CU- SEM III -BCM112- Management of Financial Institutions and Services

BACHELOR OF COMMERCE SEMESTER III MANAGEMENT OF FINANCIAL INSTITUTIONS AND SERVICES BCM112

CHANDIGARH UNIVERSITY Institute of Distance and Online Learning Course Development Committee Prof. (Dr.) R.S.Bawa Pro Chancellor, Chandigarh University, Gharuan, Punjab Advisors Prof. (Dr.) Bharat Bhushan, Director – IGNOU Prof. (Dr.) Majulika Srivastava, Director – CIQA, IGNOU Programme Coordinators & Editing Team Master of Business Administration (MBA) Bachelor of Business Administration (BBA) Coordinator – Dr. Rupali Arora Coordinator – Dr. Simran Jewandah Master of Computer Applications (MCA) Bachelor of Computer Applications (BCA) Coordinator – Dr. Raju Kumar Coordinator – Dr. Manisha Malhotra Master of Commerce (M.Com.) Bachelor of Commerce (B.Com.) Coordinator – Dr. Aman Jindal Coordinator – Dr. Minakshi Garg Master of Arts (Psychology) Bachelor of Science (Travel &Tourism Management) Coordinator – Dr. Samerjeet Kaur Coordinator – Dr. Shikha Sharma Master of Arts (English) Bachelor of Arts (General) Coordinator – Dr. Ashita Chadha Coordinator – Ms. Neeraj Gohlan Academic and Administrative Management Prof. (Dr.) R. M. Bhagat Prof. (Dr.) S.S. Sehgal Executive Director – Sciences Registrar Prof. (Dr.) Manaswini Acharya Prof. (Dr.) Gurpreet Singh Executive Director – Liberal Arts Director – IDOL © No part of this publication should be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording and/or otherwise without the prior written permission of the authors and the publisher. SLM SPECIALLY PREPARED FOR CU IDOL STUDENTS Printed and Published by: TeamLease Edtech Limited www.teamleaseedtech.com CONTACT NO:01133002345 For: CHANDIGARH UNIVERSITY Institute of Distance and Online Learning

First Published in 2021 All rights reserved. No Part of this book may be reproduced or transmitted, in any form or by any means, without permission in writing from Chandigarh University. Any person who does any unauthorized act in relation to this book may be liable to criminal prosecution and civil claims for damages. This book is meant for educational and learning purpose. The authors of the book has/have taken all reasonable care to ensure that the contents of the book do not violate any existing copyright or other intellectual property rights of any person in any manner whatsoever. In the event the Authors has/ have been unable to track any source and if any copyright has been inadvertently infringed, please notify the publisher in writing for corrective action CONTENT

Unit - 1: Introduction Financial System and Markets ...................................................... 5 Unit - 2: RBI....................................................................................................................... 15 Unit - 3: Monetary and fiscal policies ............................................................................... 41 Unit - 4: Overview of Foreign Exchange Market ............................................................. 64 Unit - 5: Financial Sector Reforms in India ..................................................................... 89 Unit - 6: Overview of Financial Services ........................................................................ 102 Unit - 7: Management of Commercial Banks Banking Industry in India ..................... 125 Unit - 8: Management of Non-Banking Financial Institutions....................................... 149 Unit - 9: State Level Institutions .................................................................................... 164 Unit - 10: Insurance & Mutual Fund organisations ...................................................... 176 Unit - 11: Management of Financial Services Leasing and Hire Purchase ................... 190 Unit - 12: Other financial services................................................................................... 201

UNIT - 1: INTRODUCTION FINANCIAL SYSTEM AND MARKETS Structure 1.0. Learning Objectives 1.1. Introduction 1.2. Nature of Financial System 1.3. Role of Financial System 1.4. Components of Financial System 1.5. Classification of Financial Assets 1.6. Classification of 1.7. Summary 1.8. Key Words/Abbreviations 1.9. Learning Activity 1.10. Unit End Questions (MCQ and Descriptive) 1.11. References 1.0 LEARNING OBJECTIVES After studying this unit, students will be able to: • Describe the components of financial system • Explain the functions of financial system • Outline the Role of Financial system • Describe the nature of Financial System • Explain the classification of Financial Assests. 1.1 INTRODUCTION

Introduction The term ‘finance’ refers to monetary resources & the term ‘financing’ refers to the activity of providing required monetary resources to the needy persons and institutions. The term ‘financial system’ refers to a system that is concerned with the mobilization of the savings of the public and providing of necessary funds to the needy persons and institutions for enabling the production of goods and/or for provision of services. Thus, a financial system can be understood as a system that allows the exchange of funds between lenders, investors, and borrowers. In other words, the system that facilitates the movement of finance from the persons who have surplus funds to the persons who need it is called as financial system. It consists of complex, closely related services, markets, and institutions used to provide an efficient and regular linkage between investors and depositors. Financial systems operate at national, global, and firm-specific levels. It includes the public, private and government spaces and financial instruments which can relate to countless assets and liabilities. In simple words, the financial system is explained as follow;  A financial system functions as an intermediary between savers and investors. It facilitates the flow of funds from the areas of surplus to the areas of deficit. It is concerned about the money, credit and finance.  A financial system may be defined as a set of institutions, instruments and markets which promotes savings and channels them to their most efficient use. It consists of individuals (savers), intermediaries, markets and users of savings (investors). Definition According to Prasanna Chandra,“Financial system consists of a variety of institutions, markets, and instruments related in a systematic manner and provide the principal means by which savings are transformed into investments”. According to Van Home, “Financial system allocates savings efficiently in an economy to ultimate users either for investment in real assets or for consumption”.

1.2 NATURE OF FINANCIAL SYSTEM  Financial system acts as a bridge between savers and borrowers  It consists of a set of inter-related activities and services  It consists of both formal and informal financial sectors.The existence of both formal and informal system is also called as financial dualism.  It formulates capital, investment and profit generation  It is universally applicable at firm level, regional level, national level and international level  It consists of financial institutions, financial markets, financial services, financial instruments, financial practices and financial transactions.  Transfer Funds Financial system helps in transferring of financial resources from one person to another person. This system includes financial markets, financial intermediaries, financial assets and services which facilitates fund movements in an economy.  Mobilizes Saving It helps in allocating ideal lying resources with peoples into productive means. Financial system is the one which obtains funds from savers and provide it to those who are in need of it for various development purposes.  Risk Allocation

Diversification of risk in an economy is important feature of financial system. Financial system allocates people’s funds in various sources due to which risk is diversified.  Facilitates Investment Financial system encourages investment by peoples into different investment avenues. It provides various income-generating investment options to peoples for investing their savings.  Enhances Liquidity Financial system helps in maintaining optimum liquidity in an economy. It facilities free movement of funds from households (savers) to corporates (investors) which ensures sufficient availability of funds. 1.3 ROLE OF FINANCIAL SYSTEM Facilitates Payment Mechanism: Financial system provides a payment mechanism for the smooth flow of funds among peoples in an economy. Buyers and sellers of goods or services are able to perform transactions with each other due to the presence of a financial system. Reduces Risk: It aims at reducing the risk by diversifying it among a large number of individuals. Financial system distributes funds among a large number of peoples due to which risk is shared by many peoples. Brings Savers and Investors Together: Financial system serves as a means of bridging the gap between savings and investment. It acquires money from those with whom it is lying idle and transfers it to those who need it for investing in productive ventures. Assist In Capital Formation: Financial system has an efficient role in the capital formation of the country. It enables big corporates and industries to acquire the required funds for performing or expanding their operations thereby leading to capital formation in the nation. Improves Standard of Living :

It raises the standard of living of peoples by promoting regional and rural development of the country. The financial system promotes the development of a weaker sections of society through cooperative societies and rural development banks. Facilitates Economic Development :  Financial system influences the pace of economic growth or development of an economy. It aims at optimum utilization of all financial resources by investing all idle lying resources into useful means which leads to the creation of wealth. Functions of Financial System The functions of a good financial system are manifold. They are as follows:  Regulation of currency: As a part of the financial system, central banks generally control the supply of a currency and interest rates, while currency traders control exchange rates.  Banking functions (a) to assemble capital and make it effective; (b) to receive deposits and make collections; (c) to check out and transfer funds; (d) to discount or lend; (e) to exercise fiduciary or trust powers; (f) to issue circulating notes.  Performance of agency services and custody of cash reserves: Different constituents of the financial system act as the agents for their clients. They buy and sell shares and bonds, receive and pay utility bills, premiums, dividends, rents and interest for their clients.  Management of national reserves of international currency: Various parts of financial system help the economy in particular and polity in general to manage international reserve.  Credit control: Financial system controls credit by serving the dual purpose of: (a) increasing sales revenue by extending credit to customers who are deemed a good credit risk, and

(b) minimizing risk of loss from bad debts by restricting or denying credit to customers who are not a good credit risk.  Ensure stability of the economy: Financial system performs the function of administering national, fiscal, and monetary policy to ensure the stability of the economy.  Supply and deployment of funds for productive use: Financial markets permit the transfer of funds (purchasing power) from one agent to another for either investment or consumption purposes.  Maintaining liquidity: Financial markets provide the holders of financial assets with a chance to resell or liquidate these assets.  Price determination: Financial markets provide vehicles by which prices are set both for newly issued financial assets and for the existing stock of financial assets.  Information aggregation and coordination: Financial markets act as collectors and aggregators of information about financial asset values and the flow of funds from lenders to borrowers.  Risk sharing: Financial markets allow a transfer of risk from those who undertake investments to those who provide funds for those investments.  Improve efficiency: Financial markets reduce transaction costs and information costs.  Ensure long term growth to itself: Long-term growth of financial markets is ensured through:  Giving autonomy to Financial Institutions to become efficient under competition  Education of investors  Consolidation through mergers  Facilitating entry of new institutions to add depth the market  Minimizing regulatory. 1.4 COMPONENTS OF FINANCIAL SYSTEM The following are the components of financial system  Financial Assets  Financial Markets

 Financial Rate of Return  Financial Instruments  Financial Services Fig 1.2 components of financial system Financial Assets : Meaning of financial assets : Financial assets refer to the cash or cash equivalents that are used for production or consumption or for further creation of assets. Cash, Bank Deposits, Shares, Debentures, Investment in Gold, Land &

Buildings, Contractual right to receive cash or another financial asset, etc., are called as financial assets. 1.5 CLASSIFICATION OF FINANCIAL ASSETS Financial assets are classified in two ways  On the basis of marketability  On the basis of nature Classification of Financial Assets on the basis of marketability  Marketable – The financial assets that can be bought and sold are called as marketable financial assets. They include Shares, Government Securities, Bonds, Mutual Funds, Units of UTI, Bearer Debentures Non-marketable – The financial assets that cannot be bought and sold are called as nonmarketable finance assets. They include Bank Deposits, Provident Funds, LIC Policies, Company Deposits, Post Office Certificates Classification of Financial Assets on the basis of nature  Money or Cash Asset – Coins, Currency Notes, Bank Deposits  Debt Asset – Debenture & Bonds  Stock Asset – Equity Shares & Preference Shares Financial Intermediaries/ Financial Institutions Financial Intermediaries/Financial Institutions : Different kinds of organizations/institutions which intermediate and facilitate financial transactions of both individual and corporate customers are called as financial intermediaries or financial institutions. Basically they are classified into two types:  Unorganized Sector  Organized Sector Unorganized Sector The sector that is not governed by any statutory or legal authority is known as unorganized sector. This sector consists of the individuals and institutions for whom there are no standardized rules and regulations governing their financial dealings. They are not under the supervision and control of RBI

or any other regulatory body. This sector consists of the individuals and institutions like Local money lenders, Pawn brokers, Traders, Landlords, Indigenous bankers, etc., who lend money to needy persons and institutions. Organized Sector The sector that is governed by some statutory or legal authority is known as organized sector. This sector consists of the institutions like Commercial Banks, Non-Banking Financial Institutions, etc. They are further classified into two:  Capital Market Intermediaries  Money Market Intermediaries Capital Market Intermediaries Capital Market refers to the market for long term finance. The intermediaries provide long term finance to individuals and corporate customers. IDBI, SFCs, LIC, GIC, UTI, MFs, EXIM BANK, NABARD, NHB, NBFCs (Hire Purchasing, Leasing, Investment and Finance Companies) Government (PF, NSC) etc., are in the organized sector providing long term finance. Money Market Intermediaries Money Market refers to the market for short term finance. The intermediaries provide short term finance to individuals and corporate customers. RBI, Commercial Banks, Co-operative Banks, Post Office Savings Banks, Government (Treasury Bills) are in the organized sector providing short term finance. Financial Markets: The group of individuals and corporate institutions dealing in financial transactions are termed as financial markets. The centres or arrangements that facilitate buying and selling of financial assets, claims and services are the constituents of financial market. Basically they are classified into two categories:  Unorganized Market  Organized Market Unorganized Market The sector that is not governed by any statutory or legal authority is known as unorganized sector. This sector consists of the individuals and institutions for whom there are no standardized rules and regulations governing their financial dealings. They are not under the supervision and control of RBI or any other regulatory body. Local money lenders, Pawn brokers, Traders, Landlords, Indigenous bankers, etc., who lend money are in the unorganized sector.

Organized Market The sector that is governed by some statutory or legal authority is known as organized sector. This sector consists of the institutions for whom there are standardized rules and regulations governing their financial dealings. They are under the supervision and control of RBI and other statutory bodies. They are further classified into two: A. Capital Market B. Money Market C. Foreign Exchange Market A. CAPITAL MARKET Capital Market refers to the market for long term finance. Financial assets which have a long or indefinite maturity period are dealt in this market. Capital Market is further classified into the following three: a) Industrial Securities Market b) Government Securities Market c) Long-term Loans Market a) Industrial Securities Market - The financial market where industrial securities like equity shares, preference shares, debentures, bonds, etc., are dealt with is called as Industrial Securities Market. In this market, the industrial concerns raise their capital and debts by issuing appropriate securities. This market is again classified into the following two viz., Primary Market and Secondary Market Primary Market - The financial market concerned with the fresh issue of industrial securities is called as primary market. It is also called as new issue market. In this market, industrial securities which are issued for the first time to the public are dealt. Secondary Market - The financial market concerned with the purchase and sale of already existing industrial securities is called as secondary market. In this market, industrial securities which are already held by the individuals and institutions are bought and sold. Generally, these securities are quoted in the stock exchanges. This market consists of all the stock exchanges recognized by the Government of India. Securities Contracts (Regulation) Act, 1956 regulates the stock exchanges and

Bombay Stock Exchange is the main stock exchange in India which leads the other stock exchanges. b) Government Securities Market or Gilt-edged Securities Market - The financial market where Government securities like stock certificates, promissory notes, bearer bonds, treasury bills, etc., are dealt with is called as Government Securities Market. The long term securities issued by the Central Government, State Governments, Semi-government authorities like City Corporations, Port Trusts, etc., Improvement Trusts, State Electricity Boards, All India and State level financial institutes and public sector enterprises are bought and sold in this market. c) Long-term Loans Market - The financial market where long-term loans are provided to the corporate customers is called as Long-term Loans Market. Development Banks and Commercial Banks play a major role in this market. This market is classified into three categories viz., Term loans market, Mortgages market and Financial guarantees market: Term loans market - This market consists of the industrial financing institutions which supply long term loan to corporate customers. They are created by the Government both at the national level and regional level. They provide term loans to corporate customers and also help them in identifying investment opportunities. They also encourage new entrepreneurs and support modernization efforts. IDBI, IFCI, ICICI, SFCs, etc., come under this market. Mortgages market - This market consists of the institutions which supply mortgage loan mainly to individuals. The term ‘mortgage’ refers to the transfer of interest in a specific immovable property to secure a loan. Financial guarantees market - This market consists of the institutions which provide financial guarantee to individuals and corporate customers. The term ‘guarantee’ refers to a contract whereby one person promises another person to discharge the liability of a third person in case of his default. There are different types of guarantees prominent among them are Performance guarantee and Financial guarantee. B. MONEY MARKET : Money Market refers to the market for short term finance. Financial assets which have a short period of maturity are dealt in this market. Near money like Trade Bills, Promissory Notes, Short term Government Papers, etc., are traded in this market.

Composition of money market (Financial instruments dealt in money market) The money market comprises of the following:  Call money market  Commercial bills market  Treasury bills market  Short-term loan market Call money market - The market where finance is provided just against a call made by the borrower is called call money market. In this market finance is provided for an extremely short period of time. Commercial bills market - The market where finance is provided by discounting of commercial bills is called as commercial bills market. The term ‘commercial bills’ refer to the bills of exchange arising out of genuine trade transactions. Treasury bills market - The market where finance is provided against the treasury bills is called as treasury bills market. The term ‘treasury bill’ refers to the promissory notes or finance bills issued by the government for its short-term finance requirements. Short-term loans market - The market where finance is provided in the form of short term loans is called as short term loans market. The term ‘short-term’ refers to a period less than one year. Commercial banks provide short term loans in the form of overdrafts and cash credits. These loans are given to meet the working capital requirements of traders and industrialists. C. FOREIGN EXCHANGE MARKET : The market where foreign currencies are bought and sold against domestic currency is called foreign exchange market. In other words, the system where the domestic currency is converted into foreign currency and vice-versa is called as foreign exchange market. Financial Rate of Return The term ‘financial rate of return’ refers to the percentage of income generated from the financial assets throughout its effective life. For calculation of financial rate of return, two types of incomes are considered. The first type of income is the annual income generated i.e., dividend on shares or interest on securities. The second type of income is the capital

appreciation. Capital appreciation means increase in the value of securities over and above the purchase price of the securities. Financial rate of return acts as a tool for investment decisions of the public and other financial institutions. The financial system should offer attractive rate of return on investments so that the investors would be ready to invest their surplus funds in the financial markets. The return on Government securities and bonds are generally less than the Commercial securities as the risk involved in Government securities is comparatively less. The central bank of the country fixes the key interest rates like CRR, SLR, REPO rates, Reverse REPO rates, etc. The rate of return on any security depends on the risk involved in the investment, the duration of the investment, the purpose for which the investment is utilized, the risk free rate of return, etc. The interest rate policy of the country is designed by the central bank to achieve the following objectives:  To enable the government to borrow funds at a lower rate of interest  To ensure stability by striking a balance between the economic growth and inflation  To mobilize savings in the economy  To support specific sector through concessional lending rates. Illustration Mr. A subscribes to the equity shares of RKS Ltd., on 1/4/2014 for Rs. 1,00,000. After receiving 15% dividend from the company, he sells the said equity shares for Rs. 1,20,000. What is the financial rate of return? Solution Investment value Rs. 1,00,000 Income generated = Dividend + Capital appreciation = Rs. 15,000 + Rs. 20,000 = Rs. 35,000 Financial rate of return = (Income generated / Investment) X 100 = (35,000 / 1,00,000) X 100

= 35% 1.6 FINANCIAL INSTRUMENTS Financial instruments refer to the documents that represent financial claim. A financial claim is claim to the repayment of a certain amount of money at the end of a specified period along with interest or dividend. Shares, Government Securities, Bonds, Mutual Funds, Units of UTI, Debentures, Bank Deposits, Provident Funds, LIC Policies, Company Deposits, Post Office Certificates, etc., are some of the examples of financial instruments. These instruments are classified into two types, viz., Primary securities and Secondary securities. Primary Securities – These are the financial instruments that are issued directly to the savers by the users of the funds. For example, shares or debentures issued by a joint stock company directly to the public and institutions are called as primary securities. Secondary Securities – These are the financial instruments that are issued to the savers by some intermediaries. For example, units issued by Unit Trust of India and other Mutual Fund Organizations are called as secondary securities. Financial Services Financial services refer to the activities of channelizing the flow of funds from the savers to the users. It involves the mobilization of savings of the persons and institutions who have surplus funds and allocating or lending them to the persons and institutions who are in need of such funds. The financial services are categorized into two groups, viz., Traditional services and Modern services.  Traditional services refer to the services that the financial institutions are rendering from a very long time. They are further classified into two viz., a) Fund based services and b) Non-fund or Fee based services.  Modern services refer to the services that the financial institutions are rendering in the recent years. Role of Financial System in the Economic Development of the Country : An effective financial system in the country offers a variety of financial products and

services to suit the different requirements of the investing public and corporate. The financial system plays the following role in the economic development of the country & provides the following benefits:  Help to form huge financial resources through mobilization of savings of the public and corporate  Promote investment in agriculture, manufacturing and service industries by providing the necessary finance for the cultivation of land, production of goods and provision of services  Transfer surplus funds from one part of the economy to another keeping in mind the national priorities  Encourage people to divert their physical assets into financial assets and make it available for balanced growth of trade, commerce, agriculture, manufacturing and service industries  Provide mechanism to control the risk and uncertainties  Multiply the monetary resources by the process of credit creation  Provide a variety of financial assets to suit the different needs of investing public and corporate  Encourage entrepreneurial skills among the public  Increase the growth rate of the economy. 1.7 SUMMARY  This chapter introduces the concept of a financial system and its Components  A financial system is a vertical arrangement of a well-integrated chain of financial markets and financial • institutions for providing financial intermediation.  There are basically 2 types of financial systems-Formal and Informal.  The formal financial system is further divided in four categories – Financial Institutions, Financial Markets, • Financial Instruments and Financial Services  The financial growth of a country is of immense use in its economic Development

 Adequate capital formation is important for economic development and financial markets are of utmost importance • for capital formation.  An immature financial system hinders the growth of the economy.  The financial system is the system that allows the transfer of money between savers and borrowers.  It is a set of complex and closely interconnected financial institutions, markets, instruments, services, practices, and transactions.  India has a financial system that is regulated by independent regulators in the sectors of banking, insurance, capital markets, competition and various services sectors.  In a number of sectors Government plays the role of regulator. RBI is regulator for financial and banking system, formulates monetary policy and prescribes exchange control norms.  The commercial banking sector comprises of public sector banks, private banks and foreign banks.  The public sector banks comprise the 'State Bank of India' and its seven associate banks and nineteen other banks owned by the government and account for almost three fourth of the banking sector.  India has a two-tier structure of financial institutions with thirteen all India financial institutions and forty-six institutions at the state level. 1.8 KEY WORDS/ABBREVIATIONS Capital Market: The capital market is the market for securities, where companies and governments can raise long-term funds. Deposit: An account at a banking institution that allows money to be deposited and withdrawn by the account holder. Loan: A type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower. Money Market: That segment of the financial market in which financial instruments with high liquidity and very short maturities are traded. 1.9 LEARNING ACTIVITY 1. Briefly analyze the limitations or weaknesses of Indian financial system

2. Briefly analyze the growth of financial system in India 1.9 UNIT END QUESTIONS (MCQ AND DESCRIPTIVE) A. Descriptive Types Questions Long answer 1. Is financial system synonymous to financial markets? If yes, elucidate upon the similarities. If no, discuss the difference? 2. Examine the various components of the Indian financial system? 3. Comparing it with others, what is the main difference that you see in the components of the financial system of developed countries and that of India? 4. What in your opinion is the main reason for having various regulatory authorities in a financial system? Is the central monetary authority (the representative of the government itself) unable to control the entire system? 5. Comment on the state of Indian financial system vis a vis its international counterparts. B. Descriptive Types Questions short answer 1. What do you mean by financial system? B. Multiple Choice Questions 1.How many components are there in Indian financial system? a. 3 b. 6 c. 1 d. 4 2. Which term describes the co-existence of formal and informal financial sectors in developing countries? a. Financial Dualism b. Financial Derivatives

c. Financial Regulators d. Financial Instruments. 3. Which of the following is a part of formal financial system? a. Financial services b. Informal financial system c. Money Lenders d. Landlords 4. _______________ help financial markets and financial intermediaries to channelise funds from lenders to borrowers. a. Financial Derivatives b. State owned banks c. Financial Instruments d. Financial Regulators. 5. Which the following statements is false? a. Financial markets are a mechanism enabling participants to deal in financial claims. b. Financial instruments differ in terms of marketability, liquidity, type of option return, risk and transaction costs. c. Financial regulation is a kind of supervision, which subjects financial institutions to certain requirements, restrictions and guidelines, aiming to maintain the integrity of the financial system. d. Financial markets help the financial instruments in performing the crucial function of channel listing funds from lenders to borrowers. 6. Investors are reassured by who regulate the conduct of the financial market and intermediaries to protect investors’ interests. a.Finance Minister b.State Government c.Financial regulators d.Insurance agents

1.10 REFERENCES Text Books:  T1 Fabozzi - Foundations of Financial Markets and Institutions (Pearson Education,3rdEd.).  T2 Khan M Y - Financial Services (Tata Mc Graw Hill).  R1 Machiraju H R - Indian Financial System (Vikas Publication).  R2 Bhole L M - Financial Institutions and Markets (Tata McGraw-Hill).

UNIT - 2: RESERVE BANK OF INDIA (RBI) Structure 2.0. Learning Objectives 2.1. Introduction 2.2. History of RBI 2.3. Organizational and Management Structure of RBI 2.4. Roles and Functions of RBI 2.5. Credit Control by RBI 2.6. Summary 2.7. Key Words/Abbreviations 2.8. Learning Activity 2.9. Unit End Questions (MCQ and Descriptive) 2.10. References 2.0 LEARNING OBJECTIVES After studying this unit, students will be able to: • Understand the overview of RBI • Describe the Organisational and Management Structure of RBI • Outline the roles and Functions of RBI • Describe the Credit control policy of RBI 2.1 INTRODUCTION The Reserve Bank of India (RBI) is India's central banking and monetary authority. RBI regulates loans offered by banks and non-banking financial institutions to government entities, businesses, and consumers and controls the availability of funds in the financial system for credit. RBI sets the direction for interest rates and price stability and conducts fund raising activities for the central and the state governments through the auction of government securities. Reserve Bank is

also responsible for monitoring the foreign exchange flows into the Indian economy, managing currency exchange rates and supervising how banks and non-banking financal institutions function. RBI was originally privately owned but is now owned wholly by the Indian government. Set up on April 1, 1935 under the Reserve Bank of India Act, RBI’s central office was initially in Kolkata but moved to Mumbai in 1937. Definition Hawtrey holds that “Central Bank is the lender of last resorts”. Shaw defines a Central Bank as a “A bank which controls credit”. The Reserve Bank of India is India's central bank and regulatory body under the jurisdiction of Ministry of Finance, Government of India and is responsible for the issue and supply of the Indian rupee and the regulation of the Indian banking system. Objectives of RBI : The Preamble to the Reserve Bank of India Act, 1934 spells out the objectives of the Reserve Bank as: “To regulate the issue of Bank notes and the keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage.” In simple,  Regulating the issue of currency in India;  keeping the foreign exchange reserves of the country;  establishing the monetary stability in the country; and developing the financial structure of the country on sound lines consistent with the national socio-economic objectives and policies. 2.2 HISTORY OF RBI Establishment The Reserve Bank of India was established in 1935 under the provisions of the Reserve Bank of India Act, 1934 in Calcutta, eventually moved permanently to Mumbai. Though originally privately owned, was nationalized in 1949.

2.3 ORGANISATION AND MANAGEMENT STRUCTURE OF RBI: The Reserve Bank”s affairs are governed by a central board of directors. The board is appointed by the Government of India for a period of four years, under the Reserve Bank of India Act.  Full-time officials : Governor and not more than four Deputy Governors. The current Governor of RBI is Mr. Urjit Pattel. There are 3 Deputy Governors presently – B P Kanungo, N S Vishwanathan and Viral V Acharya.  Nominated by Government: ten Directors from various fields and two government Officials  Others: four Directors – one each from four local boards POWERS OF RESERVE BANK OF INDIA (RBI) The Reserve Bank of India (RBI) regulates and supervises Public Sector And Private Sector Banks. Under the provisions of the Banking Regulation Act, 1949, it can, inter alia―  inspect the bank and its books and accounts (section 35(1) ibid.);  examine on oath any director or other officer of the bank (section 35(3) ibid.);  cause a scrutiny to be made of the affairs of the bank (section 35(1A) ibid.);  give directions to secure the proper management of the bank (section 35A ibid.);  call for any information of account details (section 27(2) ibid.);

 determine the policy in relation to advances by the bank (section 21 ibid.);  direct special audit of the bank (section 30(1B) ibid.); and  direct the bank to initiate insolvency resolution process in respect of a default, under the provisions of Insolvency and Bankruptcy Code, 2016 (section 35AA ibid.). Further, in respect of nationalized banks and the State Bank of India (SBI), under the provisions of the Banking Companies (Acquisition and Transfer of Undertakings) Acts of 1970 and 1980 (“Bank Nationalization Acts”) and the State Bank of India Act, 1955 (“SBI Act”) respectively, inter alia― RBI’s nominee Director is a member on—  the nationalized bank’s Management Committee of the Board, which exercises the powers of the bank’s Board with regard to credit proposals above specified threshold (section 9(3)(c) of the Bank Nationalisation.Acts, and paragraph 13 of the Nationalised Banks (Management and Miscellaneous Provisions) Schemes of 1970 and 1980 made by the Government under the Bank Nationalisation Acts), and  the Executive Committee of the Central Board of SBI, which may deal with any matter within the competence of the Central Board subject to SBI General Regulations, 1955 and Central Board’s directions (sections 19(f) and 30 of SBI Act, and regulation 46 of SBI General Regulations, 1955);  RBI approves the appointment and fixes the remuneration of the bank’s auditors (section 10 of the Bank Nationalisation Acts, and section 41 of the SBI Act); and  RBI can appoint additional Directors on the nationalized banks’ Boards and State Bank of India’s Central Board (section 9A of the Bank Nationalisation Acts, and section 19B of the SBI Act). In addition, whole-time Directors of nationalized banks and State Bank of India are appointed in consultation with RBI. RBI has powers under other laws as well, which include, inter alia, the power under section 12 of the Foreign Exchange Management Act, 1999 to inspect for compliance with the Act and rules etc. made there under. RBI also maintains the Central Repository of Information on Large Credits (CRILC) on aggregate fund-based and non-fund-based exposures of Rs. 5 crore and above of all banks. Further, RBI maintains the Central Fraud Registry and banks report all frauds involving amount above Rs. 1 lakh to RBI. In addition, RBI’s Master Directions on Frauds lay out guidelines on categorization, reporting and review of frauds, along with norms for consequent provisioning.

The powers of RBI are wide-ranging and comprehensive to deal with various situations that may emerge in all banks, including public sector banks. No proposal with regard to change in RBI’s powers in respect of public sector banks is presently under consideration/consultation. Improvement in regulatory functioning being an ongoing process, Government engages with stakeholders, including RBI, and discusses issues as they evolve. METHODS OF NOTE ISSUE Simple Deposit System: Under this system, the monetary authority is required to keep 100% of the bullion (gold or silver) for every note issued. That is why it is also known as the Full Reserve System. This system has certain merits. It is safe and enjoys public confidence because there is full backing of the bullion for every note issued. The monetary authority cannot take any arbitrary decision in issuing notes. So there is no possibility of over issue of notes. There is also the saving of precious metals through debasement because metal coins are not circulated. However, this system lacks in elasticity firstly, because the money supply cannot be increased without the full backing of bullion reserves. This may be harmful during war or emergency or for development. It may also adversely affect trade and currency. Second, this system is especially unsuited for poor countries lacking insufficient quantities of gold or silver. Third, it is uneconomical for it does not make a profitable use of bullion reserves lying idle with the monetary authority. Thus this system is highly impracticable in modern times. Perhaps this is the reason for its being not put into practice in any country of the world. Fixed fiduciary system : Under this system, a fixed amount of notes is issued by the central bank against reserves of government securities. Such amount is issued on the faith or fiduciary of the central bank and is called the fiduciary limit. The central bank is required to keep 100% gold reserves beyond the fiduciary limit. The fiduciary limit is raised from time to time with the expansion of trade and industry. This system was introduced in England in 1844, in India in 1860, followed by Japan and Norway. This system ensures security, inspires public confidence, and is without any danger of mismanaging the currency through over issue of notes by the central bank. But it has also certain disadvantages. First, it is a rigid and inelastic system because in times of a financial emergency, notes cannot be issued without keeping cent per cent gold in reserves.

Second, the system is inconvenient because in the event of a fall in gold reserves, the central bank has to withdraw notes from circulation with the result that the quantity of money is reduced in the country with its adverse effects on prices, trade and industry. Third, this system is uneconomical because gold reserves are blocked up with the central bank. It was, therefore, abandoned by all countries after World War I when they faced these problems. Maximum Fiduciary System : Under this system, there is a maximum limit up to which the central bank is authorised to issue notes without any gold reserves. But there has to be full backing of gold reserves beyond this limit. The central bank is, however, authorised to raise or lower the maximum fiduciary limit and to fix the quantity of gold reserves. Thus this system is not rigid but is elastic. It is also economical because the gold reserves can be kept to the minimum to meet the requirements of trade and industry. In case the central bank fixes the fiduciary limit very high; there may be excess of notes in circulation thereby leading to inflation. This system was in operation in France, Japan, Russia, Norway, Finland and England. This system has one major defect that there is the possibility of inflation through over issue when the maximum limit may be raised by the government. Proportional Reserve System : In this system, a certain percentage of the total notes issued by the central bank has to be in gold reserves and the remaining in the form of government securities. This percentage varied between 25 to 40 per cent in countries like Switzerland, Holland, Belgium, USA and India. This system is simple and elastic. The money supply can be changed with changes in the percentage of gold reserves. It provides sufficient security because a certain percentage of note issue is supported by gold. Still, this system has certain drawbacks. Firstly, It is uneconomical because large quantities of gold reserves have to be kept which cannot be issued for productive purposes. Second, if the gold reserves fall, the reduction in currency in circulation may be more than in proportion to the fall in reserves. This may lead to deflationary tendencies. The opposite may happen when gold reserves increase.’ This system was in vogue in India between 1927 to 1956. Minimum reserve system: Under the minimum reserve system, the central bank is authorised to issue notes up to any

extent but it must keep a statutory minimum reserve of gold and foreign securities. India adopted this system of note issue in 1956 after discarding the proportional reserve system. Accordingly, the Reserve Bank of India is required to keep a minimum reserve of Rs. 200 crores. Of this, Rs. 115 crores must be in gold and Rs85 crores in foreign securities. This system is highly useful for developing countries because they can meet their financial requirements by printing more notes. They can also reduce the money supply to check inflation. It is, therefore, an elastic system. Further, it is very economical because only a small and fixed amount of gold is required to be kept in reserve. Despite these merits, the minimum reserve system is a dangerous tool in the hands of the monetary authority. It can print any number of notes, thereby creating inflationary pressure within the economy. A corrupt and inefficient government can bring disaster to the economy by excessive printing of notes and thus lose confidence of the people. On the other hand, an efficient and honest administration can transform the economy by a judicious use of this system. 2.4 ROLES AND FUNCTIONS OF RBI Functions of RBI : The functions of RBI may be classified under three heads viz., traditional functions, promotional functions and supervisory functions. Traditional functions 1. Monopoly of note issue: – In terms of section 22 of the RBI Act, the RBI is given the statutory power to issue notes on a monopoly basis. No other bank or institution is allowed to issue notes for public circulation. In the earlier days, the notes used to be issued on the basis of “Proportional Reserve System” wherein the notes were issued in proportion to the reserves of gold coins, gold bullion and foreign securities. However, due to difficulty of maintaining the reserves proportionately, now the “Minimum Reserve System” is adopted to issue notes. Under this system, the RBI should maintain a minimum reserve of Rs. 200 crore worth of gold coins, gold bullion and foreign securities in which gold coin and gold bullion should not be less than 115 crore. Presently RBI issues notes of Rs. 10 denomination and above. Coins and notes of less than Rs. 10 denomination are issued by the government of India. The management of circulation of money is done through currency chests maintained by RBI, SBI, Subsidiaries of SBI,

Public Sector Banks, Government Treasuries and Sub-treasuries. Currency chests refer to the receptacles in which stocks of issuable and new notes and coins are stored. 2. Banker to the Government: - In terms of section 21 of the RBI Act, the government should entrust its money remittance, exchange and banking transactions in India to RBI. In terms of section 21A the state governments should also entrust their remittance, exchange and banking transactions in the respective states to RBI. Therefore, RBI acts as a banker to both the central and state governments. RBI does not earn any income by conducting these functions. However, it earns income by way of commission for managing the governments’ public debt. By virtue of section 45 of the RBI Act, wherever RBI has no branch, SBI or its subsidiaries are required to function as the agents and sub-agents of RBI. These agent or sub-agent banks would get commission on all transactions conducted on turnover basis. Being a banker to the governments the RBI extends “Ways and Means Advances (WMA)” to both central and state governments. “Ways and Means Advances (WMA)” refers to the credit facility to meet the temporary shortfall in government revenue as compared to the monthly expenditure. As a banker to the government RBI renders the following services to the government. a) Collection of taxes b) Payment to various parties c) Accepting of deposits from governments d) Collection of cheques and drafts e) Providing of short term loans to the government f) Maintaining various accounts of the government departments g) Maintaining of currency chests h) Advising the government on their borrowing programs i) Maintaining and operating the central government accounts in International Monetary Fund (IMF)

3. Agent and Advisor to the Government: - The RBI acts as the financial agent and adviser to the government and renders the following services Managing the public debts and accepting the loans on behalf of the government a) Issue of government bonds, treasury bills, etc. b) Advising the government in all important economic and financial matters of the country 4. Banker to the Banks: - The RBI acts as banker to all the scheduled banks. All banks in India are required to keep certain percentage of their demand and time liabilities as reserves with the RBI. This is known as Cash Reserve Ratio (CRR) 5. Acting as National Clearing House: - The RBI acts as the clearing house for settlement of banking transactions in India. The function of clearing house is to settle the interbank claims easily and at low cost. Wherever the RBI does not have a clearing house, the function of clearing house is carried out in the premises of State Bank of India. 6. Acting as Controller of Credit: - One of the primary functions of the commercial banks is credit creation by automatically creating a deposit account as and when a loan or advance is sanctioned to the customer. Credit creation has a direct impact on the economic conditions of the country. Hence the RBI acts as the controller of credit creation through quantitative and qualitative measures. By acting as the controller of credit, RBI would strive to achieve the following objectives: a) Maintaining the desired level of circulation of money b) Maintaining the stability in the prevailing price level in the economy c) Controlling the effects of trade cycles d) Controlling the fluctuations in the foreign exchange rates e) Channelizing the credit to productive sectors of the economy The important measures used by RBI for control of credit creation are: a) Bank Rate Policy

b) Open Market Operations c) Variation of SLR d) Variation of CRR e) Fixation of Margin Requirements f) Moral Suasion g) Issue of Directives h) Direct Action 7. Acting as Custodian of Foreign Exchange Reserves: - The RBI acts as custodian of foreign exchange reserves. Foreign-exchange reserves (also called forex reserves or FX reserves or official international reserves or international reserves), refers to the foreign currency deposits and bonds held by central banks and monetary authorities. It commonly includes foreign exchange and gold, special drawing rights (SDRs) and International Monetary Fund (IMF) reserve positions. Foreign exchange reserves are important indicators of ability to repay foreign debt and for currency defense, and are used to determine credit ratings of nations. 8. Foreign Exchange Control: - Foreign exchange control, popularly referred to as ‘exchange control’ refers to the activity of regulating the demand for foreign exchange for various purposes against the supply constraints. When the Government finds a shortage of foreign exchange due to the low level of external reserves on account of deficit in the balance of payments, exchange control becomes necessary. Exchange control implies a kind of rationing of foreign exchange for the various categories of demand for it. The Reserve Bank of India implements exchange control on a statutory basis. The Foreign Exchange Regulation Act, 1973 empowers the bank to regulate investments as well as trading, commercial and industrial activities in India of foreign concerns (other than banking), foreign nationals and non-resident individuals. Moreover, the holding of immovable property abroad and the trading, commercial and industrial activities abroad by Indian nationals are also regulated by the Bank under exchange control. The Reserve Bank manages exchange control in accordance with the general policy of the Central Government. In India, exchange control is grossly related to and supplemented by trade control. While trade control is confined to

the physical exchange of goods, exchange control implies supervision over the settlement of payments – financial transactions pertaining to the country’s exports and imports. Comparatively, exchange control is more comprehensive than trade control, since it covers all exports and imports as well as invisible and capital transactions of the country’s balance of payments. Under the present exchange control system, the Reserve Bank does not directly deal with the public. The bank has authorized foreign exchange departments of commercial banks to handle the day-to-day transactions of buying and selling foreign exchange. Further, the bank has given money changer’s licences to certain established firms, hotels, shops, etc. to deal in foreign currencies and travellers’ cheques to a limited extent. 9. Publication of Economic Statistics and Other Information: - The RBI collects statistical and other information on economic and financial matters of the country. The statistics and other information so collected are published periodically in an analytical manner. It also presents the genuine financial position of the government and the economic condition of the whole country. 10. Fights against the Economic Crisis: - The RBI aims at the economic stability in the country. Whenever it feels that there is a danger to the economic stability, it immediately interferes and takes suitable measures to put the economy on the right track. For this purpose, it forms and implements various policies and adopts various quantitative and qualitative measures. Promotional Functions 1. Promotion of Banking Habits: - The RBI promotes banking habits among the public through expanding the banking business to various corners of the country and also by establishing various corporations like Deposit Insurance Corporation, Unit Trust of India, IDBI, NABARD, Agricultural Refinance Corporation, Industrial Reconstruction Corporation of India, etc. 2. Providing of Refinance for Export Promotion: - The RBI takes initiative for widening the facilities for financing of foreign trade. Export Credit and Guarantee Corporation (ECGC) and EXIM Bank are established for the purpose of expanding the foreign trade. It also encourages export trade through refinance facilities for export credit granted by commercial banks. Further, it prescribes rates of interest on export credits. 3. Promotion of Agriculture: - The RBI promotes agriculture through financial

facilities on a regular basis. For this purpose, it provides refinance facility to NABARD. Through NABARD it provides short- term and long-term financial facilities at lower rate of interest to agriculture and allied activities. 4. Promotion of Small Scale Industries: - The RBI takes active steps for the promotion of SSI through issuing directives to the commercial banks to extend credit facilities to SSIs. It also encourages commercial banks to provide guarantee services to SSIs. RBI has classified bank advances to SSI as priority sector advance. 5. Promotion of Co-operative Banks: - The RBI extends indirect financing facilities to co-operative banks and connects them with the main banking system of the country. Supervisory Functions 1. Granting of license to Banks: - The RBI grants license to open new banks. It also grants license to open new branches or close existing branches. With this function, the RBI ensures avoidance of unnecessary competition among banks, even growth of banks in different regions, adequate banking facility in all regions, etc. 2. Inspection and Enquiry: - The RBI inspects and makes enquiry in respect of various matters covered under Banking Regulation Act, 1949. 3. Deposit Insurance Scheme: - The RBI implements the deposit insurance scheme for the benefit of small depositors. Under this scheme, deposit of an individual depositor upto Rs. 1,00,000 is guaranteed for payment. Through this scheme, the confidence of common people on the banking system is improved. 4. Review of Working: - The RBI periodically reviews the work done by the commercial banks. It takes suitable measures to enhance the efficiency of the banks and make various policy changes and implement programs for the wellbeing of the nation and for improving the banking system as a whole. 5. Control of NBFCs: - The RBI issues necessary directions to the NBFCs and conducts inspections through which it exercises control over such institutions. Deposit mobilization by NBFCs requires permission from RBI. 2.5 CREDIT CONTROL BY RBI Credit control is an important tool used by Reserve Bank of India, a major weapon of the monetary policy used to control the demand and supply of money (liquidity) in the economy. Central Bank administers control over the credit that the commercial banks grant. Such a method

is used by RBI to bring \"Economic Development with Stability\". It means that banks will not only control. inflationary trends in the economy but also boost economic growth which would ultimately lead to increase in real national income stability. In view of its functions such as issuing notes and custodian of cash reserves, credit not being controlled by RBI would lead to Social and Economic instability in the country. Need for credit control Controlling credit in the economy is amongst the most important functions of the Reserve Bank of India. The basic and important needs of credit control in the economy are-  To encourage the overall growth of the \"priority sector\" i.e. those sectors of the economy which is recognized by the government as \"prioritized\" depending upon their economic condition or government interest. These sectors broadly totals to around 15 in number.  To keep a check over the channelization of credit so that credit is not delivered for undesirable purposes.  To achieve the objective of controlling inflation as well as deflation.  To boost the economy by facilitating the flow of adequate volume of bank credit to different sectors.  To develop the economy. Objectives of credit control The broad objectives of credit control policy in India have been-  Ensure an adequate level of liquidity enough to attain high economic growth rate along with maximum utilisation of resource but without generating high inflationary pressure.  Attain stability in the exchange rate and money market of the country.  Meeting the financial requirement during a slump in the economy and in the normal times as well.  Control business cycle and meet business needs. Methods of credit control There are two methods that the RBI uses to control the money supply in the economy-  Quantitative method  Qualitative method

General or Quantitative Credit Control Measures By virtue of provisions under the RBI Act, 1935 and BR Act, 1949 the RBI exercises credit control through the following quantitative measures: 1. Bank Rate Policy: - Bank Rate, also called as Discount Rate refers to the long-term rate at which RBI lends money to the commercial banks for their liquidity requirements. Bank rate acts as leader of interest rates in the economy of the country. RBI keeps modifying the bank rate to control inflation and recession. At present the bank rate is 7% (September 2015). In the recent years, the RBI is not using bank rate for monetary management. Instead, it is using MSF rate. The present MSF rate is the same as bank rate. 2. Marginal Standing Facility (MSF) - It is a special window for banks to borrow from RBI against approved government securities in an emergency situation like an acute cash shortage. MSF rate is always higher than Repo rate. Current MSF Rate is 7% (June 2016) 3. Open Market Operations: - Open market operations refers to the buying and selling of government securities in the open market in order to expand or contract the amount of money in the banking system. While purchase of government securities by RBI injects more money into the banking system, the sale of government securities takes away money from the banking system. 4. Cash Reserve Ratio (CRR): - By virtue of provisions under the RBI Act, 1935 every commercial bank has to keep a certain percentage (3% to 15%) of its time and demand deposits in the form of cash reserve with the RBI. The percentage of cash reserve to be maintained by commercial banks with RBI is called as Cash Reserve Ratio (CRR). By increasing or decreasing the CRR, RBI regulates the available cash with banking system for lending activities. When a bank's deposits increase by Rs100, and if the cash reserve ratio is 9%, the banks will have to hold Rs. 9 with RBI and the bank will be able to use only Rs 91 for investments and lending purpose. Therefore, higher the ratio, the lower is the amount that banks will be able to use for lending and investment. This power of Reserve bank of India to reduce the lendable amount by increasing the CRR, makes it an instrument in the hands of a central bank through which it can control the amount that banks lend. Thus, it is a tool used by RBI to control liquidity in the banking system. At present the CRR is 4% (June 2016)

5. Statutory Liquidity Ratio: - Every bank is required to maintain at the close of business every day, a minimum proportion of their Net Demand and Time Liabilities as liquid assets in the form of cash, gold and un-encumbered approved securities. Net Demand Liabilities refer to the bank accounts from which one can withdraw his money at any time (like savings accounts and current account). Time Liabilities refer to the bank accounts from which one cannot immediately withdraw his money but have to wait for certain period (like fixed deposit accounts). The ratio of liquid assets to demand and time liabilities is known as Statutory Liquidity Ratio (SLR). RBI is empowered to increase this ratio up to 40%. An increase in SLR restricts the bank's leverage position to pump more money into the economy and vice versa. Thus, it is a tool used by RBI to control the capacity of a bank to extend credit facility. At present the SLR is 21.25% (June 2016) 6. Repo and Reverse Repo Rates: - Repo (Repurchase) rate also known as the benchmark interest rate is the rate at which the RBI lends money to the banks for a short term. When the repo rate increases, borrowing from RBI becomes more expensive. If RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate. Similarly, if it wants to make it cheaper for banks to borrow money it reduces the repo rate. Reverse Repo rate is the short term borrowing rate at which RBI borrows money from banks. The Reserve bank uses this tool when it feels there is too much money floating in the banking system. An increase in the reverse repo rate means that the banks will get a higher rate of interest from RBI. As a result, banks prefer to lend their money to RBI which is always safe instead of lending it others (people, companies etc) which is always risky. Repo Rate signifies the rate at which liquidity is injected in the banking system by RBI, whereas Reverse Repo rate signifies the rate at which the central bank absorbs liquidity from the banks. Reverse Repo Rate is linked to Repo Rate with a difference of 0.5% between them. At present the Repo and Reverse Repo Rate is 6.5% and 6% (June 2016). Selective or Qualitative Credit Control Measures Under selective credit measures, the credit is provided to only selected borrowers for only selected purposes depending upon the specific needs of the economy. The important measures under this are as follows:

1. Ceiling on Credit: - Under this measure, the RBI fixes the maximum ceiling on the amount of loan that can be granted by the commercial banks against certain controlled securities. 2. Margin Requirements: - Under this measure, the RBI fixes the margin requirement for sanctioning loan. Margin refers to the amount to be contributed by the borrower towards the collateral security against which the loan is raised. For example, if the borrower wants to do a business that requires an investment of Rs. 100, the bank may require him to contribute Rs. 20 as capital and the remaining Rs. 80 may be sanctioned by the bank as loan. In this case, Rs. 20 contributed by the entrepreneur is called as margin money. The credit creation by banks may be controlled by either increasing or decreasing the margin requirement so that the lending capacity of the bank is controlled. 3. Discriminatory Interest Rate (DIR): - Under this measure, the RBI fixes different rates of interest on different types of loans and ensures flow of credit to various sectors. For example, RBI fixes concessional rate of interest on the loan sanctioned to priority or weaker sectors and ensures flow of more credit to that sector. 4. Directives: - Under this measure, the RBI issues directives to the banks regarding the purpose for which loans may or may not be given by them. 5. Direct Action: - Under this measure, the RBI may take direct action by refusing to rediscount the bill or cancelling the license of the bank. This measure is rarely adopted by the RBI 6. Moral Suasion: - Under this measure, the RBI issues periodical letters requesting the banks to exercise control over the credit in general or advances against particular commodities. The RBI may also organize periodical meetings with the officials of the banks and persuade them to control the credit towards certain directions.

2.6 SUMMARY  RBI is regulator for financial and banking system, formulates monetary policy and prescribes exchange control norms.  Non-banking Financial Institutions provide loans and hire-purchase finance, mostly for retail assets and are regulated by RBI.  RBI also regulates foreign exchange under the Foreign Exchange Management Act (FEMA).  The Banking Regulation Act, 1949, gave RBI the powers to regulate, supervise and develop the banking system.  In 2001, RBI issued licenses to 2 new banks, Kotak Mahindra and Rabo Bank. FDI limit in the banking sector increased to 51 percent.  In 2002, Union Government allows the conversion of the branch operations of foreign banks into subsidiaries. RBI approves the merger of ICICI and ICICI Bank, making it the second largest bank in India. in terms of assets. Kotak Mahindra Finance, an NBFC, announces its intention to convert itself into a bank.  The cooperative banks are under the regulatory control of Reserve Bank of India (RBI).  The RBI now regulates and supervises the activities of NBFCs with a view to ensure their growth on sound.  The Reserve Bank of India Act, 1934 was commenced on April 1, 1935. The Act, 1934 provides the statutory basis of the functioning of the bank.  The bank was constituted for the need to regulate the issue of banknotes, maintain reserves with a view to securing monetary stability and operate the credit and currency system of the country to its advantage.

 Reserve Bank plays very important role in Indian economy by maintaining economic stability, price stability and ensuring overall development of the economy.  The main functions of the RBI include being the bank of note issue.  RBI is also the banker to the Indian government.  It also performs the function of being a bankers' bank and the lender of the last resort. 2.7 KEY WORDS/ABBREVIATIONS RBI Fiduciary Proportional Minimum Bank Rate Reserve reserve system Policy System Open Market Moral Suasion Custodian Refinance NBFCs Operations Quantitative Qualitative Marginal Cash Reserve Statutory method method Standing Facility(MSF) Ratio (CRR) Liquidity Ratio 2.8 LEARNING ACTIVITY Activity 1 : Find how many companies are registered under RBI as equipment leasing, hire-purchase, loan and investment companies respectively. Enlist the major players in each. Activity 2. : Find out what are the developmental activities RBI is involved in and evaluate them one by one. 2.9 UNIT END QUESTIONS (MCQ AND DESCRIPTIVE) A. Descriptive Types Questions 1. Describe the supervision framework prescribed by the RBI ? 2. What is the differences between Bank Rate and Repo Rate?

3. What role is played by the RBI in order to keep the economy stable? 4. “RBI has started doing commercial banking functions also.” Discuss. 5. Do you think RBI has been able to successfully shield Indian economy from the global recession? Support your argument with reasons. Short Answer 6. “RBI has emerged as one of the strongest central banking authorities of the world.“ Comment. 7. Discuss about the relationship between the commercial bank and RBI. How does RBI regulate the working of commercial banks? 8. What are the current challenges to Indian monetary policy? B. Multiple Choice Questions 1. The monetary functions are also known as the .............. functions of the RBI. a. Attracting and Retaining High-Quality Employees b. Central Banking c. Continuously Motivating Them To Improve Their Performance. d. All of these 2. Which of the following defines Non Banking Financial Companies? a. Chapter IVC of the Reserve Bank of India Act, 1934. b. Chapter IIIB of the Reserve Bank of India Act, 1934. c. Chapter IVE of the Reserve Bank of India Act, 1934 d. Chapter IIIC of the Reserve Bank of India Act, 1934 3. The can ask information relating to, as well as issue directions for the conduct of the NBFCs’ business. a. CBI b. SBI c. RBI d. SEBI 4. Being the monetary authority of the economy, RBI is responsible for ................, ............... and ................ the monetary policy of India. a. implementing, formulating, monitoring

b. Coordinationg and Ordering c. Supervision, Control and Maintain d. Manage, Supervision and Control. 5. The ................ function of the RBI may be regarded as a non-monetary function. a. supervisory b. Control c. Manage d. Maintain 2.10 REFERENCES Text Books:  T1 Fabozzi - Foundations of Financial Markets and Institutions (Pearson Education,3rdEd.).  T2 Khan M Y - Financial Services (Tata Mc Graw Hill).  R1 Machiraju H R - Indian Financial System (Vikas Publication).  R2 Bhole L M - Financial Institutions and Markets (Tata McGraw-Hill).

UNIT - 3: MONETARY AND FISCAL POLICIES Structure 3.0. Learning Objectives 3.1. Introduction 3.2. Objectives of Monetary Policies 3.3. Advantages and Disadvantages of Monetary Policies 3.4. Instruments of Monetary Policy 3.5. Fiscal Policy 3.6. Various Types of Fiscal Policies 3.7. Difference between Fiscal and Monetary Policies. 3.8. Summary 3.9. Key Words/Abbreviations 3.10. Learning Activity 3.11. Unit End Questions (MCQ and Descriptive) 3.12. References 3.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  Understand the concept of Monetary Policy  Describe the Advantages and Disadvantages of Monetary Policy  Evaluate the instruments of Monetary Policy  Explain the Fiscal Policy.  Describe the difference between Monetary and Fiscal Policy.

3.1 INTRODUCTION The Monetary Policy is the plan of action undertaken by the monetary authority, especially the central banks, to regulate and control the demand for and supply of money to the public and the flow of credit so as to achieve the macroeconomic goals. The goals of the monetary policy are to control the money supply and set the inflation rate and the interest rate at a level such that the price stability and overall trust in the currency are ensured. Also, the monetary policy contributes towards the economic growth and stability, reduce unemployment and maintain a predictable exchange rate with other currencies. Definition “Monetary policy involves the influence on the level and composition of aggregate demand by the manipulation of interest rates and the availability of credit”-D.C. Aston. R.P. Kent has defined the monetary policy as “The management of the expansion and contraction of the volume of money in circulation for the explicit purpose of attaining a specific objective such as full employment.” Dr.D.C. Rowan remarked, “The monetary policy is defined as discretionary action undertaken by the authorities designed to influence: a. The supply of money, b. Cost of Money or rate of interest and The availability of money.” 3.2 OBJECTIVES OF MONETARY POLICIES According to RBI Governor Dr. D. Subba Rao, “The objectives of monetary policy in India are price stability and growth. These are pursued through ensuring credit availability with stability in the external value of rupee and overall financial stability.” Following are the main objectives of monetary policy: To Regulate Money Supply in the Economy: Money supply includes both money in circulation and credit creation by banks. Monetary policy is farmed to regulate the money supply in the economy by credit expansion or credit contraction. By credit expansion (giving more loans), the money supply can be expanded. By credit

contraction (giving less loans) money supply can be decreased. The main aim of the monetary policy of the Reserve Bank was to control the money supply in such a manner as to expand it to meet the needs of economic growth and at the same time contract it to curb inflation. In other words monetary policy aimed at expanding and contracting money supply according to the needs of the economy. To attain price stability: Another major objective of monetary policy in India is to maintain price stability in the country. It implies Control over inflation. Price level, is affected by money supply. Monetary policy regulates money supply to maintain price stability. To Promote Economic Growth: An important objective of monetary policy is to make available necessary supply of money and credit for the economic growth of the country. Those sectors which are quite significant for the economic growth are provided with adequate availability of credit. To Promote Saving And Investment: By regulating the rate of interest and checking inflation, monetary policy promotes saving and investment. Higher rates of interest promote saving and investment. 3.3 ADVANTAGES AND DISADVANTAGES OF MONETARY POLICIES Advantages of Monetary Policy :  It Can Bring Out The Possibility Of More Investments Coming In And Consumers Spending More. In an expansionary monetary policy, where banks are lowering interest rates on loans and mortgages, more business owners would be encouraged to expand their ventures, as they would have more available funds to borrow with affordable interest rates. Plus, prices of commodities would also be lowered, so consumers will have more reasons to purchase more goods. As a result, businesses would gain more profit while consumers can afford basic commodities, services and even property.  It Allows For The Imposition Of Quantitative Easing By The Central Bank. The Federal Reserve can make use of a monetary policy to create or print more

money, allowing them to purchase government bonds from banks and resulting to increased monetary base and cash reserves in banks. This also means lower interest rates and, eventually, more money for financial institutions to lend its borrowers.  it can lead to lower rates of mortgage payments. As monetary policy would lower interest rates, it would also mean lower payments home owners would be required for the mortgage of their houses, leaving homeowners more money to spend on other important things. It would also mean that consumers will be able to settle their monthly payments regularly—a win-win situation for creditors, merchandisers and property investors as well!  It Can Promote Low Inflation Rates. One of the biggest perks of monetary policy is that it can help promote stable prices, which are very helpful in ensuring inflation rates will stay low throughout the country and even the world. As inflation essentially makes an impact on the way we spend money and how much money is worth, a low inflation rate would allow us to make the best financial decisions in life without worrying about prices to drastically rise unexpectedly.  It promotes transparency and predictability. A monetary policy would oblige policymakers to make announcements that are believable to consumers and business owners in terms of the type of policy to be expected in the future.  It promotes political freedom. Since the central bank can operate separately from the government, this will allow them to make the best decisions based upon how the economy is performing doing at a certain point in time. Also, the banks would operate based on hard facts and data, rather than the wants and needs of certain individuals. Even the Federal Reserve can operate without being exposed to political influences.  Disadvantages of Monetary Policy  It Does Not Guarantee Economy Recovery. Economists who criticize the Federal Reserve on imposing monetary policy argue

that, during recessions, not all consumers would have the confidence to spend and take advantage of low interest rates, making it a disadvantage.  it is not that useful during global recessions. Proponents of expansionary monetary policy state that even if banks lower interest rates for consumers to spend more money during a global recession, the export sector would suffer. If this is the case, export losses would be more than what commercial organizations could earn from their sales.  Its Ability To Cut Interest Rates Is Not A Guarantee. Though a monetary policy is said to allow banks to enjoy lower interest rates from the Central Bank when they borrow money, some of them might have the funds, which means that there would be insufficient funds that people can borrow from them.  It Can Take Time To Be Implemented. With things expected to be done immediately in these modern times, implementing a monetary can certainly take time, unlike other types of policies, such as a fiscal policy, that can help push more money into the economy faster. According to experts, changes that are made for a monetary policy might take years before they begin to take place and make changes felt, especially when it comes to inflation.  It Could Discourage Businesses To Expand. With this policy, interest rates can still increase, making businesses not willing to expand their operations, resulting to less production and eventually higher prices. While consumers would not be able to afford goods and services, it would take a long time for businesses to recover and even cause them to close up shop. Workers would then lose their jobs. Monetary policy is used in to help keep economic growth and stability, but there is no guarantee that it would always help society, considering that it also has its own set if drawbacks.  TO CONTROL BUSINESS CYCLES: Boom and depression are the main phases of business cycle. Monetary policy puts a check

on boom and depression. In period of boom, credit is contracted, so as to reduce money supply and thus check inflation. In period of depression, credit is expanded, so as to increase money supply and thus promote aggregate demand in the economy.  TO PROMOTE EXPORTS AND SUBSTITUTE IMPORTS: By providing concessional loans to export oriented and import substitution units, monetary policy encourages such industries and thus help to improve the position of balance of payments.  TO MANAGE AGGREGATE DEMAND: Monetary authority tries to keep the aggregate demand in balance with aggregate supply of goods and services. If aggregate demand is to be increased than credit is expanded and the interest rate is lowered down. Because of low interest rate, more people take loan to buy goods and services and hence aggregate demand increases and vice-verse.  TO ENSURE MORE CREDIT FOR PRIORITY SECTOR: Monetary policy aims at providing more funds to priority sector by lowering interest rates for these sectors. Priority sector includes agriculture, small- scale industry, weaker sections of society, etc.  TO PROMOTE EMPLOYMENT: By providing concessional loans to productive sectors, small and medium entrepreneurs, special loan schemes for unemployed youth, monetary policy promotes employment.  TO DEVELOP INFRASTRUCTURE: Monetary policy aims at developing infrastructure. It provides concessional funds for developing infrastructure. 3.4 INSTRUMENTS OF MONETARY POLICIES The instruments of monetary policy are of two types: first, quantitative, general or indirect; and second, qualitative, selective or direct. They affect the level of aggregate demand through the supply of money, cost of money and availability of credit. Of the two types of instruments, the first category includes bank rate variations, open market operations and changing reserve requirements. They are meant to regulate the overall level of credit in the economy through commercial banks. The selective credit controls aim at controlling specific types of credit. They include changing margin requirements and regulation of consumer credit. We discuss them as under:

 BANK RATE POLICY: The bank rate is the minimum lending rate of the central bank at which it rediscounts first class bills of exchange and government securities held by the commercial banks. When the central bank finds that inflationary pressures have started emerging within the economy, it raises the bank rate. Borrowing from the central bank becomes costly and commercial banks borrow less from it. The commercial banks, in turn, raise their lending rates to the business community and borrowers borrow less from the commercial banks. There is contraction of credit and prices are checked from rising further. On the contrary, when prices are depressed, the central bank lowers the bank rate. It is cheap to borrow from the central bank on the part of commercial banks. The latter also lower their lending rates. Businessmen are encouraged to borrow more. Investment is encouraged. Output, employment, income and demand start rising and the downward movement of prices is checked.  Open Market Operations: Open market operations refer to sale and purchase of securities in the money market by the central bank. When prices are rising and there is need to control them, the central bank sells securities. The reserves of commercial banks are reduced and they are not in a position to lend more to the business community. Further investment is discouraged and the rise in prices is checked. Contrariwise, when recessionary forces start in the economy, the central bank buys securities. The reserves of commercial banks are raised. They lend more. Investment, output, employment, income and demand rise and fall in price is checked.  Changes In Reserve Ratios: This weapon was suggested by Keynes in his Treatise on Money and the USA was the first to adopt it as a monetary device. Every bank is required by law to keep a certain percentage of its total deposits in the form of a reserve fund in its vaults and also a certain percentage with the central bank. When prices are rising, the central bank raises the reserve ratio. Banks are required to keep more with the central bank. Their reserves are reduced and they lend less. The volume of investment, output and employment are adversely affected. In the opposite case, when the reserve ratio is