PRINCIPLES AND

PRACTICE OF BANKING

Reserve Bank of India

(RBI)
Organization and Management
and Its Role
1
 1. RBI : Historical Back-
Drop
 Earliest Initiative: First attempt to set up Govt. Bank
in 1773 by then Governor of West Bengal East India Co.
 Imperial Bank – 1921: Amalgamation of three
Presidency Banks into Imperial Bank – Became Govt.
Banker and Issue and control of currency.
 Hilton Young Commission (Royal Commission
on Indian Currency and Finance) – 1926:
Recommended setting up of The RBI for Central Bank
functions. Recommendations reinforced by Central
Banking Enquiry Committee-1931
 Establishment of The RBI: The Reserve Bank of
India Act-1934 enacted and RBI set up on April 1, 1935
as private bank with initial paid up capital of Rs.5crore.
 Nationalization of RBI: After Independence RBI
nationalized under amended The RBI Act -1948
2
 2. Objectives
Preamble of RBI: Preamble of RBI Act-1934 lay down
the objective of RBI “ to regulate the issue of Bank
Notes and Keeping of Reserves with a view to securing
monetary stability in India and generally operate the
currency and credit system of the country to its
advantage.”
Other objectives:
 Remain free from political influence.

 Discharge central banking functions in the money

market
 Assist the planned process of development of the
Indian economy.
 Promotion of monetization and monetary integration of
the economy.
RBI by act to perform all the functions of central bank
together with developmental and promotional functions
attuned to the course of planning in the country.
 3. Composition of Indian
Banking System
Indian Banking System
Reserve Bank of India

Scheduled Commercial Banks Scheduled Cooperative Banks

Public Private Foreign Regional S. Urban S. State

Sector sector Banks in Rural Banks- Coop. Coop.
Banks-27 Banks-37 India-40 196 Banks-52 Banks-16

Nationalized State Bank of Old Private New Private

Banks India its Banks-22 Banks-8
-19 Subsidiaries-8 4
 4. Governing Body
Central Board: Consist of 20 Directors including Governor
as Chairman, Deputy Governors not more than four, 14
Directors out of which four – one each from Local
Board and one Government Official nominated by
Central Government. Entrusted with responsibility of
policy making, general supervision and direction of
affairs and business of Reserve Bank.
Local Board: Four Local Boards for Four Regions:
Western with Head quarters in Mumbai, Eastern with
Kolkata, Northern with New Delhi and Southern with
Chennai. Consist of Five Directors appointed by Central
Govt. for four years. They represent territorial and
economic interests of local cooperatives and
indigenous banks. Advise Central Board on matters of
local importance.
Governor: Chairman of Board as well as the Chief
Executive authority. Assisted by Deputy Governors.
Appointed for Five Years. 5
 5. Organizational
Structure
Banking Department: Banker to Govt. and member Banks. Consist of
Public Accounts Department, Public Debt Department, Deposit
Accounts Department and Securities Department.
Issue Department: Management of Note Issue. Consists of General
Department - deals with resource operations : supply of notes and
coins from Govt. press and Mints and Cash Department dealing with
cash transactions.
Department of Currency and Management: Forecasting currency
requirements, allocation of currency to various branches of Issue
Department based on demand pattern etc.
Department of Banking Operations and Development (DBOD):
Responsible for supervision, control and development of commercial
banking system in the country. Regulating commercial banks under
regulatory provisions of The Banking Act, 1949. Fulfilling objective of
promotion and development of sound and competitive banking system.
Focusing on prudential regulations, licensing of new banks/foreign
banks etc.,
 6. Organizational
Structure (contd.)
Exchange Control Department: Controlling foreign exchange
transactions and maintaining exchange rate stability.
Rural Planning and Credit Department: District Credit Plans, Lead Bank
Scheme, Financial Assistance for NABARD, Special Studies for
promoting IRDP, Framing policies for rural credit/development and
Microfinance.
Department of Economic Analysis and Policy: Economic Research,
Reviews financial and banking conditions, Report on Currency and
Finance, RBI Bulletins, Policy studies on emerging aspects of
banking and economy and Annual Reports.
Other Departments: Dept. of Statistical Analysis and Computer
Services, Dept. of Administration and Personnel, Legal Dept.
Management Services Dept., Dept. of Non-Banking Companies,
Banking Supervision, Credit Planning Cell, Dept. of External
Investment and Operations, Deposit Insurance and Credit Guarantee
Corporation, Industrial and Export Credit Dept., Secretary’s Dept.,
RBI Service Board and Human Resource Development Dept.
(Training Institutions). 7
 7. Functions of RBI
Operational Framework – Performs all functions of Central
Bank. Besides developmental and promotional functions consistent
with planning priorities.
Bank for Note Issue:
 Sole right to issue currency notes of Rs.2 and above. One Rupee
Note and coins by MF but circulated under RBI supervision.
 All notes issued by RBI legal tender/ guaranteed by Central Govt.
 Rules Governing Note Issue: Proportionate Reserve System of 40%
Gold Reserve. Since 1957, followed Minimum Reserve System –
Rs.200 crore of Gold and foreign exchange of which Rs.115 crore
Gold. Adopted .
 Design, form, denomination and material of notes subject to
approval by Govt.
 Currency Chests: For provision of remittance facilities to banks and
public, facilitating treasuries and bank to function by minimum
cash balance and facilitating exchange of New for old/soiled notes.
8
 8. Banker to Governments
Banker to Central and State Governments:
 Banking transactions of Governments – Maintaining Deposit
accounts , Collection and Payment on behalf of Governments,
Transfer and Remittance facilities. - Maintains Current Account of
Central Govt. with minimum balance of Rs.50 crore. – In places
where RBI no Branch, SBI Acts as RBI agent.
 Managing public debts (now delinked) and issue of new loans. –
Ways and Means Advances repayable within three months.
 Act as agent for Government for treasury bills and Govt. Securities.
Banks required to invest certain proportion of investment in Govt.
Securities - Statutory Liquid Ratio (SLR) –Now 25 %.
 Advising Governments on financing, resource mobilization and
institutional arrangements for flow of resources for Plans.
 Advising Government on international finance, foreign trade and
foreign exchange.
 Represent Government as member of IMF, The World Bank and
other international forums. 9
 9. Banker’s Bank
Banker to Scheduled Commercial Banks:
 Maintaining Cash Reserves – As per Act amended 1962,
Minimum of 3 percent of total liabilities (Demand and Time
Deposits).
 Acting as clearing agent for commercial banks.
 Serving as lender of last resort by rediscounting bills of
exchange or providing loans against eligible securities
during credit stringency. Lender of Last Resort implies:
 RBI provide loans to banks which are solvent and facing
liquidity crunch.
 Loans given at a penal rate of interest,
 Loans given against eligible collateral security
 Loans provided till such time bank turns solven
10
 10. Foreign Exchange
Management
 Custodian of country’s foreign exchange reserves:
Intervenes (buying and selling) in FEM to ensure smooth and
orderly exchange transactions and to promote a stable exchange
rates.
 Transition from FERA to FEMA: Exchange control first
introduced in 1939 under Defense of India Rules; statutorily laid
down by Foreign Exchange Regulatory Act-1947 and amended in
1973 as Foreign Exchange Regulations Act. (FERA). Now replaced
by Foreign Exchange Management Act -1999 (FEMA).
Under FERA: RBI controlled collection and allocation of Foreign
exchange and Fixed Exchange Rate and administer foreign
exchange control.
Under FEMA: RBI authorizes Banks and authorized dealers to
handle market transactions of foreign exchange.
 RBI now focuses on development of competitive FEM, Manage
Exchange Reserves and Manage stability in Exchange Rate by
market intervention. No exchange control. 11
 11. Development Role
Need for Development Role:
 Development of financial market: Predominance of indigenous
banks, imperfections in the financial system, promotion of
monetization of economy.
 Development of economy by ensuring proper allocation of credit
among various sectors.
Developmental Role Played by RBI:
 Lead Bank Scheme: Geographical spread of Branch net work.
 Agricultural Finance/Priority Sector Advances: Role of ACD to
provide financial accommodation to cooperatives, expertise and
training, Agricultural Credit Funds
 Institutional Development: IDBI, ARDC/now NABARD, Credit
Guarantee Corporation, Deposit Insurance Corporation, Regional
Rural Banks(RRBs), Exim Bank., UTI, NHB, NIBM, College of
Agricultural Banking.
 Training and Research: Collection of data, promote policy and
action oriented research and training: BTC, NIBM etc. 12
 12. Regulatory Role
Objective: Regulate money supply to achieve price stability and
development objectives. – Maintain value of rupee, ensure healthy
and sound banking system, and ensure effective coordination and
control over credit portfolio of Banks through monetary policy.
Rationale/Need for Regulation: Safeguard interest of Depositors,
maintain liquidity of Banks, ensure orderly and efficient functioning
of Banking system, ensure efficient and productive use of credit,
control money supply to achieve monetary policy objectives and
control foreign exchange.
Regulatory Provisions under RBI Act: Approve chairman,
Licensing of Banks, restrictions on opening new branch, inspection
of Banks , Providing guidelines and Directives on credit policies,
Carrying out periodical reviews of banking operations, monitoring
banks implementation of prudential regulations, overview and
exercise control over methods of operation and management of
Banks , to remove management, supervising amalgamation and
liquidation of Banks, appointing liquidator, and impose penalty .
13
 13. Supervisory
Framework of RBI.
RBI adopted Basel Committee - 25 core principles for
effective banking supervision.
 Department of Supervision separated from DBOD in

1993. Two Departments: DBS and DNBS set up under

the Board of Financial Supervision (BFS) with Governor
as chairman in 1994.
 Supervisory process include : On-site Inspection and

Off-site Monitoring and surveillance system

 On-site Inspection: Annual Financial Inspections (AFI)

undertaken directly by RBI or external auditors, focuses

on statutory mandated areas, solvency, liquidity and
financial and operational health of the bank.
 RBI identifies areas of concerns and draws up action

plan to monitor. 14
14. Off-site
Monitoring/Surveillance
Objective: To maintain continuous surveillance on performance, and
financial health of banks during the period between the two on-site
inspection and trigger timely supervisory /corrective actions.
Modus Operandi : Monthly, Quarterly, Half-yearly and Annual Returns
mainly focusing on CRAR, operating results, lending portfolio, large
credit exposure, profile of ownership, asset-liability management,
foreign currency business etc. Build computerized data base and
analyze and review at periodical intervals,
Banks are rated as per CAMELS Supervisory Model: C= Capital
Adequacy, A= Asset Quality, M= Management , E=Earnings,
L=Liquidity and S= Systems and controls for Indian Banks and CALCS
Model: C=Capital Adequacy, A= Asset quality, L=Liquidity,
C=Compliance and S=Systems for foreign bank branches.
Prompt Corrective Action (PCA): More focused and enforcement-oriented
follow-up.
Now moving towards Risk Based Supervision (RBS): Focused on Risk
profile of Banks based on BASEL Accord./norms
15
 15. Process of making
Monetary Policy
 RBI responsible for formulating and implementing MP in India
 MP is analytical, consultative and participative process –
Significant technical, analytical, institutional and dynamic inputs
go into process of making MP.
 A committee of Board chaired by the Governor meets every week
to review monetary, economic and financial conditions and
implementation of MP and decide course of action needed.
 A MP Strategy Group analyzes strategies on an on-going basis
 MP communicated to public by way of Annual Monetary Policy
Statement of RBI Governor in April and Mid-term review in October
every year.
 Monetary Policy Announcement contains in detail information on
working of economy, rationale behind the policy , targeted
objectives, monetary, growth and inflationary targets, and
institutional and structural aspects of policy measures.
 Periodic consultation with MF, Govt. of India, market participants,
financial institutions. 16
 16. Objectives of Monetary
Policy of RBI
Economic Policy Objectives: Achieve faster growth, ensure
reasonable degree price stability, and promote distributive justice
(Equity). RBI Monetary Policy be consistent with overall objectives.
Broad objectives of RBI Monetary policy :
 To maintain a reasonable degree of price stability.
 To help accelerate the rate of economic growth – ensure adequate
flow of credit to productive sectors.
Emphasis between two objectives : Changed from year to year
depending on conditions prevailing in that year and previous.
Whenever inflation high, price stability received more emphasis.
Equity left to Fiscal policy, Price stability helps poor and inflation hurts
them most. Price stability has social dimension.
Trade-off between Inflation and Growth: Whether pursuit of objective of
price stability undermines ability of economy to attain and sustain
high growth. Regime of rising prices adversely affects saving and
speculative investment more attractive. Regulation of money supply
affects adversely allocation of credit to productive sectors and thus
slow down growth. Trade off between two emphasized.
 17. RBI MP Prior to Bank
Nationalization
 Financial Market highly segmented and regulated. Interest Rates
administered by RBI. Credit to commercial sector regulated; multiple
lending rates and directed credit at subsidized interest.
 RBI relied on Direct Method such as Interest rate regulations,
Selective Credit Control and CRR as major MP Instruments to
neutralize monetary impact of Govt. Deficit and assist Govt.
borrowing operations..
 Bank Rate and Open Market Operations only limited roles in
Command and control Approach.
 Nexus between MP and Fiscal Policy: MP used as an institutional
arrangement for financing Govt. deficit. Practice of extending Short
term credit to Central Govt. resulted in automatic monetization of
fiscal deficit. With low yield, RBI residual subscriber to Govt.
Securities not traded in the market. Demand for Govt. Securities
created through increases in SLR. RBI Credit constituted 75% of
Monetary base (Reserve Money) in 1970s increased to 92% during
1980s.
 18. RBI MP after
Nationalization
 After nationalization of Banks, modus operandi for conducting MP
changed. CRR and Credit Rationing through Selective Credit Controls
became instruments with virtual exclusion of others.
 Refinance used to fill shortfall of credit targets of banks in relation to
demand.
 Interest rate structure administered rendering it inflexible and sterile as
an instrument of Monetary Policy.
 CRR and SLR used to neutralize inflationary impact of growing deficit.
RBI Act amended: first to increase CRR from 5 percent of Demand
Deposits and 2 percent of time deposits to 5 to 20 percent of Demand
Deposits and 2 and 8 percent of time deposits besides Reserve up to
100 percent against incremental deposits in 1956, and in 1959 to
minimum 3 percent of all deposits and could vary 3 and 15 percent.
SLR limit was fixed at 25 to 40 percent.
 Single most important instrument used to conduct monetary policy
after 1970s, increase in CRR. And SLR as source of government
borrowing
19
 19. RBI MP after Bank
Nationalization
 CRR: In 1973, CRR was 3 percent, in 1989 reached statutory
maximum of 15 percent. SLR, 25 percent in 1970 reached 38.5
percent in 1989. Besides 10%CRR on incremental deposits. CRR
and SLR used to meet growing govt. deficits.
 Credit Rationing: Minimum margins, ceiling on amount of
credit and discriminatory interest on certain loans used as
instruments.
 Credit Authorization Scheme (CAS): Mandatory for banks
to obtain prior approval for any credit of Rs. one crore and above
for single party. Abolished in 1989 and replaced by Credit
Monitoring Arrangements(CMA). RBI to monitor all loans
exceeding Rs. 5crore to single party for working capital and Rs.
2crore for term loans.
 Impact: During 1950s, inflation was 1.8 percent. During 1960s,
6.2 percent, and in 1970s and 1980s higher than 10 percent. High
inflation and low growth. Phenomenal increase in money supply.
Ultimately led to economic/banking crisis in 1990-91 20
 20. Chakravarthy Committee
Recommendations
Objective: RBI in 1982 set up a committee under Chairmanship of
Sukhamoy Chakravarthy with objective of evaluating various
instruments of monetary policies, assessing interaction of
monetary policy and public Debt Management and recommending
appropriate measures for improving effectiveness of monetary
policy.
Recommendations of Committee:
 Price Stability: Existence of multiplicity of objectives and stressed

price stability as primary objective. To achieve price Stability,

Govt. should aim at raising output levels and RBI should control
expansion in Reserve Money and Money Supply.
 Monetary Targeting: Stressing inter-relation between money,

output and prices, recommended formulation of monetary policy

based on monetary targeting-Target for growth of money supply
based on anticipated growth in output and price situation.
 RBI and Govt. evolve a policy framework on level of monetary

expansion and extent of monetization of fiscal deficit.

21. Chakravarthy Committee
Recommendations (Contd.)
 Interest Rate Policy: Interest rate played an important role in
mobilization of savings and allocation of resources and cannot
arbitrarily set. Envisaged strong supportive role in monetary
regulation and recommended:
 Greater freedom for Banks in determining lending rates.
 Use of Concessional rates as distributive devise in selective basis
 Positive Real Interest rates for deposits after adjustment of inflation.
 Restructuring of Money Market: Strengthening of Treasury Bills
Market and Call Money Market and Commercial Bills Market in
allocation of short term resources with minimum costs and delays.
 Bank Credit Policy: Bank credit in the form of loans and bill finance
instead Cash Credit. To promote Bill financing, interest rate of 2
percent lower than Minimum Lending Rate.
 Monetary Policy: i)RBI should not depend on single instrument of
monetary policy. Ii) Adopt regulatory measures slowly so that effects
not drastic. Iii) Creation of Reserve Money within limits.
22
 22. RBI Monetary Policy:
Post-Reform Period
Multiple Indicator Approach: RBI monetary Policy undergone fundamental
change in objectives, framework and instruments. Adopted multiple indicator
approach - Market based interest rates, currency availability, credit position,
capital flows, fiscal state, inflation rate, exchange rate etc related to output
growth with necessary flexibility to respond to changes in formulation of
policy framework. Market-oriented approach instead command /control.
Monetizing Fiscal Deficits: No automatic monetization of Fiscal Deficits.
Agreement between Govt. and RBI and introduction of Ways and Means
Advances to provide temporary accommodation to enable Govt. to take care
of mismatch between receipts and expenditures. Government Securities
market related.
Monetary Instruments: Emphasis on market oriented instruments: OMP and
market related interest rates. CRR reduced from 15 percent in 1991 to 4.5
percent in 2003. Object to reduce statutory minimum of 3 percent. SLR also
brought down to statutory limit of 25 percent level . Interest rates deregulated.
Bank Rate limited role.

23
 23. RBI Monetary Policy:
Post-Reform Period (Contd.)
 Interest Rates: Interest Rates deregulated. Banks given
operational flexibility to determine deposit and lending rates with
certain restrictions for saving deposits and small loans. Interest
rates for Govt. Securities linked to market
 Liquidity Adjustment Facility (LAF): RBI uses LAF as flexible
instrument for liquidity management and regulating interest rates.
Along with LAF, OMOs expected to play key role in RBI MP.
 Monetary Targeting Framework: Broad Money (M3) considered for
Intermediate Target of monetary policy. Exercise focused around
working out money growth strategy based on money demand
function consistent with projected GDP growth and reasonable
inflation threshold.
 Transparency: Transparency in monetary policy widened and
deepened through consultation and publication of detailed results
of analysis and projections. Objective: Reduction in market ‘s
uncertainty and improve understanding of conducting monetary
policy 24
 24. LAF as a tool of MP
 LAF: Mechanism by which RBI draws funds from money market
when surplus and infuses liquidity when short of supply.
Important MP instrument to manage day to day liquidity
mismatches and smoothen volatility in money market.
 LAF operates on daily basis by way of repo and reverse-repo.
Repos: Mode of borrowing where borrower sells securities with
agreement to buy them back next day at a predetermined price.
Difference between sale and repurchase prices indicate repo rate
(interest cost of funds). In Reverse repo, lender buys securities
with an agreement to sell them back at a predetermined rate.
 In auction, borrowers bids for funds indicating amount they want
to borrow and the rate willing to pay.
 Initially auctions conducted daily with one day maturity, now
multiple reo/reverse repo auctions with 3 to 7 days maturity.
 Minimum size bids reduced from Rs.10 crore to Rs.5 crore to allow
smaller operators.
 From uniform price auction method to Multiple auction methods
25
25. Independence of Central
Bank
 Originally Central Banks set up by private shareholders to maintain
political independence. General opinion against any kind of state
interference. Rationale for independence : State control result in
mismanagement of currency and credit. If CB under state control,
continuity of policies not guaranteed with changing Governments
nor freedom from political bias assured.
 After Second World War, with emphasis on development, trend
towards state control of CBs. Bank policy and policy of Govt.
should all times in harmony and policy subject to supreme
authority of Govt. Independent Monetary policy sometimes defeat
policies of State. Coordination between two inevitable.
 With globalization and liberalization, Global trend increasingly legal
independence. Away from Govt. control. Independence means
operational freedom, accountability, transparency and creation of
executive monetary policy mechanism not Advisory one. Divesture
of supervisory and quasi-fiscal functions.
 No general consensus. 26
 26. Independence of RBI
 RBI when set up Hindu marriage between Bank of England
(dominant husband) and RBI (subservient wife), RBI to function on
advisory capacity and yield Govt./BOE to determine policies.
 After Independence, Govt.- Male chauvinist husband and RBI
docile traditional wife who had forfeited minimum right of nagging
the husband. RBI dwindled to quasi-fiscal agency. Monetary policy
captive of fiscal stance and politics. A section of Finance Ministry.
A faithful implementer of MF wishes.
 With liberalization, emphasis on operational autonomy and
transparency. No independence: Neither absolute subordination
nor absolute independence status. Relationship between RBI and
Govt. autonomy in operations and harmony in Policies and
coordination with Govt. in achieving development objectives.
 India has fiscal federalism but still lacks monetary federalism
 Require Institutional, functional and financial independence.
Higher degree of operational freedom to pursue policy objectives
independently free and fair manner without political influence.