Market Reforms: The Unfinished Agenda

Context:  It’s time to address the root cause of the 1992 stock market scandal — a conflict of interest in RBI’s many roles.

Case Study: Harshad Mehta Scam

• Diversion of funds: It was a  “securities scam” in which diversion funds estimated between Rs 3,500 crore to Rs 5,000 crore from the Government Securities (G-Sec) market to stock market manipulations.

• Phases of response by the government:

• First phase:

• Creation of Securities and Exchange Board of India (SEBI): for regulating the securities market

• Created two new securities infrastructure institutions: National Stock Exchange and National Securities Depository Limited

• Second phase: Created a modern derivatives market enabling risk mitigation and improved price discovery

• Third phase: Converging of SEBI and the Forward Markets Commission into one unified set of exchange and regulatory institutions.

• Core issues involved: Failure of Public Debt Management Office (PDOD) under RBI to discharge its responsibilities provided scope for misuses of “Banker Receipts” and lack of effective supervision.

Conflicts of Interests in RBI’s functioning

• Between setting the short- term interest rate (i.e. the task of monetary policy) and selling bonds on behalf of the government 

• If the central bank tries to be an effective debt manager, it will sell bonds at high prices, i.e. keeping interest rates low, leading to an inflationary bias in monetary policy.

• Between regulation and Debt Management: When the RBI tries to do its job of selling bonds, it may use its regulatory power to force banks to hold more government bonds. 

• This undermines the growth of the deep, liquid market in G-Secs with vibrant trading and speculative price discovery.

• Conflict of interest arises when the participant in the market (RBI) is also the part of the system which controls the market infrastructure for the G-Sec markets

Way Forward: 

• Separating the debt management from the RBI

• RBI should focus on monetary policy.

• Debt management office should work as the “investment banker” for the government: Its duties shall include selling bonds and engaging in portfolio management tasks 

• Important Recommendations:

• The Narasimhan I Committee on Financial Sector Reform (1991) identified the conflicts that result when the same institution manages debt and regulates banks. 

• Working Group on Separation of Debt Management from Monetary Management (1997) had recommended the separation of the two functions.

• RBI Annual Report for 2000-01 recommended the explicit removal of the debt management function from the RBI.

Conclusion: The confluence of factors like bulging public debt suggests that it is a good time to relieve RBI from its public debt management role.