By the time this letter is published, you must have boarded the Mumbai-bound flight from Washington.

You are coming to Mint Road at a time when all macro-economic indicators are in the pink of health. The inflation rate is well below 4 per cent, interest rates are at their historic lows and foreign exchange reserves are over $85 billion.

There is plenty of liquidity in the system and the level of confidence of foreign institutional investors in Indian markets is very high.

As if these are not enough, earlier this week global rating agency Standard & Poor's raised the outlook on the Indian banking system from negative to stable. This is a recognition of an improvement in the quality of assets, higher profitability and better capital adequacy ratio of Indian banks.

In cricketing parlance, this is a dream pitch on which to bat. Before leaving for the International Monetary Fund last August, you had spent six years at the Reserve Bank opening up the money markets and simplifying some of the archaic banking rules and regulations, first as deputy to C Rangarajan and then to Bimal Jalan.

As RBI governor you will take a fresh guard on Saturday. The purpose of writing this letter is not to tell you what your agenda as the Reserve Bank governor should be (I wouldn't dare to do that) but to draw your attention to some of the realities of the financial markets in particular and the system in general.

Let me first draw your attention to the savings bank accounts, the only chained animal in the Indian banking system. After all the deregulation of lending and deposit rates, the savings bank account rate is still administered. It was cut by half a percentage point in February this year and the rate is now 3.5 per cent.

Why should all banks pay a uniform rate on savings account when all other deposit rates are free? Like term deposits, if savings bank deposit rates are left to the intermediaries, banks' cost of funds could come down substantially.

When most banks are paying around 5.5 per cent interest on long-term deposits (two years and above), a 3.5 per cent interest rate on savings deposits is certainly high because savings bank deposits are theoretically not stable deposits.

Instead of bringing it down further, ideally the rate should be left to banks. Those banks that need money can even pay a higher rate.

In this context, another question is: why can't the banks be allowed to pay different rates to different depositors? Currently, the banks have the freedom to earn different rates on their assets depending on the quality of borrowers but they cannot offer different rates to depositors. They should have the freedom to do so.

In rural areas where the branches are not computerised so transaction costs are higher, the banks should be allowed to offer less than what they offer to urban depositors. Let them have total freedom to do their own cost analysis and offer the liability rates accordingly at different locations.

There is little possibility of misusing the freedom and penalising the savings community because the competition will always keep all players on their toes -- both in terms of service as well as rates.

Another anachronism in the banking system is the stipulation on priority sector lending.

Banks need to allocate 40 per cent of their advances to small-scale, agriculture and so on. With the service sector playing a significant role in the economy, at least the composition of the priority sector needs some overhauling, if not abolished.

Credit delivery is another area where your attention is called for. Banks knock at the doors of triple-A rated companies and offer them money almost free but the small –and-medium enterprises and lower rated companies are still finding it difficult to raise money from banks.

It's true that interest rates are at historic lows but the wave of low rates has not been able to touch certain segments of industry as yet.

Bankers are wooing salaried people in Mumbai with home loans at below 8 per cent interest rate but a coffee grower in Karnataka still finds it difficult to get bank loan at a reasonable price.

We know that the financial system cannot be democratic and treat all borrowers equally but what's the point in reducing the rates if all sections of the borrowers do not get the benefit? What we are seeing today is unique: small borrowers subsidising the rates for big borrowers!

Talking about the rates, there are many disconnects in the system. First, the yield curve is flat. The cost of overnight money is 4.5 per cent, one-year (364-day treasury bill) around 4.65 per cent and 10-year 5.25 per cent.

Secondly, there is vast difference between one-year rupee assets and the one-year implied rupee rate curve (dollar asset on a fully-hedged basis). And, finally, the entire interest rate architecture is sharply divided between market rates and the rates for the economy!

The division is led by two benchmark rates -- the repo rate and bank rate. While the bank rate is perceived to be a benchmark for lending rates of banks, the repo rate is emerging as an anchor for all market rates including the deposit rates.

Converging all these rates will face a lot of structural hurdles but I am sure you will look into this aspect. Three years ago, as the head of the panel on small savings, you charted out the path for reducing administered rates. Logically, convergence of all interest rates is an extension of that exercise.

Another task before the Reserve Bank is bringing down the reserve requirements of banks -- both the cash reserve ratio as well as statutory liquidity ratio. The CRR is now 4.5 per cent and it can be brought down further to 3 per cent but the SLR cannot be brought down below the present level (25 per cent) without amending the RBI Act.

Even if you take the initiative to bring down the SLR, banks may continue to hold huge gilt portfolios (currently about 40 per cent against the stipulated 25 per cent) as this is the safest bait.

So they must be encouraged to lend. A sharp adverse interest rate movement can take the bottoms out from some of the banks that have piled up huge gilt portfolios.

The present Reserve Bank regulation on the creation of investment fluctuation reserve alone cannot absorb the shock. That is because it does not take into account the maturity profile of the gilt portfolio, so it is not an ideal instrument to ward off the market risk.

The financial markets know you as the man who talked the rupee down (they will remember the Goa speech on August 15, 1997, where you said: "As per the real effective exchange rate, it would certainly appear that the rupee is overvalued..."). You were key to debt market reforms and the introduction of the liquidity adjustment facility, which redefined the overnight call market and made the defunct repo a potent liquidity management tool.

This time around, please take a look at the derivatives market. Interest rate swaps, introduced a few years back, are gaining in turnover but interest rate futures and rupee options are not showing any signs of promise. In fact, the August turnover of interest rate futures is zero!

It is also high time the Reserve Bank of India reconsidered the short-selling of government securities. This is a political issue but with checks and balances short selling of gilt must be reintroduced (it was banned in the 1960s) if the central bank wants the debt market to deepen. In the absence of this, it's only a one-way market for gilt where the players thrive only when the interest rates drop.

Finally, banks should also be allowed to enter new areas like commodity futures. Till now they can only trade futures in precious metals. Once they are allowed to play in the futures market for tea, coffee, cotton and even electricity, it will not only open new business avenues for banks but also improve their quality of assets since farmers can hedge their positions by buying options from the banks.

I believe even the US Fed had its reservations against banks' entry into commodity futures but the Office of the Comptroller of the Currency there supported this.

C Rangarajan was known for launching regulatory reforms. Your immediate predecessor Bimal Jalan took the reforms process forward to markets zone and lent stability to the financial system to withstand the shocks of the east Asian crisis and US sanctions in the aftermath of the Pokhran nuclear blast.

There is no trade-off between stability and progress. It's perhaps time to experiment a bit. Don't push and nudge. Shake the system, Dr Reddy. No more hand-holding for the banks and the markets. Give them total freedom. Let them prove that they are mature enough to deserve it.

Yours Sincerely,

Tamal Bandyopadhyay

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