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THE RESEVE BANK OF INDIA

Finance (RBI) Reserve Bank of India

Introduction

The central bank of any country is the apex institution of its monetary system as well as financial system because monetary system is the major constituent of the country’s financial system. This is especially true in the case of developing countries like in the as the apex body, the central bank organizes, runs, supervises, regulate and develops the monetary system and thus the financial system of the country. Formulating and implementing the monetary policy are the main responsibilities of the central bank.

The Origin of Central Banking in India

Most of the Central Banks of various countries have been established in 20^th century. A large number of them were established as private institution, as it was widely believed that they should have independence and freedom from government interference. However, due to great depression, abandonment of the gold standard a swing towards left politics and acceptance of the idea that the government has an important role to ensure the well being of its citizens, the public ownership of the Central Bank became the general trend. However, it is generally accepted that the central bank of a country should be an autonomous institution and the role of the government in its functioning should not be dominating.

The Central Bank of Sweden i.e. Riks Banks of Sweden was established in 1668 and the Bank of England was established in 1694 some other countries established their Central Banks in 19^th century, but most of the countries decided to set up Central Banks in the early part of 20^th century.

Perhaps, the earliest reference to the need for an institution of Central Bank type for India be traced to a communication from Warren Hastings in 1773 recommending the establishment of a ‘General Bank in Bengal and Bihar’. There were several other suggestions later, including the amalgamation of the three President Banks then in existence, but it was only in the twenties of this century that the proposal assumed a definite shape. The amalgamation of the three Presidency Banks took Place in 1921 to established the Imperial Bank of India. The Imperial Bank of India was essentially a commercial Bank, but it performed certain banking functions, particularly as banker to the Government. However, the issue of notes was not given to it. In 1926 the Royal Commission on Currency and Finance generally knows as Hilton Young Commission, recommended that this dichotomy of functions and division of responsibility should be ended. The commission suggested the establishment of a central bank, the Reserve Bank of India, by charter on lines which experience and proved to be sound.

A Bill giving effect to the recommendation was introduced in the Legislative Assembly in January 1927, but after a few clauses were considered and approved, it was dropped on account of sharp differences of opinion on the Banks constitution and Board of Directors. The issue again became alive with the publication of the white paper on Indian Constitutional Reforms in 1933.

According to para 32 of this white paper, the proposal for the transfer of responsibility at the centre from the British to the Indian hands was made dependent on the condition that a Reserve Bank free from political influence be established and be in successful operation. Thus the proposal for setting up of a Central Bank was revived. A fresh Bill was introduced in the Indian legislative Assembly on September 8, 1933 which was passed in due course and received the Governor General’s assent on March 6, 1934 and the Bank was inaugurated on April 1, 1935.

The Separation of Burma from India and the subsequent division of India into the Dominions of India and Pakistan as well as the integration of the princely states with the Indian Union have, over. the course of years, altered the area of operations of Reserve Bank. After the separation of Burma in April 1937, the Reserve Bank of India functioned as the currency authority of that country till June 5, 1942 and as banker to the Government of Burma till March 31, 1941. On the partition of the country, the Reserve Bank rendered central banking services to Pakistan until June 30, 1948. Originally, the Bank was a shareholder's Bank. It was only in 1948, through the Reserve Bank (Transfer of Public ownership) Act, 1948 the entire share capital was acquired by Central Government. Under the amended Act, all the directors of the Central Board, including the Governor and the Deputy Governors, and all the members of the Local Boards are appointed by the Central Government.

FUNCTIONS OF THE RESERVE BANK OF INDIA

The Reserve Bank of India is the Central Bank of the Country. The main functions of a central are broadly the same all over the world, namely, acting' as note issuing authority, bankers' bank and banker to the Government. The scope and content of policy objectives vary from country to country and from period to period. It depends on the stage of development, the structure of the economy, the goals to which the Government are committed, and the current general economic situation. Even so a broad identity of approach can be understood. It is generally agreed that a central bank's objectives should be to promote or facilitate a high growth rate, full employment; price stability and a viable external payments position. It is recognised that these objectives often clash and a working optimum has to be aimed at. According the Preamble to the Reserve Bank of India Act, the main function of the Bank is to regulate the issue of Bank notes and the keeping of reserve with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage.

The Reserve Bank has the sole right to issue notes. It also acts as to the commercial banks and to' some of the financial institutions including' state cooperative banks. It holds custody of their cash reserve and grants them accommodation in a discretionary way. For the performance of its duties as the regular of credit, the Bank possesses not only the unusual instruments of general credit control such as bank rate, open market operations and the power to vary the reserve requirements of banks, but also extensive powers of selective and direct credit regulation. Another important function of the Bank, and historically the oldest, relates to the conduct of the banking and financial operations of the Government. The Bank has also an important role to play in the Maintenance, of the exchange value of the rupee in view of the close inter-dependence of international trade and national economic growth and well-being. This is of course an aspect of the wider responsibility of the central bank for the maintenance of economic and financial stability. For the performance of this function, the Bank is entrusted with the custody and the management of the country's international reserves; it acts also as the agent of the Government in respect of India's membership of the International Monetary Fund. It also exercises control over payments and receipts for international transactions in conformity with the trade control which is operated by Government.

The main functions of RBI are discussed below –

	FUNCTIONS OF THE RBI
1.	Currency Authority
2.	Banker to the Government
3.	Advisor to the Government
4.	Banker’s Bank
5.	Lender of the Last Resort
6.	Supervision of Banks
7.	Controller of Money Supply and Credit
8.	Foreign Exchange Control and Management
9.	Monetary Data and Publications
10.	Promotional Functions – (a) Promotion of Commercial Banking (b) Promotion of Co-operative Banking (c) Promotion of Agricultural and Rural Credit (d) Promotion of Industrial Finance (e) Promotion of Finance for exports

1. As Currency Authority

The Reserve Bank is the sole authority for the issue of currency in India other than one rupee coins/notes and subsidiary coins, the magnitude of which is relatively small. In India, currency still form the major part of the money supply even though its importance has declined in recent years, albeit very slowly, due to the spread of banking facilities and the banking habit. Since currency (and the deposit liabilities of the Reserve Bank which are as good as currency) constitutes the base for the expansion of money only supply, regulation of currency is an important element of monetary control. In fact, the Statute itself imposes some restrictions on note issue. One Rupee Coins and notes are issued by the Govt. of India. In terms of the Reserve Bank of India. Act, the .affairs of the Bank relating to note issue and its general banking business are conducted through two separate departments, viz., the Issue and the Banking Departments. The assets of the Issue Department, which form the backing for the note issue, are kept wholly distinct from those of the Banking Department. In practice, the distinction between the two Departments has little economic significance, since there are frequent shifts between the assets of the Issue and The Banking Departments.

Process of Notes issue

The issue of currency into circulation and its withdrawal from circulation (that is, expansion and contraction of currency, respectively) take place through the Banking Department of the Bank. Thus, if a scheduled bank wants to withdraw Rs. 1 crore from its deposit with the Reserve Bank, the transaction is handled by the Banking Department, which gives currency in the denominations required by the bank, debiting the bank's account. For this purpose, the Banking Department holds .stocks of currency, which it replenishes as and when necessary, from the Issue Department, against equivalent transfer of eligible assets. Likewise, if a bank tenders cash to the Reserve Bank for its account, the cash is received by the Banking Department. If, as a result, the holding of currency in the Banking Department becomes surplus to the normal requirements of the Department, the surplus is returned to the Issue Department in exchange for equivalent assets. In respect of the exchange of bank notes for coins and coins for notes, and change from one denomination of notes to another, the Issue Department deals directly with the public and not through the Bunking Department.

2. Banker to the Government

Now, the Reserve Bank of India is banker to the central Government as well as State Governments. It makes receipts and payments on behalf of the Government and perform other banking operations for it. All the Governments maintain their current accounts with RBI.

Before the establishment of the Reserve Bank, the more important current financial transactions of Government were handled by the Imperial Bank of India, Administration of the public debt was the direct responsibility of the Government, although the Public Debt Offices were being managed by the Imperial Bank of India.

Legal Basis of the Function: Section 20, 21 and 21A of the Reserve Bank of India Act form the statutory basis for these functions. In terms of the first two sections, the Bank has the obligation to transact the banking business of the Central Government who, in turn, are obliged to entrust the conduct of such business to the Bank. The Bank accordingly undertakes. to accept money on account of that Government, to make payments on their behalf and also to carry out their exchange, remittance and other banking operations including the management of the public debt. In terms of Section 21A, the Bank performs similar functions on behalf of the Governments by virtue of agreements entered into with them.

As banker it makes short term credit to the Government. Under law the central Government can borrow any amount from. Reserve Bank of India. But State Governments do not enjoy unlimited borrowing powers. They can borrow only up to sanctioned limits. However, in actual practice the State Governments have become used to borrow -in excess of the limits. The short term advances to the' State Governments are called ways and means advances.

As a manager of public dept., it manages all issues, services and creates market for the Government securities. Further, it is responsible for smooth functioning of securities market i.e. maintaining its' stability by regulating demand and supply of the securities. As banker to the Government it advises it on all banking and financial matters which include matters relating to international finance, mobilisation of resources, changes in banking laws, merger and consolidation of banks.

The Bank is required to maintain currency chests of its Issue Department at places prescribed by the Government, and to keep the chests supplied with sufficient notes and coins to provide currency for the transactions of the Government and reasonable remittance facilities to the public at such places. The Bank is also obliged under the agreement to remit, on account of Government, between India and London, such amounts as may be required from time to time at the prevailing market rate for telegraphic transfers.

3. Advisor to the Government

Like all central banks, the Reserve Bank acts as adviser to Government not only on banking and financial' matters but also on a wide range of economic issues including those in the field of planning and resource mobilisation. It has of course a special responsibility in respect of financial policies and measures concerning new loans, agricultural finance, co-operative organisation, industrial finance and legislation affecting banking and credit. The Bank's advice is sought on certain aspects of formulation of the country's Five Year Plans such as the financing pattern, mobilisation of resources and institutional arrangements with regard to banking and credit matters, The Bank has also to render advice to Government on various matters of international finance.

For the Purpose, the contact between the Government and the Bank is maintained formally and informally and at various levels from the Governor downwards. The Bank also keeps the Government informed of developments in the financial markets periodically.

4. Bankers' Bank

The Reserve Bank of India is statutory banker to the Government of India. It. is also banker to the state Government as per agreements signed with them. In this capacity it holds their cash reserves, lends them funds for short terms and provides economical and expeditious central clearing and remittance facilities. Thus it performs all banking operations for them.

As per central banking theory cash reserves are maintained with the central bank to facilitate clearing operations. However in case of the Reserve Bank of India, the position is slightly different. It statutorily requires commercial banks to deposit with it a stipulated ratio ranging between 3% to 15% of their total liabilities. These deposits are neither held voluntarily nor can be used for making inter-bank clearances. For these operations cash reserves in excess of the statutory requirement have to be maintained.

The RBI rediscounts the bills of the commercial banks. It provides leadership, guidance and' direction in regulating their practices. The centralisation of cash reserves with RBI is a source of strength for the system and can be employed most effectively during the periods of seasonal strain and financial crisis. It is for this reason that it is called "Reserve Bank”. As Banker’s bank the RBI can implement its monetary policy more effectively.

5. Lender of the Last Resort

It lender of the last resort for the scheduled commercial banks in India. It provides 'credit to these banks through' rediscounting facility. It is called lender of the last. .resort as normally the banks are expected to meet their requirements.' from Sources other than the Reserve Bank of India. However, the empirical evidence shows that in difficult times scheduled commercial banks have approached the RBI, too frequently, turning it into almost a lender of the regular resort rather than that of last resort, thus forcing the RBI to review the policies.

In fact, this function developed out of the unique position as central bank of the country. This function has come to be regarded as the sine qua non of the central banking. In this capacity RBI assumes the responsibility of meeting directly or indirectly all reasonable demands for financial accommodation from commercial banks, and other financial institutions.

6. Supervision of Banks

The Reserve Bank's responsibilities include, in addition to the traditional central banking functions, the development of an adequate and sound banking system for catering to the needs of trade, commerce, industry and agriculture. Under the Reserve Bank of India Act, 1934 and the Banking (Companies) Regulation Act, 1949, the Bank has been vested with extensive powers of supervision and control over commercial' and co-operative banks. The Bank's powers extend to calling for information from giving directions to even non-banking institutions receiving deposits.

The Act empowers the Bank to regulate through licensing of banks branch expansions, management of reserves and assets and regarding the amalgamations, reconstruction and liquidation. The banks send their periodic reports to the Reserve Bank of India. The RBI conducts periodic inspection of the banks. The regulation and control are required for the proper growth of sound banking.

7. Controller of Money Supply and Credit

One of the most important functions of the Reserve Bank of India is to Control the money supply and credit in the economy. This becomes all the more important as India is following the managed paper currency system which has inherent inflationary tendency. The RBI has to control money supply and credit in such a way as to ensure the reasonable achievements of all the objectives of credit control e.g. price stability, full employment, economic growth, equilibrium in the balance of payments, etc. For performing this function it has various techniques of credit control available with it. It has the wide powers to influence the volume of money supply directly or indirectly.

8. Foreign Exchange Control and Management

The Reserve Bank of India is the custodian of the country's foreign exchange reserves. It manages the exchange control. Exchange control was first imposed in India in September 1939. Exchange transactions receipts and payments are controlled now under the Foreign Exchange Regulation Act 1973 which proposed to be replaced by Foreign Exchange Management Act (FEMA). The law has centralised the foreign exchange reserves in the hands of the Reserve Bank of India. The purpose of the control is to regulate the demand for foreign exchange according to available supplies which is very important in view of the shortage of foreign exchange reserves due to growing economy.

The Reserve Bank of India acts as the agent of the Government of India in connection with membership of the International Monetary Fund (IMF). With the liberalisation of economy the regulations over foreign 'exchange have been removed considerably. However, 'despite near full convertibility of the foreign exchange the role of RBI doss not come to an end, in this regard it will be required to intervene effectively to check unwarranted and unjustified volatility of rupee against other currencies.

9. Monetary Data and Publications

The Reserve Bank of India is the main source of monetary data and also of the data relating to banking. Obviously, the data are very important for framing the economic Policies and banking policies. The Bank collects and publishes the data regularly through Weekly statements, monthly bulletins, annual report, annual report on currency anti finance, report on trends and progress of banking in India, etc.

The availability of this important data is very useful to all those who are interested in the various aspects of the Indian economy.

10. Promotional Functions

In addition to the usual central banking functions, the Reserve Bank of India has been performing a variety of promotional functions. Its promotional functions and activities have been mainly directed towards building up and strengthening financial infrastructure and filling the institutional gap by setting up new financial institutions; and by ensuring the allocation of credit in the socially desired directions. Some of its pioxii6fiOnal activities are briefly discussed below:

(a) Promotion of Commercial Banking. Under the powers vested in it under the RB I Act of 1934 and the Banking (Companies) Regulation Act 1949, it has taken a: steps from time to time for the growth of commercial banks and putting the Indian Banking System on a sound footing. These Acts include regulation of banks, setting up of Deposit Insurance Corporation, amalgamation and consolidation of hanks.

(b) Promotion of Co-operative Banking. In India's rural-based economy co-operative banks have an important role to play. The credit for expansion of co-operative banking goes to the Reserve Bank of India, which is directly or indirectly source of funds for these co-operative banks.

(c) Promotion of Agricultural and Rural Credit. In the Reserve Bank of Indio Act itself, it is recognised that it has special responsibility for providing institutional credit 'to agriculture and allied activities. It has a separate Agricultural Department. A major step in the direction was setting up of the Agricultural Refinance and Development corporation, a subsidiary of the R.B.I. Nationalisation of banks gave a further push to institutional credit in rural-areas. Establishing Regional Rural Banks and inclusion of agriculture in the priority sector are other major steps. Another development in this directions was the establishing of the National Bank for Agriculture and Rural Development (NABARD) in 1982, which took over the Agricultural Refinance and Development Corporation.

(d) Promotion of Industrial Finance. The 'commercial banks can take care of the working capital requirements of the industrial units. However; industrial growth cannot take place in the absence of medium of long term finance. Moreover, small scale industries need special attention. Setting up of Industrial Development Bank of India, Industrial Finance Corporation of India, State Financial Corporations, Small Scale-industrial Development Corporations, etc. are the notable steps in direction. The R.B.I. is the main force behind these institutions. Setting up of SIDBI is another important step.

(e) Promotion of Finance for Exports. To encourage exports, the Reserve Bank of .India has been playing its role through refinance to banks against export credit under various schemes e.g. the Bill Market Scheme; Export Bills Credit Schemes, Shipment Credit Scheme, Duty Drawback Credit Scheme. Export has been recognised as a priority sector.

In 1982, the Government of India established Export Import Bank (EXIM) as an apex bank for financing the foreign trade.

The Reserve Bank of India being the central bank of the country is prohibited from in certain activities. It can not carry on any business or trade or invest .in real estate or buildings. However, it can purchase or construct building for the purpose of offices or residences of the empolyees. In cannot perform commercial banking functions as this will amount to competing with them.

MONETARY POLICY OF THE RESERVE BANK OF INDIA

"Monetary policy refers to the use of official instruments under the control of the central bank to regulate the availability, cost and use of money and credit with the aim of achieving optimum levels of output and employment, price stability, balance of payments equilibrium or any other goals set by the state.”

The item among bank's assets having special significance in this connection is the credit extended by banks to their constituents as this constitutes nearly two-third of the money supply in Indian economy. The capacity of the banks to provide credit depends upon the cash resources i.e. cash balances in hand and with the RBI. The cash resources increase through a rise in the deposit resources of banks, or by their borrowing from the Reserve Bank of India, or by sale of their investments. Regulation of credit by the Reserve Bank of India in essence means regulation of the quantum of these reserves of the banks. If RBI desires to bring about an expansion of credit, it will adopt measures which will increase banks reserves, and likewise if credit is to be restricted, it will attempt to curtail reserves.

Legal Basis:- The statutory basis for the regulation of the credit system by the Bank is embodied in the Reserve Bank of India Act and the Banking (Companies) Regulation Act. The former Act confers on the. Bank the usual powers' available lo central banks .generally, while the later provides special powers of direct regulation of ,the operation's of commercial and co-operative banks. In considering the usual instruments of what is known as general or ,quantitative credit control, viz., the Bank rate, (also known as discount rate), open market operations and variable reserve requirements, it is important to stress that these are closely inter-related and have to be operated in co-ordination. All of them affect the level of bank reserves. Open market operations and reserve requirements directly affect the reserve base while the Bank rate produces its impact indirectly through variations in the cost of acquiring the reserves. The use of one instrument rather than another at any point of time is determined by the nature of the situation and the range of influence it is desired to wield as well as the rapidity with which the change is required to be brought about. Open market operations, for instance, are suited to carry out day-to-day adjustments on even the smallest scale. Changes in reserve requirement produce an impact at once and .would affect banks generally. The effects of Bank rate changes are not confined to the banking system and the short-term money market alone. They produce wider repercussions on the economy as a whole.

The instruments referred above are known as general or quantitative techniques or instruments of monetary policy. In addition, the RBI can use selective or qualitative techniques of control. It may be clarified that general techniques affect the volume of credit, hence the money supply by affecting the lendable resources of the banks. On the other hand, selective credit control techniques are aimed at the 'directions of the credit' rather than on the 'volume of credit'. Now we proceed to discuss the policy and the use of the techniques by the Reserve Bank of India.

Techniques used by RBI

1. Bank Rate: The Bank rate is defined in Section 49 of the Reserve Bank of India Act as `the standard rate which it (the Bank) is prepared to buy or rediscount bills, of exchange or other commercial paper eligible for purchase under this Act’. In the absence of a developed bill market this has not been truly operative. It is the rate on advances by the Bank that is important and bias been commonly treated as the equivalent of Bank rate. Viewed in the broad sense of the rate on the Bank's accommodation; the Bank rate so defined is of some significance since it forms the basis for the rates at which the Bank grants advances to various types of borrowers, including Government.

In simple words, it is the rate at which the central bank of the country makes advances to the banks against approved securities, or rediscounts eligible bills of exchange and other papers. The purpose of change in this rate is to make the accommodation from the central bank cheaper or expensive depending upon whether the purpose is to expand or contract credit. It is a signal to the money market regarding the relaxation or restraint in the policy.

The efficacy of the Bank rate instrument continues to evoke considerable controversy not only among academic people but also in central banking circles. In the developing countries, and the developed countries too, fiscal policies and direct control measures have far greater impact on fixed investment decisions than the discount rate changes. Even in the case of inventory accumulation, the Bank rate will be effective only if the Bank rate change is sharp and credit interest rates are sufficiently high to make inventory accumulation unattractive. On the other hand, discount rate changes have an impact on the movement of short-term funds to and from the country but in the developing countries generally such movements are of modest dimensions and can be largely regulated through the device of exchange control. Discount rate changes also seem to possess some psychological advantage, as indications of a tightening or a relaxation of credit policies. In the developed countries, in recent years discount rate changes have been both frequent and sharp. The approach of the Reserve-Bank of India so far has been to make a modest use of this instrument.

Between 1935 and 1962 the hank rate was changed only three times was reduced from 3.5% to 3% in November 1935, was again increased to 3.5% in November 1951 and was further raised to 4% in May 1957. Between 1962 to 1973 there were frequent changes in the bank rate. It was enhanced to 4.5% January 1963 to 5% in September 1964 and to 6% in February 1965. In September 1964, the differential interest rate on borrowings from the R.B.I. was introduced. In March 1968 in the face of recessionary trends, the rate was reduced to 5%. Subsequently it was increased to 6% in January 1971 and to 7% in May 1973, 'to 9% in July 1974 and to 10% in July 1981. During 1991 it was increased to 11 percent in July and 12 per cent in October. Thereafter, it remained unchanged till 1997.

In April 1997, the bank rate was reduced to 11 per cent. In post 1997, period the bank rate has been once again used as an instrument in the credit policy of the country.

In phases it has been brought down from 11 percent in March, 1998 to 9 percent in April 1998.

In April 2000, it was brought down to 7 percent. Due to-factors like availability of specific refinance facility available to commercial banks and bill market scheme etc., the bank rate in India has not been the 'pace setter' to other market rates of interest. The money market rates do not automatically adjust to the bank rate. Thus, it has not been a very effective instrument of monetary policy in India. However, the' things are changing now. The RBI reduced the bank rate to 6% w.e.f April, 2003.

2. Variable Reserves Requirements: Through this technique, the central bank of a country can change the `excess cash reserve' positions of the banks and hence their credit Creation capacity. It can be applied in various forms to various categories of deposits. This is a more effective tool of monetary policy as compared to bank rate and open market operations.

The Reserve Bank of India has used two methods of (i) Cash reserves ratio and (ii) Statutory Liquidity ratio for regulating the credit base of the banks.

(a) Cash Reserves Ratio

Originally, Section 42 (1) of the RBI Act required banks to maintain a minimum cash reserve of 5% of their demand liabilities and 2% of time liabilities in India. The Act was amended in 1956 empowering the RBI to vary the minimum reserves between 5% to 20% for demand liabilities and between 2% to 8% for time liabilities of the banks hi India. The Act was again amended in 1962, removing the distinction between time and deposit liabilities and authorised the Bank to vary the cash reserves ratio between 3% to 15%.

The Reserve Bank of India did not use the power till 1972-73. In June 1973, the ratio was raised from 3% to 5%. It was increased to 6% on. September 8, 1973 and to 7% on September 22, 1973. The impounded cash reserves of 2% of June 1973 were released in June 1974. 'The R.B.I. again increased the ratio to 5% in September 1976 and to 6% hr November 1976. In July—August 1981, the ratio was increased to 7% in two phases, In .October 1981, the Bank planned to increase' to '8%' in four phases. However, because of the difficult situation it was reduced to 7.25% in April 1982. In June 1982, it was further reduced to 7%. Again in two phases it was raised to 8% by July 1983.

After the beginning of the process of liberalisation of the economy the CM has been changed more frequently. From 1991 to April 1998, the CRR has been changed 26 tithes. In fact, between October 97 and April 98, it has been changed 6 times. In January 1998, the CRR was increased froth 10 to 10.5 per cent to check the downslide in rupee-dollar rate. It was reduced to 10 per cent again in March, 1998. By April 2000, it was brought down to 7 per cent and to 5 percent by April 2002. However, the cash reserve ratio has been increased to 7.75 percent w.e.f. April 26', 2005 and 8.0 per cent w.e.f. May 10, 2008. It was once again reduced to 5% w.e.f. January 12,.19.9.9.

Tarapore Committee on Capital Account Convertibility has recommended that the CRR should be brought down to 8 per cent. Once it is scaled down to 3 percent it will virtually cease to be an instrument of liquidity control.

(b) Statutory Liquidity Ratio

Under the Banking Companies Regulation Act, banks were required to maintain liquid assets, equal to 20% of their total demand and liabilities. So, when the variable cash reserves ratio was increased, the banks used to dilute the impact by liquidating excess liquid assets. To check this exercise, the Act was amended in 1952 requiring banks to maintain liquid assets equal to 25% of the time and demand liabilities in addition to cash reserves ratio.

In a phased manner the ratio was increased to 35% by October 1981. Subsequently it was gradually increased to 38.5 per cent. But under new economic policy, with a view is increase funds with banks the trend has been to reduce it.

In April, 1996 the effective SLR of the scheduled commercial banks was estimated to have fallen to 28 percent of their total net demand and time liabilities. The average SLR was estimated to be 27 per cent in December 1996. Since, the banking sector deposits lucre exempted on April 15, 1997 the average SLR has gone down below this level, In March 1998, the effective SLR has come down to 25 percent, in accordance With recommendations of Narasimham Committee. However, the SLR was reduced to 24 per cent w.e.f movement 3, 2008

3. Open Market Operations: Open market operations refer broadly to the purchase and sale by the Central Bank of a variety of assets such as foreign exchange, gold, government securities and even company share. In practice, however, these are confined to the purchase and sale of Government securities.

Originally, there was a ceiling on the RBI's holdings of Government securities. There were also restrictions on its holdings of different maturities. This obviously, restricted the Open market operations of RBI. These restrictions were removed in 1951. At present, Section 17(8) of the Reserve Bank of India Act, authorise the bank to engage in the purchase and sale of the securities of the Central Government or a State Government of any maturity or of such securities of a local authority as may be specified in this behalf of the central Government on the recommendations of the Central Board. The securities fully guaranteed as to the principal and interest by the government or authority. Thus, today there is no restriction as to either the quantity-or maturity of the securities, which the bank can purchase or sell.

The capacity of a central bank to conduct open market operations depends on the quantity and type of assets it can hold in its' portfolio and the size and depth of gilt edged market. However, the Indian gilt edged Market has been narrow. A sizeable proportion of the public debt has been held by a few large institutions. Further, the volume of transactions in the securities market for the purpose of changing their 'portfolio has' been limited. This has prevented large scale operations by RBI, as it tends to unduly disturb the security prices.

In India, the open market operations have not been used much to influence the cash reserves of banks. The main objective has been to assist debt operations of the Government and the seasonal needs of the banks. However the operations have been in tune with monetary policy of the RBI. The open market operations of the RBI have been inhibited by number of such factors. It has not been a very effective instrument of monetary policy.

Post 1991 period. The inflow of foreign exchange increased considerably after 1991. This brought more liquidity into the system. In view of this, the Reserve Bank of India resorted to large scale open market operations. The deregulation and liberalisation of the system has led to the emergence of open market operations as an important instrument in the conduct of the monetary policy. In the early months of 1998, the open market operations of the Reserve Bank, in the form of outright sales of Government Securities and repo and reverse repos operations, have gained considerable momentum.

The primary objective of these operations is to absorb or provide liquidity in the market. Although under certain circumstances repos have also been used to signal changes in interest rates. In the monetary policy of 1998-99, the announcement has been made about the introduction of one day repos. This is termed as the most important tool. The indications are that it will ultimately replace the CRR as a tool of monetary control. The CRR is to be reduced to 3 per cent in accordance with recommendations of Tarapore committee.

4. Selective and Direct Credit Control

The instrument of credit control discussed in the foregoing paragraphs are commonly known as general or quantitative methods of credit control while the regulation of credit for specific purposes or branches of economic activity is termed as selective or qualitative credit control. While general credit controls operate on the cost and total volume of credit, selective controls relate to the distribution or direction of available credit supplies. It may be mentioned that some element of selectivity can. be imparted to general credit controls also by giving concessions to priority sectors or activities; this has been so in India. The aim of selective controls is to discourage such forms of activity as are regarded to be relatively unessential or less desirable. Selective credit controls have been used in Western countries to prevent the demand durable consumer goods outrunning the supply and generating inflationary pressures.' In the U.S.A., they have been used to regulate stock market credit also. In India such controls have been used to prevent speculative hoarding of commodities like food grains and essential raw materials to check an undue rise in their prices.

Selective credit controls are considered as a useful supplement to general credit regulation. From available experience, it appears that their effectiveness is enhanced when they are used together with general credit controls. They are designed specifically to curb excesses in selected areas without affecting other types of credit. They attempt to achieve a reasonable stabilisation of prices of the concerned commodities through the/demands side, by regulating the availability of bank credit for purchasing and holding them. It should, however, be noted that prices are determined by the inter-action of supply and demand and when supply is substantially short, what selective credit controls are likely to accomplish is to moderate the price rise rather than arrest the basic trend.

Legal Basis. The Reserve Bank of India is vested with the power to exercise selective control under Section 21 and 35A of the Banking Companies Regulation Act. It is empowered to determine the policy in relation to advances to be followed in the interest of public deposits or banking policy. Furthermore, the R.B.I. is empowered to give directions to bank or banks on various aspects of credit e.g.

the purpose of the credit;
the margins to be maintained;
the maximum advances that can be made;
the rate interest and other terms and conditions on the basis of which advances may be made.

All the banks are under obligation to follow instructions of the Reserve Bank. It is also authorised to prohibit bank or banks from entering into a particular transaction or class of transactions. Now we discuss some of the selective measures of the R.B.I.

Measures

(i) Directions. Before 1956, the need for selective control measures was not felt. The excessive use of credit for speculative purposes forced the Reserve Batik of India to use its powers. It directed the banks to send their fortnightly returns on advances. The banks were directed to use restraint in advancing loans against the security of food grains. The security margin requirements were enhanced: Subsequently, it directed the banks not to advance loans for the purchase of consumer goods. Under the Credit Authorisation Scheme of 1965, the R.B.I. not only controlled the quantum of credit but also the terms and conditions of flow of credit particularly to large borrowers. It has been issuing and arising its instructions from time to time.

With a view to de-regulate and liberalise the financial system of the country RBI has .taken number of steps since 1987. The Credit Authorisation Scheme was abolished in 1988 Instead of Credit Authorisation Scheme it has evolved Credit Monitoring Arrangement under which it will monitor the credit sanctions. In recent years RBI resorted to selective monitor and determine the impact demand originating from bank credit.

(ii) Rationing. In 60's the Reserve Bank of India used rationing of credit to channelise flow of credit into desired areas. Under rationing quota system is adopted according to the needs of the economy. In a ‘priority sector quota' works as rationing of credit.

(iii) Margin Requirements. Changing margin requirements is another method followed by the Reserve Bank of India. By requiring higher margin, while accepting a commodity as a security it can decrease the flow of credit into a particular trade or vice versa. The .method has been used Since.1950's.in against providing credit against food grains of agricultural produce. An example of this is providing credit against food grains or agricultural produce. An example of this is the monetary policy for 1998-99. The policy has increased the ceiling on loans against shares from 10 lacs to 20 lacs in case of dematerialised shares. Further, the margin has also been reduced from 50 per cent to 25 per cent in case of dematerialised shades. The purpose is to encourage dematerialisation of shares i.e. replacing paper share certificates with entries of shares held with depositories. The transfer is electronic in case of dematerialised shares.

(iv) Moral Suasion. In addition to the above Mentioned methods of credit control, both quantitative and qualitative, it may be .noted that use has also been made in this country of moral suasion. Periodically, letters are issued to banks urging them to exercise control over credit in general or advances against particular commodities or unsecured advances. Discussions are also held with bankers for the same purpose. Such discussions between the Bank and the commercial banks have been frequent in the last twenty years. The Bank has been able to build up over the years good informal relations with banks. Moral suasion, backed as it is by Rank's vast powers of direct regulation, has proved quite useful. The use of this instrument is facilitated the concentration of banking business in the hands of about, twenty eight banks. The nationalisation of the major Indian scheduled commercial banks enhanced the efficacy of this instrument.

The Reserve Bank of India has used the tool quite effectively due to its good rapport with the banking system. At times it persuaded banks to maintain higher statutory liquidity ratio then legally required e.g. in 1982 banks maintained a statutory liquidity rates (SLR) of 35% against legal requirement of 25%. Moral suasion has been used effectively to check non-food credit expansion.

Upto 90's selective controls was found to be more useful by Reserve Bank of India as compared to direct controls. However, as a part of liberalisation policy, lesser reliance is being placed on instruments of selective control.

Monetary Policy in 1990's.

The overall reform process was started in 1990-91. Before that the basic goal of monetary policy was to neutralise the impact of fiscal deficit. The banks were required to absorb a sizeable portion of the government's financing requirement to keep down the cost of 'government borrowings, the yield on treasury bills and longer term paper were kept artificially low. The monetary management lead to increases in the CRR and SLR. In 1991, the two ratios taken together pre-empted 63.5 per; 'cent of demand and time 'liabilities.

A comprehensive package of stabilisation and structural reforms measures was initiated in mid 1991, adjustments were made in fiscal deficit. It was followed by decrease in incremental CRR and $LR and things started moving differently thereafter.

The recommendations of the Chakravarty Committee (1985) and the Narasimahm Committee (1991) were implemented in phased manner. This resulted into bringing down the levels of resources preemption by phased reduction in SLR and CRR and also deregulation of interest rates. In the light of recommendations of Tarapore Committee on Capital Account Convertibility CRR is to be reduced to 3 per cent.

In an important decision regarding conduct of monetary policy, Govt. in its budget for 1997-98 announced abolition of ad.hoc treasury bills from April 1997, to discipline the Govt. of India in its cash management and fiscal management. The ad-hoc treasury bills were being used by the Govt. as a cheap source of funds. This seriously, effected the conduct of monetary policy.

The ad-hoc treasury bills have been replaced by Ways and Means Advances (WMA). In principle, it is a method of managing mismatches in receipts and payments and not a source of finance. It is perceived as a watershed in the history of public finance in India.

MONETARY POLICY, 2011-12

The RBI, Governor, announced the Annual Monetary Policy for 2011-12 on May 3, 2011. Three factors have shaped the outlook and monetary 'strategy for the year 2011-12. First global commodity prices, which have surged in recent months, are likely to at best, remain firm and 'may well increase further over the course of the year. Second, headline and are inflation have significantly overshot even the most pessimistic projections over the past: few months. The first factor suggests that high inflation will persist and may get worse. The second raises concerns about inflationary expectations becoming unhinged. The third factor is the likely moderation in demand. The monetary policy in Annual Statement of 2011-12 is based on the premise that although high inflation is inimical to sustained growth in the long-run, yet bringing it down even at the cost of some growth in the short-run should take precedence.

Against this backdrop, the stance of monetary policy is as follows;

(a) Maintain an interest rate environment that moderates inflation and anchors inflation expectations. (b) Foster an environment of price stability that is conducive to sustaining growth in the medium term coupled with financial stability.

(c) Manage liquidity to ensure that it remains broadly in balance, with neither a large surplus diluting monetary transmission nor a large deficit chocking off fund flows.

The highlights of the monetary policy are as follows:

1. Short term lending rate (repo) hiked by 50 bps to 7.25%.

2. Repo rate to be only effective policy rate to better signal monetary policy stance from now on.

3. Reverse repo to be fixed 100 bps lower than the repo rate.

4. Short-term borrowing rate (reverse repo) up by 50 bps to 6.25%.

5. Cash reserve ratio (CRR) and bank rate left unchanged at 6 pc each.

6. Interest rates on savings bank deposits hiked to 4% from 3.5%.

7. Economic growth projected lower at 8% for FY 12.

8. WPI inflation projection lowered to 6%.

9. Objective is to contain inflation by curbing demand-side pressures.

10. Favours aligning of fuel prices with international crude prices to avert widening of fiscal deficit.

11. Banks to get a new overnight borrowing' window under Marginal Standing Facility at 8.25%.