CENTRAL BANKING.pdf

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CONTENTS

CENTRAL BANKING1 Overview of Central Banking

2 Indian Banking System

3 Monetary Policy

4 Public Debt Management

5 Forex Reserve Management6 Issues in Indian Rural Sector

7 Payment and Settlement System8 Financial Stability


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OVERVIEW OF CENTRAL BANKING

Central banks have been in existence since the second half of the 17th century

and over the years these have developed into organizations that are central to

not only monetary policy making but also to development and regulation of

financial system. Central Banks have evolved worldwide on a continuous basis

in response to changing political and economic forces around them. Central

banks are viewed as multi-function entities performing the tasks of wide-

ranging activities, which are special in nature. The functions of central bank

generally include currency management, banker to the government, regulation

and supervision of financial institution, managing payment and settlementsystem and formulating monetary policy for the development of the economy.

According to Bank for International Settlements, the bank in any country which

has been entrusted with the duty of regulating the volume of currency and

credit in that country can be called as central bank . The mandate of central

banks has undergone a complete metamorphosis. Expansion of the financial

system led to refinements in regulatory and supervisory framework and growth

of clearing systems. Monetary policy assumed critical importance in the

conduct of central banking with the emergence of concerns about inflation.

Similarly, many developing countries have entrusted their central banks with

the objective of economic growth along with price stability.

The central banks in developed countries came into existence to support

and supervise the banking system that was already in place, whereas the

central banks in developing countries had to first develop the banking system

and financial markets and thereafter put in place the regulatory framework for

the efficient oversight and supervision The development of global financial

markets and proliferation of financial instruments coupled with episodes of

financial crises brought to the fore central banks concern for price stability,

financial stability and risk management. The recent global financial crisis has

brought to the fore the need for enhanced role for central banks in matters

relating to financial stability as well, in addition to various other functions.

Establishment of central banks in the world can be traced to the early


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central banks founded in Europe the Swedish Riksbank in 1668 and

subsequently after some years, the establishment of Bank of England in 1694.

In the early stages of establishment of central banks, they were not intended to

perform the functions of a modern central bank but were entrusted the task of

taking care of government financial transactions and support to governments

on financial matters. But subsequently with the evolving financial system,

central banks' function encompassed monetary management, regulation and

supervision of the banking system, etc.

There were only two central banks till 1800 i.e., Riksbank and Bank

of England. Till 1873, the number of central banks globally remained in single

digit. Establishment of central bank, which started in the late 19th century, got

strengthened in 20th century and presently nearly every sovereign nation has

established its own central bank. Setting up of each central bank has a

distinctive origin. For instance, Bank of England was established to lend money

to the Government whereas, the Federal Reserve Board which came into being

in 1914 mainly for a nation-wide payment and depository system. German

central bank was set up in 1875 with a view to restore and to maintain a stable

currency.

Need fo r a Central Bank

Need for a central bank arises due to the following factors:

need for strengthening financial sector and ensuring its development for

fostering growth.

internationalisation of financial markets - making an institutional

mechanism like central bank to oversee and take regulatory measures to

ensure the process of market development is set in place in an efficient

manner.

growth of financial innovations having implications for liquidity position and

rate changes, the two aspects, which form the essence of monetary

policy.

high growth of trade in goods and services due to opening up,

necessitating the use of funds for settlement through the central banks.


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Funct ions of the Central Bank

The functions of central bank vary from country to country and consist of

not only creation of money or monetary management, but also broadly cover

management of public debt of Government, regulation and supervision of

banking entities, financing of developmental activities and other associated

functions. Hence, we may broadly classify the functions of central bank as

follows:

Monetary functions

Traditional functions

Quasi fiscal functions

Monetary function in a Central bank can be further classified into broadly

four sub functions: (a) Money supply management (b) credit policy, (c) price

stability and (d) exchange rate stability. Under money supply management, the

central bank tries to ensure that supply of money for various activities in the

economy is according to the demand by trying to ensure balanced development

of the economy. Policies are formulated to absorb excess supply of money

hanging in the system and injection of funds to the system when genuinely

required and thereby keeping the money supply within policy bound based on

the expected growth and inflation.

Traditional functions cover banker to the Government, banker to banks, lender

of last resort, regulation and supervision of financial system and payment and

settlement system. While these functions are performed by central banks

generally, in the developed countries some of these functions have been

separated (e.g., regulation and supervision) or are not performed due to moralhazard problems (e.g., lender of last resort). Central banks have traditionally

supervised commercial banks and other financial institutions. However, since

central banks are also regulators in many economies and are consequently in a

position to influence the behaviour of market participants, supervision

conducted by central banks may pose a moral hazard problem. The idea of a

separate supervisory authority has, therefore, gathered some momentum of

late. There are various arguments for having the supervisory tasks performed


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only by central banks. First, central banks collect enormous amount of data on

the financial sector and real sector alike and are, therefore, in a good position

to form relatively objective views on market expectations and the need to act

when necessary. Second, most central banks provide payment and settlement

services and are in a position to quickly monitor the liquidity position of the

system. Third, being considered as a lender-of-the-last-resort, a central bank

will get prior intimation about the borrowing requirements of the financial sector,

which would provide clues about their liquidity requirements. On the other

hand, the main arguments for not entrusting the supervisory functions with the

central bank are related to the moral hazard problem. The moral hazard

problem arises when both depositors and creditors of institutions supervised by

the central bank expect that in the event of failure of an institution, they would

be salvaged and as such there is an incentive to take unwarranted risks. In an

effort to address the moral hazard problem, some countries have set up a

separate body to undertake supervisory function the most notable being the

United Kingdom where the Financial Supervisory Authority (FSA) was created

in 1998.

Under quasi-fiscal function, a central bank is discharging its

responsibilities as a public debt manager. It is very much important to note that

the function of debt management is essentially performed by a central bank as

an agent of the Government and hence the issue of autonomy does not arise.

Many central banks have evolved from the need to have an institution that

would manage the finances of their governments. The need to manage

government debt was a function that required the central banks to undertake a

variety of fiscal transactions and consequently led to evolution of an institutional

structure to take care of all the associated functions. While some provision of

liquidity to the respective governments is required to smoothen the temporary

mismatches in revenues and expenditures, financing the persistent deficits is

being increasingly avoided. Some countries have passed legislations

prohibiting credit to their governments and enhancing their monetary policy

independence. Thus, the governments are increasingly financed by the private

sector.


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A growing trend the world over has been that of separation of debt

management function from the monetary management function, though the

actual structure differs across countries. While some OECD countries like

Germany and the UK have opted for an autonomous debt management office

to improve operational efficiency, some other countries like Australia, France

and the US have a separate office working under the aegis of Ministry of

Finance. As regards the ideal model for developing countries, opinions vary.

Some experts have argued that the separate office can be initially placed under

the Ministry of Finance, while there is also a view that in countries where fiscal

deficits are high and financial markets are underdeveloped, a separate debt

management office may be unsuitable for overall policy effectiveness of debt

management.

Central banks in emerging economies take initiatives to perform certain

developmental role for smooth conduct of its policies. It assumes the role as a

facilitator for financial market developments. It also takes initiatives in the

introduction of information technology in the functioning of the various

institutional mechanisms in the financial system for quick and smoothoperations. Central banks in several developing countries have taken initiatives

for financial sector reforms. This role is undertaken as it is increasingly evident

that competitive financial markets are necessary for efficient allocation of

resources and failures in the financial markets have serious costs in terms of

output. In developing countries, central banks have contributed towards the

development of the banking and financial sectors and made efforts to bring

them at par with their counterparts in the developed world. For this, they have

fostered the growth of their markets and institutions. The central banks

nowadays are also active in strengthening international financial architecture.

What is Central Bank Independence?

Central bank independence basically relates to three areas viz.,

personnel matters, financial aspects, and conduct of monetary policy.

Personnel independence refers to the extent to which the Government


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distances itself from appointment, term of office and dismissal procedures of

top central bank officials and the governing board. Also, it includes the extent

and nature of representation of the Government in the governing body of the

central bank. On the other hand, financial independence relates to the freedom

of the central bank to decide the extent to which Government expenditure is

either directly or indirectly financed via central bank credits. Direct or automatic

access of Government to central bank credits would naturally imply that

monetary policy is subordinated to fiscal policy. Policy independence relates to

the flexibility given to the central bank in the formulation and execution of

monetary policy.

Another school of thought looks at central bank independence from the view ofgoal independence vs. instrument independence. Goal independence refers to

a situation where the central bank itself can choose the policy priorities of

stabilizing output or prices at any given point of time, thus setting the goal of

monetary policy. Instrument independence implies that the central bank is only

free to choose the means to achieve the objective set by the Government.

Many arguments have been put forth in favour as well as against central bank

independence for a variety of reasons. First, an independent central bank

operates on a longer time scale and thus may be more inclined to adopt a more

prudent long-term perspective. Second, the priorities of the fiscal policies may

conflict with the monetary policy objectives. For example, while the government

would like to keep the cost of debt service low, the monetary authorities may

like to vary the interest rates in order to maintain price stability. An independent

central bank may be in a better position to address and resolve this conflict.

Third, in countries where debt markets are not well developed, central banksthat do not enjoy adequate independence may be forced to finance the budget

deficit by printing money, thereby interfering with the objective of price stability.

The view that central banks should be largely independent of political power is

generally believed to have emerged only in the twentieth century. The recent

revival of interest in the independence of central banks reflects several factors,

viz., the reforms in centrally planned economies, the establishment of new

European central banking arrangements and the importance of price stability in

a world characterised by substantial cross border financial flows.


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As against this, there are also contrary views. Firstly, the detractors of

autonomy argue that an independent central bank lacks democratic legitimacy.

In this context, the views of Milton Friedman that money is too important an

issue to be left to the whims of central bankers will have to be considered.

Secondly, independence may lead to frictions between the fiscal and the

monetary authorities and the resulting costs of these frictions between

monetary and fiscal policy may be somewhat costly for society, thus inhibiting

the development process. Thirdly, it is possible that the priorities between a

strong central bank and society may differ which would perhaps hamper the

growth process or economic welfare of the society. In this context, the opinions

differ widely on the relative importance between growth vis--vis inflation as

objectives of monetary policy. Ultimately everything boils down to the issue of a

responsible central bank to societal concerns.

Global Financial Crisis and Central Banks

The financial crisis which surfaced in USA in mid-2007 transformed itself into a

global financial crisis and then into a global economic crisis. The crisis has

attracted the attention of policy makers, academicians and analysts. The global

financial crisis has been attributed to a number of micro and macroeconomic

factors role of easy money, financial innovations and global imbalances on

the one hand to regulatory loopholes both at the national and global level on

the other. The crisis has necessitated the need to revisit the global regulatory

and supervisory structures and perimeters against the backdrop of rapid

financial innovations. In the backdrop of large scale disruptions in international

financial markets and deteriorating macroeconomic conditions, the nationalGovernments and central banks in several countries resorted concomitantly

with a variety of both conventional and unconventional policy actions to contain

systemic risk to shore up the confidence in the financial system and arrest the

economic slowdown. The policy responses -regulatory, supervisory, monetary

and fiscal- during the crisis have been unparalleled in terms of their scale,

magnitude and exceptional coordination across various jurisdictions. The

responses included varying combinations of monetary and fiscal measures,


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deposit guarantees, debt guarantees, capital injections and asset purchases,

which were coordinated globally.

Monetary authorities in the industrial world were the first to initiate action

by resorting to an aggressive monetary easing resulting in record low policy

rates. To contain the crisis of confidence and ease financial conditions, central

banks ventured even further by using their balance sheets in unconventional

ways. In the context of the crisis, a number of important issues have emerged

relating to the prevention and management of crises which allows us to draw

relevant lessons for both market participants and policy makers. The analysis

of underlying factors whether macroeconomic or microeconomic in nature -

responsible for evolving and intensifying the crisis have raised issues about

the role of public authorities, viz, central banks, supervisor/regulators and

governments in safeguarding financial stability. The central banks played a

decisive and active role in limiting the impact of the crisis by taking rapid and

innovative policy decisions, sometimes in cooperation with other central banks.

Experience of crisis shows that there is a good case for bringing financial

stability higher in the priorities of central banks. Thus, it is widely perceived that

there is a need to revisit and redefine the role of central banks. In this context,

the following issues have attracted attention in policy discussions.

Asset Prices and the Role of Monetary Policy

The recent financial crisis motivated a review of financial stability frameworks

and, within that, the role of central banks in financial stability. An important

lesson of the crisis is that the single-minded focus on price stability may have

yielded low and stable inflation in terms of prices of goods and services, but the

lowering of returns in the commodity/service producing sectors could have

diverted the search for yields to the financial sector. Although there are

contrasting arguments regarding the role of monetary policy in pricking asset

bubbles, it has been increasingly emphasised that the relationship between

monetary policy and asset prices needs to be revisited. Despite these

contrasting arguments, it is realised that the policy of neglect of asset price

build-up has failed and price stability does not necessarily deliver financial

stability. Therefore, it is increasingly felt that the mandate of monetary policy


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should include macro financial stability and not just price stability. The central

banks need to continuously monitor the nature of asset price booms and decide

whether monetary policy has any role in minimising the risks associated with

booms of a speculative nature.

Adequate Provision of Liquidity as a Lender of Last Resort

In addition to the conduct of monetary policy, a vital responsibility of central

banks in most countries is to perform the role of lender of last resort (LOLR). At

its core, the LOLR function is to prevent and mitigate financial instability

through the provision of liquidity support either to markets or individual financial

institutions. However, the recent crisis has brought to the fore the issue of the

efficacy of central banks as LOLR and raised the question of whether the tools

available with them are sufficient for confronting the challenges posed by a

crisis

Communication with the Market

Another issue that recent global developments have highlighted pertains to the

communication of central banks with the market. Due to lack of

comprehensiveness on various policy responses, particularly in advanced

economies, credit and financial markets remained unconvinced about the policy

measures and did not react positively for some time. This underscores the

importance of communication by policy authorities, including central banks, with

the markets. Not only central bank policy measures need to be clearly

communicated, the dissemination of information on economic outlook by

central banks is also important. During crisis, it becomes important for central

banks to ensure that their communication with the market is clear enough to

add certainty and predictability.

Lessons for Financial Regulation and Supervision

With regard to financial regulation and supervision, the following aspects are

being emphasised: Importance of System-wide Approach, Policies to Mitigate

Pro-Cyclicality in Regulation and Accounting, Enhancing Transparency and

Disclosure, Effective Regulation of Cross-border Institutions, Resolution


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Mechanism for Non-banking Financial Institutions, Mixing Commercial and

Investment Banking, Compensation Structure, Efficacy of Financial

Innovations, etc

The other important aspects of the effective functioning of central

banks are their credibility and transparency. Credibility of a central bank implies

that it has a reputation for pursuing price stability and financial stability

consistently and persistently. If a central bank is viewed as both committed to

and effective at maintaining low inflation, then inflation expectations are lower,

eventually leading to movements in prices and wages that are consistent with

low and stable inflation. Conversely, the lack of credibility leads to inflation

expectations becoming self-fulfilling. Central bank transparency is crucial for

achieving the objectives of monetary policy. Information about the objectives of

central bank and the details of conduct of monetary policy like changes in

interest rates are important as they help to anchor the public expectations.

The central banks face many challenges in the context of the global

economic crisis. These are : (i) Managing Monetary Policy in a Globalizing

Environment (ii) Redefining the Mandate of Central Banks , (iii) Responsibility

of Central Banks Towards Financial Stability, (iv) Managing the Costs and

Benefits of Regulation, (v) Managing the Balance Between the Autonomy and

Accountability of Central Banks.

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References:

Reddy, Y.V. 2001 Autonomy of the Central Bank: Changing Contours in IndiaRBI Bulletin, October 2001.

Mohan, Rakesh 2006 Evolution of Central Banking in India RBI Bulletin,

Mumbai, May 2006.

Fuhrer, Jeffrey C. 1997 Central Bank Independence and Inflation Targeting:

Monetary Policy Paradigms for the Next Millennium? New England Economic

Review, January/February 1997.

Reserve Bank of India, Report on Currency and Finance, 2007

Reserve Bank of India, Report on Currency and Finance, 2010


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Subbarao, D (2010) `Challenges for Central Banks in the Context of the Crisis,RBI Bulletin, March 2010

(Prepared by S. Arunachalaramanan, MoF, RBSC: Revised by BN Anantha

Swamy, MoF, RBSC)


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Indian Banking System

Commercial Banking An Overview

Commercial banks play a very important role in the economy. A well developed banking

system is a prerequisite for ensuring sustainable economic growth. Commercial banks

accept deposits for the purposes of lending and investment. In the process, they

channelize money from savers to borrowers and transform the maturity. This

intermediary function is the main lubricant in a well oiled economy.

The very nature of their role brings in inherent risks. As they deal with public deposits,

these are to be returned to the depositors as and when they fall due. It is, therefore,

necessary that whatever money they lend or invest is monitored carefully so as to

ensure that there is no or negligible impairment. The risk of default by some borrowers

in meeting their obligations is generally termed as credit risk. Further, as there is a

likelihood of impairment in the money that is lent / invested, there is a need to have a

reasonable cushion against unexpected losses so that the chance of depositors losing

their money is minimised. This brings in the need for adequate capital in running the

business of banking. This is generally ensured by prescribing a minimum capital for

banks in absolute terms as well as a minimum capital adequacy ratio to be maintained

by banks on an ongoing basis.

As banks typically accept shorter duration deposits and lend it for longer duration

(maturity transformation), there is a potential that they may not be able to meet the

obligations to the depositors as and when they fall due, if the maturity of assets and

liabilities are not managed effectively. Liquidity risk management is very important for

banks. This brings in the need for appropriate asset liability management by banks.

Banks also are affected by certain macro variables like interest rates, exchange rates

etc. The risk arising on account of changes in the interest rate, exchange rate, equity

price and commodity price are generally termed as market risk. This also demands that

banks maintain adequate cushion in the form of capital. Further, as the size of the bank


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grows, the volume they transact increases, the products they offer become much more

complex and their geographical spread widens significantly, operational risk

management assumes importance. The potential loss arising on account of people,

processes and systems is generally termed as operational risk.

Banks deal with public deposits and the public repose enormous trust on banks. It is

imperative that the affairs of the banks are managed in a manner not detrimental to the

public interest. This brings in the need for having a good corporate governance

framework in banks.

On account of the special role played by the banks in the economy and in order to

protect the interests of the depositors, banks are tightly regulated world over.Regulators prescribe prudential standards to be followed by the banks and it is enforced

with authority so as to keep the confidence in the banking system intact.

Deposits are the key source of funds for banks and all the banks vie for mobilising more

and more stable deposits. This nudges them to offer good customer service and

suitable products. With fierce competition amongst banks, it is the quality of customer

service that can determine the winners and losers. Banks just cannot afford to ignore

their customers.

With economies of the world integrating at a much faster rate in the recent time, the

demand on the banking sector also has grown significantly. This has led to several

product innovations, remittance schemes, derivative products etc.

2. Evolution of banking in India

The pre-independence period of Indian banking was largely characterized by the

existence of private banks organized as joint stock companies. Most banks were small

and had private shareholding of the closely held variety. They were largely localized and

many of them failed. They came under the purview of the Reserve Bank that was

established as central bank for the country in 1935. But the process of regulation and


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supervision was limited by the provisions of the Reserve Bank of India Act, 1934 and

the Companies Act, 1913. The indigenous bankers and money lenders had remained

mainly isolated from the institutional part of the system. The usurious network was still

rampant and exploitative. Co-operative credit was the only hope for credit but the

movement was successful only in a few regions.

The early years of independence (1947 to 1967) posed several challenges with an

underdeveloped economy presenting the classic case of market failure in the rural

sector, where information asymmetry limited the foray of banks. Further, the non-

availability of adequate assets made it difficult for people to approach banks. With the

transfer of undertaking of Imperial bank of India to State Bank of India(SBI) and its

subsequent massive expansion in the under-banked and unbanked centres spread

institutional credit into regions which were un-banked heretofore. Proactive measures

like credit guarantee and deposit insurance promoted the spread of credit and savings

habits to the rural areas. There were, however, problems of connected lending as many

of the banks were under the control of business houses.

The period from 1967 to 1991 was characterized by major developments like social

control of banks in 1967 and the nationalization of banks in 1969 and in 1980. The

nationalization of banks was an attempt to use the scarce resources of the banking

system for the purpose of planned development. The task of maintaining a large

number of small accounts was not profitable for the banks as a result of which they had

limited lending in the rural sector. The problem of lopsided distribution of banks and

the lack of explicit articulation of the need to channel credit to certain priority sectors

was sought to be achieved first by social control of banks and then by nationalization

of banks in 1969 and 1980. The lead bank scheme provided the blue print of further

bank branch expansion. The course of evolution of the banking sector in India since

1969 has been dominated by the nationalization of banks. This period was

characterized by rapid branch expansion that helped to draw the channels of monetary

transmission far and wide across the country. The share of unorganized credit fell

sharply and the economy seemed to come out of the low level of equilibrium trap.

However, the stipulations that made this possible and helped spread institutional credit


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and nurture the financial system, also led to distortions in the process. The

administered interest rates and the burden of directed lending constrained the banking

sector significantly. There was very little operational flexibility for commercial banks.

Profitability occupied back seat. Banks also suffered from poor governance.

The period beginning from the early 1990s witnessed the transformation of the banking

sector as a result of financial sector reforms that were introduced as a part of structural

reforms introduced /initiated in 1991. The reform process in the financial sector was

undertaken with the prime objective of having a strong and resilient banking system.

The progress that was achieved in the areas of strengthening the regulatory and

supervisory norms ushered in greater accountability and market discipline amongst the

participants. The RBI made sustained efforts towards adoption of international

benchmarks in a gradual manner, as appropriate to the Indian conditions, in various

areas such as prudential norms, risk management, supervision, corporate governance

and transparency and disclosures. The reform process helped in taking the

management of the banking sector to the level, where the RBI ceased to micro-manage

commercial banks and focused largely on macro goals. The focus on deregulation and

liberalization coupled with enhanced responsibilities for banks made the banking sector

resilient and capable of facing several newer global challenges.

In India, the commercial banks could be categorised broadly into Public Sector Banks

(which term includes Nationalised Banks, State Bank of India and its Associates and

IDBI Bank), new generation private sector banks, old generation private sector banks

and foreign banks. Regional Rural Banks set up in seventies and Local Area Banks

around the millennium are also commercial banks. The other entities of Indias banking

system are Urban co-operative banks, District Central Co-operative banks and State co-

operative banks. In respect of banks, the RBI derives its powers from the provisions of

the Banking Regulation Act, 1949, and certain select provisions of RBI Act, 1934.

As of March 31, 2009, the Indian Banking System comprised 27 public sector banks, 7

new private sector banks, and 15 old private sector banks, 31 foreign banks, 86

Regional Rural Banks (RRBs), 4 Local Area Banks (LABs), 1721 Urban Co-operative

Banks, 31 State co-operative banks and 371 district central co-operative banks. The all


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India weighted average population coverage by a commercial bank branch was 13, 400

as on June 30, 2010.

3. Public Sector Banks

Even before nationalisation of banks by the Government of India after obtaining

independence, India had several banks promoted or controlled by Governments of

princely states.

State Bank of India and Associates

In its report submitted in 1954, the All India Rural Credit Survey Committee

recommended the creation of one strong, integrated, State-sponsored, State-partnered

commercial banking institution with an effective machinery of branches spread over the

whole country. Keeping in view the above recommendation, State Bank of India wasestablished under State Bank of India Act, 1955 which acquired the Imperial Bank of

India. Nationalisation of Imperial Bank of India was the beginning of Public Sector

Banks in Independent India.

State Bank of India was required to promote banking habit in rural areas, introduce new

services to the community and provide adequate credit facilities for the productive

sectors of the economy. It was also expected to assist the Reserve Bank of India in

ensuring the flow of credit in accordance with the national priorities as set out in Five

Year Plans. A substantial portion of the shareholding was taken by Reserve Bank of

India.

Later under State Bank of India (Subsidiary Banks) Act, 1959, eight State-associated

banks were taken over by the State Bank of India as its subsidiaries, later named as

Associates. The names of the banks which were taken over was as under:

Sl

No

Name of the Bank Established

in Year

Remarks

1 State Bank of Jaipur 1943 These two banks amalgamated

to form SBBJ in 19632 State Bank of Bikaner 1944

3 State Bank of Hyderabad 1941

4 State Bank of Indore 1920 Merged with SBI recently

5 State Bank of Mysore 1913

6 State Bank of Patiala 1917


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Sl

No

Name of the Bank Established

in Year

Remarks

7 State Bank of Saurashtra 1950 Merged with SBI

8 State Bank of Travancore 1945

First phase of nationalisation

Even after State Bank of India and its Associates were taken under Government control,

there was a widespread feeling that other Indian commercial banks were not

discharging their responsibilities keeping in view the socialistic democratic principles

adopted by the State. There have been numerous complaints that these banks are not

advancing to sectors like Agriculture, Small Scale Industries etc. In December 1967, the

Government initiated the scheme of social control on Indian commercial banks. The

arrangements were enforced through a legislative measure on February 1, 1969.However, the scheme was found to be unsatisfactory and inadequate. As a result, on

July 19, 1969, 14 banks with deposits above Rs.50 crores were nationalised in order to

serve better the needs of development of the economy in conformity with the national

policy and objectives.

Some of the objectives of nationalisation of banks were as under:

- To ensure provision of adequate credit to the neglected sectors such as

agriculture, cottage and small scale industries, retail trade, exports, artisans and

self-employed persons,

- To prevent the diversion of bank finance to anti-social, less productive, low-

priorities sector and to big industrialists and businessmen,

- Giving a professional bent to bank management,

- Reduction of regional imbalances in banking facilities by opening of branches in

rural / remote and unbanked areas,

- Development of banking habits among people,

- Equitable distribution of economic power by removal of control of banks by a few

big industrialists and business houses and- Provision of adequate training as well as reasonable terms of service for bank

staff.


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Since the nationalisation of fourteen major banks, the geographical and functional

coverage of commercial banks have increased at a rate that is unprecedented in the

world. Mass banking from class banking was the motto.

Second phase of nationalisation

In order to enhance the capacity of the banking system to meet more effectively the

needs of the developing economy and to promote effectively the needs of the

developing economy and to promote the welfare of the people in conformity with the

national policy, by promulgating an ordinance on April 15, 1980, six more banks with the

deposits of Rs.200 crore and above were nationalised. Andhra Bank, New Bank of

India, Vijaya Bank, Punjab and Sind Bank, Corporation Bank and Oriental Bank of

Commerce were nationalised in the second phase.

As a result of nationalisation, there was a rapid expansion of branches of commercial

banks not only in metropolitan and urban areas but also in the rural and semi-urban

areas that were hitherto neglected by the commercial banks. Mobilisation of substantial

deposits and spreading the habit of banking has been the other significant

achievements of the nationalised banks.

IDBI Bank

IDBI was established by an Act of Parliament in July 1964. IDBI also had promoted a

new generation private sector bank in the name IDBI Bank Ltd along with SIDBI. It was

decided that the IDBI Bank Ltd would be merged with IDBI and the new entity would be

named as IDBI Bank Ltd. The final approval from RBI for the merger was given on April

1, 2005.

4. Private Sector Banks

For well over two decades, after the nationalisation of 14 larger banks in 1969, no banks

have been allowed to be set up in the private sector. Progressively, over this period,

public sector banks have expanded their branch network considerably and catered to

the socio-economic needs of large masses of population especially the weaker section

and those in the rural areas. When financial sector reforms were initiated in India in

the early nineties, guidelines for licensing of new banks in the private sector were


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issued in January 1993 and subsequently revised in January 2001. The objective was

to instil greater competition in the banking system to increase productivity and

efficiency. The initial minimum paid up capital was prescribed at Rs. 200 crore to be

raised to Rs. 300 crore within three years of commencement of business. Detailed

guidelines/requirements have been prescribed with regard to registration, licensing,

capital, ceiling on voting rights, priority sector lending, setting up of subsidies, etc.

With financial inclusion getting much sharper focus, the demand for licensing few more

banks has gained ground. Reserve Bank of India has announced a draft policy paper for

licensing more banks on August 11, 2010 seeking opinion by September 2010 from

public. The final policy would be articulated taking into account the various suggestions

received from members of public, aspiring institutions, academia etc.

5. Foreign Banks

In India the presence of foreign banks dates back to the pre-independence period.

Various Committees on financial sector reforms recommended further opening up of the

Indian banking sector to augment competition and efficiency. Furthermore, a window

for expansion of foreign banks was opened in India under the General Agreement on

Trade and Services(GATS) of World Trade Organisation(WTO)As of now, along with

allowing more branches of foreign banks, giving them more flexibility in their

operations, India has gone beyond the WTO commitment of 12 branches. In fact,

number of branches allowed each year has already been higher than WTO

commitments.

Initially foreign banks in India were allowed to enter and expand by branches-mode only

and were not permitted to own controlling stakes in domestic banks. Subsequently, the

aggregate foreign investment from all sources was allowed up to a maximum of 74

per cent of the paid-up capital of a private bank.

In February 2005 Government of India and the RBI released the Roadmap for

presence of Foreign banks in India, laying out a two-track, i.e., consolidation of the

domestic banking system(both in private sector and public sector) and gradual

enhancement of the presence of foreign banks in a synchronised manner. The


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roadmap was divided into two phases, the first phase spanning the period March 2005-

March 2009, and the second phase beginning April 2009 after a review of the

experience gained in the first phase.

In the first phase, foreign banks are permitted to establish presence by way of

WOS(Wholly-Owned Subsidiary) or conversion of the existing branches into a WOS

following the one mode presence criterion. The WOS are treated on par with the

existing branches of foreign banks for branch expansion in India. So far, however, no

bank has applied for a WOS presence.

In view of the current global financial sector turmoil, and its aftermath evolving

regulatory and supervisory scenario it has been decided, for the time being, to continue

with the current policy and procedures governing the presence of foreign banks in India.

6. Local Area Banks (LABs)

The Local Area Bank Scheme was introduced in August 1996 pursuant to the

announcement made in the Union Budget of that year. The idea behind setting up of

new private local banks with jurisdiction over two or three contiguous districts was to

help the mobilisation of rural savings by local institutions and make them available in

local areas The guidelines for setting up of LABs in the private sector were announced

by the RBI in August 1996. There were four LABs as at end-March 2009.

7. Rural financing Institutions

(i) Rural cooperative banks

Rural cooperatives occupy an important position in the Indian Financial System. These

were the first formal institutions established to purvey credit to rural India. Thus far,

cooperatives have been key instrument of financial inclusion in reaching out to the last

mile in rural areas. Cooperative banks are registered under the respective StateCooperative Societies Acts or Multi State Cooperative Societies Act, 2002 and

governed by the provisions of the respective acts. The legal character, ownership,

management, clientele and the role of state governments in the functioning of the

cooperative banks make these institutions distinctively different from commercial banks.

The distinctive feature of the cooperative credit structure in India is its heterogeneity.


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9. Looking ahead

Commercial banks; Focus is on implementing Basel II norms, which will require

improved capital planning and risk management skills.

Urban cooperative banks: Focus is on profitability, professional management and

technology enhancement.

Regional rural banks: Focus is on enhancing capability through IT and HR for serving

the rural areas.

Rural cooperative banks: Focus is on ensuring that they meet minimum prudential

standards.


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increasing openness of the Indian economy and financial reforms. In the Indian

context, financial stability could be interpreted to include three aspects, viz., (a)

ensuring uninterrupted financial transactions, (b) maintenance of a level of

confidence in the financial system amongst all the participants and stakeholders,

and (c) absence of excess volatility that unduly and adversely affects real

economic activity. It is the endeavour of the Reserve Bank to ensure all these

aspects of financial stability.

Since the late 1980s, there has been an enhanced emphasis by many central

banks on securing operational freedom for monetary policy and investing it with a

single goal, best embodied in the growing independence of central banks and

inflation targeting as an operational framework for monetary policy, which has

important implications for transmission channels. In this context, the specific

features of the Indian economy have led to the emergence of a somewhat

contrarian view: In India, adoption of inflation targeting has not been favoured ,

while keeping the attainment of low inflation as a central objective of monetary

policy, along with that of high and sustained growth that is so important for a

developing economy. Apart from the legitimate concern regarding growth as a key

objective, there are other factors that suggest that inflation targeting may not be

appropriate for India. First, unlike many other developing countries we have had a

record of moderate inflation, with double digit inflation being the exception, and

largely socially unacceptable. Second, adoption of inflation targeting requires the

existence of an efficient monetary transmission mechanism through the operation

of efficient financial markets and absence of interest rate distortions. In India,

although the money market, government debt and forex markets have indeed

developed in recent years, they still have some way to go, whereas the corporate

debt market is still to develop. Though interest rate deregulation has largely beenaccomplished, some administered interest rates still persist. Third, inflationary

pressures still often emanate from significant supply shocks related to the effect of

the monsoon on agriculture, where monetary policy action may have little role.

Finally, in an economy as large as that of India, with various regional differences,

and continued existence of market imperfections in factor and product markets


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between regions, the choice of a universally acceptable measure of inflation is

also difficult.

The objectives of monetary policy differ across countries. During the 1990s, there

was a convergence around the world in the goals and methods used to conduct

monetary policy. A number of factors were responsible for this development. First,

during the 1970s and 1980s, many countries experienced very high levels of

inflation. This led to a clear consensus that even moderate levels of inflation

damage real growth and that low inflation must therefore be a primary objective of

monetary policy. Second, evidence showed that in most countries, short-run

money demand functions are unstable and that meaningful measures of money,

such as M2 or M3, are very difficult cult to control. As a result, monetary targeting

alone was no longer viewed as a viable strategy for stabilizing prices. Finally,

excessive exchange rate volatility was seen as damaging. Following this, many

countries redesigned their policies and adopted inflation targeting. New Zealand in

1988 became the first industrialized country to adopt an explicit / hard inflation

target; Canada, Chile, and Israel adopted inflation targeting in 1991; the United

Kingdom, Australia and Sweden also changed their policy frames and adopted

inflation targeting. However, countries such as USA and India have other

objectives as well.

Framewo rk and Instrum ents

In India, monetary policy framework has undergone significant transformation over

time. In the 1960s, as inflation was considered to be structural and inflation

volatility was mainly caused by agricultural failures, there was greater reliance on

selective credit controls. The aim was to regulate bank advances to sensitive

commodities to influence production outlays, on the one hand and to limit

possibilities of speculation, on the other. In the 1970s, there was a surge in

inflation on account of monetary expansion induced by expansionary fiscal policies

besides the oil price shocks. By the early 1980s, there was a broad agreement on


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the primary causes of inflation. It was argued that while fluctuations in agricultural

prices and oil price shocks did affect prices, sustained inflation since the early

1960s could not have occurred unless it was supported by the continuous

excessive monetary expansion generated by the large-scale monetisation of the

fiscal deficit. Against the backdrop, the Committee to Review the Working of the

Monetary System (Chairman: Prof. Sukhamoy Chakravarty; 1985), set up by the

Reserve Bank, recommended a monetary targeting framework to target an

acceptable order of inflation in line with desired output growth

Over the period from 1985 to 1997, India followed a monetary policy framework

that could broadly be characterised as one of loose and flexible monetary targeting

with feedback . Under this approach, growth in broad money supply (M3) was

projected in a manner consistent with expected GDP growth and a tolerable level

of inflation. The M3 growth thus worked out was considered a nominal anchor for

policy. Reserve money (RM) was used as the operating target and bank reserves

as the operating instrument. As deregulation increased the role of market forces in

the determination of interest rates and the exchange rate, monetary targeting,

even in its flexible mode, came under stress. Capital flows increased liquidity

exogenously, put upward pressure on the money supply, prices and the exchange

rates. While most studies in India showed that money demand functions had been

fairly stable, it was increasingly felt that financial innovations and technology had

systematically eroded the predictive potential of money demand estimations

relative to the past. Interest rates gained relative influence on the decision to hold

money. Accordingly, the Monetary policy framework was reviewed towards the late

1990s, and the Reserve Bank switched over to a more broad-based multiple

indicator approach from 1998-99. In this approach, policy perspectives are

obtained by juxtaposing interest rates and other rates of return in different markets

(money, capital and government securities markets), which are available at high

frequency with medium and low frequency variables such as currency, credit

extended by banks and financial institutions, the fiscal position, trade and capital

flows, inflation rate, exchange rate, refinancing and transactions in foreign


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exchange and output. Such a shift was a logical outcome of measures taken over

the reform period since the early 1990s. The switchover to a multiple indicator

approach provided necessary flexibility to respond to changes in domestic and

international economic environment and financial market conditions more

effectively. The multiple indicators approach, conceptualized in 1998, has since

been augmented by forward looking indicators from surveys and a panel of time

series models.

Some of the important factors that shaped the changes in monetary policy

framework and operating procedures in India during the 1990s were deregulation

of interest rates, and development of the financial markets with reduced

segmentation through better linkages and development of appropriate trading,

payments and settlement systems along with technological infrastructure. Another

important development in the direction of providing safeguards to monetary policy

from the consequences of expansionary fiscal policy and ensuring a degree ofde

facto autonomy of the RBI was the delinking of budget deficit from its automatic

monetization by the Reserve Bank. The system of automatic monetisation through

ad hoc Treasury Bills was replaced with Ways and Means Advances in 1997,

because of which the Government resorted to increased market borrowings to

finance its deficit. With the enactment of the Fiscal Responsibility and Budget

Management Act in 2003, the Reserve Bank cannot participate in the primary

issues of Central Government securities with effect from April 2006.

In its monetary policy operations, the Reserve Bank uses multiple

instruments to ensure that appropriate liquidity is maintained in the system so that

all legitimate requirements of credit are met, consistent with the objective of price

stability. Towards this end, the Bank pursues a policy of active management of

liquidity through OMO including LAF, MSS and CRR, and using the policy

instruments at its disposal flexibly, as and when the situation warrants. The recent

legislative amendments enable a flexible use of the CRR for monetary

management, without being constrained by a statutory floor or ceiling on the level


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of the CRR. The amendments also enable the lowering of the Statutory Liquidity

Ratio (SLR) to the levels below the pre-amendment statutory minimum of 25 per

cent of net demand and time liabilities of banks

In the Indian context, reforms in the monetary policy operating framework,

which were initiated in the late 1980s crystallised into the Liquidity Adjustment

Facility (LAF) in 2000. Under the LAF, the Reserve Bank sets its policy rates, i.e.,

repo and reverse repo rates and carries out repo/reverse repo operations, thereby

providing corridor for overnight money market rates. The introduction of LAF has

had several advantages. First and foremost, it made possible the transition from

direct instruments of monetary control to indirect instruments. Since LAF

operations enabled reduction in CRR without loss of monetary control. Second,

LAF has provided monetary authorities with greater flexibility in determining both

the quantum of adjustment as well as the rates by responding to the needs of the

system on a daily basis. Third and most importantly, though there is no formal

targeting of a point overnight interest rate,

The instruments to manage, in the context of large capital flows and

sterilisation, has been strengthened through Market Stabilisation Scheme (MSS),

which was introduced in April 2004. As the stock of government securities

available with the Reserve Bank declined progressively and the burden of

sterilization increasingly fell on LAF operations. the Reserve Bank signed in March

2004, a memorandum of understanding (MoU) with the Government of India for

issuance of Treasury Bills and dated government securities under the Market

Stabilisation Scheme (MSS). The intention of MSS is essentially to differentiate the

liquidity absorption of a more enduring nature by way of sterilisation from the day-

to-day normal liquidity management operations. The ceiling on the outstanding

obligations of the Government under MSS has been initially indicated but is

subject to revision through mutual consultation. The issuances under MSS are

matched by an equivalent cash balance held by the Government in a separate

identifiable cash account maintained and operated by the Reserve Bank. While


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these issuances do not provide budgetary support to the Government, interest

costs are borne by the Government. These securities are also traded in the

secondary market.

There are occasions when the medium-term goals, say reduction in cash

reserve ratios for banks, conflict with short-term compulsions of monetary

management requiring actions in both directions. Drawing a distinction between

medium term reform goals and flexibility in short-term management is considered

something critical in the Indian policy environment. The success of a framework

that relies on indirect instruments of monetary management such as interest rates

is contingent upon the extent and speed with which changes in the central bank's

policy rate are transmitted to the spectrum of market interest rates and exchange

rate in the economy and onward to the real sector. Clearly, monetary transmission

cannot take place without efficient price discovery, particularly, with respect to

interest rates and exchange rates. Therefore, in the efficient functioning of

financial markets, the corresponding development of the full financial market

spectrum becomes necessary. In addition, the growing integration of the Indian

economy with the rest of the world has to be recognized and provided for.

Accordingly, reforms focused on improving operational effectiveness of monetary

policy have been put in process, while simultaneously strengthening the regulatory

role of the Reserve Bank, tightening the prudential and supervisory norms,

improving the credit delivery system and developing the technological and

institutional framework of the financial sector.

Inst i tut ional Mechanism

Monetary policy formulation is carried out by the Reserve Bank through a

consultative process. The Monetary Policy Department holds meetings with select

major banks and financial institutions, which provide a consultative platform for

issues concerning monetary, credit, regulatory and supervisory policies of the

Bank. Decisions on day-to-day market operations, including management of


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liquidity, are taken by a Financial Markets Committee (FMC), which includes

senior officials of the Bank responsible for monetary policy and related operations

in money, government securities and foreign exchange markets. The Deputy

Governor, Executive Director(s) and heads of four departments in charge of

monetary policy and related market operations meet every morning as financial

markets open for trading. They also meet more than once during a day, if such a

need arises. In addition, a Technical Advisory Committee on Money, Foreign

Exchange and Government Securities Markets comprising academics and

financial market experts, including those from depositories and credit rating

agencies, provides support to the consultative process. Besides FMC meetings,

Monetary Policy Strategy Meetings take place regularly. The strategy meetings

take a relatively medium-term view of the monetary policy and consider key

projections and parameters that can affect the stance of the monetary policy. In

pursuance of the objective of further strengthening the consultative process in

monetary policy, a Technical Advisory Committee (TAC) on Monetary Policy has

been set up with Governor as Chairman and Deputy Governor in charge of

monetary policy as Vice Chairman, three Deputy Governors, two Members of the

Committee of the Central Board and five specialists drawn from the areas of

monetary economics, central banking, financial markets and public finance, as

Members. The TAC meets ahead of the Annual Policy and the quarterly reviews of

annual policy. The TAC reviews macroeconomic and monetary developments and

advises on the stance of monetary policy. Reforms in monetary policy framework

are listed in Annex. I.

Monetary Policy Response in India to the Global Financial Crisis

The world economy today seems to be recovering from the most severe

crisis since the Great Depression of the 1930s. The financial crisis is also dubbed

as the greatest crisis in the history of financial capitalism because of the way it

simultaneously propagated to other countries. The impact of the crisis can be

gauged from the sharp upward revisions to the estimates of possible write-downs


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by banks and other financial institutions from about US$ 500 billion in March 2008

to about US$ 3.5 trillion in October 2009. More than the financial cost, the adverse

impact on the real economy has been severe: in 2009, the world GDP is estimated

by the IMF to have contracted by 0.8 per cent and the world trade volume is

estimated to have declined by 12 per cent.

How was India Impacted?

Post-Lehman, the impact of the global financial crisis was first felt through

reversal of capital flows and fall in equity prices in the domestic stock markets on

the back of large scale sell-off by the foreign institutional investors (FIIs) as a part

of the global deleveraging process. Simultaneously, there was reduced access to

external sources of funding by Indian entities due to the tightening of credit

conditions in international markets. This shortage of dollar liquidity put significant

pressures on the domestic foreign exchange market, which was reflected in

downward pressures on the Indian rupee along with its increased volatility.

Simultaneously, there was a substitution of overseas financing by domestic

financing, which brought both money market and credit market under pressure.

The transmission of this external demand shocks was swift and severe on Indias

export growth, which turned negative in October 2008. Imports too started

declining by December 2008 as domestic activity slowed. The overall impact was

reflected in a fall in investment demand and sharp deceleration in the growth of

Indian economy in the second half of 2008-09 which persisted through the first

quarter of 2009-10.

Policy Response in India

In order to limit the adverse impact of the contagion on the Indian financial

markets and the broader economy, the Reserve Bank, took a number of

conventional and unconventional measures. These included augmenting domestic

and foreign exchange liquidity and sharp reduction in the policy rates. The


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Reserve Bank used multiple instruments such as the liquidity adjustment facility

(LAF), open market operations (OMO), cash reserve ratio (CRR) and securities

under the market stabilization scheme (MSS) to augment the liquidity in the

system. In a span of seven months between October 2008 and April 2009, there

was unprecedented policy activism. For example: (i) the repo rate was reduced by

425 basis points to 4.75 per cent, (ii) the reverse repo rate was reduced by 275

basis points to 3.25 per cent, (iii) the CRR was reduced by a cumulative 400 basis

points to 5.0 per cent, and (iv) the actual/potential provision of primary liquidity was

of the order of Rs. 5.6 trillion (10.5 per cent of GDP). These measures were

effective in ensuring speedy restoration of orderly conditions in the financial

markets over a short time span. These measures were supported by fiscal

stimulus packages during 2008-09 in the form of tax cuts, investment in

infrastructure and increased expenditure on government consumption. The

expansionary fiscal stance continues during 2009-10 to support aggregate

demand. While the magnitude of the crisis was global in nature, the policy

responses were adapted to domestic growth outlook, inflation conditions and

financial stability considerations. The important among the many unconventional

measures taken by the Reserve Bank of India were rupee-dollar swap facility for

Indian banks to give them comfort in managing their short-term foreign funding

requirements, an exclusive refinance window as also a special purpose vehicle for

supporting nonbanking financial companies, and expanding the lendable

resources available to apex finance institutions for refinancing credit extended to

small industries, housing and exports.

Current Pol icy Stance

The Reserve Bank pursued an accommodative monetary policy beginning

mid-September 2008 in order to mitigate the adverse impact of the global financial

crisis on the Indian economy. The measures taken instilled confidence in market

participants and helped cushion the spillover of the global financial crisis on to our

economy. However, In October 2009, in view of rising food inflation and the risk of

it impinging on inflationary expectations, the Reserve Bank announced the first


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phase of exit from the expansionary monetary policy by terminating some sector-

specific facilities and restoring the statutory liquidity ratio (SLR) of scheduled

commercial banks to its pre-crisis level in the Second Quarter Review of October

2009. Since then, the Reserve Bank raised the cash reserve ratio (CRR) points,

and the repo and reverse repo rates. In the Second Quarter Review of the

Monetary Policy announced on November 2, 2010, the stance of monetary policy

was intended to: (i) contain inflation and anchor inflationary expectations, while

being prepared to respond to any further build-up of inflationary pressures; (ii)

maintain an interest rate regime consistent with price, output and financial stability

and (iii) actively manage liquidity to ensure that it remains broadly in balance, with

neither a surplus diluting monetary transmission nor a deficit choking off fund

flows. Following this, reverse repo rate was raised by 25 basis points to 5.25 per

cent. Similarly, repo rates were also raised by 25 basis points to 6.25 per cent.

Cash reserve ratio was retained at 6.0 per cent. Movement in key policy rates

since October 2008 is presented in Annex 2.

Overall Assessment

The monetary policy framework in India has undergone significant shifts from a

monetary targeting regime to a multiple indicators regime. Such a transition was

conditioned by the developments of financial markets, increasing integration of the

Indian economy with the global economy and changing transmission of monetary

policy. The multiple indicators approach, conceptualized in 1998, has since been

augmented by forward looking indicators from surveys and a panel of time series

models. Moreover, the multiple indicators approach continues to evolve. Though

the multiple indicators approach is subject to criticism for the absence of a clearly

defined anchor, in the wake of the recent global financial crisis there is recognitionof the usefulness of a broad indicators-based assessment of monetary policy.

Based on the comparison of the relative performance of the monetary regimes in

terms of key macroeconomic variables over three periods: (i) the decade

preceding the monetary targeting period (1976-85); (ii) monetary targeting period


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(1986-98) and (iii) multiple indicators period so far (1999-2009), the following

broad conclusions can be drawn.

First, real GDP growth, on an average, has improved successively from 4.6

per cent in the decade prior to the monetary targeting period to 5.5 per cent

in the monetary targeting period and further to 7.1 per cent in the multiple

indicators period. Not only growth has improved but it has become more

stable under the multiple indicators approach.

Second, headline WPI inflation, on an average, increased during the

monetary targeting regime alongside significant increase in fiscal deficit,

although there was a reduction in volatility in inflation. Under the multiple

indicators approach, both WPI and CPI inflation fell significantly. The fall ininflation was accompanied by substantial reduction in fiscal deficit. This

underscores the importance of fiscal consolidation to sustain higher levels

of growth with price stability.

Third, while the volatility of WPI inflation reduced during the multiple

indicators period, it increased for CPI inflation reflecting higher volatility in

food prices. This underlines the importance of supply management and a

greater focus on agricultural development to contain food price inflation.

Fourth, money supply (M3) growth declined over the regimes though

volatility of M3 increased slightly during the multiple indicators regime

reflecting emerging importance of interest rate in monetary transmission.

The shift in operating objective to stabilise overnight interest rate so that it

transmits through the term structure is reflected in a discernible reduction in

the overnight interest rate with lower volatility.

Fifth, exchange rate, on an average, has depreciated successively both in

nominal and real terms. However, it has become more stable during themultiple indicators approach than the monetary targeting regime. This could

be partly attributed to accumulation of reserves and management of

exchange rate to contain volatility.


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Sixth, the improved performance of monetary policy was facilitated by

supportive fiscal policy discontinuation of the practice of automatic

monetisation and rule-based deficit reduction programme under the Fiscal

Responsibility and Budget Management (FRBM) Act which enhanced

instrument independence of the Reserve Bank.

Finally, the recent overall improvement in macroeconomic performance

cannot be ascribed to monetary policy alone. Apart from a rule-based fiscal

policy, productivity enhancing structural reforms, sharp increase in saving

and investment, increasing integration with the global economy, a low

global inflation environment and the unleashing of the entrepreneurial spirit

of the private sector played an important role.

Conclusions

With the changing framework of monetary policy in Indian from monetary targeting

to an augmented multiple indictors approach, the operating targets and processes

have also undergone a change. There has been a shift from quantitative

intermediate targets to interest rates, as the development of financial markets

enabled transmission of policy signals through the interest rate channel. At the

same time, availability of multiple instruments such as CRR, OMO including LAF

and MSS has provided necessary flexibility to monetary operations. While

monetary policy formulation is a technical process, it has become more

consultative and participative with the involvement of market participant,

academics and experts. The internal process has also been re-engineered with

more technical analysis and market orientation. In order to enhance transparency

in communication the focus has been on dissemination of information and analysis

to the public through the Governors monetary policy statements and also throughregular sharing of policy research and macroeconomic and financial information.

(Prepared by Dr. BN Ananthaswamy, MoF)

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Annex I: Reforms in the Monetary Policy Framework

Objectives

Twin objectives of maintaining price stability and ensuring availability ofadequate credit to productive sectors of the economy to support growth continueto govern the stance of monetary policy, though the relative emphasis on these

objectives has varied depending on the importance of maintaining an appropriatebalance.Reflecting the increasing development of financial market and greaterliberalisation, use of broad money as an intermediate target has been de-emphasised and a multiple indicator approach has been adopted.Emphasis has been put on development of multiple instruments to transmitliquidity and interest rate signals in the short-term in a flexible and bi-directionalmanner.Increase of the interlinkage between various segments of the financial marketincluding money, government security and forex markets.Financial stability has emerged as one of the objectives of monetary policy inrecent years.

Instruments

Move from direct instruments (such as, administered interest rates, reserverequirements, selective credit control) to indirect instruments (such as, openmarket operations, purchase and repurchase of government securities) for theconduct of monetary policy.Introduction of Liquidity Adjustment Facility (LAF), which operates through repoand reverse repo auctions, effectively provide a corridor for short-term interestrate. LAF has emerged as the tool for both liquidity management and also as asignalling devise for interest rate in the overnight market.Use of open market operations to deal with overall market liquidity situationespecially those emanating from capital flows.Introduction of Market Stabilisation Scheme (MSS) as an additional instrument todeal with enduring capital inflows without affecting short-term liquiditymanagement role of LAF.Developmental Measures

Discontinuation of automatic monetisation through an agreement between theGovernment and the Reserve Bank. Rationalisation of Treasury Bill market.Introduction of delivery versus payment system and deepening of inter-bank repomarket.Introduction of Primary Dealers in the government securities market to play therole of market maker.

Amendment of Securities Contracts Regulation Act (SCRA), to create the

regulatoryframework.Deepening of government securities market by making the interest rates on suchsecurities market related. Introduction of auction of government securities.Development of a risk-freecredible yield curve in the government securities market as a benchmark forrelated markets.Development of pure inter-bank call money market. Non-bankparticipants to participate in other money market instruments.


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Introduction of automated screen-based trading in government securities throughNegotiated Dealing System (NDS). Setting up of risk-free payments and system ingovernmentsecurities through Clearing Corporation of India Limited (CCIL). Phasedintroduction ofReal Time Gross Settlement (RTGS) System.

Deepening of forex market and increased autonomy of Authorised Dealers.Institutional Measures

Setting up of Technical Advisory Committee on Monetary Policy with outsideexperts to review macroeconomic and monetary developments and advise theReserve Bank on the stance of monetary policy.Creation of a separate Financial Market Department within the RBI


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Annex 2: Movements in Key Policy Rates in India (Per cent)

Effective since Reverse Repo Repo Rate Cash Reserve Ratio

April 26, 2008 6.00 7.75 7.75 (+0.25)

May 10, 2008 6.00 7.75 8.00 (+0.25)

May 24, 2008 6.00 7.75 8.25 (+0.25)

June 12, 2008 6.00 8.00 (+0.25) 8.25

June 25, 2008 6.00 8.50 (+0.50) 8.25

July 5, 2008 6.00 8.50 8.50 (+0.25)

Effective since Reverse Repo Repo Rate Cash Reserve Ratio

July 19, 2008 6.00 8.50 8.75 (+0.25)

July 30, 2008 6.00 9.00 (+0.50) 8.75

August 30, 2008 6.00 9.00 9.00 (+0.25)

October 11, 2008 6.00 9.00 6.50 (2.50)

October 20, 2008 6.00 8.00 (1.00) 6.50

October 25, 2008 6.00 8.00 6.00 (0.50)

November 3, 2008 6.00 7.50 (0.50) 6.00

November 8, 2008 6.00 7.50 5.50 (0.50)

December 8, 2008 5.00 (-1.00) 6.50 (1.00) 5.50

January 5, 2009 4.00 (-1.00) 5.50 (1.00) 5.50

January 17, 2009 4.00 5.50 5.00 (0.50)

March 4, 2009 3.50 (-0.50) 5.00 (-0.50) 5.00

April 21, 2009 3.25 (-0.25) 4.75 (-0.25) 5.00

February 13, 2010 3.25 4.75 5.50 (+0.50)

February 27, 2010 3.25 4.75 5.75 (+0.25)

March 19, 2010 3.50 (+0.25) 5.00 (+0.25) 5.75


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PUBLIC DEBT MANAGEMENT

Introduction

The Reserve Bank of India, by virtue of its Act derives the right to manage the public debt of

the Central Government as well as issue of new loans, the operational aspects of which will

be governed by the agreement between the Bank and the GOI for this purpose. As regards

management of public debt for the State Governments, the RBI Act 1934 stipulates that the

Bank may undertake this task by way an agreement with each State. The procedural

aspects in debt management operations are governed by the Government Securities Act,

2006. It should be noted here that, though the term public debt includes various items of

internal as well as external liabilities of the Government, the RBI acts as the debt manager to

the Government only for marketable internal debt.

As a debt manager for both the Central and State Governments, RBI in consultation with the

Government, manages the timing of issue, composition of debt, maturity profile and the type

of instruments issued. While these functions pertain to its advisory role, operationally RBI deals

with the issue, servicing and repayment of government debt. In this context, the objective of

debt management policy has undergone changes over the years in line with the change in

RBIs role from passive to active debt manager. Initially, the debt management policy focused

on the cost of borrowing, but at present, the objective is minimizing the cost of borrowing

over the long run taking into account the refinancing risk involved, while ensuring that debt

management policy is consistent with monetary policy. Since RBI is also responsible for

monetary management, there is a need for coordination between the monetary and debt

management policies, especially in view of the large market borrowing program of the

Government to be undertaken at market related rates year after year. The interactions of the

Financial Markets Committee within the RBI, the Standing Committee on Cash and Debt

Management with representation from both RBI and the GOI, and the pre-budget interaction

between the RBI and GOI help in achieving the necessary coordination between debt

management, fiscal policy and monetary policy. In view of the conflicting roles that RBI has

to play as monetary manager and debt manager, it is proposed to remove the mandatory

nature of public debt management by the RBI by way of amendment to RBI Act.

Organisational Structure for Debt Management

Within the RBI, the Internal Debt Management Department (IDMD) performs the debt

management function. Earlier, the Secretarys Department was looking after the work

relating to debt management. In October 1992, the Internal Debt Management Cell was

constituted as an inter-disciplinary unit with the objective of evolving appropriate policies

relating to internal debt management as part of overall monetary policy and to manage

operations such as market borrowing, Open Market Operations (OMO), Ways and Means

Advances (WMA) and other related matters, as also to promote the development of an


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efficient government securities market. The Cell attained the status of a full-fledged

department in May 2003. The main functions of IDMD comprise formulation of a core

calendar for primary issuance, deciding the maturity profile of debt, designing the

instruments and methods of raising resources, deciding the size and timing of issuances.

These critical decisions are taken after considering government s needs, market conditionsand preferences of various investor segments, etc while at the same time ensuring that the

entire strategy is consistent with the overall monetary policy objectives.

The actual operations related to the raising of market loans such as acceptance of bids and

applications, settlement of securities are undertaken at the Public Debt Offices (PDO) of the

RBI. PDO also manages the registry and depository functions in relation to debt

management of the government. The Department of Government and Bank Accounts

(DGBA) maintains the central accounts regarding the market debt and also liaises with the

Government and the PDOs in matters relating to reconciliation of accounts etc.

Debt Management Policy - Changes

Prior to 1991-92, the fiscal policy compulsions rendered the internal debt management

policy passive. In order to ensure that the cost of borrowing for the government remained

low, the interest rates on government securities were administered rates which were not in

alignment with real interest rates in the market place. Such a policy of borrowing at artificially

fixed interest rates was facilitated in a captive market of banks, insurance companies and

provident funds that were statutorily required to invest in government securities. In view of

the rising requirements of the government, RBIs monetary management too was dominated

by a regime of rising CRR and SLR prescriptions. At the same time, till early 1990s, the

volume of short term debt of the government also expanded due to automatic

accommodation by the RBI through the mechanism of Ad-hoc Treasury bills. It is against this

backdrop, and in the context of overall economic and financial sector reforms, that the debt

management policy underwent a change.

The abolition of ad-hoc treasury bills from April 1997, was a watershed in the relationship of

the Bank as banker to the Government. From public debt management point of view, it

meant that the Government would need to approach the market for its short term

requirement of funds as well. In addition to this, the financial sector reforms underway since

the early 1990s, also brought in deregulation in the interest rates on government securities.

This happened through the introduction of auction method for price determination by the

market. Consequent to the above changes, the focus of debt management also underwent

certain changes and the objective now is minimizing the cost of borrowing over the long run

taking into account the refinancing risk involved, while ensuring that debt management policy

is consistent with monetary policy. Another equally important objective is the development of

the government securities market so as to enable separation of debt management from

monetary management in the long run. With increasingly active debt management policy


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coming into being, the role of RBI as adviser to the Government also began to focus on

maturity profile of debt, timing of issuances and types of instruments depending on market

conditions.

Debt management objectives

Minimization of Cost

One of the objectives of debt management has always been to ensure that the cost of

borrowing is kept low for the government. However, this objective has not always been easy

to achieve because RBIs policy has been constrained by the needs of the government.

Consequently, RBI had to take private placement or devolvement on itself so as to ensure

that the cost is not too high for the government especially when the market sentiment is

uncertain or when liquidity conditions were not appropriate. Securities thus acquired were

later off-loaded in the market through Open Market Operations. Gradually, there has been

awareness that such a support system by RBI could be detrimental to the development of

the government securities market and hence, the system of Primary Dealers (PDs) was

introduced in 1995-96 to strengthen the institutional infrastructure. In addition, with the

formation of the Cash and Debt Management Committee the liaison between the

Government and the RBI enabled the RBI to follow a strategy of timing the issues of

government loans to coincide with favourable liquidity and yield environment. After the Fiscal

Responsibility and Budget Management (FRBM) Act, 2003, RBI has stopped participating in

the primary issue of G-Secs and the PDs underwrite 100% of the primary auctions.

Refinancing / Rollover Risk

In the early nineties, with the introduction of auction mechanism, interest rates on

government securities began to be market determined. These were expected to be certainly

higher than the administered interest rates existing till then. Hence, in order to ensure that

governments cost structure was not unduly high for a longer period of time, the maturity of

new loans issued was reduced to just around 10 years. As a result, repayment obligations

began to be bunched up bringing with it the possibility of refinancing or rollover risk (risk that

government may not be able to raise the requisite amount of resources at the time of

repayment or may be able to raise the resources only at higher cost). In order to maintain such

rollover risk at acceptable levels, the RBI subsequently followed a strategy of gradually

elongating the maturity profile of governments loans through issuance of long term G-Secs.

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