Principles and Practice of Banking

PRINCIPLES AND

PRACTICE OF BANKING

Reserve Bank of India

(RBI)

Organization and Management

and Its Role

1. RBI : Historical

Back-Drop



Earliest Initiative

: First attempt to set up Govt. Bank

in 1773 by then Governor of West Bengal East India Co.

Imperial Bank – 1921

:

Amalgamation of three

Presidency Banks into Imperial Bank – Became Govt.

Banker and Issue and control of currency.



Hilton Young Commission (Royal Commission

on Indian Currency and Finance) – 1926

:

Recommended setting up of The RBI for Central Bank

functions. Recommendations reinforced by Central

Banking Enquiry Committee-1931



Establishment of The RBI:

The Reserve Bank of

India Act-1934

enacted and RBI set up on April 1, 1935

as private bank with initial paid up capital of Rs.5crore.

Nationalization of RBI:

After Independence

RBI

nationalized under amended The RBI Act -1948

2

. Objectives

Preamble of RBI:

Preamble of RBI Act-1934 lay down

the objective of RBI “ to regulate the issue of Bank

Notes and Keeping of Reserves with a view to securing

monetary stability in India and generally operate the

currency and credit system of the country to its

advantage.”

Other objectives

:



Remain free from political influence.



Discharge central banking functions in the money

market



Assist the planned process of development of the

Indian economy.



Promotion of monetization and monetary integration of

the economy.

RBI by act to perform all the functions of

central bank

together with

developmental

and

promotional functions

3. Composition of Indian

Banking System

Indian Banking System

Reserve Bank of India

Scheduled Commercial Banks Scheduled Cooperative Banks

Public Sector Banks-27 Private sector Banks-37 Foreign Banks in India-40 Regional Rural Banks-196 S. Urban Coop. Banks-52 S. State Coop. Banks-16 Nationalized Banks -19 State Bank of India its Subsidiaries-8 Old Private

Banks-22 New Private Banks-8

4. Governing Body

Central Board: Consist of 20 Directors including Governor

as Chairman, Deputy Governors not more than four, 14

Directors out of which four – one each from Local

Board and one Government Official nominated by

Central Government. Entrusted with responsibility of

policy making, general supervision and direction of

affairs and business of Reserve Bank.

Local Board: Four Local Boards for Four Regions:

Western with Head quarters in Mumbai, Eastern with

Kolkata, Northern with New Delhi and Southern with

Chennai. Consist of Five Directors appointed by Central

Govt. for four years. They represent territorial and

economic interests of local cooperatives and

indigenous banks. Advise Central Board on matters of

local importance.

Governor: Chairman of Board as well as the Chief

Executive authority. Assisted by Deputy Governors.

Appointed for Five Years.

5

. Organizational

Structure

Banking Department

Issue Department

Department of Currency and Management

:

Department of Banking Operations and Development (DBOD

):

Responsible for supervision, control and development of commercial banking system in the country. Regulating commercial banks under regulatory provisions of The Banking Act, 1949. Fulfilling objective of promotion and development of sound and competitive banking system. Focusing on prudential regulations, licensing of new banks/foreign banks etc.,

6. Organizational

Structure (contd.)

Exchange Control Department: Controlling foreign exchange

transactions and maintaining exchange rate stability.

Rural Planning and Credit Department: District Credit Plans, Lead Bank Scheme, Financial Assistance for NABARD, Special Studies for promoting IRDP, Framing policies for rural credit/development and Microfinance.

Department of Economic Analysis and Policy: Economic Research, Reviews financial and banking conditions, Report on Currency and Finance, RBI Bulletins, Policy studies on emerging aspects of banking and economy and Annual Reports.

Other Departments: Dept. of Statistical Analysis and Computer Services, Dept. of Administration and Personnel, Legal Dept. Management Services Dept., Dept. of Non-Banking Companies, Banking Supervision, Credit Planning Cell, Dept. of External Investment and Operations, Deposit Insurance and Credit Guarantee Corporation, Industrial and Export Credit Dept., Secretary’s Dept., RBI Service Board and Human Resource Development Dept.

7. Functions of RBI

Operational Framework

–

Bank for Note Issue

:

 Sole right to issue currency notes of Rs.2 and above. One Rupee

Note and coins by MF but circulated under RBI supervision.

 All notes issued by RBI legal tender/ guaranteed by Central Govt.  Rules Governing Note Issue: Proportionate Reserve System of 40%

Gold Reserve. Since 1957, followed Minimum Reserve System – Rs.200 crore of Gold and foreign exchange of which Rs.115 crore Gold. Adopted .

 Design, form, denomination and material of notes subject to

approval by Govt.

 Currency Chests: For provision of remittance facilities to banks and

public, facilitating treasuries and bank to function by minimum

cash balance and facilitating exchange of New for old/soiled notes. 8

8. Banker to Governments

Banker to Central and State Governments:



Banking transactions of Governments

Transfer and Remittance facilities. - Maintains Current Account of Central Govt. with minimum balance of Rs.50 crore. – In places

where RBI no Branch, SBI Acts as RBI agent.

 Managing public debts (now delinked) and issue of new loans. –

Ways and Means Advances repayable within three months.

 Act as agent for Government for treasury bills and Govt. Securities.

Banks required to invest certain proportion of investment in Govt. Securities - Statutory Liquid Ratio (SLR) –Now 25 %.

 Advising Governments on financing, resource mobilization and

institutional arrangements for flow of resources for Plans.

 Advising Government on international finance, foreign trade and

foreign exchange.

 Represent Government as member of IMF, The World Bank and

9. Banker’s Bank

Banker to Scheduled Commercial Banks

:



Maintaining

Cash Reserves

– As per Act amended 1962,

Minimum of 3 percent of total liabilities (Demand and Time

Deposits).



Acting as

clearing agent

for commercial banks.



Serving as

lender of last resort

by rediscounting bills of

exchange or providing loans against eligible securities

during credit stringency. Lender of Last Resort implies:



RBI provide loans to banks which are solvent and facing

liquidity crunch.



Loans given at a penal rate of interest,



Loans given against eligible collateral security

Loans provided till such time bank turns solven

10. Foreign Exchange

Management



Custodian of country’s foreign exchange reserves

Intervenes (buying and selling) in FEM to ensure smooth and orderly exchange transactions and to promote a stable exchange rates.



Transition from FERA to FEMA

introduced in 1939 under Defense of India Rules; statutorily laid down by Foreign Exchange Regulatory Act-1947 and amended in 1973 as Foreign Exchange Regulations Act. (FERA). Now replaced by Foreign Exchange Management Act -1999 (FEMA).

Under FERA: RBI controlled collection and allocation of Foreign exchange and Fixed Exchange Rate and administer foreign exchange control.

Under FEMA: RBI authorizes Banks and authorized dealers to handle market transactions of foreign exchange.

 RBI now focuses on development of competitive FEM, Manage

Exchange Reserves and Manage stability in Exchange Rate by market intervention. No exchange control. 11

11. Development Role

Need for Development Role:

 Development of financial market: Predominance of indigenous

banks, imperfections in the financial system, promotion of monetization of economy.

 Development of economy by ensuring proper allocation of credit

among various sectors.

Developmental Role Played by RBI:

 Lead Bank Scheme: Geographical spread of Branch net work.

 Agricultural Finance/Priority Sector Advances: Role of ACD to

provide financial accommodation to cooperatives, expertise and training, Agricultural Credit Funds

 Institutional Development: IDBI, ARDC/now NABARD, Credit

Guarantee Corporation, Deposit Insurance Corporation, Regional Rural Banks(RRBs), Exim Bank., UTI, NHB, NIBM, College of Agricultural Banking.

 Training and Research: Collection of data, promote policy and

12. Regulatory Role

Objective:

Rationale/Need for Regulation

Regulatory Provisions under RBI Act:

13. Supervisory

Framework of RBI

.

RBI adopted Basel Committee -

25 core principles for

effective banking supervision.



Department of Supervision separated from DBOD in

1993. Two Departments: DBS and DNBS set up under

the Board of Financial Supervision (BFS) with Governor

as chairman in 1994.



Supervisory process

include : On-site Inspection and

Off-site Monitoring and surveillance system



On-site Inspection

: Annual Financial Inspections (AFI)

undertaken directly by RBI or external auditors, focuses

on statutory mandated areas, solvency, liquidity and

financial and operational health of the bank.



RBI identifies areas of concerns and draws up action

14. Off-site

Monitoring/Surveillance

Objective:

Modus Operandi

Banks are rated as per CAMELS Supervisory Model: C= Capital Adequacy, A= Asset Quality, M= Management , E=Earnings, L=Liquidity and S= Systems and controls for Indian Banks and CALCS Model: C=Capital Adequacy, A= Asset quality, L=Liquidity, C=Compliance and S=Systems for foreign bank branches.

Prompt Corrective Action (PCA): More focused and enforcement-oriented follow-up.

Now moving towards Risk Based Supervision (RBS): Focused on Risk profile of Banks based on BASEL Accord./norms

15. Process of making

Monetary Policy

 RBI responsible for formulating and implementing MP in India  MP is analytical, consultative and participative process –

Significant technical, analytical, institutional and dynamic inputs go into process of making MP.

 A committee of Board chaired by the Governor meets every week

to review monetary, economic and financial conditions and implementation of MP and decide course of action needed.

 A MP Strategy Group analyzes strategies on an on-going basis  MP communicated to public by way of Annual Monetary Policy

Statement of RBI Governor in April and Mid-term review in October every year.

 Monetary Policy Announcement contains in detail information on

working of economy, rationale behind the policy , targeted objectives, monetary, growth and inflationary targets, and institutional and structural aspects of policy measures.

 Periodic consultation with MF, Govt. of India, market participants,

16. Objectives of Monetary

Policy of RBI

Economic Policy Objectives: Achieve faster growth, ensure

reasonable degree price stability, and promote distributive justice

(Equity). RBI Monetary Policy be consistent with overall objectives.

Broad objectives of RBI Monetary policy :

 To maintain a reasonable degree of price stability.

 To help accelerate the rate of economic growth – ensure adequate

flow of credit to productive sectors.

Emphasis between two objectives : Changed from year to year depending on conditions prevailing in that year and previous. Whenever inflation high, price stability received more emphasis.

Equity left to Fiscal policy, Price stability helps poor and inflation hurts them most. Price stability has social dimension.

Trade-off between Inflation and Growth: Whether pursuit of objective of price stability undermines ability of economy to attain and sustain high growth. Regime of rising prices adversely affects saving and speculative investment more attractive. Regulation of money supply affects adversely allocation of credit to productive sectors and thus slow down growth. Trade off between two emphasized.

17. RBI MP Prior to Bank

Nationalization

 Financial Market highly segmented and regulated. Interest Rates

administered by RBI. Credit to commercial sector regulated; multiple lending rates and directed credit at subsidized interest.

 RBI relied on Direct Method such as Interest rate regulations, Selective Credit Control and CRR as major MP Instruments to neutralize monetary impact of Govt. Deficit and assist Govt. borrowing operations..

 Bank Rate and Open Market Operations only limited roles in

Command and control Approach.

 Nexus between MP and Fiscal Policy: MP used as an institutional arrangement for financing Govt. deficit. Practice of extending Short term credit to Central Govt. resulted in automatic monetization of fiscal deficit. With low yield, RBI residual subscriber to Govt. Securities not traded in the market. Demand for Govt. Securities created through increases in SLR. RBI Credit constituted 75% of Monetary base (Reserve Money) in 1970s increased to 92% during 1980s.

18. RBI MP after

Nationalization

 After nationalization of Banks, modus operandi for conducting MP

changed. CRR and Credit Rationing through Selective Credit Controls

became instruments with virtual exclusion of others.

 Refinance used to fill shortfall of credit targets of banks in relation to

demand.

 Interest rate structure administered rendering it inflexible and sterile as

an instrument of Monetary Policy

.

 CRR and SLR used to neutralize inflationary impact of growing deficit.

RBI Act amended: first to increase CRR from 5 percent of Demand Deposits and 2 percent of time deposits to 5 to 20 percent of Demand Deposits and 2 and 8 percent of time deposits besides Reserve up to 100 percent against incremental deposits in 1956, and in 1959 to

minimum 3 percent of all deposits and could vary 3 and 15 percent. SLR limit was fixed at 25 to 40 percent.

 Single most important instrument used to conduct monetary policy

after 1970s, increase in CRR. And SLR as source of government borrowing

19. RBI MP after Bank

Nationalization



CRR:

maximum of 15 percent. SLR, 25 percent in 1970 reached 38.5 percent in 1989. Besides 10%CRR on incremental deposits. CRR and SLR used to meet growing govt. deficits.



Credit Rationing

credit and discriminatory interest on certain loans used as instruments.



Credit Authorization Scheme (CAS):

to obtain prior approval for any credit of Rs. one crore and above for single party. Abolished in 1989 and replaced by Credit Monitoring Arrangements(CMA). RBI to monitor all loans exceeding Rs. 5crore to single party for working capital and Rs. 2crore for term loans.



Impact:

6.2 percent, and in 1970s and 1980s higher than 10 percent. High inflation and low growth. Phenomenal increase in money supply. Ultimately led to economic/banking crisis in 1990-91 20

20. Chakravarthy Committee

Recommendations

Objective: RBI in 1982 set up a committee under Chairmanship of Sukhamoy Chakravarthy with objective of evaluating various instruments of monetary policies, assessing interaction of

monetary policy and public Debt Management and recommending

appropriate measures for improving effectiveness of monetary policy.

Recommendations of Committee:

 Price Stability: Existence of multiplicity of objectives and stressed

price stability as primary objective. To achieve price Stability, Govt. should aim at raising output levels and RBI should control expansion in Reserve Money and Money Supply.

 Monetary Targeting: Stressing inter-relation between money,

output and prices, recommended formulation of monetary policy based on monetary targeting-Target for growth of money supply based on anticipated growth in output and price situation.

 RBI and Govt. evolve a policy framework on level of monetary

21. Chakravarthy Committee

Recommendations

(Contd.)

 Interest Rate Policy: Interest rate played an important role in

mobilization of savings and allocation of resources and cannot arbitrarily set. Envisaged strong supportive role in monetary regulation and recommended:

 Greater freedom for Banks in determining lending rates.

 Use of Concessional rates as distributive devise in selective basis  Positive Real Interest rates for deposits after adjustment of inflation.  Restructuring of Money Market: Strengthening of Treasury Bills

Market and Call Money Market and Commercial Bills Market in

allocation of short term resources with minimum costs and delays.

 Bank Credit Policy: Bank credit in the form of loans and bill finance

instead Cash Credit. To promote Bill financing, interest rate of 2 percent lower than Minimum Lending Rate.

 Monetary Policy: i)RBI should not depend on single instrument of

monetary policy. Ii) Adopt regulatory measures slowly so that effects not drastic. Iii) Creation of Reserve Money within limits.

22. RBI Monetary Policy:

Post-Reform Period

Multiple Indicator Approach: RBI monetary Policy undergone fundamental

change in objectives, framework and instruments. Adopted multiple indicator approach - Market based interest rates, currency availability, credit position, capital flows, fiscal state, inflation rate, exchange rate etc related to output growth with necessary flexibility to respond to changes in formulation of policy framework. Market-oriented approach instead command /control.

Monetizing Fiscal Deficits: No automatic monetization of Fiscal Deficits. Agreement between Govt. and RBI and introduction of Ways and Means

Advances to provide temporary accommodation to enable Govt. to take care of mismatch between receipts and expenditures. Government Securities

market related.

Monetary Instruments: Emphasis on market oriented instruments: OMP and market related interest rates. CRR reduced from 15 percent in 1991 to 4.5 percent in 2003. Object to reduce statutory minimum of 3 percent. SLR also brought down to statutory limit of 25 percent level . Interest rates deregulated. Bank Rate limited role.

23. RBI Monetary Policy:

Post-Reform Period

(Contd.)



Interest Rates:

operational flexibility to determine deposit and lending rates with certain restrictions for saving deposits and small loans. Interest rates for Govt. Securities linked to market

 Liquidity Adjustment Facility (LAF): RBI uses LAF as flexible

instrument for liquidity management and regulating interest rates. Along with LAF, OMOs expected to play key role in RBI MP.

 Monetary Targeting Framework: Broad Money (M3) considered for

Intermediate Target of monetary policy. Exercise focused around working out money growth strategy based on money demand

function consistent with projected GDP growth and reasonable inflation threshold.

 Transparency: Transparency in monetary policy widened and

deepened through consultation and publication of detailed results of analysis and projections. Objective: Reduction in market ‘s

uncertainty and improve understanding of conducting monetary

24. LAF as a tool of MP

 LAF: Mechanism by which RBI draws funds from money market

when surplus and infuses liquidity when short of supply. Important MP instrument to manage day to day liquidity mismatches and smoothen volatility in money market.

 LAF operates on daily basis by way of repo and reverse-repo.

Repos: Mode of borrowing where borrower sells securities with agreement to buy them back next day at a predetermined price. Difference between sale and repurchase prices indicate repo rate (interest cost of funds). In Reverse repo, lender buys securities with an agreement to sell them back at a predetermined rate.

 In auction, borrowers bids for funds indicating amount they want

to borrow and the rate willing to pay.

 Initially auctions conducted daily with one day maturity, now

multiple reo/reverse repo auctions with 3 to 7 days maturity.

 Minimum size bids reduced from Rs.10 crore to Rs.5 crore to allow

smaller operators.

25. Independence of Central

Bank

 Originally Central Banks set up by private shareholders to maintain

political independence. General opinion against any kind of state interference. Rationale for independence : State control result in mismanagement of currency and credit. If CB under state control, continuity of policies not guaranteed with changing Governments nor freedom from political bias assured.

 After Second World War, with emphasis on development, trend

towards state control of CBs. Bank policy and policy of Govt. should all times in harmony and policy subject to supreme

authority of Govt. Independent Monetary policy sometimes defeat policies of State. Coordination between two inevitable.

 With globalization and liberalization, Global trend increasingly legal

independence. Away from Govt. control. Independence means

operational freedom, accountability, transparency and creation of

executive monetary policy mechanism not Advisory one. Divesture of supervisory and quasi-fiscal functions.

26. Independence of RBI

 RBI when set up Hindu marriage between Bank of England

(dominant husband) and RBI (subservient wife), RBI to function on advisory capacity and yield Govt./BOE to determine policies.

 After Independence, Govt.- Male chauvinist husband and RBI

docile traditional wife who had forfeited minimum right of nagging the husband. RBI dwindled to quasi-fiscal agency. Monetary policy captive of fiscal stance and politics. A section of Finance Ministry. A faithful implementer of MF wishes.

 With liberalization, emphasis on operational autonomy and

transparency. No independence: Neither absolute subordination nor absolute independence status. Relationship between RBI and Govt. autonomy in operations and harmony in Policies and

coordination with Govt. in achieving development objectives.

 India has fiscal federalism but still lacks monetary federalism  Require Institutional, functional and financial independence.

Higher degree of operational freedom to pursue policy objectives independently free and fair manner without political influence.