FINANCIAL INSTITUTIONS AND MARKETS( LW-2316)

MODULE II : BANKING INSTITUTIONS

2.1 Reserve Bank of India: Objective, Main Functions

2.2 Measures of Credit Control
2.3 Instruments of Credit Control
2.4 Monetary Policy
2.5 Commercial Banking System: Objective, Main Functions
2.6 Credit Creation, Credit Multiplier
2.7 NBFCs, Other Financial Institutions ,Mortgages and Amortization

PREAMBLE OF RBI

“To regulate the issue of Bank notes and 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; to have a modern monetary policy framework to meet the challenge
of an increasingly complex economy, to maintain price stability while keeping in mind the
objective of growth.”

FUNCTIONS OF RBI

Function # 1. Monopoly of Note Issue:

Like any other central bank, the RBI acts as a sole currency authority of the country. It issues
notes of every denomination, except one-rupee note and coins and small coins, through the
Issue Department of the Bank.

One- rupee notes and coins and small coins are issued by the Government of India. In
actuality, the RBI also issues these coins on behalf of the Government of India. At present,
notes of denominations of rupees two, five, ten, twenty, fifty, one hundred and five hundred
are issued by the RBI.

Prior to 1956, the principle of note issue of the RBI was based on proportional reserve system.
This system was replaced by the minimum reserve system in 1956 under which the RBI was
required to hold at least Rs. 115 crores worth of gold as backing against the currency issued.

The rest (Rs. 85 crores) should be in foreign securities, so that together with gold and foreign
exchange reserve the minimum value of these assets is Rs. 200 crores.

Function # 2. Banker’s Bank:

As bankers’ bank, the RBI holds a part of the cash reserves of commercial banks and lends
them funds for short periods. All banks are required to maintain a certain percentage (lying
between 3 per cent and 15 per cent) of their total liabilities. The main objective of changing
this cash reserve ratio by the RBI is to control credit.

The RBI provides financial assistance to commercial banks and State cooperative banks
through rediscounting of bills of exchange. As the RBI meets the need of funds of
commercial banks, the RBI functions as the Tender of the last resort’.
The RBI has been empowered by law to supervise, regulate and control the activities of
commercial and cooperative banks. The RBI periodically inspects banks and asks them for
returns and necessary information.

Function # 3. Banker to the Government:

The RBI acts as the banker to the government of India and State Governments (except Jammu
and Kashmir). As such it transacts all banking business of these Governments.

(i) Accepts and pays money on behalf of the Government.

(ii) It carries out exchange remittances and other banking operations.

As the Government’s banker, the RBI provides short-term credit to the Government of India.
This short-term credit is obtainable through the sale of treasury bills. Not only this, the RBI
also provides ways and means of advances (repayable with 90- days) to State Government. It
may be noted that the Central Government is empowered to borrow any amount it likes from
the RBI.

The RBI also acts as the agent of the Government in respect of membership of the IMF and
World Bank.

Furthermore, the RBI acts as the adviser of the Government not only on banking and financial
matters but also on a wide range of economic issues (like financing patterns, mobilisation of
resources, institutional arrangements with regard to banking and credit matters, arrangements
with regard to banking and credit matters, international finance) etc.

Function # 4. Controller of Credit:

The RBI controls the total supply of money and bank credit to sub-serve the country’s interest.
The RBI controls credit to ensure price and exchange rate stability.

To achieve this, the RBI uses all types of credit control instruments, quantitative, qualitative
and selective. The most extensively used credit instrument of the RBI is the bank rate. The
RBI also relies greatly on the selective methods of credit control. This function is so
important that it requires special treatment.

Function # 5. Exchange Management and Control:

One of the essential central banking functions performed by the Bank is that of maintaining
the external value of rupee. The external stability of the currency is closely related to its
internal stability the inherent economic strength of the country and the way it conducts its
economic and monetary affairs.

Domestic, fiscal and monetary policies have, therefore, an important role in maintaining the
external value of the currency. Reserve Bank of India has a very important role to play in this
area.

The RBI has the authority to enter into foreign exchange transactions both on its own account
and on behalf of the Government.

The official external reserves of the country consist of monetary gold and foreign assets of the
Reserve Bank, besides SDR holdings. The Reserve Bank, as the custodian of the country’s
foreign ex- change reserves, is vested with the duty of managing the investment and
utilisation of the reserves in the , most advantageous manger.
Function # 6. Miscellaneous Functions:
The RBI collects, collates and publishes all monetary and banking data regularly in its weekly
statements in the RBI Bulletin (monthly) and in the Report on Currency and Finance
(annually).

Function # 7. Promotional and Developmental Functions:

Apart from these traditional function, the RBI performs various activities of promotional and
developmental nature. It attempts to mobilise savings for productive purposes. This is done in
various ways. For instance, RBI has helped a lot in building the huge financial infrastructure
that we see now.

‘This consists of such institutions as the Deposit Insurance Corporation (to safeguard the
interests of depositors against bank failure), the Agricultural Refinance and Development
Corporation (to meet the needs of agriculturists), IFCI, SFCs, IDBI, UTI (to meet the long
and medium term needs of industry), etc.

As for cooperative credit movement, the RBI’s performance in really commendable. This has
resulted in curbing the activities of moneylenders in the rural economy.

Thus, it is clear that RBI is not a typical Central Bank as is traditionally understood. It is
something more than a Central Bank. It regulates not only currency and credit but aids the
development of the Indian economy by conducting various types of promotional activities. As
such, in RBI we see many activities combined into one.

RBI MONETARY POLICY 2019

The monetary policy is a policy formulated by the central bank, i.e., RBI (Reserve Bank of
India) and relates to the monetary matters of the country. The policy involves measures taken
to regulate the supply of money, availability, and cost of credit in the economy. The policy
also oversees distribution of credit among users as well as the borrowing and lending rates of
interest. In a developing country like India, the monetary policy is significant in the
promotion of economic growth.
The various instruments of monetary policy include variations in bank rates, other interest
rates, selective credit controls, supply of currency, variations in reserve requirements and
open market operations.
Key Indicators
Indicator Current rate (Feb-2020)
CRR 4%
SLR 18.50%
Repo rate 5.15%
Reverse repo rate 4.90%
Marginal Standing facility rate 5.40%
Bank Rate 5.40%

CRR and SLR : CRR is a cash reserve ratio and SLR is statutory liquidity ratio. Under CRR
a certain percentage of the total bank deposits has to be kept in the current account with RBI
which means banks do not have access to that much amount for any economic activity or
commercial activity. Banks can’t lend the money to corporates or individual borrowers, banks
can’t use that money for investment purposes. So, that CRR remains in current account and
banks don’t earn anything on that.

SLR, statutory liquidity ratio is the amount of money that is invested in certain specified
securities predominantly central government and state government securities. Once again this
percentage is of the percentage of the total bank deposits available as far as the particular
bank is concerned. The SLR, the money goes into investment predominantly in the central
government securities as I mentioned earlier which means the banks earn some amount of
interest on that investment as against CRR where it earns zero.

Let us look at this combination of CRR and SLR. That is the amount of money which remains
blocked for statutory reasons and is not available for investment in various other high earning
avenues like loans are securities markets or other bonds. That means it puts a certain amount
of pressure on the banks balance sheets. However, at the same time that money remains safe
and with that mechanism RBI also offers safety to the depositors who have invested money in
the banks.

Repo Rate and Reverse Repo Rate

The term ‘Repo’ stands for ‘Repurchase agreement’. Repo is a form of short-term,
collateral-backed borrowing instrument and the interest rate charged for such borrowings is
termed as repo rate. In India, repo rate is the rate at which Reserve Bank of India lends money
to commercial banks in India if they face a scarcity of funds. Commercial banks sell
government securities and bonds to Reserve Bank of India with an agreement to repurchase
the securities and bonds from Reserve Bank of India on a future date at a pre-determined
price including interest charges. Current Repo Rate as of October 2019 is 5.15%.

Reverse repo as the name suggests is an opposite contract to the Repo Rate. Reverse Repo
rate is the rate at which the Reserve Bank of India borrows funds from the commercial banks
in the country. In other words, it is the rate at which commercial banks in India park their
excess money with Reserve Bank of India usually for a short-term. Current Reverse Repo
Rate as of October 2019 is 4.90%.

Objectives of Monetary Policy

While the main objective of the monetary policy is economic growth as well as price and
exchange rate stability, there are other aspects that it can help with as well.

Promotion of saving and investment: Since the monetary policy controls the rate of interest
and inflation within the country, it can impact the savings and investment of the people. A
higher rate of interest translates to a greater chance of investment and savings, thereby,
maintaining a healthy cash flow within the economy.

Controlling the imports and exports: By helping industries secure a loan at a reduced rate
of interest, monetary policy helps export-oriented units to substitute imports and increase
exports. This, in turn, helps improve the condition of the balance of payments.

Managing business cycles: The two main stages of a business cycle are boom and depression.
The monetary policy is the greatest tool using which the boom and depression of business
cycles can be controlled by managing the credit to control the supply of money. The inflation
in the market can be controlled by reducing the supply of money. On the other hand, when the
money supply increases, the demand in the economy will also witness a rise.
Regulation of aggregate demand: Since the monetary policy can control the demand in an
economy, it can be used by monetary authorities to maintain a balance between demand and
supply of goods and services. When credit is expanded and the rate of interest is reduced, it
allows more people to secure loans for the purchase of goods and services. This leads to the
rise in demand. On the other hand, when the authorities wish to reduce demand, they can
reduce credit and raise the interest rates.
Generation of employment: As the monetary policy can reduce the interest rate, small and
medium enterprises (SMEs) can easily secure a loan for business expansion. This can lead to
greater employment opportunities.

Helping with the development of infrastructure: The monetary policy allows concessional
funding for the development of infrastructure within the country.

Allocating more credit for the priority segments: Under the monetary policy, additional
funds are allocated at lower rates of interest for the development of the priority sectors such
as small-scale industries, agriculture, underdeveloped sections of the society, etc.

Managing and developing the banking sector: The entire banking industry is managed by
the Reserve Bank of India (RBI). While RBI aims to make banking facilities available far and
wide across the nation, it also instructs other banks using the monetary policy to establish
rural branches wherever necessary for agricultural development. Additionally, the
government has also set up regional rural banks and cooperative banks to help farmers receive
the financial aid they require in no time.

Flexible Inflation Targeting Framework (FITF)

The Flexible Inflation Targeting Framework (FITF) was introduced in India post the
amendment of the Reserve Bank of India (RBI) Act, 1934 in 2016. In accordance with the
RBI Act, the Government of India sets the inflation target every 5 years after consultation
with the RBI. While the inflation target for the period between 5 August 2016 and 31 March
2021 has been determined to be 4% of the Consumer Price Index (CPI), the Central
Government has announced that the upper tolerance limit for the same will be 6% and the
lower tolerance limit can be 2% for the same.In this framework, there are chances of not
achieving the inflation target fixed for a particular amount of time. This can happen when:
The average inflation is greater than the upper tolerance level of the inflation target as
predetermined by the Central Government for 3 quarters in a row.

The average inflation is less than the lower tolerance level of the target inflation fixed by the
Central Government beforehand for 3 consecutive quarters.

Monetary Policy Tools

To control inflation, the Reserve Bank of India needs to decrease the supply of money or
increase cost of fund in order to keep the demand of goods and services in control.

Quantitative tools

The tools applied by the policy that impact money supply in the entire economy, including
sectors such as manufacturing, agriculture, automobile, housing, etc.
Reserve Ratio:
Banks are required to keep aside a set percentage of cash reserves or RBI approved assets.
Reserve ratio is of two types:

Cash Reserve Ratio (CRR) – Banks are required to set aside this portion in cash with the
RBI. The bank can neither lend it to anyone nor can it earn any interest rate or profit on CRR.
Statutory Liquidity Ratio (SLR) – Banks are required to set aside this portion in liquid
assets such as gold or RBI approved securities such as government securities. Banks are
allowed to earn interest on these securities, however it is very low.

Open Market Operations (OMO):

In order to control money supply, the RBI buys and sells government securities in the open
market. These operations conducted by the Central Bank in the open market are referred to as
Open Market Operations.

When the RBI sells government securities, the liquidity is sucked from the market, and the
exact opposite happens when RBI buys securities. The latter is done to control inflation. The
objective of OMOs are to keep a check on temporary liquidity mismatches in the market,
owing to foreign capital flow.

Qualitative tools:

Unlike quantitative tools which have a direct effect on the entire economy’s money supply,
qualitative tools are selective tools that have an effect in the money supply of a specific sector
of the economy.

Margin requirements – The RBI prescribes a certain margin against collateral, which in turn
impacts the borrowing habit of customers. When the margin requirements are raised by the
RBI, customers will be able to borrow less.

Moral persuasion – By way of persuasion, the RBI convinces banks to keep money in
government securities, rather than certain sectors.

Selective credit control – Controlling credit by not lending to selective industries or

speculative businesses.

Market Stabilisation Scheme (MSS) -

Policy Rates:

1. Bank rate – The interest rate at which RBI lends long term funds to banks is referred to as
the bank rate. However, presently RBI does not entirely control money supply via the bank
rate. It uses Liquidity Adjustment Facility (LAF) – repo rate as one of the significant tools to
establish control over money supply.

Bank rate is used to prescribe penalty to the bank if it does not maintain the prescribed SLR
or CRR.

2. Liquidity Adjustment Facility (LAF) – RBI uses LAF as an instrument to adjust liquidity
and money supply. The following types of LAF are:

Repo rate: Repo rate is the rate at which banks borrow from RBI on a short-term basis against
a repurchase agreement. Under this policy, banks are required to provide government
securities as collateral and later buy them back after a pre-defined time.

Reverse Repo rate: It is the reverse of repo rate, i.e., this is the rate RBI pays to banks in order
to keep additional funds in RBI. It is linked to repo rate in the following way:
Reverse Repo Rate = Repo Rate – 1
3. Marginal Standing Facility (MSF) Rate: MSF Rate is the penal rate at which the Central
Bank lends money to banks, over the rate available under the repo policy. Banks availing
MSF Rate can use a maximum of 1% of SLR securities.

MSF Rate = Repo Rate + 1

Dear Money Policy or Contractionary Monetary Policy:

Dear money policy is a policy when money become more expensive with the rise of interest
rate. Due to this, the supply of money also decreases in the economy, therefore it is also
referred to as the contractionary monetary policy.

This policy leads to a drop in business expansions owing to a high cost of credit, as well as a
fall in business expansion. This in turn affects employment as it brings down growth rates.
Therefore, interest rate cuts such as SLR and CRR are preferred by the government and the
corporates.

Fiscal Policy:
A policy set by the finance ministry that deals with matters related to government expenditure
and revenues, is referred to as the fiscal policy. Revenue matter include matters such as
raising of loans, tax policies, service charge, non-tax matters such as divestment, etc. While
expenditure matters include salaries, pensions, subsidies, funds used for creating capital assets
like bridges, roads, etc.
Demand Pull Inflation:
This is a state when people have excess money to buy goods in the market. RBI practises
easier control on this as it can lead to a fall in money supply in the economy, which in turn
would mean a drop in the prices.
Supply Side Inflation:
Inflation in the economy owing to constraints in the supply side of goods in the market. This
cannot be controlled by RBI as it does not control prices of commodities. The government
plays an important role in this case through fiscal policy.

COMMERCIAL BANKS

Commercial banks form a significant part of the country’s Financial Institution System.
Commercial Banks are those profit seeking institutions which accept deposits from general
public and advance money to individuals like household, entrepreneurs, businessmen etc.
with the prime objective of earning profit in the form of interest, commission etc. The
operations of all these banks are regulated by the Reserve Bank of India, which is the central
bank and supreme financial authority in India. The main source of income of a commercial
bank is the difference between these two rates which they charge to borrowers and pay to
depositers. Examples of commercial banks – ICICI Bank, State Bank of India, Axis Bank,
and HDFC Bank.

Classification of commercial banks

Scheduled banks :- Banks which have been included in the Second Schedule of RBI Act
1934. They are categorized as follows:
Public Sector Banks :- are those banks in which majority of stake is held by the government.
Eg. SBI, PNB, Syndicate Bank, Union Bank of India etc.
Private Sector Banks :- are those banks in which majority of stake is held by private
indivisuals. Eg. ICICI Bank, IDBI Bank, HDFC Bank, AXIS Bank etc.
Foreign Banks :- are the banks with Head office outside the country in which they are
located. Eg. Citi Bank, Standard Chartered Bank, Bank of Tokyo Ltd. etc.
Non scheduled commercial banks :- Banks which are not included in the Second Schedule
of RBI Act 1934.

Activities of Commercial Banks

Primary Functions of Commercial Banks:

Deposit Acceptance: Being a short term credit dealer, the commercial banks accept the
savings of public in the form of following deposits:
Fixed term deposits
Current A/c deposits
Recurring deposits
Sving A/c deposits
Tax saving deposits
Deposits for NRIs

Lending Money: a second major function is to give loans and advances and thereby earn
interest on it. This function is the main source of income for the bank. Overdraft facility:
Permission to a current A/c holder of withdrawal more than to what he has deposited.

Loans & advances: A kind of secured and unsecured loans against some kind of security.
Discounting of bill of exchange: in case a person wants money immediately, he/she can
present the B/E to the respective commercial bank and can get it discounted.

Cash credit : Facility to withdraw a certain amount of money on a given security.

Secondary Functions of Commercial Banks:

Agency functions: Bank pays on behalf of its customers as an agent and gets paid fee for
agency functions such as:
Payment of taxes, bills
Collection of funds through bills, cheques etc.
Transfer of funds
Sale-purchaseof shares and debentures
Collection/Payment of dividend or interest
Acts as trustee & executor of properties
Forex Transactions
General Utility Services: locker facility

Credit Creation: It is one of the most outstanding function of commercial banks. A bank
creates credit on the basis of its primary deposits. It further lends the money which people has
depositted with the bank also charge interest on this money, which is much higher than what
it actually pays to depositer. Thus bank generates money for itself.

Example :
Let us learn the process of credit creation by commercial banks with the help of an example.
Suppose you deposit Rs. 10,000 in a bank A, which is the primary deposit of the bank. The
cash reserve requirement of the central bank is 10%. In such a case, bank A would keep Rs.
1000 as reserve with the central bank and would use remaining Rs. 9000 for lending purposes.

The bank lends Rs. 9000 to Mr. X by opening an account in his name, known as demand
deposit account. However, this is not actually paid out to Mr. X. The bank has issued a
check-book to Mr. X to withdraw money. Now, Mr. X writes a check of Rs. 9000 in favor of
Mr. Y to settle his earlier debts.
The check is now deposited by Mr. Y in bank B. Suppose the cash reserve requirement of the
central bank for bank B is 5%. Thus, Rs. 450 (5% of 9000) will be kept as reserve and the
remaining balance, which is Rs. 8550, would be used for lending purposes by bank B.
Thus, this process of deposits and credit creation continues till the reserves with commercial
banks reduce to zero.

This process is shown in the Table-1:

From Table-1, it can be seen that deposit of Rs. 10,000 leads to a creation of total deposit of
Rs. 50,000 without the involvement of cash.

The process of credit creation can also be learned with the help of following formulae:
Total Credit Creation = Original Deposit * Credit Multiplier Coefficient
Credit multiplier coefficient= 1 / r where r = cash reserve requirement also called as Cash
Reserve Ratio (CRR)
Credit multiplier co-efficient = 1/10% = 1/ (10/100) = 10
Total credit created = 10,000 *10 = 100000

If CRR changes to 5%,

Credit multiplier co-efficient = 1/5% = 1/ (5/100) = 20
Total credit creation = 10000 * 20 = 200000

Thus, it can be inferred that lower the CRR, the higher will be the credit creation, whereas
higher the CRR, lesser will be the credit creation. With the help of credit creation process,
money multiplies in an economy. However, the credit creation process of commercial banks
is not free from limitations.

NBFCs

A Non-Banking Financial Company (NBFC) is a company registered under the Companies

Act, 1956/2013 engaged in the business of loans and advances, acquisition of
shares/stocks/bonds/debentures/securities issued by Government or local authority or other
marketable securities of a like nature, leasing, hire-purchase, insurance business, chit business
but does not include any institution whose principal business is that of agriculture activity,
industrial activity, purchase or sale of any goods (other than securities) or providing any
services and sale/purchase/construction of immovable property. A non-banking institution
which is a company and has principal business of receiving deposits under any scheme or
arrangement in one lump sum or in installments by way of contributions or in any other
manner, is also a non-banking financial company (Residuary non-banking company).

Here it means all the Company which is registered under Companies Act, 1956/2013 and who
deals in:-
1. business of loans and advances,
2. acquisition of shares/stocks/bonds/debentures/securities issued by Government or local
authority or other marketable securities of a like nature
3. leasing
4. hire-purchase
5. insurance business
6. chit business

PRINCIPAL BUSINESS as financial activity here means:

When a company’s financial assets constitute more than 50 per cent of the total
assets and income from financial assets constitute more than 50 percent of the gross income.

A company which fulfils both these criteria will be registered as NBFC by RBI.

The term ‘principal business’ is not defined by the Reserve Bank of India Act. The Reserve
Bank has defined it so as to ensure that only companies predominantly engaged in financial
activity get registered with it and are regulated and supervised by it. Hence, if there are
companies engaged in agricultural operations, industrial activity, purchase and sale of goods,
providing services or purchase, sale or construction of immovable property as their principal
business and are doing some financial business in a small way, they will not be regulated by
the Reserve Bank. Interestingly, this test is popularly known as 50-50 test and is applied to
determine whether or not a company is into financial business.

NBFCs lend and make investments and hence their activities are akin to that of banks;
however there are a few differences as given below:

1. NBFC cannot accept demand deposits;

2. NBFCs do not form part of the payment and settlement system and cannot issue cheques
drawn on itself;
3. Deposit insurance facility of Deposit Insurance and Credit Guarantee Corporation is not
available to depositors of NBFCs, unlike in case of banks.
4. Provides Banking services to People without holding a Bank license,
5. Foreign Investment allowed up to 100%.
6. An NBFC is not required to maintain Reserve Ratios (CRR, SLR etc.)
7. An NBFC cannot indulge Primarily in Agricultural, Industrial Activity, Sale-Purchase,
Construction of Immovable Property

Necessity of taking Approval of RBI for NBFC:

1.As per Section 45-IA of the RBI Act, 1934 , no Non-banking Financial company can
commence or carry on business of a non-banking financial institution without obtaining a
certificate of registration from the Bank and
2. without having a Net Owned Funds of ₹ 2 crore.

However, in terms of the powers given to the Bank, to obviate dual regulation, certain
categories of NBFCs which are regulated by other regulators are exempted from the
requirement of registration with RBI viz. Venture Capital Fund/Merchant Banking
companies/Stock broking companies registered with SEBI, Insurance Company holding a
valid Certificate of Registration issued by IRDA, Nidhi companies as notified under Section
620A of the Companies Act, 1956, Chit companies as defined in clause (b) of Section 2 of the
Chit Funds Act, 1982,Housing Finance Companies regulated by National Housing Bank,
Stock Exchange or a Mutual Benefit company.

Types of NBFC:

Types of NBFC on the basis of deposit they hold:-

1. Deposit taking
2. Non-deposit

NBFCs whose asset size is of ₹ 500 cr or more as per last audited balance sheet are
considered as systemically important NBFCs. The rationale for such classification is that the
activities of such NBFCs will have a bearing on the financial stability of the overall economy.

Types of NBFC as per their activity

1. Assets Finance Company
2. Investment Company
3. Loan Company
4. Infrastructure Finance Company
5. Core Investment Company
6. Micro Finance Company
7. Housing Finance Company
8. Infrastructure Debt Fund
9. Non-Banking Financial Company – Micro Finance Institution (NBFC-MFI)
10. Non-Banking Financial Company – Factors (NBFC-Factors)

Requirements for registration in NBFC:

A company incorporated under the Companies Act, 1956 and desirous of commencing
business of non-banking financial institution as defined under Section 45 I(a) of the RBI Act,
1934 should comply with the following:
1. It should be a company registered under the companies Act, 1956/2013.
2. It should have a minimum net owned fund of ₹ 200 lakh. (The minimum net owned fund
(NOF) required for specialized NBFCs like NBFC-MFIs, NBFC-Factors, CICs as directed by
RBI)

Readings:

1. Venezuela: All you need to know about the crisis in nine charts ,
https://www.bbc.com/news/world-latin-america-46999668)
2. Great Depression by Gene Smiley ,
https://www.econlib.org/library/Enc/GreatDepression.html
3. 2008 Financial Crisis, https://www.thebalance.com/2008-financial-crisis-3305679