Central Banking System & Rbi

9/13/2007

Structure of Indian Financial System: Central Bank of the Country (RBI in case of India) Commercial Banks

Public Sector

SBI & As Nationalised Banks RRBs

Pvt. Sector

Foreign Banks

Other Institutions

Cooperative Societies

State Coop.

Land Dev Banks

Gov

Pub Sector

Pvt. Sector

NSC, PO, EPF

Non-Scheduled Banks LIC, GIC, UTI, EXIM Bank, IDBI, IFCI, IRBI, NABARD, SFC, SIDBI, STCI, etc.

Chits, Nidhis, Corporate bodies, Hire Purch Cos., Investment Cos, Merchant Banks,

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CENTRAL BANK •

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It is the APEX monetary institute in the money market which acts as the monetary authority of the country and serves as the Government‟s bank as well as the bankers‟ bank. In brief, we may say that the central bank is an organ of the Government which, by reason of its operations influences the working of the FIs of the country.

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How does the Central Bank differ from other banks?   

Is a Government Organ It does not exist to secure maximum profit Have a special controlling relationship with the commercial banks

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General Functions of The Central Bank: 

Issue of Currency Notes:

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Issued on the basis of minimum currency reserve system.

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Acts as Government Banks:

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Collection and disbursements

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

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Temporary advance to Government in anticipation of collection of taxes

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Government‟s financial agent

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Advisor to Government regarding Monetary and Fiscal Policies

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Acts as Banker‟s Bank

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Holds certain portion of deposits of commercial banks

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Extends financial facilities to CB when there is a crisis

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Acts as a bank for central clearance

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Foreign Exchange

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Monopoly power to control and regulate foreign exchange

The Main Function of Central Bank is to Regulate the Monetary Mechanism comprising of currency, banking and credit system.

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THE RESERVE BANK OF INDIA

Mint Road, Mumbai

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Historical Perspective •

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

The earliest effort to set up a central bank dates back to 1773 when Warren Hastings, the Governor of Bengal recommended the establishment of a “General Bank in Bengal and Bihar.” The next attempt was made in 1807-08 when Robert Richards, a member of the Bombay Government submitted a scheme for a General Bank… but the Governor General was not impressed.

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

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Bank of Bombay 1840-1921

Bank of Madras 1843-1921

•The First Major step was taken in 1921 when the three Presidency Banks

were amalgamated to for the Imperial Bank of India. It was primarily a commercial bank but also performed certain central banking functions.(But note issue and Foreign exchange were the direct responsibility of the Central Govt.) •In 1926 the Hilton Young Commission recommended that the dichotomy of the functions and divisions of responsibility should be ended. It suggested the establishment of a central bank to be called as RBI. •Accordingly the gold standard and the RBI Bill was introduced in the legislative assembly in Jan 1927 but was dropped on account of sharp differences. •The Indian Constitutional Reforms in 1933 made it obligatory that the transfer of responsibility from the British Govt. in India to Indian hands was dependent on the establishment of the RBI. These events led to the introduction of a fresh bill in Sept. 1933 Bank of Bengal 1806-1921

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The Governor General gave his accent on 6th March 1934 and RBI was constituted in accordance with the provisions of the Act containing 58 sections and was inaugurated on 1st of April 1935. The RBI was constituted as a shareholder‟s bank with a fully paid up capital of Rs. 5 Crores divided into shares of Rs. 100 each. Of these 5 lakh shares, 2200 shares were subscribed by the directors of the bank and the remaining by the Pvt. Shareholders. In view of the need for close integration between bank‟s policy and those of the government, the question of state ownership surfaced time and again. But it was only after independence that the decision to Nationalise the bank was taken. In terms of RBI (Transfer to Public Ownership) Act, 1948, its entire paid up capital was transferred to Central Govt. on 1st of January 1949 when it became a state owned institution.

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Its Organization Structure and Management. •

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The OS of the RBI consists of the central board and the local boards. The RBI is managed by the Central Board of Directors comprising 20 members . There is one Governor who is the executive head and is assisted by 4 Deputy Govs. They are all appointed by the GOI for a period of 5 years. 4 Directors are nominated by the CG one each from the four local boards situated in Mumbai, Kolkata, Chennai and New Delhi.

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In addition the Central Govt. nominates 10 directors who are experts from various fields and are appointed for a period of 4 years. The 20th member of the board is one Govt. official who is usually the Secretary Ministry of Finance nominated by the Central Govt. . The Govt. official and the 4 Deputy Gov. do not have the right to vote in the meetings of the board. All powers of the bank is vested on the central board of directors. It must hold at least 6 meetings in year and at least 1 in 3 months. There are 4 local boards with headquarters at Mumbai, Delhi, Kolkata & Chennai representing Western, Northern, Easters & Southern regions respectively. The Central Govt. nominates 5 members on each local board for a period of 4 years. The chairman is elected from among the members and the manager of the RBI office in a region acts as the ex-officio Secretary of the local board.

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The head office of the RBI is at Mumbai having 16 departments such as the banking, Issue, Currency management, Exchange Control, Industrial Credit, Agricultural Credit etc.. The bank has 15 offices and 2 branches in different parts of the country. Where the RBI has no office or branch, the SBI and its 7 associates acts as its agent or sub agent.

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To Promote monetisation and monetary integration of the economy.

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To manage currency and regulate foreign exchange

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To institutionalise savings through promotion of banking habits

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

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To evolve a well differentiated structure of institution purveying credit for agriculture and allied activities.

To set up or promote several specialised FIs at all India and regional levels to widen facilities for term finance to industry To lend support to planning authorities and Govt. in their effort to accelerate the pace of economic development.

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Functions of RBI •

Traditional Function – – – – – – –

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Promotional & Developmental Functions – – – – – –

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Issue of Currency (200crg+Fex-115g) Banker to Government ( Banker‟s Bank Exchange Management and control Control of Credit Collection and Publication of Data and Report Training Facilities

Agricultural Finance Industrial Finance Export Credit Credit to priority sector Bill market scheme Development and regulation of banking system

Other Functions – – – –

Purchase and Selling of Gold Banking function with other Central Banks Worldwide Can borrow money from a scheduled bank in India or outside Issues DDs made payable at its own offices and agencies, and makes issues and circulates banks post bills

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1. Issue of Currency   

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Monopoly in notes issue 1 Re notes and coins not issued by RBI Issued on the basis of minimum currency reserve system. By RB Amendment Act 1956, a provision was made for a minimum reserve in foreign exchange. And in gold in absolute terms. 400 Cr in Foreign Reserves and a min of 115 cr in Gold. A total of 515 cr. Operates through Currency Chests at 15 offices & 2 Branches all over India supported by SBI where there is no representation.

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2. Banker to the Government •

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Maintains and operates the cash balances of the central and state Govt. on the current a/c deposit on which it pays no interest. It receives and makes payment on behalf of the central and state govt. It carries out exchange, remittance, and other banking operations on behalf of these Govts. It buys and sells Govt. Sec. in the market It manages the public debt by issuing Govt. loans and paying interest and principal It also sells T bills through tender on behalf of the Govt. It makes ways and means advances to the central & State Govts. by purchasing T bills from them for a period not exceeding 91 days. It advises the Govt. on all banking and financial matters. It acts as an agent of the Central & the State Govt. in their dealings with the IMF and World Bank, IFCA and IDA.

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3. Bankers‟ Bank 

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Under the Banking Reg. Act 1949 every bank is required to keep between 3% to 15% of the total of its time and demand liabilities with the RBI as CRR which is interest free. (Ap.07-6.5%) Every bank is also required to maintain with the RBI between 25% to 40% of its net time and demand liabilities as SLR. (25%) RBI also regulates, supervises and controls the working of the banks : Issuing of license for opening and branch exp. Calling for returns and statements and books of accounts. Issue of directions concerning terms and conditions for loans and advances. RBI acts as clearing house for banks RBI provides refinance facilities to commercial banks for export credit, against 364 days T bills.

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Frequently Used Terminologies 

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CRR [Cash Reserve Ratio] - CRR is the rate at which banks are required to maintain their reserves with the central bank on a fortnightly basis. [In recent times it has been around 4 to 4.75%] SLR [Statutory Liquidity Ratio] – SLR refers to the rate at which banks are required to maintain their reserves in government securities.

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Repo Rate, Bank Rate, Reverse Repo Rate: •

Repo Rate & Bank Rate: The Repo rate is the rate at which RBI borrows from the bank while the bank rate is the rate at which the banks borrow from the RBI. (It is the rate at which RBI rediscounts certain defined bills.) The bank rate is currently around 6%. Any revision on the bank rate by the RBI is a signal to commercial banks to revise deposit rates as well as the PLR. Repo Rate (RBI borrowing from COMB)

Comm Banks •

RBI Bank Rate (COMB borrowing from RBI)

So what is the reverse repo rate? It is the interest rate that a bank earns for lending money to the Reserve Bank of India in exchange for government securities.

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4. Exchange Mgt. Control 

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Under FERA, 1973 The RBI had to control the receipts and payments of foreign currencies. The RBI determines the external value of rupee in relation to the weighted basket of India's major trading partners with pound sterling as the intervention currency.

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5. Credit Control 

The RBI controls the money supply and credit to ensure price stability and meet the varying economic conditions of the country. For this purpose it uses the various credit control measures such as variations in interest rates, open market operations, changes in CRR and SLR, selective credit controls etc.

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6. Collection and Publication of Data and Reports •

The RBI has a division of Reports, Reviews and publications under its department of Economic analysis and policy which collects data on economic matters such as money, credit, finance, agriculture and industrial production, balance of payments, prices etc. and publishes them in various publiocations like RBI Bulletin, Weekly Statistical Supplements, Annual Report on Currency and Finance. etc.

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7. Training Facilities •

The RBI has set up a no. of training colleges and centers to provide training to the banking personnel at different levels: – –

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Banker‟s Training College (BTC) Mumbai Reserve Bank Staff College (RSBC) Madras College of Agricultural Banking (CAB) Pune Zonal Training Centres (ZTC) M,K,C,D Indira Gandhi Institute of Development Research Training in Computer Technology

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8.Promotional & Development Functions.    

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AGRICULTURAL FINANCE INDUSTRIAL FINANCE EXPORT CREDIT CREDIT TO PRIORITY SECTOR AND WEAKER SECTIONS BILL MARKET DEVELOPMENT AND REGULATION OF BANKING SYSTEM

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Agricultural Finance 

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RBI extended Assistance to the cooperative credit institutions for agricultural dev and allied rural activities right from its inception in the year 1935 For this it set up an agricultural credit department to provide long and medium term financing to these sectors. The department was taken by NABARD in the year 1982

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INDUSTRIAL FINANCE 

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An industrial credit department was set up in the year 1957 to advice and help the bank in providing financial assistance to industries and in setting up financial institutions like IDBI, IFCI, ICICI etc. It also established the National Industrial Credit (Ltop)Fund in 1964 to provide financial assistance to large scale industries.

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EXPORT CREDIT 

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The RBI provides concessional credit , refinance facilities and guarantee to commercial banks for export. It also has setup the EXIM bank to finance export trade.

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Credit to Priority Sector and Weaker Sections 

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Under its differential Rate of interest scheme the RBI provides concessional finance to priority sector and weaker sections of the society. Eg: Lead Bank Scheme Rate of int 4%

Bill Market Scheme • The RBI has been instrumental in developing the Bill market

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Objectives of Credit Control      

To Stabilize Internal Price Level To Stabilize the rate of Foreign Exchange To Protect the outflow of Gold To Control Business Cycle To Meet business needs To Ensure Growth with Stability

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Detailed Discussion: 

To Stabilise Internal Price Levels:   

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To Stabilize the rate of Foreign Exchange  

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Frequent Change in Price Adversely effects the economy Inflation and Deflation trends needs to be prevented And all these could be done by adopting a suitable Credit Control Policy. Change in internal price level effects the level of exports and imports in the country If Prices Exports and Imports therefore value of Domestic currency in the foreign market and its exchange rate ( And vice-versa)

To Protect the outflow of Gold 

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Expansion of bank credit leads to Rise in Prices thereby decreasing Export and Increasing Import. As a result an Unfavourable Balance of Payment Situation. Bank Cr Prices will & thus Exports will & Imports will

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To Control Business Cycle    

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To Meet business needs  

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Are a common phenomenon of a capitalist country and Are characterised by alternating periods of Prosperity and Depression During Prosperity ,Vol of Credit Expands leading to Rise in Prod and Employment and thus Rise in Price So , there should be Control of Bank credit in Boom Period and Expansion in Lean Period When Business Expands more credit is required and less credit is absorbed during lean periods Industry Life Cycle

To Ensure Growth with Stability 

And not only price stability or forex stability.

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Methods of Credit Control

Quantitative

Aims at controlling the Cost and Quantity of Credit 1) Bank rate or Discount rate policy 2) Open Market Operations 3) Variable Reserve Ratio

Qualitative Controls the Use and Direction of Credit (Selective Credit Control Measures) 1) Regulation of Margin Requirement 2) Regulation of Consumer Credit 3) Rationing o Credit 4) Direct Action 5) Moral Suasion 6) Publicity

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Quantitative Methods

1. Bank Rate Policy

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Bank Rate Policy: The bank rate or discount rate is the rate fixed by the CB at which it rediscounts First Class bills & Government Securities. (It is the rate of interest charged by the CB at which it provides rediscount to banks through the discount window) If CB lowers Bank Rate Borrowing becomes cheaper = So Commercial Banks will borrow more = Adv will be available at a lower cost = More Demand = More Business = Encourages rise in price.

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Limitations of Bank Rate Policy  

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Market rates do not match with bank rates Wages, Costs & Prices are not elastic. (If bank rate goes up wages, costs and prices should change which does not.) Commercial Banks do not always approach Central Bank (Because they often keep large amount of liquid assets with them) Bills of Exchange are not frequently used Pessimism or Optimism: Depends on waves of P/O among business men. At times even at increased ban rate borrowers continue to borrow. They are mostly driven by Business Considerations.

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Power to Control Deflation is Limited: Lowering the bank rate below 3% (for eg) will not necessarily lead to a decline of 3% or below in the market rates. It is non discriminatory: It doesn't distinguish between productive and unproductive activities. It is not successful in controlling BOP disequilibrium: Because there is a requirement for removal of all restrictions on foreign exchange and movements in international capital – which is not possible.

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2. Open Market Operations: 

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This method refers to the sell and purchase of securities, bills and bonds of Govt. as well as Pvt. Financial Institutions by the Central Bank. There are 2 principal motives of open market operations: 1)

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One is to influence the reserve of the commercial banks in order to control their power of credit creation To effect the market rates of interest so as to control the commercial banks‟s credit.

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Suppose Central Bank wants to control Expansion of Credit by Commercial Banks (Say in case of Inflation) It will sell Govt. Securities – say worth Rs. 10Cr.

Individuals having accounts with various commercial banks will purchase

Commercial banks will also purchase

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Limitations:      

Lack of well organised securities market. CRR is not stable Penal Bank Rate Banks Act Differently Pessimistic or optimistic Attitude Velocity of Credit money is not constant.

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3.Variable Reserve Ratio: 

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It was first suggested by Keynes in 1930 and was adopted by the Federal Rsv. Sys in the US (in the year 1935) Every Commercial Bank is required by the law to maintain a minimum % of its Deposit with the Central Bank… (it may either be a % of its term and demand deposits separately or Total Deposits.) Whatever amount of money remaining with the Commercial Banks over and above the minimum reserve is called excess reserve. When Central Bank Raises the ratio it means more money it to be kept with the Central Bank and thus less resources are available for credit creation.

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Limitations:

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Excess Reserve Clumsy method: Lacks definiteness and is inexact and uncertain. (Amount of Reserve and Place) Discriminatory: Effects different bank differently. Inflexible: is applicable all over the country universally whereas different regions have different requirements

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SELECTIVE CREDIT CONTROL METHODS 

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Selective or qualitative methods are meant to regulate and control the supply of credit among its possible users and uses. Selective instruments do not effect the total amount of credit but the amount that is put to use in a particular sector in the economy. The aim of selective credit control is to channelize the Flow of bank credit from speculative and other undesirable purposes to socially desirable and economical avenues.

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1. Regulation of Margin 

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This method is employed to prevent excessive use of credit to purchase or carry securities by speculators. The Central Bank fixes minimum margin required on loans for purchasing security or carrying security. (in other words the minimum value of loans which a borrower can have from banks on the basis of securities/ collaterals.) Eg: Suppose CB fixes 10% margin on value of securities worth Rs. 1000. So it can lend only Rs. 900 and keep Rs. 100. If it raises to 25% then commercial banks can now lend only Rs. 750 against a security of Rs. 1000. So if the Central Bank wants to curb speculation it will raise the margin requirement.

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Merits & Demerits: 

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Merits: 1) Non Discriminating (It applies equally to both borrowers and lenders thus it limits both supply and demand) 2) it is equally applicable to banks and NBFCs 3) It increases the supply of credit for more productive uses. 4) It is very effective anti-inflationary device because it controls expansion of credit in those sectors of the economy which breeds inflation. 5) It is simple to administer Demerits: 1) A borrower may not show any interest to purchase stocks with borrowed funds by pledging other assets or securities for loan… he may purchase them through some other sources. 2) He may purchase stock for cash which he would have used for purchasing supplies and materials and then borrow for those supplies and later pledge them.

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2. Regulation of Consumer Credit 

Aims to regulate Consumer Credit through :  Installment

credit  Hire Purchase Finance 

The main objective is to regulate demand for Durable Consumer Goods Minimum Down payments

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Maximum Period for Repayment

If the Central Bank finds a slump in a particular sector then it can effectively introduce this mechanism to rectify the situation Say the Automotive Sector faces a slump (then down payment requirements may be reduced and Max. period of repayment can be increased. Therefore there will be increased demand and also the allied industries will develop like rubber, plastic, spare parts etc.

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Merits and Demerits 

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Merits: 1) Effective in both boom and slump periods. Here, General Credit Control Methods fail because it operates with a time lag whereas consumer credit control method doesn't. 2) It is interest inelastic: because consumers are interested to buy under the influence of DEMONSTRATION EFFECT and rate of interest has little consideration. Demerits: 1) It is applicable to a particular class of borrowers only, therefore it discriminates among different types of borrowers.

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3. Rationing of Credit: (4 Types) 1.

2.

3. 4.

Variable Portfolio Ceiling: Here, CB fixes a ceiling on aggregate portfolios of Comm banks and they can‟t advance loans beyond their ceiling. Variable Capital Asset Ratio: this is the ratio which the CB fixes in relation to capital of a commercial bank to its total assets. Discrimination against larger Banks Rationing Credit for Selective Purposes: here, Central Bank ceases to be lender of the last Resort. (Done only in case of extreme inflationary situations.)

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4. Direct Action 

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It is done in the form of issuance of “ Directives” It is done from time to time to follow a particular policy which the CB wants to enforce immediately. Used in case of ERRING banks

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5. Moral Suasion 

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It is a method of persuasion or request, or informal suggestion or advice. Here, the executive head of the CB calls a meeting of Commercial Banks and explains them the need for adoption of a certain policy.

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6. Publicity 

The annual repots and other allied financial data of all Commercial banks are regularly published by the RBI, this forces the commercial banks to perform in accordance to the prescribed norms and requirements.

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CONCLUSION 

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Selective credit controls are not used to the total exclusion of general credit controls. In fact they are an adjunct to general quantitative control. They are meant to supplement the later and are regarded only as the „second line instrument.‟ The vital point is not the question of general vs. selective credit control or the assessment of the general pros and cons between the two methods but of their integration. Indeed the co-ordination of selective and general controls appears to be more effective then the use of any one of them singly or in isolation.

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