Shape Up or Ship Out: Why is RBI tightening the noose when banks are flourishing?
The Reserve Bank of India (RBI) is sending a clear message to financial entities: shape up or ship out. Despite the robust financial health of banks in the fiscal year 2023 to 2024, the RBI is tightening regulations to pre-empt potential issues and ensure compliance across the sector. The RBI’s actions reflect its belief that now, while the sector is strong, is the right time to address potential risks and enforce higher standards.
Let’s start with individual cases. In January, the RBI restricted Paytm Payments Bank from accepting new deposits or processing credit transactions and top-ups starting mid-March 2024. The RBI cited persistent non-compliance and supervisory concerns for this drastic action. Similarly, in April, the RBI took action against Kotak Mahindra Bank, one of the leading private banks. The bank was ordered to stop onboarding new customers through its online channels and issuing new credit cards. This was due to significant IT-related deficiencies and prolonged outages that affected not just the bank’s customers but the broader digital payment ecosystem.
The RBI’s rationale is clear: repeated failures in IT risk management and information security governance cannot be tolerated. Observers weren’t surprised by these moves. In December 2020, the RBI imposed similar restrictions on HDFC Bank, lifting them only after more than a year when the bank had completed an external audit of its systems.
Non-bank financial companies (NBFCs) haven’t escaped scrutiny either. Bajaj Auto Finance and others like JM Finance Ltd and IIFL Finance Ltd have faced restrictions due to lack of transparency in fees, charges, and loan recovery practices. The RBI’s stance is that non-compliance in one area can indicate broader issues, potentially endangering financial stability. Ensuring a culture of compliance is paramount for the RBI.
On a broader scale, the RBI has increased risk weights on personal loans, credit cards, and loans to NBFCs. These measures, introduced in November 2023, mean that banks and NBFCs must allocate more capital for these loans, which in turn reduces the incentive to lend. The aim is to curb exuberant lending and ensure that credit growth remains sustainable. The RBI’s governor emphasized this in a speech, highlighting the need for caution in lending practices to maintain stability.
Moreover, the RBI has proposed increased provisions for project finance. For under-construction projects, the provisions for standard assets will rise significantly, which will likely slow down loans for such projects. This move is bold, especially given the current policy focus on boosting private capital spending. Yet, the RBI’s primary concern remains financial stability.
Looking ahead, the RBI plans to introduce norms based on expected credit loss (ECL), which involves setting aside provisions based on rigorous assessments of expected losses. This change will likely increase provisions and impact profitability in the banking sector. However, the RBI believes that the long-term benefits of guarding against serious risks outweigh the short-term impact on banks’ bottom lines.
The philosophy driving the RBI’s actions is clear: compliance is fundamental to financial stability, and risk management cannot be left solely to the banks’ boards. Experience has shown that boards often lack the capability to make the necessary calls on risk management. Therefore, regulatory direction is both necessary and inevitable.
To improve the effectiveness of bank boards, the RBI should consider several measures. First, it should ensure that independent directors truly exercise their independence. This could involve allowing various stakeholders to nominate independent directors who are accountable to shareholders and lenders, not just to the management. Second, the RBI might reconsider leaving the appointment of independent directors entirely to bank boards. Reappointments should require the regulator’s approval, signaling disapproval where necessary.
Additionally, financial penalties should be more punitive where required. While the RBI’s fines have increased from lakhs to crores, penalties that truly bite may be necessary to ensure compliance. The RBI could also demand that some penalties impact the incentives of top management, making them directly accountable for lapses.
Finally, in cases of non-compliance or risk management failures, the RBI should direct boards to fix accountability and take action against responsible bank functionaries or board members. This approach ensures that lapses are addressed promptly and effectively.
The RBI’s proactive and intrusive regulation has proven more effective than the light-touch regulation seen in Western economies, which has been discredited in recent years. The RBI’s strategy of pre-empting risks, enforcing compliance, and maintaining financial stability is commendable and should be continued.
In essence, the RBI’s actions are akin to a vigilant coach who, even when the team is winning, pushes players to train harder and correct minor flaws. This approach ensures that the team remains unbeatable in the long run. By tightening regulations and enforcing compliance, the RBI is safeguarding the financial sector’s future, ensuring that it remains robust and resilient against potential crises.
References
Mohan, T. R. (2024). RBI Wants Financial Entities to Shape Up or Ship Out. Vol. 59, Issue №24, Economic and Political Weekly.
RBI not against any fintech; they are free to grow: Governor Shaktikanta Das. (2024, March 6). The Economic Times.
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