1

ACKNOWLEDGEMENT

I WISH TO TAKE THIS OPPORTUNITY TO EXPRESS MY

DEEP SENSE OF GRATITUDE TO PROF.VIJAY JOSHI FOR
HIS VALUABLE GUIDANCE AND ENDEAVOR. HE HAS BEEN
A CONSTANT SOURCE OF INSPIRATION AND I SINCERELY
THANK HER FOR SUGGESTIONS AND HELP US PREPARE
PROJECT ON INSTRUMENT OF CENTRAL BANKING.

2
CONTENTS
1 Introduction

2 History

3 Objectives and Goals of central banking policy

4 Instruments of central banking policy

5 Survey of monetary or central banking instruments

3
7

Introduction
A central bank, reserve bank, or monetary authority is a banking institution granted the
exclusive privilege to lend a government its currency. Like a normal commercial bank,
a central bank charges interest on the loans made to borrowers, primarily the
government of whichever country the bank exists for, and to other commercial banks,
typically as a 'lender of last resort'. However, a central bank is distinguished from a
normal commercial bank because it has a monopoly on creating the currency of that
nation, which is loaned to the government in the form of legal tender. It is a bank that
can lend money to other banks in times of need. Its primary function is to provide the
nation's money supply, but more active duties include controlling subsidized-loan
interest rates, and acting as a lender of last resort to the banking sector during times
of financial crisis (private banks often being integral to the national financial system). It
may also have supervisory powers, to ensure that banks and other financial institutions
do not behave recklessly or fraudulently.
History
In Europe prior to the 17th century most money was commodity money,
typically gold or silver. However, promises to pay were widely circulated and accepted
as value at least five hundred years earlier in both Europe and Asia. The medieval
European Knights Templar ran probably the best known early prototype of a central
banking system, as their promises to pay were widely regarded, and many regard their

4
activities as having laid the basis for the modern banking system. At about the
same time, Kublai Khan the Mongols introduced fiat currency to China, which
was imposed by force by the confiscation of specie.

As the first public bank to "offer accounts not directly convertible to coin", the Bank of
Amsterdam established in 1609 is considered to be the "first true central bank". This
was followed in 1694 by the Bank of England, created by Scottish
businessman William Paterson in the City of London at the request of the English
government to help pay for a war. Although central banks are generally associated with
fiat money, under the international gold standard of the nineteenth and early twentieth
centuries central banks developed in most of Europe and in Japan, though
elsewhere free banking or currency boards were more usual at this time. Problems with
collapses of banks during downturns, however, was leading to wider support for central
banks in those nations which did not as yet possess them, most notably in Australia.
Objectives and Goals of central banking policy

Price Stability
Unanticipated inflation leads to lender losses. Nominal contracts attempt to account for
inflation. Effort successful if monetary policy able to maintain steady rate of inflation.

High Employment
The movement of workers between jobs is referred to as frictional unemployment. All
unemployment beyond frictional unemployment is classified as unintended
unemployment. Reduction in this area is the target of macroeconomic policy.

Economic Growth
Economic growth is enhanced by investment in technological advances in production.
Encouragement of savings supplies funds that can be drawn upon for investment.
Interest Rate Stability
Volatile interest and exchange rates generate costs to lenders and borrowers.
Unexpected changes that cause damage, making policy formulation difficult.

5
Instruments of central banking policy

6
1. Bank Interest rate policy

7
By far the most visible and obvious power of many modern
central banks is to influence market interest rates; contrary to
popular belief, they rarely "set" rates to a fixed number. Although
the mechanism differs from country to country, most use a
similar mechanism based on a central bank's ability to create as
much fiat money as required. The mechanism to move the
market towards a 'target rate is generally to lend money or
borrow money in theoretically unlimited quantities, until the
targeted market rate is sufficiently close to the target. Central
banks may do so by lending money to and borrowing money
from limited number of qualified banks, or by purchasing and
selling bonds. As an example of how this functions, the Bank of
Canada sets a target overnight rate, and a band of plus or minus
0.25%. Qualified banks borrow from each other within this band,
but never above or below, because the central bank will always
lend to them at the top of the band, and take deposits at the
bottom of the band; in principle, the capacity to borrow and lend
at the extremes of the band are unlimited.]Other central banks
use similar mechanisms. It is also notable that the target rates
are generally short-term rates. The actual rate that borrowers
and lenders receive on the market will depend on credit risk,
maturity and other factors. For example, a central bank might set
a target rate for overnight lending of 4.5%, but rates for five-year
bonds might be 5%, 4.75%, or, in cases of inverted yield curves,
even below the short-term rate. Many central banks have one
primary "headline" rate that is quoted as the "central bank rate."
Bank Rate (For Non Bankers)

This is the rate at which central bank (RBI) lends money to other
banks or financial institutions. If the bank rate goes up, long-term
interest rates also tend to move up, and vice-versa. Thus, it can
said that in case bank rate is hiked, in all likelihood banks will
hikes their own lending rates to ensure and they continue to
make a profit.
8
2. Open market operations
Open market operations are the means of implementing
monetary policy by which a central bank controls its national
money supply by buying and selling government securities, or
other financial instruments. Monetary targets, such as interest
rates or exchange rates, are used to guide this implementation.
Since most money is now in the form of electronic records, rather
than paper records such as banknotes, open market operations
are conducted simply by electronically increasing or decreasing
the amount of money that a bank has, e.g., in its reserve account
at the central bank, in exchange for a bank selling or buying a
financial instrument. Newly created money is used by the central
bank to buy in the open market a financial asset, such as
government bonds, foreign currency, or gold. If the central bank
sells these assets in the open market, the amount of money that
the purchasing bank holds decreases, effectively destroying
money. The process does not literally require the immediate
printing of new currency. A central bank account for a member
bank can simply be increased electronically. However this will
increase the central bank's requirement to print currency when
the member bank demands banknotes, in exchange for a
decrease in its electronic balance. Often, the percentage of the
total money supply consisting of physical banknotes is very
small. In the United States only around 10% of the "M2" money

9
supply actually exists in the form of physical banknotes or
coins. The rest exists as credits in computerized bank
accounts.

3. Selective credit control

In India, selective credit control means control over advances
against the security of "sensitive commodities'' such as food
grains, oilseeds and sugar. There has been considerable
misunderstanding about the purpose of SCC, whose objective is
not to fight inflation.Inflation, as measured by the rise in
wholesale prices, has been hovering above the 7% mark for a
few weeks now, much above RBI’s comfort zone of 5%. The
government has already taken a series of fiscal measures and
RBI in mid-April raised the cash reserve that commercial banks
keep with the Indian central bank in an effort soak up excess
liquidity that stokes inflation. In banking parlance, margin is
collateral that a borrower has to offer to the lender to cover
credit risk. Normally, banks insist on a 25% margin for working
capital loans. This means, if a firm or a trader needs to borrow
Rs100 crore, it must have Rs25 crore of its own funds. A higher
margin will discourage a borrower to go for higher bank
borrowing .Commodities are one of the “sensitive” sectors where
banks’ exposure is always under the lens of the regulator. In
fiscal 2007, Indian banks made total commodities lending of
Rs2,206 crore, about 56% higher than what they had lent in the
previous year. However, it was much lower than the banks’
exposure to real estate market (Rs3.71 trillion) and capital
market (Rs30, 637 crore) in 2007.
4 .Statutory liquidity ratio
Every bank is required to maintain at the close of business
every day, a mini mum proportion of their Net Demand and
Time Liabilities as liquid assets in the form of cash, gold and
un-encumbered approved securities. The ratio of liquid
assets to demand and time liabilities is known as Statutory
Liquidity Ratio (SLR). Pre sent SLR is 24%. (Reduced w.e.f.

10
8/11/208, from earlier 25%) RBI is empowered to increase this
ratio up to 40%. An increase in SLR also restricts the bank’s
leverage position to pump more money into the economy.
D
The main objectives for maintaining the Statutory Liquidity Ratio
are the following:

• Statutory Liquidity Ratio is maintained in order to control the

expansion of Bank Credit. By changing the level of Statutory
Liquidity Ratio, Reserve bank of India can increase or decrease
bank credit expansion.

• Statutory Liquidity Ratio in a way ensures the solvency of

commercial banks.

• By determining Statutory Liquidity Ratio, Reserve Bank of India,

in a way, compels the commercial banks to invest in government
securities like government bonds.

If any Indian Bank fails to maintain the required level of Statutory

Liquidity Ratio, then it becomes liable to pay penalty to Reserve
Bank of India. The defaulter bank pays penal interest at the rate
of 3% per annum above the Bank Rate, on the shortfall amount
for that particular day. But, according to the Circular, released by
the Department of Banking Operations and Development,
Reserve Bank of India; if the defaulter bank continues to default
on the next working day, then the rate of penal interest can be
increased to 5% per annum above the Bank Rate.

What is SLR? (For Non Bankers)

SLR stands for Statutory Liquidity Ratio. This term is used by bankers and indicates the
minimum percentage of deposits that the bank has to maintain in form of gold, cash or

11
other approved securities. Thus, we can say that it is ratio of cash and some other
approved to liabilities (deposits) It regulates t he credit growth in India
5. Cash Reserve Ratio

5. Cash Reserve Ratio

The Reserve Bank of India (Amendment) Bill, 2006 has been
enacted and has come into force
and has come into force with its gazette notification.
Consequent upon amendment to sub Section 42(1), the
Reserve Bank, having regard to the needs of securing the
monetary stability in the country, can prescribe Cash Reserve
Ratio(CRR) for scheduled banks without any floor r a t e o r
c e i l i n g rate. [Before the enactment of this amendment,
in terms of Section 42(1) of the RBI Act, the Reserve Bank
could pre scribe CRR for scheduled banks between 3 per cent
and 20 per cent of total of their demand and time liabilities].
RBI uses CRR either to drain excess liquidity or to release
funds needed for the economy from time to time. Increase
in CRR means that banks have less funds available and
money is sucked out of circulation. Thus we can say that this
serves
Duel purposes i.e. it not only ensures that a portion of bank
deposits is totally risk-free, but also enables RBI to control
liquidity in the system and thereby, inflation by tying the
hands of the banks in lending money

CRR (For Non Bankers):

CRR means Cash Re- serve Ratio. Banks in India are required to
hold a certain proportion of their deposits in the form of
cash. However actually Banks don’t hold these as cash
with them- selves, but deposit such case w it Reserve Bank of
India(RBI) / currency chests, which is considered as
equivalent to holding cash with themselves.. This minimum
ratio (that is the part of the total deposits to be held as cash)
is stipulated by the RBI and is known as the CRR or Cash

12
Reserve Ratio.

Thus, When a bank’s deposits increase by Rs100, and if the

cash reserve ratio is 9%, the banks will have to hold additional
Rs 9 with RBI and Bank will be able to use only Rs 91 for
investments and lending / credit purpose .Therefore, higher
the ratio (i.e. CRR), the lower is the amount that banks will be
able to use for lending investment.

This power of RBI to reduce the lendable amount by

increasing the CRR, makes it an instrument in the hands of
a central bank through which it can control the amount that
banks lend. Thus, it is a tool used by RBI to control liquidity in
the banking system.

6. Credit authorization scheme

Credit authorization by a method of providing credit account

information at remote terminals. A radio frequency carrier is
modulated with a signal constituting a sequence of encoded
data, i.e., credit information, transmitted from a central station to
remote terminals, and there retrieved by demodulation of the
carrier. Credit information is derived from the retrieved signal by
electronically determining coincidence between credits data
(e.g., a credit account number) presented at remote terminals
with credit data (e.g., a sequence of "bad" credit account
numbers) of the retrieved signal. This is accomplished by
apparatus of the system including central means, e.g., a
computer, for generating the signal, a central transmitter for
transmitting the signal to the remote terminals (preferably

13
through commercial FM broadcasting subcarrier
techniques), and receivers at each of the remote terminals.
Digital circuitry at the remote terminals makes the coincidence
determination.

7. Credit Monitoring Arrangement

In order to ensure the basic financial discipline the RBI continued

to monitor and scrutinize all sanctions of bank loans exceeding
Rs.5 crores to any single party for working capital requirement
and Rs .2 crores in case of term loan. This post sanction scheme
was known as Credit Monitoring Arrangement. RBI has clearly
advised the commercial banks that there is no change in the
prescribed criteria for lending to the borrowers to meet their
working capital requirements or to meet their long-term credit
requirements. Selective credit controls have been prominent as a
weapon of credit control. During 1973-75 RBI enforced a severe
credit squeeze as an anti inflationary measure. The banks
generally had to conform to the selective control directives of RBI
and the advances against particular commodities were
maintained within the permitted limits. According to RBI the
efficacy of selective credit controls should not be assessed
mainly in terms of their positive influence on prices because the
prices depend on the availability of supply of relevant
commodities. The success of these controls should be judged in a
limited sphere.

Survey of monetary or central banking instruments

14
Central Bank instruments can be divided into two categories: Standing facilities and open
market operations. After the 1998 reform, the Bank has four standing facilities, i.e. current
accounts, an overnight lending facility, certificates of deposit and required reserves. The open
market operations available to the Bank involve outright transactions in the bond, T-bill and
foreign exchange markets,

and repo auctions. As mentioned earlier, the Central Bank has hardly been active in the bond
market since 1995 but is still a market maker for T-bills, although an end to this arrangement is
now in sight. Trading by the Bank in the foreign exchange market has decreased substantially
and has become rare after the 1997 reform.

Credit institutions’ current accounts:

The credit institutions’ current accounts with the Central Bank serve a dual purpose. One is to
act as a depository for their liquid assets which are left over

At the end of the day and cannot be invested more profitably for shorter or longer periods. The
other is that they constitute settlement accounts for the credit institutions’ transactions with the
Central Bank. Netting between deposit institutions is handled through these accounts as well
as settlements for

Trading between them and their settlements with the Central Bank. No overdraft is allowed on
these accounts and institutions which overdraw have to

Borrow overnight with one-day retroactive penalty interest. Interest terms on these accounts
set the floor for overnight deposit rates in the interbank market, since there is no need for
players there to accept a lower rate of interest than is available on such accounts. Interest
rates on current accounts are advertised and announced in advance.

Overnight borrowing:
Credit institutions trading with the Central Bank are entitled to overnight credit against
securities which the bank accepts as collateral. These securities are the same ones which
qualify for repo transactions. No ceiling is imposed on overnight borrowing for as long as credit
institutions have securities which can

Be accepted as collateral. Overnight interest rates are announced in advance. They form the
ceiling for overnight lending in the domestic interbank market since credit institutions have no
need to borrow overnight at a higher rate unless they have no securities which qualify as
collateral. Through the interest rates on its current accounts and overnight lending, the Central
Bank establishes the floor and ceiling, or a corridor, for overnight rates in the interbank market
and thereby prevents excessive fluctuations in them. Excessive interbank interest rate
fluctuations could have a disruptive effect on credit and securities markets and create
uncertainty about the Central Bank’s monetary policy

15
 Conclusion

The Central Bank as to function as market maker for T-bills.

Agreements are under preparation between the Treasury Debt
Management Agency and market players at ISE regarding their
participation in primary sales of T-bills and secondary market
making, i.e. a primary dealer arrangement. This will create
conditions for the Central Bank to pull out as market maker of
treasury bills. The system of facilities which the Bank established
in 1998 has functioned well. It appears to transmit the Bank’s
interest rate policy clearly to market participants and over the
past two years the credit institutions’ unindexed interest rate
terms and money market interest rates have by and large kept
pace with Central Bank policy rates. Currency flows and the
exchange rate have generally shown the intended movements
when the Central Bank has altered its interest rates. The impact
of the Bank’s policy rate on credit demand, however, appears
less clear and is delivered with a greater lag. This is probably
caused by the heavy weighting of indexation in the credit
market, since real yield on indexed items does not follow the
Bank’s policy rate.

16
 Group members

Pooja agarwal 02
Anjana ramesh 03
Bhagyshri 10
Aastha kabra 24
Divya khiara 27

17
18