INTRODUCTION TO CENTRAL BANK

The central bank is the bank which stands as the lender of money,
issue notes and coins, supervises, controls and regulates the activities
of the banking system and acts as the banker to the government. In
the pyramidal financial structure of a modern economy, the central
bank lies at the top. In other words, the central bank lies at the top. In
other words, central bank acts as the head of the banking institutions
of the country. The central bank is the apex institution of the
monetary and banking structure of a country. It seeks to manage a
macro economy in such a fashion as to promote social welfare. At
present there is no country in the world of any importance that does
not have a central bank. The establishment of a central bank in a
modern economy is essential as it the apex institution of a country’s
financial as well as monetary system. Thus every independent country
should have a central bank for organizing, running, supervising,
regulating and developing its monetary system. Moreover,
implementation of the government’s economic policy requires the
presence of central bank which stands as the undisputed leader of the
money market. Thus, the central bank is one of the inventions of the
modern civilization.
 FUNCTIONS OF CENTRAL BANKS

There are certain differences in the style of functioning of a central

bank in different countries. Its functions in a less developed country
differ from those in a developed country. In developed countries
Central banks, such as the Federal Reserve Board in the United States,
conducts a wide range of banking regulatory and supervisory
functions. They have substantial public responsibilities and a board
array of executive powers.

Central banks, perform certain common but vital functions in every

country. The important functions of central banks are as follows:

i. Monopoly power of note-issue.

ii. Banker’s bank.
iii. Controller of credit.
iv. Banker to the Government.
v. Custodian of Foreign Exchange reserves.
vi. Promotional and development functions.
vii. Regulator of domestic financial institutions.
 RESERVE BANK OF INDIA

The Reserve Bank of India is the central bank of India. The Reserve
Bank of India was established on April 1, 1935 in accordance with the
provisions of the Reserve Bank of India Act, 1934.

Though originally privately owned, since nationalization in 1949, the

Reserve Bank is fully owned by the Government of India. The Central
Office of the Reserve Bank was initially established in Calcutta but was
permanently moved to Mumbai in 1937. The Central Office is where
the Governor sits and where policies are formulated.

Preamble

The Preamble of the Reserve Bank of India describes the basic

functions of the Reserve Bank as:

"...to regulate the issue of Bank Notes and keeping of reserves with a
view to securing monetary stability in India and generally to operate
the currency and credit system of the country to its advantage."

Central Board
The Reserve Bank's affairs are governed by a central board of
directors. The board is appointed by the Government of India in
keeping with the Reserve Bank of India Act.

• Appointed/nominated for a period of four years

• Constitution:

o Official Directors
  Full-time : Governor and not more than four Deputy
Governors
o Non-Official Directors
 Nominated by Government: ten Directors from various fields
and one government Official
 Others: four Directors - one each from four local boards

Local Boards

• One each for the four regions of the country in Mumbai, Calcutta,
Chennai and New Delhi
 • Membership:
• Consist of five members each
• Appointed by the Central Government
• For a term of four years

Functions:
To advise the Central Board on local matters and to represent
territorial and economic interests of local cooperative and indigenous
banks; to perform such other functions as delegated by Central Board
from time to time.

Main Functions

1. Monetary Authority:

• Formulates, implements and monitors the monetary policy.

• Objective: maintaining price stability and ensuring adequate flow
of credit to productive sectors.

2. Regulator and supervisor of the financial system:

• Prescribes broad parameters of banking operations within which

the country's banking and financial system functions.
• Objective: maintain public confidence in the system, protect
depositors' interest and provide cost-effective banking services
to the public.

3. Manager of Foreign Exchange

• Manages the Foreign Exchange Management Act, 1999.

• Objective: to facilitate external trade and payment and promote
orderly development and maintenance of foreign exchange
market in India.
4. Issuer of currency:

• Issues and exchanges or destroys currency and coins not fit for
circulation.
• Objective: to give the public adequate quantity of supplies of
currency notes and coins and in good quality.

5. Developmental role

• Performs a wide range of promotional functions to support

national objectives.

6. Related Functions

• Banker to the Government: performs merchant banking function

for the central and the state governments; also acts as their
banker.
• Banker to banks: maintains banking accounts of all scheduled
banks.
 INSTRUMENTS OF CENTRAL BANKING POLICY

The legal framework of the RBI’s control over the credit structure has
been provided under the Reserve Bank of India Act, 1934 and the
Banking Regulation Act, 1949. The RBI was empowered to use almost
all the traditional instruments of credit control under the RBI Act. The
Banking Regulation Act has given it additional powers to use some
other direct methods of credit control and regulation. Thus, the RBI’s
powers to control the banking system are fairly comprehensive. Like
any other central bank, RBI resorts to bank rate, open market
operations, reserve requirements, direct action, rationing of credit and
moral suasion as instruments of its policy.

The Indian system has helped in the mobilization of the five year plans.
It has also attempted to control the inflationary process inherent in
rapid economic development. Apart from employing instruments of
credit control, the RBI directly influences commercial bank’s lending
policy, rate of interest, form of securities against loans, and portfolio
distribution. However, RBI has no powers over non-banking financial
institutions as well as indigenous bankers who also pay a major role in
financing industry. The RBI has been using both quantitative and
selective credit controls so that the deployment of loans and advances
by the commercial banks for speculative purposes was under control.
The following are the important instruments of Central Banking Policy:

1. Bank Rate Policy 6. Credit Authorization Scheme

2. Cash Reserve Ratio (CAS)
3. Open Market Operations 7. Credit Monitoring Arrangement
4. Selective Credit Controls (CMA)
5. Statutory Liquidity Ratio
BANK RATE POLICY

The rate at which a central bank is prepared to lend money to its

domestic banking system is known as bank rate. Bank rate, also
referred to as the discount rate, is the rate of interest which a central
bank charges on the loans and advances that it extends to
commercial banks and other financial intermediaries. Changes in the
bank rate are often used by central banks to control the money
supply.

The bank rate is the RBI’s discount rate. It is an important monetary

instrument in modern banking. The bank rate has an important role
to signal and/or clarify the central bank’s monetary and interest rate
stance to all participants in the financial sector and particularly to
banks. If monetary policy of the RBI is effective and credible, a
change in the bank rate will result into a change in prime lending
rate of banks. Thus, it acts as an independent instrument of
monetary control.

RBI started with a cheap money policy as per tradition of 1930s. It

had fixed a low bank rate of 3% in 1930 and did not change it till
1953 when it raised the bank rate to 3.5%. The bank rate gradually
rose to 10% in July 1981. It remained unchanged for another 10
years i.e. till 1991. It was revised upwards to 11% in July 1991 and
further to 12% in October 1991. It was reduced to 10% in the year
1998. The final reduction in the bank rate was made on April 29,
2003 from 10% to 6% per annum in phases. This was considered
necessary to counter act the inflationary pressure. However, under
the conditions that prevailed in India from time to time. The bank
rate change was not very efficient method to regulate the supply of
credit and money. The increase in the bank rate was intended to be
a warning signal for apart from its psychological effect. The
experience in India is that even as an instrument for controlling only
the amount of bank borrowings the bank rate is not very efficient.
The most important reason is that by varying merely the bank rate,
the RBI cannot vary the interest rate differential between the lending
rates of banks and the cost of borrowed reserves, the factor which
determines the extend of profitability to banks from borrowings.
The situation has changed since the introduction of economic
reforms in the year 1991. As the part of financial sector reforms the
RBI has taken steps to strengthen the bank rate as the policy
instrument for transmitting signals of monetary and credit policy. It
now serves as a reference rate for other rates in the financial
markets.

Releasing the First Quarter Review of Annual Statement on Monetary

Policy for the Year 2007-08, Reserve Bank of India Governor Y V
Reddy announced that Bank rate; reverse repo rate and repo rate
would remain unchanged.

The effectiveness of the bank rate policy depends mainly on three

factors:

1. The commercial banks in the country should not be averse to

availing rediscounting from the central bank.
2. Banks do not maintain any excess cash reserve again deposits
and thus extra ordinary demands are made by the depositors;
 they have no option except that they rediscount bills from the
central bank.
3. Banks must hold adequate quantity of such credit instrument
which will be rediscounted by the central bank as per
legislation.

The commercial banks in India are not much dependent on the RBI for
financial assistance. In absence of a well organized bill market, they
lack adequate quantity of eligible bills which can be rediscounted from
RBI. Proper organization of the various components of the money
market is a pre-requisite for the success of the RBI’s bank rate policy.

The role of Bank rate as an instrument of monetary policy has been

very limited in India. The structure of interest rates is administered by
RBI. They are not automatically linked to the bank rate. Commercial
banks enjoy specific refinance facility and not necessarily rediscount
their eligible securities with RBI at bank rate. The bill market in India
is underdeveloped and the different sub markets of the money market
are not influenced by the bank rate. The bank rate in India is also not
the ‘pace setter’ to the other market rates of interests and the money
market rates do not automatically adjust themselves to changes in the
bank rate. Again, the deposit rates and lending rates of banks are
not related to the bank rate. The GOI and RBI have been reviewing the
rules and procedures for and procedures for general access to RBI
rediscount facilities so as to make bank rates and active instrument
monetary policy. India passed through a severe liquidity crunch and
as a result the prime lending rates were ruling high. Industrial
production was affected adversely. RBI took steps to reduce the bank
rate from 12 to 11 percent in April, 1997 to 10 percent in June 1997
and 9 percent in October 1997 and was maintained at 8 per during
1999 –2000. The reduction of the bank rate was to help in the
reduction of other interest rates and to stimulate borrowings from
banks.

CASH RESERVE RATIO

Under the RBI Act, 1934, every commercial bank has to keep certain
minimum cash reserves with RBI. Initially the CRR was 5% against
demand deposits and 2% against time deposits. Since 1962, RBI was
empowered to vary the cash reserve ratio between 3% and 15% of the
total demand and time deposits. In 1973 RBI exercised this power
twice, as a form of credit squeeze. The CRR was raised from 3% to 5%
in June 1973 and again to 75 in September, 1973. RBI has revised the
CRR a number of times since then in order to influence the volume of
cash with the commercial banks and also to influence their volume of
cash with the commercial banks and also to influence their volume of
credit.

The CRR is an effective instrument of credit control in India. Under the

RBI (Amendment) Act, 1962, the RBI is empowered to determine CRR
for the commercial banks in the range of 3% to 15% for the aggregate
demand and time liabilities. This instrument of credit control was used
quite often during the 1970s and 1980s for controlling inflation. In the
late 1980s, there was rapid growth of liquidity and therefore the CRR
was raised from 10% to 15%. For another 4 years the CRR remained
unchanged at 15%.

The Narsimham Committee did not favor use of CRR to combat

inflationary pressures. According to him, a high CRR adversely affects
banks profitability. It also pressurizes banks all the time to charge
high interest rates on their commercial sector advances. Therefore,
the government decided to reduce the CRR over a four-year period to
level of below 10%. At a first step in the pursuit of this objective CRR
was reduced in two phases from 15% to 14.5% effective from April 17,
1993 and further to 14% effective from March 15, 1993. On account of
persistent inflationary pressures, the RBI again revised its policy and
raised the CRR from 14% to 15% of net demand and time liabilities in
three phases from June 11 to August 6, 1994. It helped to a decline in
money growth in 1995-96. This was also reflected in the
modernization of inflationary pressures. The CRR was brought down to
14% on December 9, 1995 and 13% on May 11, 1996. Thereafter the
rate of CRR was continuously reduced over seven years. The final
reduction of CRR was made to 4.5% of demand and time liabilities
effective from June 14, 2003. The CRR on Oct 31, 2007 was 6% of
demand and time liabilities of the banks. All these reductions of CRR
freed cash balances and the loanable resources of the commercial
banks.

The volume of cash with the commercial banks is regulated by the RBI
through the mechanism of CRR. If the RBI feels that the credit has
already been increased in the market, it increases the CRR so that the
banks have to deposit additional cash with RBI. This reduces the credit
capacity of the commercial banks and hence the credit is controlled by
RBI through the CRR. On the other hand, if the credit is low and there
are liquidity problems in the market the RBI can reduce the percentage
of CRR. As a result the banks will get more liquid cash which will
increase the liquidity in the market as well as more credit can be
created with additional cash with the banks. There was a pressure on
RBI to reduce CRR to international levels. Therefore, RBI had reduced
the CRR after 1991.
How will the CRR hike impact you as an investor/borrower

From a stock market perspective

Rising interest rates have several implications including –

Slowing downs the overall growth in the economy; this effectively

means that demand for goods and services, and investment activity,
gets adversely impacted.

Apart from the fact that overall growth is impacted, companies take a
hit on account of higher interest costs that they have to bear on their
outstanding loans (to the extent their cost of funds is not locked in)
Since some investors tend to leverage and invest in the stock markets,
higher interest rates increase expectation of returns from the stock
markets; this has the impact of lowering current stock prices. An
overall decline in stock prices has a cascading effect as leveraged
positions are unwound (on account of meeting margin requirements),
leading to still lower stock prices.

So, from a short-term perspective, higher interest rates should

adversely impact stock market sentiment.

From a long-term perspective however our expectations of returns

from the stock markets remains unchanged. As mentioned earlier,
RBI's move to tame inflation over the long term augurs well for long-
term economic growth (there is more predictability and therefore risk
premiums are lower). This will ultimately benefit well-managed
companies.
 Acknowledgement

We feel great pleasure in reporting that we have well completed our

project on “Instruments of Central Banking (Bank Rate &
Cash Reserve Ratio)” as a part of our curriculum in VI Semester
of T.Y. Banking & Insurance.

All the group members did everything to enlighten the views and
make this research successful.

At the end of this enjoyable project we would like to take this

opportunity to thank Professor Chitnis for providing us this
platform to prove our creativity through this project.

We would also like to thank family and friends for providing their
timely help during the preparation of the project.

Thank You!
 CENTRAL BANKING

T.Y. Banking and Insurance

Semester VI

Submitted to:
Prof. Chitnis

Submitted by:

Swapna Karmarkar [Roll no. 21]

Suresh Khankriyal [Roll no. 22]
Jatin Kothari [Roll no. 23]
Sonia Jose [Roll no. 24]
Shrutee Pai [Roll no. 33]
Mayur Panjari [Roll no. 34]
Swati Patil [Roll no. 35]
Yogesh Patil [Roll no. 36]