Central Banking System

Central Banking System

• Topics– Introduction

– Functions of Apex Bank of the Country– Instruments of Credit Control– Qualitative Credit Control

Introduction

Central Bank - Introduction

• Definition – A central bank is an institution that manages a state’s currency, money supply, and interest rates. Central banks also usually oversee the commercial banking system of their respective countries. Eg. ECB, Federal Reserve of US, RBI

• Primary Functions– Manage Nations’s money supply(monetary policy)

• Managing interest rates• Setting reserve requirement• Acting as the Lender of last resort to banking sector

Reserve Bank of India

Reserve Bank of India

• Establishment– The Reserve Bank of India was established on April

1, 1935 in accordance with the provisions of the Reserve Bank of India Act, 1934.

– The Central Office of the Reserve Bank was initially established in Calcutta but was permanently moved to Mumbai in 1937. The Central Office is where the Governor sits and where policies are formulated.

– Though originally privately owned, since nationalisation in 1949, the Reserve Bank is fully owned by the Government of India.

Reserve Bank of India

• Organisation of Reserve Bank– The bank is managed by a central board of

directors and four local boards of directors.

Reserve Bank of India

• Central Board• The Reserve Bank's affairs are governed by a central board of

directors. The board is appointed by the Government of India in keeping with the Reserve Bank of India Act.

• Appointed/nominated for a period of four years

– Constitution:• Official Directors

– Full-time : Governor and not more than four Deputy Governors

• Non-Official Directors– Nominated by Government: ten Directors from various fields and two

government Officials– Others: four Directors - one each from four local boards

– Functions• General superintendence and direction of the Bank's affairs

Reserve Bank of India• Local Boards

– One each for the four regions of the country in Mumbai, Calcutta, Chennai and New Delhi

– Membership:• consist of five members each• appointed by the Central Government• for a term of four years

– Functions • To advise the Central Board on local matters and to

represent territorial and economic interests of local cooperative and indigenous banks; to perform such other functions as delegated by Central Board from time to time.

Reserve Bank of India• Legal Framework

– Umbrella Acts• Reserve Bank of India Act, 1934: governs the

Reserve Bank functions• Banking Regulation Act, 1949: governs the

financial sector

Reserve Bank of India– Acts governing specific functions

• Public Debt Act, 1944/Government Securities Act (Proposed): Governs government debt market

• Securities Contract (Regulation) Act, 1956: Regulates government securities market

• Indian Coinage Act, 1906:Governs currency and coins• Foreign Exchange Regulation Act, 1973/ Foreign

Exchnage Management Act, 1999: Governs  trade and foreign exchange market

• Payement and Settlement Systems Act: Provides for regulation and supervision of payment systems in India"

Reserve Bank of India– Acts governing Banking Operations

• Companies Act, 1956:Governs banks as companies

• Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970/1980: Relates to nationalisation of banks

• Bankers' Books Evidence Act• Banking Secrecy Act• Negotiable Instruments Act, 1881

Reserve Bank of India– Acts governing Individual Institutions

• State Bank of India Act, 1954• The Industrial Development Bank (Transfer of

Undertaking and Repeal) Act, 2003• The Industrial Finance Corporation (Transfer of

Undertaking and Repeal) Act, 1993• National Bank for Agriculture and Rural

Development Act• National Housing Bank Act• Deposit Insurance and Credit Guarantee

Corporation Act

Functions of the Apex Bank of the Country

Main Functions

• Monetary Authority:– Formulates, implements and monitors the monetary policy.– Objective: maintaining price stability and ensuring adequate flow of credit to

productive sectors.• Regulator and supervisor of the financial system:

– Prescribes broad parameters of banking operations within which the country's banking and financial system functions.

– Objective: maintain public confidence in the system, protect depositors' interest and provide cost-effective banking services to the public.

• Manager of Foreign Exchange– Manages the Foreign Exchange Management Act, 1999.– Objective: to facilitate external trade and payment and promote orderly

development and maintenance of foreign exchange market in India.

Main Functions• Issuer of currency:

– Issues and exchanges or destroys currency and coins not fit for circulation.– Objective: to give the public adequate quantity of supplies of currency notes

and coins and in good quality.• Developmental role

– Performs a wide range of promotional functions to support national objectives.• Related Functions

– Banker to the Government: performs merchant banking function for the central and the state governments; also acts as their banker.

– Banker to banks: maintains banking accounts of all scheduled banks.

Instruments of Credit Control

Credit Control

Monetary Policy refers to the control of credit and total Money supply. This policy is also known as the central

bank’s policy in control of credit. Control of Money supply is very important for the economic growth of a country. If there is excess supply of money then the result will be inflation whereas tight control over money ,ay cause depression and unemployment. Therefore monetary policy is implemented to achieve various objectives such as achievement of price stability, increase employment opportunities, stimulate economic growth, achieve stable rate of the Currency and increase in investment. Monetary policy is implemented by the central bank and it uses different methods for this purpose.

These are classified into two types :Quantitative Credit Control

Qualitative Credit Control

Quantitative Credit Control

Quantitative Credit Control

• Bank Rate• Open Market Operations• Changes in the Reserve Ratio• Credit Rationing

Quantitative Credit Control

• Bank Rate:– Bank rate refers to the rate at which central bank rediscounts bills of

exchange. In other words it is the rate of interest at which the central bank advances loans to the commercial banks. In case of inflation central bank increases the bank rate due to which commercial banks have to increase the interest rate. Due to increase in the interest rate demand for the loans of commercial banks reduces and the Money supply in the country shrinks. In this way the inflation in the country is controlled. On the other hand bank rate is reduced in case of depression which results in the reduction of the interest rate and the money supply in the country is increased.

Quantitative Credit Control

• Open Market Operations:– When the central Bank purchase or sell government securities in the Open

market such as stock exchange it is called open market operations. If central banks want to reduce the money supply in the country it sells government securities to the commercial bank and the people. In this way the amount of cash with people and commercial banks is reduced due to which commercial banks decrease the number of loans whereas people’s demand for goods and services shrinks. Similarly if the central bank wants to increase the money supply it purchases the government securities due to which the amount of cash with commercial banks and people increases.

Quantitative Credit Control

• Changes in the Reserve Ratio:– Every member bank keeps a certain percentage of its total deposits with

the central bank known as Cash Reserve Ratio. Central bank uses reserve ratio to increase or decrease the Money supply in the country. For example if the central bank wants to decrease the money supply it raises the reserve ratio due to which less amount of cash is left with the commercial banks to lend. Due to lower lending the supply of money reduces along with the demand for goods and services which results in the control of inflation. Similarly central bank can increase the money supply by lowering the reserve requirements.

Quantitative Credit Control

• Credit Rationing:– Central bank uses credit rationing to fix the credit ceiling

allowed for each and every commercial bank. It means that the central bank fixes the credit limit for each commercial bank and does not give credit to them beyond that limit. Whenever the central bank desires to decrease the money supply it decreases the limit upto which it can give loans to the member banks. Similarly central bank can increase the money supply by increasing the credit limit.

Qualitative Credit Control

Qualitative Credit Control

• Change in Margin Requirements• Regulation of Customer’s Credit• Moral Suasion• Publicity• Direct Action

Qualitative Credit Control

• Change in Margin Requirements:– Every commercial bank has to keep a margin whenever it extends

loans against the security. It means that the amount of loan is lower than the actual value of security. Eg. If actual value of security is 100 and the amount of loan is 85, therefore margin requirement is 15%. Central bank can increase or decrease the money supply by changing the margin requirements. For example if central bank wants to decrease the money supply it can do so by increasing the margin requirements. In this way amount of loan decreases.

Qualitative Credit Control

• Regulation of Customer’s Credit:– Consumer credit facility refers to the act of selling a

consumer good on credit basis to the people. The method is used by the government or central bank to implement certain regulations on goods sold on credit. If the central bank wants to increase the money supply it can do so by adopting a lenient policy about the credit for purchase of consumer goods. Similarly central banks can reduce the money supply by putting restrictions on consumer credit.

Qualitative Credit Control

• Moral Suasion:– In some cases central bank morally persuades or

requests the commercial banks not to indulge themselves in such economic activities which are against the interest of the country. It regularly advices and guides the member banks to follow a particular policy for loans and refrain themselves from giving loan for speculative purposes.

Qualitative Credit Control

• Publicity:– Central banks also publishes details concerning its

policies and important information about assets and liabilities, credit and business situation etc. of commercial banks. This helps to make commercial banks as well as general public realize the monetary needs of the country. Central bank reveals some of the important information about the commercial banks so that the people know about the various activities of commercial banks and can protect themselves from any potential loss in the future.

Qualitative Credit Control

• Direct Action:– Direct action is the last resort through which central

bank takes a direct action against the bank which does not act in accordance with the policy of the central bank. In case of direct action, the central bank can impose fine and penalty and can refuse to give out loans to the commercial banks. Such type of pressure keeps commercial banks away from undesired credit activities.

Thank You

Rohit Kochhar