Regulation and Supervision: A few lessons

Regulation and supervision are much more complex than meets the eye. This post attempts to draw a few regulatory and supervisory lessons. This is against the background of a recent book by a well-known economist and former Governor, Reserve Bank of India.

A missing portrait

If one were to write the history of the Reserve Bank of India today, the midpoint would be May 1977. This was when the new Janata Government forced the resignation of K.R. Puri, the 12th Governor. M. Narasimham, his successor, has in his memoirs detailed the events that led to the resignation. After another change of government, a vindictive Puri would come back, as a one man Commission. His report faulted the conduct of gold auctions under the venerable I.G. Patel, among the most brilliant Governors of the Bank.

The portraits of the pre-1982 Governors of the Bank adorn its wonderfully wood-panelled Board Room in the old Central Office. This is now now called the Main Building. These end with I.G. Patel, the last Governor to occupy that office. Thereafter, the Central Office moved to the new building across the road in 1982. The portraits of I.G. Patel and his successors are on the 25th Floor of the present Central Office Building.

Occupying a room adjacent to the Board Room, for over a year, I noticed that only Puri’s portrait was missing. But, nobody seemed to notice, mind, or even talk about it. Appointed during the Emergency, allegedly at the behest of Sanjay Gandhi, most people consider his tenure the least inspiring. Perhaps, even the worst.

Dadabhoy (Barons of Banking, 2013), wrote that the portrait of Osborne Smith, the first Governor, was also missing for long. Someone added it later after obtaining a print from the Madras Office. Dadabhoy was probably quoting S.S. Tarapore, former Deputy Governor. He had a fund of anecdotes, and had guided Dadabhoy in the writing of the book. (More on Smith and Tarapore in later posts).

Governors and their memoirs

Out of the twelve Governors till Puri, only C.D. Deshmukh wrote his memoirs. Spouses of two Governors, Durgabai Deshmukh and Dhanvanti Rau, also wrote their memoirs. Both hardly covered the Reserve Bank of India. The first because she married Deshmukh after his Reserve Bank tenure. The second probably because she was busy with her own social reform activites. (Both are subjects for subjects for future posts.)

Out of the next twelve, four wrote their memoirs. These were M. Narasimham, I.G. Patel, Y.V. Reddy, and D. Subbarao. Manmohan Singh had a “strictly personal” memoir of sorts written by his daughter, Daman Singh, largely based on interviews with him. Two others, C Rangarajan and Bimal Jalan, have written extensively, but not yet a memoir. Raghuram Rajan published his select speeches as Governor, with a commentary. A new addition, though not a memoir, is “Overdraft: Saving the Indian Saver” by Dr. Urjit Patel, the 24th Governor. The book’s cover would remind one of the melting clocks in “Persistence of  Time” by Salvador Dali, the surrealist painter.


Unlike the books of other Governors, which covered either their entire life as in Deshmukh or Reddy, or only their tenure as Governor, as in Subbarao, this book is different. Its focus is on only one issue, that of NPAs, within what the author calls a “9R framework”. But, more than half the book are a few speeches, and a 2002 paper. Notwithstanding the narrow scope, a book by a former Governor will always command attention; such is the prestige that goes with the position.

Dr. Patel’s concerns regarding the NPA hangover from the financial crisis, need to untangle the web of opaque restructuring regulations, blanket agricultural loan waivers, and need for regulation to be ownership neutral, are unexceptionable. But, there are a few concerns, discussed below as twenty short comments.

Whose Rs are they anyway?

First, the book’s blurb claims that these problems “landed on the table of Dr. Urjit Patel when he became Governor,” and he started framing his 9R. Unless if this author got the dates jumbled up, the first 4Rs of Recognize, Record, Report, and Recovery, including the Asset Quality Review and establishment of the CRILC, the credit database, were completed by 2016, during the tenure of Governor Raghuram Rajan. Even the fifth stage of Resolution starts with the Insolvency and Bankruptcy Code, passed in May 2016, also during Rajan’s tenure.

Governor Rajan, incidentally, finds no mention in the book though he was, by consensus, the real R behind it all. Dr. Patel was then one of the four Deputy Governors, in charge of the research departments, and not the functions of regulation and supervision of banks or non-banks.

The sixth R relates to Reinforced Resolution, empowering the Reserve Bank to issue directions to banking companies to initiate an insolvency resolution process in respect of a default, under the provisions of the Insolvency and Bankruptcy Code (more on this later). The seventh is Recapitalisation. This process started not long after nationalisation, and has gone on for decades. The eighth R is that of Reset and Ring-fence. This period saw the issue of the contentious circular of 12 February 2018. The last stage of Reform, did not commence during Dr. Patel’s tenure, abruptly cut short by a resignation soon after completing two years.

On Regulation

Independence of supervisory function

Second, the theoretical rationale for central bank independence in monetary policy does not extend to banking regulation. Regulation and political processes are invariably intertwined for obvious reasons. This is particularly so when the executive delegates the function to an unelected agency without any assessment markers (Tucker, Unelected Power, 2018). In fact, such a messy relationship, which could overlap into the monetary policy function, to the detriment of the latter, is one of the reasons why some experts advocate separation of supervision from central banks. Even seasoned commentators and economists who move to the central bank do not appreciate this obvious lack of theoretical support for an independent supervisory function.

The third issue relates to the government directing the Reserve Bank of India, under Section 7 of the RBI Act, 1934, on certain regulatory issues. No regulatory or banking system can be better and more efficient than what the political system wants it to be. Beyond what is possible within the limitations of the law, the regulator can only raise red flags, and advise caution. This is especially so when it comes to government owned banks. Ultimately, in a democracy, the government is the one which is answerable to the people. The regulator cannot usurp powers without accountability.

Fourth, in the context of recent issues relating to NPA classification, regulation does not exist in a vacuum. In framing regulations specific to a country, due consideration to local legal, political, and institutional factors prevalent, including banking practices, are important.

Legitimacy of regulation

Fifth, participative regulation, where the regulator consults all stakeholders, also has greater legitimacy and better compliance. This was being followed since the late 1990s, when Governor Jalan’s tenure saw the introduction of the practice of putting reports and draft circulars in the public domain for comments. Further, almost every Committee had industry participation or consultation, so essential to enhancing legitimacy of regulation. But these were apparently missing in the process of framing some of the recent regulations.

Sixth, flexible regulation is not an oxymoron. Regulation that is responsive to specific situations and market practices will have greater legitimacy and better compliance. There is enough and more theoretical and empirical support for this. Dr. Patel himself, speaking in Washington (October 2017), endorsed such a responsive approach. What is kosher for a global audience also needs to be so in India.

Thus, the thirty-day review period from the date of missing a debt repayment is pragmatism, an acknowledgement that regulation is also a “social contract”. Defiant resistance despite nudges and public pleas finally resulted in the government issuing directions under Section 7 of the RBI Act, tying the Bank’s hands for the first time in its history. Shooting from the Bank’s shoulders might promote personal image building. But, it comes at a huge cost, and irreversible damage to an institution with almost a hundred years of history behind it.

The original sin

Seventh, requiring RBI to ask banks to refer individual cases to NCLT was the original sin. As a wisecrack put it long back, such case-to-case decisions have a tendency to become suitcase-to-suitcase decisions. This is a messy function, and is best located in the banks themselves or in government, but not in the central bank, so that the reputation and integrity of its other important functions are not compromised. This is why many central bankers preferred to keep supervision outside their remit, or in a body wholly distinct from other central bank functions.

On Regulators, and Supervisors

Eighth, a good regulator is less fastidious about regulatory design, and more concerned with policy outcomes, best achieved through appropriate incentives, as discussed below.

Cautioning banks

Ninth, Dr. Patel writes that “regulator’s inspection reports rarely cautioned banks to the extent required about the high credit growth, which was running well ahead of real growth.” The reality is otherwise. The Bank’s inspection reports invariably start with comments on this issue. This was the case even when this author started inspecting banks more than three decades back. Fast growth in credit is an early indicator of inherent weaknesses, as problem banks try to outgrow their issues. But, the individual bank regulator will always have a microfocus on the bank that is his immediate concern. Moreover, the macro picture is what the department’s Central Office, or the financial stability function, has to make out based on all such inspection reports and an array of other inputs.

Regulation vs. Supervision

On this issue, Dr. Patel uses regulation and supervision interchangeably. For the sake of clarity, the regulator lays down regulations, and the supervisor monitors the financials of regulated institutions and the quality of compliance with regulations. In some countries, the two functions could be in different institutions. Thus, there can only be supervisory reports on banks, and not “regulator’s inspection reports”.

Thankless task

Tenth, while blaming regulators (and supervisors) for lapses, it is worth quoting Prof. Charles Goodhart of the London School of Economics (and earlier, the Bank of England), incidentally Dr. Patel’s alma mater. In one of my favourite and oft-used quotes in my writings and presentations over the years, Goodhart wrote that “regulation and  supervision is a thankless task. The best  that can  be hoped for is not to be noticed. Failures  become  immediate  public knowledge  and  engender heaps of  blame, whereas successes are unknown, unrealised and unappreciated.” (Goodhart et al., 1998). In other words, whenever a supervisor is in the news, it is invariably for the wrong reasons. Hence, the hope not to get noticed.

Expertise in supervision


Eleven, the Bank has a large pool of officers who are highly competent in framing regulation and conducting supervision. They honed their skills the hard way in all grades, acquiring specialised knowledge through experience, training (including at commercial banks), and by acquiring additional qualifications. Unfortunately, they are not all placed in the right places. The regulatory and supervisory departments need to be staffed with them at all levels. For starters, how about insisting on a CAIIB/JAIIB, or its equivalent, at all levels. It is not a great exam, but it is still a pons asinorum, which most bank clerks clear within two years of joining a bank. An added measure could be to ensure that officers have worked in regulation/supervision in the lower rungs of the department for sufficiently long periods, before they are eligible to work at higher levels.

These steps will hopefully obviate the need to clarify regulations after they are issued. They would also ensure fair treatment, as in the recent case of subordinated debt holders. Most important, they will ensure that regulations are aligned to market practices thereby enhancing their legitimacy. Not to forget, they will also avoid instances of humiliating climbdowns after a regulatee takes the regulator to court.

Talking down

Twelve, on a related point, it is necessary not to talk down the skills and abilities of the Bank’s officials, especially those who inspect banks. They always work under trying circumstances and against impossible deadlines. There have been instances of officials suffering heart ailments under such pressures. If there have been some lapses, the reasons are often found in, as said earlier, having the wrong person in the wrong place. I have seen officers who would have been brilliant in certain other functions becoming completely out of sorts working in the supervisory area.

But, the saving grace is that such views are limited only to those who make top-level lateral entries to the Bank, especially those from the academia. They are not familiar with the realities of bank inspections. Such talk downs can only serve to promote the disastrous idea of lateral entries, unjustified in most cases, and outsourcing opinions when there are excellent inhouse experts.

Notwithstanding such outlier views, most speeches, comments, writings, and reputation are built on the hard work of these same hapless inspecting officers. This includes the Asset Quality Reviews conducted during Governor Rajan’s tenure. (More on AQRs below)

Square pegs in round holes

This is not to deny that an insensitive administration excels in putting square pegs in round holes. This is an issue tackled effortlessly by exceptional leaders like Dr. Y.V. Reddy. He could reach out to staff several layers his junior, all the time maintaining the utmost of courtesies (more on this in a separate post). This is in stark contrast to the approach of certain others who consider interacting with an officer even one level junior so repugnant that they forget the basics of civil conduct.

Soft regulator?

Thirteen, flowing from the above, what attracted my attention is a comment by Dr. Patel that “High professional integrity notwithstanding, the RBI’s reputation has been that of a soft regulator…” In a highly centralised organisation such as the Reserve Bank, blame if any for being a soft regulator, has to be borne by the top management. Take for instance, the Joint Parliamentary Committee Report of 1992. It had looked into irregularities in government securities transactions, popularly known as the Harshad Mehta scam. The JPC recorded that the Bank’s inspection reports contained enough information and material for early action.

Government ownership of banks

Fourteen, Dr. Patel states that “the original idea behind bank nationalization was complete government control over credit allocation to the economy, the situation in India is exactly the reverse: the RBI’s regulatory powers over GBs are weaker than those over the PBs.” (Italics as in original. GB and PB refer to government and private banks respectively).

There is the contentious aspect of this observation as to whether private banks are safer than government banks even though controls are weaker? Much has been written and spoken about this, and is an issue for a separate discussion. An equally relevant point is the objective of nationalisation. This was more about control of the “commanding heights” (please refer Indira Gandhi’s famous speech on the issue), taking banking to the masses, and to unbanked areas, and not “complete government control over credit allocation to the economy” as stated.

Fifteen, demands for more regulatory powers over government banks, on par with private banks, are reasonable. But, it needs to be strengthened by a demonstration of exercise of existing powers. Some recent experiences have not been encouraging. For instance, there are questions over why several powers in the statute were not used, or used quite late in the day, in the case of the erstwhile Global Trust Bank, or even the more recent case of YES Bank. (These will be discussed in separate posts).

Sixteen, misgivings about malfeasance in bank conduct should also be ownership-neutral. It should not be restricted to government banks. It begs questions as to the adequacy of regulatory responses to recent corporate governance failures in private sector banks. 


Individual vs Organization

Seventeen, Dr. Patel draws on the work of Gary Becker to devise a conceptual framework to understand preventive, detective and punitive vigilance (p. 94). Becker provides a simple crime-and-punishment framework which is more relevant for individuals. Such a narrow economic prism is insufficient in examining compliance by individuals. Studies of wrongful behaviour has become multidisciplinary at least from the 1970s. In the case of organizations, it is much more complex. Actions of organizations, especially in matters of credit, is the sum total of actions of hundreds of individual players, who in turn might interpret and restate regulation in their own unique ways.

Therefore, a narrow economic prism based on the basic Gary Becker framework is insufficient and outdated in dealing with financial crime and challenges of preventive vigilance. One needs to also draw lessons from, among others, new institutionalism and behavioural economics (Williamson, Akerlof, Thaler, etc.). Modern compliance theory, at least since the early 1980s, therefore draws from a multidisciplinary perspective covering, among others, psychology, sociology, new institutionalism, behavioural economics, political science, and even game theory.

Enforcement function

Eighteen, the Bank should consider placing enforcement closer to the supervisory vertical. Only then can a supervisor appreciate and give credit for extenuating circumstances, despite which violations occur. Only then will it be in line with best practices. Enforcement action divorced from a supervisory philosophy that recognizes the contexts of violations, is fated to become a blunt-edged weapon, and an early failure. The regulatees would soon consider periodical penalties as mere cost of doing business, another variable in their risk models.

Chekhov’s gun

Nineteen, Dr. Patel draws on Chekhov’s gun to justify enforcement action in the face of noncompliance. He says that the rifle shown above the mantelpiece in Act I should go off by the end of Act V. In our context, he implies that a regulation should lead to penalties sometime later. Thankfully, enforcement is not play acting. Chekhov, the great Russian author, has been misunderstood in this quote. What he meant was the reverse, in terms of both sequence and causality.

In other words, if a rifle were to go off in Act V, it should have been shown above the mantelpiece sometime earlier in the play, say, in Act I. Otherwise, it would become a case of what is called the deus ex machina, literally God from the machine. This was a literary device used in earlier Greek plays, as in Sophocles and Euripides, where complicated plots are conveniently resolved and brought to a close with God descending from a machine lowered onto the stage. Such contrived plots no doubt became unfashionable. They lost out in public imagination long before Chekhov’s time. (I will elaborate this in a later post on Chekhov’s gun)

Nature of compliance

Compliance is best achieved without even having to show the rifle, let alone use it. Prof. Hart, the great legal philosopher, called this “voluntary co-operation in a coercive system.” (Hart, The Concept of Law, 1961). The modern enforcement approach, over the last four decades, has been more nuanced and graded, starting with advisories and caution, escalating up to warnings and sanction with prolonged noncompliance. This approach resonates with Kautilya’s sama, dana, bheda, and danda, laid down in his Dandniti, which forms part of the Arthashastra. Research (including by the present author) shows that blind imposition of penalties can be counterproductive when dealing with organizations, especially when the regulation lacks legitimacy. That explains Dr Patel’s surprise at penalties being ineffective.

Final comment

Lastly, banking regulation and supervision is not a floor for flair and flamboyance. Only a novice would imagine himself swinging open the batwing door of the saloon, shooting everyone in sight, and blowing down the barrel of the smoking gun. The Bank had done AQR-like inspections in the past, in a localised manner (as in the 60s and 70s), or coordinated across the country (more recently, from the Harshad Mehta scam onwards). But, discretion was always key. Chest thumping and self-serving speeches unsettle the markets or worse, trigger runs on banks. The media glare and prime time hearings that went with AQR meant that the normal processes of strategic compromises, where bankers accept less but certain money today in place of a bigger but uncertain amount at a later date, became impossible.


One would have expected the book to be comprehensive, covering contentious issues like, say, demonetisation, filling gaps in understanding, providing new perspectives, leaving the reader better informed. On the other hand, the thrust is on showing how situations were bad before Dr. Patel came on the scene, and how it has been deteriorating, ever since he left. As the French say, Après moi, le déluge! Sadly, even the humour, rather attempts at it, falls so flat that it is difficult to differentiate it from more serious comments.


That brings me back to Dali. The cover of the book had reminded me of his painting. Dali was always original even in his eccentricities. He wrote in his autobiography that he himself was writing his story because someone had to write it one day. Anybody else would have made a mess of the job. I cannot help adding, as an aside, what else he wrote: “Of course, all will not be said today. There will be blank gaps … certain years and certain days will remain unpublished for the time being. Democratic societies are unfit for the publication of such thunderous revelations as I am in the habit of making.” Dali was an explosive, eccentric genius. This digression is, of course, for the benefit of those who might never get to read Dali.

The last time I was on the 25th Floor of the RBI Central Office was in January 2019. This was a month after Dr. Patel’s resignation, and about a month before I opted for early retirement. I noticed that Dr. Patel’s full length portrait had already found its place. Seeing me look at the painting, a mischievous person suggested that the sittings for the portrait might have delayed an imminent resignation.

I understand that miniature portraits of all Governors, including that of K.R. Puri, are in the Governor’s lounge on the 18th Floor of the Central Office Building. Nevertheless, in the interest of completeness, and with no misgivings towards anyone, especially one who passed away decades back, it is only fair that the Reserve Bank of India now commissions a full-length portrait of K.R. Puri, and places it in the old Board Room.


This started as a book review. As it grew in length, I could not publish it as a review. I plan to elaborate on several references to different aspects of regulation and supervision in future posts.

© G. Sreekumar 2021.

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