Module IV Monetary and Fiscal Environment in India

Monetary and Fiscal Environment in India: i. RBI – Role and functions. ii. Regulation of money and
credit, iii. Monetary and Fiscal Policies
Fiscal Policies
The word fiscal is derived from a Greek word Fisc which means the basket that symbolised treasury of
government. A fiscal policy is the part of economic policy that is concerned with the State’s income and
expenditure to achieve and sustain rapid economic growth in an economy. It includes public borrowing and
deficit financing. Fiscal policy determines the tax revenue, public expenditure, loans, transfers, debt
management, public borrowings, budgetary deficit, etc. Fiscal policy can be defined as the policy that is
concerned with the various aspects of the government expenditure and the tax structure. Fiscal policy helps in
the fulfilment of the objectives of the monetary policy also. It uses taxes, public expenditure, and public debt
as balancing factors in economic development. Fiscal policy includes tax policy, expenditure policy,
investment or disinvestment strategies and debt or surplus management. While fiscal policy encompasses the
taxation and expenditure decisions of the government, monetary policy deals with the supply of money in the
economy and rate of interest. It works along with the monetary policy to influence the country’s money supply.
Objectives of Fiscal Policy Fiscal Policy and Monetary Policy:
• Economic Development: The fiscal policy ensures economic development through mobilising
resources through taxation, savings etc.
• Efficient Allocation of Resources: This is facilitated through directing allocation of funds to
specified areas that foster social and economic development.
• Reduction of Inequalities of Income: This is attempted by fiscal policy through appropriate taxation
policies.
• Price Stability and Control of Inflation: Fiscal policy lays down methods to control inflation and
stabilise prices.
• Employment Generation: The expansion of infrastructure and other schemes and programmes are
given a boost by the fiscal policy that promote job opportunities and employment generation.
• Balanced Regional Development: The fiscal policy through tax exemptions, cash subsidies lead to
balanced regional development.
• Infrastructure Development: The development of infrastructure in the form of highways, ports,
railways, airports etc., is possible through generation of more resources through taxation, public bonds
and so on.
• Capital Formation: Fiscal policy facilitates increase in capital that leads to development of other
sectors of the economy.
• Foreign Exchange Earnings: The increase in foreign exchange earnings is made possible by the
abolition of taxes on export earnings, sales tax etc.
India’s fiscal system since the early 1900s, especially in taxation has undergone changes. The initial years
of India’s planned development strategy had a conservative fiscal policy to keep the deficits under control.
The tax system’s objective was the resource transfer from the private sector to the public sector to increase
the speed of industrialisation and social welfare. However, the growth did not pick up till the 1991
economic reforms. In India, the fiscal deficit was controlled by 2007-08 and it survived the economic
recession with the help of tax cuts and increase in public spending.
Instruments of Fiscal Policy
• Taxation: This is an important source of revenue in all countries. There are direct taxes paid by
an individual such as income tax, corporate tax, taxes on property and wealth. While indirect taxes
are levied on consumption. It includes sales tax, excise duty, and customs duty.
• Expenditure: Expenditure to be incurred on various areas is another instrument of fiscal policy.
• Public Debt: Borrowings from internal and external sources is another tool of fiscal policy.
Module IV Monetary and Fiscal Environment in India
• Deficit Financing: The filling of gap between the revenue and spending of government is deficit
financing. This is done either through internal sources of finance such as issuing of bonds and
securities or external borrowings from international institutions such as World Bank, IMF etc.
• Public Expenditure: This is used to stimulate or regulate an economy when it faces situations
like recession or boom. Any variation in public expenditure will have an important bearing on the
level of consumption, investment or total income. Public expenditure constitutes an important
share in total expenditure of an economy and is mainly composed of expenditure on public works,
relief expenditures, subsidies, transfer payments, salaries and social security benefits. Usually, an
expansionary fiscal policy action is used in case of recessionary situation. On the contrary, fiscal
constraints are employed during boom to avoid the consequences of hyper-inflationary tendencies.
• Taxation Policy: The tax structure of an economy occupies an important place as a fiscal policy
tool. Taxes determine the size of disposable income in the hands of economic agents and thereby
the corresponding inflationary and deflationary gaps. Tax policy has to be easy during depression
while during inflation or boom periods, it must curtail the spending ability of consumers and
investors.
• Public Debt: A properly managed public borrowing programme and debt repayment serves as a
powerful instrument in combating the macroeconomic instabilities like inflation or deflation.
Government borrowing takes place through: (i) commercial banks, (ii) non-bank financial
intermediaries, (iii) the central bank or by the printing of new money. Borrowing from general
public against the sale of bonds and securities help to reduce the consumption and private
investment spending and control inflation. If banks have excess reserves, borrowing from the
banking system enables the government to undertake investment projects stimulating the economy
out of depression. Withdrawals from the treasury add to easing depression, but account for a
negligible fraction of government borrowings. Debt monetisation (in the form of printing money)
adds liquidity in the system but is inflationary in its effect. A proper mix of public debt alternatives
is therefore necessary to ensure desirable economic outcomes.
• Budget: Budget document (financial plan of the government – usually for a year) serves as an
important policy tool to handle the economic fluctuations. Discretionary changes in expenditures
and/or tax rates through managed/balanced budget are used to stimulate the economy when in a
recession and to achieve price stability during the boom periods. A counter cyclical budgetary
policy may also be adopted by unbalanced budgeting. During the depression an unbalanced budget
implies deficit financing whereas during economic overheating episodes, it would be surplus
budget implying lower government expenditures and higher taxes.
Macroeconomic Impact The fiscal policy is adopted to achieve the following impact on the economy:
• Price Stability: Taxes and spending help the government in stabilising the fluctuation in prices and by
placing a check on higher inflationary pressures.
• Employment Generation: infrastructural Fiscal policy, through its contribution to development,
generates employment opportunities particularly in developing countries where private sector
investment is relatively low.
• Resource Mobilisation: Fiscal policy enables the mobilisation of resources needed for public
spending through taxes, public and private savings through issuance of bonds and securities.
• Resource Allocation: Fiscal policy can be an instrument in allocation of funds mobilised through
fiscal instruments (e.g. for social infrastructure, human and physical development).
• Income Redistribution: By applying the instruments of taxes and transfers, fiscal policy performs the
redistributive role. Taxes collected from rich and spent on the development of poorer sections help
reduce economic inequalities.
• Balanced Regional Development: To ensure a balanced regional development in a federal structure
like India, fiscal transfers (statutory and discretionary) are provided to the less developed regions.
Module IV Monetary and Fiscal Environment in India
• Balance of Payments: Fiscal policy actions like ‘input tax credits’ or subsidised capital to industries
help promote exports. It thereby helps to increase the forex reserves and maintain a stable external
position.
• Capital Formation and Economic Growth: Government tax rebates and increased spending boost
private investment. Increased total investments in the economy broaden the capital base (capital
deepening and capital widening) and promote economic growth.
Fiscal Policy in India: The Constitution of India provides the framework for fiscal policy of India. The federal
structure of India has divided the powers of taxation and spending between the centre and states as per the
Constitutional provisions and related laws. The states have lesser resources as compared to their expenditure
than the Centre. The centre transfers funds to the States through the Finance Commission and other means.
The Indian Constitution also provides for the Union Government to present its annual financial statement, the
taxation, and the expenditure that it will be incurring in the next fiscal year, in the form of budget which is
also prepared by the states. In 2003, the Parliament passed, at the Central level, the Fiscal Responsibility and
Budget Management Act (FRMB) to institute a new fiscal discipline framework. It aims to introduce
transparency in India’s fiscal management system. Its long-term objective is to achieve fiscal stability and to
give RBI the flexibility to deal with inflation. It was enacted to introduce more equitable distribution of India’s
debt over years. The act has been amended several times. On 1st July 2017, the Goods and Services Tax was
introduced and passed as an Act. It is a Value added Tax (VAT) which is a comprehensive indirect tax levy and
the collection of tax on inter-state supply of goods and services is by the central government.
Monetary Policy
Monetary policy deals with money supply, interest rates and availability of credit. It is the policy laid down
by the central bank of the country or any other competent monetary authority in an economy. Through
monetary policy, the central bank increases or decreases the amount of currency and credit in circulation.
Monetary policy shapes the country’s economic growth, and controls inflation by adjusting the money supply
and controlling the rate of interest. It channelises funds into the necessary areas to attain broader economic
goals. Through monetary policy, the government, or the monetary authority of the country controls the:
• Supply of money;
• Availability of money; and
• Rate of interest to attain laid down objectives aimed at economic growth and stability.
Objectives of monetary policy:
1. Economic growth: Through regulating prices and income in the economy, investment is made possible that
increases economic growth.
2. Price stability: The monetary policy attempts to achieve price stability by regulating the value of money.
In times of recession, to boost the economy the interest rates are reduced to avail loans. In certain situations,
loans are given at higher interest rates to decrease money supply.
3. Exchange rate stability: Maintenance of exchange rate stability is important for creation of international
confidence on trade. Instability in exchange rates might lead to undesirable effects such as weakening of the
value of currency, speculation, and flight of capital abroad.
4. Balance of Payments (BoP) Equilibrium: BoP is a statement of all transactions made between entities in
one country and the rest of the world over a defined period. The Reserve Bank of India through monetary
policy maintains the equilibrium.
5. Financial stability: The monetary policy attempts to ensure financial stability in the economy and to reduce
sudden volatile fluctuations in the financial market and economy.
Module IV Monetary and Fiscal Environment in India
6. Inflation target: This is also indicated by the monetary policy. In India the RBI Act provides that once in
every five years, the Government of India in consultation with the RBI sets an inflation target. The RBI has
projected the Consumer Price Index inflation at 5.7 per cent during 2021-22. India has become an emerging
market economy which makes sound monetary policy formulation more important. In India, the monetary
policy is formulated by the RBI which is mandated under the Reserve Bank of India Act 1934. It was amended
in 2016 to provide a statutory basis for implementation bring accountability and transparency. The fiscal policy
affects the ways a government controls its taxation and expenditures while the monetary policy controls the
money supply in the economy.
Instruments of Monetary Policy In order to comprehend better the monetary policy framework, it is
important to discuss the instruments of monetary policy in India. They are:
1. Bank Repo Rate: The rate at which the Central Bank of a country gives loans to commercial banks in case
of a shortage of funds is called repo rate or repurchase rate. The repo rate is used to control inflation. The
banks or financial institutions approach the RBI when they face a financial crisis for a loan and the RBI
advances the money at a rate of interest which is ‘repo rate’. The banks or financial institutions sell government
securities with a legal agreement stating that they will be repurchasing them after a fixed period.
2. Reverse Repo Rate: This is the rate at which RBI borrows money from the commercial banks. It also does
this to reduce the excess money supply in the banking system. So, the rate at which RBI borrows money from
the commercial banks within the country is called the reverse repo rate. It is used as a monetary policy
instrument by increasing or decreasing the rate. The simple implication of altering the reverse repo rate is that
an increase in the rate will decrease the money in the banking system and thus the money supply of a country
and vice versa, other variables remaining constant.
3. Cash Reserve Ratio: All commercial banks must keep a minimum amount of money in proportion to their
deposits with the RBI in cash, called, currency chests. This minimum ratio of cash to be kept with RBI is
called the Cash Reserve Ratio (CRR). This acts as another instrument of monetary policy as a higher CRR
will leave a lower amount with the commercial banks to be able to use it for loans and investment. The RBI
can control the amounts that the banks can give as loans by increasing the CRR. The RBI uses CRR also to
control liquidity in the economy.
4. Statutory Liquidity Ratio: It is relevant here to understand two terms before defining Statutory Liquidity
Ratio (SLR). They are:
• Net Demand Liabilities: The bank accounts from which one can withdraw sums of money like a
savings/current account are called net demand liabilities.
• Time Liabilities: These are those liabilities or sums of money that the banks are liable to pay to the
customers after an agreed period. These include fixed, recurring deposits, cash certificates and so on.
The SLR is the ratio of liquid assets to demand and time liabilities which can be increased by 40 % by
the RBI. It controls the supply of money into the economy by commercial banks
5. Marginal Standing Facility (MSF): The MSF is a facility which allows the commercial banks to borrow
additional overnight money from the RBI by drawing from the SLR at a penal rate of interest. This makes the
banks respond to unexpected liquidity shocks.
6. Lending Rate: These are the rates fixed by the RBI based on which money is lent to the customers. Higher
the lending rate, more costly shall be the credit given to the customer. In case rates are lower, the customers
can take more credit from the bank.
The Monetary Policy Process: Under Section 45ZB of the amended RBI Act, 1934, the Monetary Policy
Committee (MPC) was constituted by the Union Government in 2016 which comprises six members. Its main
function is to keep the inflation within limits set by the government in consultation with RBI determines the
interest rate that is needed to achieve the inflation target. The MPC is supported by the RBI’s Monetary Policy
Module IV Monetary and Fiscal Environment in India
Department in considering the viewpoints of all stakeholders and players in the economy to determine the
policy repo rate or repurchase rate.
Composition of MPC: The MPC has the following six members:
• Governor of the RBI – Chairperson, ex-officio;
• Deputy Governor of the RBI, in-charge of the monetary policy – Member, ex officio;
• One officer of the RBI to be nominated by the Central Board – Member, ex officio;
• The other three members are to be experts in the field of economics, or banking or finance or monetary
policy.
They have a term of four years unless it is extended. The MPC determines the policy interest rate to achieve
the inflation target.
The Monetary Policy Framework: The framework regarding the monetary policy in India has the objective
to set the policy repo rate by:
• evaluating the current and evolving macro – economic situation; and
• controlling the conditions of liquidity to stabilise market rates of money at or around the repo rate.
Any change in the repo rate has an effect throughout the money market and pervades the entire
financial system. This impacts the aggregate demand which determines inflation and growth.
Alternative Strategies: The main purpose of monetary policy is to ensure a stable growth in aggregate
demand. It entails avoiding aggregate demand either arising too fast resulting in inflation, or rising too slow
resulting in high unemployment and lower economic growth. There are two broad indicators [viz. (i) the
monetary targets and (ii) interest rate targets] that a central bank uses as intermediate targets to move towards
the final or ultimate targets. Like in the case of fiscal policy, the final targets of monetary policy too are
maintaining stability or growth in macroeconomic variables like unemployment rate, inflation rate and the
growth rate of real income.
Monetary Targeting: To understand the use of the monetary targeting as an intermediate measure, it is
assumed by the policymakers that other things remaining constant, an increase in money supply will reduce
the level of unemployment (by increasing the level of economic activity) and might trigger inflation in the
short run. On the contrary, slower growth in money supply leads to lower inflation and a higher short run
unemployment. Past data and expert forecasts about the probable trajectory of economy would be employed
to decide the monetary target. Once the target for the money growth rate is decided, the monetary policy
operates consistently as if the chosen target for the money growth rate is the ultimate target of the monetary
policy.
Interest Rate Targeting is a substitute for monetary targeting. The operative mechanism is that, once the
central bank sets a target rate for the call money rate, the central bank will undertake ‘open market operations’
(OMOs) with a view to keep the actual interest rates at or close to the target rate. If the actual rate exceeds the
target rate, securities are purchased through OMOs. This would increase the Fiscal and Monetary Policies:
Growth and Stabilisation liquidity and the actual rates would come down. Since the OMOs raises or lowers
the bank reserves (and thereby the bank deposits and therefore the money supply), the interest rate targeting
is an alternative to monetary targeting. A central back can target either of the two, but not both. Note that it is
convenient to track the short-term rates contemporaneously and hence these are controlled more effectively.
The call rates can therefore be regarded as short-term operating target. Changes in money supply can be
noticed with a lag of a week or two with some errors. Interest rate targeting focuses on the short-term interest
rate (such as call money rate) as long-term interest rates can be contemporaneously observed but not easily
controlled. The choice between the monetary aggregate and interest rate targeting is guided by the conditions
in an economy. For instance, monetary targeting is an ideal case for monetary policy in case the central bank
faces an interest rate insensitive (i.e. vertical) LM curve. This strategy enables the fulfilment of both the
Module IV Monetary and Fiscal Environment in India
intermediate and the final targets. On the contrary, in case of a non-vertical LM curve (interest rate sensitive),
even though the monetary target is achieved, the ultimate target, such as full employment may be missed.
Macroeconomic Impact: Monetary policy (MP) is primarily concerned with the price and exchange rate
stability, along with promotion of economic growth. Further, it also helps in the following.
• Promotion of Savings and Investment: By regulating the interest rates and inflationary tendencies
by applying the expansionary or contractionary policy stances, MP can help to influence savings and
investment.
• Regulating Imports and Exports: By extending priority loans at low interest rates, MP helps to
induce export-promotion and import substitution thereby helping to enhance the external account
position of the economy.
• Managing Business Cycles: The upswings (boom) and downswings (recession) of a business cycle
may be regulated by applying tight policy action during boom and easy policy action during recession.
It helps in averting the destabilising ramifications of business cycle fluctuations.
• Regulation of Demand Conditions: By influencing the availability of credit and its cost, monetary
policy acts as an effective tool to control the demand conditions according to the economic
circumstances.
• Employment Generation: By influencing the level of savings, investment and aggregate demand, MP
impacts favourably on employment creation.
• Infrastructural Development: By facilitating subsidised or concessional funding to priority sectors
like small-scale industries, agriculture other credit constrained sections, MP helps in infrastructural
development.
• Managing and Developing the Financial Sector: The central bank manages the banking sector in
order to ensure its smooth functioning and provision of financial services far and wide across the
country.
RESERVE BANK OF INDIA

Introduction
The Reserve Bank of India (RBI) is the Central Bank of the country. It has been established as a
body corporate under the Reserve Bank of India Act, which came into effect from 1 st April,
1935. The Reserve Bank was started as share-holders bank with a paid-up capital of Rs.5 crores.
On establishment it took over the function of management of currency from the Government of
India and power of credit control from the then Imperial Bank of India.
The Reserve Bank was nationalized in 1949 soon after the country‟s independence. The basic
reasons for nationalization were as follows:
1) There was a trend towards nationalization of Central Banks of the country in all parts of the
world after the end of the Second World War. Even the Bank of England was nationalized in
the year 1946.
2) The inflationary tendencies have started right from the beginning of the Second World War,
i.e., 1939. In order to control these tendencies effectively, it was thought proper to
nationalize the Reserve Bank of India – the Central Bank of the country, responsible for
credit and currency management.
3) The country had embarked upon a Planned Economic Programme after independence.
Nationalization of the Reserve Bank of India was necessary to use it as an effective
instrument for economic development of the country.
The Reserve Bank of India carries on its operations according to the provisions of the Reserve
Bank of India Act, 1934. The act has been amended from time to time.

Features of RBI
1) RBI formulates implements and monitors the monetary policy.
2) RBI maintains public confidence in the system, protect depositors‟ interest and provide cost-
effective banking services to the public.
3) To facilitate external trade and payment and promote orderly development and maintenance
of foreign exchange market in India.
4) To give the public adequate quantity of supplies of currency notes and coins and in good
quality.

Organizational Structure of RBI

The organizational structure of RBI consists of the Central Board and the Local Boards.
1) Central Board: The general superintendence and direction of the bank‟s affairs is vested in
the Central Board of Directors. The organzational structure of central board is shown in
figure 1.3:
Governor

Deputy Deputy Deputy Deputy

Governor Governor Governor Governor

Executive Executive Executive Executive
Director Director Director
Director
Chief Manager

Chief Accountant

Figure 1: Organization of the Reserve Bank of India

 It comprises of a Governor, not more than four Deputy Governors, and fifteen Directors. All
these persons are appointed/nominated by the Central Government. The Governor and Deputy
Governors hold office for such periods not exceeding five years as may be fixed by the
Central Government at the time of their appointed and are eligible for reappointment. As a
matter of practical convenience the Board has delegated some of its functions to a committee
called the Committee of the Central Board, consisting of the Governor, Deputy Governors, the
Directors representing or resident in the area in which the meeting is held, the Director
representing the government and other Directors as may be present at the place at the relevant
time.

2) Local Board: For each of the regional areas of the country viz. Western, Eastern, Northern
and Southern, there is a Local Board with headquarters at Mumbai, Kolkata, New Delhi and
Chennai. Local Boards consist of five members each, appointed by the Central Government.
The functions of the Local Boards are to advise the Central Board on such matters as may
generally be referred to them and to perform such duties as the Central Board may delegate
to them.

Departments of RBI
There are sixteen departments of the Reserve Bank of India. These are:
1) Issue Department: This department undertakes the job of issuing paper currency and
therefore it also makes arrangement for the distribution of paper currency. It maintains
regular accounts of the notes printed at Nasik Press. Its branches are at Bangalore, Mumbai,
Kolkata, Hyderabad, Kanpur, Chennai, Nagpur, New Delhi and Patna.
2) Banking Department: This department performs two primary functions, one of dealing with
Government transactions and floating of loans on behalf of the Central and State
Governments and arranging remittances of government funds from one place to another and
the other regarding the maintenance of cash reserves of scheduled banks, extending financial
assistance to them, whenever required and functioning as the clearing house for the
scheduled banks.
3) Banking Development: This department is concerned with the expansion of banking
facilities in the rural and semi-urban areas. It also imparts training to the scheduled banks.
4) Banking Operations: This department undertakes periodical inspections of the scheduled
banks, analyzes their balance sheets, issues licenses for opening of new banks, considers
requests for opening new branches, examines the requests of scheduled banks for increasing
the paid-up capital, examines the possibilities for the amalgamation of existing banks and
tenders advice to the scheduled banks in their day-to-day functioning.
5) Agricultural Credit: This department studies the problems connected with agricultural
credit, conducts research on rural credit problems, formulates rural credit policy of the
Reserve Bank, grants rural credit to State Governments and State Cooperative Banks and
publishes reports on agricultural credit.
6) Exchange Control: This department regulates and controls the sale and purchase of foreign
exchange.
7) Industrial Finance: This department extends financial assistance to small scale and medium
scale industries and also tenders advice to various industrial financial corporations for their
day-to-day working.
8) Non-Banking Companies: The headquarters of this department is at Kolkata and it is
chiefly concerned with the supervision of the non-banking companies and financial
institutions in the country.
9) Legal Department: This department tenders advice to the various departments of the Bank
on legal matters, prepares directives and communiqués of the Bank and gives advice to the
Bank on the proper implementation of legal matters relating to banking in the country.
10) Research and Statistics: This department undertakes research on problems in the areas of
money, credit, finance, production, etc., collects statistics about the various sectors of the
economy and publishes them; and tenders advice to the Government for the solution of
various economic problems and in the formulation of its economic and financial policies.
11) Department of Planning and Reorganization: The department formulates new plans and
reorganizes existing policies so as to make them more effective.
12) Economic Department: This department formulates banking policies for better
implementation of economic policies of the Government.
13) Inspection Department: This department undertakes inspection of various offices of the
commercial banks.
14) Department of Accounts and Expenditure: This department maintains proper records of
all receipts and expenditures of the Reserve Bank of India.
15) RBI Services Board: The Board deals with the selection of new employees for different
posts in the Reserve Bank of India.
16) Department of Supervision: This department was set up on 22 December, 1993, for
conducting proper supervision of commercial banks.

Role of Reserve Bank of India

Since its inception in 1935, the Reserve Bank of India has functioned with great success, not
only as the apex financial institution in the country but also as the promoter of economic
development. With the introduction of planning in India since 1951, the Reserve Bank
formulated a new monetary policy to aid and speed up economic development. The Reserve
Bank has undertaken several new functions to promote economic development in the country.
The major contributions of the Reserve Bank to economic development are as follows:
1) Promotion of Commercial Banking: A well-developed banking system is a precondition
for economic development. The Reserve Bank has taken several steps to strengthen the
banking system. The Banking Regulation Act, 1949 has given the Reserve Bank vast powers
of supervision and control of commercial banks in the country. The Reserve Bank has been
using these powers:
i) To strengthen the commercial banking structure through liquidation and amalgamation
of banks and through improvement in their operational standards,
ii) To extend the banking facilities in the semi-urban and rural areas, and
iii) To promote the allocation of credit in favor of priority sectors, such as agriculture, small-
scale industries, exports, etc.

The Reserve Bank is also making valuable contribution to the development of banking
system by extending training facilities, to the supervisory staff of the banks through its
„Banker‟s training colleges.
2) Promotion of Rural Credit: Defective rural credit
Promotion of Commercial Banking
system and deficient rural credit facilities are one of the
major causes of backwardness of Indian agriculture. In Promotion of Rural Credit
view of this, the Reserve Bank, ever since its
establishment, has been assigned the responsibility of Promotion of Co-operative Credit
R
reforming rural credit system and making provision of
adequate institutional finance for agriculture and other O Promotion of Industrial Finance
rural activities. The Reserve Bank has taken the
L Promotion of Export Credit
following steps to promote rural credit:
i) It has set up Agricultural Credit Department to E
Regulation of Credit
expand and co-ordinate credit facilities to the rural
areas.
Credit to Weaker Sections
ii) It has been taking all necessary measures to O
strengthen the co-operative credit system with a view Development of Bill Market
to meet the financial needs of the rural people. F

iii) In 1956, the Reserve Bank set up two funds. Namely, Exchange Controls
the National Agriculture Credit (long-term
operations) Fund and the National Agricultural Credit R Figure 2
(stabilization) Fund, for providing medium-term and B
long-term loans to the state co-operative banks.
iv) Regional rural banks have been established to promote agricultural
I credit.
v) Some commercial banks have been nationalized mainly to expand bank credit facilities in
rural areas.
vi) The National Bank for Agriculture and Rural Development has been established in 1982
as the apex institution for agricultural finance.
vii) The Reserve Bank has helped the establishment of many warehouses in the country.

As a result of the efforts made by the Reserve Bank, the institutional finance for agriculture
has been increasing considerably over the years. The agricultural output has increased by
leaps and bounds. Probably no other central bank in the world is doing so much to help,
develop and finance agricultural credit.

3) Promotion of Co-operative Credit: Promotion of co-operative credit movement is also the

special function of the Reserve Bank. On the recommendations of the Rural Credit Survey
Committee, the Reserve Bank has taken a number of measures to strengthen the structure of
co-operative credit institutions throughout the country. The Reserve Bank provides financial
assistance to the agriculturists through the co-operative institutions. The Reserve Bank has,
thus, infused a new life into the co-operative credit movement of the country.

4) Promotion of Industrial Finance: Credit or finance is the pillar to industrial development.

The Reserve Bank has been playing an active role in the field of industrial finance also. In
1957, it has set up a separate Industrial Finance Department which has rendered useful
service in extending financial and organizational assistance to the institutions providing long-
term finance. It made commendable efforts for broadening the domestic capital market for
providing the medium and long-term finance to the industrial sector. In this regard the
Reserve Bank took initiative in the establishment of a number of statutory corporations for
 the purpose of providing finance, especially medium and long-term finance, to industries;
Industrial Development Bank of India, Industrial Finance Corporation of India, State Finance
Corporations, State Industrial Development Corporations and the Industrial Credit and
Investment Corporation of India are some of the important corporations established in the
country with the initiative of the Reserve Bank.

Thus, Reserve Bank has contributed to the share capital of these institutions and providing
short-term advances also to some of them. The role of these corporations in providing
financial help to industries is commendable. The Reserve Bank has played an active role in
the establishment of the Unit Trust of India. The Unit Trust of India mobilizes the savings of
people belonging to middle and lower income groups and uses these funds for investment in
industries. By mobilizing the small savings of the people, the Unit Trust has been promoting
capital formation which is the most important determinant of economic development. The
Reserve Bank also has been encouraging commercial banks to provide credit to the small-
scale industries. It has been encouraging credit for small industries through its “Credit
Guarantee Scheme”. Small-scale industries have been recognized as a priority sector. The
Reserve Bank has also been, acting as a “developmental agency” for planning, promoting
and developing industries to fill in the gaps in the industrial structure of the country.

5) Promotion of Export Credit: “Export or Perish” has become a slogan for the developing
economies, including India. In recent years, India is keen on expanding exports. Growth of
exports needs liberal and adequate export credit. The Reserve Bank has undertaken a number
of measures for increasing credit to the export sector. For promoting export financing by the
banks, the Reserve Bank has introduced certain export credit schemes. The Export Bills
Credit Scheme and the Pre-shipment Credit Scheme are the two important schemes
introduced by the Reserve Bank. The Reserve Bank has been stipulating concessional interest
rates on various types of export credit granted by commercial banks. The Reserve Bank has
been instrumental in the establishment of Export-Import Bank. The EXIM Bank is to provide
financial assistance to exporters and importers. The Reserve Bank has authority to grant
loans and advances to the EXIM Bank, under certain conditions.

6) Regulation of Credit: The Reserve Bank has been extensively using various credit control
weapons to regulate the cost of credit, the amount of credit and the purpose of credit. For
regulating the cost and amount of credit the Reserve Bank has been using the quantitative
weapons. For influencing the purpose and direction of credit, it has been using various
selective credit controls. By regulating credit, the Reserve Bank has been able:
i) To promote economic growth in the country,
ii) To check inflationary trends in the country,
iii) To prevent the financial resources from being used for speculative purposes,
iv) To make financial resources available for productive purposes keeping in view the
priorities of the plans, and
v) To encourage savings in the country.

7) Credit to Weaker Sections: The Reserve Bank has taken certain measures to encourage
adequate and cheaper credit to the weaker sections of the society. The “Differential Rate of
Interest Scheme” was started in 1972. Under this scheme, concessional credit is provided to
 economically and socially backward persons engaged in productive activities. The Reserve
Bank has been encouraging the commercial banks to give liberal credit to the weaker sections
and for self employment schemes.

The Insurance and Credit Guarantee Corporation of India gives guarantee for loans given to
weaker sections.

8) Development of Bill Market: The Reserve Bank introduced the “Bill Market Scheme” in
1952, with a view to extend loans to the commercial banks against their demand promissory
notes. The scheme, however, was not based on the genuine trade bills. In 1970, the Reserve
Bank introduced “New Bill Market Scheme” which covered the genuine trade bills
representing sale or dispatch of goods. The bill market scheme has helped a lot in developing
the bill market in the country. The bill market scheme has increased the liquidity of the
money market in India.

9) Exchange Controls: The Reserve Bank has been able to maintain the stability of the
exchange value of the “Rupee” even under heavy strains and pressure. It has also managed
“exchange controls” successfully.
Inspite of the limitations under which it has to function in a developing country like India, the
over all performance of the Reserve Bank is quite satisfactory. It has been able to develop the
financial structure of the country consistent with the national socio-economic objectives and
priorities. It has discharged its promotional and developmental functions satisfactorily and acted
as the leader in economic development of the country.

Functions of Reserve Banks of India

The Reserve Bank of India is the Central Bank of India and therefore, it performs all those
functions which a central bank is required to perform in a country. The function of central banks
are broadly the same all over the world, but the scope and content of policy objectives vary from
country to country and from period to period depending upon a number of factors like
development and the structure of the economy, goals to which the government is committed and
the general economic situation.

The functions performed by the Reserve Bank can be classified into three categories:
1) Central banking functions.
2) Supervisory functions.
3) Promotional functions.

Central Banking Functions

1) Issue of Bank Notes: The Reserve Bank has the sole right to issue bank notes of all
denominations (except one rupee notes which are issued only by the Government of India). This
has been done to give the Reserve Bank the complete and uniform control over the currency and
the credit system of the country. The Bank has a separate “Issue Department” for this purpose.
The Bank follows the “Minimum Reserve System” for issue of bank notes.
The Reserve Bank has made adequate arrangements for holding and distributing of currency
notes and coins. The Issue Department of the Reserve Bank has its offices in seventeen
 important cities of the country. Moreover it is maintaining currency chests all over the
country.
2) Banker to Government: The Reserve Bank of India acts as the Banker to Government. It
accepts money for the account of Union and State Government in India, makes payment on
their behalf, carries out their exchange, remittance and other banking operations and manages
the public debt. It makes ways and means advances to the Government for 90 days. It advises
the Government on all monetary and banking matters.
3) Bankers’ Bank: The Reserve Bank of India acts as the bankers‟ bank. The scheduled banks
are required to maintain with the Reserve Bank as cash balance a certain percentage of their
time and demand liabilities. Every scheduled bank was required to maintain with the Reserve
Bank a cash balance equivalent to 5 per cent of its demand liabilities and 2 per cent of its
time liabilities in India. It acts as a lender of the last resort to them. The scheduled banks can
borrow money from the Reserve Bank on the basis of eligible securities or get financial
accommodation in times of need or stringency by rediscounting their bills of exchange. By
an amendment of 1962, the distinction between demand and time liabilities was abolished
and banks have been asked to keep cash reserves equal to 3 per cent of their aggregate
deposit liabilities. The minimum cash requirements can be changed by the Reserve Bank of
India.
Since commercial banks can always expect the Reserve Bank of India to come to their help
in times of banking crisis the Reserve Bank becomes not only the banker‟s bank but also the
lender of the last resort.
4) Custodian of Foreign Exchange Reserves: The Reserve Bank has been entrusted with the
responsibility of maintaining the external value of the rupee and for this purpose the bank
holds most of the foreign exchange reserves. Since India is a member of International
Monetary Fund, the Reserve Bank has to maintain fixed exchange rates with all other
member countries of the Fund. It, therefore, sells and buys foreign exchange to/from
authorized persons at rates fixed by the Government.
5) Controller of Credit: The Reserve Bank also functions as the controller of credit. It can
control by various methods the creation of credit by commercial banks.
i) It can do so through changing the bank rate or through open market operations.
According to the Banking Regulation Act of 1949, the Reserve Bank of India can ask any
particular bank or the whole banking system not to lend to particular group or persons on
the basis of certain types of securities.
ii) Since 1956, selective controls of credit are increasingly being used by the Reserve Bank.
iii) The Reserve Bank of India is armed with many more powers to control the Indian money
market. Every bank has to get a license from the Reserve Bank of India to do banking
business within India; the license can be canceled by the Reserve Bank if certain
stipulated conditions are not fulfilled.
iv) Every bank will have to get the permission of the Reserve Bank before it can open a new
branch.
v) Each scheduled bank must send a weekly return to the Reserve Bank, showing in detail,
its assets and liabilities. This power of the Bank to call for information is also intended to
give it effective control of the credit system.
vi) The Reserve Bank has also the power to inspect the accounts of any commercial bank.
Supervisory Functions
In order to promote and develop a sound and efficient system of banking in India, the Reserve
Bank has been given several supervisory powers over different banking institutions. These
powers relate to licensing and establishment, branch expansion, liquidity of assets, management,
working, amalgamation, reconstruction and liquidation of commercial and co-operative banks.
The Reserve Bank carries out periodical inspections of these banks and calls for such
information, which it considers necessary for effective performance of its functions.

The various powers vested in the R.B.I. are as follows:

1) Obtain License: Every bank wishing to commence banking business in India is required to
obtain a license from the Reserve Bank of India. The Reserve Bank, after being satisfied that it
will be in a position to pay claims of the deposits as and when they accrue and that its affairs are
being conducted in a manner not detrimental to the interests of its depositors, will grant the
license to the bank to commence banking business in India.
2) Coverage of Bank Operations: To ensure that banks are organized and conduct their
business on sound financial footings of the banking. Regulation Act has prescribed the
minimum paid up capital, reserves, cash reserves and other liquid assets depending upon the
geographical coverage of a bank‟s operations. The Reserve bank is to see the fulfillment of
these requirements.
3) Liquidation of Weak Banks: To strengthen the commercial banking structure in the
country, the R.B.I. is empowered to order the compulsory liquidation of weak banks or their
merger with the stronger one. It is empowered to inspect, make an enquiry and may take
necessary action in order to improve the operational efficiency of the bank. It may also order
for the suspension of business.
4) Branch Expansion: Every bank in the country is required to obtain permission from the
R.B.I. for its branch expansion programme. The R.B.I. can also direct a bank to open
branches in a particular area especially in small towns and rural areas so as to improve the
geographical coverage.
5) Issue Directions On Credit Control: To improve the functional coverage of banks, in order
to improve the sectoral distribution of bank credit in favor of the priority sectors such as
agriculture, small scale industries, self employed persons etc. and make more of it to the
small borrowers. The R.B.I. can issue directions to commercial banks through its credit
control measures.
6) Training of Bank Personnel: The R.B.I. has arranged for the education and training of
different categories of bank personnel by setting up a number of training institutes in the
country. The principal training institutes are Bankers Training College (Mumbai), the
National Institute of Bank Management (Mumbai), the cooperative Bankers Training College
Pune, the College of Agricultural Banking, Pune, Staff Training College, Chennai, and zonal
training centres for Staff at Mumbai, Kolkata, Chennai and New Delhi.
7) Restrict Loans And Advances: By an amendment effective from February 1,1964, the
R.B.I. is empowered to restrain control exercised by particular groups of persons over the
affairs of banks and to restrict loans and advances as well guarantees given by banks to and
on behalf of any one company, firm, association of persons or individual. The Act endorsed
 greater powers to the R.B.I. in the matters of appointment and removal of bank‟s executive
personnel.
8) Collect And Supply Information: The Reserve Bank of India has been empowered to
collect information in regard to credit facilities advanced by banks and other financial
institutions to their constituents and to supply these banks and institutions such information,
on application, in a consolidated form.
9) Spreading Banking Habits: In order to inspire greater public confidence, and spread
thereby banking habits in the country especially the lower section of the society, the R.B.I.
has set up a Deposit Insurance Corporation in 1962 as a subsidiary of the R.B.I. In later year
the scheme of deposit insurance was extended to cooperative and regional rural banks. The
amount eligible for insurance cover has been revised from time to time. On July 1,1980, it
was fixed at Rs.30,000 for each depositor in each bank.

With the nationalization of 20 major commercial banks in India (14 in July 1969 and 6 in
April 1980), the Reserve Bank of India has been in a position to exercise better control over
commercial banks. In recent years, with the establishment of regional rural banks the banking
system in India has made a commendable progress both functionally and geographically
because it is now easier for the R.B.I. to steer and direct the growth of banks in desired
direction.

Promotional Functions
The Reserve Bank of India as a Central Bank of the country has assumed greater responsibilities as
developmental and promotional agency as compared to a merely monetary authority. It not only
controls the credit and currency in the economy or maintains internal/external value of the rupee
for ensuring price stability but also acts as a promoter of financial institutions, required for meeting
specific financial requirements of the developing economy. At the time of establishment of the
Reserve Bank of India in the Year 1935, the country lacked a well-developed money market and a
well-developed commercial banking system. Moreover, it was industrially a backward country.
After independence, the country embarked upon a well-organized and planned economic
development. The process is still continuing. All this made necessary for the Reserve Bank of India
to pursue appropriate monetary and credit policy and take all necessary steps required for a fast
growth and development of all sectors of the economy, keeping in view the guidelines and policies
formulated by the Government.

The promotional steps taken by the RBI in this direction can be summarized as follows:
1) Established the Bill Market Scheme: It established the Bill Market Scheme in 1952.
2) Development of Specialized Financial Institutions: It has taken up keen interest in setting
up and development of specialized financial institutions. The number of such institutions in
whose setting up the RBI is directly or indirectly involved is steadily growing. They include
Industrial Finance Corporation of India (IFCI), State Financial Corporations (SFCs),
Industrial Development Bank of India (IDBI), Unit Trust of India (UTI), Deposit Insurance
and Credit Guarantee Corporation of India (DICGC), and National Bank for agriculture and
Rural Development (NABARD), etc.
3) Promote Regional Rural Banks: It has promoted Regional Rural Banks (RRBs) with the
cooperation of the commercial banks to extend banking facilities to the rural areas.
4) Promote National Housing Bank: It promoted in July, 1988, the National Housing Bank, as
its wholly owned subsidiary to organize and argument resources for housing. The National
Housing Bank besides providing refinance to institutions engaged in housing finance will
also extend full support to industries that augment supplies of building materials and/or
leading to construction at lower cost.
5) Establishment of Export Import Bank of India: It has helped in establishment of Export
Import Bank of India (EXIM) to provide finance to exporters. It also helps the commercial
banks in opening their branches in the foreign countries for helping in the foreign trade of the
country.
6) Promotes Research: The RBI also encourages and promotes research in the areas of
banking.

RBI’s Regulatory Environment

Prudential regulation and supervision have formed a critical component of the financial sector
reform programme since its inception and India has endeavored to international prudential norms
and practices. These norms have been progressively tightened over the years, particularly against
the backdrop of the Asian crisis. Bank exposures to sensitive sectors such as equity and real estate
have been curtailed. The Banking Regulation Act 1949 prevents connected lending (i.e., lending
by banks to directors or companies in whom Directors are interested):

1) Periodical inspection of banks has been the main instrument of supervision, though recently
there has been a move toward supplementary „on-site inspections‟ with „off-site
surveillance‟.
2) The system of „Annual Financial Inspection‟ was introduced in 1992, in place of the earlier
system of Annual Financial Review/Financial Inspections. The inspection objectives and
procedures, have been redefined to evaluate the bank‟s safety and soundness; to appraise the
quality of the Board and management; to ensure compliance with banking laws and
regulation; to provide an appraisal of soundness of the bank‟s assets; to analyze the financial
factors which determine bank‟s solvency and to identify areas where corrective action is
needed to strengthen the institution and improve its performance. Inspections based upon the
new guidelines have started since 1997.
3) A high powered Board for Financial Supervision (BFS), comprising the Governor of RBI as
Chairman, one of the Deputy Governors as Vice-Chairman and four Directors of the Central
Board of RBI as members was constituted in 1994, with the mandate to exercise the powers
of supervision and inspection in relation to the banking companies, financial institutions and
non-banking companies.
4) A supervisory strategy comprising on-site inspection, off-site monitoring and control systems
internal to the banks, based on the CAMELS (capital adequacy, asset quality, management,
earnings, liquidity and systems and controls) methodology for banks have been instituted.
The RBI has instituted a mechanism for critical analysis of the balance sheet by the banks
themselves and the presentation of such analysis before their boards to provide an internal
assessment of the health of the bank. The analysis, which is also made available to the RBI,
forms a supplement to the system of off-site monitoring of banks.
5) Keeping in line with the merging regulatory and supervisory standards at international level,
the RBI has initiated certain macro level monitoring techniques to assess the true health of
 the supervised institutions.
6) The format of balance sheets of commercial banks have now been prescribed by the RBI
with disclosure standards on vital performance and growth indicators, provisions, net NPAs,
staff productivity, etc., appended as „Notes of Accounts‟.
7) To bring about greater transparency in banks‟ published accounts, the RBI has also directed
the banks to disclosure date on movement of non-performing assets (NPAs) and provisions
as well as lending to sensitive sectors. These proposed additional disclosure norms would
bring the disclosure standards almost on par with the international best practice.

Achievements of Reserve Bank of India

Following are the main achievements of the Reserve Bank of India:
1) It has very successfully regulated credit to meet the requirements of trade, industry and
agriculture.
2) As a partner to the government it has been admirably managing the public debt.
3) It has developed and promoted sound banking practices in the country. This has inspired
public confidence in the banking system.
4) The Reserve Bank has successfully promoted the institutionalization of savings by:
i) Promoting banking habits,
ii) Extending banking facilities all over the country, and
iii) Establishing specialized financial agencies.
5) It has achieved appreciable success in promoting co-operative credit and rural credit.
6) It has achieved great success in the field of industrial credit by promoting a number of
institutions for providing medium and long-term credit.
7) The Reserve Bank has succeeded in providing credit facilities to exporters by extending
concessional credit, refinance facilities and guarantee to commercial banks. It has been
instrumental in setting up the Export-Import Bank for providing credit and other facilities to
exporters.
8) As a guardian of the banking system the Reserve Bank has been providing deposit insurance
and credit guarantee facilities to the banks through DICGC.
9) The Reserve Bank has played a crucial role in promoting social banking in the country.
10) The Reserve Bank has also been successful to a large extent in developing bill culture in the
country.
11) The Reserve Bank has been rendering a very useful service in providing information and data
on the different sectors of the economy through its publications.
12) The Reserve Bank has been successfully providing clearing house facilities through its 15
branches and 2 offices and the State Bank of India.
13) The management and control of foreign exchange by the Reserve Bank has been admirable.
14) The Reserve Bank has set up a number of training centres and colleges to impart training to
the staff of co-operative banks, commercial banks, regional rural banks, NABARD, etc., and
thus are contributing in a big way to the development of human resources in the sphere of
banking.
15) Through its department of information technology the Reserve Bank has modernized its
functioning by introducing advanced computer technology for inter-office communication and
Internet technology for information collecting and sharing. It has also encouraged
computerization of the branches of commercial banks.