1 BANKING The composition of the Indian Banking System: The organized banking system in India can be broadly divided into three categories viz., the central bank of the country known as the Reserve Bank of India, the commercial banks and the co-operative banks. Another and more common classification of banks in India is between scheduled and non-scheduled banks. The Reserve Bank of India is the supreme monetary and banking authority in the country and has the responsibility to control the banking system in the country. It keeps the cash reserves of all scheduled banks and hence is known as the “Reserve Bank”. Scheduled and Non-scheduled Bank Under the reserve Bank of India Act, 1934, banks were classified as scheduled banks and non-scheduled banks.
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BANKING
The composition of the Indian Banking System:
The organized banking system in India can be broadly divided into three
categories viz., the central bank of the country known as the Reserve Bank of India,
the commercial banks and the co-operative banks. Another and more common
classification of banks in India is between scheduled and non-scheduled banks. The
Reserve Bank of India is the supreme monetary and banking authority in the
country and has the responsibility to control the banking system in the country. It
keeps the cash reserves of all scheduled banks and hence is known as the “Reserve
Bank”.
Scheduled and Non-scheduled Bank
Under the reserve Bank of India Act, 1934, banks were classified as scheduled
banks and non-scheduled banks.
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The scheduled banks are those which are entered in the Seconds Schedule of RBI
Act, 1934. Such banks are those which have a paid-up capital and reserves of an
aggregate value of not less than Rs. 5 lakhs and which satisfy RBI that their affairs
are carried out in the interests of their depositors. All commercial banks- Indian and
foreign, regional rural banks and state co-operative banks-are scheduled banks.
Non-scheduled banks are those which have not been included in the second
schedule of RBI Act, 1934. At present, there are only three non-scheduled banks in
the country.
Scheduled banks are divided into commercial banks and co-operative banks.
Commercial banks are based on profit, while co-operative banks are based on co-
operative principle.
Commercial banks have been in existence for many decades. They mobilise
savings in urban areas and make them available to large and small industrial and
trading units mainly for working capital requirements. After 1969 commercial
banks are broadly classified into nationalized or public sector banks and private
sector banks. The State Bank of India and its associate banks along with another 20
banks are the public sector banks. The private sector banks include a small number
of Indian scheduled banks which have not been nationalized and branched of
foreign banks operating in India- commonly known as foreign exchange banks.
The Regional Rural Banks (RRBs) came into existence since the middle of
1970s with the specific objective of providing credit and deposit facilities
particularly to the small and marginal farmers, agricultural labourers and artisans
and small entrepreneurs. The Regional Rural Banks have the responsibility to
develop agriculture, trade, commerce and industry in the rural areas. The RRBs are
essentially commercial banks but their area of operation is generally limited to a
district.
THE RESERVE BANK OF INDIA AND MONETARY MANAGEMENT:
The Reserve Bank of India was inaugurated in April 1935 with a share
capital of Rs. 5crores, divided into shares of Rs.100 each fully paid up. The entire
share capital was in the beginning, owned by private shareholders. But in view of
the public nature of the Bank‟s functions, the Reserve Bank of India, Act, 1934
provided for the appointment by the Central Government of the Governor and two
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Deputy Governor (who were also directors of the central Board). The Reserve
Bank was nationalized in 1949. Besides the central Board, there are four local
Boards with headquarters at Bombay, Calcutta, Madras and New Delhi.
FUNCTIONS OF THE RESERVE BANK OF INDIA:
By the reserve Bank of India Act of 1934, all the important functions of a
central bank have been entrusted to the Reserve Bank of India.
Bank of Issue: Under Section 22 of the Reserve Bank of India Act, the
Bank has the sole right to issue bank notes of all denominations. The distribution of
one rupee notes and conies and small coins all over the country is undertaken by the
Reserve Bank as agent of the Government. The Reserve Bank has a separate Issue
Department which is entrusted with the issue of currency notes. The assets and
liabilities of the Issue Department are kept separate from those of the Banking
Department. Since 1957, the Reserve Bank of India is required to maintain gold
and foreign exchange reserves of Rs.200 crores, of which at least Rs.115 crores
should be in gold. The system as it exists today is known as the minimum reserve
system.
Bankers to Government: The second important function of the Reserve
Bank of India is to act as Government banker, agent and adviser. The Reserve Bank
is agent of central Government and of all state Government in India excepting that
of Jammu and Kashmir. The Reserve Bank has the obligation to transact
Government business, viz., to keep the cash balances as deposits free of interest, to
receive and to make payments on behalf of the Government and to carry out their
exchange remittances and other banking operations. The Reserve Bank of India
helps the Government-both the Union and the States to float new loans and to
manage public debt. The Banks makes ways and means advances to the
Governments for 90 days. It makes loans and advances to the states and local
authorities. It acts as adviser to the Government on all monetary and banking
matters.
Bankers’ Bank and Lender of the last resort: The Reserve Bank of India
acts as the bankers‟ bank. According to the provisions of the Banking Companies
Act of 1949, every scheduled bank was required to maintain with Reserve Bank a
cash balance equivalent to 5 percent of its demand liabilities and 2 per cent of its
time liabilities in India. By an amendment of 1962, the distinction between demand
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and time liabilities was abolished and banks have been asked to keep cash reserves
equal to3 percent of their aggregate deposit liabilities. The minimum cash
requirements can be changed by the Reserve Bank of India.
The scheduled banks can borrow from the Reserve Bank of India on the
basis of eligible securities or get financial accommodation in times of need or
stringency by re-discounting bills of exchange. Since commercial banks can always
expect the Reserve Banks of India to come to their help in times of banking crisis,
the Reserve Bank becomes not only the bankers‟ bank but also the lender of the last
resort.
Controller of credit: The Reserve Bank of India is the controller of
credit, i.e., it has the power to influence the volume of credit created by banks in
India. It can do so through changing the Bank rate or through open market
operations. According to the Banking Regulation Act of 1949, the Reserve Bank of
India can ask any particular bank or the whole banking system not to lend to
particular groups or persons on the basis of certain types of securities. Since 1956,
selective controls of credit are increasingly being used by the Reserve Bank.
The Reserve Bank of India is armed with many more powers to control the
India money market. Every bank has to get a licence from the Reserve Bank of
India to do banking business within India; the licence can be cancelled by the
Reserve Bank if certain stipulated conditions are not fulfilled. Every bank will have
to get the permission of the Reserve Bank it can open a new branch. Each
scheduled bank must send a weekly return to the Reserve Bank showing, in detail,
its assets and liabilities. This power of the Bank to call for information is also
intended to give it effective control of the credit system. The Reserve Bank has
also the power to inspect the accounts of any commercial bank.
As supreme banking authority in the country, the Reserve Bank of India,
therefore, has the following powers:
○ It holds the cash reserves of all the scheduled banks.
○ It controls the credit operations of banks through quantitative and
qualitative controls.
○ It controls the banking system through the system of licensing, inspection
and calling for information.
○ It acts as the lender of the last resort by providing rediscount facilities to
scheduled banks.
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Custodian of Foreign Exchange Reserves: The Reserve Bank of India
has the responsibility to maintain the official rate of exchange. According to the
Reserve Bank of India Act of 1934, the Bank was required to buy and sell at fixed
rates any amount of sterling in lots of not less than Rs. 10,000. The rate of
exchange fixed was the exchange rate fixed at 1sh.6d. Though there were periods
of extreme pressure in favour of or against the rupee. After India became a member
of the International Monetary Fund in 1946, the Reserve Bank has the responsibility
of maintaining fixed exchange rates with all other member countries of the I.M.F.
Besides maintaining the rate of exchange of the rupee, the Reserve Bank has
to act as the custodian of India‟s reserve of international currencies. The vast
sterling balances were acquired and managed by the Bank. Further the RBI has the
responsibility of administering the exchange controls of the country.
Supervisory Functions: In addition to its traditional central banking
functions, the Reserve bank has certain non-monetary functions of the nature of
supervision of banks and promotion of sound banking in India. The Reserve Banks
Act, 1934, and the Banking Regulation Act, 1949 have given the RBI wide powers
of supervision and control over commercial and co-operative banks, relating to
licensing and establishments, branch expansion, liquidity of their assets,
management and methods of working, amalgamation, reconstruction, and
liquidation. The RBI is authorized to carryout periodical inspections of the banks
and to call for return and necessary information from them. The nationalization of
14 major India scheduled banks in July 1969 has imposed new responsibilities on
the RBI for directing the growth of banking and credit policies towards more rapid
development of the economy and realization of certain desired objectives. The
supervisory functions of the RBI have helped a great deal in improving the standard
of banking in India to develop on sound lines and to improve the methods of their
operation.
Promotional Functions: With economic growth assuming a new urgency
since Independence, the range of the Reserve Bank‟s functions has steadily
widened. The Bank now performs a variety of developmental and promotional
functions, which, at one time, were regarded as outside the normal scope of central
banking. The Reserve Bank was asked to promote banking habit, extend banking
facilities to rural and semi-urban areas, and establish and promote new specialized
financing agencies. According, the Reserve bank has helped in the setting up of the
IFCI and the SFC; it set up the Deposit Insurance Corporation in 1962, the Unit
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Trust of India in 1964, the Industrial Development Bank of India in 1964, the
Agricultural Refinance Corporation of India in 1963 and the Industrial
Reconstruction Corporation of India in 1972. These institutions were set up directly
or indirectly by the Reserve Bank to promote saving habit and to mobilise saving,
and to provide industrial finance as well as agricultural finance. As far back as
1935, the Reserve Bank of India set up the Agricultural Credit Department to
provide agricultural credit. But only since 1951 the Bank‟s role in this field has
become extremely important. The Bank has developed the co-operative credit
movement to encourage saving, to eliminate money-lenders from the villages and to
route its short term credit to agriculture. The RBI has set up the Agricultural
Refinance and Development Corporation to provide long-term finance to farmers.
CREDIT CONTROL:
General Credit Controls: Since 1955-56 and particularly after 1973-74 the
inflationary rise in price has been steadily mounting. Increased Government
expenditure financed through deficit spending has the direct effect of pushing up
the prices, wages and incomes. Shortfalls in production, and hoarding and
speculation in essential commodities have contributed to this inflationary pressure.
RBI has various weapons of control and, through using them; it hopes to achieve its
monetary policy. These weapons of control are broadly two: Quantitative and
qualitative controls. Quantitative controls are used to control the volume of credit
and indirectly, to control the inflationary and deflationary pressures caused by
expansion and contraction of credit. Quantitative controls are also known as
generating credit controls and consist of bank rate policy, open market operations
and cash reserve ratio.
Bank Rate: The bank rate or the central banks‟ rediscount rate is an important
monetary instrument in modern economies. Its most useful role is to signal and/or
clarify the central banks‟ monetary and interest rate stance to all participants in the
financial sector and particularly to banks. If monetary policy is effective and
credible, a change in the bank rate will result in a change in prime lending rate of
banks and thus act as an independent instrument of monetary control. However, the
role of the bank rate as an instrument of monetary policy has been very limited in
India because of these basic factors:
■ The structure of interest rates is administered by RBI- they are not
automatically linked to the bank rate;
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■ Commercial banks enjoy specific refinance facilities, and not necessarily
rediscount their eligible securities with RBI at bank rate; and
■ The bill marked is under-developed and the different sub-markets of the
money market are not influenced by the bank rate.
In other words, the bank rate in India is not the “pace setter” to the other market
rates of interest and the money market rates do not automatically adjust themselves
to changes in the bank rate. At the sometime, the deposit rates and lending rates of
banks (and of development finance instaurations) are not related to the bank rate.
The Government of India and RBI are reviewing the rules and procedures for
general access to RBI rediscount facilities so as to make bank rate an active
instrument of monetary policy as in other modern economies.
Since the later part of 1995, India passed through a severe liquidity
crunch and as a result the prime lending rates were ruling high. Industrial
production was affected adversely. One step which RBI took was to reduce the
bank rate from 12 to 11 percent in April 1997, and gradually to 6.5 percent. The
reduction of the bank rate was to help in the reduction of other interest rates and
thus stimulate borrowing from banks.
Cash Reserve Requirements (CRR): Another weapon available to RBI for
credit control is the use of variable cash reserve requirements. Under the RBI Act,
1934, very commercial bank has to keep certain minimum cash reserve with RBI-
initially; it was 5percent against demand deposits and 2 per cent against time
deposits- these are known as the statutory cash reserve requirement between 3 per
cent and 15 percent of the total demand and time deposits.
The purpose of reducing CRR is to leave large cash reserves with banks so as to
enable them to expand bank credit. It may be mentioned that the Indian economy
has been reeling under serious economic recession for many years and reduction of
CRR and expansion of bank credit to industry and trade is one method to stimulate
the Indian economy. RBI has been pursuing its medium term objective of reducing
CRR to the statutory minimum of 3 percent.
Statutory Liquidity Requirements (SLR): Apart from cash reserve
requirement which commercial banks have to keep with RBI (under RBI Act,
1934), all commercial banks have to maintain liquid assets in the form of cash, gold
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and unencumbered approved securities equal to not less than 25 percent of their
total demand and time deposit liabilities, This is known as the statutory liquidity
requirement; this is in addition to statutory cash reserve requirements.
Maintenance of adequate liquid assets is a basic principle of sound banking.
Hence commercial banks in India have been required by the Banking Regulation
Act, 1949, to maintain minimum ratio of liquidity ratio. Accordingly, it raised the
liquidity ratio from 25 percent gradually and finally to 38.5 percent. RBI has
stepped up the liquidity ratio for two reasons:
○ Higher liquidity ratio forces commercial banks to maintain a larger
proportion of their resources in liquid form and thus reduces their
capacity to grant loans and advances to business and industry- thus it is
anti inflationary in impact, and
○ A higher liquidity ratio diverts banks from loans and advances to
investment in government and other approved securities. In other words,
a higher SLR was used to divert bank funds to finance Government
expenditure.
It may be mentioned here that stepping up statutory liquidity requirements (SLR)
and the cash reserve ratio (CRR) have the same effects, viz., they reduce the
capacity of commercial banks to expand credit to business and industry and thus are
anti-inflationary.
After accepting Narasimham Committee (1991) recommendation, RBI reduced
the SLR by successive steps to 25 per cent in October 1997. There is now a
demand to abolish SLR altogether.
Open Market Operations of RBI:
In economies with well –developed money markets, central banks
use open market operation _ i.e. buying and selling eligible securities by the central
bank in the money market- to influence the volume of cash reserves with
commercial banks and thus influence the volume of loans and advances they can
make to the industrial and loans and advances they can make to the industrial and
commercial sectors. RBI had not used this weapon for many years.
Since 1991, the enormous inflow of foreign funds into India created
the problem of excess liquidity with the banking Sector and RBI undertook large
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scale open market operations. When RBI sells Government securities in the
commercial banks and thereby, reduces the ability of banks to lend to the industrial
and commercial sectors. At any given time, the banks‟ capacity to create credit –
i.e., to give fresh loans- depends upon their surplus cash that is the amount of cash
reserves in excess of their statutory CRR. Once the surplus cash is eliminated and
even part of the statutory CRR is reduced, the banks have to contract their credit
supply so as to generate some cash reserves to meet their statutory CRR. As a
result, the supply of bank credit which involves the creation of demand deposits,
falls and money supply contracts.
PLR (Prime Lending Rate) is that rate of interest at which bank gives loans to its
prime borrowers or to blue chip, high profile borrowers like corporate Money are
call on short note means inter bank loans on a day to day basis that is loans given by
one bank to another on a day to day basis Rate of interest that prevails in market on
day to day basis call money rate depends on demands and supply on day to day
basis it is nothing to do with RBI.
Money market – market for short term funds up to 1 year.
Major players in money markets are banks
RBI contributes credit generation to commercial banks through some