NATIONAL LAW INSTITUTE
UNIVERSITY
BHOPAL, M.P.
A Project Of Banking Law
On The Topic
Monetory Role Of RBI In Regulating
The Economy
Submitted to, Submitted by,
Prof. Monica Raje Ajita Nadkarni
2012 BA LLB 101
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Acknowledgement
With my highest gratitude I would take this opportunity to acknowledge the role played by
various people in the making of my project. Firstly I would like to thank my parents who
have always supported me. Secondly I would like to thank Debashree Madam who was
instrumental in guiding me in making this project.
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Table Of Contents
Contents Page no:
1.Introduction.............................................................................................................4
2.Main functions of the RBI.......................................................................................4
3.RBI as a monetory authority....................................................................................5
4.RBI as the regulator of banking system...................................................................6
5.RBI as the regulator of payment and settlement system..........................................7
6.RBI as the regulator of credit...................................................................................7
7.RBI as the regulator of the foreign exchange...........................................................11
8.RBI as the regulator of the financial system.............................................................12
9.Conclusion................................................................................................................12
10.Bibliography...........................................................................................................13
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Introduction
The Reserve Bank of India was established on April 1, 1935 in accordance with the
provisions of the Reserve Bank of India Act, 1934. Though initially RBI was privately
owned, it was nationalized in 1949. Its central office is in Mumbai where the Governor of
RBI sits. RBI has 22 regional offices and most of them are located in state capitals. The
Reserve Bank of India also has three fully owned subsidiaries which are National Housing
Bank (NHB), Deposit Insurance and Credit Guarantee Corporation of India (DICGC),
Bharatiya Reserve Bank Note Mudran Private Limited (BRBNMPL). The functions of
Reserve Bank are governed by central board of directors. The board is appointed by the
Government of India. The directors are nominated or appointed for a period of four years. As
per the Reserve Bank of India Act there are Official Directors and Non-Official Directors.
The Official Directors are appointed by the government and include Governor and Deputy
Governors of RBI. There cannot be more than four Deputy Governors. Non-Official
Directors are nominated by the government. These include ten Directors from various fields
and one government official. Apart from these, there are four other Non-Official Directors,
one each from four local boards in Mumbai, Kolkata, Chennai and New Delhi.
Main Functions Of The RBI
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.
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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.
RBI As A Monetory Authority
Monetary policy is the process by which monetary authority of a country, generally a central
bank controls the supply of money in the economy by its control over interest rates in order to
maintain price stability and achieve high economic growth.[1] In India, the central monetary
authority is the Reserve Bank of India (RBI). is so designed as to maintain the price stability
in the economy. Other objectives of the monetary policy of India, as stated by RBI, are:
1.Price Stability
Price Stability implies promoting economic development with considerable emphasis on
price stability. The centre of focus is to facilitate the environment which is favourable to the
architecture that enables the developmental projects to run swiftly while also maintaining
reasonable price stability.
2.Controlled Expansion Of Bank Credit
One of the important functions of RBI is the controlled expansion of bank credit and money
supply with special attention to seasonal requirement for credit without affecting the output.
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3.Promotion of Fixed Investment
The aim here is to increase the productivity of investment by restraining non essential fixed
investment.
4. Restriction of Inventories and stocks
Overfilling of stocks and products becoming outdated due to excess of stock often results in
sickness of the unit. To avoid this problem the central monetary authority carries out this
essential function of restricting the ors of the economy and all social and economic class of
people
5.To Promote Efficiency
It is another essential aspect where the central banks pay a lot of attention. It tries to increase
the efficiency in the financial system and tries to incorporate structural changes such as
deregulating interest rates, ease operational constraints in the credit delivery system, to
introduce new money market instruments etc.
6.Reducing the Rigidity
RBI tries to bring about the flexibilities in the operations which provide a considerable
autonomy. It encourages more competitive environment and diversification. It maintains its
control over financial system whenever and wherever necessary to maintain the discipline
and prudence in operations of the financial system.
RBI As The Regulator Of The Banking System
The RBI regulates the Indian banking and financial system by issuing broad guidelines and
instructions. The objectives of these regulations include:
1.Controlling money supply in the system.
2.Monitoring different key indicators like GDP and inflation,
3.Maintaining people’s confidence in the banking and financial system
4. Providing different tools for customers’ help, such as acting as the “Banking
Ombudsman.
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RBI As The Regulator Of Payment And Settlement System
The central bank of any country is usually the driving force in the development of national
payment systems. The Reserve Bank of India as the central bank of India has been playing
this developmental role and has taken several initiatives for Safe, Secure, Sound, Efficient,
Accessible and Authorised payment systems in the country.
The Board for Regulation and Supervision of Payment and Settlement Systems (BPSS), a
sub-committee of the Central Board of the Reserve Bank of India is the highest policy
making body on payment systems in the country. The BPSS is empowered for authorising,
prescribing policies and setting standards for regulating and supervising all the payment and
settlement systems in the country. The Department of Payment and Settlement Systems of the
Reserve Bank of India serves as the Secretariat to the Board and executes its directions.
In India, the payment and settlement systems are regulated by the Payment and Settlement
Systems Act, 2007 (PSS Act) which was legislated in December 2007. The PSS Act as well
as the Payment and Settlement System Regulations, 2008 framed thereunder came into effect
from August 12, 2008. In terms of Section 4 of the PSS Act, no person other than the Reserve
Bank of India (RBI) can commence or operate a payment system in India unless authorised
by RBI. Reserve Bank has since authorised payment system operators of pre-paid payment
instruments, card schemes, cross-border in-bound money transfers, Automated Teller
Machine (ATM) networks and centralised clearing arrangements.
RBI As The Regulator Of Credit In The Economy
The various methods employed by the RBI to control credit creation power of the commercial
banks can be classified in two groups, viz., quantitative controls and qualitative controls.
Quantitative controls are designed to regulate the volume of credit created by the banking
system qualitative measures or selective methods are designed to regulate the flow of credit
in specific uses.
Quantitative or traditional methods of credit control include banks rate policy, open market
operations and variable reserve ratio. Qualitative or selective methods of credit control
include regulation of margin requirement, credit rationing, regulation of consumer credit and
direct action.
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
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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.
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(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:
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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
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the contrary, economic conditions are such as to limit the effectiveness of the credit control
measures.
RBI As The Regulator Of Foreign Exchange
The RBI acts as the custodian of the country’s foreign exchange reserves, manages exchange
control and acts as the agent of the government in respect of India’s membership of the IMF.
Exchange control was first imposed in India in September 1939 at the outbreak of World War
II and has been continued since. Under it, control was imposed on both the receipts and
payments of foreign exchange.
The foreign exchange regulations under the law required that all foreign exchange receipts
whether on account of export earnings, investment earnings, or capital receipts, whether oh
private account or on government account, must be sold to the RBI either directly or through
authorized dealers (mostly major commercial banks). This resulted in centralisation of
country’s foreign exchange reserves with the RBI and facilitated planned utilization of these
reserves, because all payments in foreign exchange were also controlled by the authorities.
The exchange control was so operated as to restrict the demand for foreign exchange within
the limits of the available supplies of it. Foreign exchange was rationed among competing
demands for it according to the government policy. All this became essential in the context of
actual or potential shortage of foreign exchange, which had been an important constraint on
India’s efforts at planned economic development, most of the time.
Faced with acute foreign exchange crisis, the new government at the Centre (constituted
in June 1991), took several successive steps to meet the problem:
(i) The Rupee was devalued by 18% against the US Dollar and other hard currencies in two
steps in quick succession in early July 1991 to correct substantially the over valuation of the
Rupee and thereby to make Indian exports more competitive in world markets and to make
imports into India costlier than before.
(ii) The new trade policy of July 1991 introduced a system of EXIM scrip, under which
exporters earned freely tradeable import entitlements equal to 30 per cent (or 40 per cent in
some cases) of the value of their exports. The scrip commanded premium when sold. This
system was soon discarded in favour of a system of partial (60:40) convertibility of the Indian
Rupee into foreign exchange.
(iii) Finally, in the budget for 1993-94, the Rupee was made fully convertible on trade
account. That is, the system of a single unified exchange rate of the Rupee was introduced in
place of the previous dual rates system. This single rate is determined entirely by the forces
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of demand and supply and not officially. This, of course, does not mean that one can go to a
bank and buy any amount of foreign exchange one likes against rupees.
The entire gamut of foreign exchange restrictions remain, placing a strict limit on the overall
demand for foreign exchange. The RBI continues to act as the ultimate guardian of the
foreign exchange value of the rupee and as such intervene, that is, buy and sell rupees in the
foreign exchange market at its discretion.
Even now, it is only the authorised dealers in foreign exchange (mostly banks) who can buy
and sell foreign exchange and maintain only a minimum “position” that is unmatched by buy
and sell orders. Thus, large speculators in foreign exchange have not been allowed in the
market;
(iv) Receipts and payments on capital account continue to be subject to controls; and
(v) All transactions are conducted within the framework of exchange control regulations
which are being liberalised progressively.
RBI As The Regulator And Supervisor Of The Financial System
1.The Reserve Bank Of india is also the regulator and the supervisor of the financial system
in India and prescribes broad parameters of banking operations within which the country`s
banking and financial system functions.
2.Its objectives are to maintain public confidence in the system ,protect depositors’ interest
and provide cost effective banking services in India.
3.The banking Ombudsman Scheme has been formulated by the RBI for the effective
redressal of complaints by the banking customers.
4.The RBI controls the monetory supply, monitors economic indicators like Gross Domestic
Product (GDP) and has to decide the design of Rupee bank notes as well as the coins.
Conclusion
The Resreve Bank Of India (RBI) plays an important role in achieving economic growth of a
developing country like India.It promotes economic growth with stability.It helps in attaining
full employment balance of payment disequilibrium and in stabilizing the exchange rate.The
RBI is an autonomous body promoted by the Government Of India headquartered at Mumbai
treasury foreign exchange movements and is also the primary regulator for banking and non-
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banking financial institutions.The RBI operates a number of government mints that produce
currency and coins.
Bibliography
1.www.rbi.org.in
2.www.yourarticlelibrary.com
3.www.timespro.com
4.www.preservearticles.com
5.www.en.wikipedia.org
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