As India steps into 2026, the macroeconomic moment appears unusually favourable. The Governor of the Reserve Bank of India has described the country as a “Goldilocks” economy — strong growth without runaway inflation. With labour reforms largely behind us, attention is shifting to a harder, more structural challenge: lowering the cost of capital by deepening India’s financial markets. This, however, requires confronting a long-standing and uncomfortable truth — the tangled institutional relationship between Mint Street and North Block.
Why RBI–government ties matter for financial deepening
India’s financial system has not evolved as deeply as its growth aspirations demand. Private credit remains constrained, bond markets are shallow, and banks dominate intermediation. A major reason lies in the overlapping and often conflicting roles shared by the RBI and the Ministry of Finance (MoF). These overlaps weaken regulation, distort incentives, and ultimately raise the cost of capital for businesses.
The relationship is often likened to a traditional marriage — stable, inward-looking, and resistant to reform — where disagreements are settled privately and structural change is avoided, even when dysfunction is evident.
Public sector banks: regulator versus owner
The most visible conflict arises in the oversight of public sector banks (PSBs). While the RBI regulates banks, the government owns PSBs, appoints their leadership, and issues policy directions. Unlike private banks, whose CEOs must clear the RBI’s “fit and proper” test, PSB chiefs ultimately answer to the MoF, not the regulator.
This dual control has repeatedly proven problematic. The fraud at Punjab National Bank involving Nirav Modi and Mehul Choksi in 2018 exposed how weak oversight can become when accountability is blurred. Since FY2015-16, PSBs have written off loans worth nearly ₹12 trillion, signalling persistent governance failures. RBI officials sitting on PSB boards further complicates matters, making the regulator part of the very decisions it is supposed to supervise.
An old reform blueprint still gathering dust
These concerns are not new. The recommended over two decades ago that RBI officials should not sit on PSB boards and that boards should be professionalised. Yet, successive governments and even sections within the RBI have been reluctant to implement these changes, preferring administrative convenience over regulatory clarity.
Debt management and monetary policy: a built-in conflict
A second, deeper conflict stems from the RBI’s role as the government’s debt manager. As manager of public borrowing, the RBI has an incentive to keep interest rates low to reduce the government’s borrowing costs. As a monetary authority, however, it is tasked with controlling inflation and ensuring financial stability — objectives that may require higher rates.
This conflict has concrete consequences. To ensure steady demand for government bonds amid large fiscal deficits, India relies on the statutory liquidity ratio (SLR), forcing banks to hold government securities. Though reduced from 40% in the 1980s to about 18% today, India remains among the few countries still using this instrument, alongside Bangladesh and Pakistan. The result is financial repression: private credit is crowded out and corporate bond markets struggle to develop.
Shallow credit markets and missed growth
India’s private credit-to-GDP ratio hovers around 50%, far below peers such as Vietnam, Thailand, and Malaysia, where it exceeds 100%. This gap is not merely statistical — it reflects lost investment, slower innovation, and higher financing costs for firms. The RBI’s dual role in regulating and trading in government bond markets further complicates reform, especially since the regulates corporate bonds, creating fragmented oversight.
Reforms announced — and quietly reversed
Twice, in 2007 and again in 2015, finance ministers announced plans to shift public debt management out of the RBI to a dedicated National Treasury Debt Office. Both times, the proposal was withdrawn without clear explanation. Although a debt management unit exists within the MoF today, even the Comptroller and Auditor General has flagged weaknesses in its functioning. The core conflict remains unresolved.
Fiscal dominance and its hidden costs
Former RBI Deputy Governor has described this condition as “fiscal dominance” — where high government borrowing needs constrain monetary policy. His work shows how it weakens monetary transmission, crowds out private investment, and slows the deepening of financial markets.
Why 2026 is the right moment
The current macroeconomic context offers a rare window for reform. Inflation is below the lower bound of the flexible inflation targeting regime, growth is resilient despite global shocks, and interest rates have already been reduced. There is no pressing need for fiscal stimulus. Instead, the upcoming Budget presents an opportunity for fiscal consolidation and institutional clarity.
Removing or further reducing the SLR would be a strong starting signal — forcing harder budgetary choices while freeing capital for private investment.
What to note for Prelims?
- Roles of RBI and Ministry of Finance.
- Statutory Liquidity Ratio (SLR).
- Narasimham Committee recommendations.
- Concept of fiscal dominance.
What to note for Mains?
- Conflicts of interest in RBI–government institutional design.
- Impact of SLR and public debt on financial deepening.
- Challenges in regulating public sector banks.
- Link between fiscal consolidation and monetary autonomy.
