Jagannath Institute of Management Sciences Lajpat Nagar · 2016-02-29 · Jagannath Institute of...
Transcript of Jagannath Institute of Management Sciences Lajpat Nagar · 2016-02-29 · Jagannath Institute of...
UNIT-1
DEFINITION of 'Financial System'
A financial system can be defined at the global, regional or firm specific level. The firm's
financial system is the set of implemented procedures that track the financial activities of the
company. On a regional scale, the financial system is the system that enables lenders and
borrowers to exchange funds. The global financial system is basically a broader regional
system that encompasses all financial institutions, borrowers and lenders within the global
economy.
A financial system is a network of financial institutions, financial markets, financial
instruments and financial services to facilitate the transfer of funds. The system consists of
savers, intermediaries, instruments and the ultimate user of funds. The level of economic
growth largely depends upon and is facilitated by the state of financial system prevailing in
the economy. Efficient financial system and sustainable economic growth are corollary. The
financial system mobilises the savings and channelizes them into the productive activity and
thus influences the pace of economic development. Economic growth is hampered for want
of effective financial system. Broadly speaking, financial system deals with three inter-
related and interdependent variables, i.e., money, credit and finance.
The functions of financial system can be enumerated as follows:
Financial system works as an effective conduit for optimum allocation of financial
resources in an economy.
It helps in establishing a link between the savers and the investors.
Financial system allows ‘asset-liability transformation’. Banks create claims (liabilities)
against themselves when they accept deposits from customers but also create assets when
they provide loans to clients.
Economic resources (i.e., funds) are transferred from one party to another through
financial system.
The financial system ensures the efficient functioning of the payment mechanism in an
economy. All transactions between the buyers and sellers of goods and services are
effected smoothly because of financial system.
Financial system helps in risk transformation by diversification, as in case of mutual
funds.
Financial system enhances liquidity of financial claims.
Financial system helps price discovery of financial assets resulting from the interaction
of buyers and sellers. For example, the prices of securities are determined by demand and
supply forces in the capital market.
Financial system helps reducing the cost of transactions.
Structure and Function of of Indian Financial System!
Financial System is a set of institutional arrangements through which financial surpluses in the economy
are mobilised from surplus units and transferred to deficit spenders.
The institutional arrangements include all conditions and mechanisms governing the production,
distribution, exchange and holding of financial assets or instruments of all kinds and the
organisations as well as the manner of operations of financial markets and institutions of all
descriptions.
Thus, there are three main constituents of financial system:
(a) Financial Assets
(b) Financial Markets, and
(c) Financial Institutions.
Financial assets are subdivided under two heads:
Primary securities and secondary securities. The former are financial claims against real-sector units, for
example, bills, bonds, equities etc. They are created by real-sector units as ultimate borrowers
for raising funds to finance their deficit spending. The secondary securities are financial claims
issued by financial institutions or intermediaries against themselves to raise funds from public.
For examples, bank deposits, life insurance policies, UTI units, IDBI bonds etc.
Functions of Financial System:
The financial system helps production, capital accumulation, and growth by (i) encouraging savings, (ii)
mobilising them, and (iii) allocating them among alternative uses and users. Each of these
functions is important and the efficiency of a given financial system depends on how well it
performs each of these functions.
(i) Encourage Savings:
Financial system promotes savings by providing a wide array of financial assets as stores of value aided
by the services of financial markets and intermediaries of various kinds. For wealth holders, all
this offers ample choice of portfolios with attractive combinations of income, safety and yield.
With financial progress and innovations in financial technology, the scope of portfolio choice has also
improved. Therefore, it is widely held that the savings-income ratio is directly related to both
financial assets and financial institutions. That is, financial progress generally insures larger
savings out of the same level of real income.
As stores of value, financial assets command certain advantages over tangible assets (physical capital,
inventories of goods, etc.) they are convenient to hold, or easily storable, more liquid, that is
more easily encashable, more easily divisible, and less risky.
A very important property of financial assets is that they do not require regular management of the kind
most tangible assets do. The financial assets have made possible the separation of ultimate
ownership and management of tangible assets. The separation of savings from management has
encouraged savings greatly.
Savings are done by households, businesses, and government. Following the official classification
adopted by the Central Statistical Organization (CSO), Government of India, we reclassify savers
into— household sector, domestic private corporate sector, and the public sector.
The household sector is defined to comprise individuals, non-Government, non-corporate entities in
agriculture, trade and industry, and non-profit making organisations like trusts and charitable
and religious institutions.
The public sector comprises Central and state governments, departmental and non departmental
undertakings, the RBI, etc. The domestic private corporate sector comprises non-government
public and private limited companies (whether financial or non-financial) and corrective
institutions.
Of these three sectors, the dominant saver is the household sector, followed by the domestic private
corporate sector. The contribution of the public sector to total net domestic savings is relatively
small.
(ii) Mobilisation of Savings:
Financial system is a highly efficient mechanism for mobilising savings. In a fully-monetised economy
this is done automatically when, in the first instance, the public holds its savings in the form of
money. However, this is not the only way of instantaneous mobilisation of savings.
Other financial methods used are deductions at source of the contributions to provident fund and other
savings schemes. More generally, mobilisation of savings taken place when savers move into
financial assets, whether currency, bank deposits, post office savings deposits, life insurance
policies, bill, bonds, equity shares, etc.
(iii) Allocation of Funds:
Another important function of a financial system is to arrange smooth, efficient, and socially equitable
allocation of credit. With modem financial development and new financial assets, institutions
and markets have come to be organised, which are replaying an increasingly important role in
the provision of credit.
In the allocative functions of financial institutions lies their main source of power. By granting easy and
cheap credit to particular firms, they can shift outward the resource constraint of these firms
and make them grow faster.
Structure of Indian Financial System:
Financial system operates through financial markets and institutions.
The Indian Financial system (financial markets) is broadly divided under two heads:
(i) Indian Money Market
(ii) Indian Capital Market
The Indian money market is the market in which short-term funds are borrowed and lent. The money
market does not deal in cash, or money but in bills of exchange, grade bills and treasury bills and
other instruments. The capital market in India on the other hand is the market for the medium
term and long term funds.
The role of financial systems in the economy
This section discusses the main functions of financial intermediaries and financial markets, and their
comparative roles. Financial systems, i.e. financial intermediaries and financial markets, channel
funds from those who have savings to those who have more productive uses for them. They
perform two main types of financial service that reduce the costs of moving funds between
borrowers and lenders, leading to a more efficient allocation of resources and faster economic
growth. These are the provision of liquidity and the transformation of the risk characteristics of
assets.
Provision of liquidity
The link between liquidity and economic performance arises because many high return investment
projects require long-term commitments of capital, but risk adverse lenders (savers) are
generally unwilling to delegate control over their savings to borrowers (investors) for long
periods. Financial systems mobilise savings by agglomerating and pooling funds from disparate
sources and creating small denomination instruments. These instruments provide opportunities
for individuals to hold diversified portfolios. Without pooling individuals and households would
have to buy and sell entire firms (Levine 1997).
Financial markets can also transform illiquid assets (long-term capital investments in illiquid production
processes) into liquid liabilities (financial instrument). With liquid financial markets
savers/lenders can hold assets like equity or bonds, which can be quickly and easily converted
into purchasing power, if they need to access their savings.
For lenders, the services performed by financial markets and intermediaries are substitutable around
the desired risk, return and liquidity provided by particular investments. Financial intermediaries
and markets make longer-term investments more attractive and facilitate investment in higher
return, longer gestation investment and technologies. They provide different forms of finance to
borrowers. Financial markets provide arms length debt or equity finance (to those firms able to
access markets), often at a lower cost than finance from financial intermediaries.
Transformation of the risk characteristics of assets
The second main service financial intermediaries and markets provide is the transformation of the risk
characteristics of assets. Financial systems perform this function in at least two ways. First, they
can enhance risk diversification and second, they resolve an information asymmetry problem
that may otherwise prevent the exchange of goods and services, in this case the provision of
capital (Akerlof 1970).
Financial systems facilitate risk-sharing by reducing information and transactions costs. If there are costs
associated with the channelling of funds between borrowers and lenders, financial systems can
reduce the costs of holding a diversified portfolio of assets. Intermediaries perform this role by
taking advantage of economies of scale, markets do so by facilitating the broad offer and trade
of assets comprising investors’ portfolios.
Financial systems can reduce information and transaction costs that arise from an information
asymmetry between borrowers and lenders. In credit markets an information asymmetry arises
because borrowers generally know more about their investment projects than lenders. A
borrower may have an entrepreneurial “gut feeling” that can not be communicated to lenders,
or more simply, may have information about a looming financial risk to their firm that they may
not wish to share with past or potential lenders. An information asymmetry can occur ex ante or
ex post. An ex ante information asymmetry arises when lenders can not differentiate between
borrowers with different credit risks before providing a loan and leads to an adverse selection
problem. Adverse selection problems arise when lenders are more likely to make a loan to high-
risk borrowers, because those who are willing to pay high interest rates will, on average, be
worse risks.
The problem with imperfect information is that information is a “public good”. If costly privately-
produced information can subsequently be used at less cost by other agents, there will be
inadequate motivation to invest in the publicly optimal quantity of information (Hirshleifer and
Riley 1979). The implication for financial intermediaries is as follows. Once financial
intermediaries obtain information they must be able to obtain a market return on that
information before any signalling of that information advantage results in it being bid away. If
they can not prevent information from being revealed prior to obtaining that return, they will
not commit the resources necessary to obtain it. One reason financial intermediaries can obtain
information at a lower cost than individual lenders is that financial intermediation avoids
duplication of the production of information faced by multiple individual lenders. Moreover,
financial intermediaries develop special skills in evaluating prospective borrowers and
investment projects. They can also exploit cross- customer information and re-use information
over time. Financial intermediaries thus improve the screening of potential borrowers and
investment projects before finance is committed and enforce monitoring and corporate control
after investment projects have been funded. Financial intermediation thus leads to a more
efficient allocation of capital. The information acquisition cost may be lowered further as
financial intermediaries and borrowers develop long-run relationships (Petersen and Rajan 1994
and Faulkender and Petersen 2003).
Financial markets create their own incentives to acquire and process information for listed firms. The
larger and more liquid financial markets become the more incentive market participants have to
collect information about these firms. However, because information is quickly revealed in
financial markets through posted prices, there may be less of an incentive to use private
resources to acquire information. In financial markets information is aggregated and
disseminated through published prices, which means that agents who do not undertake the
costly process of ex ante screening and ex post monitoring, can freely observe the information
obtained by other investors as reflected in financial prices. Rules and regulation, such as
continuous disclosure requirements, can help encourage the production of information.
Financial intermediaries and financial markets resolve ex post information asymmetries and the
resulting moral hazard problem by improving the ability of investors to directly evaluate the
returns to projects by monitoring, by increasing the ability of investors to influence
management decisions and by facilitating the takeover of poorly managed firms. When these
issues are not well managed, investors will not be willing to delegate control of their savings to
borrowers. Diamond (1984), for example, develops a model in which the returns from firms’
investment projects are not known ex post to external investors, unless information is gathered
to assess the outcome, i.e. there is “costly state verification” (Townsend 1979). This leads to a
moral hazard problem. Moral hazard arises when a borrower engages in activities that reduce
the likelihood of a loan being repaid. For example, when firms’ owners “siphon off” funds
(legally or illegally) to themselves or their associates through loss-making contracts signed with
associated firms.
Fund Based Services
● WORKING CAPITAL FINANCING:
A firm's working capital is the money available to meet current obligations (those due in less
than a year) and to acquire earning assets. Chinatrust Commercial Bank offers corporations
Working Capital Finance to meet their operating expenses, purchasing inventory, receivables
financing, either by direct funding or by issuing letter of credit.
Key Benefits
Funded facilities, i.e. the bank provides funding and assistance to actually purchase business
assets or to meet business expenses.
Non-Funded facilities, i.e. the bank can issue letters of credit or can give a guarantee on behalf
of the customer to the suppliers, Government Departments for the procurement of goods and
services on credit.
Available in both Indian as well as Foreign currency.
● SHORT TERM FINANCING
The bank can structure low cost credit programmes and cash flow financing to meet your
specific short-term cash requirements. The loans are structured to enhance your profitability by
scheduling the repayment to match the cash flow available to repay the debt.
● BILL DISCOUNTING
Bill discounting is a short tenure financing instrument for companies willing to discount their
purchase / sales bills to get funds for the short run and as for the investors in them. These are
customized to suit your requirement for short-term finance, from the date of sale to the date of
receipt of payment there on.
We consider two types of bills facility viz. where documents are delivered on payment, i.e. D/P
Bills and where the documents are delivered against acceptance i.e. D/A Bills.
● EXPORT CREDIT
We offer short-term working capital finance both at the pre-shipment and post-shipment stages
Pre-shipment finance facility provides liquidity for procuring raw materials, processing, packing,
transporting, meant for export.
Post-shipment finance is a credit facility extended from the date of shipment of goods till the
realization of the export proceeds. The different types of post-shipment advances include:
Export bills purchased/discounted
Export bills negotiated (against letter of credit)
Advances against bills sent on collection basis
Advances against exports on consignment basis
Exporters have the option of availing Post-Shipment finance either in rupees or in foreign currency.
● STRUCTURED FINANCE
Structured Finance describes any "non-standard" way of raising money. These tailor-made
securities go beyond "standard" securities like conventional loans, debentures, debt, and equity.
The reason to structure a more advanced security may be that conventional securities may be
unattractive, unavailable or too expensive. These products are structured for both long and
short tenor with exit options at intervals for both parties.
● TERM LENDING
CTCB offers very competitive rates for term financing. We also provide advisory services to
companies for syndication of the term loans to a wide spectrum of financial institutions.
Under Term Finance, Chinatrust Commercial Bank, offers the following:
Fund Based Finance for capital expenditure acquisition of fixed assets towards starting or
expanding a business to swap with high cost existing debt from other bank / financial institution
Non-Fund Based Finance in the form of Deferred Payment Guarantee for acquisition of fixed
assets towards starting / expanding a business or industrial unit.
A financial system refers to a system which enables the transfer of money between investors and borrowers.
A financial system could be defined at an international, regional or organization level. The term “system” in
“Financial System” indicates a group of complex and closely linked institutions, agents, procedures, markets,
transactions, claims and liabilities within a economy.
Five Basic Components of Financial System
Financial Institutions
Financial Markets
Financial Instruments (Assets or Securities)
Financial Services
Money
Financial Institutions
Financial institutions facilitate smooth working of the financial system by making investors and borrowers meet.
They mobilize the savings of investors either directly or indirectly via financial markets, by making use of
different financial instruments as well as in the process using the services of numerous financial services
providers. They could be categorized into Regulatory, Intermediaries, Non-intermediaries and Others. They
offer services to organizations looking for advises on different problems including restructuring to diversification
strategies. They offer complete array of services to the organizations who want to raise funds from the markets
and take care of financial assets for example deposits, securities, loans, etc.
Figure 1: Five Basic Components of Financial System
Financial Markets
A financial market is the place where financial assets are created or transferred. It can be broadly categorized
into money markets and capital markets. Money market handles short-term financial assets (less than a year)
whereas capital markets take care of those financial assets that have maturity period of more than a year. The
key functions are:
1. Assist in creation and allocation of credit and liquidity.
2. Serve as intermediaries for mobilization of savings.
3. Help achieve balanced economic growth.
4. Offer financial convenience.
One more classification is possible: primary markets and secondary markets. Primary markets handles new
issue of securities in contrast secondary markets take care of securities that are presently available in the stock
market.
Financial markets catch the attention of investors and make it possible for companies to finance their
operations and attain growth. Money markets make it possible for businesses to gain access to funds on a
short term basis, while capital markets allow businesses to gain long-term funding to aid expansion. Without
financial markets, borrowers would have problems finding lenders. Intermediaries like banks assist in this
procedure. Banks take deposits from investors and lend money from this pool of deposited money to people
who need loan. Banks commonly provide money in the form of loans.
Financial Instruments
This is an important component of financial system. The products which are traded in a financial market are
financial assets, securities or other type of financial instruments. There is a wide range of securities in the
markets since the needs of investors and credit seekers are different. They indicate a claim on the settlement
of principal down the road or payment of a regular amount by means of interest or dividend. Equity shares,
debentures, bonds, etc are some examples.
Financial Services
Financial services consist of services provided by Asset Management and Liability Management Companies.
They help to get the necessary funds and also make sure that they are efficiently deployed. They assist to
determine the financing combination and extend their professional services upto the stage of servicing of
lenders. They help with borrowing, selling and purchasing securities, lending and investing, making and
allowing payments and settlements and taking care of risk exposures in financial markets. These range from
the leasing companies, mutual fund houses, merchant bankers, portfolio managers, bill discounting and
acceptance houses. The financial services sector offers a number of professional services like credit rating,
venture capital financing, mutual funds, merchant banking, depository services, book building, etc. Financial
institutions and financial markets help in the working of the financial system by means of financial instruments.
To be able to carry out the jobs given, they need several services of financial nature. Therefore, Financial
services are considered as the 4th major component of the financial system.
Money
Money is understood to be anything that is accepted for payment of products and services or for the repayment
of debt. It is a medium of exchange and acts as a store of value.
Characteristics of financial service firms
There are many dimensions on which financial service firms differ from other firms in
the market. In this section, we will focus on four key differences and look at why these
differences can create estimation issues in valuation. The first is that many categories (albeit not
all) of financial service firms operate under strict regulatory constraints on how they run their
businesses and how much capital they need to set aside to keep operating. The second is that
accounting rules for recording earnings and asset value at financial service firms are at variance
with accounting rules for the rest of the market. The third is that debt for a financial service firm
is more akin to raw material than to a source of capital; the notion of cost of capital and
enterprise value may be meaningless as a consequence. The final factor is that the defining
reinvestment (net capital expenditures and working capital) for a bank or insurance company
may be not just difficult, but impossible, and cash flows cannot be computed.
The Regulatory Overlay
Financial service firms are heavily regulated all over the world, though the extent of the
regulation varies from country to country. In general, these regulations take three forms. First,
banks and insurance companies are required to maintain regulatory capital ratios, computed
based upon the book value of equity and their operations, to ensure that they do not expand
beyond their means and put their claimholders or depositors at risk. Second, financial service
firms are often constrained in terms of where they can invest their funds. For instance, until a
decade ago, the Glass-Steagall Act in the United States restricted commercial banks from
investment banking activities as well as from taking active equity positions in non-financial
service firms. Third, the entry of new firms into the business is often controlled by the
regulatory authorities, as are mergers between existing firms.
Differences in Accounting Rules
The accounting rules used to measure earnings and record book value are different for
financial service firms than the rest of the market, for two reasons. The first is that the assets of
financial service firms tend to be financial instruments (bonds, securitized obligations) that often
have an active market place. Not surprisingly, marking assets to market value has been an
established practice in financial service firms, well before other firms even started talking about
fair value accounting. The second is that the nature of operations for a financial service firm is
such that long periods of profitability are interspersed with short periods of large losses;
accounting standard have been developed to counter this tendency and create smoother earnings.
a. Mark to Market: If the new trend in accounting is towards recording assets at fair value
(rather than original costs), financial service firms operate as a laboratory for this experiment.
After all, accounting rules for banks, insurance companies and investment banks have
required that assets be recorded at fair value for more than a decade, based upon the
argument that most of a bank�s assets are traded, have market prices and therefore do not
require too many subjective judgments. In general, the assets of banks and insurance
companies tend to be securities, many of which are publicly traded. Since the market price is
observable for many of these investments, accounting rules have tilted towards using market
value (actual of estimated) for these assets. To the extent that some or a significant portion
of the assets of a financial service firms are marked to market, and the assets of most non-
financial service firms are not, we fact two problems. The first is in comparing ratios based
upon book value (both market to book ratios like price to book and accounting ratios like
return on equity) across financial and non-financial service firms. The second is in
interpreting these ratios, once computed. While the return on equity for a non-financial
service firm can be considered a measure of return earned on equity invested originally in
assets, the same cannot be said about return on equity at financial service firms, where the
book equity measures not what was originally invested in assets but an updated market value.
b. Loss Provisions and smoothing out earnings: Consider a bank that makes money the old
fashioned way – by taking in funds from depositors and lending these funds out to
individuals and corporations at higher rates. While the rate charged to lenders will be higher
than that promised to depositors, the risk that the bank faces is that lenders may default, and
the rate at which they default will vary widely over time – low during good economic times
and high during economic downturns. Rather than write off the bad loans, as they occur,
banks usually create provisions for losses that average out losses over time and charge this
amount against earnings every year. Though this practice is logical, there is a catch, insofar
as the bank is given the responsibility of making the loan loss assessment. A conservative
bank will set aside more for loan losses, given a loan portfolio, than a more aggressive bank,
and this will lead to the latter reporting higher profits during good times.
Debt and Equity
In the financial balance sheet that we used to describe firms, there are only two ways to
raise funds to finance a business – debt and equity. While this is true for both all firms, financial
service firms differ from non-financial service firms on three dimensions:
a. Debt is raw material, not capital: When we talk about capital for non-financial service firms,
we tend to talk about both debt and equity. A firm raises funds from both equity investor and
bondholders (and banks) and uses these funds to make its investments. When we value the firm,
we value the value of the assets owned by the firm, rather than just the value of its equity. With a
financial service firm, debt has a different connotation. Rather than view debt as a source of
capital, most financial service firms seem to view it as a raw material. In other words, debt is to a
bank what steel is to a manufacturing company, something to be molded into other products
which can then be sold at a higher price and yield a profit. Consequently, capital at financial
service firms seems to be narrowly defined as including only equity capital. This definition of
capital is reinforced by the regulatory authorities, who evaluate the equity capital ratios of banks
and insurance firms.
b. Defining Debt: The definition of what comprises debt also is murkier with a financial service
firm than it is with a non-financial service firm. For instance, should deposits made by customers
into their checking accounts at a bank be treated as debt by that bank? Especially on interest-
bearing checking accounts, there is little distinction between a deposit and debt issued by the
bank. If we do categorize this as debt, the operating income for a bank should be measured prior
to interest paid to depositors, which would be problematic since interest expenses are usually the
biggest single expense item for a bank.
c. Degree of financial leverage: Even if we can define debt as a source of capital and can
measure it precisely, there is a final dimension on which financial service firms differ from other
firms. They tend to use more debt in funding their businesses and thus have higher financial
leverage than most other firms. While there are good reasons that can be offered for why they
have been able to do this historically - more predictable earnings and the regulatory framework
are two that are commonly cited – there are consequences for valuation. Since equity is a sliver
of the overall value of a financial service firm, small changes in the value of the firm�s assets
can translate into big swings in equity value.
Changes have been taken place in the Indian financial system since independencs
The role of financial system in economic development has been a much discussed topic among economists. Is
it possible to influence the level of national income, employment, standard of living, and social welfare through
variations in the supply of fiancé?
Following section provides a brief history of India's shift from financial repression to financial liberalization.
Seven interrelated challenges that India faces in its second wave of financial sector reforms:
1. reducing the fiscal deficit, to reduce the risk of macroeconomic instability and to increase the
availability of finance to the private sector;
2. improving the legal, regulatory and supervisory frameworks, in order to improve banks' credit and risk
management;
3. improving systems for dealing with weak banks;
4. developing capital markets further,
5. developing pensions and insurance to increase finance for long term investments, including
infrastructure;
6. improving financial services to improve the welfare of customers and meet the challenge of
globalization of financial services; and
7. managing links to external capital markets;
and possible approaches to meeting these challenges.
The organization of the Indian financial system before 1951 had a close resemblance with the theoretical model
of a financial organization in a traditional economy. A traditional economy, according to R. L. Bennett, “is one in
which the per capital output is low and constant.”
The main elements of the financial organization in planned economic development could be categorized into
four broad groups:
a. Public /Government ownership of financial institutions.
b. Fortification of the institutional structure.
c. Protection to investors and
d. Participation of financial institutions in corporate management.
The organization of the Indian financial system, since the mid-eighties in general, and the launching of the new
economic policy in 1991 in particular, has been characterized by profound transformation.
Needs for economic reforms or new economic policy was felt mainly because of the following reasons:
Increasing in fiscal deficit was main reason to bring new economic policy. It was 5.4% of gross domestic
product in 1981-82 and rose up to 8.4 % of GDP in 1990-91.
Disequilibrium in balance of payment is occurred when total imports exceed the total exports. In 1980-81 it was
adverse with the Rs. 2,214 Crores and rose up to 17,367 Crores in 1990-91.
Petrol priceswere at high at the time of Iran war in 1990-91 and during that time India did not get any
remittances from gulf countries and which lead to adverse balance of payment. It was called Gulf Crisis.
Diminishing foreign reserves were not sufficient even to pay two weeks' imports in 1990-91. Reserves were Rs
8151 crores in 1986-87, declined up to 6252 crores in 1989-90.
Increasing pressure of inflation due to rise in prices. Cost of production is high due to high rate of inflation
which affects the domestic and foreign demand.
Lack of sufficient gain form public sector in recent years due to poor performance of some of the public sector
enterprises and suffered loss.
On view of above reasons it was inevitable for the government to adopt new economic policy.
The notable developments in the organization of the Indian financial system during this phase are briefly
outlined below with reference to (i) privatization of financial institutions (ii) reorganization of institutional
structure and (iii) investor protection. The phase III organization of the Indian financial system is portrayed in
the figure 1:-
Post -1991 phase organization of the Indian Financial System
Main Features of economic reforms
Privatization
Globalization
Liberalization
In the context of economic reforms, Privatizationmeans allowing the private sector to setup more and more of
such industries as were previously reserved for public sector. Under it existing enterprises of the public sector
are either wholly or partially sold to private sector.
Privatization was brought due to less output of public sector. It was just due to lack of decision making of
managers in public sector enterprises who always took decisions over a long time. Consequently productivity of
the public sector was to go down. In view of these reasons privatization was brought into existence so that
there would be more competition, quality of production and customer may be benefited.
Following measures were adopted in respect of privatization under economic reforms:
Sale of Public sector securities
Disinvestment in public sector
Number of industries exclusively reserved for public sector was reduced from 17 to 4
Investment in private sector was at maximum
Globalizationmeans integrating the economy of a country with the economies of other countries under condition
of freer flow of trade and capital and movement of persons across borders.
In the globalization policy it was assumed that Indian economy should have linked with the rest of world so that
there may be mutual cooperation of Indian economy with the rest of the world. Following measures were
adopted under the globalization of Indian economy are as under:
Foreign investment limit raised i.e. 40 percent to 51percent.
Devaluationwas taken place in 1991 to the extent of 20 percent on an average to promote export, import
substitution and foreign capital.
Before 1991 government had imposed many controls like restrictions on big house investment,
licensing policy, foreign exchange controls etc. but these controls spread over the economy only
corruption, long time process, political interference, and inefficiency. The rate of growth was fallen
down and reserves of foreign exchange were just sufficient to cater the needs of two weeks' import
only. There was political instability, inflation, gulf crisis, rising deficit in balance of payments etc. To
bring the economic stability and put the economy into the path of consistent growth it was must to
remove the curb rising pricing, correct adverse balance of payments etc.
UNIT-2
Bank
An establishment authorized by a government to accept deposits, pay interest, clear checks, make loans, act
as an intermediary in financial transactions, and provide other financial services to its customers.
In simple words, Banking can be defined as the business activity of accepting and safeguarding money owned
by other individuals and entities, and then lending out this money in order to earn a profit.
Banking systems can be defined as a mechanism through which the money supply of the country is created
and controlled.
In 1839, some Indian merchants in Calcutta established India's first bank known as "Union Bank", but it could
not survive for long and failed in 1848 due to economic crisis of 1848-49. Similarly, in 1863, "Bank of Upper
India" was formed but it failed in 1913.
In 1865, "Allahabad Bank" was established as a joint stock bank. This bank has survived till date and is now
considered as the oldest surviving bank in India.
What are the Functions of Banks? Diagram
The functions of banks are briefly highlighted in following Diagram or Chart.
These functions of banks are explained in following paragraphs of this article.
A. Primary Functions of Banks
The primary functions of a bank are also known as banking functions. They are the main functions of a bank.
These primary functions of banks are explained below.
1. Accepting Deposits
The bank collects deposits from the public. These deposits can be of different types, such as :-
a. Saving Deposits
b. Fixed Deposits
c. Current Deposits
d. Recurring Deposits
a. Saving Deposits
This type of deposits encourages saving habit among the public. The rate of interest is low. At present it is
about 4% p.a. Withdrawals of deposits are allowed subject to certain restrictions. This account is suitable to
salary and wage earners. This account can be opened in single name or in joint names.
b. Fixed Deposits
Lump sum amount is deposited at one time for a specific period. Higher rate of interest is paid, which varies
with the period of deposit. Withdrawals are not allowed before the expiry of the period. Those who have
surplus funds go for fixed deposit.
c. Current Deposits
This type of account is operated by businessmen. Withdrawals are freely allowed. No interest is paid. In fact,
there are service charges. The account holders can get the benefit of overdraft facility.
d. Recurring Deposits
This type of account is operated by salaried persons and petty traders. A certain sum of money is periodically
deposited into the bank. Withdrawals are permitted only after the expiry of certain period. A higher rate of
interest is paid.
2. Granting of Loans and Advances
The bank advances loans to the business community and other members of the public. The rate charged is
higher than what it pays on deposits. The difference in the interest rates (lending rate and the deposit rate) is
its profit.
The types of bank loans and advances are :-
a. Overdraft
b. Cash Credits
c. Loans
d. Discounting of Bill of Exchange
a. Overdraft
This type of advances are given to current account holders. No separate account is maintained. All entries are
made in the current account. A certain amount is sanctioned as overdraft which can be withdrawn within a
certain period of time say three months or so. Interest is charged on actual amount withdrawn. An overdraft
facility is granted against a collateral security. It is sanctioned to businessman and firms.
b. Cash Credits
The client is allowed cash credit upto a specific limit fixed in advance. It can be given to current account
holders as well as to others who do not have an account with bank. Separate cash credit account is
maintained. Interest is charged on the amount withdrawn in excess of limit. The cash credit is given against
the security of tangible assets and / or guarantees. The advance is given for a longer period and a larger
amount of loan is sanctioned than that of overdraft.
c. Loans
It is normally for short term say a period of one year or medium term say a period of five years. Now-a-days,
banks do lend money for long term. Repayment of money can be in the form of installments spread over a
period of time or in a lumpsum amount. Interest is charged on the actual amount sanctioned, whether
withdrawn or not. The rate of interest may be slightly lower than what is charged on overdrafts and cash
credits. Loans are normally secured against tangible assets of the company.
d. Discounting of Bill of Exchange
The bank can advance money by discounting or by purchasing bills of exchange both domestic and foreign
bills. The bank pays the bill amount to the drawer or the beneficiary of the bill by deducting usual discount
charges. On maturity, the bill is presented to the drawee or acceptor of the bill and the amount is collected.
B. Secondary Functions of Banks
The bank performs a number of secondary functions, also called as non-banking functions.
These important secondary functions of banks are explained below.
1. Agency Functions
The bank acts as an agent of its customers. The bank performs a number of agency functions which includes :-
a. Transfer of Funds
b. Collection of Cheques
c. Periodic Payments
d. Portfolio Management
e. Periodic Collections
f. Other Agency Functions
a. Transfer of Funds
The bank transfer funds from one branch to another or from one place to another.
b. Collection of Cheques
The bank collects the money of the cheques through clearing section of its customers. The bank also collects
money of the bills of exchange.
c. Periodic Payments
On standing instructions of the client, the bank makes periodic payments in respect of electricity bills, rent,
etc.
d. Portfolio Management
The banks also undertakes to purchase and sell the shares and debentures on behalf of the clients and
accordingly debits or credits the account. This facility is called portfolio management.
e. Periodic Collections
The bank collects salary, pension, dividend and such other periodic collections on behalf of the client.
f. Other Agency Functions
They act as trustees, executors, advisers and administrators on behalf of its clients. They act as
representatives of clients to deal with other banks and institutions.
2. General Utility Functions
The bank also performs general utility functions, such as :-
a. Issue of Drafts, Letter of Credits, etc.
b. Locker Facility
c. Underwriting of Shares
d. Dealing in Foreign Exchange
e. Project Reports
f. Social Welfare Programmes
g. Other Utility Functions
a. Issue of Drafts and Letter of Credits
Banks issue drafts for transferring money from one place to another. It also issues letter of credit, especially
in case of, import trade. It also issues travellers' cheques.
b. Locker Facility
The bank provides a locker facility for the safe custody of valuable documents, gold ornaments and other
valuables.
c. Underwriting of Shares
The bank underwrites shares and debentures through its merchant banking division.
d. Dealing in Foreign Exchange
The commercial banks are allowed by RBI to deal in foreign exchange.
e. Project Reports
The bank may also undertake to prepare project reports on behalf of its clients.
f. Social Welfare Programmes
It undertakes social welfare programmes, such as adult literacy programmes, public welfare campaigns, etc.
g. Other Utility Functions
It acts as a referee to financial standing of customers. It collects creditworthiness information about clients of
its customers. It provides market information to its customers, etc. It provides travellers' cheque facility.
Banks are those institutions which conduct the business purely on profit motive. Banks receive surplus
money from the people who are not using it and lend to those who need it for productive purpose. When we
speak of abank, we generally mean a commercial bank. Commercial banks are those institutions which
conduct the business purely on profit motive. Commercial banks receive surplus money from the people who
are not using it and lend to those who need it for productive purpose.
A commercial bank is a dealer in short and medium-term credit. It borrows money from a group of people at a
lower rate of interest and lends to the other group of people at some higher rate of interest. The difference
between the two rates of interest is the profit of the bank.
1. Definition Of A Commercial Bank:
Some important definitions of commercial bank are given below.
"A bank is a firm which collects money from those who have it spare. It lends to those who require it."
1.2. Professor Parking:
"A bank is a firm that takes deposits from households and firms and makes loans to other household and
firms.
2. Functions Of Commercial Bank:
In modern time, the functions of a modem commercial bank are manifold. The functions of a bank may
broadly be divided into two parts.
Basic or primary functions.
Secondary functions.
3. Primary Functions Of Commercial Bank
Basic or primary functions of a commercial bank are very important in nature. These functions provide t base
of the whole operation of the bank. The basic functions of a commercial bank are as under
3.1. Accepting deposits:
Accepting deposits is the most important function of all commercial banks. Deposit is the basis of commercial
banks' activities. In order to attract The general public to deposit their surplus money in the bank, the bank
offers to deposit money in any of the following accounts:
3.1.1. CURRENT OR DEMAND ACCOUNT:
Current or demand account is one where the amount can be withdrawn at any time by the depositor.
3.1.2. SAVING ACCOUNT:
Saving account is suitable for non-trading and small income earners. Saving account helps in mobilization of
the saving of low income people. The commercial banks pay interest on this type cf deposits.
3.1.3. FIXED DEPOSIT ACCOUNT OR TERM DEPOSIT ACCOUNT:
Fixed deposit account is the account in which amounts are deposited for a certain fixed period of time. The
deposits cannot be withdrawn before the expiry of this fixed period. The longer the period of deposits, the
higher is the rate of profit.
3.1.4. FOREIGN CURRENCY ACCOUNT:
Foreign currency account is opened only in authorized branches. A foreign currency account may be a foreign
currency saving account or foreign currency term deposit account. Foreign currency account in Pakistan can
be opened in USA Dollar, UK Pound, German Mark, Japanese Yen, etc. This account is exempted from all taxes
and deduction. No income tax or Zakat is deducted from this account.
3.2. Advancing Loans:
The second important function of commercial bank is advancing loans to the individuals, businessmen and
government bodies. The loans are granted out of deposited money. Generally, a commercial bank grants
short-term loans.
Banks grant loan in any of the following forms:
3.2.1. OVERDRAFT:
Overdraft is a short-term loan granted by commercial banks to their account holders. Under this type of loan,
the customers are allowed to draw more than what they have in their current accountup to a certain limit.
The excess amount overdrawn is called overdraft.
3.2.2. CASH CREDIT:
Cash credit is a very common form of loan granted by commercial banks to businessmen and industrial units
against the security of goods. The loan granted under this head is credited tocurrent account opened in the
name of borrower. The borrower can withdraw money throughcheques according to his requirement. The
interest is charged on the amount actually withdrawn by the borrower.
3.2.3. LOANS:
Commercial banks grant loans for short and medium-term to individuals and traders against the security of
movable and immovable property. The amount of loan is credited to the borrower's account. Interest is
charged on the entire loan sanctioned.
3.2.4. DISCOUNTING BILLS OF EXCHANGE:
Banks provide short term lean to the businessmen by discounting bills of exchange. Discounting the bills of
exchange means the arrangements of making payments before maturity of bills of exchange. The payment
made by the bank to the holder of bill of exchange before its maturity is the amount of loan. The discount
charged is the earning of the bank.
4. Secondary Functions Of A Commercial Bank:
The secondary functions of commercial bank can be classified under the following heads.
1. Agency functions
2. General utility functions
3. Miscellaneous functions
4.1. Agency Functions:
The banks render important services as agent on behalf of their customers in return for a small commission.
When banks act as agent, law of agency applies. The agency functions or services of bank are as follows:
4.1.1. COLLECTION OF CHEQUES:
Commercial banks collect the cheques, bills of exchange, etc, on behalf of their customers. Banks collect local
and outstation cheques and bills of exchange through clearing house facilities provided by the central bank,
4.1.2. COLLECTION OF INCOME:
The commercial banks collect dividends, interest on investment, pension and rent of property due to the
customers. When any income is collected by the bank, a credit voucher is sent to the customer for
information.
4.1.3. PAYMENT OF EXPENSES:
The banks make payment of insurance premiums, rent, trade subscription, school fee and other obligation of
the customers. When any expense is paid by the bank, a debit voucher is sent to the customer for information.
4.1.4. DEALER IN SECURITIES:
The banks carry out purchase and sale of securities on behalf of their customers. Banks do it well because
they are aware of the market conditions.
4.1.5. ACTS AS TRUSTEE:
The banks act as trustee to manage trust property as per instructions of property owners. Banks are required
to follow the terms and conditions of trust deed.
4.1.6. ACTS AS AN AGENT:
Commercial bank sometimes acts as an agent on behalf of its customers at home or abroad in dealing with
other banks or financial institutions.
4.1.7. OBEYS STANDING INSTRUCTIONS:
Sometimes, customer may order his bank to do something on his behalf regarding the conduct of his account.
This written order is called standing instruction. The bank being the agent of its customer obeys the standing
instructions.
4.1.8. ACTS AS TAX CONSULTANT:
Commercial bank acts as tax consultant to its client. The commercial bank prepares general sales tax return,
income tax return, etc. Tiles the same with tax authorities.
4.2. General Utility Functions:
Commercial bank performs different utility functions for their customers. When bank performs utility
functions, it does not act as an agent of the customers. The general utility functions are as follows:
4.2.1. PROVIDES LOCKERS FACILITIES:
Commercial banks provide lockers facilities to its customers for safe custody of Jewelery, shares, securities
and other valuables. This has minimized the risk of losing due to theft.
4.2.2. ISSUE OF TRAVELER'S CHEQUE:
Bank issues traveler's cheques to the customers for traveling in and outside the country.
4.2.3. FOREIGN EXCHANGE:
Commercial banks deal in foreign exchange. This enables the individuals and businessmen to obtain foreign
currency in exchange of their home currency. For dealing in foreign exchange, commercial banks have to
obtain permission from the central bank.
4.2.4. TRANSFER OF MONEY:
Commercial banks provide facilities for the transfer of money to any place within and outside the country.
The funds are transferred by means of draft, telephonic transfer, electronic transfer etc.
4.2.5. FINANCES FOREIGN TRADE:
A commercial bank finances foreign trade by accepting foreign bills of exchange. Bank also issues letter of
credit on behalf of its customers to facilitate foreign trade. According to Sir John Poget:
"The issuing of letters of credit is the basic function of a bank."
The focus of banking is varied, the needs diverse and methods different. Thus, we need distinctive
kinds of banks to cater to the above-mentioned complexities. Deposit-taking institutions take the form of
commercial banks, which accept deposits and make commercial, real estate, and other loans. There are also
mutual savings banks, which accept deposits and make mortgage and other types of loans. Another type is
credit unions, which are cooperative organizations that issue share certificates and make member (consumer)
and other loans.
The banking industry can be divided into following sectors, based on the clientele served and products and
services offered:
1. Retail Banks
2. Commercial banks
3. Cooperative banks
4. Investment Banks
5. Specialized banks
6. Central banks
Retail Banks:
Retail banks provide basic banking services to individual consumers. Examples include savings banks, savings
and loan associations, and recurring and fixed deposits. Products and services include safe deposit boxes,
checking and savings accounting, certificates of deposit (CDs), mortgages, personal, consumer and car loans.
Commercial Banks:
Banking means accepting deposits of money from the public for the purpose of lending or investment.
Commercial Banks provide financial services to businesses, including credit and debit cards, bank accounts,
deposits and loans, and secured and unsecured loans. Due to deregulation, commercial banks are also
competing more with investment banks in money market operations, bond underwriting, and financial advisory
work. Commercial banks in modern capitalist societies act as financial intermediaries, raising funds from
depositors and lending the same funds to borrowers. The depositors’ claims against the bank, their deposits,
are liquid, meaning banks are expected to redeem deposits on demand, instantly.
Banks’ claims against their borrowers are much less liquid, giving borrowers a much longer span of time to
repay money owed banks. Because a bank cannot immediately reclaim money lent to borrowers, it may face
bankruptcy if all its depositors show up on a given day to withdraw all their money.
There are two types of commercial banks, public sector and private sector banks.
Public Sector Banks:
Public sectors banks are those in which the government has a major stake and they usually need to emphasize
on social objectives than on profitability.
Private sector banks:
Private sector banks are owned, managed and controlled by private promoters and they are free to operate as
per market forces.
Investment Banks:
An investment bank is a financial institution that assists individuals, corporations and governments in raising
capital by underwriting and/or acting as the client's agent in the issuance of securities. An investment bank may
also assist companies involved in mergers and acquisitions, and provide ancillary services such as market
making, trading of derivatives, fixed income instruments, foreign exchange, commodities, and equity securities.
Investment banks aid companies in acquiring funds and they provide advice for a wide range of transactions.
These banks also offer financial consulting services to companies and give advice on mergers and acquisitions
and management of public assets.
Cooperative Banks:
Cooperative Banks are governed by the provisions of State Cooperative Societies Act and meant essentially for
providing cheap credit to their members. It is an important source of rural credit i.e., agricultural financing in
India.
Specialized Banks:
Specialized banks are foreign exchange banks, industrial banks, development banks, export-import banks
catering to specific needs of these unique activities. These banks provide financial aid to industries, heavy
turnkey projects and foreign trade.
Central Banks:
Central banks are bankers’ banks, and these banks trace their history from the Bank of England. They
guarantee stable monetary and financial policy from country to country and play an important role in the
economy of the country. Typical functions include implementing monetary policy, managing foreign exchange
and gold reserves, making decisions regarding official interest rates, acting as banker to the government and
other banks, and regulating and supervising the banking industry.
These banks buy government debt, have a monopoly on the issuance of paper money, and often act as a
lender of last resort to commercial banks. The term bank nowadays refers to these commercial banks. The
Central bank of any country supervises controls and regulates the activities of all the commercial banks of that
country. It also acts as a government banker. It controls and coordinates currency and credit policies of any
country. The Reserve Bank of India is the central bank of India.- Learn more at www.technofunc.com. Your
online source for free professional tutorials.
Banking sector has witnessed enormous growth in the past decades. The banks have transformed themselves
from traditional deposit and borrowing institutes to large organizations offering a variety of services. Discussion
about various classifications of banks.
The banking industry can be divided into two categories commercial banking and investment banking.
Commercial Banking:
This category represents consumer and business banking and includes commercial and foreign banks, savings
and loan associations, credit unions, thrifts, and other savings banks. Commercial banks in modern capitalist
societies act as financial intermediaries, raising funds from depositors and lending the same funds to
borrowers. The depositors’ claims against the bank, their deposits, are liquid, meaning banks are expected to
redeem deposits on demand, instantly. Banks’ claims against their borrowers are much less liquid, giving
borrowers a much longer span of time to repay money owed banks. Because a bank cannot immediately
reclaim money lent to borrowers, it may face bankruptcy if all its depositors show up on a given day to withdraw
all their money.
Products and services include consumer and commercial deposits, consumer loans, mortgage and real estate
loans, overseas operations, investment in high-grade securities, and commercial and industrial loans.
Investment Banking:
The products and services of this category include managing portfolios of financial assets, trading in securities,
fixed income, commodity and currency, corporate advisory services for mergers and acquisitions, corporate
finance, and debt and equity underwriting. Trading activities include trading both on behalf of clients or on the
banks own account.
Other Classifications:
Banking products can be further classified as Retail Banking, Corporate Banking and Risk and Capital
Management. In modern world banks perform and manage all the following functions and different
classifications exist based on the need:
Retail Banking
Corporate Banking
Banking Operations
Risk Management
Asset Management
Wealth Management
Treasury Management
Cards Issuance and Management
Trading Intermediary acting as Depository Participant, Registry, Exchanges, Trading or Broker Dealer
Banking Functions:
The banking industry is growing rapidly. It's estimated that the assets of the 1,000 largest banks are worth
almost $100 trillion USD. With the growth in the industry banks manages a diverse portfolio of functions. Apart
from the segments discussed above banks also need to manage following functions and can also be classified
based on functions:
Banking Technology
Internal and External Reconciliations
Internal and External Clearing
Surveillance
Human Resources
Finance
Legal and Compliance
Sales and Trading
Transaction Banking
Banking sector in India has witnessed unparalled growth in the last decade.- Learn more at
www.technofunc.com. Your online source for free professional tutorials.
Commercial banks: These banks function to help the entrepreneurs and businesses. They
give financial services to these businessmen like debit cards, banks accounts, short term
deposits, etc. with the money people deposit in such banks. They also lend money to
businessmen in the form of overdrafts, credit cards, secured loans, unsecured loans and
mortgage loans to businessmen. The commercial banks in the country were nationalized in
1969. So the various policies regarding the loans, rates of interest and loans etc are
controlled by the Reserve Bank. These days, the commercialized banks provide some
services given by investment banks to their clients.
The commercial banks can be further classifies as: public sector bank, private sector banks,
foreign banks and regional banks.
1. The public sector banks are owned and operated by the government, who has a
major share in them. The major focus of these banks is to serve the people rather
earn profits. Some examples of these banks include State Bank of India, Punjab
National Bank, Bank of Maharashtra, etc.
2. The private sector banks are owned and operated by private institutes. They are
free to operate and are controlled by market forces. A greater share is held by
private players and not the government. For example, Axis Bank, Kotak Mahindra
Bank etc.
3. The foreign banks are those that are based in a foreign country but have several
branches in India. Some examples of these banks include; HSBC, Standard Chartered
Bank etc.
4. The regional rural banks were brought into operation with the objective of
providing credit to the rural and agricultural regions and were brought into effect in
1975 by RRB Act. These banks are restricted to operate only in the areas specified by
government of India. These banks are owned by State Government and a sponsor
bank. This sponsorship was to be done by a nationalized bank and a State
Cooperative bank. Prathama Bank is one such example, which is located in
Moradabad in U.P.
Cooperative banks: These banks are controlled, owned, managed and operated by cooperative
societies and came into existence under the Cooperative Societies Act in 1912. these banks are
located in the urban as well in the rural areas. Although these banks have the same functions as the
commercial banks, they provide finance to farmers, salaried people, small scale industries, etc. and
their rates of interest of interest are lower as compared to other banks.
There are three types of cooperative banks in India, namely:
1. Primary credit societies: These are formed in small locality like a small town or a
village. The members using this bank usually know each other and the chances of
committing fraud is minimal.
2. Central cooperative banks: These banks have their members who belong to the
same district. They function as other commercial banks and provide loans to their
members. They act as a link between the state cooperative banks and the primary
credit societies.
3. State cooperative banks: these banks have a presence in all the states of the
country and have their presence throughout the state.
Various Types of Banks and Their Functions – Banking Study Material & Notes
Broadly, banks are classified either into commercial banks or as central bank. they are also classified as
Scheduled and Non-scheduled Banks.
Scheduled banks have been included in the second schedule of the Reserve Bank, and fulfils the following
three criteria:
1. It must have a paid up capital of at least Rs. 5 lakhs.
2. It must fulfil the RBI norms about no activity that may be detrimental to the depositors interests.
3. It must be a Corporation(not a partnership or a single ownership firm).
Non-Scheduled Banks are excluded from the Second schedule of RBI. The Reserve Bank does not exercise
much control over them, but they report monthly to RBI.
I. Public Sector Banks – Majority stake is held by Government
State Bank of India and its associate banks: These associate banks are State Bank of Bikaner &
Jaipur, State Bank of Hyderabad, State Bank of Mysore, State Bank of Patiala, and State Bank of
Travancore.
Nationalised Banks– These are those commercial banks that have been nationalized for fulfilling the
social objectives of the government. There are 20 Nationalised banks in India. These are – Allahabad
Bank, Andhra Bank, Bank of Maharashtra, Bank of Baroda, Canara Bank, Central Bank of India, Bank
of India, , Corporation Bank, Dena Bank, Indian Overseas Bank, IDBI Bank Ltd., Oriental Bank of
Commerce, Indian Bank, Punjab & Sind Bank, Punjab National Bank, Union Bank of India, Syndicate
Bank, United Bank of India,UCO Bank, and Vijaya Bank.
Regional Rural Banks(RRB)– These banks have been established to strengthen the rural economy.
They facilitate the credit and deposit flow for farmers, artisans, labourers in their limited local area.
These banks are jointly owned by the central and state government along with a sponsor commercial
bank.
II. Private Sector Banks – Majority share capital is with private individuals & corporates
Old Private Banks – There are fourteen old private banks operating in India. These banks were not
nationalised when other banks were nationalised in 1969 and 1980. These are- Catholic Syrian Bank
Ltd., Dhanalakshmi Bank Ltd., City Union Bank Ltd., Federal Bank Ltd., Lakshmi Vilas Bank Ltd., ING
Vysya Bank Ltd., Karur Vysya Bank Ltd., Karnataka Bank Ltd., , Nainital Bank Ltd., Ratnakar Bank
Ltd., Jammu & Kashmir Bank Ltd., South Indian Bank Ltd., SBI Commercial & International Bank Ltd,
and Tamilnad Mercantile Bank Ltd.
New Private Banks- There are seven new private banks functioning in the Indian economy. These
are- Axis Bank Ltd., Development Credit Bank Ltd, ICICI Bank Ltd., IndusInd Bank Ltd., Kotak
Mahindra Bank Ltd., HDFC Bank Ltd., and Yes Bank Ltd.
Foreign Banks- These banks have their registered head offices in a foreign country, while they
operate their branches in India. They can operate in India either through wholly-owned subsidiaries or
through branches. There are 32 foreign banks operating their various branches in India.
Co-operative Banks – Cooperative banks are those scheduled banks that are regulated by RBI,
under a cooperative structure to provide credit to all actegories of businesses. Their ownership
structure is unique where like minded individuals and companies pool in money together to support
credit facilities to businesses. These can operate in either Urban or Rural setting. That is another
criteria to differentiate these co-operative banks.
The types of banks in India can be understood from the following table, which explains what kind of
customer base different types of banks have.
.
Indian Banking System: Structure and other Details!
Bank is an institution that accepts deposits of money from the public.
Anybody who has account in the bank can withdraw money. Bank also lends money.
Indigenous Banking:
The exact date of existence of indigenous bank is not known. But, it is certain that the old banking
system has been functioning for centuries. Some people trace the presence of indigenous banks to the
Vedic times of 2000-1400 BC. It has admirably fulfilled the needs of the country in the past.
However, with the coming of the British, its decline started. Despite the fast growth of modern
commercial banks, however, the indigenous banks continue to hold a prominent position in the Indian
money market even in the present times. It includes shroffs, seths, mahajans, chettis, etc. The
indigenous bankers lend money; act as money changers and finance internal trade of India by means
of hundis or internal bills of exchange.
Defects:
The main defects of indigenous banking are:
(i) They are unorganised and do not have any contact with other sections of the banking world.
(ii) They combine banking with trading and commission business and thus have introduced trade risks
into their banking business.
(iii) They do not distinguish between short term and long term finance and also between the purpose
of finance.
(iv) They follow vernacular methods of keeping accounts. They do not give receipts in most cases and
interest which they charge is out of proportion to the rate of interest charged by other banking
institutions in the country.
Suggestions for Improvements:
(i) The banking practices need to be upgraded.
(ii) Encouraging them to avail of certain facilities from the banking system, including the RBI.
(iii) These banks should be linked with commercial banks on the basis of certain understanding in the
respect of interest charged from the borrowers, the verification of the same by the commercial banks
and the passing of the concessions to the priority sectors etc.
(iv) These banks should be encouraged to become corporate bodies rather than continuing as family
based enterprises.
Structure of Organised Indian Banking System:
The organised banking system in India can be classified as given below:
Reserve Bank of India (RBI):
The country had no central bank prior to the establishment of the RBI. The RBI is the supreme
monetary and banking authority in the country and controls the banking system in India. It is called
the Reserve Bank’ as it keeps the reserves of all commercial banks.
Commercial Banks:
Commercial banks mobilise savings of general public and make them available to large and small
industrial and trading units mainly for working capital requirements.
Commercial banks in India are largely Indian-public sector and private sector with a few foreign
banks. The public sector banks account for more than 92 percent of the entire banking business in
India—occupying a dominant position in the commercial banking. The State Bank of India and its 7
associate banks along with another 19 banks are the public sector banks.
Scheduled and Non-Scheduled Banks:
The scheduled banks are those which are enshrined in the second schedule of the RBI Act, 1934.
These banks have a paid-up capital and reserves of an aggregate value of not less than Rs. 5 lakhs,
hey have to satisfy the RBI that their affairs are carried out in the interest of their depositors.
All commercial banks (Indian and foreign), regional rural banks, and state cooperative banks are
scheduled banks. Non- scheduled banks are those which are not included in the second schedule of
the RBI Act, 1934. At present these are only three such banks in the country.
Regional Rural Banks:
The Regional Rural Banks (RRBs) the newest form of banks, came into existence in the middle of
1970s (sponsored by individual nationalised commercial banks) with the objective of developing rural
economy by providing credit and deposit facilities for agriculture and other productive activities of al
kinds in rural areas.
The emphasis is on providing such facilities to small and marginal farmers, agricultural labourers, rural
artisans and other small entrepreneurs in rural areas.
Other special features of these banks are:
(i) their area of operation is limited to a specified region, comprising one or more districts in any
state; (ii) their lending rates cannot be higher than the prevailing lending rates of cooperative credit
societies in any particular state; (iii) the paid-up capital of each rural bank is Rs. 25 lakh, 50 percent
of which has been contributed by the Central Government, 15 percent by State Government and 35
percent by sponsoring public sector commercial banks which are also responsible for actual setting up
of the RRBs.
These banks are helped by higher-level agencies: the sponsoring banks lend them funds and advise
and train their senior staff, the NABARD (National Bank for Agriculture and Rural Development) gives
them short-term and medium, term loans: the RBI has kept CRR (Cash Reserve Requirements) of
them at 3% and SLR (Statutory Liquidity Requirement) at 25% of their total net liabilities, whereas for
other commercial banks the required minimum ratios have been varied over time.
Cooperative Banks:
Cooperative banks are so-called because they are organised under the provisions of the Cooperative
Credit Societies Act of the states. The major beneficiary of the Cooperative Banking is the agricultural
sector in particular and the rural sector in general.
The cooperative credit institutions operating in the country are mainly of two kinds: agricultural
(dominant) and non-agricultural. There are two separate cooperative agencies for the provision of
agricultural credit: one for short and medium-term credit, and the other for long-term credit. The
former has three tier and federal structure.
At the apex is the State Co-operative Bank (SCB) (cooperation being a state subject in India), at the
intermediate (district) level are the Central Cooperative Banks (CCBs) and at the village level are
Primary Agricultural Credit Societies (PACs).
Long-term agriculture credit is provided by the Land Development Banks. The funds of the RBI meant
for the agriculture sector actually pass through SCBs and CCBs. Originally based in rural sector, the
cooperative credit movement has now spread to urban areas also and there are many urban
cooperative banks coming under SCBs.
Banking is defined as the accepting purpose of lending or investment of deposits, money from the
public, repayable on demand or otherwise and withdrawable by cheque, draft, order or otherwise —
this definition is given in Indian Banking Regulation Act (1949). From this definition, we can say that a
bank has two main features: (1) the bank accepts deposits of money which are withdrawable by
cheques, (2) the bank uses the deposits for lending. To be recognised as bank the institution must use
the deposits to give loans to the general public.
If an institution accepts deposits withdraw able by cheques but uses the deposits for its own purpose,
such an institution cannot be regarded as a bank. Post office, savings banks are not banks, because
they accept chequable deposits but do not sanction loans. In the same way. Lie is not bank because it
does not grant loans in general. LITI, LIC, IDBI etc. are regarded as the non- banking financial
institutions as they do not create money.
Types of Banks:
Some important types of banks in countries like India are discussed below:
(a) Organized and unorganized banking:
Indian banking system can broadly be classified into two categories:
(i) Organized banking and
(ii) Unorganized banking.
That part of Indian banking system which does not fall under the control of our central bank (i.e.
Reserve Bank of India) is called as un-organised banking. For example, Indigenous banks. Whereas,
organized banking system refers to that part of the Indian banking system which is under the
influence and control of the Reserve Bank of India. For example. Commercial Banks, Industrial Banks,
Agricultural Banks.
(b) Scheduled and Non-scheduled banks:
Under the Reserve Bank of India Act, 1939, banks were classified as scheduled banks and non
scheduled banks.. The scheduled banks are those which are entered in the second schedule of RBI
Act, 1939. Scheduled banks are those banks an which have a paid up capital and reserves of
aggregate value of not less than Rs 5 lakhs and which satisfy RBI.
All Commercial Banks, Regional Rural Banks, State Cooperative Banks are scheduled banks. On the
other hand, non-schedule banks are those banks whose total paid up capital is less than Rs 5 lakh and
RBI has no specific control over these banks. These banks are not included in the second schedule of
RBI Act, 1934.
(c) Indigenous Bankers:
From very ancient days indigenous banking as different from the modern western banking has been
organized in the form of family or individual business. They have been called by various names in
different parts of the country as Shroffs, Sethus, Sahukars, Mahajans, Chettis and so on. They vary in
their size from petty money lenders substantial shroffs.
(d) Central Bank:
In each country there exists central bank which controls a country’s money supply and monetary
policy. It acts as a bank to other banks, and a lender of last resort. India Reserve Bank of India (RBI)
is the Central Bank.
(e) Commercial Bank:
A bank dealing with general public, accepting deposits from making loans to large numbers of
households and firms. Through the process of accepting deposits and lending, commercial banks
create credit in the economy. Some examples (commercial banks in India are State Bank India (SBI),
Punjab National Bank (PNB) etc.
(f) Development Banks:
Development banks are specialised financial institutions. To promote economic development,
development banks provide medium term and long term loans the entrepreneurs at relatively low rate
o interest rates. Some examples of development banks in India are Industrial Development Bank of
India (IDBI), Industrial Financial Corporation of India (IFCI), Industrial Credit and Investment
Corporation of India (ICICI) etc.
(g) Co-Operative Banks:
Co-operative banks are organised under the provisions of the Co- operative societies law of the state.
These banks were originally set up in India to provide credit to the farmers at cheaper rates. However,
the co-operative banks function also in the urban sectors.
(h) Land Mortgage Banks:
The primary objective of these banks is to provide long-term loans to farmers at low rates in matters
related to land, The land mortgage banks are also known as the Land Development Banks.
(i) Regional Rural Banks:
Regional Rural Banks (RRBs) are established in the rural areas to meet the needs of the weaker
section of the rural population.
(j) National Bank for Agricultural and Rural Development (NABARD):
This bank was established in 1982 in India in view of providing the rural credit to the farmers.
Actually, it is an apex institution which coordinates the functioning of different financial institutions
working in the field of rural credit. NABARD has been making continuous efforts through its micro-
finance programme or improving the access of the rural poor to formal institutional credit. The self
help group (SHG) – Bank linkage programme was introduced in 1992 as a mechanism to provide
financial services to the rural poor people on a sustainable basis.
(k) Exchange Banks:
These banks are engaged in buying and selling foreign exchange. These banks help the growth of
international trade.
(i) Exim Bank:
It is popularly known as ‘Export Import Bank’. Such banks provide long term financial assistance to
the exporters and importers.
Commercial Banks in India: Role, Structures and Importance!
1. Role and Importance of Commercial Banks:
The functions of commercial banks explain their importance in the economic development of a
country.
Banks help in accelerating the economic growth of a country in the following ways:
1. Accelerating the Rate of Capital Formation:
Commercial banks encourage the habit of thrift and mobilise the savings of people. These savings are
effectively allocated among the ultimate users of funds, i.e., investors for productive investment. So,
savings of people result in capital formation which forms the basis of economic development.
2. Provision of Finance and Credit:
Commercial banks are a very important source of finance and credit for trade and industry. The
activities of commercial banks are not only confined to domestic trade and commerce, but extend to
foreign trade also.
3. Developing Entrepreneurship:
Banks promote entrepreneurship by underwriting the shares of new and existing companies and
granting assistance in promoting new ventures or financing promotional activities. Banks finance sick
(loss-making) industries for making them viable units.
4. Promoting Balanced Regional Development:
Commercial banks provide credit facilities to rural people by opening branches in the backward areas.
The funds collected in developed regions may be channelised for investments in the under developed
regions of the country. In this way, they bring about more balanced regional development.
5. Help to Consumers:
Commercial banks advance credit for purchase of durable consumer items like Vehicles, T.V.,
refrigerator etc., which are out of reach for some consumers due to their limited paying capacity. In
this way, banks help in creating demand for such consumer goods.
2. Structure of Commercial Banks in India:
The commercial banks can be broadly classified under two heads:
1. Scheduled Banks:
Scheduled Banks refer to those banks which have been included in the Second Schedule of Reserve
Bank of India Act, 1934.
In India, scheduled commercial banks are of three types:
(i) Public Sector Banks:
These banks are owned and controlled by the government. The main objective of these banks is to
provide service to the society, not to make profits. State Bank of India, Bank of India, Punjab National
Bank, Canada Bank and Corporation Bank are some examples of public sector banks.
Public sector banks are of two types:
(a) SBI and its subsidiaries;
(b) Other nationalized banks.
(ii) Private Sector Banks:
These banks are owned and controlled by private businessmen. Their main objective is to earn profits.
ICICI Bank, HDFC Bank, IDBI Bank is some examples of private sector banks.
(iii) Foreign Banks:
These banks are owned and controlled by foreign promoters. Their number has grown rapidly since
1991, when the process of economic liberalization had started in India. Bank of America, American
Express Bank, Standard Chartered Bank are examples of foreign banks.
2. Non-Scheduled Banks:
Non-Scheduled banks refer to those banks which are not included in the Second Schedule of Reserve
Bank of India Act, 1934.
Major functions of the RBI are as follows:
1. Issue of Bank Notes:
The Reserve Bank of India has the sole right to issue currency notes except one rupee notes which are
issued by the Ministry of Finance. Currency notes issued by the Reserve Bank are declared unlimited
legal tender throughout the country.
This concentration of notes issue function with the Reserve Bank has a number of advantages: (i) it
brings uniformity in notes issue; (ii) it makes possible effective state supervision; (iii) it is easier to
control and regulate credit in accordance with the requirements in the economy; and (iv) it keeps faith
of the public in the paper currency.
2. Banker to Government:
As banker to the government the Reserve Bank manages the banking needs of the government. It has
to-maintain and operate the government’s deposit accounts. It collects receipts of funds and makes
payments on behalf of the government. It represents the Government of India as the member of the
IMF and the World Bank.
3. Custodian of Cash Reserves of Commercial Banks:
The commercial banks hold deposits in the Reserve Bank and the latter has the custody of the cash
reserves of the commercial banks.
4. Custodian of Country’s Foreign Currency Reserves:
The Reserve Bank has the custody of the country’s reserves of international currency, and this enables
the Reserve Bank to deal with crisis connected with adverse balance of payments position.
5. Lender of Last Resort:
The commercial banks approach the Reserve Bank in times of emergency to tide over financial
difficulties, and the Reserve bank comes to their rescue though it might charge a higher rate of
interest.
6. Central Clearance and Accounts Settlement:
Since commercial banks have their surplus cash reserves deposited in the Reserve Bank, it is easier to
deal with each other and settle the claim of each on the other through book keeping entries in the
books of the Reserve Bank. The clearing of accounts has now become an essential function of the
Reserve Bank.
7. Controller of Credit:
Since credit money forms the most important part of supply of money, and since the supply of money
has important implications for economic stability, the importance of control of credit becomes obvious.
Credit is controlled by the Reserve Bank in accordance with the economic priorities of the government.
The RBI was established in 1935. It was nationalised in 1949. The RBI plays role of regulator of the
banking system in India. The Banking Regulation Act 1949 and the RBI Act 1953 has given the RBI
the power to regulate the banking system.
The RBI has different functions in different roles. Below, we share and discuss some of the functions of
the RBI.
RBI is the Regulator of Financial System
The RBI regulates the Indian banking and financial system by issuing broad guidelines and
instructions. The objectives of these regulations include:
Controlling money supply in the system,
Monitoring different key indicators like GDP and inflation,
Maintaining people’s confidence in the banking and financial system, and
Providing different tools for customers’ help, such as acting as the “Banking Ombudsman.”
RBI is the Issuer of Monetary Policy
The RBI formulates monetary policy twice a year. It reviews the policy every quarter as well. The main
objectives of monitoring monetary policy are:
Inflation control
Control on bank credit
Interest rate control
The tools used for implementation of the objectives of monetary policy are:
Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR),
Open market operations,
Different Rates such as repo rate, reverse repo rate, and bank rate.
RBI is the Issuer of Currency
Section 22 of the RBI Act gives authority to the RBI to issue currency notes. The RBI also takes action
to control circulation of fake currency.
RBI is the Controller and Supervisor of Banking Systems
The RBI has been assigned the role of controlling and supervising the bank system in India. The RBI is
responsible for controlling the overall operations of all banks in India. These banks may be:
Public sector banks
Private sector banks
Foreign banks
Co-operative banks, or
Regional rural banks
The control and supervisory roles of the Reserve Bank of India is done through the following:
Issue Of Licence: Under the Banking Regulation Act 1949, the RBI has been given powers to
grant licenses to commence new banking operations. The RBI also grants licenses to open new
branches for existing banks. Under the licensing policy, the RBI provides banking services in
areas that do not have this facility.
Prudential Norms: The RBI issues guidelines for credit control and management. The RBI is a
member of the Banking Committee on Banking Supervision (BCBS). As such, they are
responsible for implementation of international standards of capital adequacy norms and asset
classification.
Corporate Governance: The RBI has power to control the appointment of the chairman and
directors of banks in India. The RBI has powers to appoint additional directors in banks as
well.
KYC Norms: To curb money laundering and prevent the use of the banking system for financial
crimes, The RBI has “Know Your Customer“ guidelines. Every bank has to ensure KYC norms
are applied before allowing someone to open an account.
Transparency Norms: This means that every bank has to disclose their charges for providing
services and customers have the right to know these charges.
Risk Management: The RBI provides guidelines to banks for taking the steps that are
necessary to mitigate risk. They do this through risk management in basel norms.
Audit and Inspection: The procedure of audit and inspection is controlled by the RBI through
off-site and on-site monitoring system. On-site inspection is done by the RBI on the basis of
“CAMELS”. Capital adequacy; Asset quality; Management; Earning; Liquidity; System and
control.
Foreign Exchange Control: The RBI plays a crucial role in foreign exchange transactions. It
does due diligence on every foreign transaction, including the inflow and outflow of foreign
exchange. It takes steps to stop the fall in value of the Indian Rupee. The RBI also takes
necessary steps to control the current account deficit. They also give support to promote
export and the RBI provides a variety of options for NRIs.
Development: Being the banker of the Government of India, the RBI is responsible for
implementation of the government’s policies related to agriculture and rural development. The
RBI also ensures the flow of credit to other priority sectors as well. Section 54 of the RBI gives
stress on giving specialized support for rural development. Priority sector lending is also in key
focus area of the RBI.
Apart from the above, the RBI publishes periodical review and data related to banking. The role and
functions of the RBI cannot be described in a brief write up. The RBI plays a very important role in
every aspect related to banking and finance. Finally the control of NBFCs and others in the financial
world is also assigned with RBI.
The Role of RBI in Indian Economy - India's central banking institution.
RBI through printing new money and through monetary policy monitors and influences the movement of a
number of macro economic indicators including interest rates, inflation rate, money supply and Gross
Domestic Product (GDP).
RBI as Issuer of Currency
The RBI controls the nation’s money supply and is the only authority empowered to print new currency notes.
As the production and consumption in the economy rises because of a rise in population or for any other
reason, more money is needed to support this growth. RBI prints money primarily based on this growth in the
economy (i.e. GDP) and for replacing old and soiled notes.
Role of RBI in regulating Monetary Policy
Monetary policy refers to the use of certain regulatory tools under the control of the RBI in order to regulate the
availability, cost and use of money and credit. There are several direct and indirect tools which RBI can use to
regulate the financial markets and maintain stability. Important ones are discussed below:
Direct regulation:
Cash Reserve Ratio (CRR): CRR is the minimum amount of cash that commercial banks have to keep with
the RBI at any given point in time. Banks are required to hold a certain proportion of their deposits in the form
of cash with RBI. RBI uses CRR either to drain excess liquidity from the economy or to release additional funds
needed for the growth of the economy.
For example, if the RBI reduces the CRR from 5% to 4%, it means that banks will now have to keep a lesser
proportion of their deposits with the RBI making more money available for business. Similarly, if RBI decides to
increase the CRR, the amount available with the banks goes down.
Statutory Liquidity Ratio (SLR): SLR is the amount that commercial banks are required to maintain in the
form of gold or government approved securities before providing credit to the customers. SLR is stated in terms
of a percentage of total deposits available with the bank and is determined and maintained by the Reserve
Bank of India in order to control the expansion of bank credit. For example, currently, commercial banks have
to keep gold or government approved securities for a value equal to 23% of their total deposits.
Repo Rate: The rate at which the RBI is willing to lend to commercial banks is called Repo Rate. Whenever
banks have any shortage of funds they can borrow from the RBI, against securities. If the RBI increases the
Repo Rate, it makes borrowing expensive for banks and vice versa. As a tool to control inflation, RBI increases
the Repo Rate, making it more expensive for the banks to borrow from the RBI with a view to restrict the
availability of money. Similarly, the RBI will do the exact opposite in a deflationary environment.
Reverse Repo Rate: The rate at which the RBI is willing to borrow from the commercial banks is called reverse
repo rate. If the RBI increases the reverse repo rate, it means that the RBI is willing to offer lucrative interest
rate to banks to park their money with the RBI. This results in a decrease in the amount of money available for
banks customers as banks prefer to park their money with the RBI as it involves higher safety. This naturally
leads to a higher rate of interest which the banks will demand from their customers for lending money to them.
The Repo Rate and the Reverse Repo Rate are important tools with which the RBI can control the availability
and the supply of money in the economy.
The central bank of our country is the Reserve Bank of India (RBI). It was established in 1935 (by the RBI Act, 1934) on the
basis of recommendation of Hilton Young commission as a private shareholders’ bank with a paid up capital of rupees
five crores. Starting as a private shareholders’ bank, the Reserve Bank of India was nationalised in 1949 and
emerged as the central banking body of India.
The functions of the Reserve Bank today can be categorised as follows:
Monetary and Credit policy
Foreign exchange management
Currency management
Banker to banks & Lender of the last resort
Banker to the Central and State Governments
Central clearing house of payment and settlement systems
Performing developmental and promotional functions
Monetary and Credit Policy
One of the most important functions of central banks is formulation and execution of monetary policy. Over time, the
objectives of monetary policy in India have evolved to include maintaining price stability, ensuring adequate flow of
credit to productive sectors of the economy for supporting economic growth, and achieving financial stability. The
policy by which desired level of money flow and its demand is regulated is known as monetary and credit policy.
The Governor of the Reserve Bank announces the Monetary Policy in April every year for the financial year that ends
in the following March. This is followed by three quarterly reviews in July, October and January. However, depending
on the evolving situation, the Reserve Bank may announce monetary measures at any point of time. There are many
tools by which RBI regulates the desired kind of credit and monetary policy- CRR, SLR, Bank Rate, Repo Rate,
Reverse Repo Rate (explained later).
Currency management
Under Section 22 of the RBI Act, the bank has the sole right to issue bank notes of all denomination.
The Indian Currency is called the Indian Rupee and its sub-denomination the Paisa. The printing of Re.1 and Rs.2
denominations has been discontinued. However, notes in these denominations issued earlier are still valid and in
circulation. Coins up to 50 paisa are called “small coins” and coins of Rupee one and above are called “Rupee coins”.
The RBI Act requires that the Reserve Bank’s affairs relating to note issue and its general banking business be
conducted through two separate departments – the Issue Department and the Banking Department. RBI issues
currency on the basis of Minimum Reserve System under which it keeps a minimal backing of 200 crores; out of
which 115cr worth of Gold and 85cr worth of securities and Bonds of foreign governments.
Foreign exchange management
The Reserve Bank, as the custodian of the country’s foreign exchange reserves, is vested with the responsibility of
managing their investment. The basic parameters of the Reserve Bank’s policies for foreign exchange reserves
management are safety, liquidity and returns. While safety and liquidity continue to be the twin-pillars of reserves
management, return optimisation has become an embedded strategy within this framework.
Within this framework, the Reserve Bank focuses on:
a) Maintaining market’s confidence in monetary and exchange rate policies.
b) Enhancing RBI intervention in stabilising foreign exchange markets.
c) Limiting external vulnerability by maintaining foreign currency liquidity to absorb shocks during times of crisis,
including national disasters or emergencies.
The foreign exchange reserves include foreign currency assets (FCA), Special Drawing Rights (SDRs) and gold.
SDRs are held by the Government of India. The foreign currency assets are managed following the principles of
portfolio management.
Banker to banks & Lender of the last resort
Banks are required to maintain a portion of their demand and time liabilities as cash reserves with the Reserve Bank,
thus necessitating a need for maintaining accounts with the Bank. In order to facilitate a smooth inter-bank transfer of
funds, or to make payments and to receive funds on their behalf, banks need a common banker. In order to meet the
above objectives, in India, the Reserve Bank provides banks with the facility of opening accounts with itself. This is
the ‘Banker to Banks’ function of the Reserve Bank.
As Banker to Banks, the Reserve Bank provides short-term loans and advances to select banks, when necessary, to
facilitate lending to specific sectors and for specific purposes. The Reserve Bank also acts as the ‘lender of last
resort’. It can come to the rescue of a bank that is solvent but faces temporary liquidity problems by supplying it with
much needed liquidity when no one else is willing to extend credit to that bank.
Banker to the Central and State Governments
The Reserve Bank of India Act, 1934 requires the Central Government to entrust the Reserve Bank with all its
money, remittance, exchange and banking transactions in India and the management of its public debt. The Reserve
Bank may also, by agreement, act as the banker to a State Government. Currently, the Reserve Bank acts as banker
to all the State Governments in India, except Jammu & Kashmir and Sikkim.
The Reserve Bank also undertakes to float loans and manage them on behalf of the Governments. It also provides
Ways and Means Advances – a short-term interest bearing advance – to the Governments, to meet the temporary
mismatches in their receipts and payments. It also acts as adviser to Government, whenever called upon to do so, on
monetary and banking related matters.
Central clearing house of payment and settlement systems
The increasing monetisation in the economy, the country’s large geographic expanse, people’s preference for paper-
based instruments and rapid changes in technology are among factors that make this task a formidable one.
The various initiatives taken by RBI are:
Computerisation
Pre-paid payment instruments
Cheque Truncation System (CTS)
Electronic Clearing Service (ECS)
National Electronic Clearing Service (NECS)
Electronic Funds Transfer (EFT)
The Real Time Gross Settlement (RTGS) system
Performing developmental and promotional functions
The Reserve Bank’s developmental role includes ensuring credit to productive sectors of the economy, creating
institutions to build financial infrastructure, and expanding access to affordable financial services. It also plays an
active role in encouraging efficient customer service throughout the banking industry, as well as extension of banking
service to all, through the thrust on financial inclusion. Towards this goal, which has evolved over many years, the
Reserve Bank has taken various initiatives like Priority Sector Lending, Lead Bank Scheme, Kisan Credit Cards,
Differential Interest Rate Scheme, setting up of various institutions like SIDBI, NABARD.
The Reserve Bank of India and its functions
The Reserve Bank of India was established in the year 1935 in accordance with the Reserve Bank of India Act, 1934. The Reserve Bank of India is the central Bank of India entrusted with the multidimensional role. It performs important monetary functions from issue of currency note to maintenance of monetary stability in the country. Initially the Reserve Bank of India was a private share holder’s company which was nationalized in 1949. Its affairs are governed by the Central Board of Directors appointed by the Government of India. Since its inception the Reserve Bank of India had played an important role in the economic development and monetary stability in the country. Pre Independence
The Royal Commission on Indian Currency and Finance appointed on August 25, 1925 has suggested the establishmentof the Central Bank in India, later the Indian Central Banking Enquiry Committee, 1931 stressed the establishment of the Central Bank in India. The Reserve of Bank was established on April 1, 1935 under the Reserve Bank of India Act, 1934.The main object of Reserve of India is, “to regulate the issue of Bank notes and the keeping of reserves with a view to securing monetary stability in India and generally to operate the currency any credit system of the country to its advantage” The Reserve Bank of India was established as a private share holder’s bank. The Central office of Reserve Bank of India was initially located in Calcutta which was later shifted to Bombay. The Reserve Bank of India issued first of its currency notes in January 1938 in denomination of Rs.5 and Rs.10 and later in the same year denomination of Rs.100, Rs.1000 and Rs.10000 were issued
Post Independence
The Reserve Bank of India was nationalized in the year 1949 through the Reserve Bank (Transfer of Public Ownership) Act, i948 and all shares were transferred to Central Government. The Reserve bank of India is constituted for the management of currency and for carrying the business of banking in accordance with provisions of the Act. It is a body corporate having perpetual succession, common seal and can be sued or sue in its name. The general supervision and direction of the affairs of the Reserve Bank is entrusted with Central Board of Directors.
Composition of Central Board
The Central Board consists of Governor, deputy Governor, Ten Director nominated by the Central Government and two Government official nominated by the Central Government. The deputy Governor and Director are eligible to attend meeting of the Central Board but are not entitled to vote. The Governor and deputy Governor hold office for term of five years and are entitled for a re-appointment. The Directors are appointed for a term of four and hold office during the pleasure of the president. The meeting of the Central Board is convened at least six times in a year.
Composition of Local Board
A local board is formed in each four zones consisting of five members which are appointed by the Central Government. There is Chairperson of the Board who is elected among the member. The members of the Board have a hold office for a term of four years and eligible for reappointment. The Local Board advice on matters referred to it by the Central Board and performs duties delegated to it by the Central Board.
Functions of Reserve bank of India
Banker to Government
The Reserve Bank of India accepts and makes payment on behalf of Central Government. It carries out its exchange, remittance, management of public debt and other banking function of the Central Government. The Central Government entrusts its money, remittance, exchange and banking transactions in India with the Reserve Bank of India. It deals in repo or reverse repo.
Right to Issue Bank note
The Reserve Bank of India has the sole right to issue bank notes in India. The bank notes are legal tender guaranteed by the Central Government. The issue of bank note is conducted by a separate department called issue department. The Central Government on the recommendation of Central Board specifies denomination of bank notes including discontinuance of bank notes. The Central Government approves design, form and material of Bank notes on consideration of recommendations of the Central Board.
Formulates Banking policy
The Reserve is empowered to formulate banking policy in the interest of the public or depositors banking policy in relation to advances and provide direction on the purpose of the advances, margins to be maintained in a secured advances, the maximum amount of advance may be made, the rate of interest, terms and conditions for advances or guarantees may be given.
Licensing Authority
The Reserve Bank of India is empowered to grant license to commence banking business in India, including the power to cancel a license granted to a banking company. A petition was filed under Article 226 of the Constitution, challenging the constitutional validity of section 22 of the Banking Companies Act, 1949. Section 22 empowers, Reserve Bank of India to grant license to Banks and banks which were already in existence on the commencement of the Act have to apply for license before the expiry of six months from commence.The petitioner contended that the section 22 of the Banking Regulating Act, 1949 is in restraint of trade and business hence unconstitutional. The writ was dismissed and the High Court declared section 22 of the Banking Regulating Act, 1949 as constitutionally valid and cherished the role of Reserve Bank of India in the economic development of the country. The Madras High Court meticulously said, “The Reserve Bank of India was established with a view to fostering the banking business and not for impeding the growth of such business. The powers vested in it under Section 22 are not one invested with a mere officer of the Bank. The standards for the exercise of the power have been laid down in Section 22 itself. The Reserve Bank is a non-political body concerned with the finances of the country. When a power is given to such a body under a statute which prescribes the regulations of a Banking Company, it can be assumed that such power would be exercised so that genuine: banking concerns could be allowed to function as a bank, while institutions masquerading as banks or those run on unsound lines or which would affect the interests of the public could be weeded out.”
Banker’s Bank
The banks listed in second schedule and non schedule banks shall maintain a cash reserve ratio with the Reserve bank of India with a view to securing the monetary stability in the country. It provides loans and advances in foreign currency to scheduled Banks and to other financial institution. It purchases, sells or discount any bill of exchange or promissory note or makes a loan or advances to schedule bank.
Depositor Awareness and Education
The Reserve Bank of India has constituted a fund called “Depositor Education and Awareness Fund.” The fund is utilized for the promotion of depositors’ interest and other purposes in the interest of the depositor.
Regulation and Management of Foreign Exchange
The Reserve Bank of India is empowered to regulate, prohibit, and restrict dealing in foreign exchange. It issues license to banks and other institution to act as the authorized agency in the foreign exchange market.
The Reserve Bank of India performs various traditional central banking functions as well as undertakes
different promotional and developmental measures to meet the dynamic requirements of the country.
The broad objectives of the Reserve Bank are:
(a) Regulating the issue of currency in India;
(b) keeping the foreign exchange reserves of the country;
(c) establishing the monetary stability in the country; and
(d) developing the financial structure of the country on sound lines consistent with the national socio-economic
objectives and policies. Main functions of the Reserve Bank are described below:
1. Note Issue:
The Reserve Bank has the monopoly of note issue in the country. It has the sole right to issue currency notes of
all denominations except one-rupee notes. One-rupee notes are issued by the Ministry of Finance of the
Government of India. The Reserve Bank acts as the only source of legal tender because even the one-rupee
notes are circulated through it. The Reserve Bank has a separate Issue Department, which is entrusted with the
job of issuing currency notes. The Reserve Bank has adopted minimum reserve system of note issue. Since 1957,
it maintains gold and foreign exchange reserves of Rs. 200 crore, of which at least Rs. 115 crore should be in
gold.
2. Banker to Government:
The Reserve Bank acts as the banker, agent and adviser to Government of India:
(a) It maintains and operates government deposits,
(b) It collects and makes payments on behalf of the government,
(c) It helps the government to float new loans and manages the public debt,
(d) It sells for the Central Government treasury bills of 91 days duration,
(e) It makes 'Ways and Means' advances to the Central and State Governments for periods not exceeding three
months,
(f) It provides development finance to the government for carrying out five year plans,
(g) It undertakes foreign exchange transactions on behalf of the Central Government,
(h) It acts as the agent of the Government of India in the latter's dealings with the International Monetary Fund
(IMF), the World Bank, and other international financial institutions, (i) It advises the government on all
financial matters such as loan operations, investments, agricultural and industrial finance, banking, planning,
economic development, etc.
3. Banker's Bank:
The Reserve Bank acts as the banker's bank in the following respects:
(a) Every Bank is under the statutory obligation to keep a certain minimum of cash reserves with the Reserve
Bank. The purpose of these reserves is to enable the Reserve Bank to extend financial assistance to the
scheduled banks in times of emergency and thus to act as the lender of the last resort. According to the Banking
Regulation Act, 1949, all scheduled banks are required to maintain with the Reserve Bank minimum cash
reserves of 5% of their demand liabilities and 2% of their time liabilities. The Reserve Bank (Amendment) Act,
1956 empowered the Reserve Bank to raise the cash reserve ratio to 20% in the case of demand deposits and to
8% in case of time deposits. Due to the difficulty of classifying deposits into demand and time categories, the
amendment to the Banking Regulation Act in September 1972 changed the provision of reserves to 3% of
aggregate deposit liabilities, which can be raised to 15% if the Reserve Bank considers it necessary,
(b) The Reserve Bank provide financial assistance to the scheduled banks by discounting their eligible bilk and
through loans and advances against approved securities,
(c) Under the Banking Regulation Act,1949 and its various amendments, the Reserve Bank has been given
extensive powers of supervision and control over the banking system. These regulatory powers relate to the
licensing of banks and their branch expansion; liquidity of assets of the banks; management and methods of
working of the banks; amalgamation, reconstruction and liquidation of banks; inspection of banks; etc.
4. Custodian of Exchange Reserves:
The Reserve Bank is the custodian of India's foreign exchange reserves. It maintains and stabilises the external
value of the rupee, administers exchange controls and other restrictions imposed by the government, and
manages the foreign exchange reserves. Initially, the stability of exchange rate was maintained through selling
and purchasing sterling at fixed rates. But after India became a member of the international Monetary Fund
(IMF) in 1947, the rupee was delinked with sterling and became a multilaterally convertible currency. Therefore
the Reserve Bank now sells and buys foreign currencies, and not sterling alone, in order to achieve the objective
of exchange stability. The Reserve Bank fixes the selling and buying rates of foreign currencies. All Indian
remittances to foreign countries and foreign remittances to India are made through the Reserve Bank.
5. Controller of Credit:
As the central bank of the country, the Reserve Bank undertakes the responsibility of controlling credit in order
to ensure internal price stability and promote economic growth. Through this function, the Reserve Bank
attempts to achieve price stability in the country and avoids inflationary and deflationary tendencies in the
country. Price stability is essential for economic development. The Reserve Bank regulates the money supply in
accordance with the changing requirements of the economy. The Reserve Bank makes extensive use of various
quantitative and qualitative techniques to effectively control and regulate credit in the country.
6. Ordinary Banking Functions:
The Reserve Bank also performs various ordinary banking functions:
(a), It accepts deposits from the central government, state governments and even private individuals without
interest,
(b) It buys, sells and rediscounts the bills of exchange and promissory notes of the scheduled banks without
restrictions,
(c) It grants loans and advances to the central government, state governments, local authorities, scheduled
banks and state cooperative banks, repayable within 90 days,
(d) It buys and sells securities of the Government of India and foreign securities,
(e) It buys from and sells to the scheduled banks foreign exchange for a minimum amount of Rs. 1 lakh,
(f) It can borrow from any scheduled bank in India or from any foreign bank,
(g) It can open an account in the World Bank or in some foreign central bank.
(h) It accepts valuables, securities, etc., for keeping them in safe custody.
(i) It buys and sells gold and silver.
7. Miscellaneous Functions:
In addition to central banking and ordinary banking functions, the Reserve Bank performs the
following miscellaneous functions:
(a) Banker's Training College has been set up to extend training facilities to supervisory staff of commercial
banks. Arrangements have been made to impart training lo the cooperative personnel,
(b) The Reserve Bank collects and publishes statistical information relating to banking, finance, credit,
currency, agricultural and industrial production, etc. It also publishes the results of various studies and review
of economic situation of the country in its monthly bulletins and periodicals.
8. Forbidden Business:
Being the central bank of the country, the Reserve Bank:
(a) Should not compete with member banks and
(b) should keep its assets in liquid form to meet any situation of economic crisis.
Therefore, the Reserve Bank has been forbidden to do certain types of business:
(a) It can neither participate in, nor directly provide financial assistance to any business, trade or industry,
(b) It can neither buy its own shares not those of other banks or commercial and industrial undertakings,
(c) It cannot grant unsecured loans and advances,
(d) It cannot give loans against mortgage security,
(e) It cannot give interest on deposits.
(f) It cannot draw or accept bills not payable on demand,
(g) It cannot purchase immovable property except for its own offices.
9. Promotional and Developmental Functions:
Besides the traditional central banking functions, the Reserve Bank also performs a variety of
promotional and developmental functions:
(a) By encouraging the commercial banks to expand their branches in the semi-urban and rural areas, the
Reserve Bank helps (i) to reduce the dependence of the people in these areas on the defective unorganised
sector of indigenous bankers and money lenders, and (ii) to develop the banking habits of the people
(b) By establishing the Deposit Insurance Corporation, the Reserve Bank helps to develop the banking system
of the country, instills confidence of the depositors and avoids bank failures,
(c) Through the institutions like Unit Trust of India, the (Reserve Bank helps to mobilise savings in the country,
(d) Since its inception, the Reserve Bank has been mating efforts to promote institutional agricultural credit by
developing cooperative credit institutions.
(e) The Reserve Bank also helps to promote the process of industrialisation in the country by setting up
specialised institutions for industrial finance,
(f) it also undertakes measures for developing bill market in the country.
Traditional Functions of RBI ↓
Traditional functions are those functions which every central bank of each nation performs all over the
world. Basically these functions are in line with the objectives with which the bank is set up. It
includes fundamental functions of the Central Bank. They comprise the following tasks.
1. Issue of Currency Notes : The RBI has the sole right or authority or monopoly of issuing
currency notes except one rupee note and coins of smaller denomination. These currency
notes are legal tender issued by the RBI. Currently it is in denominations of Rs. 2, 5, 10, 20,
50, 100, 500, and 1,000. The RBI has powers not only to issue and withdraw but even to
exchange these currency notes for other denominations. It issues these notes against the
security of gold bullion, foreign securities, rupee coins, exchange bills and promissory notes
and government of India bonds.
2. Banker to other Banks : The RBI being an apex monitory institution has obligatory powers
to guide, help and direct other commercial banks in the country. The RBI can control the
volumes of banks reserves and allow other banks to create credit in that proportion. Every
commercial bank has to maintain a part of their reserves with its parent's viz. the RBI.
Similarly in need or in urgency these banks approach the RBI for fund. Thus it is called as the
lender of the last resort.
3. Banker to the Government : The RBI being the apex monitory body has to work as an
agent of the central and state governments. It performs various banking function such as to
accept deposits, taxes and make payments on behalf of the government. It works as a
representative of the government even at the international level. It maintains government
accounts, provides financial advice to the government. It manages government public debts
and maintains foreign exchange reserves on behalf of the government. It provides overdraft
facility to the government when it faces financial crunch.
4. Exchange Rate Management : It is an essential function of the RBI. In order to maintain
stability in the external value of rupee, it has to prepare domestic policies in that direction.
Also it needs to prepare and implement the foreign exchange rate policy which will help in
attaining the exchange rate stability. In order to maintain the exchange rate stability it has to
bring demand and supply of the foreign currency (U.S Dollar) close to each other.
5. Credit Control Function : Commercial bank in the country creates credit according to the
demand in the economy. But if this credit creation is unchecked or unregulated then it leads
the economy into inflationary cycles. On the other credit creation is below the required limit
then it harms the growth of the economy. As a central bank of the nation the RBI has to look
for growth with price stability. Thus it regulates the credit creation capacity of commercial
banks by using various credit control tools.
6. Supervisory Function : The RBI has been endowed with vast powers for supervising the
banking system in the country. It has powers to issue license for setting up new banks, to
open new braches, to decide minimum reserves, to inspect functioning of commercial banks in
India and abroad, and to guide and direct the commercial banks in India. It can have
periodical inspections an audit of the commercial banks in India.
Developmental / Promotional Functions of RBI ↓
Along with the routine traditional functions, central banks especially in the developing country like
India have to perform numerous functions. These functions are country specific functions and can
change according to the requirements of that country. The RBI has been performing as a promoter of
the financial system since its inception. Some of the major development functions of the RBI are
maintained below.
1. Development of the Financial System : The financial system comprises the financial
institutions, financial markets and financial instruments. The sound and efficient financial
system is a precondition of the rapid economic development of the nation. The RBI has
encouraged establishment of main banking and non-banking institutions to cater to the credit
requirements of diverse sectors of the economy.
2. Development of Agriculture : In an agrarian economy like ours, the RBI has to provide
special attention for the credit need of agriculture and allied activities. It has successfully
rendered service in this direction by increasing the flow of credit to this sector. It has earlier
the Agriculture Refinance and Development Corporation (ARDC) to look after the credit,
National Bank for Agriculture and Rural Development (NABARD) and Regional Rural Banks
(RRBs).
3. Provision of Industrial Finance : Rapid industrial growth is the key to faster economic
development. In this regard, the adequate and timely availability of credit to small, medium
and large industry is very significant. In this regard the RBI has always been instrumental in
setting up special financial institutions such as ICICI Ltd. IDBI, SIDBI and EXIM BANK etc.
4. Provisions of Training : The RBI has always tried to provide essential training to the staff of
the banking industry. The RBI has set up the bankers' training colleges at several places.
National Institute of Bank Management i.e NIBM, Bankers Staff College i.e BSC and College of
Agriculture Banking i.e CAB are few to mention.
5. Collection of Data : Being the apex monetary authority of the country, the RBI collects
process and disseminates statistical data on several topics. It includes interest rate, inflation,
savings and investments etc. This data proves to be quite useful for researchers and policy
makers.
6. Publication of the Reports : The Reserve Bank has its separate publication division. This
division collects and publishes data on several sectors of the economy. The reports and
bulletins are regularly published by the RBI. It includes RBI weekly reports, RBI Annual
Report, Report on Trend and Progress of Commercial Banks India., etc. This information is
made available to the public also at cheaper rates.
7. Promotion of Banking Habits : As an apex organization, the RBI always tries to promote
the banking habits in the country. It institutionalizes savings and takes measures for an
expansion of the banking network. It has set up many institutions such as the Deposit
Insurance Corporation-1962, UTI-1964, IDBI-1964, NABARD-1982, NHB-1988, etc. These
organizations develop and promote banking habits among the people. During economic
reforms it has taken many initiatives for encouraging and promoting banking in India.
8. Promotion of Export through Refinance : The RBI always tries to encourage the facilities
for providing finance for foreign trade especially exports from India. The Export-Import Bank
of India (EXIM Bank India) and the Export Credit Guarantee Corporation of India (ECGC) are
supported by refinancing their lending for export purpose.
Supervisory Functions of RBI ↓
The reserve bank also performs many supervisory functions. It has authority to regulate and
administer the entire banking and financial system. Some of its supervisory functions are given below.
1. Granting license to banks : The RBI grants license to banks for carrying its business.
License is also given for opening extension counters, new branches, even to close down
existing branches.
2. Bank Inspection : The RBI grants license to banks working as per the directives and in a
prudent manner without undue risk. In addition to this it can ask for periodical information
from banks on various components of assets and liabilities.
3. Control over NBFIs : The Non-Bank Financial Institutions are not influenced by the working
of a monitory policy. However RBI has a right to issue directives to the NBFIs from time to
time regarding their functioning. Through periodic inspection, it can control the NBFIs.
4. Implementation of the Deposit Insurance Scheme : The RBI has set up the Deposit
Insurance Guarantee Corporation in order to protect the deposits of small depositors. All bank
deposits below Rs. One lakh are insured with this corporation. The RBI work to implement the
Deposit Insurance Scheme in case of a bank failure.
Reserve Bank of India's Credit Policy ↓
The Reserve Bank of India has a credit policy which aims at pursuing higher growth with price
stability. Higher economic growth means to produce more quantity of goods and services in different
sectors of an economy; Price stability however does not mean no change in the general price level but
to control the inflation. The credit policy aims at increasing finance for the agriculture and industrial
activities. When credit policy is implemented, the role of other commercial banks is very important.
Commercial banks flow of credit to different sectors of the economy depends on the actual cost of
credit and arability of funds in the economy.
Download E-book With Latest Functions of RBI ↓
To read latest functions of RBI, please download official free e-book published by RBI. This free e-book
is a pdf document compressed in a Rar file (8.92 MB). To extract and read this PDF document, you'll
need 'Winrar' and 'Adobe Acrobat Reader' softwares (both are free) installed on your computer.
Credit rationing refers to the situation where lenders limit the supply of additional credit to borrowers
who demand funds, even if the latter are willing to pay higher interest rates. It is an example of market
imperfection, or market failure, as the price mechanism fails to bring about equilibrium in the market. It
should not be confused with cases where credit is simply "too expensive" for some borrowers, that is,
situations where the interest rate is deemed too high. On the contrary, the borrower would like to
acquire the funds at the current rates, and the imperfection refers to the absence of equilibrium in spite
of willing borrowers. In other words, at the prevailing market interest rate, demand exceeds supply, but
lenders are not willing to either loan more funds, or raise the interest rate charged, as they are already
maximising profits.
Three main types of credit rationing can usually be distinguished:
The most basic form of credit rationing occurs if the borrower cannot provide sufficient collateral.
Collateral is important because repayment promises are not credible per se. Therefore, lenders require
mortgages, reservations of property rights, or security assignments as collateral. Plunges in collateral
values enhance credit rationing.
"Redlining" refers to the situation where some specific group of borrowers, who share an identifiable
trait, cannot obtain credit with a given supply of loanable funds, but could if the supply were increased.
More importantly, they would not be able to get loans even if they were willing to pay higher interest
rates.
"Pure credit rationing" refers to the situation where, within an observationally indistinguishable group,
some obtain credit, while others do not, and will not receive credit even if they are willing to pay a
higher interest rate.A third and less interesting type is disequilibrium credit rationing, which is a
temporary feature of the market, due to some friction preventing clearing.
Open market operations (OMOs)--the purchase and sale of securities in the open market by a central bank--are a key tool used by the Federal Reserve in the implementation of monetary policy. The short-term objective for open market operations is specified by the Federal Open Market Committee (FOMC). OMOs are conducted by the Trading Desk at the Federal Reserve Bank of New York. The range of securities that the Federal Reserve is authorized to purchase and sell is relatively limited. The authority to conduct OMOs is found in section 14 of the Federal Reserve Act.
The Federal Reserve Bank of New York publishes a detailed explanation of OMOs each year in its Annual Report.
OMOs can be divided into two types: permanent and temporary. Permanent OMOs are generally used to accommodate the longer-term factors driving the expansion of the Federal Reserve's balance sheet--primarily the trend growth of currency in circulation. Permanent OMOs involve outright purchases or sales of securities for the System Open Market Account (SOMA), the Federal Reserve's portfolio. Temporary OMOs are typically used to address reserve needs that are deemed to be transitory in nature. These operations are either repurchase agreements (repos) or reverse repurchase agreements (reverse repos or RRPs). Under a repo, the Trading Desk buys a security under an agreement to resell that security in the future. A repo is the economic equivalent to a collateralized loan, in which the difference between the purchase and sale prices reflects interest.
The Federal Reserve Bank of New York publishes details on its website of all permanent and temporary operations.
Permanent Open Market Operations
Temporary Open Market Operations
Each OMO affects the Federal Reserve's balance sheet; the size and nature of the effect depends on the specifics of the operation. The Federal Reserve publishes its balance sheet each week in the H.4.1 statistical release, "Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Reserve Banks." The release separately reports securities held outright, repos, and reverse repos.
Before the global financial crisis, the Federal Reserve used OMOs to adjust the supply of reserve balances so as to keep the federal funds rate--the interest rate at which depository institutions lend reserve balances to other depository institutions overnight--around the target established by the FOMC. The Federal Reserve's approach to the implementation of monetary policy has evolved considerably since the financial crisis, and particularly so since late 2008 when the FOMC established a near-zero target range for the federal funds rate.
An open market operation (OMO) is an activity by a central bank to give (or take) liquidity in its currency
to (or from) a bank or a group of banks. The central bank can either buy or sell government bonds in the
open market (this is where the name was historically derived from) or, which is now mostly the
preferred solution, enter into a repo or secured lending transaction with a commercial bank: the central
bank gives the money as a deposit for a defined period and synchronously takes an eligible asset as
collateral. A central bank uses OMO as the primary means of implementing monetary policy. The usual
aim of open market operations is - asides from supplying commercial banks with liquidity and
sometimes taking surplus liquidity from commercial banks - to manipulate the short-term interest rate
and the supply of base money in an economy, and thus indirectly control the total money supply, in
effect expanding money or contracting the money supply. This involves meeting the demand of base
money at the target interest rate by buying and selling government securities, or other financial
instruments. Monetary targets, such as inflation, interest rates, or exchange rates, are used to guide this
implementation.
SETTLEMENT OF FOREIGN EXCHANGE TRANSACTIONS:
Settlements of Foreign Exchange Transactions are made through the following accounts: -
1) NOSTRO Account: Our Account with you;
ex: The account maintained by an Authorised Dealer with a foreign bank is called "NOSTRO" Account or "Our Account with You". When an instrument like a cheque or an export bill is purchased the same is sent to the overseas bank (correspondent) for realisation, the amount is collected and credited to Authorised Dealer’s account with them.
Similarly, when a draft is issued on a banks foreign correspondent it will be paid at the overseas centre by debiting the NOSTRO Account of the issuing bank.
2) VOSTRO Account: Your Account with us
Ex.: Foreign banks (Correspondents) also maintain accounts with any bank in India in Indian
Rupees for the purpose of settling their rupee transactions and these accounts are called
"VOSTRO" Accounts meaning "Your Account with us".
3) LORO Account: Their account with them
Ex.: Just like State bank Of India maintaining an account with foreign correspondent say BTC, New York, Canara Bank may also maintain a Nostro Account with them. When SBI advises BTC New York for transfer of funds to Canara Bank Account with them, Canara Bank Account is titled as Loro Account "i.e. their account with you".
Credit control is most important function of Reserve Bank of India. Credit control in the economy is
required for the smooth functioning of the economy. By using credit control methods RBI tries to
maintain monetary stability. There are two types of methods: Quantitative control to regulates the
volume of total credit. Qualitative Control to regulates the flow of credit Here is a brief description of
the quantitative and qualitative measures of credit control used by RBI.
Quantitative Measures The quantitative measures of credit control are as follows: Bank Rate Policy The
bank rate is the Official interest rate at which RBI rediscounts the approved bills held by commercial
banks. For controlling the credit, inflation and money supply, RBI will increase the Bank Rate. Open
Market Operations Open Market Operations refer to direct sales and purchase of securities and bills in
the open market by Reserve bank of India. The aim is to control volume of credit. Cash Reserve Ratio
Cash reserve ratio refers to that portion of total deposits in commercial Bank which it has to keep with
RBI as cash reserves. Statutory Liquidity Ratio SLR refers to that portion of deposits with the banks which
it has to keep with itself as liquid assets(Gold, approved govt. securities etc.) If RBI wishes to control
credit and discourage credit it would increase CRR & SLR. Qualitative Measures Qualitative measures are
used by the RBI for selective purposes. Some of them are Margin requirements This refers to difference
between the securities offered and amount borrowed by the banks. Consumer Credit Regulation This
refers to issuing rules regarding down payments and maximum maturities of instalment credit for
purchase of goods. RBI Guidelines RBI issues oral, written statements, appeals, guidelines, warnings etc.
to the banks. Rationing of credit The RBI controls the Credit granted / allocated by commercial banks.
Moral Suasion Psychological means and informal means of selective credit control. Direct Action This
step is taken by the RBI against banks that don’t fulfil conditions and requirements. RBI may refuse to
rediscount their papers or may give excess credits or charge a penal rate of interest over and above the
Bank rate, for credit demanded beyond a limit.
I.Quantitative Method:
(i)Bank Rate:
The bank rate, also known as the discount rate, is the rate payable by commercial banks on the loans
from or rediscounts of the Central Bank. A change in bank rate affects other market rates of interest. An
increase in bank rate leads to an increase in other rates of interest and conversely, a decrease in bank
rate results in a fall in other rates of interest.
A deliberate manipulation of the bank rate by the Central Bank to influence the flow of credit created by
the commercial banks is known as bank rate policy. It does so by affecting the demand for credit the
cost of the credit and the availability of the credit.
An increase in bank rate results in an increase in the cost of credit; this is expected to lead to a
contraction in demand for credit. In as much as bank credit is an important component of aggregate
money supply in the economy, a contraction in demand for credit consequent on an increase in the cost
of credit restricts the total availability of money in the economy, and hence may prove an anti-
inflationary measure of control.
Likewise, a fall in the bank rate causes other rates of interest to come down. The cost of credit falls, i. e.,
and credit becomes cheaper. Cheap credit may induce a higher demand both for investment and
consumption purposes. More money, through increased flow of credit, comes into circulation.
A fall in bank rate may, thus, prove an anti-deflationary instrument of control. The effectiveness of bank
rate as an instrument of control is, however, restricted primarily by the fact that both in inflationary and
recessionary conditions, the cost of credit may not be a very significant factor influencing the
investment decisions of the firms.
(ii)Open Market Operations:
Open market operations refer to the sale and purchase of securities by the Central bank to the
commercial banks. A sale of securities by the Central Bank, i.e., the purchase of securities by the
commercial banks, results in a fall in the total cash reserves of the latter.
A fall in the total cash reserves is leads to a cut in the credit creation power of the commercial banks.
With reduced cash reserves at their command the commercial banks can only create lower volume of
credit. Thus, a sale of securities by the Central Bank serves as an anti-inflationary measure of control.
Likewise, a purchase of securities by the Central Bank results in more cash flowing to the commercials
banks. With increased cash in their hands, the commercial banks can create more credit, and make
more finance available. Thus, purchase of securities may work as an anti-deflationary measure of
control.
The Reserve Bank of India has frequently resorted to the sale of government securities to which the
commercial banks have been generously contributing. Thus, open market operations in India have
served, on the one hand as an instrument to make available more budgetary resources and on the other
as an instrument to siphon off the excess liquidity in the system.
(iii)Variable Reserve Ratios:
Variable reserve ratios refer to that proportion of bank deposits that the commercial banks are required
to keep in the form of cash to ensure liquidity for the credit created by them.
A rise in the cash reserve ratio results in a fall in the value of the deposit multiplier. Conversely, a fall in
the cash reserve ratio leads to a rise in the value of the deposit multiplier.
A fall in the value of deposit multiplier amounts to a contraction in the availability of credit, and, thus, it
may serve as an anti-inflationary measure.
A rise in the value of deposit multiplier, on the other hand, amounts to the fact that the commercial
banks can create more credit, and make available more finance for consumption and investment
expenditure. A fall in the reserve ratios may, thus, work as anti-deflationary method of monetary
control.
The Reserve Bank of India is empowered to change the reserve requirements of the commercial banks.
The Reserve Bank employs two types of reserve ratio for this purpose, viz. the Statutory Liquidity Ratio
(SLR) and the Cash Reserve Ratio (CRR).
The statutory liquidity ratio refers to that proportion of aggregate deposits which the commercial banks
are required to keep with themselves in a liquid form. The commercial banks generally make use of this
money to purchase the government securities. Thus, the statutory liquidity ratio, on the one hand is
used to siphon off the excess liquidity of the banking system, and on the other it is used to mobilise
revenue for the government.
The Reserve Bank of India is empowered to raise this ratio up to 40 per cent of aggregate deposits of
commercial banks. Presently, this ratio stands at 25 per cent.
The cash reserve ratio refers to that proportion of the aggregate deposits which the commercial banks
are required to keep with the Reserve Bank of India. Presently, this ratio stands at 9 percent.
II.Qualitative Method:
The qualitative or selective methods of credit control are adopted by the Central Bank in its pursuit of
economic stabilisation and as part of credit management.
(i)Margin Requirements:
Changes in margin requirements are designed to influence the flow of credit against specific
commodities. The commercial banks generally advance loans to their customers against some security
or securities offered by the borrower and acceptable to banks.
More generally, the commercial banks do not lend up to the full amount of the security but lend an
amount less than its value. The margin requirements against specific securities are determined by the
Central Bank. A change in margin requirements will influence the flow of credit.
A rise in the margin requirement results in a contraction in the borrowing value of the security and
similarly, a fall in the margin requirement results in expansion in the borrowing value of the security.
(ii)Credit Rationing:
Rationing of credit is a method by which the Central Bank seeks to limit the maximum amount of loans
and advances and, also in certain cases, fix ceiling for specific categories of loans and advances.
(iii)Regulation of Consumer Credit:
Regulation of consumer credit is designed to check the flow of credit for consumer durable goods. This
can be done by regulating the total volume of credit that may be extended for purchasing specific
durable goods and regulating the number of installments through which such loan can be spread.
Central Bank uses this method to restrict or liberalise loan conditions accordingly to stabilise the
economy.
(iv)Moral Suasion:
Moral suasion and credit monitoring arrangement are other methods of credit control. The policy of
moral suasion will succeed only if the Central Bank is strong enough to influence the commercial banks.
In India, from 1949 onwards, the Reserve Bank has been successful in using the method of moral suasion
to bring the commercial banks to fall in line with its policies regarding credit. Publicity is another
method, whereby the Reserve Bank marks direct appeal to the public and publishes data which will have
sobering effect on other banks and the commercial circles.
Effectiveness of Credit Control Measures:
The effectiveness of credit control measures in an economy depends upon a number of factors. First,
there should exist a well-organised money market. Second, a large proportion of money in circulation
should form part of the organised money market. Finally, the money and capital markets should be
extensive in coverage and elastic in nature.
Extensiveness enlarges the scope of credit control measures and elasticity lends it adjustability to the
changed conditions. In most of the developed economies a favourable environment in terms of the
factors discussed before exists, in the developing economies, on the contrary, economic conditions are
such as to limit the effectiveness of the credit control measures.
The most important function of the Central Bank is to control credit. The Central Bank uses various
methods to control credit. This method can be classified into two broad categories. They are:
Methods of Credit Controls
Quantitative Methods
1. Bank rate policy
2. Open market operations
3. Variation of cash reserve ratio
4. 'Repo' or Repurchase Transactions
Qualitative Methods
1. Fixation of margin requirements
2. Rationing of credit
3. Regulation of consumer credit
4. Controls through directives
5. Moral suasion
6. Publicity
7. Direct action
Let us discuss these methods one by one.
Quantitative Methods of Credit Control
The quantitative methods of credit control are the general and traditional methods. They aim at the
regulation of the quantity of credit and not its application in various uses. They are expected to control
and adjust the total quantity of deposits created by the commercial banks.
They relate to the volume in general. These methods are indirect in nature. The objectives of quantitative
methods of credit control are as follows:
(i) Controlling the volume of credit in the economy.
(ii) Maintaining equilibrium between saving and investment in the economy.
(iii) Maintaining the stability in exchange rates.
(iv) Correcting disequilibrium in the balance of payments of the country.
(v) Removing shortage of money in the money market.
The important methods under this category are, 1. Bank Rate Policy
It is also known as discount rate policy. Bank rate is the rate at which the Central Bank is prepared to
rediscount the approved bills or to lend on eligible paper.
This weapon can be used independently or along with other weapon. By changing this rate the Central
Bank control the volume of credit. The bank rate is raised in times of inflation and is lowered in times of
deflation.
A rise in the bank rate is usually preceded by the following events:
(i) Over supply of money and rising price level.
(ii) Great demand for money caused by active trade.
(iii) Adverse rate of exchange, and
(iv) Unfavorable balance of trade.
In times of adverse balance of payments and rising price level, the Central Bank increases the bank rate
and thereby forces the market rates to go up. Because of this, credit becomes dear and borrowing from
banks becomes costly. The speculators are discouraged to buy and stock goods.
They start selling their stock of goods in the market, and the prices take a downward trend. Exports begin
to rise and the imports decline. Foreign investors are encouraged to keep their cash balances within the
county so as to earn the increased rate of interest. The adverse balance of payments gradually disappears.
A rise in bank rate has the following consequences:
There is a corresponding rise in the market rate that is, the rate charged by financial institution.
The prices of fixed interest bearing securities tend to register a decline because the interest rate ruling in
the market would be higher than the rate originally fixed on such securities.
A shift in investments from fixed interest bearing securities to equities results in a rise in the prices of the
latter, especially, shares of growing companies.
There is shrinkage in investment on capital assets due to the shortage of finances.
Fall in the prices of consumer commodities due to less spending and the unloading of stocks.
Transference of foreign money into the country due to the high rates of interest ruling and the consequent
improvement in the foreign exchange position.
Increase in exports.
But in times of falling prices, the Central Bank lowers the bank rate and brings about a fall in the market
rates of interest. This will lead to increased volume of trade, investment, production and employment and
ultimately leads to the rise in the price level.
Conditions for the Operation of Bank Rate Policy
To use the weapon of bank rate policy some basic requirements are to be fulfilled. The impact of a change
in the Bank rate depends upon the following:
(i) Existence of close nexus between Bank Rate and market rates, i.e., the extent of the dependence of
commercial banks on the Central Bank for funds.
(ii) The availability of funds to banks from other sources.
(iii) The extent to which other interest rates are directly influenced by changes in the bank rate. If the
other rates of interest in the market do not respond to bank rate changes desired results cannot be
realized.
(iv) The degree of importance attached to a change in the bank rate as an indicator of the monetary policy.
(v) There must be an organized short-term funds market in the country
(vi) There must be a great measure of elasticity in the economic structure of the country. When prices fall,
the various elements in the cost of production like wages citations of Bank Rate Policy
The report of Macmillan Committee stated that the bank rate policy is an absolute essay for the sound
management of a monetary system. It is an important weapon of edit control."But, it suffers from the
following limitations:
(i) The rate of interest in money market may not change according to the changes in the bank rate.
(ii) In rigid economic system, i.e., planned and regulated economies, the prices and costs may not change
as a result of changes in the rate of interest.
(iii) The bank rate cannot be the sole regulator of the economic system, and the volume of savings and
investments cannot be controlled through the rate of interest alone. The effectiveness of changes in
interest rate depends upon the elasticity of demand for capital goods.
(iv) The effect of rise in the bank rate in controlling credit for industrial and commercial purpose is
limited. If the businessmen take the view that prices will continue to rise, a slight rise in the rate of
interest will not discourage them to expand their activity with borrowed money. So long as prices have a
tendency to rise and so long as there is business optimism, businessmen would be willing to pay higher
interest rates.
(v) In ties of depression, a fall in the rate of interest can hardly stimulate economic activity. Because the
businessmen may not be prepared to increase their activity if they fear about the future. Prof. Sayers
considers the bank rate as a halting, clumsy and indeed a brutal instrument.
(vi) The change in the methods of financing by the business firms reduces the importance of bank rate
policy In recent years the commercial banks have ample liquid resources of their own. The business firms
depend more on sloughing back of profits than borrowing from commercial banks.
(vii) The conflicting effects of bank rate also reduce the importance of this weapon. When the bank rate is
increased the foreign capital may flow into the country, thus, making credit control difficult.
(viii) Indiscriminate nature of bank rate policy: The bank rate policy does not discriminate the activities
into productive and unproductive activities. It affects both the activities on the same footing. This will
adversely affect the genuine productive activities with increased rate of interest.
Because of these limitations, the bank rate policy has lost its importance. But during e inflationary
situations it can be used with some modifications. But it may not regain its order importance.
Open Market Operations
Open market operation refers to buying and selling of eligible securities by the Central Bank in the money
market and capital market. The buying and selling of securities by the Central Bank results in an increase
or decrease in the cash resources of the commercial banks. This in turn affects the credit creation of the
commercial banks.
Open market opera- ions tend immediately to increase or decrease the quantity of money in circulation
and the ash resource of Commercial Banks.
Objectives of Open Market Operation
The weapon of open market operation helps in achieving the following objectives:
(a) To make the bank rate policy effective and successful.
(b) To avoid disturbances in the money market as a result of movement of Government funds or seasonal
movements of funds generally.
(c) To eliminate the effects of inflow or outflow of gold by import and export under Gold Standard.
(d) To support Government credit in connection with the issue of new loans or the conversion of the
existing loans.
(e) To counteract extreme trends in business situation by buying securities during periods of low
economic activity and selling them in periods of high economic activity.
(f) To create and maintain conditions of cheap money as an aid to business recovery.
(g) To avoid undue fluctuations in the prices of Government securities and to correct undesirable or
unjustifiable spreads between the yields of various types of securities.
(h) To absorb an excess of liquid funds.
(i) To insulate the credit structure from sudden and temporary changes in the balances of payments
position.
The most important reason is the decline of discount rate as an instrument of credit control and the
consequent need for another and more direct method.
Open market operations became necessary in order to implement the policy of cheap money. These
operations have been considerably facilitated as a result of increased volume and variety of Government
and other gilt-edged securities traded in markets of most countries.
Method of Operation
If the Central Bank wants to reduce the volume of credit created by the banks, it sells eligible securities in
the market. When the banks and the public purchase these securities, they have to make payments to the
Central Banks.
This results in the movement of cash from Commercial Banks to Central Bank. As a result of this the
primary reserves of the banks fall. Hence, the capacity of the banks to expand credit will be contracted. In
times of inflation the Central Bank sells eligible securities in the open market.
When the Central Bank wants to expand the volume of credit, it starts buying the approved securities
from the open market. Now, the Central Bank has to make payments to the commercial banks and the
public for the purchases made from them.
This result in the movement of cash from the Central Bank to commercial banks. As a result, the cash
reserves in the hands of commercial banks will increase. They find themselves in a position to expand
credit. This is followed during deflationary situations.
Prerequisites for the Success of Open Market Operations
(a) The market for the securities should be well organized, deep, active and broad based.
(b) The rate of interest offered on government securities should be competitive.
(c) The existence of sufficient number of securities.
(d) The willingness of commercial banks to lend.
(e) The maintenance of rigid cash reserve ratio by the commercial banks.
(f) Willingness of the general public to borrow money from the commercial banks.
(g) Commercial banks should not have direct access to accommodation "from the Central Bank.
Limitations of Open Market Operations
The following are the main limitations of the open market operations.
(i) Quantity of money circulation may not change:
It depends upon the close connection that prevails between the operations and the quantity of money in
circulation. Quantity of money should at least approximately change according to operations. But in
actual practice it may not change in the desired direction due to two factors, such as hoarding and
dishoarding of cash and inflow and outflow of capital, etc.
(ii) Influence of economic and political reasons:
It is assumed that the commercial banks increase or decrease their loans and advances in accordance with
the changes in their cash reserves. But they may not do so due to monetary, economic and political
reasons. Even though there is an increase in their cash reserves, they may not expand the credit for want
of credit-worthy borrowers.
(iii) Pessimistic approach of Businessmen affects the operations:
The demand for bank credit cannot be wholly controlled by commercial banks or by the Central Bank, but
it depends upon the actions if the businessmen. The Central Bank may buy securities and increase the
cash base of the commercial banks. The commercial banks may be willing to expand credit. But the
businessmen may not borrow if they are pessimistic about the future.
(iv) Not effective in developing countries:
The effectiveness of open market operations depends upon the existence of a broad and active securities
market, in short-term as well as long-term securities. But such markets are to be found only in advanced
countries. However, the increased ' ovum of treasury bills in many countries are proving helpful for
effective open market options.
(v) Dependence of resources of the Central Bank:
The Central Bank must be capable of launching operations on the necessary scale, which depends upon its
resources. The resources of the Central Bank in turn depend upon its constitution and the policy of its
Government.
(vi) Lacks immediate effect: The additional cash put into the money market by the Central Bank by
purchasing of securities will not come to the commercial banks immediately as deposits. It takes time to
reach the commercial banks. Therefore the effect of this weapon may not be immediate due to this time
lag.
Variation of Cash Reserve Ratios
The weapon of variation of cash reserve ratios has been suggested as a supplement to other methods of
credit control because of its efficacy under all conditions. The commercial banks have to keep a minimum
cash reserve with the Central Bank.
Under this method, the Central Bank has the power to vary the percentage of deposits that must
statutorily be kept with it by commercial banks, within certain limits. When the Central Bank wants to
reduce credit, it will increase the cash ratio to be kept by the commercial banks.
This reduces the capacity of the commercial banks to lend and thus, the credit creation is controlled.
When the Central Bank considers increasing the credit, it will lower the cash reserve ratio. Now the
commercial banks will nave additional cash which will lead to credit expansion.
In India the Cash Reserve Ratio has become an important tool to control or expand liquidity position with
the banking system. When excess liquidity is available with banks the CRR is hiked to impound excess
cash. Similarly, this rate is also used to stabilize Exchange Rate of Rupee.
When Exchange Rate of Rupee comes under attack from speculators, CRR is raised to arrest the fall in
value of Rupee. The CRR is often changed these days.
However, the rate is drastically reduced in recent times. In April 1999, it stood at 10.5 per cent for
commercial banks. In May 1999, it was reduced by 0.5 per cent and stood at 10.0 per cent and in
November 1999 it was further decided to 9 per cent of net demand and time liabilities of banks.
Limitations of Variations of Cash Reserve Ratios
The method of variation of reserve ratio suffers from the following limitations:
(a) This method may not be successful and effective if the commercial banks have excess cash reserves
with them.
(b) The success of this method depends upon the customer's willingness to borrow from the banks. If they
are not willing to borrow the credit cannot be expanded even if the commercial banks have adequate cash
reserves with them.
(c) This method imposes an increased burden on the credit system. Under this system the commercial
banks follow very cautious activities and many not extend credit facilities even if they have surplus
reserves due to the fear that they may be asked to maintain higher cash reserves than before.
This results in keeping idle cash reserves. Keeping such idle cash balances leads to higher rate of interest
on bank advances and the burden ultimately falls on the borrowers.
(d) Discriminatory in effect that banks have to keep a certain percentage of cash reserves with the Central
Bank. And the percentage may vary depending upon the policy of the Central Bank. This causes serious
effects on small banks which find it difficult to maintain additional reserves.
(e) This method lacks flexibility. It cannot be well adjusted to meet sectoral requirements or localized
situations of reserve stringency or surplus.
(f) This method is inexact and creates uncertainty because the commercial banks are always under certain
fear of sudden changes in the cash reserves that they have to keep with the Central Bank.
(g) The weapon of variation of cash reserves gives a sweeping power to central bank over commercial
banks. It is actually a very powerful weapon, but it may cause much suffering if it is not used properly.
(h) The variation of cash reserve ratio is a powerful weapon. A slight change in the cash reserve may lead
to either multiple expansion or contraction of credit. Thus, it is suitable only when it is desired to effect
major charges in the reserves of the commercial banks. But when marginal adjustments in the reserves
are expected, this method is not suitable.
Variation of Cash Reserve Ratio vs. Open Market Operations
Variation of cash reserves is superior to open market operations in the following respects:
(a) The success of open market operations depends upon the existence of a broad and developed capital
market and a large supply of Government securities with the Central Bank to conduct such operations on
an extensive scale.
In countries where open market operations cannot be carried out on an extensive scale due to the absence
of these conditions, the variation of cash reserves has an increasing influence on the Central Bank.
(b) The large scale sale of securities by the Central Bank as a part of open market operations policy will
depress the value of securities and bring loss to the Central Bank. If the values of securities fall,
commercial banks also incur loss as their portfolio consists of a large volume of government securities.
The variation of cash reserves secures the same results as open market operations but without the loss
that may arise in dealing in securities. When commercial banks are asked by the Central Bank to increase
the percentage of reserves, they may of course sell securities for maintaining increased case reserve.
In order that the sale of Government securities by commercial banks does not depress its price realization,
the central bank may simultaneously buy such securities. It may however be stated that this method may
help commercial banks to avoid incurring losses in the sale of securities, it may not serve the objective of
the central bank,
(c) Another limitation of open market operations is that the cash reserves of commercial banks may be so
excessive that Central Bank may not be able to reduce them by selling securities available with it but a
change in reserve requirements achieve the result easily with a mere change in the reserve rate,
(d) Whenever the Central Bank conducts open market purchase of securities, the volume of earning assets
held by the banks in their portfolio is reduced. Variable reserve ratios do not affect the earning assets of
banks unless banks sell securities to increase their reserves.
(e) The new method of credit control can be adopted to strengthen the Central Banking control under
highly liquid monetary conditions or conversely under conditions of severe credit stringency.
It has been suggested that open market operations and variation of cash ratios should be followed as
complementary to each other. A judicious combination of both will remedy the defects of each technique
when used individually, and produce good results.
Repo' Transactions
'Repo' stands for repurchase. 'Repo' or Repurchase transactions are undertaken by the central bank to
influence money market conditions. Under 'Repo' transaction or agreement one party lends money to
another for a fixed period against the collateral of securities approved for this purpose.
At the end of the fixed period, the borrower will repurchase the securities at the predetermined price. The
difference between the repurchase price and the original sale price will be the cost for the borrower.
In other words, instead of a pure or simple borrowing of funds, the borrower parts with securities to the
lender with an agreement to repurchase at the end of the fixed period. This parting with the securities will
make the cost of borrowing, known as 'Repo Rate' little cheaper than pure borrowing.
'Repo' transactions are conducted in Money market to manipulate short-term interest rate and to manage
liquidity levels. 'Repos' are conducted by central banks to absorb or drain liquidity from the system. In
case they desire to inject fresh funds in the cash market, they will conduct 'Reverse Repo' transactions.
In the reverse repo 'the securities are received first against money paid and returned after receipt of
money, at the end of the agreed period. In India, 'Repos' are normally conducted for a period of 3 days.
The eligible securities for the purpose are decided by RBI. These securities are usually Government
promissory notes, Treasury bills and some public sector bonds.
Qualitative Methods of Credit Control
The qualitative credit control is also called as selective credit control. It is used as an adjunct to general
credit control. In certain situations quantitative credit control may not be helpful. At times it may harm
certain sectors of the economy.
Because, the quantitative methods control the volume of credit in total, it does not discriminate the credit
flow into productive and unproductive purposes. Thus, it affects the genuine productive purposes also.
But, the selective credit control provides for such discrimination.
Under these methods the credit is made available for the productive and priority sectors and restricted to
others. This is very much helpful to the developing and underdeveloped economies.
Selective Credit Control
The selective credit control methods control certain types of credit and not all credit. They directly affect
the demand for bank credit as also the capacity of the banks to lend. They can be used more effectively
without any changes in the prevailing rates of interest.
Objectives of Selective Credit Control
a) The following are the main objectives of selective credit control measures:
b) To distinguish between essential and non-essential uses of bank credit.
c) To ensure adequate credit to the desired sectors and curtail the flow of credit to less essential economic
activities.
d) To control the consumer credit used for purchase of durable consumer goods.
e) To control a particular sector of the economy without affecting the economy as a whole.
f) To correct the unfavorable balance of payments of the country.
g) To control the inflationary pressures in the particular and important sector of the economy.
h) To control the credit created by other institutions.
Methods of Selective Credit Control
The Central Bank uses the following qualitative methods to control the credit in the economy:
1. Fixation of margin requirements:
The Central Bank prescribes the margin which banks and other lenders must maintain for the loans
granted by them against commodities, stocks and shares. To restrict the speculative dealing in stock
exchanges, the Central Bank prescribes the margin requirements for securities dealt with.
When the Central Bank prescribes higher margin the borrowers can obtain less amount of credit on his
stock. If the margin prescribed is low, the speculators can borrow from bankers buy the commodity,
storage and sell only after price rise. To contract credit, the Central Bank raises margins and lowers the
margins to expand the credit available.
Objectives of Margin Requirements
The Central Bank may prescribe margin requirements to achieve the following objectives:
(i) To divert investible funds from speculative to productive lines.
(ii) To reduce the volume of credit created by commercial banks.
(iii) To reduce the prospect of making speculative profits in stock exchanges.
(iv) To reduce the risks and uncertainties of joint stock companies by maintaining the stability of stock
prices.
2. Rationing of credit:
The Central Bank controls the credit created by the banks through the rationing of credit. Under this
method, the Central Bank fixes a maximum limit for loans that a commercial bank can provide to a
particular sector or for all purposes. This can be achieved through the following two methods:
(i) Variable portfolio ceiling:
Under this method, the Central Bank fixes a ceiling on the aggregate portfolios of commercial banks above
which loans and advances should not be increased. It may even fix a ceiling for specific categories of
credit. It may also fix a maximum limit for the loans that the commercial banks can borrow from the
Central Bank.
(ii) Variable capital assets ratio:
Under this method, the Central Bank can fix the minimum ratios which the capital and surplus of banks
must bear to the volume of assets or specific categories thereof of the commercial banks. The Central
Banks can change such minimum ratio from time to time. Rationing of credit can play a great role in
planned economies.
It secures diversion of commercial resources into the channels fixed by the public authority in achieving
the objectives of planning.
3. Regulation of consumer credit:
The Central Bank to regulate the consumer credit, fixes the down payments and the period over which the
installments are spread. In developed countries, large portion of national income is spent on consumer
durable goods such as cars, refrigerators, costly furniture, etc.
The installment credit for consumer durable goods plays an important part in certain economies.
Expansion of such credit affects the developed economies adversely. Many countries have adopted this
weapon to control credit allowed to the consumers.
It is essential to regulate consumer expenditure on such durable goods to control inflations. The method
of control involves the following steps.
Steps involved in Controlling Consumer Credit
1. The scope of regulation with respect to particular consumer durable goods will have to be defined.
2. Fix the minimum down payment.
3. The length of the period over which installment payments may be spread will have to be fixed.
4. The maximum cost of installment purchases exemptions have to be prescribed.
Effect of Control
To control inflation a large number of durable goods will be listed for control, the minimum down
payments will be raised, the period over which installment payment can be spread will be reduced and
finally the maximum exemption costs will be lowered.
4. Control through Directives:
The Central Bank issues directives to control the credit created by commercial banks. The directives may
be in the form of written orders, warnings or appeals, etc. Through such directives the Central Bank aims
to achieve the following objectives:
(i) To control the lending policies of the commercial banks.
(ii) To prevent the flow of bank credit into non-essential lines.
(iii) To divert the credit to productive and essential purposes.
(iv) To fix maximum credit limits for certain purposes.
The Central Bank issues directives from time to time and the commercial banks abide
5. Moral Suasion:
Under this method, the Central Bank merely uses its moral influence on the commercial banks. It includes
the advice, suggestion request and persuasion with the commercial banks to co-operate with the Central
Bank.
If the commercial banks do not follow the advice extended by the Central Bank, no penal action is taken
against them. The success of this method depends upon the co-operation between the Central Bank and
Commercial Banks and the respect the Central Bank commands from other banks.
6. Publicity:
The Central Banks generally use the method of publicity to control the credit creation of commercial
banks. Under this method, the Central Bank gives wide publicity to its credit policy through its bulletins.
By this, the Central Bank educates the general public regarding the monetary policy and its objectives.
Through such publicity, the commercial banks are guided and change their lending policies accordingly.
7. Direct Action:
The method of direct action is the most effective weapon of Central Bank to control credit creation. The
Central Bank uses this method to enforce both quantitative and selective credit controls. It is used as a
supplement to other methods of credit control.
The Central Bank can take action against the banks which contravene its instructions. But this method
may lead to conflict between the central bank and commercial banks.