3. Indian Economy : RBI – Banking and Finance

Why Do We Need a Bank ?

• A bank is a type of financial institution that issues credit and accepts public deposits. Through capital markets, lending activities can be carried out directly or indirectly.
• Simply a bank can translate savings into investments.
• Commercial banks exhibit the money multiplier effect by accepting deposits, holding a certain amount as a reserve, and then dispersing the funds as loans to add liquidity to the economy.

Why Do We Need a Central Bank ?

1. Every country has a central bank that oversees all of the other banks in that country. Simply, the most important function of the central bank of a country is to protect the interest of the depositors.
2. The central bank of our country is the Reserve Bank of India. The central bank’s primary duties include serving as the government’s bank and directing and supervising all other banking institutions in the country.
3. The duties of a country’s central bank are listed below:
   • Guiding the banks
   • Issuing currency
   • Implementing the monetary policies
   • Supervisor of the financial system

Difference Between Savings Account and Current Account

• A savings account is a deposit account which allows limited transactions, while a Current Account is meant for a large number of daily transactions and has less/no restriction on transaction limit.
• A savings account is most suitable for people who are salaried employees or have a monthly income whereas, Current Accounts work best for traders and entrepreneurs who need to access their accounts frequently.
• Savings accounts earn interest, while there is no such earning from a Current Account. A Current Account is actually a no-interest-bearing deposit account.

Demand and Time deposits

Demand deposits : These are deposits that banks have to pay on demand. They include:

1. Current Bank Account deposits
2. Savings Bank Account deposits
3. Margins held against letters of credit/guarantees

Time deposits : These are deposits that banks have to pay after a specific time period. They include

1. Fixed Deposits
2. Cash Certificates
3. Cumulative and Recurring deposits

Demand and Time Deposits Together are called Total Deposits.

Assets and Liabilities of Bank

• The assets are items that the bank owns. This includes loans, securities, and reserves.
• Liabilities are items that the bank owes to someone else, including deposits and bank borrowing from other institutions .

Money Market:

Consists of various banks such as

1. Commercial Banks
   • Public Banks
   • Private Banks
   • Foreign Banks
2. Payment Banks
3. Small Finance Banks
4. Regional Rural Banks
5. Cooperative Banks

Reserve Bank of India ( RBI )

• The Reserve Bank of India was established on April 1, 1935, in accordance with the provisions of the Reserve Bank of India Act, of 1934.
• It’s a statutory and extra-constitutional body.
• The Central Office of the Reserve Bank was initially established in Kolkata but was permanently moved to Mumbai in 1937. The Central Office is where the Governor sits and where policies are formulated.
• Though originally privately owned, since nationalization in 1949, the Reserve Bank is fully owned by the Government of India.
• Reserve Bank of India works as per the RBI Act 1934.
• In addition to the headquarter, the RBI has 27 regional offices and 4 sub-regional offices.
• RBI is headed by the governor and the current governor is Shaktikanta Das.
• The term of Governor & deputy Governor is usually three years (not always) But can be changed by the central government.
• The Governor of RBI is assisted by four deputy governors.
• The first governor of RBI in 1934 was Sir Osborne Smith.
• The first governor of RBI in independent India was C.D. Deshmukh.

Is RBI an Autonomous Body?

1. RBI is not an autonomous body. According to section 7 and section 58 of the RBI Act, the Government of India can interfere in the working of RBI.
2. According to Section 7, the Central Government may from time to time give such directions to the Bank as it may, after consultation with the Governor of the Bank, consider it necessary in the public interest.
3. According to Section 58 the Central Board may, with the previous sanction of the 5 [Central Government], 8 [by notification in the Official Gazette] make regulations consistent with this Act to provide for all matters for which provision is necessary or convenient for the purpose of giving effect to the provisions of this Act.

Central Board of RBI

The Reserve Bank’s affairs are governed by a central board of directors. The board is appointed by the Government of India in keeping with the Reserve Bank of India Act.

• Appointed/nominated for four years
• Constitution:
  • Official Directors:
    • Full-time: Governor and not more than four Deputy Governors
  • Non-Official Directors
    • Nominated by Government: ten Directors from various fields and two government Official
    • Others: four Directors – one each from four local boards
  • Functions: General superintendence and direction of the Bank’s affairs.

Monetary Policy

• Monetary policy is the macroeconomic policy laid down by the central bank.
• It involves the management of money supply and is the demand side economic policy used by the government of a country to achieve macroeconomic objectives like inflation, consumption, growth and liquidity.
• Under the Monetary Policy, RBI has two important functions:
  • Controlling interest rate.
  • Controlling inflation.
• During high inflation, RBI increases interest rates as high interest rates will lead to less borrowing. Thus, high-interest rates will decrease the money supply in the economy and inflation will be controlled.
• What if the Government wants a lower interest rate and growth rate? This leads to conflict between RBI and Government.
• Such an incident happened in 2016. In 2016 Government of India passed RBI Amendment Act 2016 to form a monetary policy committee. The Committee will consist of six members (Three members from RBI and rest three members nominated by the Government of India)

The Monetary Policy Committee ( MPC )

Section 45ZB of the amended RBI Act, 1934 provides for an empowered six-member monetary policy committee (MPC) to be constituted by the Central Government by notification in the Official Gazette.

The first such MPC was constituted on September 29, 2016. The present MPC members, as notified by the Central Government in the Official Gazette of October 5, 2020, are as under:

1. Governor of the Reserve Bank of India Chairperson, ex officio;
2. Deputy Governor of the Reserve Bank of India, in charge of Monetary Policy Member, ex officio;
   • RBI Governor is assisted by 4 deputy governors
     • Shri Swaminathan J
     • M Rajeshwar Rao
     • T Ravi Shankar
     • M D Patra
   • One officer of the Reserve Bank of India to be nominated by the Central Board -Member, ex officio;
   • Prof. Ashima Goyal, Professor, Indira Gandhi Institute of Development Research-Member;
   • Prof. Jayanth R. Varma, Professor, Indian Institute of Management, Ahmedabad-Member;
   • Dr Shashanka Bhide, Senior Advisor, National Council of Applied Economic Research, Delhi-Member.
3. The MPC determines the policy repo rate required to achieve the inflation target.
4. The MPC is required to meet at least four times a year.
5. The quorum for the meeting of the MPC is four members.
6. Each member of the MPC has one vote, and in the event of an equality of votes, the Governor has a second or casting vote.
7. Each Member of the Monetary Policy Committee writes a statement specifying the reasons for voting in favor of, or against the proposed resolution.

The Monetary Policy Framework

In May 2016, the RBI Act, 1934 was amended to provide a statutory basis for the implementation of the flexible inflation targeting framework.

Inflation Target: Under Section 45ZA, the Central Government, in consultation with the RBI, determines the inflation target in terms of the Consumer Price Index (CPI), once in five years and notifies it in the Official Gazette. Accordingly, on August 5, 2016, the Central Government notified in the Official Gazette 4 per cent Consumer Price Index (CPI) inflation as the target for the period from August 5, 2016, to March 31, 2021, with the upper tolerance limit of 6 percent and the lower tolerance limit of 2 per cent.

On March 31, 2021, the Central Government retained the inflation target and the tolerance band for the next 5-year period – April 1, 2021, to March 31, 2026.

Section 45ZB of the RBI Act provides for the constitution of a six-member Monetary Policy Committee (MPC) to determine the policy rate required to achieve the inflation target.

Is Inflation a Good Thing ?

• Inflation refers to a general increase in the prices of goods and services in an economy.
• 2% – 6% inflation allows households and businesses to make financially sound decisions on saving, investing and borrowing money.
• RBI is tasked with keeping inflation at a healthy level by adjusting the nation’s money supply and interest rates.
• When the economy is expanding too quickly and inflation rises, RBI will typically raise interest rates to reduce the amount of cash in circulation. This makes it more expensive for people to borrow money, which slows economic growth and reduces inflation.
• While high inflation can be harmful, too little inflation can also weaken the economy. When the economy is struggling and inflation is too low, RBI will take the opposite approach by lowering interest rates or buying assets to increase cash circulation. The goal is to make it easier for people to borrow money and spur economic activity.

Functions of RBI

Issuer of Bank Notes : RBI enjoys the monopoly of issuing currency notes except for 1 rupee note. The 1 rupee note and the coins of all denominations are minted and issued by GOI (and not RBI), but they are circulated through the RBI. The RBI adopted the minimum reserve system for note issues in 1957 according to which it has to maintain gold and foreign currency reserves worth 200 crore, out of which a minimum of 115 crore should be in gold.

Banker to the Government : RBI acts as a banking agent and financial advisor to the Central as well as the State Governments. It manages government accounts and treasuries. It performs the function of crediting loans to the governments without any interest for the short term. RBI buys and sells Government Securities (G-Secs) on the government’s behalf. It gives monetary and financial advice to the governments.

Bankers’ Bank: All the other banks in the country keep their part of cash balances with RBI as a deposit to meet the liabilities in the time of crisis scheduled. Scheduled Commercial Banks keep cash balances in two ways:
1. They keep part of the cash balance with themselves.
2. The other part is kept with the RBI as deposits.

Lender of Last Resort : RBI is not only a banker to the banks but also a lender of last resort. That means, in times of crisis, the Scheduled Commercial Banks approach the RBI to get financial assistance. As RBI is the lender of last resort, it gives opportunity, enabling itself to exercise control over the banking system of the country.

Custodian of Foreign Exchange Reserves : RBI functions as the custodian of the nation’s foreign exchange reserves. To stabilise the rupee’s external value, the RBI maintains the reserves of foreign currencies which also helps to stabilise the exchange rate and promote international trade.

Controller of Credit or Money Supply : RBI controls the increase or decrease in the volume of money supply according to the monetary requirement of the nation. This is important to control the inflation and deflation in the economy. RBI stabilises the general price level and increases the output.

Regulator of the Banks : RBI is entitled to regulatory powers under the RBI Act, of 1934, and the Banking Regulation Act, of 1949. Regulations relate to licensing of banks, expansion of Commercial Banks in terms of their branches in the country or abroad, prescribing minimum requirements of paid-up capital and reserves, etc.

Issues and Manage Government Bonds in India : These serve as instruments for the government to borrow money from the public and manage its fiscal requirements.

Section 24 of RBI Act

Subject to the provisions of sub-section (2) bank notes shall be of the denominational value of two rupees, five rupees, ten rupees, twenty rupees, fifty rupees, one hundred rupees, five hundred rupees, one thousand rupees, five thousand rupees and ten thousand rupees or of such other denominational values, not exceeding ten thousand rupees, as the Central Government may, on the recommendation of the Central Board, specify in this behalf.

The Central Government may, on the recommendation of the Central Board, direct the non-issue or the discontinuance of the issue of bank notes of such denominational values as it may specify on this behalf.

Indian Coinage Act, 2011

❖ Coins may be minted at the Mints or any other place authorised under the proviso to section 3 of such denominations not higher than one thousand rupees and of such dimensions and designs and containing such metals or mixed metals of such composition or any other material as may be prescribed by the Government.

❖ A half-rupee coin, for any sum not exceeding ten rupees; any other coin, for any sum not exceeding one rupee, provided that the coin has not been defaced and has not lost weight to be less than such weight as may be prescribed in its case.

Minimum Reserve System

• Reserve Bank of India issues currency based on a minimum reserve system (MRS) under which it keeps minimum banking of Rs. 200 cr, out of this Rs. 115 cr. of gold and Rs. 85 cr of Government securities of foreign govt.
• This system was adopted by the RBI in 1986.

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