Financial Standards and Codes: Report of The Advisory Group on
Transparency in Monetary and Financial Policies - Transparency in Policy Formulation

The Advisory Group appreciates the fact that the transitional path to greater transparency, accountability and autonomy in monetary policy would not be without problems but the benefits in terms of efficiency of monetary policy are so great that such a transition necessarily has to be made. India is not a unique case facing transition problems. The Advisory Group, after studying the working of the monetary policy formulation process in a number of countries, has come to the conclusion that the US, UK and South Africa experience holds considerable relevance to the Indian situation. The Advisory Group recognises that it would be neither feasible nor desirable merely to mimic the policy formulation process in other countries. The RBI should have a well defined monetary policy formulation framework with the procedures being clearly laid out. This would also need a viable institutional framework within which monetary policy decisions are made in a transparent manner.

The present RBI Act does not provide for any Monetary Policy Committee and it would not be possible, under the extant legislative framework, to set up a Committee independent of the RBI Board. It would, however, be possible to take a cue from the institutional framework worked out while setting up the Board for Financial Supervision (BFS). The Advisory Group recommends that, even without any legislative changes, the RBI should set up a Monetary Policy Committee (MPC) as a Committee of the RBI Central Board. There could be a seven member MPC consisting of the Governor, the three Deputy Governors and three other members drawn from the RBI Central Board; concerned Executive Directors and Departmental Heads dealing with monetary policy, internal debt, exchange rate management and economic analysis could be permanent invitees. The tenure of non-executive MPC members could be coterminous with that of the Central Board Directors, i.e. four years, with a clause for reappointment. There should be a convention under which the members are appointed for different periods to ensure periodic new appointments while ensuring continuity. The members of the MPC should be knowledgeable in the areas of macro economics, monetary analysis, central banking policy and operations and banking and finance. More importantly, to ensure against any conflict of interest, the three Board members who would be on the MPC should be independent professionals. It would be desirable to ab initio delineate the role of the non-executive members vis-a-vis the executive members; moreover, the question of information access and staff support as between non-executive and executive members should be addressed upfront to head off any inherent conflicts. The Advisory Group recommends that the MPC be set up early so as to give the MPC some time to work out its modalities and to undertake a few trial runs before the formal procedures are put in place starting from say the next financial year.

An increasing number of central banks have adopted inflation targeting as their ultimate policy objective and there is greater transparency in such countries as objectives and performance gain greater credibility. Monetary policy, however, works with relatively long lags of 18-24 months and hence the policy has to be formulated based on an assessment of conditions which are expected to prevail 18-24 months after the policy is announced. The appropriateness of monetary policy cannot be judged by the current situation. Given the monetary policy lag, the need for preemptive action is not easily appreciated and, therefore, the RBI has to effectively communicate to the public that its policy actions are to have prospective relevance. While ex post transparency is a precondition for assessing accountability, what is also vital is ex ante transparency in that the RBI needs to explicitly state what it is setting out to achieve and the instrumentality of attaining the objectives. It is, however, legitimate to surprise markets with unanticipated policy action. The Advisory Group recommends that the Government of India should consider setting out to the RBI a single objective for monetary policy viz. the inflation rate, as has been done by a number of governments abroad. The inflation rate target could be defined, illustratively, as an average over say a three year period starting from a back year. The inflation target should be a range, say an average over a stipulated period and with tolerance limits and when the inflation rate is outside the tolerance limits it should warrant a tightening or relaxation of monetary policy as appropriate. While setting the inflation target it would be best to use the inflation rate as reflected in, say the Wholesale Price Index (WPI) the terms of which are widely understood. The principal objective should be clearly set out to the RBI by way of a public statement as to the responsibility of the RBI. While doing so, the government could also make public its other objectives which have been taken into account while setting out the principal objective of monetary policy.

The Advisory Group recommends that once the single objective is set out, the remit of the MPC would be clear and the RBI should be given unfettered instrument freedom and held fully accountable for attaining this objective. The RBI should not be held accountable for the other objectives though the government should retain the right to alter the principal objective in the light of unfolding developments. The credibility of the entire exercise would, however, require that the resetting of the principal objective is undertaken only under exceptional circumstances and with a transparent public statement giving the rationale for resetting the principal objective.

If the principal objective is set out in terms of an inflation mandate, and the RBI is able to achieve it, this would be the best contribution that monetary policy could make towards longer term stable growth of the economy. Again, keeping the inflation rate low would contribute to exchange rate stability. In this sense the principal objective approach would be quite consistent with the attainment of other objectives of overall economic policy viz. growth and exchange stability.

There is some merit in having an overriding provision under which the government can give a directive on monetary policy to the RBI but this should be in writing and in specific terms, and applicable for a specific period; this should require Parliamentary endorsement after being placed on the Table of the House.

The Advisory Group suggests that there should be a monthly meeting of the MPC on a predetermined date, such as the last Wednesday of the month. The Committee of the Board has a tradition of a predetermined weekly meeting. To facilitate the deliberations of the MPC the RBI should undertake the preparation of position papers on monetary policy, debt management, external sector developments and the overall macro economy. The RBI has, over time, progressively tried to hone its analytical skills and while it would be difficult immediately to emulate the depth of analysis, as in say the UK, or the US, the RBI can progressively enhance its capabilities so that in a 3-5 years period it should be able to come upto the best international standards of analysis and disclosure of the policy process.

With monthly meetings of the MPC a convention should develop wherein the RBI should time its measures immediately after the MPC meeting and even when no measures are envisaged there should be a short statement on the decisions of the MPC immediately after the meeting. It would be desirable to avoid, as far as possible, policy action in between MPC meetings so that the markets are not in a state of perennial suspense; of course in unusual circumstances the RBI should retain the freedom to act between two MPC meetings.

As stated earlier the MPC would be a Committee of the Central Board and in the ultimate analysis the Central Board would bear the responsibility for RBI actions. The Advisory Group would urge that the RBI should develop a healthy tradition of accepting the recommendations of the MPC save in very exceptional circumstances and in such cases the RBI should publicly justify its actions.

A legitimate question that arises is what should be disclosed by the MPC. It is clear that the facts should be disclosed but for credibility, the Advisory Group is of the view that there should also be a gradual revealing of the course of discussions leading up to the formulation of policy and there should be timely release of this information as is done in the US, the UK and certain other countries. While undertaking such disclosures there has to be finesse to ensure against market disruption as a result of disclosures. Ultimately, market depth and resilience and greater disclosure are interactive and the thrust should be on working towards greater transparency, but such a move could be well calibrated over the next 3-5 years.

While a short statement should be issued immediately after the meeting of the MPC, the Advisory Group recommends that if the MPC is set up say in 2000-01, the minutes of the meeting of the MPC should be made public from 2001-02 twelve weeks after the meeting; with satisfactory experience the lag could be gradually reduced to eight weeks from 2002-03 and to four weeks from 2003-04. From 2001-02 there should be a very brief release of the minutes giving the broad thrust of the discussions and the decisions. From 2002-03 the minutes could be made somewhat more detailed. From 2003-04 the minutes should be not only more detailed but reveal the number of votes for or against key decisions and the alternative viewpoints should be revealed anonymously. The Advisory Group recommends that after sufficient experience is gained, and the assessment is that greater transparency in setting out differences in views and the rationale expressed by members would not be disruptive, at an appropriate future date, the individual names of member of the MPC for or against a decision could be revealed. Meanwhile what could be revealed is how the official and non-official members voted. The working of the MPC should be seen as a collegiate approach rather than a hierarchical approach. The minutes and related documents which are put in the public domain should contain, apart from the decisions, the key assumptions and rationale of policies. The Advisory Group recognises that the extent of disclosure would need to evolve in keeping with the changes in the policy formulation process. It is essential to ensure that transparency per se does not inhibit the free flow of deliberations in the MPC and, therefore, the extent to which the proceedings are made public would need to be undertaken with due finesse and in a phased manner.

The present Advisory Group is conscious of the fact that the RBI has set up a number of other Advisory Groups which would, inter alia, deal with regulation and supervision, accounting disclosures etc. Since the terms of reference of the present Advisory Group cover monetary and financial policies the Group has also given some attention to those policies which have a bearing on monetary policy. The importance of adequate transparency and disclosure in the financial system has come to the fore particularly after the East Asian currency crisis where opacity in the banking sector was clearly identified as a contributory factor to the crisis. As mentioned in an earlier Chapter transparency is the obverse of disclosure, and just as it is necessary for regulators to be transparent, it is equally incumbent on the regulated institutions to be transparent. Internationally, there is a strong consensus emerging in favour of greater disclosure of the components of capital funds, accounting policies, valuation and the emphasis on risk management, assessment of capital adequacy on a consolidated basis and the internal capital allocation process. In this connection the BIS has set out several standards on supervision, transparency, loan accounting and disclosure practices, risk disclosures and accounting standards. While these issues would no doubt be considered in detail by other Advisory Groups, the present Advisory Group recognises that these matters will impinge on monetary policy. Improved disclosures are a complement to the regulatory/supervisory process and ultimately provide for less supervisory intervention.

While the BIS New Capital Adequacy Framework is still under consideration the Advisory Group is appreciative of the fact that the RBI has applied itself purposefully to assess the impact of the proposed new norms for emerging countries and the need for caution while implementing these norms; moreover, the RBI has publicised its views on the matter to enable a wider understanding of the implications of the New Capital Adequacy Framework. This is in keeping with the move towards greater transparency.

The focus on disclosures is essentially from the perspective of the audited accounts. The Advisory Group is, however, of the view that there is inadequate attention to disclosure of supervisory information which could become a vital instrument of market discipline. Banks and other financial institutions owe it to their depositors to provide relevant information on performance in simple language easily understood by depositors. The present disclosure standards in India can, by no means be considered to be satisfactory. While stressing the need for greater disclosure the Advisory Group recognises the need for legitimate protection of proprietorial information. The need for greater disclosure becomes particularly relevant as there would, in future, be increased emphasis on capital requirements based on internal risk assessment.

The Advisory Group stresses that where there is regulatory forbearance it should be undertaken transparently. The Advisory Group stresses that as far as possible the regulatory regime should be rule based with minimum of discretion. Such a regime would obviously reinforce transparency. Excessive discretion is the antithesis of transparency.

An important issue relates to the transparency aspects of adverse action by the supervisory authority. Supervisory information is contained in Inspection Reports, ratings by the supervisor and formal enforcement actions taken, including the imposition of penalties, specific recommendations to management for action to curb risk taking and reduce costs etc., to turn around a bank under what is sometimes called a Prompt Corrective Action Regime. While such communications by the supervisor are not in the public domain, suffice it to indicate that since the early nineties in the US, the regulatory agencies are required to make public all formal enforcement actions imposed on banks. The experience has been that while such disclosures do have an impact on the volume of business of the concerned banks the disclosures have not been destabilising. In fact, these disclosures allow market discipline to work more effectively which adds to credibility and confidence in the system. While the US experience does not appear to have been replicated elsewhere, and publication of supervisory information is still being debated, suffice it to note that such disclosures are made to good purpose in Chile.

The Advisory Group commends the recent RBI initiative to release a Discussion Paper on Prompt Corrective Action (PCA) and it is hoped that after receiving appropriate feedback the RBI would put in place a PCA regime as part of a commitment to adopt the international best practices and comply fully with the Core Principles of Supervision. The PCA would, inter alia, cover parameters on the capital to risk assets ratio (CRAR), net non-performing assets (NPAs) and return on assets (ROA).

A pertinent issue is whether information on adverse action by the supervisor can be held back from the market. While supervisors would be wary of disclosing adverse actions, there would inevitably be certain signals which cannot be prevented from reaching the market. First, there could be leakage of information from within the concerned banks. Secondly, restrictions imposed by the supervisor could be discussed by market participants as portfolios change and the impact of various cost cutting measures cannot but be in the public domain as the banks comply with the supervisor’s instructions. Thirdly, in the case of a bail out by the authorities it is difficult to envisage that it would be possible to keep such action under wraps. It is conceivable that proper disclosure by the supervisor and the concerned banks would have less destabilising effects as against overreactions by markets based on speculative and incomplete information on the content of adverse action. The Advisory Group, therefore, urges that the regulatory/supervisory authorities in India should give early consideration to introducing, in a phased manner, a practice of disclosure of adverse action. The Advisory Group stresses that with predominant public ownership it is important to avoid the pitfalls of regulatory capture and this would, to some extent, be avoided by disclosure of adverse action. Moreover, in a situation where public ownership provides an anchor against panic reactions, disclosures per se are unlikely to be dislocative; on the contrary disclosures could have a salutary effect of strengthening the overall system by putting such information in the public domain.

While there are fears that disclosure of adverse action can have a systemic fall-out, the Advisory Group is of the view that so long as adverse action is taken at the incipient stage of infringement, and is seen to be objective and non-discriminatory the adverse action would be mild and would not have systemic dangers. The Advisory Group recommends that when penalties are imposed, however small, they should be publicised; minimal but timely adverse action would alert all stakeholders viz. owners, depositors and employees and there would be early convergence to least cost remedial action.

Monetary policy and exchange rate policy are closely inter-related and as already indicated these two segments of overall economic policy are mutually driven. In terms of transparency, the setting out of the principal objective of monetary policy would, in a sense, also provide the broad contours for exchange rate policy. The Advisory Group appreciates the sensitivities associated with exchange rate policy and it is recognised that the RBI does put out a significant amount of information on exchange rates and the management of the foreign exchange reserves. The RBI makes available daily information on exchange rates, turnover in the forex markets, including forward transactions, and also releases weekly data on movements in the foreign exchange reserves. Information is also released in the RBI Monthly Bulletin on the Nominal Effective Exchange Rate (NEER) and the Real Effective Exchange Rate (REER). Moreover, as indicated above, the RBI has for many years been publishing monthly information on the gross intervention (purchases and sales) and the position regarding net forward liabilities; in fact on this latter aspect the RBI has to its credit a long history of transparency of forex operations, far beyond that in a number of developed countries. This is an instance where Indian practices are ahead of international "best practices". The Advisory Group is of the view that the Indian disclosure standards compare favourably when considered against the disclosure template set out in the BIS Report on Enhancing Transparency Regarding the Authorities Foreign Currency Liquidity Position (September 1998). The Advisory Group recommends that the RBI should continue to be in the avant garde on disclosure of forward liabilities. Revealing the maturity pattern of forward liabilities would help stabilise market reaction to variations in the reserves resulting from maturing forward purchases/sales.

While recognising these commendable efforts the Advisory Group recommends that the efficiency of the forex market would be greatly enhanced if, without in any way compromising the freedom of action on exchange rate policy, the RBI were to reveal on a regular basis, separately, its direct and indirect intervention operations.

The Committee on Banking Sector Reforms (April 1998) had stressed the need for integration of the money, securities and forex markets and that to enable the various segments to function well they should be seamless and changes in one segment should have an impact on other segments. Over the years, particularly after the submission in 1987 of the Report of the Working Group on the Money Market, a series of measures have been taken to bring about a progressive integration of financial markets. The Advisory Group is of the view that for an effective transmission of monetary policy the changes in the various segments of the financial markets should be allowed to traverse freely through different segments of the financial markets.