What assurance can the RBI Board provide that important discussions and decisions will not be shared by its non-executive directors with their parent (or related) organisations that may have some  commercial interest in financial sector?

Institutional accountability of the Reserve Bank of India (RBI), as a central bank, can come in two major ways: a) long term measures such as making the RBI directly accountable to the Parliament and the mechanisms that go with it; and b) short term measures such making the board of RBI accountable and the aspects associated with this. 

While it is easy to propose long term measures and distract from the real issue at hand, in my opinion, certain short term steps can and should be immediately taken by Dr Rajan (the RBI Governor, who has sweeping powers) and the Ministry of Finance to make the RBI more administratively accountable.

Simple things, as given below, can be done to achieve this quickly. Just as charity begins at home, accountability must start with the RBI board which is in fact the first and most important layer in a multi-layered accountability process. Long term measures such as the RBI governor reporting to Hon Parliament and other such aspects (discussed in part III of this series) can happen eventually as also the formal adoption of the (proposed) Indian financial code. However, as Dr Rajan has so convincingly argued many times, there are low hanging fruits to be plucked and they need to be harvested right away with regard to the issue of making RBI more accountable. These are indeed the focus of this second article in a three part series

But before we discuss the substantive issues, let us go back to the RBI Act, 1934 whose preamble notes that the primary function of RBI is as follows:

"...to regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage."ⁱ

Therefore, as India’s central bank that has been created by society at large (and not just governments or politicians), the RBI has one key objective - the need to preserve the value of the bank notes which it has been mandated to issue for use by all of us. I emphasise maintenance in value because any erosion of this value would mean that we, the people, would lose the overall value of our wealth. To me that would amount to a betrayal of the trust which, we the people, have placed in RBI as the central bank. And in my opinion, this trust cannot be built either by government ownership of the RBI or the laws that have helped establish it, but rather by the efficiency, professionalism, integrity and adherence to good governance by those who run the RBI. And of those who run the RBI, the most important, in my opinion, is the board of the RBI, which is sacrosanct and must be so maintained. Thus, the first line of accountability would have to be the board of RBI and it must be made accountable to the people of India. That said, what then are the changes required to ensure this?

Specifically, this in effect would translate into the following:

1. Using the Board as the key evaluator of RBI’s performance: Treating the board as the key evaluator of RBI’s performanceⁱⁱ as also that of the Governor (both as a leader and manager). The non-executive (independent) members must be capable of performing this task appropriately and independently. At a later stage, as is being tried by some central banks, the RBI could even consider the establishment and use of an independent “lead non-executive director” position and facilitate regular independent meetings of the non-executive directors (alone) so that the above is achieved in an objective manner.

2. Ensuring a transparent Board appointment process: Competency-based processes must be used for selection of people (who have the capacity, ethics, skills and orientation) to serve on the RBI board. Filling up vacancies on the RBI board should thus be through proper procedure, involving a search and selection committee with at least 2 to 4 names being proposed for each board vacancy. The finance ministry can easily do this and thereby, set the highest standards of corporate governance to RBI as an institution. If appointment of board members is compromised, then, corporate governance and accountability of RBI as an institution (and more importantly, as India’s central bank) would suffer as seems to be the case because of certain recent events.

Thus, the need of the hour is a transparent board appointment policy for the RBI and this policy must also ensure that directors have adequate skills and experience (apart from the availability of time to do their job effectively). The policy must also ensure that the overall composition of the RBI’s board of directors is suitably diverse — including more women, youth and individuals with the requisite skills (and appropriate backgrounds) on the RBI board is perhaps a way to improve the boards’ overall functioning and effectiveness. The policy must also ensure that conflict of interest issues are taken into account with regard to board appointments so that the independence of the non-executive directors is not compromised, under any circumstances (what-so-ever).

3. Establishing critical non-negotiables for Board composition: People who have an on-going direct commercial interest in the provision of financial services (through banking companies, NBFCs, equity investments in such institutions and other related institutions) should NOT be appointed to the board. This single step should go a long way in enhancing accountability of RBI as an institution and must be implemented forthwith. Likewise, relatives and/or very close friends of the RBI staff (including the Governor, Deputy Governors, Executive Directors and other board members) should NOT be appointed to the RBI board. Similarly, it may be wiser to keep politicians out of the RBI board. Let me make one thing clear here. This is not an exhaustive list of non-negotiables. Rather, it must be viewed as a starter’s set that provides examples of the kind of relationships that are better avoided to enable effective functioning of the RBI board and more importantly, facilitate public confidence with regard to the same.

Otherwise, serious conflicts of interests and related situations, like what happened in the case of Mr Rajat Gupta, could happen here, much to the detriment of the reputation of the RBI. This is not to be construed that people with background in economics, finance, business administration and related areas should not be appointed to RBI’s board. They can be, provided, they meet the minimum non-negotiable criteria, such as those given above. In fact, the Financial Sector Legislative Reforms Commission has made (similar) good suggestions in this regardⁱⁱⁱ.

Let me give you a couple of examples to explain this further. Take the case of Mr KM Birla. By virtue of having served on the RBI board for several years, he could have lobbied^iv (with the RBI) to facilitate the entry of large industrial business groups into banking – a practice that is still avoided in many countries. Please note that the current round of banking licenses to be given by the RBI includes large industrial business groups as applicants for banking licenses. 

Likewise, it is completely inappropriate for people like Dr Mor to serve on the RBI board given that he was and still appears to be connected with IFMR trust^v (at least there are some websites and documents which say that he is still connected^vi), which has strong interests in the financial sector through its involvement with financial inclusion and also its investments in NBFCs MFIs

Look at it this way.

The RBI is the regulator and supervisor of the financial sector in India and the board of RBI is involved in many critical deliberations related to the financial sector. What assurance can the RBI Board provide that these important discussions and decisions will not be shared by non-executive directors with their parent (or related) organisations that have some form of commercial interest in the financial sector? In fact, providing RBI board membership to anyone connected with institutions that have a strong commercial interest in the financial sector will for the above reason give undue advantage to these institutions as they will gain access to what economists often call as “superior information”. Dr Rajan should be able to understand this better than anyone else!

And this is not to say that people who have in the past served in organisations with a commercial interest in financial sector cannot become board members of the RBI. Maintaining a cooling period of between 3 – 5 years, before they are appointed to the RBI board seems an advisable strategy.

Again, let me remind the readers that the case of Mr Rajat Gupta looms large and should not be forgotten. Therefore, it would be prudent and appropriate if those with strong and on-going commercial interests in the financial sector are not made board members of the RBI.

4. Circumscribing the term of an RBI Board member: Restricting board terms for people (on the RBI board) to a maximum of 8 years (2 terms of four years each) and ensuring regular induction of new members is very critical. When board members get older than the furniture in the boardroom, experience suggests that they could be compromised in different ways and therefore, ‘unrestricted board terms’ as practice, is better avoided. This needs to be implemented immediately at the RBI.

5. Facilitating evaluation of Board member performance: Having a compulsory formal evaluation of the functioning of the RBI’s board of directors by an external independent evaluator is very necessary and some central banks have even started experimenting with this idea. And the results of this evaluation should be made available to the public—officially publishing the evaluation (on their website) is an aspect that could also be considered by RBI. It goes without saying that independent evaluators—individuals and/or institutions—must not have not had a material relationship (as defined in common parlance) with the Reserve Bank of India.

6. Ensuring RBI Board members do not get involved in non-Board activities: Ensuring that board members do not head or serve on other RBI committees (outside of the RBI Board) concurrently is a very important issue. The RBI board’s primary task, as noted earlier, is very clear – to monitor RBI’s performance and that of its executives including the Governor and act as the first stage of defence in the multi-layered accountability mechanism. That being the case, they cannot and should not serve on any committees other than board sub-committees. For example, during the 2010 AP micro-finance crisis, the committee headed by Mr Yezdi Malegam is a perfect example of a committee appointed appropriately as it was entirely a board sub-committee. I have no issues with that.

However, take the case of the new financial inclusion committee headed by Dr Mor, who is also a central board member nominated from the eastern board. That is not appropriate because Dr Mor, being a part of the central board, will have a natural duty to evaluate the work of the RBI, which would also include these very advisory committees. This is indeed a serious conflict of interest and that is why board members should perform only roles meant for them. Likewise, Dr Mor’s participation in the RBI (external) banking selection advisory panel is again highly inappropriate for the same reasons.

7. Reducing key person dependence: Look at the key person dependence at RBI on Dr Mor, especially in 2013. This is clearly bad practice of corporate governance and it reduces the accountability of RBI as an institution. As noted above, Dr Mor has been made the chair of the newly constituted financial inclusion committee (September 23^rd 2013), is part of the banking selection advisory panel (October 4^th 2013) and may be member of other board sub-committees that we have no information about.

As on date, Dr Mor, is a member of the eastern board of RBI, member of the central board of the RBI, member of the financial inclusion committee under Dr K C Chakrabarthy, head of the newly appointed committee on financial inclusion, member of the bank selection advisory panel, member of the research advisory panel of CAFRAL (which is said to be housed in RBI headquarters and completely funded by the RBI) and may be part of more committees.

This would never happen in any other central bank. With all due respect, I am not sure that the RBI is acting with accountability, when it puts a single board member on so many non-board committees and panels, which the Board (of which he is part of) will ultimately have to evaluate! And given Dr Mor’s linkages (as noted earlier)^vii with IFMR trust, which works with NBFCs MFIs and is involved with financial inclusion, I am indeed sure that what is happening is NOT at all appropriate from an accountability perspective.

8. Emphasising procedural accountability: If you look at the global sub-prime crisis (and the same is true of the AP 2010 micro-finance crisis) and I quote from The Financial Crisis Inquiry Report (FCIC) report which notes that:

“Dramatic failures of corporate governance and risk management at many systemically important financial institutions were a key cause of this crisis. There was a view that instincts for self-preservation inside major financial firms would shield them from fatal risk-taking without the need for a steady regulatory hand, which, the firms argued, would stifle innovation. Too many of these institutions acted recklessly, taking on too much risk, with too little capital, and with too much dependence on short-term funding. In many respects, this reflected a fundamental change in these institutions ...which focused their activities increasingly on risky trading activities that produced hefty profits. They took on enormous exposures in acquiring and supporting subprime lenders and creating, packaging, repackaging, and selling trillions of dollars in mortgage-related securities, including synthetic financial products. Like Icarus, they never feared flying ever closer to the sun.”^viii

And the results are there to see for all of us from both the global sub-prime and the 2010 AP micro-finance crisis

Likewise, the proposed financial inclusion committee under Dr Mor is to recommend the overall regulatory architecture for the financial inclusion sector. As noted earlier, the Dr Mor committee comprises (at least in majority) of industry insiders with significant conflicts of interests (such as those who have applied for a banking license and those connected to banking license applicants) and those having direct/indirect linkages with institutions that have a commercial interest in financial inclusion. That this committee is to recommend the regulatory framework for financial inclusion is surely akin to what happened in the global sub-prime as noted above. And by appointing such an (industry insider) committee, the RBI has shown that it does not have the PROCEDURAL ACCOUNTABILITY required of a central bank. The same is the case with the banking selection advisory panel, which is again an inappropriately constituted body! In fact, the manner and urgency with which both these committees have been set up, especially, when both topics are the subject of discussion at the Hon Parliamentary Standing Committee on Finance (PSCF), certainly shows that the RBI has not followed the norms of PROCEDURAL ACCOUNTABILITY expected of central banks.

1. Adopting an official formal code of conduct publicly: Lastly, an official code of conduct needs to be FORMALLY and publicly adopted by the RBI board with regard to various aspects including activities and roles that board members can engage in (as board members of the RBI), disclosures to be made them with regard to conflicts of interest and several other issues. While as Dr Subba Rao, the former Governor has said, an informal code is perhaps in place at the RBI, let me state unequivocally that no informal code can be a substitute for a formal official code^ix adopted publicly. And indeed disclosures on various aspects including conflicts of interest must form a very critical part of this code.

Look at it this way. The RBI has fair practice and other codes for various stakeholders including NBFCs. Is it not fair that the RBI has an official code adopted formally for its board and staff? And once adopted formally, it should be available publicly and board members would have to make appropriate disclosures as per the code. This is a very simple task to set the ball rolling for greater institutional accountability and Dr Rajan must push hard to get this done quickly so that ‘the RBI indeed becomes the change that it wants to ultimately see on the ground in India’s financial sector’.