Introduction

Since the initiation of reforms in the early 1990s, the Indian economy
has achieved high growth in an environment of macroeconomic and financial
stability. The period has been marked by broad based economic reform that
has touched every segment of the economy. These reforms were designed
essentially to promote greater efficiency in the economy through promotion
of greater competition. The story of Indian reforms is by now well-
documented (e.g., Ahluwalia, 2002); nevertheless, what is less appreciated is
that India achieved this acceleration in growth while maintaining price and
financial stability. As a result of the growing openness, India was not
insulated from exogenous shocks since the second half of the 1990s. These
shocks, global as well as domestic, included a series of financial crises in
Asia, Brazil and Russia, 9/11 terrorist attacks in the US, border tensions,
sanctions imposed in the aftermath of nuclear tests, political uncertainties,
changes in the Government, and the current oil shock. Nonetheless, stability
could be maintained in financial markets. Indeed, inflation has been
contained since the mid-1990s to an average of around five per cent,
distinctly lower than that of around eight per cent per annum over the
previous four decades. Simultaneously, the health of the financial sector has
recorded very significant improvement.
India's path of reforms has been different from most other emerging
market economies: it has been a measured, gradual, cautious, and steady
process, devoid of many flourishes that could be observed in other countries.
I shall argue in this paper that reforms in the financial sector and monetary
policy framework have been a key component of the overall reforms that
provided the foundation of an increased price and financial stability. Reforms
in these sectors have been well- sequenced, taking into account the state of
the markets in the various segments.
The main objective of the financial sector reforms in India initiated in
the early 1990s was to create an efficient, competitive and stable financial
sector that could then contribute in greater measure to stimulate growth.
Concomitantly, the monetary policy framework made a phased shift from
direct instruments of monetary management to an increasing reliance on
indirect instruments.
 However, as appropriate monetary transmission cannot take place
without efficient price discovery of interest rates and exchange rates in the
overall functioning of financial markets, the corresponding development of
the money market, Government securities market and the foreign exchange
market became necessary. Reforms in the various segments, therefore, had to
be coordinated. In this process, growing integration of the Indian economy
with the rest of the world also had to be recognised and provided for.

Against this backdrop, the coverage of this paper is threefold. First, I

will give a synoptic account of the reforms in financial sector and monetary
policy. Second, this is followed by an assessment of these reforms in terms of
outcomes and the health of the financial sector. Finally, lessons emerging
from the Indian experience for issues of topical relevance for monetary
authorities are considered in the final Section.

Financial Sector and Monetary Policy: Objectives and Reforms

Till the early 1990s the Indian financial sector could be described as a
classic example of “financial repression” a la McKinnon and Shaw.
Monetary policy was subservient to the fisc. The financial system was
characterised by extensive regulations such as administered interest rates,
directed credit programmes, weak banking structure, lack of proper
accounting and risk management systems and lack of transparency in
operations of major financial market participants (Mohan, 2004b). Such a
system hindered efficient allocation of resources. Financial sector reforms
initiated in the early 1990s have attempted to overcome these weaknesses in
order to enhance efficiency of resource allocation in the economy.
Simultaneously, the Reserve Bank took a keen interest in the
development of financial markets, especially the money, government
securities and forex markets in view of their critical role in the transmission
mechanism of monetary policy. As for other central banks, the money market
is the focal point for intervention by the Reserve Bank to equilibrate short-
term liquidity flows on account of its linkages with the foreign exchange
market. Similarly, the Government securities market is important for the
entire debt market as it serves as a benchmark for pricing other debt market
instruments, thereby aiding the monetary transmission process across the
yield curve.
 The Reserve Bank had, in fact, been making efforts since 1986 to
develop institutions and infrastructure for these markets to facilitate price
discovery. These efforts by the Reserve Bank to develop efficient, stable and
healthy financial markets accelerated after 1991. There has been close co-
ordination between the Central Government and the Reserve Bank, as also
between different regulators, which helped in orderly and smooth
development of the financial markets in India

What have been the major contours of the financial sector reforms in India? For
the sake of completeness, it is useful to have a quick run-down of these:
 Removal of the erstwhile existing financial repression
 Creation of an efficient, productive and profitable financial sector
 Enabling the process of price discovery by the market determination of
interest rates that improves allocative efficiency of resources
 Providing operational and functional autonomy to institutions
 Preparing the financial system for increasing international competition
 Opening the external sector in a calibrated manner; and
 Promoting financial stability in the wake of domestic and external
shocks.
 The financial sector reforms since the early 1990s could be analytically
classified into two phases.1 The first phase - or the first generation of reforms
- was aimed at creating an efficient, productive and profitable financial sector
which would function in an environment of operational flexibility and
functional autonomy. In the second phase, or the second generation reforms,
which started in the mid-1990s, the emphasis of reforms has been on
strengthening the financial system and introducing structural improvements.
Against this brief overview of the philosophy of financial sector reforms, let
me briefly touch upon reforms in various sectors and segments of the
financial sector.

Banking Sector

The main objective of banking sector reforms was to promote a

diversified, efficient and competitive financial system with the ultimate goal
of improving the allocative efficiency of resources through operational
flexibility, improved financial viability and institutional strengthening. The
reforms have focussed on removing financial repression through reductions
in statutory pre- emptions, while stepping up prudential regulations at the
same time. Furthermore, interest rates on both deposits and lending of banks
have been progressively deregulated.
As the Indian banking system had become predominantly government
owned by the early 1990s, banking sector reforms essentially took a two
pronged approach. First, the level of competition was gradually increased
within the banking system while simultaneously introducing international
best practices in prudential regulation and supervision tailored to Indian
requirements. In particular, special emphasis was placed on building up the
risk management capabilities of Indian banks while measures were initiated
to ensure flexibility, operational autonomy and competition in the banking
sector. Second, active steps were taken to improve the institutional
arrangements including the legal framework and technological system. The
supervisory system was revamped in view of the crucial role of supervision in
the creation of an efficient banking system.
2
 Measures to improve the health of the banking system have included
(i) restoration of public sector banks' net worth through recapitalisation where
needed; (ii) streamlining of the supervision process with combination of on-
site and off-site surveillance along with external auditing; (iii) introduction
of risk based supervision; (iv) introduction of the process of structured

Reddy (2002) noted that the approach towards financial sector reforms in
India has been based on five principles: (i) cautious and appropriate
sequencing of reform measures; (ii) introduction of mutually reinforcing
norms; (iii) introduction of complementary reforms across monetary, fiscal
and external sectors;
(iv) development of financial institutions; and (v) development of financial
markets. and discretionary intervention for problem banks through a prompt
corrective action (PCA) mechanism; (v) institutionalisation of a mechanism
facilitating greater coordination for regulation and supervision of financial
conglomerates; (vi) strengthening creditor rights (still in process); and
(vii) increased emphasis on corporate governance.
Consistent with the policy approach to benchmark the banking system
to the best international standards with emphasis on gradual harmonisation,
all commercial banks in India are expected to start implementing Basel II
with effect from March 31, 2007 – though a marginal stretching beyond this
date should not be ruled out in view of the latest indications on the state of
preparedness (Reddy, 2006a). Recognising the differences in degrees of
sophistication and development of the banking system, it has been decided
that the banks will initially adopt the Standardised Approach for credit risk
and the Basic Indicator Approach for operational risk. After adequate skills
are developed, both by the banks and also by the supervisors, some of the
banks may be allowed to migrate to the Internal Rating Based (IRB)
Approach. Although implementation of Basel II will require more capital for
banks in India, the cushion available in the system - at present, the Capital to
Risk Assets Ratio (CRAR) is over 12 per cent - provides some comfort. In
order to provide banks greater flexibility and avenues for meeting the capital
requirements, the Reserve Bank has issued policy guidelines enabling
issuance of several instruments by the banks viz., innovative perpetual debt
instruments, perpetual non-cumulative preference shares, redeemable
cumulative preference shares and hybrid debt instruments.

3
 Box I
Reforms in the Banking Sector
A. Competition Enhancing Measures
 Granting of operational autonomy to public sector banks, reduction
of public ownership in public sector banks by allowing them to raise
capital from equity market up to 49 per cent of paid-up capital.
 Transparent norms for entry of Indian private sector, foreign and
joint-venture banks and insurance companies, permission for foreign
investment in the financial sector in the form of Foreign Direct
Investment (FDI) as well as portfolio investment, permission to
banks to diversify product portfolio and business activities.
 Roadmap for presence of foreign banks and guidelines for mergers
and amalgamation of private sector banks and banks and NBFCs.
 Guidelines on ownership and governance in private sector banks.
B.Measures Enhancing Role of Market Forces
 Sharp reduction in pre-emption through reserve requirement, market
determined pricing for government securities, disbanding of
administered interest rates with a few exceptions and enhanced
transparency and disclosure norms to facilitate market discipline.
 Introduction of pure inter-bank call money market, auction-based
repos-reverse repos for short-term liquidity management, facilitation
of improved payments and settlement mechanism.
 Significant advancement in dematerialisation and markets for
securitised assets are being developed.
C.Prudential Measures
 .Introduction and phased implementation of international best
practices and norms on risk-weighted capital adequacy requirement,
accounting, income recognition, provisioning and exposure.
 Measures to strengthen risk management through recognition of
different components of risk, assignment of risk-weights to various
asset classes, norms on connected lending, risk concentration,
application of marked-to-market principle for investment portfolio
and limits on deployment of fund in sensitive activities.
 'Know Your Customer' and 'Anti Money Laundering' guidelines,
roadmap for Basel II, introduction of capital charge for market risk,
higher graded provisioning for NPAs, guidelines for ownership and
governance, securitisation and debt restructuring mechanisms
norms, etc.

D. Institutional and Legal Measures

 Setting up of Lok Adalats (people’s courts), debt recovery tribunals,
asset reconstruction companies, settlement advisory committees,
corporate debt restructuring mechanism, etc. for quicker recovery/
restructuring.
  Promulgation of Securitisation and Reconstruction of Financial

Assets and Enforcement of Securities Interest (SARFAESI) Act,

2002 and its subsequent amendment to ensure creditor rights.

Setting up of Credit Information Bureau of India Limited (CIBIL)

for information sharing on defaulters as also other borrowers.
 Setting up of Clearing Corporation of India Limited (CCIL) to act as
central counter party for facilitating payments and settlement system
relating to fixed income securities and money market instruments.
E.Supervisory Measures
 Establishment of the Board for Financial Supervision as the apex
supervisory authority for commercial banks, financial institutions
and non-banking financial companies.
 Introduction of CAMELS supervisory rating system, move towards
risk-based supervision, consolidated supervision of financial
conglomerates, strengthening of off- site surveillance through
control returns.
 Recasting of the role of statutory auditors, increased internal control
through strengthening of internal audit.
 Strengthening corporate governance, enhanced due diligence on
important shareholders, fit and proper tests for directors.

F.Technology Related Measures

 Setting up of INFINET as the communication backbone for the
financial sector, introduction of Negotiated Dealing System (NDS)
for screen-based trading in government securities and Real Time
Gross Settlement (RTGS) System
G. Reforms in the Monetary Policy Framework
H. The basic emphasis of monetary policy since the initiation of reforms
has been to reduce market segmentation in the financial sector through
increased interlinkages between various segments of the financial market
including money, government security and forex market. The key policy
development that has enabled a more independent monetary policy
environment as well as the development of Government securities market
was the discontinuation of automatic monetisation of the government's
fiscal deficit since April 1997 through an agreement between the
Government and the Reserve Bank of India in September 1994. In order to
meet the challenges thrown by financial liberalisation and the growing
complexities of monetary management, the Reserve Bank switched from a
monetary targeting framework to a multiple indicator approach from 1998-
99. Short-term interest rates have emerged as the key indicators of the
monetary policy stance. A significant shift is the move towards market-
based instruments away from direct instruments of monetary management.
 In line with international trends, the Reserve Bank has put in place a

liquidity management framework in which market liquidity is managed

through a mix of open market (including repo) operations (OMOs),
changes in reserve requirements and standing facilities, reinforced by
changes in the policy rates, including the Bank Rate and the short term
(overnight) policy rate. In order to carry out these market operations
effectively, the Reserve Bank has initiated several measures to strengthen
the health of its balance sheet.
I. Over the past few years, the process of monetary policy formulation has
become relatively more articulate, consultative and participative with
external orientation, while the internal work processes have also been re-
engineered. A recent notable step in this direction is the constitution of a
Technical Advisory Committee on Monetary Policy comprising external
experts to advise the Reserve Bank on the stance of monetary policy (Box
II).
J. Following the reforms, the financial markets have now grown in size, depth
and activity paving the way for flexible use of indirect instruments by the
Reserve Bank to pursue its objectives. It is recognised that stability in
financial markets is critical for efficient price discovery. Excessive
volatility in exchange rates and interest rates masks the underlying value of
these variables and gives rise to confusing signals. Since both the exchange
rate and interest rate are the key prices reflecting the cost of money, it is
particularly important for the efficient functioning of the economy that they
be market determined and be easily observed. The Reserve Bank has,
therefore, put in place a liquidity management framework in the form of a
liquidity adjustment facility (LAF) for the facilitation of forex and money
market transactions that result in price discovery sans excessive volatility.
The LAF coupled with OMOs and the Market Stabilisation Scheme (MSS)
has provided the Reserve Bank greater flexibility to manage market
liquidity in consonance with its policy stance. The introduction of LAF had
several advantages (Mohan, 2006b).
 . First and foremost, it helped the transition from direct instruments of
monetary control to indirect and, in the process, certain dead weight
loss for the system was saved.
 Second, it has provided monetary authorities with greater flexibility in
determining both the quantum of adjustment as well as the rates by
responding to the needs of the system on a daily basis.
 Third, it enabled the Reserve Bank to modulate the supply of funds on
a daily basis to meet day-to-day liquidity mismatches.
 Fourth, it enabled the Reserve Bank to affect demand for funds through
policy rate changes.
 Fifth and most important, it helped stabilise short-term money market
rates.
 BOX II
Reforms in the Monetary Policy Framework
Objectives
 Twin objectives of “maintaining price stability” and “ensuring
availability of adequate credit to productive sectors of the
economy to support growth” continue to govern the stance of
monetary policy, though the relative emphasis on these objectives
has varied depending on the importance of maintaining an
appropriate balance.
 Reflecting the increasing development of financial market and
greater liberalisation, use of broad money as an intermediate
target has been de-emphasised and a multiple indicator approach
has been adopted.
 Emphasis has been put on development of multiple instruments to
transmit liquidity and interest rate signals in the short-term in a
flexible and bi-directional manner.
 Increase of the interlinkage between various segments of the
financial market including money, government security and forex
markets.
Instruments
 Move from direct instruments (such as, administered interest
rates, reserve requirements, selective credit control) to indirect
instruments (such as, open market operations, purchase and
repurchase of government securities) for the conduct of monetary
policy.
 Introduction of Liquidity Adjustment Facility (LAF), which
operates through repo and reverse repo auctions, effectively
provide a corridor for short-term interest rate. LAF has emerged
as the tool for both liquidity management and also as a signalling
devise for interest rate in the overnight market.
 Use of open market operations to deal with overall market
liquidity situation especially those emanating from capital flows.
 Introduction of Market Stabilisation Scheme (MSS) as an
additional instrument to deal with enduring capital inflows
without affecting short-term liquidity management role of LAF.
Developmental Measures
 Discontinuation of automatic monetisation through an agreement
between the Government and the Reserve Bank. Rationalisation
of Treasury Bill market. Introduction of delivery versus payment
system and deepening of inter-bank repo market.
 Introduction of Primary Dealers in the government securities
market to play the role of market maker.
 Amendment of Securities Contracts Regulation Act (SCRA), to
create the regulatory framework.
  Deepening of government securities market by making the
interest rates on such securities market related. Introduction of
auction of government securities. Development of a risk-free
credible yield curve in the government securities market,
benchmark for related markets.
 Development of pure inter-bank call money market. Non-bank
participants to participate in other money market instruments.
 Introduction of automated screen-based trading in government
securities through Negotiated Dealing System (NDS). Setting up
of risk-free payments and system in government securities
through Clearing Corporation of India Limited (CCIL). Phased
introduction of Real Time Gross Settlement (RTGS) System.
 Deepening of forex market and increased autonomy of Authorised
Dealers.
Institutional Measures
 Setting up of Technical Advisory Committee on Monetary Policy
with outside experts to review macroeconomic and monetary
developments and advise the Reserve Bank on the stance of
monetary policy.
Creation of a separate Financial Market Department within the RBI
  .

LAF has now emerged as the principal operating instrument of

monetary policy. Although there is no formal targeting of a point overnight
interest rate, the LAF is designed to nudge overnight interest rates within a
specified corridor, the difference between the fixed repo and reverse repo
rates currently being 100 basis points. The evidence suggests that this effort
has been largely successful with the overnight interest rate moving out of this
corridor for only a few brief periods. The LAF has enabled the Reserve Bank
to de-emphasise targeting of bank reserves and focus increasingly on
interest rates. This has helped in reducing the cash reserve ratio (CRR)
without loss of monetary control.

Given the growing role played by expectations, the stance of monetary policy
and its rationale are communicated to the public in a variety of ways. The
enactment of the Fiscal Responsibility and Budget Management Act, 2003 has
strengthened the institutional mechanism further: from April 2006 onwards, the
Reserve Bank is no longer permitted to subscribe to government securities in
the primary market. The development of the monetary policy framework has
also involved a great deal of institutional initiatives to enable efficient
functioning of the money market: development of appropriate trading,
payments and settlement systems along with technological infrastructure.
 Financial Markets

The success of a framework that relies on indirect instruments of

monetary management such as interest rates, is contingent upon the extent
and speed with which changes in the central bank's policy rate are transmitted
to the spectrum of market interest rates and exchange rate in the economy and
onward to the real sector. Given the critical role played by financial markets
in this transmission mechanism, the Reserve Bank has taken a number of
initiatives to develop a pure inter-bank money market. A noteworthy and
desirable development has been the substantial migration of money market
activity from the uncollateralised call money segment to the collateralised
market repo and collateralised borrowing and lending obligations (CBLO)
markets. The shift of activity from uncollateralised to collateralised segments
of the market has largely resulted from measures relating to limiting the call
market transactions to banks and primary dealers only. This policy-induced
shift is in the interest of financial stability and is yielding results.
Concomitantly, efforts have been made to broaden and deepen the
Government securities market and foreign exchange market so as to enable
the process of efficient price discovery in respect of interest rates and the
exchange rate (Boxes III and IV).
It is pertinent to note that the phased approach to development of
financial markets has enabled RBI's withdrawal from the primary market
since April 1, 2006. This step completes the transition to a fully market based
system in the G-sec market. Looking ahead, as per the recommendations of
the Twelfth Finance Commission, the Central Government would cease to
raise resources on behalf of State Governments, who, henceforth, have to
access the market directly. Thus, State Governments' capability in raising
resources will be market determined and based on their own financial health.
In order to ensure a smooth transition to the new regime, restructuring of
current institutional processes has already been initiated (Mohan, 2006c).
These steps are helping to achieve the desired integration in the conduct of
monetary operations.
Box III
Reforms in the Government
Institutional
Measures Securities Market
 Administered interest rates on government securities were replaced by
an auction system for price discovery.
 Automatic monetisation of fiscal deficit through the issue of ad hoc
Treasury Bills was phased out.
 Primary Dealers (PD) were introduced as market makers in the
government securities market.
 For ensuring transparency in the trading of government securities,
Delivery versus
Payment (DvP) settlement system was introduced.
 Repurchase agreement (repo) was introduced as a tool of short-term
liquidity adjustment. Subsequently, the Liquidity Adjustment Facility
(LAF) was introduced.
 LAF operates through repo and reverse repo auctions and provide a
corridor for short-term interest rate. LAF has emerged as the tool for
both liquidity management and also signalling device for interest rates
in the overnight market. The Second LAF (SLAF) was introduced in
November 2005.
 Market Stabilisation Scheme (MSS) has been introduced, which has
expanded the instruments available to the Reserve Bank for managing
the enduring surplus liquidity in the system.
 Effective April 1, 2006, RBI has withdrawn from participating in
primary market auctions of Government paper.
 Banks have been permitted to undertake primary dealer business while
primary dealers are being allowed to diversify their business.
 Short sales in Government securities is being permitted in a calibrated
manner while guidelines for ‘when issued’ market have been issued
recently.

Increase in Instruments in the Government Securities Market

 91-day Treasury bill was introduced for managing liquidity and
benchmarking. Zero Coupon Bonds, Floating Rate Bonds, Capital
Indexed Bonds were issued and exchange traded interest rate futures
were introduced. OTC interest rate derivatives like IRS/ FRAs were
 introduced.
 Outright sale of Central Government dated security that are not owned
have been permitted, subject to the same being covered by outright
purchase from the secondary market within the same trading day
subject to certain conditions.
 Repo status has been granted to State Government securities in order to
improve secondary market liquidity.

Enabling Measures

 Foreign Institutional Investors (FIIs) were allowed to invest in

government securities subject to certain limits.
 Introduction of automated screen-based trading in government
securities through Negotiated Dealing System (NDS).
 Setting up of risk-free payments and settlement system in government
securities through Clearing Corporation of India Limited (CCIL).
 Phased introduction of Real Time Gross Settlement System (RTGS).
 Introduction of trading in government securities on stock exchanges for
promoting retailing in such securities, permitting non-banks to
participate in repo market.
 Recent measures include introduction of NDS-OM and T+1 settlement
norms.

As regards the foreign exchange market, reforms focused on market

development with inbuilt prudential safeguards so that the market would not
be destabilised in the process (Reddy, 2002). The move towards a market-
based exchange rate regime in 1993 and the subsequent adoption of current
account convertibility were the key measures in reforming the Indian foreign
exchange market. Banks are increasingly being given greater autonomy to
undertake foreign exchange operations. In order to deepen the foreign
exchange market, a large number of products have been introduced and entry
of new players has been allowed in the market (Box IV).
Summing up, reforms were designed to enable the process of efficient
price discovery and induce greater internal efficiency in resource allocation
within the banking system. While the policy measures in the pre-1990s period
were essentially devoted to financial deepening, the focus of
reforms in the last decade and a half has been engendering greater efficiency
and productivity in the banking system. Reforms in the monetary policy
framework were aimed at providing operational flexibility to the Reserve
Bank in its conduct of monetary policy by relaxing the constraint imposed by
passive monetisation of the fisc.

BOX IV
REFORMS IN THE FOREIGN
Exchange Rate
Regime EXCHANGE MARKET
 Evolution of exchange rate regime from a single-currency fixed-
exchange rate system to fixing the value of rupee against a basket of
currencies and further to market-determined floating exchange rate
regime.
 Adoption of convertibility of rupee for current account transactions
with acceptance of Article VIII of the Articles of Agreement of the
IMF. De facto full capital account convertibility for non residents and
calibrated liberalisation of transactions undertaken for capital account
purposes in the case of residents.
Institutional Framework
 Replacement of the earlier Foreign Exchange Regulation Act (FERA),
1973 by the market friendly Foreign Exchange Management Act, 1999.
Delegation of considerable powers by RBI to Authorised Dealers to
release foreign exchange for a variety of purposes.
Increase in Instruments in the Foreign Exchange Market
 Development of rupee-foreign currency swap market.
 Introduction of additional hedging instruments, such as, foreign
currency-rupee options. Authorised dealers permitted to use innovative
products like cross-currency options, interest rate swaps (IRS) and
currency swaps, caps/collars and forward rate agreements (FRAs) in
the international forex market.
Liberalisation Measures
 Authorised dealers permitted to initiate trading positions, borrow and
invest in overseas market subject to certain specifications and
ratification by respective Banks’ Boards. Banks are also permitted to
fix interest rates on non-resident deposits, subject to certain
specifications, use derivative products for asset-liability management
and fix overnight open position limits and gap limits in the foreign
exchange market, subject to ratification by RBI.
 Permission to various participants in the foreign exchange market,
including exporters, Indians investing abroad, FIIs, to avail forward
cover and enter into swap transactions without any limit subject to
genuine underlying exposure.
 FIIs and NRIs permitted to trade in exchange-traded derivative
 contracts subject to certain conditions.
 Foreign exchange earners permitted to maintain foreign currency
accounts. Residents are permitted to open such accounts within the
general limit of US $ 25, 000 per year.

Financial Sector and Monetary Policy Reforms:

An Assessment Banking Sector

An assessment of the banking sector shows that banks have
experienced strong balance sheet growth in the post-reform period in an
environment of operational flexibility. Improvement in the financial health of
banks, reflected in significant improvement in capital adequacy and improved
asset quality, is distinctly visible. It is noteworthy that this progress has been
achieved despite the adoption of international best practices in prudential
norms. Competitiveness and productivity gains have also been enabled by
proactive technological deepening and flexible human resource management.
These significant gains have been achieved even while renewing our goals of
social banking viz., maintaining the wide reach of the banking system and
directing credit towards important but disadvantaged sectors of society. A
brief discussion on the performance of the banking sector under the reform
process is given below.

Spread of Banking
The banking system's wide reach, judged in terms of expansion of
branches and the growth of credit and deposits indicates continued financial
deepening (Table 1). The population per bank branch has not changed much
since the 1980s, and has remained at around 16,000.
 Table 1: Progress of Commercial Banking in India
1969 1980 1991 1995 2000 2005
1 2 3 4 5 6 9
1 No. of Commercial Banks 73 154 272 284 298 288
2 No. of Bank Offices 8,262 34,59 60,57 64,23 67,86 68,33
4 0 4 8 9
Of which
Rural and semi-urban 5,172 23,22 46,55 46,60 47,69 47491
bank 7 0 2 3
offices
3 Population per Office 64 16 14 15 15 16
(’000s)
4 Per capita Deposit (Rs.) 88 738 2,368 4,242 8,542 16,69
9
5 Per capita Credit (Rs.) 68 457 1,434 2,320 4,555 10,13
5
6 Priority Sector 15 37 39 34 35 40
Advances@ (per
cent)
7 Deposits (per cent of 16 36 48 48 54 65
National Income)
Source: Reserve Bank of India

In the post-reform period, banks have consistently maintained high

rates of growth in their assets and liabilities. On the liability side, deposits
continue to account for about 80 per cent of the total liabilities. On the asset
side, the shares of loans and advances on the one hand and investments on
the other hand have seen marked cycles, reflecting banks' portfolio
preferences as well as growth cycles in the economy. The share of loans and
advances declined in the second half of 1990s responding to slowdown in
investment demand as well as tightening of prudential norms. With
investment demand again picking up in the past 3-4 years, banks' credit
portfolio has witnessed sharp growth. Banks' investment in gilts have
accordingly seen a significant decline in the past one year, although it still
remains above the minimum statutory requirement. Thus, while in the 1990s,
greater investments and aversion to credit risk exposure may have deterred
banks from undertaking their ‘core function’ of financial intermediation viz.,
accepting deposits and extending credit, they seem to have struck a greater
balance in recent years between investments and loans and advances. The
improved atmosphere for recovery created in the recent years seems to have
induced banks to put greater efforts in extending loans.
Capital Position and Asset Quality
Since the beginning of reforms, a set of micro-prudential measures
have been stipulated aimed at imparting strength to the banking system as
well as ensuring safety. With regard to prudential requirements, income
recognition and asset classification (IRAC) norms have been strengthened to
approach international best practice. Initially, while it was deemed to attain a
CRAR of 8 per cent in a phased manner, it was subsequently raised to 9 per
cent with effect from 1999-2000.
The overall capital position of commercial banks has witnessed a
marked improvement during the reform period (Table 2). Illustratively, as at
end-March 2005, 86 out of the 88 commercial banks operating in India
maintained CRAR at or above 9 per cent. The corresponding figure for 1995-
96 was 54 out of 92 banks. Improved capitalisation of public sector banks
was initially brought through substantial infusion of funds by government to
recapitalise these banks. Subsequently, in order to mitigate the budgetary
impact and to introduce market discipline, public sector banks were allowed
to raise funds from the market through equity issuance subject to the
maintenance of 51 per cent public ownership. Ownership in public sector
banks is now well diversified. As at end-March 2005, the holding by the
general public in six banks ranged between 40 and 49 per cent and in 12
banks between 30 and 49 per cent. It was only in four banks that the
Government holding was more than 90 per cent.
 Table 2: Distribution of Commercial Banks
According to Risk-weighted
Capital Adequacy
(Number of banks)
Year Below Betwe Betwe Above Total
4 per en 4-9 per en 9-10 per 10 per
cent cent* cent@ cent
1 2 3 4 5 6
1995-96 8 9 33 42 92
2000-01 3 2 11 84 100
2004-05 1 1 8 78 88
* : Relates to 4-8 per cent before
1999-2000, @: Relates to 8-10 per
cent before 1999-2000. Source:
Reserve Bank of India.

Despite tightening norms, there has been considerable improvement in

the asset quality of banks. India transited to a 90-day NPL recognition norm
(from 180-day norm) in 2004. Nonetheless, non-performing loans (NPLs), as
ratios of both total advances and assets, have declined substantially and
consistently since the mid-1990s (Table 3). Improvement in the credit
appraisal process, upturn of the business cycle, new initiatives for resolution
of NPLs (including promulgation of the Securitisation and Reconstruction of
Financial Assets and Enforcement of Security Interest (SARFAESI) Act), and
greater provisioning and write-off of NPLs enabled by greater profitability,
have kept incremental NPLs low.
Table 3: Non-Performing Loans (NPL) of Scheduled
Commercial Banks
(Per cent)
Gross NPL/ Gross NPL/ Net NPL/ Net NPL/
advances Assets advances Assets
1 2 3 4 5
1996-97 15.7 7 8.1 3.3
1997-98 14.4 6.4 7.3 3.0
1998-99 14.7 6.2 7.6 2.9
1999-00 12.7 5.5 6.8 2.7
2000-01 11.4 4.9 6.2 2.5
2001-02 10.4 4.6 5.5 2.3
2002-03 8.8 4 4.4 1.9
2003-04 7.2 3.3 2.9 1.2
2004-05 5.2 2.6 2 0.9
Source Reserve Bank of India.
Competition and Efficiency

In consonance with the objective of enhancing efficiency and

productivity of banks through greater competition - from new private sector
banks and entry and expansion of several foreign banks - there has been a
consistent decline in the share of public sector banks in total assets of
commercial banks. Notwithstanding such transformation, the public sector
banks still account for nearly three-fourths of assets and income. Public
sector banks have also responded to the new challenges of competition, as
reflected in their increased share in the overall profit of the banking sector.
This suggests that, with operational flexibility, public sector banks are
competing relatively effectively with private sector and foreign banks. Public
sector bank managements are now probably more attuned to the market
consequences of their activities (Mohan, 2006a). Shares of Indian private
sector banks, especially new private sector banks established in the 1990s, in
the total income and assets of the banking system have improved
considerably since the mid-1990s (Table 4). The reduction in the asset share
of foreign banks, however, is partially due to their increased focus on off-
balance sheet non-fund based business.
 Table 4: Bank Group-wise Shares: Select Indicators
(Per cent)
1995-96 2000-01 2004-05
1 2 3 6
Public Sector Banks
Income 82.5 78.4 75.6
Expenditure 84.2 78.9 75.8
Total Assets 84.4 79.5 74.4
Net Profit -39.1 67.4 73.3
Gross Profit 74.3 69.9 75.9
New Private Sector Banks
Income 1.5 5.7 11.8
Expenditure 1.3 5.5 11.4
Total Assets 1.5 6.1 12.9
Net Profit 17.8 10.0 15.0
Gross Profit 2.5 6.9 10.7
Foreign Banks
Income 9.4 9.1 7.0
Expenditure 8.3 8.8 6.6
Total Assets 7.9 7.9 6.8
Net Profit 79.8 14.8 9.7
Gross Profit 15.6 15.7 9.0
Source: Reserve Bank of India.

Efficiency gains are also reflected in containment of the operating

expenditure as a proportion of total assets (Table 5). This has been achieved
in spite of large expenditures incurred by Indian banks in installation and
upgradation of information technology and, in the case of public sector
banks, large expenditures under voluntary pre-mature retirement of nearly 12
per cent of their total staff strength.
 Table 5: Earnings and Expenses of Scheduled Commercial Banks
(Rs.
billion)
Year Total Total Interest Total Interest Establishme Net
nt
Assets Earning Earning Expense Expense Expenses Interes
s s s s t
Earnin
g
1 2 3 4 5 7 8 9
1969 68 4 4 4 2 1 2
(6.2) (5.3) (5.5) (2.8) (2.1) (2.5)
1980 582 42 38 42 27 10 10
(7.3) (6.4) (7.2) (4.7) (1.7) (1.8)
1991 3,275 304 275 297 190 76 86
(9.3) (8.4) (9.1) (5.8) (2.3) (2.6)
2000 11,055 1,149 992 1,077 690 276 301
(10.4) (9.0) (9.7) (6.2) (2.5) (2.7)
2005 22,746 1,867 1,531 1,660 866 491 665
(8.2) (6.7) (7.3) (3.8) (2.2) (2.9)
Note: Figures in brackets are ratios to total assets.
Source: Reserve Bank of India.

Improvements in efficiency of the banking system are also reflected,

inter alia, in costs of intermediation. which, defined as the ratio of operating
expense to total assets, witnessed a gradual reduction in the post reform
period across various bank groups barring foreign banks (Table 6). However,
intermediation costs of banks in India still tend to be higher than those in
developed countries. Similarly, the cost income-ratio (defined as the ratio of
operating expenses to total income less interest expense) of Indian banks has
shown a declining trend during the post reform period. For example, Indian
banks paid roughly 45 per cent of their net income towards managing labour
and physical capital in 2004 as against nearly 72 per cent in 1993 (Mohan,
2006a). Indian banks thus recorded a net cost saving of nearly 27 per cent of
their net income during the post reform period.
 Table 6: Intermediation Cost* of Scheduled
Commercial Banks: 1996-
2005
(as percentage to total asset)
Year Public Sector New Private Forei All
(end-March) Banks Banks gn Schedule
Ban d
ks Commer
cial
Banks
1 2 3 4 5
1996 2.99 1.82 2.78 2.94
1997 2.88 1.94 3.04 2.85
1998 2.66 1.76 2.99 2.63
1999 2.65 1.74 3.40 2.65
2000 2.52 1.42 3.12 2.48
2001 2.72 1.75 3.05 2.64
2002 2.29 1.12 3.03 2.19
2003 2.25 1.95 2.79 2.24
2004 2.20 2.02 2.76 2.20
2005
*
2.03 2.06 2.85 2.09
Intermediation cost = operating expenses.
Source: Computed from Statistical Tables relating to Banks in
India, RBI, various years

Productivity
What is most encouraging is the very significant improvement in the
productivity of the Indian banking system, in terms of various productivity
indicators. The business per employee of Indian banks increased over three-
fold in real terms from Rs.5.4 million in 1992 to Rs.17.3 million in 2005,
exhibiting an annual compound growth rate of more than 9 per cent (Table 7).
The profit per employee increased from Rs.20,000 to Rs. 130,000 over the
same period, implying a compound growth of around 15.5 per cent. Branch
productivity also recorded concomitant improvements. These improvements
could be driven by two factors: technological improvement, which expands
the range of production possibilities and a catching up effect, as peer
pressure
amongst banks compels them to raise productivity levels. Here, the role of
new business practices, new approaches and expansion of the business that
was introduced by the new private banks has been of the utmost importance.

Table 7: Select Productivity Indicators of Scheduled Commercial

Banks
(Rs. million at 1993-94
prices)
Year Business Prof Business per
per it per branch
employ employee
ee
1 2 3 4
1992 5.4 0.02 109.9
1996 6.0 0.01 119.6
2000 9.7 0.05 179.4
2005 17.3 0.13 267.0
Source: Statistical Tables relating to Banks in India.

Monetary Policy
What has been the impact of the monetary policy? From the innumerable
dimensions of impact of monetary policy, let me focus on some select
elements.

Inflation
Turning to an assessment of monetary policy, it would be reasonable to
assert that
monetary policy has been largely successful in meeting its key objectives in
the post-reforms period. Just as the late 1990s witnessed a fall in inflation
worldwide, so too has India. Inflation has averaged close to five per cent per
annum in the decade gone by, notably lower than that of eight per cent in the
previous four decades (Chart 1). Structural reforms since the early 1990s
coupled with improved monetary-fiscal interface and reforms in the
Government securities market enabled better monetary management from the
second half of the 1990s onwards. More importantly, the regime of low and
stable inflation has, in turn, stabilised inflation expectations and inflation
tolerance in the economy has come down. It is encouraging to note that
despite record high international crude oil prices, inflation remains low and
inflation expectations also remain stable. Since inflation expectations are a
key determinant of the actual inflation outcome, and given the lags in
monetary transmission, we have been taking pre-emptive measures to keep
inflation expectations stable.2 As discussed further below, a number of
instruments, both existing as well as new, were employed to modulate
liquidity conditions to achieve the desired objectives. A number of other
factors such as increased competition, productivity gains and strong corporate
balance sheets have also contributed to this low and stable inflation
environment, but it appears that calibrated monetary measures had a
substantial role to play as well.
 Chart 1 : Wholesale Price Inflation in India
Per cent 30

25

20

15

10

0
1971

-5

WPI Inflation 5-Year Moving Average

Challenges posed by large capital inflows

It is pertinent to note that inflation could be contained since the mid-
1990s, despite challenges posed by large capital flows. Following the
reforms in the external sector, foreign investment flows have been
encouraged. Reflecting the strong growth prospects of the Indian economy,
the country has received large investment inflows, both direct and portfolio,
since 1993- 94 as compared with negligible levels till the early 1990s. Total
foreign investment flows (direct and portfolio) increased from US$ 111
million in 1990-91 to US$ 17,496 million in 2005-06 (April- February). Over
the same period, current account deficits remained modest – averaging one
per cent of GDP since 1991-92 and in fact recorded small surpluses during
2001-04. With capital flows remaining in excess of the current financing
requirements, the overall balance of payments recorded persistent surpluses
leading to an increase in reserves. Despite such large accretion to reserves,
inflation could be contained reflecting appropriate policy responses by the
Reserve Bank and the Government.
The emergence of foreign exchange surplus lending to continuing and
large accretion to reserves since the mid 1990s has been a novel experience
for India after experiencing chronic balance of payment problems for almost
four decades. These surpluses began to arise after the opening of the current
account, reduction in trade protection, and partial opening of the capital
account from the early to mid 1990s. The exchange rate flexibility practiced
since 1992-93 has been an important part of the policy response needed to
manage capital flows.
 The composition of India's balance of payments has undergone
significant change since the mid 1990s. In the current account, the growth of
software exports and, more recently, of business process outsourcing, has
increased the share of service exports on a continuing basis. Even more
significant is the growth in remittances from non-resident Indians (NRIs),
now amounting to about 3 per cent of GDP. The latter exhibit a great deal of
stability. The remittances appear to consist mainly of maintenance flows
that do not seem to be affected by exchange rate, inflation, or growth rate
changes. Thus, the Indian current account exhibits only a small deficit, or a
surplus, despite the existence of merchandise trade deficit that has grown
from
3.2 per cent of GDP in the mid 1990s to 5.3 per cent in 2004-05. On the
capital account, unlike other emerging markets, portfolio flows have far
exceeded foreign direct investment in India in recent years. Coupled with
other capital flows consisting of official and commercial debt, NRI deposits,
and other banking capital, net capital flows now amount to about 4.4 per cent
of GDP.
The downturn in the Indian business cycle during the early part of this
decade led to the emergence of a current account surplus, particularly
because the existence of the relative exchange rate insensitive remittance
flows. Consequently, foreign exchange reserves grew by more than US $ 120
billion between April 2000 and April 2006.
The management of these flows involved a mix of policy responses
that had to keep an eye on the level of reserves, monetary policy objectives
related to the interest rate, liquidity
management, and maintenance of healthy financial market conditions with
financial stability. Decisions to do with sterilisation involve judgements on
the character of the excess forex flows: are they durable, semi-durable or
transitory. This judgement itself depends on assessments about both the real
economy and of financial sector developments. Moreover, at any given time,
some flows could be of an enduring nature whereas others could be of short
term, and hence reversible.
On an operational basis, sterilisation operations through open market
operations (OMOs) should take care of durable flows, whereas transitory
flows can be managed through the normal daily operations of the LAF.
By 2003-04, sterilisation operations, however, started appearing to be
constrained by the finite stock of Government securities held by the Reserve
Bank. The legal restrictions on the Reserve Bank on issuing its own paper
also placed constraints on future sterilisation operations. Accordingly, an
innovative scheme in the form of Market Stabilisation Scheme (MSS) was
introduced in April 2004 wherein Government of India dated
securities/Treasury Bills are being issued to absorb enduring surplus liquidity.
These dated securities/Treasury Bills are the same as those issued for normal
market borrowings and this avoids segmentation of the market. Moreover, the
MSS scheme brings transparency in regard to costs associated with
sterilisation operations. Hitherto, the costs of sterilisation were fully borne by
the Reserve Bank in the first instance and its impact was transmitted to the
Government in the form of lower profit transfers. With the introduction of the
MSS, the cost in terms of interest payments would be borne by the
Government itself in a transparent manner.
It is relevant to note that the MSS has provided the Reserve Bank the
flexibility to not only absorb liquidity but also to inject liquidity in case of
need. This was evident during the second half of 2005-06 when liquidity
conditions became tight in view of strong credit demand, increase in
Government’s surplus with the Reserve Bank and outflows on account of
bullet redemption of India Millennium Deposits (about US $ 7 billion). In
view of these circumstances, fresh issuances under the MSS were suspended
between November 2005 and April 2006. Redemptions of securities/Treasury
Bills issued earlier – along with active management of liquidity through
repo/reverse repo operations under Liquidity Adjustment Facility - provided
liquidity to the market and imparted stability to financial markets (Chart 2).
With liquidity conditions improving, it was decided to again start issuing
securities under the MSS from May 2006 onwards. The issuance of securities
under the MSS has thus enabled the Reserve Bank to improve liquidity
management in the system, to maintain stability in the foreign exchange
Rupees crore

market and to conduct monetary policy in accordance with the stated

objectives.
 Chart 2 : Liquidity Management
140,000
120,000
100,000
80,000
60,000
40,000
20,000
0
-20,000
-40,000
Jun-04

Oct-04

Jun-05

Feb-06
Feb-05

Oct-05
Dec-04

Dec-05
Apr-04

Aug-04

Apr-05

Aug-05

Apr-06
LAF MSS Centre's Surplus with the RBI

The Indian experience highlights the need for emerging market

economies to allow greater flexibility in exchange rates but the authorities
can also benefit from having the capacity to intervene in foreign exchange
markets in view of the volatility observed in international capital flows. A
key lesson is that flexibility and pragmatism are required in the management
of the exchange rate and monetary policy in developing countries, rather than
adherence to strict theoretical rules.
Three overarching features marked the transition of India to an open
economy. First, the administered exchange rate became market determined
and ensuring orderly conditions in the
foreign exchange market became an objective of exchange rate management.
Second, as already indicated, vicissitudes in capital flows came to influence
the conduct of monetary policy. Third, lessons of the balance of payments
crisis highlighted the need to maintain an adequate level of foreign exchange
reserves and this in turn both enabled and constrained the conduct of
monetary policy. From hindsight, it appears that the strategy paid off with the
exchange rate exhibiting reasonable two-way movement (Chart 3).
Rupees per US dollar

Chart 3 : Exchange Rate

Index (1993-94=10
50 110
48 105
46 100
44 95
42 90
40 85
38 80
36 75
34
32
30

Rupees per US dollar

REER (36-currency weight, trade-based) (right scale) NEER (36-currency weight, trade-based) (right scale)
Apr-93

Apr-94

Apr-95

Apr-96

Apr-97

Apr-98

Apr-99

Apr-00

Apr-01

Apr-02

Apr-03

Apr-04

Apr-05

Credit Delivery
Given that the Indian financial system is still predominantly bank
based, bank credit continues to be of great importance for funding different
sectors of the economy. Consequent to deregulation of interest rates and
substantial reduction in statutory pre-emptions, there was an expectation that
credit flow would be correspondingly enhanced. In the event, banks
continued to show a marked preference for investments in government
securities with no reduction in the proportion of their assets being held in
investments in government securities, until recently, when credit growth
picked up in 2003-04. With the shift in approach from micro management of
credit through various regulations, credit allocation targets, and administered
 interest rates, to a risk based system of lending and market determined
interest rates, banks have to develop appropriate credit risk assessment
techniques. Apart from promoting healthy credit growth, this is also critical
for the efficiency of monetary management in view of the move to use of
indirect instruments in monetary management.
The stagnation in credit flow observed during the late 1990s, in
retrospect, was partly caused by reduction in demand on account of increase
in real interest rates, turn down in the business cycle, and the significant
business restructuring that occurred during that period. A sharp recovery has
now taken place.
The stagnation during the 1990s has seen a sharp recovery in the past
few years. The credit-GDP ratio, after moving in a narrow range of around 30
per cent between the mid-1980s and late 1990s, started increasing from 2000-
01 onwards (Chart 4). It increased from 30 per cent during 1999-00 to 41 per
cent during 2004-05 and further to 48 per cent during 2005-06. However,
sharp growth of credit in the past couple of years has also led to some areas
of policy concern and dilemmas, as discussed later.
 Per cent
Chart 4: Credit-GDP Ratio
50
45
40
35
30
25
20
15
10
1970-71

1972-73

1974-75

1976-77

1978-79

1980-81

1982-83

1984-85

1986-87

1988-89

1990-91

1992-93

1994-95

1996-97

1998-99

2000-01

2002-03

2004-05
How did the monetary policy support the growth momentum in the
economy? As inflation, along with inflation expectations, fell during the
earlier period of this decade, policy interest rates were also brought down.
Consequently, both nominal and real interest rates fell. The growth rate in
interest expenses of the corporates declined consistently since 1995-96, from
25.0 per cent to a negative of 11.5 per cent in 2003-04 (Table 8). Such
decline in interest costs has significant implications for the improvement in
bottom lines of the corporates. Various indicators pertaining to interest costs,
which can throw light on the impact of interest costs on corporate sector
profits have turned positive in recent years.

Table 8: Monetary Policy and Corporate

Performance: Interest Rate
Related Indicators
Year Growth Rate in Interest Debt Service to Interest Coverage
Ratio Expenses (%) Total uses of Funds (ICR) #
1990-91 16.2 22.4 2.8
1991-92 28.7 28.3 2.7
1992-93 21.6 24.4 2.4
1993-94 3.1 20.9 2.9
1994-95 8.1 27.2 3.5
1995-96 25.0 21.5 3.6
1996-97 25.7 18.7 2.9
1997-98 12.5 8.1 2.8
1998-99 11.1 17.6 2.6
1999-00 6.7 17.6 2.8
2000-01 7.1 14.0 2.8
2001-02 -2.7 19.4 2.7
2002-03 -11.2 8.9 3.7
2003-04 -11.5 14.1 4.9

.
 Some Emerging Issues
This review of financial sector reforms and monetary policy has
documented the calibrated and coordinated reforms that have been
undertaken in India since the 1990s. In terms of outcomes, this strategy has
achieved the broad objectives of price stability along with reduced medium
and long term inflation expectations; the installation of an institutional
framework and policy reform promoting relatively efficient price discovery
of interest rates and the exchange rate; phased introduction of competition in
banking along with corresponding improvements in regulation and
supervision approaching international best practice, which has led to notable
improvement in banking performance and financials. The implementation of
these reforms has also involved the setting up or improvement of key
financial infrastructure such as payment and settlement systems, and clearing
and settlement systems for debt and forex market functioning. All of this
financial development has been achieved with the maintenance of a great
degree of financial stability, along with overall movement of the economy
towards a higher growth path.
With increased deregulation of financial markets and increased
integration of the global economy, the 1990s were turbulent for global
financial markets: 63 countries suffered from systemic banking crises in that
decade, much higher than 45 in the 1980s. Among countries that experienced
such crises, the direct cost of reconstructing the financial system was
typically very high: for example, recapitalisation of banks had cost 55 per
cent of GDP in Argentina, 42 per cent in Thailand, 35 per cent in Korea and
10 per cent in Turkey. There were high indirect costs of lost opportunities and
slow economic growth in addition (McKinsey & Co., 2005). It is therefore
particularly noteworthy that India could pursue its process of financial
deregulation and opening of the economy without suffering financial crises
during this turbulent period in world financial markets. The cost of
recapitalisation of public sector banks at less than 1 per cent of GDP is
therefore low in comparison. Whereas we can be legitimately gratified with
this performance record, we now need to focus on the new issues that need to
be addressed for the next phase of financial development.
That current annual GDP growth of around 8 per cent can be achieved
in India at an about 30 per cent rate of gross domestic investment suggests
that the economy is functioning quite efficiently. We need to ensure that we
maintain this level of efficiency and attempt to improve on it further. As the
Indian economy continues on such a growth path and attempts to accelerate
it, new demands are being placed on the financial system.
 Growth Challenges for the Financial Sector

Higher sustained growth is contributing to the movement of large

numbers of households into ever higher income categories, and hence higher
consumption categories, along with enhanced demand for financial savings
opportunities. In rural areas in particular, there also appears to be increasing
diversification of productive opportunities. Thus, the banking system has to
extend itself and innovate to respond to these new demands for both
consumption and production purposes. This is particularly important since
banking penetration is still low in India: there are only about 10-12 ATMs in
India per million population, as compared with over 50 in China, 170 in
Thailand, and 500 in Korea. Moreover, the deposit to GDP ratio or the
loans/GDP ratio is also low compared to other Asian countries (McKinsey &
Co., 2005).
On the production side, industrial expansion has accelerated;
merchandise trade growth is high; and there are vast demands for
infrastructure investment, from the public sector, private sector and through
public private partnerships. Furthermore, it is the service sector that has
exhibited consistently high growth rates: the hospitality industry, shopping
malls, entertainment industry, medical facilities, and the like, are all
expanding fast. Thus a great degree of diversification is taking place in the
economy and the banking system has to respond adequately to these new
challenges, opportunities and risks.
In dealing with these new consumer demands and production demands
of rural enterprises and of SME's in urban areas, banks have to innovate and
look for new delivery mechanisms that economise on transaction costs and
provide better access to the currently under- served. Innovative channels for
credit delivery for serving these new rural credit needs, encompassing full
supply chain financing, covering storage, warehousing, processing, and
transportation from farm to market will have to be found. The budding
expansion of non- agriculture service enterprises in rural areas will have to be
financed to generate new income and employment opportunities. Greater
efforts will need to be made on information technology for record keeping,
service delivery, reduction in transactions costs, risk assessment and risk
management. Banks will have to invest in new skills through new recruitment
and through intensive training of existing personnel.
 It is the public sector banks that have the large and widespread reach,
and hence have the potential for contributing effectively to achieve financial
inclusion. But it is also they who face the most difficult challenges in human
resource development. They will have to invest very heavily in skill
enhancement at all levels: at the top level for new strategic goal setting; at the
middle level for implementing these goals; and at the cutting edge lower
levels for delivering the new service modes. Given the current age
composition of employees in these banks, they will also face new recruitment
challenges in the face of adverse compensation structures in comparison with
the freer private sector. Meanwhile, the new private sector banks will
themselves have to innovate and accelerate their reach into the emerging low
income and rural market segments. They have the independence and
flexibility to find the new business models necessary for serving these
segments.
A number of policy initiatives are underway to aid this overall process
of financial inclusion and increase in banking penetration. The Parliament has
passed the Credit Information Bureau Act that will enable the setting up of
credit information bureaus through the mandatory sharing of information by
banks. The Reserve Bank is in the process of issuing guidelines for the
formation of these bureaus. As this process gathers force, it should contribute
greatly in reducing the costs of credit quality assessment. Second,
considerable work is in process for promoting micro- finance in the country,
including the consideration of possible legislation for regulation of micro-
finance institutions. Third, the Reserve Bank has issued guidelines to banks
enabling the outsourcing of certain functions including the use of agencies
such as post offices for achieving better outreach. These are all efforts in the
right direction, but much more needs to be done to really achieve financial

inclusion in India.
The challenges that are emerging are right across the size spectrum of
business activities. On the one hand, the largest firms are attaining economic
sizes such that they are reaching the prudential exposure limits of banks, even
though they are still small relative to the large global MNCs. On the other
hand, with changes in technology, there is new activity at the small and
medium level in all spheres of activity. To cope with the former, the largest
Indian banks have to be encouraged to expand fast, both through organic
growth and through consolidation; and the corporate debt market has to be
 developed to enable further direct recourse to financial markets for the
largest firms. For serving and contributing to the growth of firms at the lower
end, banks have to strengthen their risk assessment systems, along with better
risk management. Funding new entrepreneurs and activities is a
fundamentally risky business because of the lack of a previous record and
inadequate availability of collateral, but it is the job of banks to take such
risk, but in a measured fashion. Given the history of public sector banks
outlined earlier, such a change in approach requires a change in mind set, but
also focused training in risk assessment, risk management, and marketing.
Various policy measures are in process to help this transition along.
The Reserve Bank issued new guidelines in 2004 on "Ownership and
Governance in Private Sector Banks". These guidelines have increased the
minimum capital for private sector banks to Rs.3 billion; provided enhanced
guidance on the fit and proper nature of owners, board members and top
management of these banks; and placed limitations on the extent of dominant
shareholdings. These measures are designed to promote the healthy growth of
private sector banks and along with better corporate governance as they
assume greater weight in the economy. An issue of relevance here is that of
financial stability. To a certain extent, the predominance of government
owned banks has contributed to financial stability in the country. Experience
has shown that even the deterioration in bank financials does not lead to
erosion of consumer confidence in such banks. This kind of consumer
confidence does not extend to private sector banks. Hence, as they gain in
size and share, capital enhancement and sound corporate governance become
essential for financial stability. Second, the lending ability of banks has been
potentially constrained by the existing provisions for statutory pre-emption of
funds for investment in government securities. A bill has been introduced in
Parliament to amend the existing Banking Regulation Act to eliminate the
minimum 25 per cent limit of investment in government securities. As the
fiscal situation improves consistent with the FRBM Act, it will then be
possible to reduce the statutory pre-emption, enabling greater fund flow to the
private sector for growth. Third, the bill also provides for raising of capital
through BASEL II consistent innovative instruments, enabling the capital
expansion of banks needed for their growth.
Greater Capital Market Openness: Some Issues

An important feature of the Indian financial reform process has been

the calibrated opening of the capital account along with current account
convertibility. The Government and the Reserve Bank have already appointed
a Committee to advise on a roadmap for fuller capital account convertibility.
Decisions on further steps will be taken after that committee submits its
report in a couple of months. Meanwhile, we can note some of the issues that
will need attention as we achieve fuller capital account openness.
A key component of Indian capital account management has been the
management of volatility in the forex market, and of its consequential impact on
the money market and hence on monetary operations guided by the extant
monetary policy objectives. This has been done, as outlined, through a
combination of forex market intervention, domestic liquidity management, and
administrative instructions on regulating external debt in different forms.
Correspondingly, progress has been made on the functioning of the government
securities market, forex market and money market and their progressive
integration. Particular attention has been given to the exposure of financial
intermediaries to foreign exchange liabilities, and of the government in their
borrowing programme. So far, some degree of success has been achieved in that
the exchange rate responds to the supply demand conditions in the market and
exhibits two way flexibility; the interest rate is similarly flexible and market
determined; healthy growth has taken place in trade in both goods and services;
and inward capital flows have been healthy
 .
We have to recognise that fuller capital account openness will lead to a
confrontation with the impossible trinity of simultaneous attainment of
independent monetary policy, open capital account, and managed exchange
rate. At best, only two out of the three would be feasible. With a more open
capital account as a `given' and if a choice is made of an `anchor' role for
monetary policy, exchange rate management will be affected. A freely
floating exchange rate should, in fact, engender the independence of
monetary policy. It needs to be recognised, however, that the impact of
exchange rate changes on the real sector is significantly different for reserve
currency countries and for developing countries like India. For the former
which specialise in technology intensive products the degree of exchange rate
pass through is low, enabling exporters and importers to ignore temporary
shocks and set stable product prices to maintain monopolistic positions,
despite large currency fluctuations. Moreover, mature and well developed
financial markets in these countries, have absorbed the risk associated with
exchange rate fluctuations with negligible spillover on the real activity. On
the other hand, for the majority of developing countries which specialise in
labour-intensive and low and intermediate technology products, profit
margins in the intensely competitive markets for these products are very thin
and vulnerable to pricing power by large retail chains. Consequently,
exchange rate volatility has significant employment, output and distributional
consequences (Mohan, 2004a; 2005). In this context, managing exchange rate
volatility would continue to be an issue requiring attention.
A further challenge for policy in the context of fuller capital account
opennes will be to preserve the financial stability of different markets as
greater deregulation is done on capital outflows and on debt inflows. The
vulnerability of financial intermediaries can perhaps be addressed through
prudential regulations and their supervision; risk management of non-
financial entities will have to be through further developments in both the
corporate debt market and the forex market, which enable them to manage
their risks through the use of newer market instruments. This will require
market development, enhancement of regulatory capacity in these areas, as
well as human resource development in both financial intermediaries and
non-financial entities. Given the volatility of capital flows, it remains to be
seen whether financial market development in a country like India can be
such that this volatility does not result in unacceptable disruption in exchange
rate determination with inevitable real sector consequences, and in domestic
monetary conditions. If not, what will be the kind of market interventions that
will continue to be needed and how effective will they be?
Another aspect of greater capital market openness concerns the
presence of foreign banks in India. The Government and Reserve Bank
outlined a roadmap on foreign investment in banks in India in February 2005,
which provides guidelines on the extent of their presence until 2009. This
roadmap is consistent with the overall guidelines issued simultaneously on
 ownership and governance in private sector banks in India. The
presence of foreign banks in the country has been very useful in bringing
greater competition in certain segments in the market. They are significant
participants in investment banking and in development of the forex market.
With the changes that have taken place in the United States and other
countries, where the traditional barriers between banking, insurance and
securities companies have been removed, the size of the largest financial
conglomerates has become extremely large. Between 1995 and 2004, the size
of the largest bank in the world has grown three-fold by asset size, from
about US $ 0.5 trillion to US $ 1.5 trillion, almost double the size of Indian
GDP. This has happened through a great degree of merger activity: for
example, J.P.Morgan Chase is the result of mergers among 550 banks and
financial institutions. The ten biggest commercial banks in the US now
control almost half of that country's banking assets, up from 29 per cent just
10 years ago (Economist, 2006). Hence, with fuller capital account
convertibility and greater presence of foreign banks over time, a number of
issues will arise. First, if these large global banks have emerged as a result of
real economies of scale and scope, how will smaller national banks compete
in countries like India, and
will they themselves need to generate a larger international presence?
Second, there is considerable discussion today on overlaps and potential
conflicts between home country regulators of foreign banks and host country
regulators: how will these be addressed and resolved in the years to come?
Third, given that operations in one country such as India are typically small
relative to the global operations of these large banks, the attention of top
management devoted to any particular country is typically low.
Consequently, any market or regulatory transgressions committed in one
country by such a bank, which may have a significant impact on banking or
financial market of that country, is likely to have negligible impact on the
bank's global operations. It has been seen in recent years that even relatively
strong regulatory action taken by regulators against such global banks has
had negligible market or reputational impact on them in terms of their stock
price or similar metrics. Thus, there is loss of regulatory effectiveness as a
result of the presence of such financial conglomerates. Hence there is
inevitable tension between the benefits that such global conglomerates bring
and some regulatory and market structure and competition issues that may
arise.
Along with the emergence of international financial conglomerates we
are also witnessing similar growth of Indian conglomerates. As in most
countries, the banking, insurance and securities companies each come under
the jurisdiction of their respective regulators. A beginning has been made in
organized cooperation between the regulators on the regulation of such
conglomerates, with agreement on who would be the lead regulator in each
case. In the United States, it is a financial holding company that is at the core
of each conglomerate, with each company being its subsidiary. There is, as
yet, no commonality in the financial structure of each conglomerate in India:
in some the parent company is the banking company; whereas in others there
is a mix of structure. For Indian conglomerates to be competitive, and for
them to grow to a semblance of international size, they will need continued
improvement in clarity in regulatory approach.
As the country's financial system faces each of these challenges in the
coming years, we will also need to adapt monetary policy to the imperatives
brought by higher growth and greater openness of the economy.
High Credit Growth and Monetary Policy

High and sustained growth of the economy in conjunction with low

inflation is the central concern of monetary policy in India. As noted above,
we have been reasonably successful in meeting these objectives. In this
context, one issue still remains: whether monetary policy should have only
price stability as its sole objective, as suggested by proponents of inflation
targeting. Several central banks, such as, Bank of Canada, Bank of England,
and the Reserve Bank of New Zealand, have adopted explicit inflation
targets. Others, whose credibility in fighting inflation is long established
(notably, the US Federal Reserve), do not set explicit annual inflation targets.
Central banks are thus clearly divided on the advisability of setting explicit
inflation targets. In view of the difficulties encountered with monetary
targeting and exchange rate pegged regimes, a number of central banks
including some in emerging economies have adopted inflation targeting
frameworks.3
The simple principle of inflation targeting thus is also not so simple
and poses problems for monetary policy making in developing countries.
Moreover, concentrating only on numerical inflation objectives may reduce
the flexibility of monetary policy, especially with respect to other policy
goals, particularly that of growth.
In India, we have not favoured the adoption of inflation targeting,
while keeping the attainment of low inflation as a central objective of
monetary policy, along with that of high and sustained growth that is so
important for a developing economy. Apart from the legitimate concern
regarding growth as a key objective, there are other factors that suggest that
inflation targeting may not be appropriate for India. First, unlike many other
developing countries we have had a record of moderate inflation, with double
digit inflation being the exception, and which is largely socially unacceptable.
Second, adoption of inflation targeting requires the existence of an efficient
monetary transmission mechanism through the operation of efficient financial
markets and absence of interest rate distortions. In India, although the money
market, government debt and forex market have indeed developed in recent
years, they still have some way to go, whereas the corporate debt market is
still to develop. Though interest rate deregulation has largely been
accomplished, some administered interest rates still persist. Third,
inflationary pressures still often emanate from significant supply shocks
related to the effect of the monsoon on agriculture, where monetary policy
action may have little role. Finally, in an economy as large as that of India,
with various regional differences, and continued existence of market
imperfections in factor and product
.
 A contemporary issue in central banking is the appropriate response of
monetary policy to sharp asset price movements, that may accompany high
corporate growth. In an era of price stability and well-anchored inflation
expectations, imbalances in the economy need not show up immediately in
overt inflation. Increased central bank credibility is a double-edged sword as
it makes it more likely that unsustainable booms could take longer to show
up in overt inflation. For instance, unsustainable asset prices artificially boost
accounting profits of corporates and thereby mitigate the need for price
increases; similarly, large financial gains by employees can partly substitute
for higher wage claims. In an upturn of the business cycle, self-reinforcing
processes develop, characterised by rising asset prices and loosening external
financial constraints. 'Irrational exuberance' can drive asset prices to
unrealistic levels, even as the prices of currently traded goods and services
exhibit few signs of inflation (Crockett, 2001). These forces operate in
reverse in the contraction phase. In the upswing of the business cycle,
financial imbalances, therefore, get built-up. There is, thus, a 'paradox of
credibility' (Borio and White, 2003). In view of these developments, it is felt
that credit and monetary aggregates – which are being ignored by many
central banks in view of the perceived instability of money demand - need to
be monitored closely since sharp growth in these aggregates is a useful
indicator of future instability.
In India, like other countries, we have also seen large rallies in asset
prices. Concomitantly, credit to the private sector has exhibited sharp growth
in the past two years – averaging almost 30 per cent per annum. While the
credit growth has been broad-based, credit to the retail sector is emerging as a
new avenue of deployment for the banking sector led by individual housing
loans. To illustrate, the share of housing in incremental bank credit has
increased from 2.9 per cent in 1995-96 to 11.1 per cent in 2004-05, while the
share of industry went down from 64.9 per cent in 1995-96 to 25.6 per cent in
2004-05.4 Data for retail credit is not available prior to 1998-99; its share too
has increased from 19.4 per cent in 1998-99 to 24.3 per cent in 2004-05.
Nonetheless, in the light of high credit growth, there is a need to
ensure that asset quality is maintained. Since growth in credit was relatively
higher in a few sectors such as retail credit and real commercial estate,
monetary policy faces a dilemma in terms of instruments. An increase in
policy rate across the board could adversely affect even the productive
sectors of the economy such as industry and agriculture. While policy rates
have indeed been raised, they have been mainly aimed at reining in inflation
expectations in view of continuing pressures from high and volatile crude oil
prices. Therefore, while ensuring that credit demand for the productive
sectors of the economy is met, the Reserve Bank has resorted to prudential
measures in order to engineer a ‘calibrated’ deceleration in the overall growth
 of credit to the commercial sector. Accordingly, the Reserve Bank has
raised risk weights on loans to these sectors. It also more than doubled
provisioning requirements on standard loans for the specific sectors from 0.4
per cent to 1.0 per cent. Thus, the basic objective has been to ensure that the
growth process is facilitated while ensuring price and financial stability in the
economy.
It is in this context, and consistent with the multiple indicator approach
adopted by the Reserve Bank, that monetary policy in India has consistently
emphasised the need to be watchful about indications of rising aggregate
demand embedded in consumer and business confidence, asset prices,
corporate performance, the sizeable growth of reserve money and money
supply, the rising trade and current account deficits and, in particular, the
quality of credit growth. In retrospect, this risk sensitive approach has served
us well in containing aggregate demand pressures and second round effects to
an extent. It has also ensured that constant vigil is maintained on threats to
financial stability through a period when inflation was on the upturn and asset
prices, especially in housing and real estate, are emerging as a challenge to
monetary authorities worldwide. Significantly, it has also reinforced the
growth momentum in the economy. It is noteworthy that the cyclical
expansion in bank credit has extended over an unprecedented 30 months
without encountering any destabilising volatility but this situation warrants
enhanced vigilance.
Concluding Observations
To conclude, the financial system in India, through a measured,
gradual, cautious, and steady process, has undergone substantial
transformation. It has been transformed into a reasonably sophisticated,
diverse and resilient system through well-sequenced and coordinated policy
measures aimed at making the Indian financial sector more competitive,
efficient, and stable. Concomitantly, effective monetary management has
enabled price stability while ensuring availability of credit to support
investment demand and growth in the economy. Finally, the multi-

.
pronged approach towards managing capital account in conjunction with
prudential and cautious approach to financial liberalisation has ensured
financial stability in contrast to the experience of many developing and
emerging economies. This is despite the fact that we faced a large number of
shocks, both global and domestic. Monetary policy and financial sector
reforms in India had to be fine tuned to meet the challenges emanating from
all these shocks. Viewed in this light, the success in maintaining price and
financial stability is all the more creditworthy.
As the economy ascends a higher growth path, and as it is subjected to
greater opening and financial integration with the rest of the world, the
financial sector in all its aspects will need further considerable development,
along with corresponding measures to continue regulatory modernization and
strengthening. The overall objective of maintaining price stability in the
context of economic growth and financial stability will remain.

An exclusive project report on the Reserve Bank of India.

This report will help you to learn about:-

 Constitution of the Reserve Bank of India
 Organisational Structure and Management of RBI
 Objectives
 Functions
 Roles
 Exchange Control Management
 Methods of Credit Control
 Achievements
 Failure.
 Contents:

1. Project Report on the Constitution of the Reserve Bank of India

2. Project Report on the Organisational Structure and Management of RBI
3. Project Report on the Objectives of the Reserve Bank of India
4. Project Report on the Functions of the Reserve Bank of India
5. Project Report on the Roles of the Reserve Bank of India
6. Project Report on the Exchange Control Management by the Reserve
Bank of India
7. Project Report on the Methods of Credit Control by the Reserve Bank of
India
8. Project Report on the Achievements of the Reserve Bank of India
9. Project Report on the Failure of the Reserve Bank of India

1. Project Report on the Constitution of the Reserve Bank of India:

The origin of the Reserve Bank of India in 1935 was the culmination of a long
series of efforts. The earliest effort to set up a central bank dates back to
January 1773 when Warren Hastings, the Governor of Bengal, recommended
the establishment of a “General Bank in Bengal and Bihar”. The next attempt
was made in 1807-08 when Robert Richards, a member of the Bombay
Government submitted a scheme for a “General Bank”. But the Governor-
General was not impressed.

The name of John Maynard Keynes also figures in the events leading to the
establishment of the RBI. As a member of the Royal Commission on Indian
Finance and Currency of 1931, Keynes submitted a memorandum entitled
“Proposals for the Establishment of a State Bank in India”. The State Bank
proposed by Keynes was to perform both central banking and commercial
banking functions. However, the scheme could not be implemented due to the
outbreak of the First World War.

The first major step was taken in 1921 when the three Presidency Banks were
amalgamated to form the Imperial Bank of India. It was primarily a commercial
bank but it also performed certain central banking functions, such as acting as
banker to the Government and to some extent as bankers’ bank. But the
regulation of note issue and management of foreign exchange were the direct
responsibility of the Central Government.

In 1926, the Hilton Young Commission recommended that the dichotomy of

functions and division of responsibility should be ended. It suggested the

establishment of a central bank to be called the “Reserve Bank of India”.

 Accordingly, the Gold Standard and Reserve Bank of India Bill was introduced
in the Legislative Assembly in January 1927 but was dropped on account of
sharp differences of opinion on the bank’s ownership and the composition of its
Board of Directors.

The Indian Constitutional Reforms in 1933 made it obligatory that the transfer
of responsibility from the British Government in India to Indian hands was
dependent on the establishment of a Reserve Bank free from political influence
and its successful operation. These events led to the introduction of a fresh bill
in the Indian Legislative Assembly on 8 September, 1933; which was passed by
it on 22 December, 1933 and by the Council of States on 16 February, 1934. It
received the Governor-General’s assent on 6 March, 1934. The Reserve Bank
of India was constituted in accordance with the provisions of the Act containing
58 Sections and was inaugurated on 1 April, 1935.

The RBI was constituted as a shareholders’ bank with a fully paid-up capital of
Rs.5 crores divided into shares of Rs.100 each. Of these 5 lakh shares, 2200
shares were subscribed by the Directors of the Bank and the remaining by private
shareholders.

In view of the need for close integration between the Bank’s policies and those
of the Government, the question of State ownership of the Bank was raised
from time to time. But it was only after Independence that the decision to
nationalize the Bank was taken.

In terms of the Reserve Bank (Transfer to Public Ownership) Act, 1948, its
entire paid-up capital was transferred to the Central Government on 1 January
1949 when it became a State-owned institution.

2. Project Report on the Organisational Structure and Management of

RBI:
The organisational structure of the RBI consists of the Central Board and the
Local Boards. The RBI is managed by the Central Board of Directors
comprising 20 members. There is one Governor who is the executive head of
the Bank. He is assisted by four Deputy Governors. They are appointed by the
Government of India for a period of five years. Four Directors are nominated
by the Central Government, one each from the four Local Boards situated at
“Mumbai, Kolkata, Chennai and Delhi. In addition, the Central Government
nominates ten Directors who are experts from various fields.

They are appointed for four years. The 20th member of the Board is one
 Government official who is usually the Secretary, Ministry of Finance
nominated by the Central Government. The government official and the four
Deputy Governors do not have the right to vote at the meetings of the Board.

All powers of the Bank are vested in the Central Board of Directors. It must
hold at least six meetings in a year and at-least one in three months. However,
the Governor is empowered to call a meeting of the Board whenever he likes.
The Governor and Deputy Governors are whole-time paid officers of the Bank
while the other Directors are part-time officers who receive T.A. and other
allowances prescribed for them when they attend the meetings of the Board.

There are four Local Boards with headquarters at Mumbai, Kolkata, Chennai
and Delhi representing the Western, Eastern, Southern and Northern regions
respectively. The Central Government nominates five members on each Local
Board for a four-year term. The Chairman is elected from among the members
and the Manager of the RBI office in a region acts as the ex-officio Secretary of
the Local Board.

The RBI is managed by the Central Board of Directors with the Governor as its
Chairman. The Governor is the chief executive of the Bank who exercises wide
powers of supervision and issues directions on behalf of the Board. He is
assisted by four Deputy Governors and four Executive Directors.

The Head Office of the RBI at Mumbai, which has sixteen departments such as
the Banking, Issue, Currency Management, Exchange Control, Industrial Credit,
Agricultural Credit, etc. The bank has 15 offices and 2 branches in different parts
of the country. Where the RBI has no office or branch, the State Bank of India
and its 7 associates act as its agents or sub-agents.

3 Objectives of Reserve Bank of India:

The broad objectives of the Reserve Bank of India as spelt out in the preamble
to the RBI Act, 1934 are “to regulate the issue of Bank notes and the keeping of
reserves with a view to securing monetary stability in India and generally to
operate the currency and credit system of the country to its advantage”.

What was implied in the objectives stated was more concretely stated in the
First Five-Year Plan: “It would have to take on a direct and active role, firstly,
in creating and helping to create the machinery needed for financing
developmental activities all over the country, and secondly, ensuring that the
finance available flows in the directions intended”.

Thus the main objectives of the RBI have been:

1. To promote monetisation and monetary integration of the economy.

2. To manage currency and regulate foreign exchange.

3. To institutionalise savings through promotion of banking habit.

4. To build up a sound and adequate banking and credit structure.

5. To evolve a well-differentiated structure of institutions purveying credit for

agriculture and allied activities.

6. To set up or promote several specialised financial institutions at the all-India

level and regional levels to widen facilities for term finance to industry.

7. To lend support to planning authorities and governments in their efforts to

accelerate the pace of economic development with stability and social justice.

4. Functions of Reserve Bank of India:

The Reserve Bank of India performs all the traditional functions of a central
bank. At the same time, it also undertakes active promotional and
developmental functions.

Thus we divide the functions of the RBI into two parts:

(1) Traditional Functions, and

(2) Promotional and Developmental Functions.

These are discussed as under:

1. Traditional Functions:

The RBI performs the following traditional functions:

 (1) Issue of Currency:

The RBI acts as the currency authority. As such, it has the monopoly of issuing
currency of all denominations except one rupee notes and coins, and small coins
which are issued by the Ministry of Finance of the Government of India. At
present, the RBI is issuing notes of the denominations of Rs.10,20, 50,100. and
500.

These notes are printed and issued by its Issue Department. Rs.1,2 and 5 coins,
and small coins issued by the Ministry of Finance are also distributed by the
Issue Department. For the distribution of notes and coins of ah denominations
to the public and banks, the Issue Department maintains currency chests at its
15 offices and 2 branches and elsewhere keeps them with the State Bank of
India, and its 7 associates, some public sector banks, and State Government
treasuries and sub-treasuries.

The RBI issues currency on the basis of minimum of Rs.200 crores of gold and
foreign exchange reserves, of which at least Rs.115 crores worth of gold must
be there.

(2) Banker to Government:

The RBI acts as banker to the Central Government and the State Governments.

As such, it renders the following services to them:

(i) It maintains and operates the cash balances of the Central and State
Governments in the current account deposit on which it pays no interest.

(ii) It receives and makes payments on behalf of the Central and State
Governments.

(iii) It carries out exchange, remittance and other banking operations on behalf
of these Governments.

(iv) It buys and sells Government securities in the market.

(v) It manages the public debt by issuing Government loans and paying interest

and principal.

(vi) It also sells treasury bills through tender on behalf of the Government.
(vii) It makes ways and means advances to the Central and State Governments
by purchasing treasury bills from them for a period not exceeding 91 days.

(viii) It advises the Governments on all banking and financial matters, such as
financing of five year plans and resource mobilisation, balance of payments,
etc.

(ix) It acts as the agent of the Central and State Governments in their dealings
with the International Monetary Fund, the World Bank, International Financial
Corporation, IDA, Exim Bank, and other financial institutions.

(3) Bankers’ Bank:

Firstly, The RBI acts as banker to the scheduled commercial banks in India. As
such, it keeps a part of the cash reserves of these banks and provides them with
remittance facilities. Under the Banking Regulation Act, 1949, every bank is
required to keep between 3% to 15% of the total of its time and demand
liabilities with the RBI as cash reserve ratio which is interest-free.

The CRR which was reduced to 14 per cent effective 15 May, 1993 was again
raised to 15 per cent effective 6 August, 1994. Besides, every bank is required
to maintain with the RBI between 25% to 40% of its net time and demand
liabilities as the Statutory Liquidity Ratio (SLR). It had been reduced from
34.75 per cent to 33.75 per cent effective 16 May 1994. The incremental SLR
continues to be 25 per cent. Secondly, the RBI supervises, regulates and
controls the working of banks in India.

These powers relate to issue of licence for opening and branch expansion,
calling of returns/ statements, inspection of books and accounts, issue of
directions concerning terms and conditions of advances, giving approval for the
appointment of chairman and directors, and to acquire or approve the merger of
any bank. Thirdly, the RBI acts as a clearing house for banks.

It has clearing houses at its 17 offices/branches and at other places the State
Bank of India and its associates provide clearing and remittance facilities on its
behalf. Fourthly, the RBI provides refinance facilities to commercial banks for
export credit, against 364-Day Treasury Bills, stand-by refinance limits against
the collateral of approved securities (that is for those banks having excess SLR)
and discretionary refinance including li9mits under the facility to draw without

prior approval from the RBI.

(4) Exchange Management and Control:

The RBI manages and controls the country’s foreign exchange reserves and
external value of the rupee. Under the Foreign Exchange Regulation Act, 1973,
the RBI controls the receipts and payments of foreign currencies. Foreign
currencies coming into India are required to be sold and exchanged for the
rupee either direct to the RBI or to major commercial banks authorised by it.

Similarly, foreign currencies are allowed to persons travelling abroad and to

importers by the RBI as per rules laid down by it. All such transactions of
foreign currencies are made at rates fixed by the RBI from time to time.

The RBI determines the external value of the rupee in relation to the weighted
basket of India’s major trading partners with pound-sterling as the intervention
currency. Since the exchange value of these currencies keeps on changing in
the international market, the RBI also changes the exchange rate of the rupee in
relation to other currencies such as dollar, mark, yen, sterling etc. Effective 1
March, 1994, the RBI introduced full convertibility of rupee to the entire
current account transactions.

(5) Control of Credit:

The RBI controls the money supply and credit to ensure price stability and meet
the varying economic conditions of the country. It estimates the credit needs of
the economy in relation to the targets laid down in the five-year plans and
ensures the supply of credit to different sectors. For this purpose, it uses various
credit control measures such as variations in interest rates, open market
operations, changes in CRR and SLR, selective credit controls, etc.

(6) Collection and Publication of Data and Reports:

The RBI has a Division of Reports, Reviews, and Publications under its
Department of Economic Analysis and Policy which collects data on economic
matters such as money, credit, finance, agricultural and industrial production,
balance of payments, prices, etc. and publishes them in various publications.

Some of its important publications are the Reserve Bank of India Bulletin
(monthly) and its Weekly Statistical Supplements, Annual Report on Currency
and Finance, and Report on Trend and Progress on Banking in India, etc.
Besides, it brings out Occasional Papers by its experts, and conducts surveys
and publishes reports on them.

(7) Training Facilities:

The RBI has set up a number of training colleges and centres to provide
training to the banking personnel at different levels.

They are:

(i) Bankers Training College (BTC):

The BTC is located at Mumbai. It provides training to senior officers of the

Bank in the areas of application of statistical methods, negotiating skills,
counseling import-export financing. Service Area Approach, etc.

(ii) Reserve Bank Staff College (RBSC):

The RBSC is located at Chennai. It conducts training programmes for officers

of the Bank on areas of investment and fund management, financial services,
housing finance, customer service, etc. Officials of foreign banks also
participate.

(iii) College of Agricultural Banking (CAB):

The CAB is located at Pune-and it caters to the training needs of personnel of

co-operative banks, commercial banks, regional rural banks, NABARD, RBI,
Deposit Insurance and Credit Guarantee Corporation, Government officials,
and also officials from South Asian and African countries. It conducts training
programmes in the field of agricultural finance, rural banking and allied
subjects.

(iv) Zonal Training Centres (ZTCs):

The ZTCs are situated in Mumbai, Kolkata, Chennai and New Delhi. They
provide training to class III and class IV staff of the Bank. These centres also
conduct training programmes on computer and customer service. The RBI has
also introduced training in commercial banking for the banks’ officers at these
Zonal centres.

(v) Indira Gandhi Institute of Development Research:

This was set up by the RBI in 1987. It conducts research on projects and
arranges workshop, conferences and seminars.

(vi) Training in Computer Technology:

The RBI set up the Department of Computer Technology in 1995 for efficient
and quick use of new technologies. This Department provides incentives to the
Bank’s staff to acquire qualifications in computer technology.

2. Promotional and Developmental Functions:

The RBI has been taking a direct and active role, first, in creating or helping to
create the machinery needed for financing development activities all over the
country, and secondly, ensuring that the finance available flows in socially
desired directions.

In order to achieve these two objectives the RBI has been financing agriculture,
industry and exports. It has also been instrumental in the development and
regulation of the banking system and the bill market. We refer to these
activities of the RBI briefly. They are discussed in detail in subsequent
sections.

(1) Agricultural Finance:

The RBI has been extending advice and financial assistance to the co-operative
credit institutions for the development of agriculture and allied rural activities
since its inception in 1935. For this purpose it set up an Agricultural Credit
Department and separate funds for providing medium-term and long-term
finance. Since 1982, the functions of this Department and those of the funds
have been passed on to the National Bank for Agriculture and Rural
Development (NABARD).

(2) Industrial Finance:

The RBI set up an Industrial Credit Department in 1957 to advise and help the
bank in providing financial assistance to industries and in setting up financial
institutions like State Financial Institutions, IFCI, IDBI, ICICI, etc. It also
established the National Industrial Credit (Long-Term Operations) Fund in
1964 to provide financial assistance to large scale industries.

(3) Export Credit:

The RBI provides concessional credit, refinance facilities and guarantee to

commercial banks for exporters. It has also set up the Export-Import Bank of
India to finance export trade.

(4) Credit to Priority Sector and Weaker Sections:

Under its Differential Rate of Interest Scheme, the RBI provides concessional
finance to priority sectors and weaker sections of the society at 4 per cent
interest rate.

(5) Bill Market Scheme:

The RBI has been instrumental in developing a well-organised bill market

scheme in order to provide rediscounting facilities to commercial banks from
the Bank and other financial institutions.

(6) Development and Regulation of Banking System:

The RBI has played an important role in the development and promotion of
banking in the country. It has spread banking to the remotest corners of India
through its Lead Bank Scheme, SAA, and Regional Rural Banks. It has helped
in promoting development banking by establishing such financial institutions as
IDBI, IFCI, ICICI, SIDBI, etc. Further, the RBI has strengthened the banking
system in India and placed it on a sound footing through a judicious policy of
regulation and control of banks.

3. Other Functions:
The RBI also performs the following banking functions also:

(a) It issues demand drafts made payable at its own offices or agencies, and
makes, issues and circulates bank post-bills.

(b) It can borrow money from a scheduled bank in India or from central banks
in other countries.

(c) It is authorised to open an account or make an agency agreement with

central banks in other countries and act as their agent and invest funds in their
shares.

(d) It purchases and sells gold and bullion.

4. Prohibitory Functions:
The RBI Act prohibits the Bank to perform certain functions so that it may not
compete with other banks and may keep its assets in liquid form to meet any
eventuality.

Some of its prohibited functions are:

(a) It cannot participate in any business, trade or industry,

(b) It cannot buy its own shares or those of any other banking company or of
any corporation. Nor can it give loan on the security of shares,

(c) It cannot give loans against immovable property,

(d) It cannot purchase immovable property except for its offices,

(e) It cannot accept bills not payable on demand,

(f) It cannot give interest on deposits held by it.

5. Project Report on the Roles of the RBI:

A. Role in Agricultural Finance:
Since its inception in 1935, the Reserve Bank of India hag teen entrusted with
the task of formulating agricultural credit policy, developing an infrastructure
for implementing it, giving advice on these matters to the State and Central
Governments, and providing credit for agricultural and allied activities.

The RBI has been performing these tasks in the following ways:

(i) Agricultural Credit Department (ACD):

Along with the RBI, a separate Agricultural Credit Department was set up in
1935 to study the problems of agricultural credit, to develop co-operative credit
movement, and to provide necessary advice, guidance and financial assistance.

Its main functions were:

(a) To maintain an expert staff to study all problems of agricultural credit and
provide consultation to the Central and State Governments, State Co-operative
Banks, and other banking organisations; and

(b) To co-ordinate the operations of the RBI relating to agricultural credit with
those State Co-operative Banks and other organisations engaged in the supply
of agricultural credit.

(ii) All India Rural Credit Survey Committee:

The RBI appointed an All India Rural Credit Survey Committee in 1951 which
submitted its report in 1954. The Committee observed that the contribution of
co-operatives in providing rural finance was only 3 per cent in total rural credit.
It, therefore, made a number of recommendations for strengthening co-
operative credit movement and to provide more funds for agricultural and allied
activities.

On the recommendations of the Committee, the Reserve Bank made the

following changes to develop co-operative credit movement and to provide
agricultural finance:

(1) Integrated Scheme of Rural Credit:

The RBI Act was amended to implement the integrated scheme of rural credit.

The main features of the scheme were:

(a) State partnership in co-operative credit institutions between credit societies

with marketing and processing activities; and

(b) Administration through adequately trained and efficient personnel

responsive to the needs of the rural population.

The RBI was required to play an active role in the development of co-operative
credit, coordinating credit with marketing, processing end ware housing
activities, and training of co-operative personnel. As a result of the
implementation of this scheme, it was revealed by the All India Rural Debt and
investment Survey conducted by the RBI (1961-62) that the share of co-
operatives in rural credit increased from 3.1 per cent in 1951-52 to 25.8 per
cent in 1961-62.

(2) State Bank of India:

It was on the recommendations of the Committee that the imperial Bank of

India was nationalised in 1955 and renamed the State Bank of India. The RBI
became its major shareholder. The SBI has been entrusted with the task of
financing agricultural operations.

(3) Agricultural Credit Board (ACB):

Though the Committee recommended the formation of a Statutory Agricultural

Credit Board, the RBI constituted a Standing Advisory Committee on
Agricultural Credit in 1956. Later-on it was changed into the Standing
Advisory Committee on Rural and Co-operative Credit.

It was again reconstituted in 1970 as the Agricultural Credit Board. It

formulated policies relating to agricultural finance and co-ordinated the
activities of co-operative credit institutions-, the RBI, and commercial banks in
providing refinance facilities. The NABARD has taken over the activities of the
Board since July 1982.

(4) Rural Credit Funds:

On the recommendations of the Committee, the RBI established in February

1956 the National Agricultural Credit (Long-Term Operations) Fund to grant
long-term loans to State Governments and Land Development Banks to enable
them to subscribe to the share capital of co-operative banks and cooperative
societies.

The RBI also established the National Agricultural (Stabilisation) Fund in June
1956 for converting short term agricultural loans into medium term loans by the
State Co-operative Banks to enable cooperative societies to repay loans in case
of default by borrowers as a result of drought, famines or other natural
calamities.

These funds have been transferred to the NABARD since July 1982 and
renamed as National Rural Credit (Long Term Operations) Fund and National
Rural Credit (Stabilisation) Fund.

(iii) Establishment of Other Organisations:

With a view to provide larger credit facilities to the rural sector, the RBI has
also been instrumental in the establishment of the following organisations:

(1) Nationalisation of Banks:

In 1969,14 scheduled banks were nationalised and 6 more commercial banks

were nationalised in 1980 in order to spread a network of their branches in rural
areas so as to provide larger credit facilities for agricultural and allied activities.

(2) Agricultural Refinance and Development Corporation (ARDC):

The RBI set up the Agricultural Refinance Corporation in July, 1963 which was
subsequently renamed as Agricultural Refinance and Development
Corporation. The main objectives of the Corporation were to provide medium
and long term refinance to Central Land Mortgage Banks, State Co-operative
Banks and commercial banks; and to subscribe to the debentures of Central
Land Mortgage Banks and State Co-operative Banks. Since its inception in
1963 to June 1982, it sanctioned 19,601 schemes and disbursed Rs.2,808
crores. With the establishment of the NABARD in July 1982, the ARDC was
merged with it.

(3) Regional Rural Banks (RRBs):

The RBI was instrumental in establishing RRBs in 1975. The RBI issues
licences to sponsoring commercial banks for opening branches of RRBs which
are routed through the NABARD after July 1982. The RBI has vested the work
of financing and supervision of the RRBs to the NABARD. The principal
objective of the RRBs is to grant loans and advances to the weaker sections of
the rural population and to co-operatives.

(4) National Bank for Agriculture and Rural Development (NABARD):

The NABARD was established in July 1982 as an apex rural development bank
by merging ACD of the RBI, ARDC, and the NRC (LTO) Fund and NRC
(Stabilisation) Fund of the RBI. The RBI lends to the NABARD under the
General Line of Credit (GLC) for short periods, and also contributes annually
to the NRC (LTO) Fund and NRC (Stabilisation) Fund of the NABARD. The
National Bank provides credit, refinance and institutional building facilities to
integrated rural development. The RBI sanctioned Rs.3,750 crores to NAB
ARE» in 1992-93 under general line of credit.

(5) Service Area Approach (SAA):

The RBI introduced the SAA scheme from April 1989 whereby the service area
of the branch of a commercial hank, a co-operative bank, and a RRB covers 15
to 25 villages. Every branch in the service area prepares a credit plan relating to
agricultural and allied activities for the target groups and for lending to the
priority sector categories of borrowers in particular.

(iv) Help to Co-operatives:

The RBI inspects and audits the accounts of co-operative societies. It provides
cheap remittance facilities to them. It renders them advice about making
adjustments of their loans and assets. It also runs the College of Agricultural
Banking at Pune where it conducts training programmes in the field of
agricultural finance, rural banking and allied subjects for the personnel of co-
operative and other banks.

(v) Financial Assistance:

The RBI dos not provide direct finance to agriculturists but through the State
Co-operative Banks and NABARD. It provides short-term, medium-term and
long-term financial assistance to meet the needs of rural and allied activities.

(1) Short-Term Advances:

The RBI grants short term loans and advances to State Co-operative Banks for
the purpose of general banking business against the pledge of Government and
other approved securities. The RBI also lends to NABARD under the GLC for
short term lending operations for agricultural and other purposes.

The NABARD, in turn, makes short-term advances to State Co-operative

Banks for agricultural operations, marketing of crops, purchase and distribution
of chemical fertilisers, financing of cottage and small scale industries, working
capital requirements of co-operative sugar factories, etc. Short term advances of
the RBI/NABARD to the State Co-operative Banks amounted to Rs,7,358
crores in 2002-03.

(2) Medium-Term Advances:

Medium term loans and advances are granted by the RBI to the State Co-
operative Banks for the purpose of general banking business against the pledge
of Government and other approved securities for a period of 15 months to 5
years at an interest rate below the bank rate.

The NABARD also gives medium term loans from NRC (Stabilisation) Fund
for conversion of short term into medium term loans, and from the NRC (LTO)
Fund for approved agricultural purposes and purchase of shares in co-
Operative processing societies by farmer members of FACs, The medium term
loans and advances by RBI/NABARD to the State Co-operative Banks
amounted to Rs.493 crores in 2002-03.

(3) Long-Term Advances:

The RBI provides long term advances for agricultural and allied activities to the
State Governments to enable them to contribute to the share capital of co-
operatives and the NRC (LTO) Fund and NRC (Stabilisation) Fund. During
1990-91, the RBI contributed Rs.375 crores to the NRC (LTO) Fund and Rs.10
crores to the NRC (Stabilisation) Fund. The RBI/NABARD sanctioned long-
term credit limits amounting to Rs.61 crores to State Governments for
contribution to the share capital of co-operative credit institutions during 2002-
03.

Conclusion:

The Reserve Bank’s role in rural finance is confined to the following areas:
advisory, training supervision, strengthening of rural credit institutions,
formulating rural credit policy and providing refinance facilities. The RBI has
been successful in creating a number of institutions like the RRBs, NABARD,
etc., and strengthening of co-operative banking in rural areas in order to
provide credit facilities for agricultural and allied activities.’

Role in Industrial Finance:

The Reserve Bank has been playing an important role in providing finance
indirectly to large, medium and small scale industries. Towards this end, it has
been instrumental in setting up a number of financial corporations at the Centre
and in the States. The RBI provides long term loans as well as medium/short
term credit facilities to these financial institutions.

(i) RBI Assistance to Financial Institutions:

To provide credit facilities to industries, the RBI has helped in the

establishment of the following financial institutions:

(1) Industrial Finance Corporation of India (IFCI):

The IFCI was set up in 1948 by the RBI with the objective of providing
medium and long-term financial assistance to the industrial sector. The RBI
subscribed 40 per cent of the issued capital of the Corporation. It also
subscribed to the debentures of the Corporation. In 1964, it was made a
subsidiary of the Industrial Development Bank of India.

(2) National Industrial Credit (Long Term Operations) Fund:

The RBI created the NIC (LTO) Fund in 1964 for providing long term credit
limits to the leading financial institutions such as IDBI, IRBI, etc.

(3) Industrial Development Bank of India (IDBI):

The RBI established in 1964 ‘the IDBI as the principal financial institution for
industrial finance in the country. It is a wholly owned subsidiary of the RBI. It
provides direct assistance to medium and large industrial concerns by
purchasing/underwriting their shares and debentures. It also provides refinance
facilities to other term

lending institutions in the large, medium and small scale sectors. During 1992-
93, the RBI sanctioned a special refinance facility of Rs.400 crores to IDBI. It
did not sanction any amount after this.

(4) Industrial Credit and Investment Corporation of India (ICICI):

The ICICI was established in 1955 as a public limited company at the initiative
of the World Bank. The RBI played an indirect role in its formation. The ICICI
provides assistance for industrial development and investment, by way of rupee
and foreign currency loans, underwriting and direct participation to shares,
debentures and guarantees. The RBI provides medium/ short term credit limits
to the ICICI against the security of eligible usance bills rediscounted by it. It
sanctioned Rs.33 crores to the ICICI as credit limits for the year 1990-91. No
amount was sanctioned after this.

(5) Industrial Reconstruction Bank of India (IRBI):

The IRBI was established in 1985 after reconstituting the erstwhile Industrial
Reconstruction Corporation of India. It is the principal credit and reconstruction
agency for rehabilitation of sick and closed industrial units. It assists industrial
concerns by grant of term loans and advances, underwriting of stocks, shares,
bonds and debentures, and guarantees for loans/deferred payments. During
1990-91, the RBI sanctioned Rs.35 crores to the IRBI as long-term assistance
from the NIC (LTO) Fund. No amount had been sanctioned after this.

(6) State Financial Corporations (SFCs):

SFCs are the state-level development banks set up under the SFCs Act, 1951
for the development of medium and small scale industries in their respective
States. At present there are 18 SFCs which provide financial assistance to
industries by way of term loans, direct subscription to equity/ debentures,
discounting of bills of exchange and guarantees. Most of the IDBI schemes for
assistance to small and medium sectors are operated through SFCs. During
1999-2000, the RBI sanctioned fresh adhoc borrowing limits aggregating to
Rs.152.5 crores to 15 SFCs.

(7) Small Industries Development Bank of India (SIDBI):

The SIDBI was set up as a wholly-owned subsidiary of IDBI on 2 April, 1990.

It aims at ensuring larger flow of financial and non-financial assistance to small
scale industrial sector. Its major activities relate to refinance of loans and
advances, discounting and rediscounting of bills, extension of seed capital/ soft
loans, granting direct assistance and refinancing of loans, providing services
like factoring leasing etc., and extending financial support to Small Industries
Development Corporations. During 1995-96, the RBI sanctioned long-term
credit assistance to SIDBI amounting to Rs. 224 crores. It made no sanction
after this.

(8) Export-Import Bank of India (Exim Bank):

The Exim Bank was set up in January 1982 as a statutory corporation of the
Central Government. It provides financial assistance to promote Indian exports
through direct financial assistance, overseas investment, finance, term finance
for export production and export development, pre-shipment credit, buyers’
credit, lines of credit, relending facility, export bills rediscounting, refinance to
commercial banks, finance for computer software exports, finance for export
marketing and bulk import finance to commercial banks.

It also extends non-fund facility to Indian exporters in the form of guarantees.

The lending programme of the Exim Bank covers various stages of export such
as from the development of export markets to expansion of production capacity
for exports production for exports and post-shipment financing.

Its focus is on export of manufactured goods, project exports, exports of

technology services, export of manufactured goods and export of computer
software. The RBI sanctioned Rs.120 crores as long-term assistance to the
Exim Bank out of NIC (LTO) Fund in 1990-91. It made no sanction after this.

(9) National Housing Bank (NHB):

The NHB was set up in 1988 to meet the requirements of housing finance. Its
paid-up capital of Rs.250 crores is fully subscribed by the RBI. The bank is
providing assistance through Home Loan Account Scheme, liberalised lending
by commercial banks and refinance facilities.

Refinance is for land development and shelter programmes of public/private

agencies and co-operatives. During 1992- 93 the RBI sanctioned a loan of
Rs.one crore to NHB out of the National Housing Credit (Long-Term
Operations) Fund set up by the RBI. No amount was sanctioned after this.

(ii) Credit Guarantee Schemes:

The RBI established in 1971 the Credit Guarantee Corporation of India in order
to encourage greater flow of bank credit to small borrowers. In 1978, this
Corporation was merged with the Deposit Insurance Corporation and renamed
as Deposit Insurance and Credit Guarantee Corporation (DICGC).

Thus Corporation guarantees support for the entire priority sector advances by
banks and other approved financial institutions to small borrowers and small
scale industries. At present, the DICGC is operating three credit guarantee
schemes. The RBI does not lend to the Corporation and has simply helped in its
formation.

(iii) Industrial Credit Department:

Earlier, the RBI had established the Industrial Credit Department in 1957 to
solve the problems of industrial finance. It was this Department which
administered the Credit Guarantee Scheme for SSI introduced in July 1960.
With the formation of DICGC, this department was wound up by the RBI in
1981.

(iv) Credit Monitoring Arrangement (CMA):

The RBI introduced the CMA in place of the Credit Authorisation Scheme
(CAS) in October 1988 whereby it delegated authority to banks to sanction
credit proposals of large borrowers and thereafter submit the same for post-
sanction scrutiny to the RBI. These credit limits relate to working capital (of
Rs. 5 crores and above), term finance (of Rs. 2 crores and above), sale of
machinery on deferred payments, etc. in case of large scale industries. The
CMA has made possible prompt and easy availability of credit to large
industries with post- sanction by the RBI.

From 1992-93, the working capital credit limit has been raised from Rs.5crores
to Rs. 10 crores. The CMA has also been extended to the export sector, The
RBI has advised banks to meet the additional credit needs of exporters in full
even if sanction of additional credit exceeds maximum permissible bank
finance (MPBF), provided exporters have firm orders or confirmed letters of
credit.

This facility has been extended to exports by small scale industries where the
working capital limit from banks is less than Rs. 1 crore, provided their exports
are not less than 25 per cent of their total turnover during the previous
accounting year. Further, this facility has been given to
companies/organisations engaged in the marketing/trading of the products of
village, tiny and small scale industrial units.

Conclusion:

The RBI has done a remarkable job in creating a number of financial

institutions and evolving credit guarantee schemes to help finance large,
medium and small industries, and small borrowers. It provides direct long-term
assistance from the NIC (LTO) Fund and medium/short-term assistance to
financial institutions.

It also changes its credit policy from time to time to help the industrial sector to
get larger financial assistance from banks.

Role in the Development of Bill Market Scheme:

The RBI pioneered the development of the bill market scheme for trade and
industry in 1952. Its aim was to induce banks to provide finance against bills of
exchange and promissory notes for 90 days. The scheduled commercial banks
were allowed to convert a part of their advances, loans, cash credits or
overdrafts into usance promissory notes for 90 days for lodging as collateral
(security) for advances from the RBI. Since this scheme was primarily meant to
accommodate the banks, it did not help in developing a bill market.

In November 1970, the RBI introduced the Bill Rediscounting Scheme with
several new features. Under this scheme, all licensed scheduled commercial
banks were made eligible to rediscount with the RBI genuine trade bills arising
out of sale or despatch of goods. But this did not lead to the development of bill
culture as preference for cash credit type of financing continued in the country.

Several difficulties were cited by trade and industry in developing the bill
market:

(a) Non-availability of stamp paper of required denomination,

(b) The need to affix stamp on each bill and payment of stamp duty,

(c) Reluctance of industry, trade and Government Departments to accept bills,

(d) Absence of specialised credit information agencies,

(e) Absence of any active secondary market for bills as rediscounting is

permitted only with the apex level financial institutions, and

(f) Administrative work involved in handling invoices/documents of title to

goods.

The Committee to Review the working of the Monetary System (1985) and the
Working Group on the Money Market (1986) set up by the RBI made a number
of recommendations which have since been accepted and implemented by the
RBI as under:

1. The RBI has developed the treasury bills or Government Securities market in
14-day Treasury Bills, 91-day Treasury Bills, 182-day Treasury Bills and 364-
day Treasury Bills.

2. In order to augment the facilities for rediscounting and to provide liquidity to

the bills, the RBI has been progressively permitting a larger number of financial
institutions eligible for rediscounting bills. Apart from all scheduled
commercial banks and selected urban co-operative banks, 21 other financial
institutions like LIC, UTI, GIC, NABARD, all development banks; all mutual
funds, etc., are included in the scheme.

3. The RBI has set up the Discount and Finance House of India (DFHI) as a
major financial institution to rediscount commercial bills, treasury bills and
Government dated securities which it has been doing since its inception on 15
April 1988.

4. In May 1994, the RBI set up the Securities Trading Corporation of India
(STCI) to develop secondary market in Government securities and Treasury
bills. The STCI undertakes ready forward transactions in Treasury Bills and
Government dated securities. From March 1996, it has become a primary dealer
in Government securities.

5. Besides, the DFHI and the STCI, the RBI has granted permission to ICICI
Securities, SBI Gilts Ltd., PNB Gilts Ltd. and Gilt Securities Trading
Corporation Ltd. to operate as primary dealers in Government securities. The
RBI also provides liquidity support to them in the form of reverse Repos in
Government dated securities and 91-Day Treasury Bills.

6. Up to September 1988 under the bill rediscounting procedure, the bills had to
be endorsed and lodged with the rediscounting banks or institutions. But
preference for cash-credit type of financing continued because certain
administrative difficulties, were faced by banks in following this procedure.

In October, 1988, the RBI introduced the scheme of derivative usance

promissory note for the purpose of rediscounting of bills whereby banks could
draw a derivative usance promissory note for suitable sums with maturity up to
90 days on the basis of bona-fide commercial or trade bills discounted at their
branches. Since August, 1989, the derivative promissory note has been
exempted from stamp duty. Thus a major administrative constraint in the use of
the bill system has been removed.

7. To encourage the development of bill finance and bill culture, the RBI had
fixed a discount rate equivalent to an effective interest rate of 15.5 per cent.
Further, to stimulate the supply of funds in the rediscount market, the RBI had
fixed the ceiling on rediscount rate at 12.5 per cent. But this rediscount rate was
not applicable when banks and financial houses rediscounted bills with DFHI
which could fix its own discount rates for bills. With effect from 1 May, 1989,
the bill rediscounting rate has been totally freed.

8. The Working Group on the Money Market (1986) made recommendations

for developing bill financing in relation to cash credit system and developing
the bill culture. In pursuance of the recommendations, the RBT advised banks
to fix for the Credit Authorisation Scheme (CAS) now covered by the Credit
Monitoring Scheme since October 1988, to attain a ratio of bill acceptance to
their inland credit purchases of 25 per cent and a bill discounting limit of the
same order.

9. To secure finance from banks against bills accepted by the large scale units
for prompt payment to small scale units, the RBI has introduced a Drawee Bill
Scheme.

10. The RBI advised commercial banks in July, 1992 that:

(a) They should be cautious in discounting bills drawn by finance companies

set up by large industrial houses on other group companies;

(b) They should not rediscount the bills discounted by non-bank financial
companies and thus desist from providing any rediscount facility to finance
companies; and

(c) They should ensure that the overall credit limit provided to finance
companies and to hire-purchase and equipment leasing companies should not
exceed three times the net worth of such companies.

11. Recognising the need to derive the benefit of internationally competitive

rates, the RBI decided to allow with effect from 7 April, 1993 authorised
dealers in India to rediscount export bills abroad at rates linked to international
interest rates.

Defects:

Despite these measures, the RBI has failed to develop bill finance and bill
culture in the country. Bill financing hardly covers about 4 per cent of the total
credit covered by banks today.

There are many reasons for this:

(a) The Government, public sector undertakings, and large industries do not
accept bills as a basis for financing business,

(b) The bill market is primarily confined to derivative usance promissory notes
rather than to genuine trade bills,

(c) Indigenous bills of exchange, known as hundis, which finance a large

segment of commerce and trade in India are not recognised by the RBI. For a
faster growth of bill financing and bill culture, the RBI should try to remove
these drawbacks of the bill market.

6. Project Report on Exchange Control Management by RBI:

The RBI manages and controls the country’s foreign exchange reserves and the
external value of the rupee. Foreign exchange is managed and controlled in
order to overcome the deficit in balance of payments. The RBI controls and
manages the inflow and outflow of foreign currencies under the Foreign
Exchange Regulation Act, 1973 and Foreign Exchange Regulation

(Amendment) Act, 1993.

Foreign currencies coming into India are required to be sold and exchanged for
the rupee either direct to the RBI or to its authorised dealers. Its authorised
dealers include certain commercial banks, hotels, firms, shops, etc. which deal
in foreign currencies and foreign travellers’ cheques. They are also authorised
to lend and borrow foreign currency among themselves in the inter-bank market
locally.

The actual lending limit for each authorised dealer is fixed by the RBI
depending upon the size of its operations and other relevant factors. Authorised
dealers are permitted to maintain with overseas branches and correspondents,
balances in foreign currencies at levels which are commensurate with normal
needs of their business, such as payments towards imports or maturing
deliveries under forward contracts. They are also permitted to transfer foreign
currency funds rendered surplus over normal anticipated needs of their business
on a day-to-day basis to special interest bearing accounts.

The blanket foreign exchange permits are issued to exporters in lump sums.
Exporters are allowed to receive export proceeds through normal banking
channels. The payments for imports against foreign currency loans / credits
extended by foreign governments / financial institutions are made either under
the Direct Payment Method, also known as Letter of Commitment Method or
Reimbursement Method.

Since 1991 significant changes have been made in the exchange rate system by
the RBI. In July, 1991, the rupee was devalued by about 20 per cent with
respect to US dollar in two stages. Simultaneously, the Exim Scrip Scheme was
introduced under which certain imports were permitted only against export
entitlement.

This was followed by partial convertibility of rupee in 60:40 ratio with effect
from 1 March, 1992. This was the Liberalised Exchange Rate Management
System (LERMS). Under this system, all foreign exchange receipts on current
account transactions (i.e. exports, remittances etc.) were required to be
surrendered to the authorised dealers (ADs) in full.

The rate of exchange for these transactions was the free market rate quoted by
the ADs. The ADs, in turn, surrendered to the RBI 40 per cent of their purchase
of foreign currencies at the exchange rate announced by the RBI. They were
free to sell the balance of 60 per cent of foreign exchange in the free market.
All importers of goods and services and persons travelling abroad bought
foreign exchange at market- determined rates from the ADs subject to
liberalised exchange control rules.

The RBI issued instructions to authorised dealers to sell foreign exchange

without prior approval for business visits overseas sponsored by
firms/companies/ organisations, visits by self-employed professionals and by
journalists on short-term assignments, for medical treatment abroad, persons
proceeding abroad for employment/emigration and on the hospitality of the
overseas organisation, to exporters by way of agency commission and
settlement of quality claims, for sundry personal and commercial remittances,
etc. In all such cases, except exporters, the sale of foreign exchange limit had
been raised between $ 100 to $ 500.

Under LERMS, the Reserve Bank provides foreign exchange at the official
exchange rate in the following cases:

(a) For import of crude, diesel and kerosene by the Indian Oil Corporation,

(b) For import of fertilisers by MMTC.

(c) For discharge of financing arrangements like payments under Banker’s

Acceptance Facility and Suppliers’ Credit in respect of items (a) and (b) above
by IOC and MMTC respectively,

(d) For import of goods by Ministries and Departments of Government of India

on a certification from the Financial Adviser/Internal Finance Wing of the
Ministry concerned that the import of such goods is as per authorisation of the
Foreign Exchange Budget of the Department of Economic Affairs,

(e) For import of Life-saving Drugs and Equipment.

(f) For meeting 40 per cent of foreign exchange requirements of Advance

Licences, Imprest Licence and import for replenishment of raw materials for
Gem and Jewelry exports.

With effect from 2 March, 1993, the dual exchange rate system was replaced by
the Unified Exchange Rate System (UERS) under which the 60:40 ratio was
extended to 100 per cent conversion. The UERS was introduced to rectify the
anomaly of the LERMS under which exporters and other earners of foreign

exchange indirectly subsidized certain imports. Under this system, the

exchange rate was fully determined by market forces of relative demand and
supply.
The RBI had been announcing its buying and selling rates at the ongoing
market rates for transactions with ADs. This system permitted 100 per cent
conversion of the rupee for all exports and imports of goods. But the official
RBI exchange rate continued for the conversion of items not permitted under
the UERS. These included more than half-a-dozen invisible items of current
account and all capital account payments. Further, various exchange control
norms of the RBI remained in operation with a few relaxations.

As a result of the operation of the UERS, the exchange rate remained more or
less steady at the level of Rs.31.37 per dollar. With stability in the exchange
rate and the large inflow of resources following liberalisation of foreign
investment policy and removal of industrial and trade restrictions, there had
been substantial improvement in the current account deficit. This led to the
current account convertibility of the rupee effective 1 March, 1994.

The RBI announced further relaxations in the exchange control regulations on a

number of invisible items as part of the current account convertibility of the
rupee. The final step towards current account convertibility was taken in
August 1994 by further liberalisation of invisibles payments and acceptance of
the obligations under Article VIII of the IMF. Under it, India is committed to
forsake the use of exchange restrictions on current international transactions.

There is no officially fixed exchange rate of the rupee. Instead, the rate is
determined by the demand and supply conditions in the foreign exchange
market. The RBI intervenes to maintain orderly market conditions and to curb
excessive speculation in foreign exchange.

Foreign exchange is released by authorised dealers (ADs) for various purposes

like foreign travel, medical treatment, gifts, services, studies, etc. Release of
foreign exchange by ADs for the above purposes was initially governed by
limits laid down by the RBI.

Beyond the specified limits foreign exchange could be obtained after seeking
prior approval of the RBI. Effective July 1995, the RBI has permitted ADs to
provide exchange facilities to their customers for the above mentioned purposes
beyond the indicative limit without its prior approval, provided they are
satisfied about the bonafides of the application. But, they are required to report
such transactions to the RBI.

The process of liberalisation towards current account convertibility has been

continued by delegating more powers to ADs.
(1) They have been permitted to export their surplus stocks of foreign currency
notes and coins for realisation of proceeds to private money changers abroad, in
addition to their overseas branches and correspondents.

(2) They have been permitted to allow EEFC (Exchange Earners Foreign
Currency) account holders to utilise funds held in such accounts for making
remittances in foreign exchange connected with their trade and business related
transactions which are of current account nature.

(3) The RBI has set up Inter-Bank Forex Clearing House where foreign
exchange transactions by ADs are cleared.

(4) The RBI has set up a Market Intelligence Cell to study and closely monitor
the developments in the Indian foreign exchange market. The Cell receives
from the ADs on a daily basis information on forex transactions which are
critically analysed and followed up.

7. Project Report on the Methods of Credit Control by RBI:

To achieve these objectives, the RBI follows the following methods of credit
control:

(i) Open Market Operations:

Open market operations refer to the sale and purchase of gold related securities
and other securities, bills and bonds of Government by the RBI from and to the
public and financial institutions. To control inflation and tackle the problem of
excess liquidity due to foreign exchange inflows, the RBI sells Government
securities. As a result, there is reduction in the cash balances of banks and other
deposits of banks held by the RBI.

The opposite happens when the RBI purchases securities from the open market.
In Government securities, there were adhoc Treasury Bills which were replaced
by Ways and Means Advances from April 1997. They are meant to serve as a
means of meeting temporary mismatches between the receipts and expenditure
of the Central Government rather than a source of financing fiscal deficit.

This has provided more flexibility to the RBI in operating its monetary policy.
Besides, to control fluctuations in call money market rates repos/reverse repo
auctions, first on daily basis then with 3-7 day maturity, were introduced under
full-fledged liquidity, Adjustment Facility (LAF) effective August 2000.
Besides, weekly auctions of 14-day Treasury Bills and 28-days Treasury Bills;

fortnightly auctions of 182-day Treasury Bills; and monthly auctions of 364-

day Treasury Bills were started from 1997-98.
The RBI has been resorting to open market operations in order to reduce the
lending power of commercial banks because its sale of securities have normally
exceeded its purchases. But the effectiveness of open market operations as an
instrument of credit control in India is limited by a number of factors.

First, except for the gilt- edged market in India, there is the absence of other
first class securities.

Second, the market for Government securities is a ‘captive’ market over which
the RBI has almost a monopoly and some institutional investors like LIC, UTI,
GIC, and commercial banks, etc. are required to invest in them.

Third, open market operation: are being used as an instrument of debt-

management rather than to influence the cost and availability of credit. As such,
open market operations have not been a success in India.

(ii) Bank Rate Policy:

The bank rate is the’ rate fixed by the central bank at which it rediscounts first
class bills of exchange and government securities held by commercial banks.
But in India, the bank rate policy is limited to give advances to commercial
banks against first class bills of exchange by the RBI.

The latter include Government securities and genuine trade bills. Under the Bill
Rediscounting Scheme introduced in November 1970, all licensed scheduled
commercial banks are eligible to rediscount with the RBI genuine trade bills
arising out of sale or despatch of goods.

The objectives of the RBI’s bank rate policy are to influence the availability
and cost of credit. The RBI has been unsuccessful in achieving these objectives.
From its establishment in 1935 up to 14 November. 1951, the bank rate was
stable at 3 per cent.

It was cheap monetary policy which led to an unlimited expansion of credit.

Consequently, speculative activities received encouragement and the deficit in
balance of payments increased. For the first time, the bank rate was raised to
3.5 per cent in November 1951.

It was raised to 4 per cent in May 1957, to 4.5 per cent in January, 1963; to 5
per cent in September, 1964; to 6 per cent in January, 1971 and to 7 per cent in

May 1973. With an unprecedented rise in prices, the RBI resorted to a policy of
dear money in July 1974 and raised the bank rate to 9 per cent in 1977, to 10
per cent in July 1981, to 11 per cent in July 1991 and to 12 per cent in October
1991.
To overcome recession in the economy, the RBI started following cheap money
policy by reducing the bank rate to 11 per cent in April 1997 and subsequently
by stages to 6 per cent on April 29,2003. Thus the bank rate had not been used
as an instrument of credit control till 1973. It is only in the 1980s and 1990s
that its proper use has been made in the form of cheap or dear monetary policy.

(iii) Interest Rate Policy:

Interest rate adjustment is a flexible and potent tool of credit policy. It
reinforces restrictive/liberal impact of credit policy. In order to supplement the
bank rate policy, the RBI has been following the policy of changing the interest
rate structure for different sectors of the economy in the light of evolving
economic trends.

(a) Deposit Rates:

Since November 1975, the RBI has been following the policy of administered
interest rates. This policy has the twin objectives of mobilising savings and
providing funds for productive activities in the priority sectors of the economy
at concessional rates of interest.

The interest rates on all saving instruments including bank deposits are
sometimes reduced to prevent banks from getting locked into longer period
maturities. At other times, they are raised to assist the banks in deposit
mobilisation and to offer a better rate of savings. Up to 21 April, 1992, the term
deposit rates of scheduled commercial banks were prescribed in three slabs of
maturities and rates.

Effective 22 April, 1992, the banks were given freedom to determine the term
deposits of three maturity slabs of their choice, subject to a choice of interest
rate ‘not exceeding 13 per cent. With the fall in inflation rate, the ceiling rate
was gradually reduced to ‘not exceeding 10 per cent’ by 2 September 1993.
When the inflation rate started rising, the ceiling rate was gradually raised to
‘not exceeding 12 per cent’ effective 18 April, 1995 for 46 days to 3 years and
above.

To augment the resources of banks and to impart greater flexibility to term

deposit rate structure, the banks have been allowed freedom to fix their own
interest rates on domestic term deposits of all categories. The minimum period

of term deposits has been gradually reduced from 46 days to 30 days; and
subsequently to 15 days. Effective May 2001, the banks had been permitted to
pay higher interest rates to senior citizens on their term deposits by 0.5 to 1.0
per cent.
The savings deposit rate has been lowered from to 4.0 per cent to 3.0 per cent
effective March 1,2003. Term deposit rates on NRE accounts were also
rationalised in accordance with the domestic rates. With a view to maintaining
the differential between the interest rates on term deposits and NRE Rupee term
deposits, banks were permitted to offer differential rates of interest on NRE
deposits on size-group basis subject to the overall ceiling rate effective 27
April, 2000. Effective 4 April, 1996, interest rates on NRE term deposits of
over two years had been freed for banks.

(b) Lending Rates:

The lending rate structure prescribed for banks since their nationalisation in
1969 had been cumbersome and complicated. It was characterised by a
multiplicity of rates relating, to numerous criteria, such as size of loan, priority
of a sector, location of activity, specific programmes, income of borrowers, etc.
In September 1990, the RBI rationalised the lending rate structure of
commercial banks. It is linked to the size of loan granted by the commercial
banks.

When the inflation rates were high, upward revisions were made in the lending
rates of commercial banks. The first upward revision was made on 13 April,
1991, when the minimum rate on advances above Rs.2 lakh was raised from 16
per cent to 17 per cent effective 13 April, 1991 and gradually to 20 per cent on
9 October, 1991.

As the inflation rate declined and the macroeconomic situation improved, the
lending rate was reduced gradually from 20 per cent to 14 per cent effective 1
March, 1994. Effective 18 October, 1994, the prescription of a minimum
lending rate has been abolished and banks have been given freedom to fix the
prime lending rate (PLR) for all advances above Rs.2 lakh. Each bank is
required to declare its PLR and made uniformly applicable to all its branches.

In keeping with its policy of rationalisation of the lending rate structure

according to the size of credit limit, the RBI reduced the number of categories
from six to three by April 1993. The three categories with interest rates
effective 18 October, 1994 were – (a) Up to Rs.25,000 at 12 per cent (fixed);
(b) Over Rs.25,000 and up to Rs.2 lakh at 13 per cent (fixed); and (c) Over Rs.2
lakh freed.

Under the DIR (Differential Interest Rate) scheme, term loans are provided to
small and water transport operators, professionals and self-employed in the
priority sector at the concessional rate of 4 per cent by both the commercial
banks and urban co-operative banks. They are required to lend 40 per cent of
their total advances to the priority sector.
Along with the above measures, interest rates on export credit are reviewed
from time to time with a view to providing an incentive to exporters for
repatriating the proceeds as well as discouraging them from delaying
repatriation of export proceeds.

On pre-shipment export credit, banks have been allowed to charge 10 per cent
interest up to 180 days and 13 per cent beyond 180 days to 270 days since 1
April, 1999. On post-shipment export credit upto 90 days, the interest rate has
been 10 per cent since 1 April, 1999, beyond 90 days to 6 months, and beyond
six months the banks are free to charge interest rates decided by them.

(iv) Changes in Variable Reserve Ratio:

The variable reserve ratio is a very effective instrument of monetary control
with the RBI.

In India, the variable reserve ratio is of the following types:

(a) Cash Reserve Ratio (CRR):

Since the establishment of RBI till 1956, the commercial banks were required
to keep 2 per cent of their time deposits and 5 per cent of their demand deposits
with the RBI in the form of reserves. Thus this tool of monetary policy was not
used for more than 20 years in India.

With the RBI Amendment Act, 1956, the RBI was empowered to raise the time
deposits of commercial banks from 2 to 8 per cent and the demand deposits
from 5 to 20 per cent. By the RBI Amendment Act, 1962 the distinction
between time and demand deposits was abolished and the provision was made
to keep the CRR between 3 to 15 per cent. After this, the RBI had been making
changes in the CRR in keeping with the monetary and economic conditions.

Effective 1 July, 1989, instead of separate ratios for different types of liabilities,
there is a uniform CRR of 15 per cent of the entire net demand and time
liabilities (NDTL) of banks, including FCNR and NRE accounts. The CRR was
reduced to 14 per cent effective 15 May, 1993 and again raised to 15 per cent
effective 6 August, 1994.

This was to meet monetary pressure arising from large capital inflows. For the
same reason, the CRR on FCNR accounts was raised to 15 per cent and on
NRNR deposits to 7.5 per cent. When these conditions reversed and money
growth slowed, the CRR was reduced from 15 per cent to 14 per cent effective
9 December 1995 and that on FCRR and NRNR deposited removed.

To augment the lendable resources of banks, the CRR was further reduced from
14 per cent to 13 per cent effective 11 May, 1996, and to 12 per cent effective 6
July, 1996 and in subsequent years gradually to 8 per cent on 1 April, 2000 and
to7.5 per cent on 14 May, 2001.

The reduction in CRR to 7.5 per cent has been done to enable banks to reduce
their PLR and to release more liquidity into the monetary system. As a policy
measure, the variations in CRR has been more successful in controlling credit
than open market operations and bank rate policy.

(b) Statutory Liquidity Ratio (SLR):

Another important tool of monetary policy with the RBI is the Statutory
Liquidity Ratio (SLR) which supplements the CRR. Under the Banking
Regulation Act, 1949, the commercial banks are required to keep 20 per cent of
their net demand and time liabilities (NDTL) deposits with them in the form of
liquidity ratio.

In this liquidity ratio are included excess reserves, current account balances of
the commercial banks with the RBI and other banks, gold and unencumbered
approved securities. But whenever the RBI raised the CRR, the commercial
banks would make this unsuccessful by increasing their liquidity power through
the sale of government securities. In order to overcome this weakness, the SLR
was raised to 25 per cent by the Banking Amendment Act of 1962.

But the cash reserves kept with the RBI were not included in this ratio. In order
to contain the liquidity growth in the banking system and consequent monetary
expansion, the SLR was raised to 30 per cent in November, 1972. Since then it
had been revised upward regularly so that with effect from 22 September, 1990
it had been 38.5 per cent.

To make more funds available for commercial bank lending, the base SLR on
NDTL was reduced gradually and by the end of 1996, it was brought down to
25 per cent as per the recommendations of the Narasimhan Committee.

The incremental SLR is 25 per cent. This refers to the ratio, the banks are

required to keep if there NDTL increase over the base SLR. The advantages of
SLR are that by implementing it along with CRR, it controls the liquidity of
banks and thereby limits their power to make advances to trade and industry.
Thus the quantitative monetary policy is successful in reducing inflationary
pressures. Second, more financial resources are available to the government for
its use.

(v) Selective Credit Controls:

Selective credit controls are meant to regulate and control the supply of credit.
They aim at channelising the flow of bank credit from speculative and other
undesirable purposes to socially desirable and economically useful uses. Thus
they help in curtailing the rise in prices of commodities.

The method of selective credit controls was introduced in India by the RBI in
May 1956.

Under this:

(i) It fixes minimum margins for advances against securities for banks. These
margins are from 20 to 100 per cent;

(ii) It fixes ceilings on maximum advances against stocks of certain

commodities to traders;

(iii) It fixes minimum discriminatory rates of interest for certain kinds of

advances by banks;

(iv) It prohibits advances for financing hoarding of certain commodities; and

(v) Prohibits the discounting of bills of exchange relating to the sale of some
selected commodities.

Selective credit controls relate to such commodities as cotton, wheat, paddy/

rice, pulses, oilseeds, vegetable oils, sugar, gur and khandsari, man-made fibres
and cloth. The rate of interest charged on advances by banks against the
security of such commodities is higher than on other securities.

If the RBI wants to control speculation on the prices of such commodities, it

raises the minimum margins. In case it wants to liberalise credit facilities for
them, it lowers the minimum margins. It does so in keeping with changing
market conditions.
For instance, to curb inflationary pressures, the RBI had fixed the ceiling of 45
per cent on the incremental net non-food credit deposit ratio for banks from
October 1989. Further, restrictions had been placed on loans for purchase of
consumer durables and other non-priority sector personal loans. The minimum
margin for loans against shares and debentures/bonds was fixed at 75 per cent.

When in early 1992, the inflation rate started declining, the banks were advised
to support the revival of productive activity. At the same time, effective 22
April, 1992, all restrictions on credit or purchase of consumer durables, other
non-priority sector personal loans and stipulation on net non-food credit-deposit
ratio were removed.

Effective 21 October, 1996, selective credit controls on pulses, coarse grains,

oil seeds, vanaspati, sugar, gur, khandsari, cotton, kapas had been abolished,
except buffer stocks. Banks were given freedom to fix margins on advances
against sensitive commodities, except unreleased stocks of sugar for which 15
per cent margin had been fixed. Effective 2 December, 1996, the banks were
granted freedom to advance loans against shares/debentures with the maximum
limit of Rs. 10 lakh. It has since been raised to Rs.20 lakh.

Credit Monitoring Arrangement (CMA):

With effect from 10 October 1988, the RBI dispensed with the Credit
Authorisation Scheme (CAS) and introduced the Credit Monitoring
Arrangement (CMA) for bank lending for working capital purposes. Under the
revised scheme effective 30 October, 1996 all sanctions/ renewals of credit
limits to borrowers enjoying fund-based working capital limits of Rs. 10 crores
and above and term loans in excess of Rs. 5 crores were required to be reported
by the banks to the RBI for post-sanction scrutiny.

All sanctions/renewals of credit limits were required to be reported to the RBI.

In this way, the RBI regulated the sanctioning of loans by banks through CMA.
The CMA was discontinued from 8 December, 1997.

In recent years, the Reserve Bank has announced several steps to facilitate the
flow of credit to the commercial sector, particularly for exports, information
technology, infrastructure, agriculture, small scale industries, etc.

The coverage of the priority sector credit has been widened considerably. Bank
credit to NBFCs (non-bank financial companies) for on-lending to small road
and water transport operators, software industry having credit limit up to Rs.1
crore, to the food and agro-based sector, to NBFCs and financial institutions for
on-lending to the tiny sector, and to both public and private sector undertaking
for financing infrastructure projects is now being treated as priority sector
lending. Besides, bank lending to sensitive sectors comprising capital market,
real estate (housing) and commodities is regulated in keeping with the trends in
the economy.

Their Effectiveness:

Selective credit controls have been more effective in controlling credit than the

quantitative methods. They have been instrumental in channelising the flow of

credit from speculative and other undesirable purposes to socially desirable and
economically useful purposes.

They have helped in restricting the demand for money by laying down certain
conditions for borrowers by fixing minimum margin requirements and other
limits. Thus they have been successful in regulating credit for different uses in
various sectors of the economy according to plan priorities.

Despite all these successes, selective credit controls have failed to control the
demand for and supply of money in the country. They have, therefore, failed to
control inflationary pressures. With the introduction of commercial paper by
the large organised sector, the RBI’s control over credit through the CMA had
become less effective. Now large industries can raise money directly from the
market at cheaper rates than bank credit.

Moreover, trade and industry can get funds from non-bank financial
institutions, mutual fund’s, etc. which have made selective credit controls less
effective. Above all, selective credit controls alone are not effective in
controlling credit. They must be combined with general (or quantitative)
control measures like bank rate, open market operation, CRR, SLR, etc.

(vi) Direct Action:

The Banking Companies Act, 1949 empowers the RBI to caution or prohibit
banks generally or any individual bank in particular, from entering into any
particular transaction or class of transactions. The RBI has also the power to
inspect any bank and its books accounts. On a report from the RBI, the Central
Government may prohibit any bank from receiving fresh deposits or direct the
RBI to order for the winding up of the bank or its merger with some other bank.

(vii) Moral Suasion:

Besides, the above noted quantitative and qualitative measures of credit control,
the RBI also follows the method of moral suasion. By this method of
persuasion, suggestion and advice, the RBI asks the banks to follow its declared
monetary policy from time to time.

By sending circular letters or calling meetings of directors of banks, it

persuades them not to give credit for speculative activities and/or to give more
credit facilities to priority sectors of the economy. Before the nationalisation of
20 banks in India, the method of moral suasion was not successful but now all
banks follow the RBI guidelines. As a matter of fact, the RBI is so powerful
that no bank dares to ignore its circulars and suggestions.

8. Project Report on the Achievements of the Reserve Bank of India:

Some of the principal achievements of the RBI are as follows:

(i) Regulator of Credit:

The bank has been successfully regulating credit in the economy to meet the
requirements of trade, industry and agriculture during periods of recession and
inflation. For this purpose, it followed a cheap money policy in the early phase
of development planning and after that a policy of controlled monetary
expansion to meet the requirements of a growing economy.

(ii) Banker to the Government:

As banker to the Government, the RBI has been admirably managing the public
debt. It has successfully floated loans on behalf of the Central and State
Governments at low interest rates. It has also provided ways and means
advances to the State Governments through the sale of treasury bills. It has
been rendering advice to the Government on economic matters in general and
on financial matters in particular.

(iii) Development of Sound Banking System:

Another achievement of the Bank has been that it has developed and promoted
sound banking practices in the country. In exercise of the powers vested in it by
the Banking Regulation Act, it has been keeping a constant vigil over the

banks, trying to remove their defects, and strengthening them. Consequently,

this has inspired public confidence in the banking system as a whole.

(iv) Institutionalisation of Savings:

The RBI has been successfully promoting the institutionalisation of savings by
promoting banking habits, by large scale extension of banking facilities in rural
and urban areas, and promoting and establishing new specialised financial
agencies.

(v) In the Field of Co-Operative Credit:

The RBI has successfully promoted co-operative credit. It has Strengthened co-
operatives by setting up NRC (LTO) Fund and NRC (Stabilisation) Fund and
NABARD which now administers these Funds. It also finances the State Co-
operative Banks. It has been due to the efforts of the RBI that the co-operative
movement has been placed on a sound footing.
(vi) In the Field of Rural Credit:
The Bank has been admirably engaged in the task of promoting rural credit
since its inception. It runs a separate department to render advice to the
Government on rural credit. By adopting the multi-agency approach (viz. the
commercial banks, the co-operative banks, the RRBs, and NABARD), it has
been successful in providing credit for the development of agriculture, trade,
commerce, industry, and other productive activities in the rural areas.