If you want to be well-versed with how India works, the country’s financial aspect is something you must essentially know about. Being a vital part of India’s financial system, the Reserve Bank of India or RBI is a must-read.
Before we get into the details of RBI, let us brief you on what exactly it is.
Table of Contents
- What is RBI?
- History of RBI
- Pre-RBI Era
- Organisation structure
- How RBI Regulates the Financial Markets
- Functions of RBI
- Limitations of the RBI
- Effect on Economy: How does RBI Control Interest Rates?
- RBI Annual Publications
What is RBI?
Reserve Bank of India or RBI is the central bank of the country that serves India’s financial market in several ways. RBI was established under the Reserve Bank of India Act on April 1st, 1935. It was set up during the British-Raj, by the commendation of the Hilton Young Commission.
The RBI applies monetary policies to promote financial stability in India. It is also the authorising body in controlling the national currency and credit structures.
History of RBI
Central banks are a relatively recent concept in our country. Most central banks, as we know them today, came about in the 20th century.
The Hilton Young Commission initially suggested the formation of the Reserve Bank of India. Its operations began on April 1st, 1935.
The bank was fundamentally instituted to perform three main functions:
- Acquiring monetary stability by regulating reserves
- Paying attention to banknote issues
- Facilitating the nation’s currency and credit systems
The functions performed by the Controller of Currency and the Imperial Bank of India were handed over to the RBI by the Government. This includes managing the debts and accounts of the Government. The offices of the Banking sector were set in Calcutta, Madras, Delhi, Bombay and Rangoon. The branches of the Issue Department are presently in Calcutta, Madras, Bombay, Rangoon, Karachi, Kanpur and Lahore.
The Reserve of Bank of India stood out because of its contribution to agricultural development. The developmental significance of RBI became prominent in the 1960s. It brought in a financial angle that regulated development greatly.
Initially, the RBI was only formed to serve a bank for private shareholders. It became the nation’s central bank in the years 1949, after independence.
Before the RBI came into force, the Imperial Bank of India performed all the functions typically executed by a central bank.
The Imperial Bank of India incorporated three Presidency banks into one solid unit. It was established in 1921 under the Imperial Bank of India Act, 1920. The idea behind the Imperial Bank of India was to have a body that executes all the functions Central Bank.
Despite Burma’s/Myanmar’s separation from the Indian Union in 1937, the RBI still played the role of Central Bank for Burma as well. The RBI continued to do so until the Japanese Occupation of Burma and finally superseded in April of 1947. After India’s partition, The RBI acted as the Central Bank of Pakistan as well until June of 1948, after which, the State Bank of Pakistan took control.
The Reserve Bank of India has a central board of directors that supervise the functions and general affairs of the bank. Each board is appointed for 4 years, after which the Government of India re-elects the members of the board, under the Reserve Bank of India Act.
- Central Board of Directors: The board consists of one Governor and a maximum of four Deputy Governors.
- The Government of India appoints ten directors from separate fields, along with two government Officials.
- The Deputy Governors and Directors can attend board meetings. However, they do not have the power to vote.
- Others: There is one director from each local board.
How RBI Regulates the Financial Markets
The Reserve Bank of India is involved in regulating the financial market and maintaining its stability. This regulation is taking place in direct and indirect ways.
Cash Reserve Ratio (CRR): The mandatory bank’s share in the total deposit of any bank is regulated in the form of liquid cash by the RBI. This share is called the Cash Reserve Ratio or CRR. The RBI utilises CRR in two ways:
- Releasing excess liquidity from the nation’s economy
- Discharging extra funds required for the economy’s growth
Statutory Liquidity Ratio (SLR): Apart from the CRR, banks must also upkeep liquid assets. These assets can be in the form of gold or approved securities. If the SLR increases, banks reduce allowing loans.
Repo Rate/ Repurchase Rate: The standard interest rate at which RBI allows other banks to borrow money for a short period is called the Repurchase rate or Repo rate. An increase in the repo rates makes money lending by RBI a more expensive task. Consequently, the customers or the public need to carry the burden of high-interest rates. RBI increases the Repo Rate as a tool to manage inflation. This way, borrowing money from the RBI will become more expensive due to the low availability of money. During times of deflation, the RBI does vice-versa.
Reverse Repo Rate (RRR): The rate at which the RBI borrows money from other banks is called the Reverse Repo Rate or RRR. RRR is a short-term rate. The RBI employs this system to keep inflation in check, during times of excessive money flow in the bank. RBI increases RRR to offer profitable interest rates to banks to deposit their money to the RBI. Accordingly, there is a decrease in the amount of money for customers. Banks then choose to deposit their money to the RBI, ensuring better safety.
Functions of RBI
The functions of RBI can be categorised under three headings:
- Traditional Functions
- Supervisory Functions
- Promotional Functions
These functions include fundamental activities that all central banks of every nation are expected to perform.
Issuance of Notes:
The present note issuance system is called the ‘Minimum Reserve System’. Reserve Bank of India now produces the new Mahatma Gandhi notes in 10-rupee denominations. The RBI is exclusively authorised for these functions under section 22, Reserve Bank of India Act of 1934.
The role of the bank is not limited to producing currency, withdrawing or circulating it. It is also responsible for the exchange between coins and notes of various denominations, as per public demand. Every affair associated with the issuance of notes is dealt with by the Bank’s ‘Issue Department’. RBI is the only body authorised to produce currency notes in the country.
Banker, Agent and Financial Advisor:
Under section 20, Reserve Bank of India Act od 1934, the RBI plays a role as the ‘Government’s Banker’.
Section 21 of the RBI Act states that the Government must assign its money transfer, exchange and other transactions in India to the Reserve Bank of India. Section 21A also states that similar services will be provided to State Governments as well. The RBI does not profit from these functions; however, it receives a certain commission for handling the public debt of governments.
Section 45 of the RBI Act states that SBI or other affiliates are selected as sub-managing bodies wherever the RBI does not have a branch. These banks collect a certain commission for each transaction that is made based on turnover.
The Reserve Bank of India is also the financial advisor for the Government. It guides the government in various economic and financial situations. It performs the following functions:
- Helping the Government’s borrowing programme
- Represents the Government internationally
- Collection of taxes and fulfilling payments on the Government’s behalf
- Handling drafts and cheques from the accounts of the Government
- Offers reserves for foreign exchange to the Government
- Issues loans to the Government
- In charge of the IMF accounts of Central Government
Bank to Bank:
Another role of the RBI is to act as a parent body to many commercial banks. It is the primary managing institution whose duty is to supervise and monitor all the commercial banks of the country. The RBI is responsible for managing the volume of the bank reserve and consents banks to issue a credit in appropriate shares.
Each bank is required to deposit a minimum cash reserve of a certain amount with the RBI. The significance of this deposit is for the RBI to assist these banks financially in emergencies. In these situations, the RBI can be the lender, acting as a last resort. It helps the scheduled banks against securities by loans and advances and overlooks appropriate bilk.
The Banking Regulation Act of 1949 states that all registered banks need to maintain a minimum cash reserve of 5% and 2%, of these demand and time liabilities, respectively. This amendment gave the RBI a great power to administrate and manage the banking system of the country.
The Reserve Bank Amendment Act 1956 enable the Reserve Bank to go to India to increase the cash reserve ratio by 20% for demand deposits and 8% for time deposits. However, in 1972 a new amendment called the Banking Regulation Act came into action. Its significance was to avoid trouble in categorizing demand and time deposits by changing the reserve percentage to 3% of deposit liabilities. The RBI is given the power to increase it 15% if found necessary.
Supervising Exchange Rate and Custodian of Exchange Reserves:
Another key function of the RBI is to regulate the nation’s currency value. The RBI stabilises the foreign value of Indian rupee. It maintains foreign exchange resources and gold bullions, protecting them from the currency note issue. It is also responsible for handling the adversative payment balance with other countries.
For the RBI to stabilise the exchange rate, it must balance the demand and supply of foreign currency. One way the RBI maintains this equilibrium is by either buying or selling foreign currency.
In brief, the functions of RBI here are to:
- Regulate the exchange rate between our currency and foreign currencies
- Control foreign exchange
- Negotiate monetary authorities with other financial institutions.
- Maintain foreign exchange reserves
Transfers, Settlement and Clearance:
The Reserve Bank of India is responsible for settling all bank transaction in India. This makes interbank settlements for other banks a lot simpler. Its function as ‘clearing house’ is taken up by the State Bank of India wherever the RBI does not have a branch. The clearance of these settlements by the RBI is fully on-screen.
Clearing the inter-bank cheque is ideally done twice daily. The clearing value is different for cheques of one lakh rupees or more and is higher than the normal rate. The ‘National Clearing Cell’ is a unit of RBI that is responsible for carrying out these functions.
If commercial banks have no other financial source to rely on, the RBI provides them with financial assistance. The RBI offers a credit option for commercial banks on eligible securities. This includes trade bills that are generally accessed at a Bank Rate.
Being the nation’s central bank, the RBI oversees the controlling of credit. The objective is to make sure the internal price is stable, in turn facilitating the economy’s growth. Stability of internal price is crucial for development economically. The RBI controls the supply of money based on the economical requirements and its dynamic demands.
The RBI employs various effective methods to handle credit in India. There are quantitative techniques which comprise of the open market procedure, variable reserve ration and bank rate policy. The other type is qualitative techniques which include elective credit control, margin requirements, direct action, ration credits etc.
Along with carrying out the traditional banking functions, the RBI is also responsible for non-monetary functions. This included supervising banks and promoting sound banking in the nation. These non-monetary functions have played a prominent role in the betterment of their overall operative. These functions allow the RBI to effectively manage the whole financial system of the country.
Issuing Licenses to Banks:
The RBI is responsible for granting licenses to new banks that have started setting up in India. These licenses that the RBI issues are also necessary for the opening or closing of bank branches. This way, the RBI can make sure that there is no unrequired competition between various banks in a certain area. The growth of each bank can occur uniformly in given regions. This also enables the RBI to filter out unfit candidates for opening private banks.
Inspection of Banks:
Another duty of the Reserve Bank of India is to inspect and make a required enquiry for affairs that come under the RBI Act and the Banking Regulation Act. The Banking Regulation Act states the terms of inspection of banks and other financial institutions. This is concerning the banks’ such as deposits, advances, loans, investment functions and other banking operations, all of which are required for the efficient functioning of the banks.
This system ensures that all banks and financial institutions function properly, fulfilling all the required duties systematically. The idea is to enable these banks to maximally profit while still following all the rules. There is a periodic inspection that happens either once or twice a year which covers every bank’s branches. The banks must immediately act on any dysfunctionality or lapses that are highlighted during the inspection. This type of inspection is called an ‘on-site inspection’ where the RBI has the power to shut down any bank for misconduct. The RBI makes sure that all the conditions for schedules banks are satisfied and not violated.
The RBI also demands a regular update on specific liabilities and aspects of the bank, ensuring the functioning of the bank is healthy and efficient. This type of inspection is called an ‘on-site inspection’.
Management of Non-Banking Finance Bodies:
The RBI is also responsible for overlooking Non-Banking Finance bodies and schedules inspection where it can exercise its power. Although the monetary policy does not state any power to control over NBFCs, it is still a vital duty that the RBI carries out. One of its powers includes the requirement for NBFCs to be granted permission by the RBI before engaging in any deposit-taking operations.
Execution of the Deposit Insurance Scheme:
In favour of small bank depositors, the RBI is responsible for implementing a Deposit Insurance Scheme. The Reserve Bank of India ensures the insurance of all deposits within Rs. 1 lakh under the Deposit Insurance Guarantee Corporation. Accordingly, deposits of cooperative banks, commercial banks and RRBs are covered by this scheme as well. However, this scheme does not cover fixed deposits with financial institutions like IDBI, ICICI, etc. This function has greatly helped the banking standards in India.
Regular Reviewing of the Functionality of Commercial Banks:
The RBI conducts regular reviews to look after the functioning of commercial banks. It takes all the necessary steps to promote banks’ efficiencies and bring about required policy changes. The RBI implements various programmes to ensure healthy growth of the economy and improves the banking system.
There are several functions that the Central Bank is responsible for discharging apart from the traditional and supervisory ones. These non-monetary functions are essential for the overall betterment of the nation and the banking system.
Expanding the Banking System and Promoting Bank Habits:
The RBI is responsible for promoting banking habits in the nation’s economy and to functionally expand the banking system.
To reinstate this, the RBI initiated the following acts:
- Deposit Insurance Corporation, 1962
- Agricultural Refinance Corporation, 1963
- IDBI, 1964
- Unit Trust of India, 1964
- Industrial Reconstruction Corporation of India, 1972
- NABARD, 1988
To facilitate industrialization in India, the RBI also established numerous industrial finance corporations like Investment Corporation of India, Industrial Finance Corporation of India and Industrial Credit.
Boosting Exports by Refinance Provision:
The Reserve Bank of India boosts exports by offering financial provisions for foreign trades. It handles this through The Export Credit and Guarantee Corporation (ECGC) and Exim Bank. The ECGC gives insurance on exports and the EXIM bank offers long-term financial assistance to various project exporters.
The RBI offers to refinance provisions to export credit by scheduled commercial banks to enhance export in India. The RBI ensures the interest rates on export credit to be fixed at a lower rate.
Aiding the Agricultural Sector:
The agricultural sector receives indirect financial support from the RBI regularly. It offers both short and long-term options for agriculture and related activities.
NABARD is a body that was established by the RBI to overlook the management of agricultural and rural credit. NABARD runs The National Rural Credit Funds, provides financial support to the rural regions. As of now, the RBI contributes Rs. 1.00 crore to the fund.
The RBI extends more inexpensive financial facilities to the agricultural division. Through the General Line of Credit to NABARD, the RBI provides a significant amount of money for the rural sector.
Collection of Data and Publishing Reports:
The RBI is responsible for collecting data about savings, investment, interest rates, inflation, deflation, etc, which greatly helps various policymakers and researchers.
Through its Publication division, it also publishes that data on relevant sectors of the economy. Its publications include annual reports, weekly reports, reports on trends and progress of scheduled commercial banks.
Prescribing Banks with Minimum Statutory Requirements:
The RBI fixes certain specifications regarding the minimum statutory requirements. This includes liquid assets, cash reserves, capital, etc. RBI prescribes all the banks with these requirements under the RBI Act and Banking Regulation Act, both of which working towards different goals.
Here are some examples:
- CRR prescription for effective monetary regulation and money supply
- Statutory Reserves Appropriation for a safe banking system
- SLR prescription for the bank’s liquidity position
The RBI is also responsible for ensuring that all banks set aside certain provision against bad bank loans. This way, the RBI guarantees monetary and banking structure by promoting healthy bank practices, price stability, and growth.
Helping Industrial Finance:
The RBI has played a vital role in industrial development. It has taken numerous steps to boost the overall quality of the industrial sector like playing a role in the establishment of various industrial institutions. These institutions include IDBI, SIDBI, ICICI Ltd., etc.
The Small-Scale Industries or SSI Sector is responsible for a large part of the nation’s employment and is an essential aspect in Indian Exports as well. The RBI provides financial aid to small scale industries by improving credit supply. It orders commercial banks to offer sufficient financial assistance to the SSI sector. It also takes steps to actively promote commercial banks to extend guarantee services to the SSI sector. ‘Priority sector advances’ are the banks’ advances towards the SSI sector.
The RBI recognised the importance of this sector and initiated the opening of dedicated SSI bank outlets. It then encouraged scheduled commercial banks to offer reasonable financial and technical aid to all the SSI-dedicated branches. So far, the RBI has successfully opened about 30 lakh SSI branches all over India.
Facilities for Co-operative Sector:
The RBI bridges the gap between the cooperative sector and banking system by funding the State Co-operative Banks indirectly. The finance route goes through NABARD most times.
Training Facilities for Banking Staff:
Another role the RBI plays is to provide required training to the staff in the banking business. The RBI helps in this by establishing various colleges for bankers’ training. Bank Staff College (BSC) and the National Institute of Bank Management (NIBM) offer bank training programmes.
Limitations of the RBI
- The RBI cannot offer financial assistance or direct money to any commercial enterprise or trade.
- The RBI does not have the power to provide loans on the security of shares or any property.
- The RBI cannot purchase immovable property.
- The RBI is prohibited from purchasing shares of industrial undertakings.
Effect on Economy: How does RBI Control Interest Rates?
Interest rates play a significant role in the nation’s inflation and development. An increase in interest rates leads to reduced borrowing power of companies and citizens, provided they are not abundant on cash.
Higher interest rates also influence the Foreign Direct Investment or FDI. With higher interest rates, many companies wait until the rates fall. Once they do, these companies proceed to invest in any sector they want to.
Now, if the interest rates have fallen, the flow of money in the market will increase. Consequently, the public will have more purchasing power. However, the demand will most likely cross the supple in the market. Therefore, the price of goods will shoot up.
The Reserve Bank of India publishes a monthly review of the monetary policy. In this, the RBI closely examines all the factors affecting the national and global economy. This review comprises of the factors such as international investments, inflation, the position of the market and overall economic development. It monitors these trends before publishing a fully detailed review.
This is how the Reserve Bank of India decides interest rates for various banks. These interest rates can sometimes be changed or revised based on the performance of the market and fund availability.
RBI Annual Publications
Annual Report: The Reserve Bank of India announces a statutory report called the Annual Report, yearly. This report assesses and tracks the development of the nation’s economy.
Report on Trend and Progress of the Indian Banking System: The RBI releases a report on the financial sector, evaluating all its policies and progress of the previous year.
Currency and Finance Report: The staff of the RBI produces a report that emphasises on a particular theme. This report gives a detailed analysis of the economy and the addresses issues associated with the theme.
Report on State Finances and Budget Study: This report studies the details of state-wise financial status. It analyses a data-based idea on the financial status of various state governments throughout India. This report addresses relevant issues based on data inputs.
A Handbook- About the Statistics of Indian Economy: This report is an essential step taken by the Reserve Bank of India for the betterment of distribution of data. It is the source of key statistics about various aspects of India’s banking system.
Statistical Tables About Indian Banks: This publication contains information about the complete data analysis of timelines of all Scheduled Commercial Banks or SCBs. It also includes balance sheets and performance data of every SCB across India. This report categorises data associated with state-wise, bank-wise and bank-group wise aspects.
Lectures: The RBI schedules three lectures every year. One lecture is given by a renowned economist while the other two lectures are conducted by ex-Governors of the RBI.
Basic Statistical Returns: This is a journal that focuses on annual data. It presents details of the number of employees, offices and the credit and deposits of scheduled banks. These details are as meticulous as information associated with regional, district and state-wise news. This report also includes details of population and credit supplies of all banks.
The Reserve Bank of India illustrates in its preamble that its primary function is regulating the issuance of banknotes and managing reserves. This is to ensure secure monetary stability in our nation and to achieve the best results from the country’s credit and currency systems.
Being the central bank of India, the RBI is responsible for carrying out a wide range of function as we have seen above. It is the backbone of the financial scheme in India and has a significant role in the development of the nation’s economy. This is how it ensures the safe-keeping and efficiency of the banking system in India.