Role of RBI in Indian Economy

IFS / Role of RBI in Indian economy/SVIM MBA Finance’ 07-09

.

AN ASSIGNMEMT ON

ROLE OF RESERVE BANK OF INDIA IN INDIAN ECONOMY SUBMITTED BY SACHIN NANDHA (23) SUBMITTED TO : Prof. KAUMUDI UPADHYAY Prof. KALPESH PRAJAPATI ACADEMIC YEAR 2007-09 SUBMITTED TO S.V. INSTITUTE OF MANAGEMENT, KADI AFFILIATED TO HEMCHANDRACHARYA NORTH GUJARAT UNIVERSITY PATAN

1

IFS / Role of RBI in Indian economy/SVIM MBA Finance’ 07-09

Preamble : The Preamble of the Reserve Bank of India describes the basic functions of the Reserve Bank as: "...to regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage."

2

IFS / Role of RBI in Indian economy/SVIM MBA Finance’ 07-09

An overview : Central Bank is an apex financial institution of a country. It is needed to regulate and control the monetary system of an economy. The need for a central bank in India was felt during 18th century. The earliest attempts to set up a central bank dates back to 1773 when Warren Hastings recommended to establish the “General Bank of Bengal and Bihar” as Central Bank of India. In 1913 Lord Keynes also recommended to set up a Central Bank. Later on in 9121, by amalgamating three presidency Banks (Presidency Bank of Bengal, Presidency Bank of Madras and Presidency Bank of Bombay), Imperial Bank of India was set up. Though Imperial Bank of India performed certain central banking function, but the right of Note issue was not given to Imperial Bank Of India and Government of India performed the function of credit control. The establishment of a Central Bank that would issue notes and at the same time function as banker to the Government was recommended in 1926 by the Royal Commission in Indian Currency and Finance (known as the Hilton Young Commission). In 1931, Central Banking inquiry Committee also recommended for setting up of a Central Bank in India. In 1933,the “Round Table Conference” also suggested to set up a Central bank free from political influence. As a result of all these recommendations and suggestions, a fresh bill was passed by the assembly on December 22,1933 and got Governor General Ascent on March 6,1934. Thus, the Reserve Bank of India started working since, 1st April, 1935 in accordance with the provision of the Reserve Bank of India Act, 1934.

Objectives and Reasons for the Establishment of R.B.I. : The main objectives for establishment of RBI as the Central Bank of India were as follows: To manage the monetary and credit system of the country. To stabilizes internal and external value of rupee. For balanced and systematic development of banking in the country. For the development of organized money market in the country. For proper arrangement of agriculture finance. For proper arrangement of industrial finance. For proper management of public debts.

3

IFS / Role of RBI in Indian economy/SVIM MBA Finance’ 07-09

To establish monetary relations with other countries of the world and international financial institutions. For centralization of cash reserves of commercial banks. To maintain balance between the demand and supply of currency. According to the Reserve Bank of India Act, the aim of RBI is, “to regulate the issue of bank notes and keeping of reserve with a view to secure system of the country to its advantage.”

Nationalization of Reserve Bank of India : Initially, the RBI was established as shareholder’s bank. Its share capital was Rs. 5 crores, divided into 5 lakh fully paid up share of Rs. 100 each. Our of this, share of the nominal value of Rs. 2,20,000 (2200 shares) were allotted to the Central Government for disposal at par to the Directors of the Central Board of the Bank seeking to obtain the minimum share qualification. The remaining share capital was owned by the private individuals. Thus, the control on the policy of the RBI remained with the Government. The RBI is governed by the Central Board of Directors. The Governor and two deputy-Governor are appointed by the Government and other members of the Governing Board are appointed by individual shareholders. In order to regulate and control monetary and credit policy of the country, the Government is empowered to supersede the central Board of Directors of the RBI if the Board fails to discharge its obligations cast upon it by the RBI Act. The demand for nationalization of RBI was started with the setting up of RBI. It was felt that RBI should be nationalized in tune with the changing national and international political and economical scenario. The objective of its nationalization was stated, “to implement the Government’s policy that the Bank should function as state-owned institution and to meet the general desire that control of the government over the bank’s activities should be extended to ensure greater co-ordination in the monetary economic and financial policies.” In February, 1947, it was decided to nationalize RBI. Thus, the RBI was nationalized with the passing of the Reserve Bank of India (transfer to public ownership) Act in 1948. in terms of the Act, the entire share were transferred to the central Government on payment of compensation to the shareholders @ Rs. 118 and 62 paisa per share of Rs. 100. Thus since January 1, 1949, the the reserve bank of India is functioning as a state owned and state controlled(nationalized) bank. The nationalization of the RBI was also justified by passing of the Banking Regulation Act, 4

IFS / Role of RBI in Indian economy/SVIM MBA Finance’ 07-09

1949 conferring on the vast power central bank to control the activities of the commercial banks.

Organization & management of RBI : Central Board of Directors (20 Directors) Dr. D. Subbarao Dr. Rakesh Mohan Shri V. Leeladhar Smt. Shyamala Gopinath Smt. Usha Thorat Dr. Ashok S. Ganguly Shri Azim Premji Shri Kumar Mangalam Birla Smt. Shashi Rekha Rajagopalan hri Suresh Neotia Dr. A. Vaidyanathan Prof. Man Mohan Sharma Dr. D. Jayavarthanavelu Shri Sanjay Labroo Shri H. P. Ranina Shri Y.H. Malegam Shri Suresh D. Tendulkar Prof. U. R. Rao Shri Lakshmi Chand Governor (one) (Chairman and full-time officer) Dr. D. Subbarao Deputy Governors (Four) (All full-time officers) Dr. Rakesh Mohan Shri V. Leeladhar Smt. Shyamala Gopinath Smt. Usha Thorat 5

IFS / Role of RBI in Indian economy/SVIM MBA Finance’ 07-09

Directors (Fifteen) (All part-time officers) 10 nominated by Central Govt. Dr. Ashok S. Ganguly Shri Azim Premji Shri Kumar Mangalam Birla Smt. Shashi Rekha Rajagopalan hri Suresh Neotia Dr. A. Vaidyanathan Prof. Man Mohan Sharma Dr. D. Jayavarthanavelu Shri Sanjay Labroo Shri H. P. Ranina 4 Nominated by Local Boards Shri Y.H. Malegam Shri Suresh D. Tendulkar Prof. U. R. Rao Shri Lakshmi Chand 1 Nominated by Central Govt. as Govt. officer Local Boards

Eastern Region (Kolkata)

Western Region (Mumbai)

Northen Region (New Delhi)

The organization of RBI can be divided into three parts: 1) Central Board of Directors. 2) Local Boards 3) Offices of RBI

6

Southern Region (Chennai)

IFS / Role of RBI in Indian economy/SVIM MBA Finance’ 07-09

1.Central Board of Directors : The organization and management of RBI is vested on the Central Board of Directors. It is responsible for the management of RBI.Central Board of Directors consist of 20 members. It is constituted as follows. a)One Governor: it is the highest authority of RBI. He is appointed by the Government of India for a term of 5 years. He can be re-appointed for another term. b)Four Deputy Governors: Four deputy Governors are nominated by Central Govt. for a term of 5 years c)Fifteen Directors : Other fifteen members of the Central Board are appointed by the Central Government. Out of these , four directors,one each from the four local Boards are nominated by the Government separately by the Central Government. Ten directors nominated by the Central Government are among the experts of commerce, industries, finance, economics and cooperation. The finance secretary of the Government of India is also nominated as Govt. officer in the board. Ten directors are nominated for a period of 4 years. The Governor acts as the Chief Executive officer and Chirman of the Central Board of Directors. In his absence a deputy Governor nominated by the Governor, acts as the Chirman of the Central Board. The deputy governors and government’s officer nominee are not entitled to vote at the meetings of the Board. The Governor and four deputy Governors are full time officers of the Bank. 2. Local Boards : Besides the central board, there are local boards for four regional areas of the country with their head-quarters at Mumbai, Kolkata, Chennai, and New Delhi. Local Boards consist of five members each, appointed by the central Government for a term of 4 years to represent territorial and economic interests and the interests of co-operatives and indigenous banks. The function of the local boards is to advise the central board on general and specific issues referred to them and to perform duties which the central board delegates.

7

IFS / Role of RBI in Indian economy/SVIM MBA Finance’ 07-09

3. Offices of RBI: The Head office of the bank is situated in Mumbai and the offices of local boards are situated in Delhi, Kolkata and Chennai. In order to maintain the smooth working of banking system, RBI has opened local offices or branches in Ahmedabad, Bangalore, Bhopal, Bhubaneshwar, Chandigarh, Guwahati, Hyderabad, Jaipur, Jammu, Kanpur, Nagpur, Patna, Thiruvananthpuram, Kochi, Lucknow and Byculla (Mumbai). The RBI can open its offices with the permission of the Government of India. In places where there are no offices of the bank, it is represented by the state Bank of India and its associate banks as the agents of RBI.

Administrative department of RBI : In order to maintain smooth functioning, RBI has establish different administrative departments which are the part of its internal organization. These are a follows : I. Department of currency management. II.Department of banking supervision. III.Rural planning and credit department. IV.Department of banking operations and development. V.Exchange control department. VI.Secretary’s department VII.Industrial and export credit department VIII.Department of administration and personnel management IX.Department of Government and Bank accounts. X.Department of non-Banking supervision. XI.Internal debt management cell. XII.Inspection department. XIII.Department of information and technology. Other department : Besides these above departments RBI has other departments such as premises department, press relation department, personnel policy department etc.

8

IFS / Role of RBI in Indian economy/SVIM MBA Finance’ 07-09

Role of Reserve Bank of India The reserve Bank of India is the central bank of India. Therefore, it performs all those functions which are essentially being performed by the central bank of a country. The important functions of the reserve Bank of India are as follows :

(1) Issue of notes: The reserve Bank of India enjoys monopoly in the issue of currency notes as central Bank of the country. All the currency notes except one rupee note are issued by RBI. One rupee note and all coins of small magnitude are issued by the Government of India and are circulated through the Reserve Bank of India. The RBI Act permits RBI to issue notes in the denominations of rupees 2,5,10,20,50,100,500,1000,5000,10,000. Although the RBI had issued all these denominations, but at present notes of all denominations except 5,000 and 10,000 are being issued in circulation. The RBI has established a separate department for this purpose known as issuing department. The basis of note issue is minimum Reserve system. The RBI has been issuing currency notes on the principle of Banking system, in which cent per gold/precious metals reserves are not required. In this system RBI have to maintain a minimum reserve of Rs. 200 crore as security against note issue. In which a minimum reserve of Rs. 115 crore has been maintain in gold and remaining Rs. 85 crore reserve in foreign securities. The value of gold reserve held by the issue department has not been less than Rs. 85 crore at the time of an emergency. In the year of 2006-07 reserve bank has allotted Rs. 2020 crore to security press for printing of notes and the number of units printed in this year stands at 1248.4 crore. Against it in the year of 2007-08 (June-July) it has allocated Rs. 2026 crore and the number of units printed is 1393. despite increasing price of paper reserve bank has able to decrease the per unit printing price from Rs. 1.62 in 2006-07 to Rs. 1.46 in the year of 200708.

9

IFS / Role of RBI in Indian economy/SVIM MBA Finance’ 07-09

NM3 is the residency-based broad money aggregate and L1, L2 and L3 are liquidity aggregates compiled on the recommendations of the Working Group on Money Supply (Chairman: Dr. Y.V. Reddy, 1998). L1 = NM3 + Select deposits with the post office saving banks. L2 = L1 +Term deposits with term lending institutions and refinancing institutions (FIs)+ Term borrowing by FIs +Certificates of deposit issued by FIs. L3 = L2 + Public deposits of NBFCs. Expansion in monetary and liquidity aggregates has remained strong during 2007-08 so far. Accretion to bank deposits, led by time deposits, remained buoyant. Year-on-year (y-o-y) growth of broad money (M3) as on January 4, 2008 was higher than that at end-March 2007, and was also above the indicative trajectory of 17.0-17.5 per cent for 2007-08 set out in the Annual Policy Statement (April 2007). Growth in bank credit moderated, consistent with policy projections. Banks' investments in SLR securities, as a proportion of their net demand and time liabilities (NDTL), were higher than at end-March. The Reserve Bank continued with the policy of active management of liquidity through increases in the cash reserve ratio (CRR), issuances of securities under the Market Stabilization Scheme (MSS), operations under the liquidity adjustment facility (LAF) and conduct of open market operations (OMO). Broad money growth (M3), year-on-year (y-o-y), was higher at 22.4 percent on January 4, 2008, as compared with 21.3 per cent at end-March 10

IFS / Role of RBI in Indian economy/SVIM MBA Finance’ 07-09

2007and 20.8 per cent a year ago. This reflected a strong expansion in aggregate deposits, which on a year-on-year basis, remained higher than the projected trajectory of Rs.4,90,000 crore for 2007-08 set out in the Reserve Bank's Annual Policy Statement. Monetary expansion was mainly driven by sizeable accretion of net foreign exchange assets. The other major source of monetary expansion, i.e., bank credit to the commercial sector decelerated during the same period. Non-food credit (inclusive of non-SLR investments) decelerated and was close to the policy projection of 24.0-25.0 per cent. Expansion in the residency based new monetary aggregate (NM3) - which does not directly reckon nonresident foreign currency deposits such as FCNR(B) deposits also accelerated to 22.5 per cent on January 4, 2008 from 20.0 per cent a year ago, mainly reflecting the decline in non-resident foreign currency deposits during this period. Growth in liquidity aggregate, L1, at 22.4 per cent at end-December 2007 was also higher than that of 19.4 per cent a year ago (Table 19 and Chart 8). Taking into consideration the trends in monetary aggregates and in order to absorb excess liquidity from the system, the Reserve Bank has increased the CRR by 250 basis points since December 2006. The ceiling on the outstanding amount under the Market Stabilization Scheme (MSS) for the year 2007-08 was also successively raised on four occasions to Rs.2,50,000 crore. On a year-on-year basis, currency with the public increased by 15.1 per cent, lower than the growth of 16.8 per cent in the corresponding period of the previous year. Growth in demand deposits was also lower than a year ago as well as that at end-March 2007.

(2) Banker, Agent and advisor to the Government : The reserve bank of India acts as the banker, agent and advisor to the Government of India. It accepts payments for the account of the union and a state governments and also makes payments on behalf of the Government. On behalf of the Government, RBI carries remittances, managing foreign exchange reserves and public debts and other banking operation. It also makes way and means advances to the central and state Government repayable within three months. The reserve bank of India carries out agency functions of the Government as the commercial banks carries out on behalf of their customers. The state Bank of India works as an agent of the RBI where its offices do not exist. The RBI does not charge any fee for its operation from the Central and state Governments. It also does not pay any interest on the deposits of the central and state Government accounts. The reserve Bank, as the agent of the 11

IFS / Role of RBI in Indian economy/SVIM MBA Finance’ 07-09

Government, issues Government securities to the public and collect money on behalf of the Government. It also manages public debts to the central and state Governments. The RBI pays interest on the securities and redeemed at the time of maturity and also maintain accounts of this effect. The RBI also issues treasury bills of Government for three months. The RBI is also authorized to make to the central and state Government, ways and means advances which are repayable in three months. It not only advises Govt. on all monetary and banking issues but also on a wide range of economic issues including those in the field of planning and resource mobilization. It also manages foreign exchange reserves to meet the important requirement. Thus, RBI acts as the custodian public debts. It also advises Govt. in the matters of agriculture credit, cooperation, banking and credit and investment of funds. The issue, management and administration of the public debt of the Government is a major function of the RBI for which it charges a commission. The objective of the debt management policy is to raise resources from the market at the minimum cost, while containing the refinance risk and maintaining consistency with the monetary policy objectives, to bridge temporary mismatches in the cash flows (i.e. temporary gaps between receipts and payments), the RBI provides Ways and Means Advances (WAMAs). The maximum maturity period of these advances is three months. The WAMAs to the state Governments are of three types : (1) normal advances, that is advances without any collateral security; (2) secured advances, which are secured against the pledge of central Governments securities and (3) special advances granted by the RBI at its discretion. In addition to WAMAs, the state government make heavy use of overdrafts from the RBI, in excess of the credit limits (WAMAs) granted by the RBI. Overdrafts are, in a way, unauthorized WAMAs drawn by the state governments, on the RBI. In fact, the management of these overdrafts is on of the major responsibilities of the RBI these days. The interest charged by the RBI on the WAMAs is related to a graduated scale of interest based on its duration. Overdrafts upto 7 days are charged at the bank rate and an interest of 3 per cent above the bank rate is charged from the 8th day onwards. The provisional net allocation under market borrowing programme of the State Governments for 2008-09 is placed at Rs.44,629 crore. Taking into account repayments of Rs.14,371 crore, the gross market borrowings of State Governments are estimated at Rs.59,000 crore. During the current year so far(up to July 18, 2008), eight State Governments raised Rs.8,712 crore through auctions with a cut-off yield in the range 8.39-9.81 per cent as compared withRs.7,153 crore by 13 State Governments (cut-off yield 12

IFS / Role of RBI in Indian economy/SVIM MBA Finance’ 07-09

ranging from 8.30-8.57 percent) during the corresponding period of the previous year. The weighted average interest rate on market loans firmed up to 8.87 per cent during 2008-09 (up to July 18, 2008) from 8.41 per cent during the corresponding period of 2007-08(Table 21). The spreads of State Government securities over the yields of Central Government security of corresponding maturity ranged between 30 and 98 basis points as against 22 and 35 basis points during the corresponding period of 2007-08. The average daily utilization of WMA and overdraft by the States during 2008-09 (up to July 18, 2008) was Rs.351 crore as compared with Rs. 736 crore during the corresponding period of 2007-08 (Chart 6). Four States availed of WMA and three States resorted to overdraft during 2008-09 (up to July 18, 2008) as compared with six States and three States, respectively, during the corresponding period of the previous year.

13

IFS / Role of RBI in Indian economy/SVIM MBA Finance’ 07-09

The cash surplus position of the States, as reflected in their average investments in Treasury Bills (14-day Intermediate Treasury Bills and Auction Treasury Bills) was higher at Rs. 82,637 crore on July 18, 2008 than that of Rs.75,659 crore on July 18, 2007. The average investments by the States in Treasury Bills during 2008-09 (up to July 18, 2008) amounted to Rs. 81,750 crore as compared with Rs. 70,608 crore during the corresponding period of 2007-08 (Chart 7).

14

IFS / Role of RBI in Indian economy/SVIM MBA Finance’ 07-09

(3) Banker’s Bank : As an apex bank the RBI acts as banker of the banks and lender of the last resort. Under the RBI Act, the bank has been vested with extensive powers of supervision and control over all scheduled commercial and cooperative banks. Once the name of a bank is incorporated in the second schedule of the RBI Act, it becomes entitled to refinance facility from the RBI. Under the act, every schedule bank is required to keep with the RBI a cash balance of 5% of its total demand and time liabilities as cash reserve ratio. Now, CRR has reduced from 5% to 4.75 with effect from 16 November,2002. the cash reserve ratio may be between 3 to 15% as decided by the Reserve Bank. This provision is also applicable on non-scheduled banks. This provision of cash reserve enables the Reserve Bank to control credit which is created by commercial banks. In case of need of funds, commercial banks can borrow funds from Reserve Bank on the basis of eligible securities or get financial accommodation in times of need or stringency by rediscounting their bills of exchange. Therefore, commercial banks always look upon the Reserve Bank at the Time of financial crisis. Fom the data below it is clear that Growth in deposits, issuances of fresh capital and internal generation of funds by banks on the one hand, and moderation in credit growth on the other, enabled banks to deploy their funds in Government and other approved securities, which increased by 24.7 per cent, y-o-y, as on January 4, 2008 as compared with 5.9 per cent a year ago.

(4) Custodian of Foreign Exchange Reserves : one of the important function performed by the Reserve Bank is that of external value of the rupee. Apart from adopting appropriate monetary polices for the economic stability in the country and thereby exchange stability in the long-term, the Reserve Bank has to ensure that the normal short-term fluctuations in trade do not affect the exchange rate. This is secures by the centralization of the entire foreign exchange reserves of the country with the Reserve Bank of India. In order to maintain stability in exchange rates, the Reserve Bank enter into foreign exchange transactions. It also administers foreign currency for the central Government, state Govt. and Indian embassies in foreign countries. There is a separate department for 15

IFS / Role of RBI in Indian economy/SVIM MBA Finance’ 07-09

this purpose in RBI known as “Exchange control currencies and tries to maintain balance between the demand and supply of foreign exchange. The Reserve Bank is also authorized to buy and sell foreign exchange from and to scheduled banks.

During 2007-08, the Indian rupee generally exhibited two-way movements (Chart 31). The rupee moved in the range of Rs.39.26-43.15 per US dollar during 2007-08. The rupee depreciated during the first half of August 2007 due to bearish conditions in the Asian stock markets including India, strong FII outflows and concerns over sub-prime lending crisis in the US, while it appreciated thereafter reflecting large capital inflows, weakening of the US dollar vis-à-vis other currencies and strong performance in the domestic stock markets. However, the rupee started depreciating against the US dollar from the beginning of February 2008 on account of bearish conditions in the stock market, capital outflows, rising crude oil prices and increased demand for US dollars by corporates. The exchange rate of the rupee was Rs.39.99 per US dollar on March 31, 2008. At this level, the Indian rupee appreciated by 9.0 per cent over its level on March 31, 2007. Over the same period, the rupee appreciated by 7.6 per cent against the Pound sterling, while it depreciated by 7.8 per cent against the Euro, 7.6 per cent against the Japanese yen and 1.1 per cent against the Chinese yuan. During 2008-09 so far (up to July 23, 2008), the Indian rupee generally depreciated. The rupee moved in the range of Rs.39.89-43.16 per 16

IFS / Role of RBI in Indian economy/SVIM MBA Finance’ 07-09

US dollar during the first quarter. The rupee, which depreciated during fourth quarter of 2007-08,up to mid-March 2008, appreciated thereafter till end-March 2008, reflecting strong DI inflows. After trading in a range of Rs. 39.89-40.02 per US dollar till April 22,2008, the rupee broke above the value of Rs. 40.00 per US dollar on April 24, 2008.The rupee depreciated continuously thereafter, reflecting large capital outflows by FIIs (US $ 5.2 billion during the first quarter of 2008-09), increased demand for dollars by the oil companies and bearish stock market conditions. The exchange rate of the rupee was Rs.42.33 per US dollar on July 23, 2008. At this level, the Indian rupee depreciated by 5.5 per cent over its level on March 31, 2008. Over the same period, the rupee depreciated by 5.7 per cent against the Pound sterling, 5.5per cent against the Euro and 8.2 per cent against the Chinese Yuan, while appreciated by 1.8 per cent against the Japanese yen.

(5) Regulation of Banking System : The prime duty of the reserve Bank is to regulate the banking system of our country in such a way that the people of the country can trust in the banking Up to perform its duty. The Reserve Bank has following powers in this regard: I.Licensing : According to the section 22 of the Banking Regulation Act, every bank has to obtain license from the Reserve Bank. The Reserve Bank issues such license only to those banks which fulfill condition of the bank should be strong. The RBI is also empowered to cancel the license granted to a bank works against the interests of the depositors. II. Management: Section 10 of the Banking Regulation Act embowered the Reserve Bank to change manager or director of any bank if it considers it necessary or desirable. III. Branch Expansion : Section 23 requires every bank to take prior permission from Reserve Bank to open new places of business in India or ro change the location of an existing place of business in India or abroad.

17

IFS / Role of RBI in Indian economy/SVIM MBA Finance’ 07-09

IV. Power of inspection of Bank : Under Section 35, the Reserve Bank may inspect any bank and its books and its books and accounts either at its own initiative or at the instance of the Central Government. If, on the basis of the inspection report submitted by the Reserve Bank. Central Government is of the opinion that the affairs of the bank are being conducted to the detriment of the interests of depositors, it may direct to the Reserve Bank to apply for the winding up of such bank.

V. Power to issue Directions: Section 35(A) of IBR Act confers powers to RBI to issue direction or to prevent the affairs of the being conducted in manner detriment to the interests of the depositors or in a manner prejudicial to the interests of the bank or to secure proper management of the bank. Section 36 confers powers on the RBI to caution or prohibit banks against entering into any particular transaction and generally give advice to any bank. It may pass orders requiring the bank to carry out the specified instructions. In order to develop a strong banking structure in the country the RBI promotes amalgamation or merger of weak banks so that they can develop as a strong bank. Section 38 of the Act, empowered RBI to request to High Court to windup the bank which has no hopes of improvement.

(6) Clearing House Functions The RBI operates clearing houses to settle banking transactions. The RBI manages 14 major clearing houses of the country situated in different major cities. The State Bank of India and its associates look after clearing houses function in other parts of the country as an agent of RBI.

(7) Credit Control Credit control is a very important function of RBI as the Central Bank of India. For smooth functioning of the economy RBI control credit through quantitative and qualitative methods. Thus, the RBI exercise control over the credit granted by the commercial bank. Details of this has been discussed as a separate hading.

18

IFS / Role of RBI in Indian economy/SVIM MBA Finance’ 07-09

The reserve Bank is the most appropriate body to control the creation of credit in view if its functions as the bank of note issue and the custodian of cash reserves of the member banks. Unwarranted fluctuations in the volume of credit by causing wide fluctuations in the value of money cause great social & economic unrest in the country. Thus, RBI controls credit in such a manner, so as to bring ‘Economic Development with stability’. It means, bank will accelerate economic growth on one side and on other side it will control inflationary trends in the economy. It leads to increase in real national income of the country and desirable stability in the economy.

Objectives of credit control : To obtain stability in the internal price level. To attain stability in exchange rate. To stabilize money market of a country. To eliminate business cycles-inflation and depression-by controlling supply of credit. To maximize income, employeement and output in a country. To meet the financial requirements of an economy not only during normal times but also during emergency or war. To help the economic growth of a country within specified period of time. This objective has become particularly necessary for the less developed countries of present day world.

Methods and instruments of credit control : There are many methods of credit control. These methods can be broadly divided into two categories : I. Quantitative or General Methods. II. Qualitative or selective methods. The quantitative methods of credit control aim at influencing the quantity or total volume of credit in an economy during a particular period of time. The qualitative methods of credit control aim at influencing the quality of use of credit with respect to a particular area or field of activity. Quantitative system of credit control includes following instruments : 1) Bank Rate 2) Open Market Operation (OMO) 19

IFS / Role of RBI in Indian economy/SVIM MBA Finance’ 07-09

3) Change in Cash Reserve Ratio (CRR) 4) Statutory Liquidity Ratio (SLR) 5) Repo and Reverse repo rate Qualitative system consist of the following instruments : 1) 2) 3) 4)

Selective credit control Rationing of Credit Moral Persuasion Direct Action

With the inflation rate based on wholesale price index hardening since the Annual Policy Statement was announced, an adjustment of overall aggregate demand on an economy-wide basis was warranted to ensure that generalized instability did not develop and eroded the hard-earned gains in terms of both outcomes of and positive sentiments on India’s growth momentum. In this regard, monetary policy had to urgently address aggregate demand pressures, which appeared to be strongly in evidence. Apart from the build-up in inflationary expectations, this was reflected in (i) strong investment demand; (ii) sustained high growth in domestic capital goods production albeit with some moderation in 2008-09 so far; (iii) revival in the production of consumer goods with a turnaround in the production of 20

IFS / Role of RBI in Indian economy/SVIM MBA Finance’ 07-09

durables; (iv) widening trade deficit and some tightening of external financing conditions in the ongoing global financial turmoil; and (v) emergence of fiscal pressures due to the possibility of enhanced subsidies on account of food, fertilizer and POL as well as for financing deferred liabilities relating to farm loan waivers. Keeping in view the liquidity conditions and inflationary pressures in the economy, the cash reserve ratio was raised by 75 basis points to 8.25 per cent during April-May 2008 in three stages of 25 basis points each effective from April 26, May 10, and May 24, 2008. On May 30, 2008, special market operations were announced to alleviate the binding financing constraints face by public sector oil companies in importing POL as also to minimize the potential adverse consequences for financial markets in which these oil companies are important participants. On a review of the current macroeconomic and overall monetary conditions and with a view to containing inflation expectations, the repo rate under the Liquidity Adjustment Facility (LAF) was raised by 25 basis points to 8.0 per cent with effect from June 12, 2008. Consistent with the overall stance of monetary policy set out for 2008-09 in April 2008 in terms of ensuring a monetary and interest rate environment that accords high priority to price stability, well anchored inflation expectations and orderly conditions in financial markets and on the basis of incoming information and domestic and global macroeconomic and financial developments, it was decided on June 24, 2008 to increase the repo rate under the LAF by 50 basis points to 8.50 per cent with effect from June 25, 2008 and the CRR by 50 basis points to 8.75 per cent in two stages of 25 basis points each with effect from July 5, 2008 and July 19, 2008 (Table 35).

I. Qualitative Methods of Credit Control 1) Bank Rate : Bank Rate is the rate at which central bank grant loans to the commercial banks against the security of government and other approved first class securities. According to section 49 of RBI Act, “Bank Rate is the standard rate on which RBI purchase or discount such exchange bills or commercial papers which can be purchased under this act.” Reserve Bank of India controls credit by affecting quantity and cost of credit money through its bank rate policy. But this method of credit control would

21

IFS / Role of RBI in Indian economy/SVIM MBA Finance’ 07-09

be effective only when there is organized money market and commercial banks depend on reserve bank for their credit. Reserve Bank adopts cheap or Dear Monetary Policy according to the economic conditions of the country. RBI decreases bank rate to increase the quantity of the credit. This is called Cheap monetary policy. Decease in bank rate decreases cost of credit i.e. decrease in interest rate. As a result of this quantity of credit increases. According to dear monetary policy of RBI increases bank rate to decrease quantity of credit in the country. Increase in bank rate increases cost of credit i.e. increase interest rate and this will result in decrease in quantity of credit. Operation of Bank Rate Policy in India : At the time of establishment of RBI the bank rate was 3.5% which had changed time to time. Till 1951, the bank rate was constant at 3% as Reserve Bank followed Cheap Money Policy during this period. Since 1951 till now bank rate has continuously changing. In 1991 at the time of higher inflation, bank rate has changed twice and increased from 10% to 11%. On 29 April, 1998, it has reduced from 11% to 9%. It was further reduced to 8% in march, 1999 and 7% in April,2000. it was further reduced to 8% in march,1999 and 7% in April,2000. it was further changed several times and on 23 October, 2001 it reduced to 6.5%. Now The bank rate policy of credit control has not been succeed in India. As it is failed to control inflationary trend in the economy. It has failed to influence interest rate in the money market. The bank rate policy proves inefficient due to following reasons : Major part of the credit in the market is made available by nonbanking institutions. The interest charged by these institutions have no direct relation with the bank rate. Most of the changes in bank rate has been made effective for combating inflationary trends. Speculative tendencies in the economy carry large premiums in the form of huge margins of profit. A small change in bank rate does nor significantly affect the profit margin. Priority sector leading has almost become immense to the effect of changes in the bank rate. Increasing non-dependence of commercial banks on the central bank for rediscounting facilities is one of the ineffective bank rate in India. Though the bank rate policy has not been effective in India. Yet the Reserve Bank has been using it more and more as a weapon to control deflationary pressure in the economy. During the last few years, the bank rate has been 22

IFS / Role of RBI in Indian economy/SVIM MBA Finance’ 07-09

reduced several times to combat the deflationary pressures in the economy. But this year it is currently stipulated at 6%. 2) Open Market Operations : The term ‘Open market operation’ implies the purchase and sale by the Central Bank not only the Govt. securities but also of other eligible papers. Like bills and securities of private concerns section 17(8) of RBI Act. Empowers Reserve Bank to purchase the securities of central Govt. state Govt. and other autonomous institutions. Apart from this section 17(2)(A) empower Reserve Bank to purchase or sell of short term bills. Open market operations are used as supporting instrument of bank rate. This method is used to influence the flow of credit. Sale and purchase of Govt. securities influence the cash reserve ratio with the commercial banks and hence these operations control their credit creation power. These operation will have both anti-inflationary and anti-deflationary effects. When the economy is faced with the inflationary pressures, the central bank would like the commercial banks to contract the supply of credit. To achieve this objective the central bank would sell the Govt. securities to the commercial banks. The banks would transfer a part of their cash reserve to the central bank towards the payment for these securities. Consequently the cash reserve with the commercial banks will be reduced. It would lead to a contraction in the credit creation power of the commercial banks. Similarly, open market operations can also be used as anti-deflationary measures. In this situation, the central bank will purchase securities from the commercial banks. In this situation, the central bank will purchase securities from the commercial banks. In the process. The cash reserves with the commercial banks will increase and they would be enabled to create more credit. The open market operations in India are limited by Reserve Bank. The bank has used this policy only to make successful government debt policy and to maintain price stability of Govt. securities. It is used to fulfill seasonal credit requirements of commercial banks. 3) Cash Reserve Ratio (CRR) : The RBI controls credit through change in Cash Reserve Ratio of commercial banks. According to section 42(1) of RBI Act every schedule bank has to maintain a certain percentage reserve of its time and demand deposits. This ratio can be varied from 3% to 15% as directed by the Reserve 23

IFS / Role of RBI in Indian economy/SVIM MBA Finance’ 07-09

Bank. Reserve Bank itself changed this ratio according to the credit requirement of the economy. It has been changed several times in the history of Reserve Bank of India. The cash reserve ratio affects on the lend able funds of commercial banks. If this ratio increases the credit creation capacity of commercial banks decreases. On the other hand if this ratio decreases the credit creation capacity of commercial banks increases. On 17 April 2008, the Reserve Bank of India hiked the cash reserve ratio of scheduled commercial banks, regional rural banks, scheduled state co-operative banks and scheduled primary (urban) co-operative banks by 50 basis points to 8 per cent in two stages effective 26 April 2008 and 10 May 2008. The monetary authority stated that as a result of the above increase in CRR on liabilities of the banking system, an amount of about Rs.18,500 crore of resources of banks would be absorbed. In this context, it may be noted that surplus liquidity in the banking system amounted to Rs.2,43,566 crore as on 4 April 2008. The Reserve Bank's move comes at a time when there are only 12 days left for its monetary policy. The monetary policy is due to be announced on 29 April 2008.The hike in the cash reserve ratio of banks is a measure aimed at reducing liquidity in the banking system thereby reducing the money supply which in turn is expected to help curb inflation. The CRR hike will put margins of banks under a bit of a pressure since they wont be earning anything on the money that they park with the RBI as cash reserve. The CRR hike will put margins of banks under a bit of a pressure since they wont be earning anything on the money that they park with the RBI as cash reserve. On 29 April 2008, the Reserve Bank of India released its annual monetary policy statement for the year 2008-09. It increased the cash reserve ratio for scheduled commercial banks by 25 basis points to 8.25 per cent with effect from 24 May 2008. It was only less than a fortnight ago that the bank had raised the cash reserve ratio. On 17 April, the monetary authority had announced that the CRR would be raised by 25 basis points with effect from 26 April 2008 and by another 25 basis points with effect from 10 May 2008. The two increases announced on 17 April were expected to suck out Rs.18,500 crore from the banking system. Recently, RBI has hiked the cash reserve ratio (CRR) by 25 basis points to 9 per cent beginning 30 August 2008. The 25 basis points hike in the cash reserve ratio will suck out about Rs.8,000-8,500 crore of liquidity from the banking system.

24

IFS / Role of RBI in Indian economy/SVIM MBA Finance’ 07-09

4) Statutory Liquidity Ratio (SLR) : According to the section 24 of the Banking Regulation Act. Every schedule Bank have to maintain a minimum of 25% as cash of its total deposits. The Reserve Bank of India is empowered to change this ratio. As on 21, 1997, it was fixed to 25% of the total deposits of Banks. It also influences the credit creation capacity of the banks. The effect of bi\both cash reserve ratio and statutory liquidity ratio on credit expansion is similar. Penalties are levied by RBI for not maintaining these ratios from scheduled banks. 5) Repo rate and Reverse repo rate : There is two kind of repo and are as under : I. Inter bank repo : Such repos are now permitted only under regulated conditions. Repos are misused by banks/brokers during the 1992 securities scam. They were banned subsequently . with the lifting of the ban in 1995, repos were permitted for restricted, eligible participants and instruments. Initially, repo deals were allowed in T-bills and five dated securities on the NSE. With gradual liberalization over the years, all central govt. dated securities, state Govt. security and T-bills of all maturities have been made eligible for repo. Banks and PDs can undertake repo deals if they are routed through the SGL, accounts maintained by the RBI. Repos are allowed to develop a secondary market in PSU bonds, FIs bonds, corporate bonds and private debt securities if they are held in demat form and the deals are done through recognized stock exchange(s). there are no restrictions regarding a minimum period for inter-bank repo deals. Non-bank participants (i.e., FIs and other specified participants) are allowed to participate only in the reverse repo, that is they can only lend money to other eligible participants. The non-bank entities holding SGL accounts with the RBI can enter into reverse repo transactions with banks/PDs, in all Government securities. II.

RBI Repos :

The RBI undertakes repo/reverse repo operations with banks and PDs as part of its OMOs, to absorb/inject liquidity. With the introduction of the LAF, the RBI has been injecting liquidity into the system through repo on a daily 25

IFS / Role of RBI in Indian economy/SVIM MBA Finance’ 07-09

basis. The repo auctions are conducted on all working days except Saturdays and are restricted to banks and PDs. This is in addition to the liquidity support given by the RBI to the PDs through refinance/reverse repo facility at a fixed price. Auctions under LAF were earlier conducted on a uniform price basis, that is, there was a single repo rate for all successful bidders. Multiple price auction was introduces subsequently. The weighted average cut-off yield in case of a multiple price auction is released top the public. This, along with the cut-off price, provides a band for call money to operate. The RBI conducts repo auctions to provide banks with an outlet for managing short-term liquidity; even out short-term liquidity fluctuations in the money market; and optimize returns on short-term surplus liquid funds. The RBI has switched over from discriminatory price auction repo to the daily fixed rate repos auction system. Fixed rate repos are single money market rates, bring about orderly conditions in the forex market and impart stability to short-term interest rates by setting a floor for call money rates. The RBI participants actively in the call money market with LAF repos operations conducted throught the year to modulate the surplus liquidity in thee market. It also conducts reverse repo operations under the LAF to prevent sudden spurts in the call rates. Both repos and reverse repo operations play an effective role in imparting stability to the market. The repo rate has become akin to a singling rate, togther with the B/R. the repo rate serve the purpose of a floor and the B/R, that of a cap for the money market to operate within an interest corrodor. With the introduction of variable repo rates and daily repo auctions, a market-determined benchmark is expected to emerge for the call (overnight) rate. As a result of the conversion of the call/money market into a pure inter-bank call/notice money market, the repo rate, along with the B/R and CRR, emerged as an important tool of liquidity and monetary management. To sum up, the RBI’s regulation of money and credit now comprises of (1) the reactivation of OMOs and introduction of repos, (2) the introduction of LAF and its emergence as one of the significant operating instruments, (3) the reactivation of B/R and the use of repo rate, (4) the continuation of the use of the CRR. The B/R changes, combined with changes in the CRR and LAF repo rates have emerged as active and important tools of liquidity and monetary management. The LAF has developed as an effective tool for absorbing/injecting liquidity on a day to day basis in a flexible manner and for providing a corridor for the call money and other money markets. On 29 July 2008, the Reserve Bank of India increased the repo rate by 50 basis points to 9 per cent. Banks are aggressively using the repo 26

IFS / Role of RBI in Indian economy/SVIM MBA Finance’ 07-09

facility of the RBI since the beginning of July. They borrowed almost Rs.38,900 crore per day from the RBI through its liquidity adjustment facility. Therefore the hike in the repo rate by the RBI will surely put some pressure on the cost of funds of banks. As in the year of 2004 CRR was 4.50% and Repo stands at 6% and reverse repo was 4.50% but at that time inflation was around 4.6%, on September 18, inflation rate zoom past to 7.9% but Repo and Reverse repo rate remained unchanged and CRR increases by 0.25 basis point to 4.75% consecutively on October 2, increase in CRR by 0.25 point following high inflation rate then from October, 2004 to july, 2006 there is continuous increase of 0.25 point each level in Reverse repo rate against which CRR stands unchanged at 5% and inflation was decreasing at that time, again from December, 2006 following high inflation rate CRR was hiked to 0.25 point and Repo rate was at 7.25% while Reverse repo rate remains unchanged to 6%.on January 2007 inflation rose to 6.4 and CRR again increased to 5.50 %. On a review of the current macroeconomic and overall monetary conditions and with a view to containing inflation expectations, the repo rate under the Liquidity Adjustment Facility (LAF) was raised by 25 basis points to 8.0 per cent with effect from June 12, 2008. Consistent with the overall stance of monetary policy set out for 2008-09 in April 2008 in terms of ensuring a monetary and interest rate environment that accords high priority to price stability, well anchored inflation expectations and orderly conditions in financial markets and on the basis of incoming information and domestic and global macroeconomic and financial developments, it was decided on June 24, 2008 to increase the repo rate under the LAF by 50 basis points to 8.50 per cent with effect from June 25, 2008 and the CRR by 50 basis points to 8.75 per cent in two stages of 25 basis points each with effect from July 5, 2008 and July 19, 2008.

II. Qualitative Methods of Credit Control Under section 21 of RBI Act, Reserve Bank is empowered to regulate control and direct the commercial banks regarding their loans and advances. Qualitative methods are used to effect the use, distribution and direction of credit. It is used to encourage such economic authorities as desirable and to discourage those which are injurious for the economy. Reserve Bank of

27

IFS / Role of RBI in Indian economy/SVIM MBA Finance’ 07-09

India from time to time adopted the following qualitative methods of credit control. 1) Selective Credit Control : Section 36(1) (a) of the Banking Regulation Act, empowers the RBI to contain or prohibit banking companies generally or any banking company. The objective of these controls is to discourage some forms of activities while encouraging others. Such controls are used in respect of agriculture commodities, which are subject to speculative hoarding and wide price fluctuation. Under section 21 of the banking regulation Act, 1949, the Reserve Bank is empowered to issue directives to banking companies regarding making of advances. These directions may be as follows : The purpose for which advances may or may not be made. Fixing the margin requirements for advances against each commodity. Fixing of maximum limit to be advanced by banks to a particular borrower. Fixing of rate of interest and other terms for making advances. Fixing of maximum guarantees may be given by the banks on behalf of any firm or company. Prohibition on grant of credit against book debts and clean credits. Some of the elative credit controls are as follows : (a) Differential Discount Rates : The reserve Bank fixes different discounting rates for the bills of different sectors. The sector for which more credit is to be made available the exchange bills re discounted at a lower rate. On the other hand, if RBI wants to discourage credit for a particular sector, it increases the discount rate for bills or the facility for rediscounting is postponed. (b) Credit Authorization Scheme : This scheme was introduced with the objectives of enforce financial discipline on the larger borrowers and ensure that they did not pre-empt scare bank resources. Through this scheme, the RBI regulate not only the quantum but also the term of credit flows. Under this scheme, commercial banks are required to obtain RBI’s permission before sanctioning any fresh credit of Rs. Six crore or more to any single borrower. This limit may be changed time by time. 28

IFS / Role of RBI in Indian economy/SVIM MBA Finance’ 07-09

(c) Fixation of Margin : The commercial banks generally advance loans to their customers against some security or securities offered by the borrowers and acceptable to the banks. The commercial banks do not lend up to the full amount of the value of a security but lend an amount less than its value. The margin requirements against specific securities are determined by the Reserve Bank. RBI changed the margin frequently according to the credit policy. Changes in margin requirements are designed to influence the flow of credit against specific commodities. A rise in the margin requirements results in contraction in the borrowing value of the security and similarly, a fall in the margin requirement results in expansion in the borrowing value of the security. If RBI desires that more loans should be advanced against particular securities, it can lower the margin requirement. Similarly, if RBI desires to check the expansion of credit against particular securities it can raise the margin requirement. (d) Reserve Bank can also instruct commercial banks charging discriminating rates of interest on certain types of advances (e) Reserve Bank from time to time fixes ceiling n amount of credit for certain purposes. (f) Reserve Bank can ban on advances to specific sector to check inflationary pressures. 2) Rationing of Credit : In this method the RBI seeks to limit the maximum or ceiling of loans and advances and also in certain cases, fixes ceiling for specific categories of loans and advances. If the rationing of credit is done with reference to the total amount, it is a quantitative control, but if it is done with reference to specific types of credit, it assumes a qualitative control. Reserve Bank can also prescribe the minimum ratio between capital and total assets. 3) Moral Persuasion : Moral persuasion refers to those cases where the Reserve Bank endeavors to achieve its object by making suitable representations to the banking institutions concerned and relying on its moral influence and power of persuasion. Being an apex institution and lender of the last resort, the RBI 29

IFS / Role of RBI in Indian economy/SVIM MBA Finance’ 07-09

can use its more pressure and persuade the commercial bank to follow its policy. During inflationary conditions it may request the commercial banks not to press for frequent loans, to refuse loans to the customers and to refrain from investing funds in the unproductive or less productive occupations. 4) Publicity : The RBI may also follow the policy of publicity in order to make known to the public its views about the credit expansion or contraction. It may issue warning to the people and commercial banks, substantiating its views by facts, figures and statements, through the media of publicity. This method, however, is ineffective in the developing economies where mass illiteracy exists and people do not understand the implications of the policy. 5) Direct Action : Under Banking Regulations Act, the RBI is empowered to initiate direction action against those commercial banks which ignore its advice. In such cases RBI can impose restriction on sanctioning of loans and advances of concerned banks. Winding up of Bank of Karad in 1992 because of financial irregularities and putting up of certain restrictions on the working of Metropolitan Co-operative Bank are the examples of direct action initiated by RBI. The RBI may refuse rediscounting facilities to the banks who do not cooperative with the policies of the Bank.

(8) Other Functions The RBI performs following other functions: (i)

(ii)

(iii)

Agriculture Credit : All matters relating to agriculture credit are looked after by RBI before the establishment of NABARD in 1982. Now all functions relating to agriculture and rural development are performed by NABARD. Industrial Finance : The RBI has contributed in the share capital of industrial finance institutions such as Industrial Finance Corporation of India, Industrial Development Bank of India, State Finance Corporations etc. Thus RBI indirectly contributes in the field of industrial finance. Publication of Data : The RBI publishes statistics regarding money, price, finance etc, in its periodicals. This provides valuable 30

IFS / Role of RBI in Indian economy/SVIM MBA Finance’ 07-09

information for Govt., business and industries. These information are helpful to take decisions. The important publications of RBI are the Reserve Bank of India Annual Report, currency and finance, trends and progress of Banking etc. At present, there are more than 100 publications of RBI. (iv) Banking Education and Training : The RBI has been organizing various education and training programmes for bank employees and officers. ‘Banker Training College’ Mumbai has been setup by RBI for the training of Bank officers. Other important training institutes such as “College of Agriculture Banking (Pune), Reserve Bank staff Training College (Chennai) etc. had been setup by the RBI. RBI had also setup regional training centers at Mumbai, Kolkata, Chennai and Delhi. (v) Remitting Facility :Reserve Bank Provides remitting facilities to the central Government, state Government and semi-Government institutions free of cost. It also provides this facility to cooperative banks free of cost. (vi) Conversion of currency : The RBI converts spoiled currency in to fresh currency. It also provides facilities to convert currency notes into small denominating coins. (vii) To accept Deposits : The RBI accept deposits from Central and state Government’s institution and individual persons without paying interest. (viii) Transactions with international institutions : All international economic transactions are being made through RBI. RBI opens its accounts in the central bank of member countries of IMF. It also deals with IMF, World Bank and other international financial institutions. (ix) Transactions in precious metals : In order to fulfill its obligations, RBI buys and sells precious metals, gold coins etc. RBI can borrow funds by mortgaging these precious metals. (x) Expansion of Banking facilities : RBI has played an important role in expansion of banking facilities in the rural areas of the country. At the end of June, 2001, there are 65,931 bank branches are situated in country, out of which more than half of the branches are situated in rural areas. At the end of 2000, on an average there was only one bank branches at a population of 5,000 in the country.

31

IFS / Role of RBI in Indian economy/SVIM MBA Finance’ 07-09

(xi)

Supply of Development Finance : The RBI provides development finance for the different parts of the economy. It leads economic development of the country as a whole.

32

IFS / Role of RBI in Indian economy/SVIM MBA Finance’ 07-09

BIBLIOGRAPHY BOOKS : Dr. V.K. Vashisth & Dr. H.R. Swami & Dr. B.P.Gupta (2003); BANKING AND FINANCE, first edition, page no.6.1 to 6.26. M Y Khan (2007); INDIAN FINANCAIL SYSTEM, 5th edition, page no.10.4 ECONOMIC TIMES(Gujarati), 13th September,2008, page no.7. WEBSITES www.rbi.org.in

Troublesome

to acquire, troublesome to protect, troublesome if lost, troublesome if spent; money is nothing but trouble, from beginning to end. - Panchatantra, 200 BC

33