Exclusive | ‘Ours is a hybrid approach, moving increasingly towards principle-based regulation’: RBI Governor

On August 5, you said there was no proposal to close the FCNR(B) swap window prematurely. Nine days later, the RBI advanced the deadline by a month. What changed so materially during those nine days?

Advancing the last day of the swap window for FCNR(B) deposits is a well-thought-out, calibrated, prudent and data-driven response to the evolving situation. The second thing I would mention is that it is from a position of strength. From all three schemes put together, we expect inflows of at least $80 billion. This reflects the strong macroeconomic fundamentals of our country and would also further strengthen our balance of payments.

In early August, we were still assessing the situation, which was evolving very fast. However, the possibility of an early closure was not ruled out. I would like to highlight the use of the words “as of now” when I mentioned that there was no proposal to advance the last date. I would also like to draw your attention to the fact that it was mentioned that we would keep you informed of a decision, clearly implying that an early closure was not ruled out.

Subsequently, as we continued to monitor the external position and the inflows, we considered it appropriate to advance the date. You will appreciate that the flows have been stronger than we expected and even stronger than what most market participants expected. One also needs to remember that there is diminishing marginal utility from every dollar that is swapped. At the same time, there is an increasing marginal cost because you need to sterilise it for a longer period. The announcement may appear sudden, but the time given is more than two weeks, and we believe that it is sufficient for all participants to make the necessary arrangements and benefit from the scheme during the remaining period.

Critics have called this a policy U-turn and questioned whether the likely scale of inflows—and their impact on liquidity and the rupee—was inadequately assessed. How do you respond?

It would not be correct to call it a U-turn; it is a calibration. It should be seen as the ability of the central bank to be flexible in its approach and data-dependent, based on rapidly evolving conditions in these uncertain times. The underlying objective of the facility remains the same: to attract foreign currency assets and further strengthen our external sector. The decision regarding the closure of this temporary facility is therefore part of external-sector management.

What is the estimated cost—or contingent liability—to the RBI over the three-to-five-year maturity of the swaps, and how will it ultimately appear on the central bank’s balance sheet?

The foreign currency assets that we receive through the swaps will be shown as foreign currency assets on our balance sheet, so they will expand our balance sheet. The forward leg will be shown as a contingent liability and will therefore be an off-balance-sheet item. Overall, we believe that the net impact will be positive. However, it is difficult to accurately assess and calculate the costs and benefits because there are so many parameters to consider, and these themselves evolve over the swap period with broader macroeconomic and geopolitical developments.

The rupee has depreciated substantially over the past year, while the RBI’s net short forward-dollar position has risen to a record level. Is the growing use of forwards a deliberate structural shift in the RBI’s intervention strategy, and are there limits to how large that position can safely become?

The net forward position that we have right now is very manageable. It is primarily on account of the swaps that we undertook earlier to infuse liquidity and those undertaken now to strengthen our balance-of-payments position. The exchange rate continues to be market-determined. Our policy on intervention remains the same: to curb excessive volatility and any undue speculative activity. We are committed to ensuring orderly financial conditions and, at the same time, orderly movements in exchange rates.

The RBI has raised its FY27 growth forecast to 6.7% and lowered its inflation projection to 5%, yet monetary policy remains on hold. What is the principal constraint today?

The inflation-growth dynamics when the MPC met in August were more or less similar to those at the June policy meeting, with marginal changes—the inflation projection was lowered by 10 basis points and the growth projection raised by 10 basis points.

It is important to understand that a monetary response to a supply-driven shock is warranted if there is a broadening or generalisation of inflation, a de-anchoring of inflation expectations or persistent inflation. On all three counts, the MPC felt that there was limited evidence. Headline inflation, while elevated, was primarily due to supply shocks and limited to food and fuel. There were also limited signs of its generalisation, as could be seen from the core inflation data. Similarly, inflation expectations, though slightly higher, remained contained. Moreover, high inflation is expected to moderate from its peak in Q3. The shock, therefore, did not warrant a monetary response to curtail demand when the MPC met.

At the same time, the MPC noted signs of inflation normalising from the benign levels seen hitherto. I would like you to recall that average inflation last year was only 2% when the policy rate was reduced to 5.25%. Since then, headline inflation rose to 3.9% in the first quarter. Moreover, underlying inflation, as measured by core inflation excluding precious metals, is expected to align with core inflation in Q4 of this year. Thus, there is a normalisation of inflation in this financial year, especially towards the end, which may suggest a recalibration of policy rates. However, the MPC decided to wait for greater certainty, especially regarding the inflation trajectory and the level at which inflation may settle, before recalibrating the policy rate to ensure an appropriate real interest rate.

The MPC also felt that it should remain watchful for any generalisation of inflation or de-anchoring of inflation expectations that could warrant a response to curtail demand.

I must mention that while it is primarily the domestic macroeconomic situation and inflation-growth dynamics that determine our monetary policy, global macroeconomic conditions and geopolitics also have a bearing on the Indian economy. We are watchful on that account. Going forward, we will monitor the inflation trajectory, the level at which inflation settles, any generalisation of inflation and any de-anchoring of expectations before moving forward.

In monetary policy, you have mentioned that El Niño and the monsoon are matters of concern. Is that still the case?

The rainfall deficit is currently about 12.6% from the normal level, and net sowing is 2% lower than last year. However, we have sufficient food buffers. The government has been very proactive in managing the supply side. Agriculture itself has become more resilient to monsoon-related uncertainty and volatility because of better agricultural practices, the use of drought-resistant crops and seeds, and a larger area under irrigation. While the risks remain, we are watchful, and they will obviously be taken into consideration in our policymaking.

You have repeatedly stressed financial stability. Where do you currently see the greatest pockets of vulnerability?

The system-level financial parameters of banks and NBFCs continue to be strong and robust. Banks have a CRAR of almost 18%, a liquidity coverage ratio of about 127%, a GNPA ratio of 1.7% and an NNPA ratio of 0.4%. Our stress tests, which we conduct twice a year, indicate that even under highly adverse conditions, all banks will remain resilient and have sufficient capital to absorb those shocks.

As of now, we do not see any vulnerability in any particular sector. We are watchful, and our supervision team is alert. We continuously monitor developments in all major regulated entities on a real-time basis as well as through off-site supervision. There are no major risks developing at the systemic level.

Bank balance sheets are considerably stronger, but deposit growth has often struggled to keep pace with credit. Is India approaching a structural funding constraint that could limit credit growth, and do banks need to rethink deposit pricing more fundamentally?

This is an often-asked question. Let me make a few observations. First, every rupee of credit creates a rupee of deposit. If you look at the data in absolute terms, you will find a more or less one-to-one relationship between credit and deposit growth. The growth rates, however, are different. Deposit growth is lower because the deposit base is about 25% larger, given that credit-deposit ratios are around 80-82%. That is why the rate of deposit growth is lower than that of credit.

The amount of credit that banks can provide depends on their capital. The CRAR, as I mentioned earlier, is almost 18%, well above the norm. The other factor determining their ability to provide credit is the reserves and system liquidity that we provide. System liquidity is ample today.

Banks can, of course, be constrained by their own liquidity because of the LCR requirements. That can constrain them to some extent. But the LCR today is 127%. As of now, banks are not constrained in providing more credit.

The nature of deposits is changing, with a large share of retail deposits moving towards money markets and capital markets. This has implications for liquidity and decreases the money multiplier without impeding banks’ ability to create money and provide credit.

The RBI has increasingly favoured principle-based and harmonised regulation. Banks, however, sometimes argue that frequent regulatory changes raise compliance costs and reduce predictability. How do you strike the balance between regulatory agility and providing institutions with a stable rulebook?

Our approach to regulation-making has been to make it proportionate—proportionate to the risks and the capabilities of regulated entities. It has been prescriptive, of course, but is moving increasingly towards principle-based regulation. While we have hybrid regulations, both principle-based and rule-based regulation have advantages.

Rule-based regulation can create a culture of creative compliance and a tick-box approach. At the same time, it may require more frequent changes as experience increases, the economy grows and the financial system evolves.

A principle-based approach has the advantage of not needing to be adapted too frequently. However, it can suffer from interpretational issues and inconsistent application across regulated entities. It can also increase compliance costs because banks must formulate their own policies for prudential reasons.

Our approach is therefore a hybrid one, moving increasingly towards principle-based regulation. The effort is to be transparent, give regulated entities sufficient time and guide them towards prudent management and better customer conduct.

You have said AI could do for lending what UPI did for payments, while warning that it could erode human judgement. In practical terms, which banking decisions should never be left entirely to an algorithm?

AI has the potential to improve the speed, quality and consistency of decision-making by regulated entities. It has great scope for application. We have always emphasised that it should be used to facilitate decision-making and not to eliminate or replace human judgement entirely.

The use of AI should have adequate human oversight, especially in areas involving high risk, high impact, material customer outcomes or implications for the financial soundness of the entity or the system. Particular use cases can include credit appraisal, risk management and legal compliance. In all areas, AI should be used as a facilitative technology and not as a replacement for humans.

As India explores linking fast-payment systems and CBDCs with other BRICS countries, what is the realistic objective?

First, we are looking to make cross-border payments across countries cheaper, more accessible, safe, secure and fast. That is the primary purpose and is also the G20 objective.

If payments in local currencies become easier, it is possible that this will promote the use of local currencies, including the Indian rupee. However, that will depend on several other factors, including the openness and depth of our financial system and the scale and nature of capital flows, trade-related flows and remittances.

The purpose is not to replace any currency. It is to diversify, make our system more resilient and give customers more options and choices.

The bank-board governance framework was recently released, with the guidelines shifting from a prescriptive agenda to a flexible, principle-based model. Does giving boards greater flexibility also raise the bar for accountability—particularly if governance failures occur in areas that the board chooses to delegate?

The board has ultimate responsibility for the bank’s strategy, financial soundness, governance and risk management. While it can delegate operational functions to management, accountability for these broader areas remains with the board.

This is in line with internationally accepted governance principles. The idea behind this reform is to ensure that boards have sufficient time to dwell on strategic issues rather than operational ones.

The Prime Minister has spoken about the ambition of having an Indian bank among the world’s top five. What, in your view, would Indian banks need to do differently to achieve that global scale and competitiveness?

Indian banks certainly have the scale and ability to achieve a larger global footprint. They are on the right path. They will have to continue improving governance and institutional strength, building a sound risk-management culture, sustaining good customer service and retaining customer trust.

They need to invest continuously in technology, reduce costs, improve efficiency, expand their reach and enhance the customer experience. At the same time, they must continuously train and equip their human capital to adapt nimbly to a growing economy and a fast-evolving financial system.

If they continue doing these fundamental things, I believe it is only a matter of time before they are among the world’s top banks.

But do you think a merger would be the faster way to get there? Would that take us there more quickly than relying on a standalone bank?

I think what we need is a good, strong banking system with healthy competition. The government merged a few banks earlier. Whether there is a case for further mergers is a call the government can take.

Upper-layer guidelines have been issued, yet there has been a lack of clarity over one company’s qualification for several years. This is leading to speculation. What is the RBI’s position?

We are not changing any regulations. This is an operational issue, and we would not like to comment on questions specific to an individual regulated entity.

Despite efforts to strengthen fraud detection and prevention, bank frauds remain a concern. What are the biggest gaps the RBI sees in banks’ fraud-prevention systems, and what more needs to be done?

Technology is changing the nature of fraud. Cyber fraud, unauthorised access and attacks on payment systems are becoming increasingly sophisticated. Banks and regulated entities therefore need to strengthen their early-warning systems and increase the use of analytics.

We also need to be more proactive rather than reactive. Because the nature of fraud is changing so rapidly, this must be a continuous effort rather than a one-time exercise. Finally, regulated entities will have to make greater use of technology while also building stronger human capabilities to effectively prevent and reduce such frauds.

There was a lot of chatter about Mythos, but things seemed to have calmed down within a few months. Has the focus shifted?

While we may not be talking about it all the time, we are working on it with our regulated entities and other stakeholders. The engagement includes building the capabilities of regulated entities, using technology and increasing customer awareness. It also involves giving them suitable guidance for improvement through our directions, regulations and inspection notes.