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

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 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."

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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.

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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,

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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

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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 Western Northen Southern

Region Region Region Region
(Kolkata) (Mumbai) (New Delhi) (Chennai)

The organization of RBI can be divided into three parts:

1) Central Board of Directors.
2) Local Boards
3) Offices of RBI

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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.

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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.

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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 2007-
08.

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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

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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

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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

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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.

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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).

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(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

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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

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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.

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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.

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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)

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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) Selective credit control

2) Rationing of Credit
3) Moral Persuasion
4) 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

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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

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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 non-
banking 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

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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

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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.

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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

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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

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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

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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.

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(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

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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) 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.
(ii) 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.
(iii) Publication of Data : The RBI publishes statistics regarding
money, price, finance etc, in its periodicals. This provides valuable

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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.

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(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.

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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

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