Principles and Practice of Banking

PRINCIPLES AND PRACTICE OF BANKING

Reserve Bank of India (RBI) Organization and Management and Its Role 1

1. RBI : Historical BackDrop  

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Earliest Initiative: First attempt to set up Govt. Bank

in 1773 by then Governor of West Bengal East India Co. Imperial Bank – 1921: Amalgamation of three Presidency Banks into Imperial Bank – Became Govt. Banker and Issue and control of currency.

Hilton Young Commission (Royal Commission on Indian Currency and Finance) – 1926: Recommended setting up of The RBI for Central Bank functions. Recommendations reinforced by Central Banking Enquiry Committee-1931 Establishment of The RBI: The Reserve Bank of India Act-1934 enacted and RBI set up on April 1, 1935 as private bank with initial paid up capital of Rs.5crore. Nationalization of RBI: After Independence RBI nationalized under amended The RBI Act -1948

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2. Objectives Preamble of RBI: Preamble of RBI Act-1934 lay down

the objective of RBI “ to regulate the issue of Bank Notes and Keeping of Reserves with a view to securing monetary stability in India and generally operate the currency and credit system of the country to its advantage.” Other objectives:  Remain free from political influence.  Discharge central banking functions in the money market  Assist the planned process of development of the Indian economy.  Promotion of monetization and monetary integration of the economy. RBI by act to perform all the functions of central bank together with developmental and promotional functions attuned to the course of planning in the country.

3. Composition of Indian Banking System Indian Banking System Reserve Bank of India

Scheduled Commercial Banks

Public Sector Banks-27

Nationalized Banks -19

Private sector Banks-37

Foreign Banks in India-40

State Bank of India its Subsidiaries-8

Scheduled Cooperative Banks

Regional Rural Banks196

Old Private Banks-22

S. Urban Coop. Banks-52

S. State Coop. Banks-16

New Private Banks-8 4

4. Governing Body Central Board: Consist of 20 Directors including Governor as Chairman, Deputy Governors not more than four, 14 Directors out of which four – one each from Local Board and one Government Official nominated by Central Government. Entrusted with responsibility of policy making, general supervision and direction of affairs and business of Reserve Bank. Local Board: Four Local Boards for Four Regions: Western with Head quarters in Mumbai, Eastern with Kolkata, Northern with New Delhi and Southern with Chennai. Consist of Five Directors appointed by Central Govt. for four years. They represent territorial and economic interests of local cooperatives and indigenous banks. Advise Central Board on matters of local importance. Governor: Chairman of Board as well as the Chief Executive authority. Assisted by Deputy Governors. Appointed for Five Years. 5

5. Organizational Structure

Banking Department: Banker to Govt. and member Banks. Consist of Public Accounts Department, Public Debt Department, Accounts Department and Securities Department.

Deposit

Issue Department: Management of Note Issue. Consists of General Department - deals with resource operations : supply of notes and coins from Govt. press and Mints and Cash Department dealing with cash transactions.

Department of Currency and Management: Forecasting currency requirements, allocation of currency to various branches of Issue Department based on demand pattern etc.

Department of Banking Operations and Development (DBOD): Responsible for supervision, control and development of commercial banking system in the country. Regulating commercial banks under regulatory provisions of The Banking Act, 1949. Fulfilling objective of promotion and development of sound and competitive banking system. Focusing on prudential regulations, licensing of new banks/foreign banks etc.,

6. Organizational Structure (contd.) Exchange Control Department: Controlling foreign exchange transactions and maintaining exchange rate stability. Rural Planning and Credit Department: District Credit Plans, Lead Bank Scheme, Financial Assistance for NABARD, Special Studies for promoting IRDP, Framing policies for rural credit/development and Microfinance. Department of Economic Analysis and Policy: Economic Research, Reviews financial and banking conditions, Report on Currency and Finance, RBI Bulletins, Policy studies on emerging aspects of banking and economy and Annual Reports. Other Departments: Dept. of Statistical Analysis and Computer Services, Dept. of Administration and Personnel, Legal Dept. Management Services Dept., Dept. of Non-Banking Companies, Banking Supervision, Credit Planning Cell, Dept. of External Investment and Operations, Deposit Insurance and Credit Guarantee Corporation, Industrial and Export Credit Dept., Secretary’s Dept., RBI Service Board and Human Resource Development Dept. 7 (Training Institutions).

7. Functions of RBI Operational Framework – Performs all functions of Central Bank. Besides developmental and promotional functions consistent with planning priorities.

Bank for Note Issue: 

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Sole right to issue currency notes of Rs.2 and above. One Rupee Note and coins by MF but circulated under RBI supervision. All notes issued by RBI legal tender/ guaranteed by Central Govt. Rules Governing Note Issue: Proportionate Reserve System of 40% Gold Reserve. Since 1957, followed Minimum Reserve System – Rs.200 crore of Gold and foreign exchange of which Rs.115 crore Gold. Adopted . Design, form, denomination and material of notes subject to approval by Govt. Currency Chests: For provision of remittance facilities to banks and public, facilitating treasuries and bank to function by minimum cash balance and facilitating exchange of New for old/soiled notes.

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8. Banker to Governments Banker to Central and State Governments: 

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Banking transactions of Governments – Maintaining Deposit accounts , Collection and Payment on behalf of Governments, Transfer and Remittance facilities. - Maintains Current Account of Central Govt. with minimum balance of Rs.50 crore. – In places where RBI no Branch, SBI Acts as RBI agent. Managing public debts (now delinked) and issue of new loans. – Ways and Means Advances repayable within three months. Act as agent for Government for treasury bills and Govt. Securities. Banks required to invest certain proportion of investment in Govt. Securities - Statutory Liquid Ratio (SLR) –Now 25 %. Advising Governments on financing, resource mobilization and institutional arrangements for flow of resources for Plans. Advising Government on international finance, foreign trade and foreign exchange. Represent Government as member of IMF, The World Bank and 9 other international forums.

9. Banker’s Bank Banker to Scheduled Commercial Banks: 

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Maintaining Cash Reserves – As per Act amended 1962, Minimum of 3 percent of total liabilities (Demand and Time Deposits). Acting as clearing agent for commercial banks. Serving as lender of last resort by rediscounting bills of exchange or providing loans against eligible securities during credit stringency. Lender of Last Resort implies: RBI provide loans to banks which are solvent and facing liquidity crunch. Loans given at a penal rate of interest, Loans given against eligible collateral security Loans provided till such time bank turns solven 10

10. Foreign Exchange Management 

Custodian of country’s foreign exchange reserves: Intervenes (buying and selling) in FEM to ensure smooth and orderly exchange transactions and to promote a stable exchange rates.

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Transition from FERA to FEMA: Exchange control first introduced in 1939 under Defense of India Rules; statutorily laid down by Foreign Exchange Regulatory Act-1947 and amended in 1973 as Foreign Exchange Regulations Act. (FERA). Now replaced by Foreign Exchange Management Act -1999 (FEMA). Under FERA: RBI controlled collection and allocation of Foreign exchange and Fixed Exchange Rate and administer foreign exchange control. Under FEMA: RBI authorizes Banks and authorized dealers to handle market transactions of foreign exchange. RBI now focuses on development of competitive FEM, Manage Exchange Reserves and Manage stability in Exchange Rate by market intervention. No exchange control. 11

11. Development Role Need for Development Role: 

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Development of financial market: Predominance of indigenous banks, imperfections in the financial system, promotion of monetization of economy. Development of economy by ensuring proper allocation of credit among various sectors.

Developmental Role Played by RBI:  

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Lead Bank Scheme: Geographical spread of Branch net work. Agricultural Finance/Priority Sector Advances: Role of ACD to provide financial accommodation to cooperatives, expertise and training, Agricultural Credit Funds Institutional Development: IDBI, ARDC/now NABARD, Credit Guarantee Corporation, Deposit Insurance Corporation, Regional Rural Banks(RRBs), Exim Bank., UTI, NHB, NIBM, College of Agricultural Banking. Training and Research: Collection of data, promote policy and 12 action oriented research and training: BTC, NIBM etc.

12. Regulatory Role Objective: Regulate money supply to achieve price stability and development objectives. – Maintain value of rupee, ensure healthy and sound banking system, and ensure effective coordination and control over credit portfolio of Banks through monetary policy.

Rationale/Need for Regulation: Safeguard interest of Depositors, maintain liquidity of Banks, ensure orderly and efficient functioning of Banking system, ensure efficient and productive use of credit, control money supply to achieve monetary policy objectives and control foreign exchange.

Regulatory Provisions under RBI Act: Approve chairman, Licensing of Banks, restrictions on opening new branch, inspection of Banks , Providing guidelines and Directives on credit policies, Carrying out periodical reviews of banking operations, monitoring banks implementation of prudential regulations, overview and exercise control over methods of operation and management of Banks , to remove management, supervising amalgamation and liquidation of Banks, appointing liquidator, and impose penalty . 13

13. Supervisory Framework of RBI. RBI adopted Basel Committee - 25 core principles for effective banking supervision.  Department of Supervision separated from DBOD in 1993. Two Departments: DBS and DNBS set up under the Board of Financial Supervision (BFS) with Governor as chairman in 1994.  Supervisory process include : On-site Inspection and Off-site Monitoring and surveillance system  On-site Inspection: Annual Financial Inspections (AFI) undertaken directly by RBI or external auditors, focuses on statutory mandated areas, solvency, liquidity and financial and operational health of the bank.  RBI identifies areas of concerns and draws up action 14 plan to monitor.

14. Off-site Monitoring/Surveillance

Objective: To maintain continuous surveillance on performance, and financial health of banks during the period between the two on-site inspection and trigger timely supervisory /corrective actions.

Modus Operandi : Monthly, Quarterly, Half-yearly and Annual Returns mainly focusing on CRAR, operating results, lending portfolio, large credit exposure, profile of ownership, asset-liability management, foreign currency business etc. Build computerized data base and analyze and review at periodical intervals, Banks are rated as per CAMELS Supervisory Model: C= Capital Adequacy, A= Asset Quality, M= Management , E=Earnings, L=Liquidity and S= Systems and controls for Indian Banks and CALCS Model: C=Capital Adequacy, A= Asset quality, L=Liquidity, C=Compliance and S=Systems for foreign bank branches. Prompt Corrective Action (PCA): More focused and enforcement-oriented follow-up. Now moving towards Risk Based Supervision (RBS): Focused on Risk profile of Banks based on BASEL Accord./norms 15

15. Process of making Monetary Policy  

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RBI responsible for formulating and implementing MP in India MP is analytical, consultative and participative process – Significant technical, analytical, institutional and dynamic inputs go into process of making MP. A committee of Board chaired by the Governor meets every week to review monetary, economic and financial conditions and implementation of MP and decide course of action needed. A MP Strategy Group analyzes strategies on an on-going basis MP communicated to public by way of Annual Monetary Policy Statement of RBI Governor in April and Mid-term review in October every year. Monetary Policy Announcement contains in detail information on working of economy, rationale behind the policy , targeted objectives, monetary, growth and inflationary targets, and institutional and structural aspects of policy measures. Periodic consultation with MF, Govt. of India, market participants, 16 financial institutions.

16. Objectives of Monetary Policy of RBI Economic Policy Objectives: Achieve faster growth, ensure reasonable degree price stability, and promote distributive justice (Equity). RBI Monetary Policy be consistent with overall objectives. Broad objectives of RBI Monetary policy :  To maintain a reasonable degree of price stability.  To help accelerate the rate of economic growth – ensure adequate flow of credit to productive sectors. Emphasis between two objectives : Changed from year to year depending on conditions prevailing in that year and previous. Whenever inflation high, price stability received more emphasis. Equity left to Fiscal policy, Price stability helps poor and inflation hurts them most. Price stability has social dimension. Trade-off between Inflation and Growth: Whether pursuit of objective of price stability undermines ability of economy to attain and sustain high growth. Regime of rising prices adversely affects saving and speculative investment more attractive. Regulation of money supply affects adversely allocation of credit to productive sectors and thus slow down growth. Trade off between two emphasized.

17. RBI MP Prior to Bank Nationalization 

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Financial Market highly segmented and regulated. Interest Rates administered by RBI. Credit to commercial sector regulated; multiple lending rates and directed credit at subsidized interest. RBI relied on Direct Method such as Interest rate regulations, Selective Credit Control and CRR as major MP Instruments to neutralize monetary impact of Govt. Deficit and assist Govt. borrowing operations.. Bank Rate and Open Market Operations only limited roles in Command and control Approach. Nexus between MP and Fiscal Policy: MP used as an institutional arrangement for financing Govt. deficit. Practice of extending Short term credit to Central Govt. resulted in automatic monetization of fiscal deficit. With low yield, RBI residual subscriber to Govt. Securities not traded in the market. Demand for Govt. Securities created through increases in SLR. RBI Credit constituted 75% of Monetary base (Reserve Money) in 1970s increased to 92% during 1980s.

18. RBI MP after Nationalization 

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After nationalization of Banks, modus operandi for conducting MP changed. CRR and Credit Rationing through Selective Credit Controls became instruments with virtual exclusion of others. Refinance used to fill shortfall of credit targets of banks in relation to demand. Interest rate structure administered rendering it inflexible and sterile as an instrument of Monetary Policy. CRR and SLR used to neutralize inflationary impact of growing deficit. RBI Act amended: first to increase CRR from 5 percent of Demand Deposits and 2 percent of time deposits to 5 to 20 percent of Demand Deposits and 2 and 8 percent of time deposits besides Reserve up to 100 percent against incremental deposits in 1956, and in 1959 to minimum 3 percent of all deposits and could vary 3 and 15 percent. SLR limit was fixed at 25 to 40 percent. Single most important instrument used to conduct monetary policy after 1970s, increase in CRR. And SLR as source of government borrowing 19

19. RBI MP after Bank Nationalization

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CRR: In 1973, CRR was 3 percent, in 1989 reached statutory maximum of 15 percent. SLR, 25 percent in 1970 reached 38.5 percent in 1989. Besides 10%CRR on incremental deposits. CRR and SLR used to meet growing govt. deficits.

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Credit Rationing: Minimum margins, ceiling on amount of credit and discriminatory interest on certain loans used as instruments.

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Credit Authorization Scheme (CAS): Mandatory for banks to obtain prior approval for any credit of Rs. one crore and above for single party. Abolished in 1989 and replaced by Credit Monitoring Arrangements(CMA). RBI to monitor all loans exceeding Rs. 5crore to single party for working capital and Rs. 2crore for term loans.

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Impact: During 1950s, inflation was 1.8 percent. During 1960s, 6.2 percent, and in 1970s and 1980s higher than 10 percent. High inflation and low growth. Phenomenal increase in money supply. Ultimately led to economic/banking crisis in 1990-91 20

20. Chakravarthy Committee Recommendations Objective: RBI in 1982 set up a committee under Chairmanship of Sukhamoy Chakravarthy with objective of evaluating various instruments of monetary policies, assessing interaction of monetary policy and public Debt Management and recommending appropriate measures for improving effectiveness of monetary policy. Recommendations of Committee:  Price Stability: Existence of multiplicity of objectives and stressed price stability as primary objective. To achieve price Stability, Govt. should aim at raising output levels and RBI should control expansion in Reserve Money and Money Supply.  Monetary Targeting: Stressing inter-relation between money, output and prices, recommended formulation of monetary policy based on monetary targeting-Target for growth of money supply based on anticipated growth in output and price situation.  RBI and Govt. evolve a policy framework on level of monetary expansion and extent of monetization of fiscal deficit.

21. Chakravarthy Committee Recommendations (Contd.) 

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Interest Rate Policy: Interest rate played an important role in mobilization of savings and allocation of resources and cannot arbitrarily set. Envisaged strong supportive role in monetary regulation and recommended: Greater freedom for Banks in determining lending rates. Use of Concessional rates as distributive devise in selective basis Positive Real Interest rates for deposits after adjustment of inflation. Restructuring of Money Market: Strengthening of Treasury Bills Market and Call Money Market and Commercial Bills Market in allocation of short term resources with minimum costs and delays. Bank Credit Policy: Bank credit in the form of loans and bill finance instead Cash Credit. To promote Bill financing, interest rate of 2 percent lower than Minimum Lending Rate. Monetary Policy: i)RBI should not depend on single instrument of monetary policy. Ii) Adopt regulatory measures slowly so that effects not drastic. Iii) Creation of Reserve Money within limits. 22

22. RBI Monetary Policy: Post-Reform Period Multiple Indicator Approach: RBI monetary Policy undergone fundamental change in objectives, framework and instruments. Adopted multiple indicator approach - Market based interest rates, currency availability, credit position, capital flows, fiscal state, inflation rate, exchange rate etc related to output growth with necessary flexibility to respond to changes in formulation of policy framework. Market-oriented approach instead command /control. Monetizing Fiscal Deficits: No automatic monetization of Fiscal Deficits. Agreement between Govt. and RBI and introduction of Ways and Means Advances to provide temporary accommodation to enable Govt. to take care of mismatch between receipts and expenditures. Government Securities market related. Monetary Instruments: Emphasis on market oriented instruments: OMP and market related interest rates. CRR reduced from 15 percent in 1991 to 4.5 percent in 2003. Object to reduce statutory minimum of 3 percent. SLR also brought down to statutory limit of 25 percent level . Interest rates deregulated. Bank Rate limited role.

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23. RBI Monetary Policy: Post-Reform Period (Contd.) 

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Interest Rates: Interest Rates deregulated. Banks given operational flexibility to determine deposit and lending rates with certain restrictions for saving deposits and small loans. Interest rates for Govt. Securities linked to market Liquidity Adjustment Facility (LAF): RBI uses LAF as flexible instrument for liquidity management and regulating interest rates. Along with LAF, OMOs expected to play key role in RBI MP. Monetary Targeting Framework: Broad Money (M3) considered for Intermediate Target of monetary policy. Exercise focused around working out money growth strategy based on money demand function consistent with projected GDP growth and reasonable inflation threshold. Transparency: Transparency in monetary policy widened and deepened through consultation and publication of detailed results of analysis and projections. Objective: Reduction in market ‘s uncertainty and improve understanding of conducting monetary 24 policy

24. LAF as a tool of MP 

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LAF: Mechanism by which RBI draws funds from money market when surplus and infuses liquidity when short of supply. Important MP instrument to manage day to day liquidity mismatches and smoothen volatility in money market. LAF operates on daily basis by way of repo and reverse-repo. Repos: Mode of borrowing where borrower sells securities with agreement to buy them back next day at a predetermined price. Difference between sale and repurchase prices indicate repo rate (interest cost of funds). In Reverse repo, lender buys securities with an agreement to sell them back at a predetermined rate. In auction, borrowers bids for funds indicating amount they want to borrow and the rate willing to pay. Initially auctions conducted daily with one day maturity, now multiple reo/reverse repo auctions with 3 to 7 days maturity. Minimum size bids reduced from Rs.10 crore to Rs.5 crore to allow smaller operators. From uniform price auction method to Multiple auction methods 25

25. Independence of Central Bank 

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Originally Central Banks set up by private shareholders to maintain political independence. General opinion against any kind of state interference. Rationale for independence : State control result in mismanagement of currency and credit. If CB under state control, continuity of policies not guaranteed with changing Governments nor freedom from political bias assured. After Second World War, with emphasis on development, trend towards state control of CBs. Bank policy and policy of Govt. should all times in harmony and policy subject to supreme authority of Govt. Independent Monetary policy sometimes defeat policies of State. Coordination between two inevitable. With globalization and liberalization, Global trend increasingly legal independence. Away from Govt. control. Independence means operational freedom, accountability, transparency and creation of executive monetary policy mechanism not Advisory one. Divesture of supervisory and quasi-fiscal functions. No general consensus. 26

26. Independence of RBI 

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RBI when set up Hindu marriage between Bank of England (dominant husband) and RBI (subservient wife), RBI to function on advisory capacity and yield Govt./BOE to determine policies. After Independence, Govt.- Male chauvinist husband and RBI docile traditional wife who had forfeited minimum right of nagging the husband. RBI dwindled to quasi-fiscal agency. Monetary policy captive of fiscal stance and politics. A section of Finance Ministry. A faithful implementer of MF wishes. With liberalization, emphasis on operational autonomy and transparency. No independence: Neither absolute subordination nor absolute independence status. Relationship between RBI and Govt. autonomy in operations and harmony in Policies and coordination with Govt. in achieving development objectives. India has fiscal federalism but still lacks monetary federalism Require Institutional, functional and financial independence. Higher degree of operational freedom to pursue policy objectives independently free and fair manner without political influence.