21
Feb

Monetary Policy Transmission in India – Part 1

By Madhu Srinivas, IFMR Finance Foundation

Monetary policy plays a significant role in determining the trajectory of a country’s economy. While not directly affecting the structure of a financial system, the policy significantly influences the actions of economic agents of the financial system, including financial institutions. In that respect, the mechanics and effectiveness of transmission is of considerable interest to us. In this post, which is the first in a two-part series, we take a brief look at the mechanics of Monetary Policy Transmission in general and how it operates in India.

Introduction

Dr. Raghuram.G. Rajan, former RBI Governor, in a statement after assuming office on September 4, 2013 observed that:

The primary role of the central bank, as the RBI Act suggests, is monetary stability, that is, to sustain confidence in the value of the country’s money. Ultimately, this means low and stable expectations of inflation, whether that inflation stems from domestic sources or from changes in the value of the currency, from supply constraints or demand pressures.” While there are many views on the objectives of monetary policy, the above statement captures the broad commonalities among the various views and could be taken as the official stance of RBI. This is further strengthened with the RBI formally adopting Inflation Targeting Framework.

It is generally accepted in literature that monetary policy has limited effects on aggregate supply or productive capacity. However, in the presence of credit constraints, the ability of firms to expand capacities is impacted, thus affecting aggregate supply[1]. Following the financial crisis of 2008-09 overall monetary policy transmission seems to have weakened in most Advanced Economies (AE)[2]. In contrast, recent evidence suggests that the interest rate channel, one of the many channels for monetary policy transmission, is strengthening in many Emerging Market Economies (EMEs), including India[3]. This can be attributed, among other things, to reduced fiscal dominance, more flexible exchange rates and development of market segments[4].

Prior to the recommendations of the Expert Committee to Revise and Strengthen the Monetary Policy Framework (Chair: Dr.Urjit Patel, 2014), India was following reserve targeting as the mechanism for monetary policy transmission – i.e., base money, borrowed reserves, and non-borrowed reserves. However, we have moved towards a formal, interest rate targeting regime (based on CPI) and away from the earlier reserve money system. One of the main reasons for moving from a money aggregate system to an interest rate regime is the erosion in stability and predictability of the relationship between money aggregates, output and prices. This erosion was further exacerbated with the proliferation of financial innovations, advances in technology and progressive global integration.

Mechanics of Transmission

The transmission mechanism can be characterised by the Taylor’s rule of thumb[5] (a simplified version of one of the main quantitative tools used by central bankers to arrive at a nominal policy interest rate) –

i =π + r* + 0.5(π –π*) + 0.5 (y – y*)], or [ i =π* + r* + 1.5(π –π*) + 0.5 (y – y*)]

Where

i = nominal interest rate

π = rate of inflation

π* = inflation target

r*= neutral real rate

(y-y*) = output gap

The policy transmission mechanism broadly involves two steps –

  1. Transmission from the policy rate to key rates in the financial markets
  2. Transmission from the financial markets to final objectives like inflation, employment and output

The effectiveness of transmission in both steps depends to a large extent on the structure of the financial system. The three main components of the system which determine effectiveness are[6] –

  1. The size and reach of the system – given that the formal financial system does not intermediate for most economic agents in India, this weakens transmission
  2. The magnitude of financial frictions – a recent empirical study[7] suggests that the relative scarcity, or impediments, in the provision of public goods in India, such as – enforcement of property rights, efficiency and impartiality of the legal system, adequacy of accounting and disclosure standards –  tend to enhance the frictions in the financial sector and, to that extent, impede policy transmission
  3. The degree of competition in the financial sector – there is evidence[8] that the banking sector is highly concentrated in India, suggesting a low degree of competition in the sector

In sum, it can be said that the structure of the financial sector in India tends to weaken the monetary policy transmission.

Channels of Transmission

Monetary policy transmission in India happens through the following channels –

  1. Interest Rate channel – Empirical studies show that there exists bi-directional causality between call money rates and interest rates in other segments such as the government debt market, credit market or equities market and the forex market[9]. Also studies have shown that the transmission through this channel is asymmetric, i.e the extent of policy rate transmission is different between liquidity surplus and liquidity deficit conditions, with the transmission being more effective during liquidity deficit conditions[10]. One reason could be that banks would be more dependent on liquidity provided by RBI during tight liquidity conditions and hence more sensitive to the short term interest rate influenced by RBI.
  2. Credit channel – India is banking-dominated economy, even though the role of equity and debt markets has been rising the past few years[11]. High-dependence on bank finance makes the bank lending and the balance sheet channels particularly important for monetary transmission, which is also seen through Granger causality tests[12]. In terms of balance sheet effects, credit growth is seen to have an inverse relationship with movements in the policy rate. A 100 basis points increase in policy rate reduced the annualised growth in nominal and real bank credit by 2.78 per cent and 2.17 per cent, respectively[13].
  3. Exchange Rate channel – The exchange rate channel works primarily through consumption switching between domestic and foreign goods. This channel is weak in India with some evidence of weak exogeneity[14]. This is mainly because of India’s limited integration with world financial markets and RBI’s intervention in forex markets[15]. Despite all this, it is found that exchange rate depreciation is a key source of risk to inflation[16].
  4. Asset Price channel – Empirical evidence for India indicates that asset prices, especially stock prices, react to interest rate changes, but the magnitude of the impact is small[17]. With the increasing use of formal finance for acquisition of real estate, the asset price channel of transmission has improved. However, during periods of high inflation, there is a tendency for households to shift away from financial savings to other forms of savings such as gold and real estate that tend to provide a better hedge against inflation. To the extent that these acquisitions are funded from informal sources, they may respond less to contractionary monetary policy, thus weakening the asset price channel in India[18].

In all this, it should be borne in mind that there is considerable lag in the transmission of monetary policy. In India, monetary policy impacts output with a lag of 2-3 quarters and WPI inflation with lag of 3-4 quarters, with the impact persisting for 8-12 quarters. Also as can be seen from the above summary of channels, the interest rate channel is the strongest[19].

In the next post, we will take a closer look at the impediments to policy transmission in India and also list the recent measures taken by RBI/Government to overcome these impediments. Finally we will look at what recent empirical evidence has to say on effectiveness of policy transmission in India.


[1] Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework (Chair: Dr. Urijit Patel, 2014)

[2] Bouis (2013) et al, OECD Working Paper No. 1081

[3] Mohanty, M.S. and P. Turner (2008): “Monetary Policy Transmission in Emerging Market Economies: What is New?”, BIS Policy Paper No.3, January

[4] Gumata, N., A Kabundi and E. Ndou (2013): “Important channels of transmission of monetary policy shock in South Africa”, ERSA Working Paper No. 375, Cape Town

[5] Urjit Patel Committee Report (2014)

[6] Mishra, Montiel and Sengupta (2016) :“Monetary Transmission in Developing Countries – Evidence from India”

[7] Ibid

[8] Ibid

[9] Urjit Patel Committee Report (2014)

[10] Bhupal Singh (RBI 2011) :“ How asymmetric is the monetary policy transmission to Financial markets in India”

[11] Ibid , Chart IV.1

[12] ibid

[13] Pandit, B.L. and P. Vashisht (2011), “Monetary Policy and Credit Demand in India and Some EMEs”, Indian Council for Research on International Economic Relations, Working Paper No.256, Khundrakpam (2011) and Khundrakpam and Jain (2012)

[14] Ray, P., H. Joshi and M. Saggar (1998): “New Monetary Transmission Channels: Role of Interest Rate and Exchange Rate in the Conduct of Monetary Policy”, Economic and Political Weekly, 33(44), 2787-94

[15] Mishra, Montiel and Sengupta (2016): “Monetary Transmission in Developing Countries – Evidence from India”

[16] Urjit Patel Committee Report (2014), Table IV.1

[17] Singh, B. and S. Pattanaik (2012): “Monetary Policy and Asset Price Interactions in India: Should Financial Stability Concerns from Asset Prices be Addressed Through Monetary Policy?”, Journal of Economic Integration, Vol. 27,167-194

[18] Urjit Patel Committee Report (2014)

[19] ibid

12
Jan

Comments on the Report of Watal Committee on Digital Payments

By Malavika Raghavan, IFMR Finance Foundation

Shortly after Christmas last month, a press release from the Ministry of Finance on 28th December announced that the Committee on Digital Payments (chaired by Ratan P. Watal) had submitted its Report. IFMR Finance Foundation’s Future of Finance Initiative has provided its response to the Report.

The Committee had been constituted in August 2016 with a term of 1 year to review the payments system in the country and to recommend appropriate measures for encouraging digital payments. It’s recommendations were however delivered in 4 months. The Report notes that the Committee calibrated its recommendations to fast track the attainment of its ‘Vision’: to significantly reduce cash usage in the economy and facilitate the provision of ubiquitous digital payment services and infrastructure in the country (page 21 of the Report).

The Report contains recommendations which could have far-reaching impacts on Indian financial systems design, particularly for the regulatory architecture and the operation of payment systems in the country. It recommends:

  • the set-up of an independent “Payments Regulatory Board” within the RBI, which is unprecedented,
  • large scale amendments to the main Payments legislation, the Payment and Settlement Systems Act 2007, and
  • several measures to Government around incentivising digital payments by absorbing costs into the system.

We welcome the Report’s recommendation to include a section on customer protection explicitly in primary legislation dealing with payment systems. In the course of setting out its 13 headline recommendation, the Report shows a strong preference for supporting the use of Aadhar (and related payment systems) to verify and authenticate transactions. It supports the development of new innovations which are still in the regulatory “grey area” such as Direct Carrier Billing. The Report appears to recommend action on matters around the edges of digital payments for e.g. recommending disincentives on customers and merchants for using of cash, the use of Aadhaar where PAN numbers are not available and on income tax filings. In our response, we have also sought to highlight significant concerns that we have with some of these recommendations given the implications for customer protection and systemic risk.

Our submission to the Committee is available here.

About the Future of Finance Initiative:

The Future of Finance Initiative (FFI) is housed within IFMR Finance Foundation and aims to promote policy and regulatory strategies that protect citizens accessing finance given the sweeping changes that are reshaping retail financial services in India – including those driven by Indiastack, Payments Banks, mobile usage and the growing P2P market.

23
Dec

Electronic Financial Data and Privacy in India

By Bhusan Jatania, IFMR Finance Foundation

Earlier this week, the Secretary for the Ministry of Electronics and Information Technology (MeitY) confirmed that MeitY is set to review the legal framework for digital payments and cybersecurity[1]. This is an important move, and one that needs to take note of important blind spots in a key legislation that governs the handling of personal financial information – the Information and Technology Act, 2000 (IT Act). This post draws from our work as part of the Future of Finance Initiative and flags some blind spots in the IT Act that must be addressed in an environment where retail finance is seeing increasing digitisation.

Looking back at 2016, the push towards the digitisation of financial services has been one of defining themes of the year. As more and more Indians make digital payments, we are creating digital footprints of our financial behaviour on a scale the country has never seen before. Meanwhile, India remains one of the world’s largest economies without a law on privacy rights of citizens. This has prompted the Supreme Court to consider – in the context of making Aadhar mandatory for availing governmental benefits[2] – if our Constitution provides for a fundamental right to privacy, although there is no express mention in this regard. As it currently stands, we have retrofitted the Information Technology Act, 2000 (IT Act), originally enacted to give legal sanctity to electronic governance, to provide minimum safeguards in this regard.

This begs the question: who collects the data from this trail, and what are the general obligations that bind them to keep this confidential?

Part of the answer to this question lies in the IT Act – the overarching law governing the collection and use of personal information in electronic form.[3]

1. Requirements

The IT Act applies to these types of entities set-up in India and engaging in commercial/ professional activities (Body Corporates):

(a) company,
(b) firm,
(c) sole proprietorship, or
(d) other association of individuals.

A Body Corporate which either collects, processes, stores, transfers or accesses any sensitive personal data or information (Sensitive Data) in a computer resource has certain compliance requirements[4]. Financial information, defined as “bank account or credit card or debit card or other payment instrument details”, is classified as Sensitive Data.

The Body Corporate must take prior written consent of the data subject for collecting Sensitive Data, adopt a privacy policy and appoint a grievance officer for resolving complaints within 30 days. The Body Corporate must also inform the data subject (i.e. the person whose data is being collected) of:

(a) the fact that Sensitive Data is being collected,
(b) the purpose for which Sensitive Data is collected,
(c) the intended recipients of Sensitive Data,
(d) the name and address of the entity collecting Sensitive Data, and
(e) the entity retaining Sensitive Data.

The Body Corporate must also:

  • provide options to the data subject to decline providing Sensitive Data for availing a service and to withdraw consent which has been given already,
  • allow data subjects to review their Sensitive Data and modify/ update/ correct it (if found outdated/ incorrect), and
  • ensure that Sensitive Data is used as per specified purpose and not retained for a period longer than required for its lawful use (or as required by any other law).

2. What are the blind-spots?

Transaction records: For starters, it remains unclear if ‘financial information’ includes transaction records of the individuals as well, such as say credit card spending patterns or utility bill payments.

Newer forms of data: Newer forms of personal data that may be of a sensitive nature, such as browsing history, call records, social media behaviour, and so on, that are recently finding use in underwriting in financial services, do not have protections that sensitive personal data or information has.

Data retention and collection: Moreover, while a Body Corporate cannot hold Sensitive Data beyond the purpose for which the information was collected, there are no bright-line rules (such as purging the information within 30 days of purpose expiry). Market practice has also evolved in the direction of taking all-encompassing consents, making purpose limitation difficult to enforce.

Foreign banks, government departments and non-Body Corporates: The IT Act will likely not apply to foreign banks branches operating in India (of which there were 325 as of 31 December 2015 [5]) where they have not set-up Indian subsidiaries. The IT Act will also not apply to non-profit organisations, banking business correspondents, individual chartered accountants/ mutual fund distributors/ investment advisors/ insurance brokers etc. Significantly, there is no right to privacy under the IT Act for data collected by a government department, authority, commission or board as these will not be regarded as Body Corporates.

3. What happens if the IT Act is violated?

In India, we lack a dedicated data protection authority to supervise breaches of the IT Act, which are generally dealt with by the Secretary of Department of Information Technology at the state-level, who can impose up to 3 years of imprisonment or fine up to Rs. 500,000. Appeals from such decisions are heard by the country’s only Cyber Appellate Tribunal in New Delhi, which has decided a total of 17 matters since inception and had 66 appeals pending as of March 2016 (due to the continuing absence of a Chairperson since mid-2011). There has also been a long-standing proposal to have a bench of the Cyber Appellate Tribunal in Bengaluru[6].

In theory, an individual whose data has been mishandled under the IT Act can get up to Rs. 5 crore as compensation for negligent handling of his Sensitive Data by a Body Corporate, if he suffers a wrongful loss or a third party makes a wrongful gain.

4. Way Forward

While India deserves a stand-alone privacy statute, the IT Act framework can be extended to all non-public personal information[7] handled by a financial service provider in the interim.

To strengthen the current regime, financial service providers could be required to have nodal privacy officers for overseeing compliance with privacy requirements and to act as single point of contact for addressing customer complaints. Filings with financial regulators could also include a section on the status of such compliances with built-in consequences for violation.

Financial service providers should also be required to provide privacy notice (in model form) to each customer at the point of first engagement and on an annual basis subsequently. The notice can have the provider’s privacy policy in plain language, details of customer information collected, entities with which it can share the information and an accessible opt-out option to prevent information sharing (other than for compulsory purposes such as credit reporting).

Overall, electronic financial data protection in India is based on rudimentary regulations with limited enforcement and lack of distinct treatment by financial sector regulators. It is essential to make major upgrades to the data protection regime given the size, scale and detail of electronic data collection in the financial space.

About the Future of Finance Initiative:

The Future of Finance Initiative (FFI) is housed within IFMR Finance Foundation and aims to promote policy and regulatory strategies that protect citizens accessing finance given the sweeping changes that are reshaping retail financial services in India – including those driven by Indiastack, Payments Banks, mobile usage and the growing P2P market.



1 – See: http://www.thehindu.com/business/Economy/Reviewing-legal-framework-for-securing-digital-payments/article16896971.ece and http://www.livemint.com/Industry/VcLcVc6huMHGloWSSfe2EK/Govt-plans-tighter-privacy-rules-for-electronic-payments.html. Note that the The Information Technology Act, 2000 is administered by MeitY.
2 – In the matter of Justice K.S. Puttaswamy v. Union of India, order dated 11 August 2015.
3 – While we focus on the IT Act, we do note that codes of conduct have been developed by sector-specific regulators which impose an obligation of customer data confidentiality. However there is currently no clear mechanism for tracking/ reporting of privacy violations (under say Reserve Bank of India’s banking ombudsman scheme or Securities and Exchange Board of India’s SCORES system) and also no specific penalty implications for such conduct.
4 – There is a safe harbour provision for Body Corporates handling customer data under outsourcing contracts and not dealing directly with data subjects.
5 – See: https://www.rbi.org.in/commonman/upload/english/content/pdfs/71207.pdf.
6 – See: http://www.thehindu.com/news/cities/bangalore/Proposal-to-set-up-Bangalore-bench-of-Cyber-Appellate-Tribunal/article14948497.ece.
7 – The IT Act defines ‘personal information’ as “any information that relates to a natural person, which, either directly or indirectly, in combination with other information available or likely to be available with a body corporate, is capable of identifying such person.”

7
Nov

Infograph: Recommendations for Modernising India’s Banking Sector

In the below infograph we highlight the recommendations from IFMR Finance Foundation’s latest research note “Modernisation of India’s Banking Sector”.

modernisebanking_infograph

Click here to download PDF of the infograph.

26
Oct

A brief comparison of Regulatory Requirements of Payments Banks, Small Finance Banks and Universal Banks

By Madhu Srinivas, IFMR Finance Foundation 

RBI recently released the operating guidelines for the Small Finance banks and Payments Banks on October 6, 2016. To take stock of these, we have put together a brief comparison of the regulatory requirements of these banks against those for universal banks.

Payments Banks (PB) Small Finance Banks (SFB) Universal Banks (scheduled commercial bank /
SCB)
Functions
Payments and Remittances Yes Yes Yes
Credit No

Yes,

a)75% of ANBC to qualify under PSL. While 40% of its ANBC should be allocated to different sub-sectors under PSL as per the extant PSL prescriptions, SFBs can allocate the balance 35% to any one or more sub-sectors under PSL where it has competitive advantage, and,

b) Atleast 50% of loan portfolio should have loans and advances not exceeding Rs. 25 Lakhs

SFBs can participate in securitisation as originators for risk transfer but not as purchasers of other banks’ loans

Yes

40% of ANBC to qualify under PSL

Savings Yes, only demand deposits (savings and current accounts), aggregate limit per customer shall not exceed ₹100,000. Amounts beyond this limit can be swept into accounts opened for customer at a SFB/SCB, with prior written consent of customer. Yes – both demand and term deposits Yes – both demand and term deposits
Business Correspondent (BC) Yes. Can become BC to another bank, and in the process offer credit. Also can engage BCs, including those of promoter/ partner/ group companies at an arm’s length basis, for expanding their business. Cannot be a BC to another bank. Yet can engage BCs, including those of promoter/ partner/ group companies at an arm’s length, for expanding their business. Interoperability of BCs is allowed, though it is unclear what interoperability means in this context, except for opening of deposit accounts. Offline BCs will not be allowed. No requirements to have base branch for a set number of BCs/ access points. Can use BCs to expand their business with no restrictions on having a set number of BC’s to be mapped to a base branch. While a BC can be a BC for more than one bank, at the point of customer interface, shall represent and provide banking services of only one bank. Offline BCs are allowed provided that all off-line transactions are accounted for and reflected in the books of the bank by the end of the day.
Prudential Requirements
Capital Adequacy Requirements 15% – their risk exposure would be almost entirely limited to operational risk* 15% – risk exposure includes credit risk, market risk, operational risk* 9% – risk exposure includes credit risk, market risk, operational risk
CET1 Capital 6.0% 6.0% 5.5%
Minimum Tier 1 Capital 7.5% 7.5% 7.0%
Capital Conservation Buffer NA NA 1.25%
SLR/CRR Yes Yes Yes
Investment Norms Only in Govt Securities (atleast 75% of Demand Deposit Balances) and in demand and time deposits in SCBs As applicable to commercial banks As per extant guidelines
Other Activities
Products Some form of prior RBI approval required for
products to be sold by PB. RBI also reserves the right to restrict or discontinue the products being sold by the PB
NA NA
Derivatives Only for the purposes of hedging foreign currency positions arising from business activities. Only the below mentioned derivatives can be used. Also no credit derivatives cannot be purchased or sold:
a) interest rate futures for proprietary hedging;
b) Foreign exchange derivatives to hedge foreign currency positions arising from business activities
No such restrictions
Para Banking Activities Can undertake other non-risk sharing simple financial services activities, not requiring any commitment of their own funds, such as distribution of mutual,fund units, insurance products, pension products, etc. with the prior approval of the RBI and after complying with the requirements of the sectoral regulator for such products Same as PBs Can undertake other financial activities like investment in VC Funds, equipment Leasing , Hire Purchase and Factoring,
Primary Dealership, Mutual fund (both Risk Sharing and Broking), insurance (both Risk Sharing and Broking),Portfolio Management Services, among other activities
Risk Management As applicable to commercial banks As applicable to commercial banks As per extant guidelines

Please let us know your thoughts/feedback on the above comparisons in the comments section below.


* The prudential frameworks for market risk and operational risk are being examined by RBI and the instructions in this regard are expected to be issued separately.