Introduction :
The Reserve Bank of lndia (RBI) is the central banking authority and the regulator of the Indian Banking System. RBI draws its regulatory powers from the Reserve Bank of lndia Act, 1934 and the Banking Regulation Act,1949. Banking regulation is not peculiar to India. Every country regulates its banking system through some authority. For example, the Bank of England regulates the banking system in UK. Similarly, the Federal Reserve Board is the regulator of the banking system in USA.
Let's review the various functions of RBI.
Learning Objectives
- Identify the constitution and objectives of RBI.
- Identify the functions of RBI.
- Review RBl's tools of monetary control.
- Understand the composition and rationale of priority sector advances.
- Review the regulatory restrictions imposed by RBI on bank lending.
Importance of Banking Regulation :
A banking system needs to be regulated to check imprudence of the players and to curb possibilities of misuse of public money. Let's look into the rationale behind such regulation:
a) Public confidence and trust: It generates, maintains and promotes public confidence and trust in the financial and banking system.
b) Investors’ interest: It protects investors' interest by ensuring adequate and timely disclosure by the institutions. It also ensures that investors have access to information.
c) Fair and efficient financial markets: It ensures that the financial markets are both fair and efficient.
d) Adherence to rules: It ensures that participants measure up to the rules of the marketplace. In a developing country like India, the roles of the banking regulator (performed by RBI) and the securities market regulator (performed by
the Securities and Exchange Board of lndia, or SEBI) are crucial in achieving a stable banking and financial system.
Constitution of RBI :
RBI was constituted under the Reserve Bank of lndia Act, 1934 on the basis of the recommendations of the Hilton Young Commission and started functioning from 1 April, 1935. It is the oldest among central banks operating in developing countries.
Let's learn about the constitution of RBI.
Ownership :
RBI is a state-owned institution under the Reserve Bank (Transfer of Public Ownership) of India Act, 1948. The Act empowers the Union Government to issue such directions to
RBI as is necessary in public interest. However, the Union Government must consult the RBI Governor before issuing the directions.
Control :
The control of RBI vests in the Central Board of Directors. The Central Board of Directors comprises of the Governor, four Deputy Governors, two representatives of the Ministry of
Finance, 10 Directors nominated by the Union Government and four Directors from the local boards (one each from Mumbai, Chennai, New Delhi and Kolkata).
Appointment :
- Governor and Deputy Governors: The Union Government appoints the Governor and the four Deputy Governors.
- Finance Ministry representatives: The Ministry selects its two representatives.
- Directors: The Union Government nominates the 12 directors.
- Directors from Local Boards: Each local board has five members who select the director.
Internal Management :
RBl's internal management is based on functional specialisation and coordination among about 20 departments. Its headquarters are in Mumbai.
Objectives of RBI :
The preamble to the Reserve Bank of lndia Act, 1934 contains the main objectives of RBI. According to the preamble, constituting a Reserve Bank for India is necessary to regulate the issue of bank notes and to maintain reserves with a view to securing monetary stability in India. Another objective is to operate the credit and currency system of the country to its advantage.
The main objectives of RBI are discussed as follows.
Monetary Stability :
RBI aims to maintain monetary stability of the country such that its business and economic life can contribute to the welfare gains of a mixed economy.
Financial Stability :
RBI aims to maintain financial stability and ensure sound financial institutions to enable economic units to conduct their business with confidence.
Payment Systems :
RBI aims to stabilise the payment systems to ensure safe and efficient executions of financial transactions.
Credit Allocation :
RBI aims to ensure that the credit allocation reflects the national economic priorities and social concerns.
price Stability :
RBI aims to provide a reasonable degree of price stability by regulating the overall volume of money and credit in the economy.
Development of Financial Markets :
RBI aims to promote the development of financial markets and systems to enable itself to operate and regulate efficiently.
Functions of RBI :
Let's go through the main functions of RBI.
Issue of Notes : Notes Issuance
- Sole authority: RBI has the sole authority for the following: Issuing currency notes and coins, Putting the currency notes and coins into circulation Withdrawing or exchanging currency notes - Denominations issued: RBI has issued and circulate notes of the denomination of Rs. 5, 10, 20, 50, 100, 500 and 2000. It has about 17 Issue Offices. As part of the demonetisation exercise by the RBI in 2016, Rs, 1000 notes have been discontinued, Rs. 2000 notes have been introduced and Rs. 500 notes have been replaced with new notes of the same denomination.
- Issue of Coins:
Currently coins in circulation are 50 paise, Re. 1, Rs. 2, Rs. 5 and Rs. 10.
- Currency Chests:
Currency chests store new and reissuable notes and coins. These chests are kept by
selected banks as agents of RBI. There are above 4,000 currency chests and 3700+ small coin depots.
- Cover for notes issue: RBI keeps a minimum value of gold coins, bullions and foreign securities as a part of the total approved assets. These act as a cover for the notes issued
Government's Banker :
Government's Bank
RBI is the banker to the Central and State Governments. lts provides them with services such as deposits and withdrawal of funds, making payments and receipts, collection and transfer of funds and management of public debt. Government deposits are received free of interest and RBI does not take any remuneration for the routine banking services of the Government. However it charges a commission, from the concerned governments, for
managing public debt and interest on overdrafts. RBl's role as the banker to the government includes:
- Facilitating receipts and payments to the Central and State Government accounts
- Managing domestic debt and raising debt from the public
- Enabling the government to raise debt from the securities market
- Driving monetary policy on behalf of the government
Subject to certain rules and limits, it makes Ways and Means Advances' to Central and State Governments on the amount of overdrafts with a view to contain the fiscal deficit decided by the Central Government.
Banker's Bank :
RBI is the banker to every bank in the country. Commercial banks and state cooperative banks, which are scheduled banks, have to keep stipulated reserves in cash and approved securities as a percentage of their Demand and Time Liabilities (DTL). These reserves help RBI regulate the banks' ability to create credit and thus affect money supply in the economy.
The role of RBI as a banker's bank covers:
- Enabling inter-bank obligations
- Enabling efficient fund transfer
- Ensuring that statutory reserve requirements are met
- Acting as a lender of the last resort
RBI also changes its bank rate to regulate the cost of bank credit and thereby its volume indirectly. It also acts as a 'lender of the last resort' for banks by rediscounting bills and by
refinance mechanism for certain kinds of credit, subject to the conditions laid down in its annual Credit Policy.
Bank's Supervision :
Since 1993, RBI performs dedicated bank supervisory functions besides its traditional central banking operations. The Board of Financial Supervision (BFS) was formed in 1994 to supervise the Indian financial system that includes, apart from commercial and state co-operative banks, All India Financial Institutions (AIFIs) and Non-Banking Finance Companies (NBFCs). BFS has a full time vice.chairman and six other members, apart from the RBI Governor as its chairman.
RBl's supervisory powers include:
- Issuing licences for new banks and new branches for the existing banks
- Prescribing minimum requirements for the paid-up capital and reserves, maintenance of cash reserves and other liquid assets
- Ensuring appropriate lending to priority sectors
- Prescribing guidelines with respect to prudential norms, interest rates, income recognition, investment valuation, asset classification, exposure limits, etc.
- Inspecting the functioning of scheduled banks in India and abroad and ensuring their sound working
- Conducting ad-hoc investigations into complaints, frauds and irregularities relating to banks and other financial Institutions
- Controlling appointments, reappointments and terminations of Chief Executive Officers (CEOs) and chairmen of private banks
- Approving or compelling amalgamation or merger of two banks
Development of the Financial System:
Apart from its regulatory and supervisory role, RBI is also responsible for development of the financial system of the country. It has created specialised institutions for specific purposes such as:
- Industrial finance:
The Industrial Development Bank of India (IDBI), established in 1964, and Small Industries
Development Bank oflndia (SIDBI), established in 1989, provides finance to industries.
- Agricultural credit:
National Bank for Agriculture and Rural Development (NABARD), established in 1981,
provides agricultural credit.
- Export—import finance:
Export-Import Bank of India (EXIM Bank), established in 1981, provides finance for
export and import.
- Deposit insurance and credit guarantee:
Deposit Insurance and Credit Guarantee Corporation of lndia (DICGC) provides deposit insurance and credit guarantee to small depositors and borrowers.
RBI has also initiated several schemes, which have significantly impacted the banking development in the country over the last five decades. Some of these schemes are:
- Bill Market Scheme of 1952 and 1970 - Lead Bank Scheme for backward districts development (1970s)
- Priority Sector Advances Scheme
- Financial literacy and financial inclusion programs to increase the reach, penetration and usage of banking facilities in remote areas RBI is also trying to integrate the large unorganised financial sector that includes indigenous bankers and NBFCs, into the
organised financial system by regulating them to some extent.However this task is enormous
Exchange Control :
RBI has the responsibility of maintaining stability of the external value of the Indian Rupee. Earlier, it regulated the foreign exchange market in terms of the Foreign Exchange Regulation Act (FERA), 1947. Now, it is guided by the Foreign Exchange Management Act (FEMA), 1999. RBI performs the following tasks:
- Administering foreign exchange control:
It administers foreign exchange control through its Foreign Exchange Department. It authorises specified bank branches and other dealers, called Authorised Dealers (ADs), to deal in prescribe types of foreign exchange transactions. It issues the AD series of circulars for regulating such transactions.
- Managing exchange rate:
It manages the exchange rate between the Indian Rupee and foreign currencies. The exchange rate is maintained by selling and buying foreign exchange to and from ADs and by other means.
Managing foreign exchange reserves:
It manages foreign exchange reserves of the country and maintains reserves in gold and foreign securities issued by foreign governments and international financial institutions.
Monetary Control :
RBI controls the overall money supply in the Indian economy by regulating the volume and cost of bank credit (via the Bank Rate). Money supply change is a technique of controlling
inflation and deflation. RBI issues its monetary and credit policies annually.
Regulating Payments and Settlements :
As per the Payment and Settlement Systems Act 2007 (PSS Act), RBI has complete authority to govern the payment and settlement systems across India. Most payment and settlement systems operate on the Indian Financial Network or INFINET and use digital signatures to authorise transactions. Systems used are retail payment systems and large value payment systems.
Financial Stability :
The Financial Stability Unit is a department set up by the RBI that has the following responsibilities:
- Surveying the financial system at a macro prudential level
- Assessing the financial stability of the economy and designing future plans
- Preparing financial reports
- Identifying and tracking specific indicators of financial instability
- Conducting stress tests to assess the resilience of the economy
Tools of Monetary Control :
RBl's tools of monetary control are CRR, SLR, bank rate, OMO and SCC. Let's go through these tools.
CRR ( Cash Reserve Ration ) :
Cash Reserve Ratio (CRR) is the mandatory cash that all scheduled and non-scheduled banks keep with RBI as a percentage of their Net Demand and Time Liabilities (NDTL). Demand liabilities of a bank represent its deposits that are payable on the depositors' demand. Current and savings deposits are two examples of demand liabilities. On the other hand, time liabilities are time deposits that are repayable on the specified maturities.
Regulatory cash reserves are kept with RBI to meet these liabilities on time, to ensure adequate liquidity with the bank. The bank has to pay a penal interest if it fails to maintain the prescribed CRR at given intervals. This penal interest is calculated on the shortfall by adjustment from the interest receivable on the balances with RBI. An increase in CRR squeezes the liquidity in banking system and reduces the lending capacity of lending banks. This can result in an increase in the call rates. A decrease in CRR enhances Ioanable funds with the banks and reduces their dependence on the call and term money market. This will reduce the call rates.
S L R : Statutory Statutory Liquidity Ratio (SLR) :
refers to the supplementary liquid reserve requirements of banks. This requirement is in addition to CRR. All banks (scheduled and non-scheduled) maintain SLR. SLR is maintained in the form of cash in hand (exclusive of the minimum CRR), current account
balances with State Bank of India (SBI) and other public sector commercial banks, unencumbered approved securities and gold. A certain percentage of a bank's NDTL may be prescribed by RBI as the SLR.SLR has three objectives:
- Restricting expansion of banks' credit.
- Increasing banks' investment in approved securities.
- Ensuring banks' solvency. An increase in SLR, by RBI, results in a reduction in the lending capacity of banks by preempting a portion of their NDTL for government or other approved securities. It also increases the lending rates in the face of an increasing demand for bank credit. Thus, an increase in SLR has a deflationary impact on the economy. The reverse happens with a cut in SLR.
Bank Rate :
Bank Rate is the rate at which RBI is prepared to buy or rediscount bills of exchange or other eligible commercial paper from banks. Bank rate is a standard rate. It is the basic cost of refinancing and rediscounting from RBI. RBI uses the bank rate to:
- Affect the cost and availability of refinance, and
- Change the Ioanable resources of banks and otherfinancial institutions.
A change in bank rate affects the interest rates on loans and deposits in the banking system. Although the change is in the same direction, the extent of the change might not be the same. Post deregulation and banking reforms since 1991, RBI has gradually loosened its direct regulation of deposit and lending rates and has left these to banks to decide through their boards, with a few exceptions. However, it can still affect the interest rates via changes in its bank rate, whenever the situation of the economy warrants it.
Open Market Operations :
Open Market Operations (OMOs) refer to sale or purchase of government securities by RBI in the open market. This is done with a view to increasing or decreasing the liquidity in the banking system and thereby affecting the Ioanable funds with banks. For open market sale or purchase, RBI can also change the interest rate structure through its pricing policy.
Selective Credit Control (SCC) :
Under Sections 21 and 35A of the Banking Regulation Act, RBI issues directives that stipulate certain restrictions on bank advances against specified sensitive commodities. The commodities are:
- Pulses, other food grains such as coarse grains, oilseeds, oils including vanaspati, all imported oil seeds and oils.
- Sugar including imported sugar (except buffer stocks and unreleased stock of sugar with sugar mills).
- Gur and khandsari.
- Cotton textiles, raw cotton and kapas.
- Paddy/rice and wheat.
RBI issues Selective Credit Control (SCC) directives to prevent speculative holding of essential commodities and the resultant rise in their prices. RBI's general guidelines on SCC are:
- Banks should not allow customers dealing in SCC commodities any credit facilities that would directly or indirectly defeat the purpose of the SCC directives. This includes credit facilities against book debts/receivables or even collateral securities like insurance
policies, shares, stocks and real estate.
- Credit limits against each commodity, covered by SCC directives, should be segregated. SCC restrictions are applied to each of such segregated limits.
The Liquidity Adjustment Facility (LAF) :
LAF allows banks to make liquidity adjustments at repo rate. Banks can borrow from the RBI at the repo rate by pledging additional securities.
The Marginal Standing Facility (MSF) :
It allows scheduled commercial banks to borrow from the RBI overnight upto 2% of their NDTL at 1% over the repo rate, by pledging government securities. Minimum size of borrowing is Rs. 1 crore.
Regulatory Restrictions on Lending :
Let's go through the regulatory restrictions on lending by banks, laid in terms of RBI directives and the Banking Regulation Act, 1949.
Regulatory Restrictions :
i) Advance against shares: No advance or loan can be granted against security ofa bank's own shares or against partly paid shares of a company.
ii) Holding of shares: No bank can hold shares:
a) in a company as pledgee or as mortgagee in excess of 30% of the paid-up capital of that company or 30% of the bank's paid-up capital and reserves, whichever is less (Sec.19 (2) of BRA).
b) in a company in the management of which any Managing Director or Manager of the bank is concerned or interested (Sec. 19 (3) of BRA).
iii) Aggregate investments: A bank's aggregate investment in shares, Certificate of Deposits (CDs), bonds, etc.,should not exceed 40% its net owned funds as at the end ofthe previous year.
iv) Loans against specific instruments: No bank should grant loans against:
a) CDs
b) FDs issued by other banks
c) Money Market Mutual Funds
v) RBI guidelines: Banks should adhere to RBI guidelines relating to the level of credit, margin and interest rate for loans against security of commodities covered by the Selective Credit Control Directives of RBI.
vi) Loans to directors and relatives: Banks should not grant loans to:
a) its Directors or firms in which a Director is interested as a partner/manager/employee/guarantor (certain exemptions are however allowed)
b) relatives (as defined by RBI) of Directors
c) Directors of other banks and their relatives
vii) Loans to Willful Defaulters: Banks should not sanction a new or additional facility to borrowers appearing in RBI's list of "Willful Defaulters" for a period of five years from the date of publication of the list by RBI.
viii) Exposure Limits: Banks have been advised by RBI to limit their exposure to certain sectors, as well as individual and group borrowers.
Inclusion of Urban Cooperative Banks :
Starting 2013, only licensed primary cooperative banks that fulfill the
following criteria would be treated as a financial institution:
- Rs. 750 cr of DTL
- Minimum 12% Capital to Risk (Weighted) Assets Ratio
(CRAR)
- Net profit for 3 consecutive years
- Gross NPAs under 5%
- Meets regulatory norms, including CRR and SLR requirements
Summary :
Let's recap the key points ofthis lesson.
RBI is the regulator ofthe Indian Banking System. Its main
objectives include maintaining financial solvency and liquidity in the
banking system and providing stability in the exchange rate. RBI's
main functions include notes issuance, banks‘ supervision, I
development ofthe financial system, exchange control and -
monetary control. RBI exercises monetary control with the help of
tools such as CRR, SLR, LAF, MSF, OMOs and bank rates. RBI
directives and the Banking Regulation Act impose certain L}
regulatory restrictions on lending by banks to ensure prudence and
to prevent abuse of bank credit.
In this lesson, you have learnt about:
- The constitution and objectives of RBI
- The main functions of RBI
- The tools RBI uses for monetary control
- The regulatory restrictions imposed by RBI on bank lending
