyone. After my term ended, I realized I had contributed to changes in different areas. I wanted to offer a cohesive view of these contributions, reflecting on the common threads running through my speeches.Â
This led to the extensive preface chapter in the book titled "Fiscal Dominance: A Theory of Everything in India." The main idea I aimed to convey is that India, after moving towards decentralization and privatization in the '90s, seems to be regressing towards centralization. The central bank, under pressure from the government's short-term demands and fiscal pressures, plays a crucial role in this. The book argues that we can no longer separate fiscal stability and financial stability; they are closely tied. The dominance of central bank policies is a powerful mechanism strengthening this link. The book offers a roadmap, simplifying concepts, presenting evidence, and suggesting reforms for both fiscal and financial stability. In essence, the book is part of my ongoing effort to advocate for necessary changes, aiming for sustainable and stable growth in India, moving away from entrenched poverty levels, and creating a better financial ecosystem.
Q2) You've outlined two key points to address the banking crisis, emphasizing the need to fix the health of the banking sector and develop financial markets. Can you share specific examples of the challenges faced in implementing these reforms and any unexpected roadblocks encountered during the process?
Viral Acharya: The challenge we face in India, and in other countries like China, is unique to emerging markets where a significant portion of the banking sector, and sometimes also of other financial firms like insurance companies and non-bank finance (NBFCs), is owned by the government. The problem arises when these government-owned banks incur massive losses. Strangely, even when losses are substantial, depositors still trust that the government will back the bank's liabilities, and they continue depositing money. During the global financial crisis, weaker public sector banks in India received more deposits because people believed in the safety of government-owned banks.
Now, why is this still a crisis? It's because we shouldn't only look at it from the perspective of depositors withdrawing their money. The real issue is that the health of banks is crucial for the well-being of the overall economy. Banks play a vital role in providing credit to individuals, small and medium-sized businesses, and large corporations, facilitating productive investments. When a bank is making losses and isn't getting recapitalized, the real economy suffers. In the case of undercapitalized state-owned banks, they engage in two problematic practices.
Firstly, they indulge in "zombie lending," where they keep extending loans to defaulted borrowers, essentially pretending that everything is fine. Regulators often turn a blind eye, leading to a situation where good money is thrown after bad. This practice ultimately burdens taxpayers with losses. Secondly, these undercapitalized banks resort to "lazy lending," meaning they prefer buying government bonds because they lack capital and avoid taking new risks. While these practices might seem fine in the short term, they have long-term consequences.
Zombie lending makes credit more expensive for the healthy parts of the economy. Lazy lending generates minimal returns on banks' balance sheets, hindering their ability to serve depositors effectively. In India, state-owned banks are gradually losing their share of deposits in the market, indicating a slow-moving crisis. Despite this gradual pace, the real engine of the economy, which relies on private credit, growth, and private investments, is stagnating. I refer to these issues as a "silent crisis" because they can persist for years, even a decade or more, causing a loss in the growth potential of the economy.
Q3) Your advocacy for strong, independent central banking is well-known. The prevailing sentiment among external observers is that India might be moving away from central bank independence.Â
Viral Acharya: There is a significant connection between the government and the central bank, as I discuss in my book. Over time, the government's ability to manage balance sheets improves during periods of strong economic growth, making it easier to borrow at reasonable costs without dominating the central bank. This eliminates the need for interventions like interest rate cuts or relaxation of lending standards.
Economic conditions play a crucial role in shaping this dynamic. For instance, in the '70s and '80s, India operated as a centralized, nationalized economy with substantial state involvement in both the real economy and banking. However, imbalances accumulated, leading to a balance of payments crisis. The subsequent liberalization in the '90s created a conducive environment for the central bank to gain autonomy.
Despite these positive shifts, the global financial crisis disrupted the trend. Slower growth and fiscal stimulus measures weakened government balances, eroding the conditions for central bank autonomy. The household savings rate also declined over the last decade, further impacting the economy. This shift is reflected in the re-emergence of fiscal dominance over the central bank, marked by pressure points such as interventions in government bond markets and regulatory forbearances.  Â
In 2018, economic challenges included uneven growth post-demonetization, GST rollout stress, and rising core inflation. The government, eyeing the upcoming election, proposed transferring a significant portion of Reserve Bank provisions to fund populist spending. This move was resisted by the Reserve Bank to maintain operational autonomy, causing discussions around invoking Section 7 of the RBI Act.
Eventually, a committee, led by Dr. Bimal Jalan, outlined a framework for future transfers, ensuring transparency and a reasoned approach. The government, bypassing the original populist plan, received a justified transfer during the 2020 pandemic. While decisions and outcomes could be debated, the commitment to financial stability laid down over decades remains an advantage for the economy, unfolding over several years.
So, the importance of central bank independence, enshrined in the letter of the law, becomes crucial as conditions for fiscal dominance evolve. The weakness of existing laws, such as the RBI Act, underscores the need for institutions that promote rule-based decision-making, preventing undue pressure and maintaining regulatory standards.
Q4) How has the economic crisis, exacerbated by the COVID-19 pandemic influenced the dynamics between governments and banks?
Viral Acharya: Drawing from my past experiences, even in the face of substantial shocks, maintaining a well-capitalized and robust banking system pays off in the long run. Reflecting on the aftermath of the global financial crisis, countries like the United States, which promptly addressed their banking system failures, demonstrated more robust growth and resilience compared to regions like parts of Europe, where decisive recapitalization did not occur. Applying this lesson to the COVID-19 crisis, it was crucial to provide relief and debt restructuring to the real economy. However, it was equally essential to devise a strategy for the banking sector to absorb resulting losses promptly. Delaying provision for those losses may lead to undercapitalized banks, focused on legacy issues rather than efficiently channeling capital for post-COVID recovery. While regulators globally have chosen a soft landing approach, economic losses must be acknowledged and prepared for to prevent leaving lasting scars on the real economy in the future. Therefore, the current favorable equity market conditions should be utilized decisively over the next few years to ensure the financial sector's health as we enter a phase of renewed growth impulses.
Q5) Your book has received acclaim for its proposed solutions to financial challenges. Could you briefly share some key messages for policymakers, and practitioners to take away after reading your book, considering its implications for India's economic trajectory?
Viral Acharya: The central themes revolve around two main pillars: fiscal and financial stability. On the fiscal side, operational autonomy for the central bank is crucial. The government should distance itself from public sector banks, considering options like reprivatization to reduce control rights. Strengthening the RBI Act is essential for empowering the central bank in overseeing public sector banks, and ensuring regulatory neutrality between private and public banks.
Moving to rule-based decision-making is the second pillar. Currently, discretion in central bank policies, especially in bank supervision, hampers financial stability. Adopting rule-based frameworks, similar to inflation targeting, enhances transparency and accountability. Implementing steady and accelerated provisioning, utilizing stress tests effectively, and avoiding mid-year changes to accounting rules are steps toward rule-based decision-making.
The third point emphasizes the central bank's role in resisting fiscal dominance. Asserting its independence and adhering to long-term mandates—protecting depositors, maintaining external sector stability, and ensuring price stability—are vital. Drawing clear lines upfront prevents compromise on these mandates.
Additionally, greater transparency in central bank research and making it accessible to a wider audience fosters a robust data-driven approach. Scrutiny and external input on central bank research contribute to improving the quality and discipline of the analyses.
Lastly, in the current scenario, capital infusion into banks, particularly public sector banks, is crucial to ensure in case stresses arise in the future. While restructuring schemes have been introduced when problems arise, a proactive definitive plan for bank recapitalization, especially through divestments and reprivatization, is essential. The focus on capital becomes paramount for restoring and then maintaining financial stability. For further details, I encourage readers to explore the book, which presents these concepts in an accessible manner.