Central Bankingin India

(As per the New Syllabus of Mumbai University for T.Y.BBI,Semester VI w.e.f. 2014-2015)

Dr. K. Govinda BhatM.Sc., M.A., LL.B., MBA, CAIIB, Ph.D.

Ex Principal, Corporation Bank Staff Training College,Mangalore - 575 002.

Email: Kgbhat@bqlsg.com

Fourth Revised Edition: 2015

MUMBAI NEW DELHI NAGPUR BENGALURU HYDERABAD CHENNAI PUNE LUCKNOW AHMEDABAD ERNAKULAM BHUBANESWAR INDORE KOLKATA GUWAHATI

© AuthorNo part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by anymeans, electronic, mechanical, photocopying, recording and/or otherwise without the prior written permission of thepublisher.

First Edition : 2006Second Edition : 2008Third Revised Edition : 2012Fourth Revised Edition : 2015

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Ahmedabad : 114, “SHAIL”, 1st Floor, Opp. Madhu Sudan House, C.G. Road, Navrang Pura,Ahmedabad - 380 009. Phone: 079-26560126; Mobile: 09377088847

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Bhubaneswar : 5 Station Square, Bhubaneswar - 751 001 (Odisha).Phone: 0674-2532129, Mobile: 09338746007

Indore : Kesardeep Avenue Extension, 73, Narayan Bagh, Flat No. 302, IIIrd Floor,Near Humpty Dumpty School, Indore - 452 007 (M.P.). Mobile: 09303399304

Kolkata : 108/4, Beliaghata Main Road, Near ID Hospital, Opp. SBI Bank,Kolkata - 700 010, Phone: 033-32449649, Mobile: 7439040301

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Preface to the Fourth EditionGlobalization of economies has integrated the financial markets across the world. This has led to

increased risk in financial services in general and banking services in particular. The sub-prime crisesand the recent weaknesses in European economies have emphasized the need for standardizedregulations and oversight of the banking system. Introduction of Basel guidelines are importantinitiatives taken by the global community of Central Banks to contain the risk and improve the generalhealth of banks across the globe.

Central Banks across the globe have taken suitable measures to improve the stability of therespective economies by introducing international best practices. In India, Reserve Bank of India hasbeen playing important role in introduction of reforms in banking and supervision of banks. Thecountry has gained on account of the stringent and conservative approach adopted by the Central Bankand strong policy guidelines implemented by the RBI. Indian banking system could withstand theglobal setback in the aftermath of the sub-prime crises.

RBI has played an important role in the development of global Central Banking guidelines byactively participating in the apex body of Central Banks of the world. It has provided importantsuggestions in Central Banking. The role of RBI has undergone drastic changes during the post-reformperiod as a Central Bank of the country. RBI plays an important role in monetary and fiscal policyformulation, developmental banking, financial inclusion, banking supervision and regulation. TheCentral Bank has played important role in building the banking infrastructure and policy frameworkespecially during the post-reform period. India can feel proud of the good progress made in CentralBanking by the RBI.

This book Central Banking in India is written as per the syllabus of B.Com. (Banking andInsurance) course of Mumbai University. This is the fourth edition of the book. During last decade, theCentral Banking role has changed from time to time. The book is revised periodically to capture thechanging role of the Central Bank. Some of the modules of this book are rewritten to make the bookup-to-date and relevant to the contemporary students and teachers. I am confident that the students andteaching community will find the book useful academically.

I thankfully acknowledge the support given by the students and teachers for the earlier editions.I solicit similar support and encouragement for this updated edition. I thank the well-wishers andreaders for their support, guidance and constructive criticism. I welcome suggestions for furtherimprovements.

26th Nov, 2014Mumbai Dr. K. Govinda Bhat, Ph.D.

SyllabusModule - A: Rationale and Functions of Central Bank 15

1. Evolution and Functions of Central Banking: Evolution of Theory and Practice ofCentral Banking, Development of Central Banks in Developed and DevelopingCountries.

2. Functions of a Central Bank: Banker to Government, Banker to Banks, MonetaryPolicy Functions, Currency Issue and Management, Payment System Function,Maintaining Internal and External Values of Currency, Regulation, Facilitation andSupervision of Financial System, Promotional Functions to Support Growth andOther National Objectives, Development of Financial Markets, Institutions andCommunication Policies.

3. Contemporary Issues: Desirability, Autonomy and Independence, Credibility,Accountability and Transparency of a Central Bank, Conflict with Fiscal Policies.

Module - B: Central Banking in India 151. Reserve Bank of India: Organizational Evolution, Constitution and Governance,

Major Organizational and Functional Developments over the Time, RecentDevelopments, RBI Act.

2. India Specific Issues: Banking Regulation Act, FEMA, Banking OmbudsmanScheme, Financial Sector Reforms, Other Financial Regulators and Division ofFunctions. Institutions Set up by RBI; NABARD, IDBI, DFHI, IRBI, UTI.

Module - C: Monetary Policy and Credit Policy 151. Monetary Policy: Objectives, Reconciling Dual Objectives, The Taylor Rule,

Indicators of Policy, Instruments of Policy (Bank Rate, OMO, CRR, SLR etc.),Policy Transmission Mechanism and Channels, Transparency of Policies, Lags inPolicy.

2. Credit Policy: Objectives, Theory and Practice, Instruments.3. An Overview of Fiscal Policy: Importance of Budgets, Union Budget, State Budget,

Finances of Union and State Governments, Finance Commission.4. Striking Balance between Inflation and growth through Monetary and Fiscal Policies.

Module - D: Supervision and Financial Stability 151. Indian Financial System: Constituents of Indian Financial Markets and their

Regulation. Evolution of Bank Regulation and Supervision.2. Financial Stability: Financial Development vs. Financial Stability, Risks to

Financial Stability, Early Warning Signals and Remedial Action, LiquidityManagement, Regulation and Supervision of Banks, Risk Management in Banks, TheBasel Norms, Prudential Norms, Effect of Liberalization and Globalization onFinancial Stability, Linkage to International Financial Stability, InternationalStandards and Codes, Role of Supervisor under Basel-II.

Question Paper Pattern

Test 75 Marks

Sr. No. Particulars Marks

Q. 1(a) Unit 1 8

Q. 1(b) Unit 1 7

OR

Q. 1(c) Unit 1 8

Q. 1(d) Unit 1 7

Q. 2(a) Unit 2 8

Q. 2(b) Unit 2 7

OR

Q. 2(c) Unit 2 8

Q. 2(d) Unit 2 7

Q. 3(a) Unit 3 8

Q. 3(b) Unit 3 7

OR

Q. 3(c) Unit 3 8

Q. 3(d) Unit 3 7

Q. 4(a) Unit 4 8

Q. 4(b) Unit 4 7

OR

Q. 4(c) Unit 4 8

Q. 4(d) Unit 4 7

Q. 5 Explain the following concepts (any 5 out of 8) (covering theentire syllabus)

15

ORShort notes (any 3 out of 5) (covering the entire syllabus) 15

Contents

1. Evolution and Functions of Central Bank 1 – 6

2. Functions of Central Banking 7 – 25

3. Contemporary Issues in Central Banking 26 – 34

4. Reserve Bank of India 35 – 51

5. Central Banking – India Specific Issues 52 – 72

6. Monetary Policy 73 – 95

7. Credit Policy 96 – 101

8. An Overview of Fiscal Policy 102 – 110

9. Indian Financial System 111 – 122

10. Financial Stability 123 – 148

Learning Objectives:After reading this unit, participants would be able to know:

After studying this unit, the student should be able to know the evolution and function ofCentral banking.

Structure1.1 Introduction1.2 Evolution of Theory and Practice of Central Banking1.3 Development of Central Banks in Developed and Developing Countries1.4 Let Us Sum Up

1.1 IntroductionCentral bank is a national financial institution. It exercises control over key aspects of the

financial system, economic problems and the various banking crises. In the early 20th centuryhighlighted the need for a proper well designed institution in the form of a Central bank. The need wasemphasized by the International Financial Conference held at Brussels in 1920. Since then, theinstitution of Central bank has become more formal and the functioning of Central banking has beenrecognized as an important part of the economic and financial system of the country.

1.2 Evolution of Theory and Practice of Central Banking1.2.1: The primary stimulus for establishing Central banks and strengthening their activities in

many parts of the world in the twentieth century, emanated from exigency of war financing. Economichistorians have pointed out that war finance was prime consideration for constitution of many of theearly Central banks. Also, war financing led to nationalization of many Central banks, which till thenwere functioning as private entities. Once the spectre of war receded, the role of Central banking came

Evolution andFunctions of Central

Bank1

Chapter

2 Central Banking in India

to be increasingly focused in mobilizing resources for planned development and at the same time intackling high inflation.

The first Central bank, the Sveriges Riksbank, was established in Sweden in 1668; and the secondCentral bank was Bank of England (BoE), set up in 1694 under a Royal Charter of the UnitedKingdom. Most of the bigger European Central Banks were established in the 19th century, while theGerman Bundesbank and the US Federal Reserve System came into being in the 20th century.

1.2.2: The early Central banks were established primarily to finance commerce, foster growth ofthe financial system and to bring uniformity in note issue. The Bank of England initially functioned asthe banker and debt manager to the government. As a commercial bank, BoE also took deposits andissued notes. With the renewal of Bank of England’s (BoE’s) Charter in 1781, it was described as ‘ThePublic Exchequer’ and acted as the banker’s bank as well. In the 19th century, the BoE undertook therole of Lender of Last Resort (LOLR) to banks, providing stability during financial crisis. The BoEwas nationalized in 1946 and it remained the Treasury’s adviser, agent and debt manager.

1.2.3: The Banque de France was set up in 1800 to restore confidence in the French bankingsystem after the financial upheavals of the revolutionary period. The Banco de Portugal, which wasestablished as a public limited company in 1846, was a note issuing commercial bank, whose main jobwas maintaining convertibility of its notes and making a profit for its shareholders.

1.2.4: In Germany, the Bundesbank was set up in 1957 by the Bundesbank Law. Its predecessorwas known as the Reichs bank, was operational from 1876 to 1945. Unlike some of the otherEuropean countries where Central banks were set up in the seventeenth and early eighteenth centry,Central banking per se came late to Germany, as a stable state came into existence only in 1871. Therationale for setting up a Central Bank in Germany was the desire to have a uniform system of coinage,weights and measures.

1.2.5: The Bank of Italy was founded in 1893 as part of the reorganization of the Italian bankingand monetary system that had reached the state of near collapse at the beginning of the 1890s. Thefundamental task of the bank was to free itself from the problems inherited, primarily by cleaning thebalance sheet and restoring a capital base.

1.2.6: The wave of bank failures and the need for a lender of last resort also led to theestablishment of the US Federal Reserve System (US Fed). Prior to the establishment of US Fed,public opinion in the US was in favour of free banking.

1.2.7: As notes became the legal tender and ceased to be convertible into gold, the power ofCentral banks over money supply increased and price stabilization policies became feasible. After theFirst World War, the role of Central banks became even more important as the role of supervising thebusiness of private commercial banks was added and lender of last resort function to stabilize thebanking system during financial panics was strengthened. The First World War also led to the Centralbanks increasing involvement in extending credit to the respective governments. In order to handletheir new role as managers of government paper in the open market and were entitled to develop openmarket policy instruments for fine-tuning of interest rates and for credit and money supply expansion.This gave rise to more discretionary powers to Central banks to conduct their operations. Since 1933,in the US and shortly after the Second World War in Germany, Central banks were empowered tocharge minimum reserve requirements, which constituted an important and direct tool of monetarymanagement.

1.2.8: As financial systems developed, Central banks had to reorient their policies and strengthentheir roles in order to cope with the new challenges. During global crisis such as the great depression

Evolution and Functions of Central Banking 3

of 1930s, the mandate given to most Central banks included monetary stability, promotion of fullemployment and maximization of growth. The role of Central banks was thus, enhanced successivelyafter every crisis.

As indicated previously, Central banks functions have evolved over time, especially after theeconomies encountered difficult periods or crises. The functions of Central bank can be broadlycategorized into monetary policy functions, banker to the banks, banker to the government anddevelopment functions. The functions of note issue and maintenance of internal and external value ofcurrency evolved as the key functional areas of Central banks and the responsibility of promotinggrowth was subsequently added to it. This set of functions became the core monetary policy functions.

1.2.9: With the development of financial sector, subsequently, lender-of-last-resort function grewto encompass the role of a regulator and supervisor. This role has assumed wider objective of financialstability in recent years and includes allied activities pertaining to adoption of technology in banking.Many Central banks were originally established predominantly to finance the activities of theirgovernments. This function has been reviewed and many Central banks have ceased to finance theirgovernments in recent years. Central banks have assumed many new functions that focus ondevelopment of markets, institutions and communication policies.

1.2.10: The concept of Central bank as such has been mostly the product of twentieth century.Historically, some bank or the other used to perform the functions of a Central bank in the 19thcentury. Bank of England performed the functions of a Central bank without really being called aCentral bank for a long time. Also the Imperial Bank of India performed some of the functions ofCentral bank such as acting as a banker to the government. Some European countries entrusted Centralbanking functions to commercial banks. There was no institution called Central bank although thefunctions were performed by some commercial banks. These commercial banks subsequently becameCentral banks. By the beginning of the twentieth century, the old colonial countries were still withouta Central bank, particularly in Asia, Africa and Central America. Now, almost all countries havecentral banks.

1.2.11: The new wave of thinking was first seen in the working of the central banks in industrialeconomies. Central banks in emerging market economies could not afford to lag behind. They, in facthave, found it necessary to adapt themselves to the changing economic environment, reorient theirtraditional tasks, and ready themselves to face new challenges and growing economic uncertainties.The notion that Central bankers make a living by printing notes is old-fashioned and is no longer valid,nor do Central bankers depend solely on their ability to lend to governments or to banks for theirupkeep. No doubt, they have to take care of payment system and act as bankers to government andbanks. But they do much more. They are there to prevent financial failures, and have to be accountablefor their actions.

1.2.12: In view of the above, it can be concluded that Central banks have evolved in accordancewith the specific requirements of the economies in which they are situated and in response to thenature of demands made on them. Their roles expanded as the situation unfolded and theory of centralbanking began to emerge simultaneously.

1.2.13: The Central banks in developing countries struggle with shallow and segmented marketsand they have often had to deal with situations of market failure and financial repression. Foreffectively overcoming these limitations, Central banks had to act at two separate levels. First, theyhad to rely more on direct or sectoral tools in the conduct of monetary policy. Second, they needed tomake sustained efforts to develop their markets. Only when the markets were fairly developed couldthey move on to the market-based instruments. Their role is often that of the facilitator who fosters

4 Central Banking in India

development of the financial sector to subserve the needs of government and meet the socio-economicgoals of the country.

1.2. 14: Central banking was initially practiced with an array of informal norms, conventions andself-imposed codes of conduct. These were later formalized into theory and institutionalized into lawsthat apply to today’s Central banking institutions. These laws have been amended and modifiedperiodically to suit the evolving financial structures in most countries. The practice of Central bankingrevolves around ‘Rules vs. Discretion’ type of judgements. In emerging economies, however, Centralbanks need to embrace discretion rather than rules in view of the specific features of these economies.The operational strategies of Central banks accordingly are modulated appropriately by tailoring someto the country-specific scenarios. At the same time, Central banks should be conscious of theimperatives of moving towards the adoption of international best practices. It has been recognized thatthe adoption of international best practices would help them in resolving the kind of dilemmas facedby Central bankers in terms of preserving their autonomy, shielding themselves from politicalpressures and ensuring their accountability to the public. Such an interaction between theory andpractice forms the basis of their co-evaluation.

1.3 Development of Central Banks in Developed and DevelopingCountries

1.3.1: There are marked differences in Central bank functions as between developed anddeveloping countries. The developed countries are characterized by a well diversified and strongfinancial super structure. They are advanced in the sense of both financial widening and financialdeepening. Hence, the monetary transmission processes are quick. Any change in interest rates in onemarket triggers an immediate response from various other markets and sets the move for reallocationof resources. For example, for the greater part of the period from 1970 through October 1979, theFederal Reserve relied on federal funds rate, the rate that banks charge one another on overnight loansof reserves – as its operating target in seeking to attain its monetary objectives. The objective of suchexercise is to keep the federal funds rate at the desired level so as to equalize the demand for supply ofreserves at this rate.

1.3.2: In the developed countries, there is a preponderant use of cheques/drafts rather thancurrency as a means of payment mechanisms. Hence, the currency management of Central banks tendsto be minimal as compared to developing countries. As against this, in developing countries, currencyforms a major proportion of money supply in view of the fact that a vast majority of population usesthe currency as a means of payment. The currency to deposit ratio is generally very high in developingcountries as compared to developed countries. As currency forms a major chunk of money supply,currency management task becomes complex and intricate. The developing countries are characterizedby poor financial infrastructure and the banking network is sparsely spread. Central banks of suchcountries need to expend efforts at creating financial infrastructure for channelizing savings forinvestment purposes.

1.3.3: Further, as compared to developed countries, the developing countries are faced with theproblem of existence of informal markets. It is generally observed that a significant part of economicactivity springs from these informal markets. These informal markets operate independent of theorganized money market. This considerably weakens the monetary transmission processes indeveloping countries as interest rate signals from the Central bank generally do not affect theoperations of informal markets. Even within the organized financial segment, in view of the weak

Evolution and Functions of Central Banking 5

financial structure, the effect of Central bank policies is not fully realized. This renders monetarypolicy transmission mechanism somewhat weak.

1.3.4: As a result, the role of Central banks in developing countries of today is somewhat differentfrom what it was in developed countries, when they were developing. Whereas in industrial countries,the main role for which the Central banks were formed was that of the lender of last resort, indeveloping countries like India, Central banks came into existence to promote the spread ofcommercial banks and other channels of credit flow. The genesis of the Central banks in severaldeveloping countries could be attributed to performing of developmental role.

1.3.5: There is a marked difference between the Central banks of older developing countries andthose in transition economies. The older developing countries have been developing their systems andoperating procedures gradually, whereas the transition economies had the benefit of being late comerson the scene and have, therefore, been able to choose from a variety of frameworks and learn from theexperiences of other countries. Central banks in these economies have been able to start on a cleanslate and successfully graft systems from developed countries. On the other hand, the older developingcountries needed framework compatible with their existing systems. Obliviously, merely grafting ofthe developed country models may not be suitable for such countries. The framework and systemsmay have to be tailored to the specific features of the transition economies before adopting them.

1.3.6: Each Central bank has a distinctive historical origin and were set to perform certain tasks.These developments that unfolded over the years, to a large extent, shaped the way in which theyoperate today. Thus, there is very little generic theory of Central banking per se; most of it has evolvedin the course of their operations. In other words, there has been a co-evolution of both theory andpractice of Central banking.

1.4 Let Us Sum UpThis Unit broadly deals with tracing the evolution of Central banking in different countries.

Central banking has evolved over time, responding to exigencies of emerging economic situations.While the developed markets are characterized by well developed financial markets, the developingcountries are faced with weak or fragile markets. Central banks in developing countries are mandatedto develop the banking system. They also act as bankers to the government. Functions of Centralbanks differ from country to country. Central banks carry out developmental function, supervisoryfunction, monetary control functions for economic development in most of the countries.

Check Your ProgressI. Multiple Choice Questions. Choose the most appropriate answer from the

choices given below each question1. The primary stimulus for establishing Central banks and strengthening their activities in many

parts of the world in twentieth century, emanated from:(a) Exigency of war financing(b) Financing of trade(c) The need to act as banker to banks(d) Global developments

2. The country that has not embraced the inflation target regime is(a) Australia(b) Canada

6 Central Banking in India

(c) New Zeeland(d) India

3. The major weaknesses faced by Central banks in emerging economies are:(a) Weak financial system(b) Financing government debt(c) Both (a) and (b)(d) None of these

4. The oldest Central bank is(a) Banque de France(b) Sveriges Riksbank(c) Bundes bank(d) Bank of Italy(e) Federal Reserve System

5. Bundesbank is the Central bank of :(a) United States(b) Italy(c) Germany(d) England(e) France

Key to Answers1. (a), 2. (d), 3. (c), 4. (b), 5. (c).

References1. Indian Institute of Banking and Finance: Central Banking, Macmillan Publishers India Ltd.2. Dr. K. Bhat Govinda: Central Banking in India, 3rd Edition, 2012, Himalaya Publishing House,

Mumbai.3. Balachandran, G. (1998): The Reserve Bank of India 1951-1967, Oxford University Press.4. Chandavarkar, A. (1996): Central Banking in Developing Countries, McMillan Ltd.5. Reserve Bank of India, 2001: Reserve Bank of India Functions and Working.6. Vasudevan, A. (2003): Central Banking for Emerging Economies, Academic Foundation, New

Delhi.7. Annual Report of Reserve Bank of India (2009-10 to 2013-14).