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Structure of Indian Financial System:

Central Bank of the Country (RBI in

case of India)

Cooperative

Societies

Other

InstitutionsCommercial

Banks

Public

Sector

Pvt.

Sector

State

Coop.

Land

Dev

Banks

Pub

SectorGov

Pvt.

Sector

SBI & As

Nationalised

Banks

RRBs

Foreign Banks

Non-Scheduled

Banks

NSC, PO, EPF

LIC, GIC, UTI,

EXIM Bank, IDBI,

IFCI, IRBI,

NABARD, SFC,

SIDBI, STCI, etc.

Chits, Nidhis,

Corporate

bodies, Hire

Purch Cos.,

Investment Cos,

Merchant

Banks,

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CENTRAL BANK

• It is the APEX monetary institute in the money market

which acts as the monetary authority of the country

and serves as the Government‟s bank as well as the

bankers‟ bank.

• In brief, we may say that the central bank is an

organ of the Government which, by reason of its

operations influences the working of the FIs of the

country.

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How does the Central Bank differ from

other banks?

Is a Government Organ

It does not exist to secure maximum profit

Have a special controlling relationship with the

commercial banks

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General Functions of The Central Bank:

Issue of Currency Notes: Issued on the basis of minimum currency reserve system.

Acts as Government Banks: Collection and disbursements

Mgt of public debt and issue of new loans and treasury bills

Temporary advance to Government in anticipation of collection of taxes

Government‟s financial agent

Advisor to Government regarding Monetary and Fiscal Policies

Acts as Banker‟s Bank Holds certain portion of deposits of commercial banks

Extends financial facilities to CB when there is a crisis

Acts as a bank for central clearance

Foreign Exchange Monopoly power to control and regulate foreign exchange

The Main Function of Central

Bank is to Regulate the Monetary

Mechanism comprising of

currency, banking and credit

system.

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THE

RESERVE BANK OF INDIA

Mint Road, Mumbai

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Historical Perspective

• The origin of RBI in 1935 was the culmination of a long series of efforts.

• The earliest effort to set up a central bank dates back to 1773 when WarrenHastings, the Governor of Bengal recommended the establishment of a“General Bank in Bengal and Bihar.”

• The next attempt was made in 1807-08 when Robert Richards, a member ofthe Bombay Government submitted a scheme for a General Bank… but theGovernor General was not impressed.

• Again in 1931, John Maynard Keynes – A member of Royal Commission onIndian Finance and Currency submitted a memorandum entitled “Proposal forthe establishment of a State Bank of India” which was to perform bothCentral Banking and Commercial Banking in India. But due to the outbreakof the First World War this could not be implemented.

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Bank of Bengal 1806-1921

Bank of Bombay 1840-1921 Bank of Madras 1843-1921

•The First Major step was taken in 1921 when the three Presidency Bankswere amalgamated to for the Imperial Bank of India. It was primarily acommercial bank but also performed certain central bankingfunctions.(But note issue and Foreign exchange were the directresponsibility of the Central Govt.)•In 1926 the Hilton Young Commission recommended that the dichotomyof the functions and divisions of responsibility should be ended. Itsuggested the establishment of a central bank to be called as RBI.•Accordingly the gold standard and the RBI Bill was introduced in thelegislative assembly in Jan 1927 but was dropped on account of sharpdifferences.•The Indian Constitutional Reforms in 1933 made it obligatory that thetransfer of responsibility from the British Govt. in India to Indian handswas dependent on the establishment of the RBI. These events led to theintroduction of a fresh bill in Sept. 1933

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• The Governor General gave his accent on 6th March 1934 and

RBI was constituted in accordance with the provisions of the Act

containing 58 sections and was inaugurated on 1st of April 1935.

• The RBI was constituted as a shareholder‟s bank with a fully paid

up capital of Rs. 5 Crores divided into shares of Rs. 100 each. Of

these 5 lakh shares, 2200 shares were subscribed by the directors

of the bank and the remaining by the Pvt. Shareholders.

• In view of the need for close integration between bank‟s policy

and those of the government, the question of state ownership

surfaced time and again. But it was only after independence that

the decision to Nationalise the bank was taken. In terms of RBI

(Transfer to Public Ownership) Act, 1948, its entire paid up

capital was transferred to Central Govt. on 1st of January 1949

when it became a state owned institution.

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Its Organization Structure and

Management.

• The OS of the RBI consists of the central board andthe local boards.

• The RBI is managed by the Central Board ofDirectors comprising 20 members . There is oneGovernor who is the executive head and is assistedby 4 Deputy Govs. They are all appointed by theGOI for a period of 5 years.

• 4 Directors are nominated by the CG one eachfrom the four local boards situated in Mumbai,Kolkata, Chennai and New Delhi.

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• In addition the Central Govt. nominates 10 directors who are expertsfrom various fields and are appointed for a period of 4 years.

• The 20th member of the board is one Govt. official who is usually theSecretary Ministry of Finance nominated by the Central Govt. .

• The Govt. official and the 4 Deputy Gov. do not have the right tovote in the meetings of the board. All powers of the bank is vestedon the central board of directors.

• It must hold at least 6 meetings in year and at least 1 in 3 months.

• There are 4 local boards with headquarters at Mumbai, Delhi,Kolkata & Chennai representing Western, Northern, Easters &Southern regions respectively. The Central Govt. nominates 5members on each local board for a period of 4 years. The chairmanis elected from among the members and the manager of the RBIoffice in a region acts as the ex-officio Secretary of the local board.

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The head office of the RBI is at Mumbai having 16

departments such as the banking, Issue, Currency

management, Exchange Control, Industrial Credit,

Agricultural Credit etc..

The bank has 15 offices and 2 branches in different

parts of the country. Where the RBI has no office or

branch, the SBI and its 7 associates acts as its agent

or sub agent.

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To Promote monetisation and monetary integration of the economy.

To manage currency and regulate foreign exchange

To institutionalise savings through promotion of banking habits

To build up a sound and adequate banking and credit structure.

To evolve a well differentiated structure of institution purveying

credit for agriculture and allied activities.

To set up or promote several specialised FIs at all India and regional

levels to widen facilities for term finance to industry

To lend support to planning authorities and Govt. in their effort to

accelerate the pace of economic development.

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Functions of RBI

• Traditional Function

– Issue of Currency (200crg+Fex-115g)

– Banker to Government (

– Banker‟s Bank

– Exchange Management and control

– Control of Credit

– Collection and Publication of Data and Report

– Training Facilities

• Promotional & Developmental Functions

– Agricultural Finance

– Industrial Finance

– Export Credit

– Credit to priority sector

– Bill market scheme

– Development and regulation of banking system

• Other Functions

– Purchase and Selling of Gold

– Banking function with other Central Banks Worldwide

– Can borrow money from a scheduled bank in India or outside

– Issues DDs made payable at its own offices and agencies, and makes issues and circulates banks post bills

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1. Issue of Currency

Monopoly in notes issue

1 Re notes and coins not issued by RBI

Issued on the basis of minimum currency reserve system. By RB

Amendment Act 1956, a provision was made for a minimum

reserve in foreign exchange. And in gold in absolute terms.

400 Cr in Foreign Reserves and a min of 115 cr in Gold. A

total of 515 cr.

Operates through Currency Chests at 15 offices & 2 Branches

all over India supported by SBI where there is no

representation.

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2. Banker to the Government

• Maintains and operates the cash balances of the central and state Govt. onthe current a/c deposit on which it pays no interest.

• It receives and makes payment on behalf of the central and state govt.

• It carries out exchange, remittance, and other banking operations on behalfof these Govts.

• It buys and sells Govt. Sec. in the market

• It manages the public debt by issuing Govt. loans and paying interest andprincipal

• It also sells T bills through tender on behalf of the Govt.

• It makes ways and means advances to the central & State Govts. bypurchasing T bills from them for a period not exceeding 91 days.

• It advises the Govt. on all banking and financial matters.

• It acts as an agent of the Central & the State Govt. in their dealings withthe IMF and World Bank, IFCA and IDA.

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3. Bankers‟ Bank

Under the Banking Reg. Act 1949 every bank is required to keep

between 3% to 15% of the total of its time and demand liabilities

with the RBI as CRR which is interest free. (Ap.07-6.5%)

Every bank is also required to maintain with the RBI between 25%

to 40% of its net time and demand liabilities as SLR. (25%)

RBI also regulates, supervises and controls the working of the banks :

Issuing of license for opening and branch exp. Calling for returns

and statements and books of accounts. Issue of directions concerning

terms and conditions for loans and advances.

RBI acts as clearing house for banks

RBI provides refinance facilities to commercial banks for export

credit, against 364 days T bills.

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Frequently Used Terminologies

CRR [Cash Reserve Ratio] - CRR is the rate at which

banks are required to maintain their reserves with

the central bank on a fortnightly basis. [In recent

times it has been around 4 to 4.75%]

SLR [Statutory Liquidity Ratio] – SLR refers to the

rate at which banks are required to maintain their

reserves in government securities.

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Repo Rate, Bank Rate, Reverse Repo

Rate:

• Repo Rate & Bank Rate: The Repo rate is the rate at which RBI borrows from

the bank while the bank rate is the rate at which the banks borrow from the

RBI. (It is the rate at which RBI rediscounts certain defined bills.) The bank rate

is currently around 6%. Any revision on the bank rate by the RBI is a signal to

commercial banks to revise deposit rates as well as the PLR.

• So what is the reverse repo rate? It is the interest rate

that a bank earns for lending money to the Reserve

Bank of India in exchange for government securities.

Comm

BanksRBI

Repo Rate (RBI borrowing from COMB)

Bank Rate (COMB borrowing from RBI)

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4. Exchange Mgt. Control

Under FERA, 1973 The RBI had to control the

receipts and payments of foreign currencies.

The RBI determines the external value of rupee in

relation to the weighted basket of India's major

trading partners with pound sterling as the

intervention currency.

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5. Credit Control

The RBI controls the money supply and credit to

ensure price stability and meet the varying economic

conditions of the country. For this purpose it uses the

various credit control measures such as variations in

interest rates, open market operations, changes in

CRR and SLR, selective credit controls etc.

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6. Collection and Publication of Data

and Reports

• The RBI has a division of Reports, Reviews and

publications under its department of Economic

analysis and policy which collects data on economic

matters such as money, credit, finance, agriculture

and industrial production, balance of payments,

prices etc. and publishes them in various

publiocations like RBI Bulletin, Weekly Statistical

Supplements, Annual Report on Currency and

Finance. etc.

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7. Training Facilities

• The RBI has set up a no. of training colleges and

centers to provide training to the banking personnel

at different levels:

– Banker‟s Training College (BTC) Mumbai

– Reserve Bank Staff College (RSBC) Madras

– College of Agricultural Banking (CAB) Pune

– Zonal Training Centres (ZTC) M,K,C,D

– Indira Gandhi Institute of Development Research

– Training in Computer Technology

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8.Promotional & Development

Functions.

AGRICULTURAL FINANCE

INDUSTRIAL FINANCE

EXPORT CREDIT

CREDIT TO PRIORITY SECTOR AND WEAKER

SECTIONS

BILL MARKET

DEVELOPMENT AND REGULATION OF BANKING

SYSTEM

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Agricultural Finance

RBI extended Assistance to the cooperative credit

institutions for agricultural dev and allied rural

activities right from its inception in the year 1935

For this it set up an agricultural credit department

to provide long and medium term financing to these

sectors. The department was taken by NABARD in

the year 1982

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INDUSTRIAL FINANCE

An industrial credit department was set up in the

year 1957 to advice and help the bank in

providing financial assistance to industries and in

setting up financial institutions like IDBI, IFCI, ICICI

etc.

It also established the National Industrial Credit (Lt-

op)Fund in 1964 to provide financial assistance to

large scale industries.

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EXPORT CREDIT

The RBI provides concessional credit , refinance

facilities and guarantee to commercial banks for

export.

It also has setup the EXIM bank to finance export

trade.

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Credit to Priority Sector and Weaker

Sections

Under its differential Rate of interest scheme the RBI

provides concessional finance to priority sector and

weaker sections of the society.

Eg: Lead Bank Scheme Rate of int 4%

Bill Market Scheme

• The RBI has been instrumental in developing

the Bill market

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Objectives of Credit Control

To Stabilize Internal Price Level

To Stabilize the rate of Foreign Exchange

To Protect the outflow of Gold

To Control Business Cycle

To Meet business needs

To Ensure Growth with Stability

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Detailed Discussion:

To Stabilise Internal Price Levels: Frequent Change in Price Adversely effects the economy

Inflation and Deflation trends needs to be prevented

And all these could be done by adopting a suitable Credit Control Policy.

To Stabilize the rate of Foreign Exchange Change in internal price level effects the level of exports and imports in the

country

If Prices Exports and Imports therefore value of Domestic currency

in the foreign market and its exchange rate ( And vice-versa)

To Protect the outflow of Gold Expansion of bank credit leads to Rise in Prices thereby decreasing Export

and Increasing Import. As a result an Unfavourable Balance of Payment

Situation.

Bank Cr Prices will & thus Exports will & Imports will

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To Control Business Cycle Are a common phenomenon of a capitalist country and

Are characterised by alternating periods of Prosperity and Depression

During Prosperity ,Vol of Credit Expands leading to Rise in Prod and

Employment and thus Rise in Price

So , there should be Control of Bank credit in Boom Period and

Expansion in Lean Period

To Meet business needs When Business Expands more credit is required and less credit is absorbed

during lean periods

Industry Life Cycle

To Ensure Growth with Stability And not only price stability or forex stability.

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Methods of Credit Control

Quantitative Qualitative

Aims at controlling the Cost

and Quantity of Credit1) Bank rate or Discount

rate policy

2) Open Market Operations

3) Variable Reserve Ratio

Controls the Use and

Direction of Credit (Selective

Credit Control Measures)

1) Regulation of Margin

Requirement

2) Regulation of Consumer

Credit

3) Rationing o Credit

4) Direct Action

5) Moral Suasion

6) Publicity

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Quantitative Methods

Bank Rate Policy: The bank rate or discount rate is

the rate fixed by the CB at which it rediscounts First

Class bills & Government Securities. (It is the rate of

interest charged by the CB at which it provides

rediscount to banks through the discount window)

If CB lowers Bank Rate Borrowing becomes cheaper

= So Commercial Banks will borrow more = Adv will

be available at a lower cost = More Demand = More

Business = Encourages rise in price.

1. Bank Rate Policy

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Limitations of Bank Rate Policy

Market rates do not match with bank rates

Wages, Costs & Prices are not elastic. (If bank rate goes up wages, costs and prices should change which does not.)

Commercial Banks do not always approach Central Bank (Because they often keep large amount of liquid assets with them)

Bills of Exchange are not frequently used

Pessimism or Optimism: Depends on waves of P/O among business men. At times even at increased ban rate borrowers continue to borrow. They are mostly driven by Business Considerations.

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Power to Control Deflation is Limited: Lowering the

bank rate below 3% (for eg) will not necessarily

lead to a decline of 3% or below in the market

rates.

It is non discriminatory: It doesn't distinguish between

productive and unproductive activities.

It is not successful in controlling BOP disequilibrium:

Because there is a requirement for removal of all

restrictions on foreign exchange and movements in

international capital – which is not possible.

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2. Open Market Operations:

This method refers to the sell and purchase of securities, bills and bonds of Govt. as well as Pvt. Financial Institutions by the Central Bank.

There are 2 principal motives of open market operations:

1) One is to influence the reserve of the commercial banks in order to control their power of credit creation

2) To effect the market rates of interest so as to control the commercial banks‟s credit.

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Suppose Central Bank wants to control Expansion of

Credit by Commercial Banks (Say in case of

Inflation) It will sell Govt. Securities – say worth Rs.

10Cr.

Individuals having accounts with

various commercial banks will purchaseCommercial banks will also purchase

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Limitations:

Lack of well organised securities market.

CRR is not stable

Penal Bank Rate

Banks Act Differently

Pessimistic or optimistic Attitude

Velocity of Credit money is not constant.

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3.Variable Reserve Ratio:

It was first suggested by Keynes in 1930 and wasadopted by the Federal Rsv. Sys in the US (in the year1935)

Every Commercial Bank is required by the law to maintaina minimum % of its Deposit with the Central Bank… (itmay either be a % of its term and demand depositsseparately or Total Deposits.)

Whatever amount of money remaining with theCommercial Banks over and above the minimum reserve iscalled excess reserve.

When Central Bank Raises the ratio it means more moneyit to be kept with the Central Bank and thus less resourcesare available for credit creation.

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Excess Reserve

Clumsy method: Lacks definiteness and is inexact and uncertain.

(Amount of Reserve and Place)

Discriminatory: Effects different bank differently.

Inflexible: is applicable all over the country universally whereas

different regions have different requirements

Limitations:

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SELECTIVE CREDIT CONTROL

METHODS

Selective or qualitative methods are meant toregulate and control the supply of credit among itspossible users and uses.

Selective instruments do not effect the total amountof credit but the amount that is put to use in aparticular sector in the economy.

The aim of selective credit control is to channelizethe Flow of bank credit from speculative and otherundesirable purposes to socially desirable andeconomical avenues.

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1. Regulation of Margin

This method is employed to prevent excessive use of creditto purchase or carry securities by speculators.

The Central Bank fixes minimum margin required on loansfor purchasing security or carrying security. (in other wordsthe minimum value of loans which a borrower can have frombanks on the basis of securities/ collaterals.)

Eg: Suppose CB fixes 10% margin on value of securitiesworth Rs. 1000. So it can lend only Rs. 900 and keep Rs.100. If it raises to 25% then commercial banks can now lendonly Rs. 750 against a security of Rs. 1000. So if theCentral Bank wants to curb speculation it will raise themargin requirement.

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Merits & Demerits:

Merits: 1) Non Discriminating (It applies equally to bothborrowers and lenders thus it limits both supply anddemand) 2) it is equally applicable to banks and NBFCs3) It increases the supply of credit for more productive uses.4) It is very effective anti-inflationary device because itcontrols expansion of credit in those sectors of the economywhich breeds inflation. 5) It is simple to administer

Demerits: 1) A borrower may not show any interest topurchase stocks with borrowed funds by pledging otherassets or securities for loan… he may purchase them throughsome other sources. 2) He may purchase stock for cash whichhe would have used for purchasing supplies and materialsand then borrow for those supplies and later pledge them.

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2. Regulation of Consumer Credit

Aims to regulate Consumer Credit through : Installment credit

Hire Purchase Finance

The main objective is to regulate demand for Durable Consumer Goods

Minimum Down

payments

Maximum Period

for Repayment

If the Central Bank finds a slump in a particular sectorthen it can effectively introduce this mechanism torectify the situation

Say the Automotive Sector faces a slump (then down payment requirements may bereduced and Max. period of repayment can be increased. Therefore there will beincreased demand and also the allied industries will develop like rubber, plastic, spareparts etc.

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Merits and Demerits

Merits: 1) Effective in both boom and slump periods.Here, General Credit Control Methods fail because itoperates with a time lag whereas consumer creditcontrol method doesn't. 2) It is interest inelastic: becauseconsumers are interested to buy under the influence ofDEMONSTRATION EFFECT and rate of interest has littleconsideration.

Demerits: 1) It is applicable to a particular class ofborrowers only, therefore it discriminates amongdifferent types of borrowers.

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3. Rationing of Credit: (4 Types)

1. Variable Portfolio Ceiling: Here, CB fixes a ceiling on

aggregate portfolios of Comm banks and they can‟t

advance loans beyond their ceiling.

2. Variable Capital Asset Ratio: this is the ratio which the

CB fixes in relation to capital of a commercial bank to

its total assets.

3. Discrimination against larger Banks

4. Rationing Credit for Selective Purposes: here, Central

Bank ceases to be lender of the last Resort. (Done

only in case of extreme inflationary situations.)

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4. Direct Action

It is done in the form of issuance of “ Directives” It is

done from time to time to follow a particular policy

which the CB wants to enforce immediately.

Used in case of ERRING banks

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5. Moral Suasion

It is a method of persuasion or request, or informal

suggestion or advice.

Here, the executive head of the CB calls a meeting

of Commercial Banks and explains them the need

for adoption of a certain policy.

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6. Publicity

The annual repots and other allied financial data of

all Commercial banks are regularly published by

the RBI, this forces the commercial banks to perform

in accordance to the prescribed norms and

requirements.

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CONCLUSION

Selective credit controls are not used to the total

exclusion of general credit controls. In fact they are

an adjunct to general quantitative control. They are

meant to supplement the later and are regarded only

as the „second line instrument.‟

The vital point is not the question of general vs.

selective credit control or the assessment of the

general pros and cons between the two methods but

of their integration. Indeed the co-ordination of

selective and general controls appears to be more

effective then the use of any one of them singly or in

isolation.