 "financial sector, banking")
As we enter 2026, the Reserve Bank of India (RBI) governor calls India a “Goldilocks” economy, with robust growth and low inflation. After labour reforms, the next target should be reducing the cost of capital by deepening the financial markets. This might therefore be a good time to untangle the web of nested relationships between the Ministry of Finance (MoF) and Mint Street (RBI), which has created huge conflicts of interest and needs to be disentangled if India wants to deepen and modernise its financial system.
The relationship is often described as a traditional marriage between a husband (MoF) and wife (RBI), with the government playing the proverbial mother-in-law. Disputes are usually settled at home, not in public, and there is no question of divorce. If disputes do arise, the government — like most mothers-in-law — typically sides with the son, that is, the MoF. But sometimes, disputes do spill out.
One such incident was when the huge fraud of ₹13,000 crore (approximately $2 billion) at the government-owned Punjab National Bank (PNB) came to light in early 2018, involving still absconding merchants Nirav Modi and Mehul Choksi. The then finance minister Arun Jaitley blamed the RBI for poor regulatory oversight, and the RBI governor shot back in a public lecture arguing that the RBI’s regulatory powers over public sector banks (PSBs) are very weak. PSB’s have written off ₹12 trillion of loans (over $30 billion) between FY2015-16 and FY2024-25, suggesting huge regulatory and oversight problems in them. Another fraud has just been reported at PNB. Private commercial banks have had problems as well but not on the scale seen in PSBs.
The RBI’s oversight of PSBs is weak because, while it approves the appointment of private bank chief executive officers (CEOs) to ensure they are “fit and proper,” it does not have that power over PSBs. PSB CEOs know that they must follow directives from the MoF, not their official regulator, the RBI. What makes this regulatory relationship even more complicated is that RBI officials sit on the board of each PSB and are therefore implicitly complicit in the decisions taken by the board, while also being the regulator. Waves of non-performing loans have repeatedly surfaced in PSBs, suggesting that this arrangement does not help their oversight functions. A few RBI governors have felt this arrangement is not healthy, but others are comfortable with it. A solution was provided by the Narasimham Committee-II of 1998, which recommended that the RBI not sit on PSB boards and pushed for greater professionalisation of PSB boards — but this has so far not been accepted by both the MoF and the RBI.
A second major problem in the RBI’s relations with the MoF and the government more broadly is that the RBI is also the debt manager for the government, which creates a huge conflict of interest with its monetary policy role. As debt manager, the RBI would like to keep interest rates low to ensure the government is able to borrow at the lowest possible cost. It also forces banks to hold government bonds, which start to interfere with their liquidity requirements. Since India has unusually high public sector borrowing requirements — because central and state governments run exceedingly high deficits — to keep borrowing costs down, it imposes a statutory liquidity ratio (SLR), which requires banks to hold government bonds (considered a form of liquidity).
India’s SLR has come down from 40 per cent in the 1980s to 18 per cent, but India, along with Bangladesh at 13 per cent and Pakistan at 15 per cent, remains among the only countries still using this outdated instrument. This financial repression hurts the development of a commercial bond market and crowds out private credit growth. India’s private credit-to-gross domestic product (GDP) remains extremely low at around 50 per cent of GDP — better than Bangladesh and Pakistan, but far below countries like Vietnam, Thailand, and Malaysia, where it is over 100 per cent of GDP.
A related problem is that the RBI both regulates the government bond market and operates in it as a trader. The Securities and Exchange Board of India (Sebi) regulates the commercial bond market. But if Sebi were to be given the responsibility of regulating the government bond market, and the RBI trades in that market, it would then come under Sebi regulation, resulting in a case of one regulator regulating another regulator. The obvious solution is not to have the RBI as the government’s debt manager.
Twice — first in 2007 and again in 2015 — finance ministers P Chidambaram and Jaitley, belonging to two different parties, announced that the public debt management function would be moved from the RBI and managed by a National Treasury Debt Office, but both times the announcement was inexplicably withdrawn. A debt management unit was established in the finance ministry in 2015 to prepare debt strategies and analyse risks, and consultations are held twice annually between the RBI and the MoF on the management of debt. But the Comptroller and Auditor General of India has given this unit poor scores and, in any case, the underlying conflicts of interest in having the RBI manage public debt remain.
Why reform has been so difficult is because of extremely high combined fiscal deficits of the centre and the states. The RBI’s former deputy governor Viral Acharya has documented the costs of this fiscal dominance. He has shown its crowding-out impact through the credit and bond market channels, and even how it harms monetary transmission and hampers the deepening of the financial system. There is no better time than now to address these issues. Inflation is down, even below the FIT (flexible inflation targeting) regime’s lower limit and the economy is growing well — despite Trump’s tariffs. The RBI has just lowered interest rates, so more fiscal spending to boost growth — a common demand of business lobbies and politicians — is currently not needed.
The upcoming Budget is an opportunity for serious fiscal consolidation and to start disentangling this unhealthy relationship between the RBI and the government, which is hurting the deepening and effectiveness of India’s financial sector. A good place to start would be removing the SLR, thereby putting additional pressure on the MoF to rein in the fiscal deficit. A friendly, clean divorce is often healthier than a messy marriage.
The author is a distinguished visiting scholar at the Institute for International Economic Policy, George Washington University. His book Unshackling India (HarperCollins India) was declared the best new book in economics by the Financial Times in 2022
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
