MODULE A: RATIONALE AND FUNCTIONS OF CENTRAL BANK

1. Theory and Practice of Central Banking: Evolution

1.1 INTRODUCTION
Both the theory and prac�ce of Central Banking have evolved over �me, responding to
exigencies of emerging economic situa�ons. It must be said that there is no unique Central
Bank Model, although there is an element of core component which is possibly common to
most central banks.
1.2 GLOBAL EVOLUTION OF CENTRAL BANKS
The primary s�mulus for establishing central banks and strengthening their ac�vi�es in
many parts of the world in the twen�eth century, emanated from exigency of war financing.
Economic historians have pointed out that war finance was the prime considera�on for
cons�tu�on of many of the early central banks.

Founded in 1694 under a Royal Charter of the United Kingdom, the Bank of England (BoE),
known as the old lady of Threadneedle Street, acted asthe government’s bank
Banks under European System of Central banks
The Bank of France
The Banco de Portugal,
Germany, the Bundesbank ( whenever a conflict arises between the central bank and the
government, it is the Bundesbank’s view that prevails)
The Bank of Italy

The Federal Reserve System’s structure is composed of the Board of Governors or the
Federal Reserve Board (FRB), Federal Open Market Commitee (FOMC),
The FOMC sets monetary policy and consists of all seven members of the Board of
Governors and the twelve regional bank presidents
US Government receives all the system’s annual profits, a�er a statutory dividend of 6% on
member banks’ capital investment is paid
1.3 REASONS FOR THE PROLIFERATION OF CENTRAL BANKS

The reasons for the origin and prolifera�on of central banks, , of course, lay in the need
for an appropriate authority to be entrusted with the func�on of note issue; need for an
agency to act as a banker and lender to the government, and finally the need for an
agency to regulate and supervise the banks

1.4 CONFLICTING ROLE AND RESPONSIBILITIES OF CENTRAL BANKS

The role of a central bank as a banker to the government gained renewed relevance,
par�cularly in �mes of war. The current professional thinking, however, is that the role of
a central bank as a debt manager in a sense is conflic�ng with the core objec�ve of the
central bank, namely, price stability. Many central banks pursue price stability as a major
objec�ve of monetary policy. As debt managers of the government, it was observed that
central banks financed government deficits par�ally. This process of extending credit to
the government puts pressure on monetary policy of central banks as they need to
create excess money to meet government needs.
The reasons for the origin and prolifera�on of central banks, as men�oned earlier, of
course, lay in the need for an appropriate authority to be entrusted with the func�on of
note issue; need for an agency to act as a banker and lender to the government, and
finally the need for an agency to regulate and supervise the banks

1.5 DEVELOPMENT OF CENTRAL BANKS IN DEVELOPED AND DEVELOPING COUNTRIES

There are marked differences in the development of central bank func�ons as between
developed and developing countries. The developed countries are characterized by a
well-diversified and strong financial superstructure. They are advanced in the sense of
both financial widening and financial deepening. Hence, the monetary transmission
processes of central banks are smooth and fast. The policy signals are
transmited quickly.

2. Functions of Central Banks

2.1 INTRODUCTION
The evolu�on of central banks, the underlying ra�onale and their prolifera�on has been
dealt with in Unit 1. The func�ons of a central bank vary in nature and with the stage of
economic development of the country where the central bank is situated, the nature of
mandate it has been given and the degree of opera�onal independence it enjoys. The issue
of opera�onal independence gained relevance as central banks are given the responsibility
of maintaining price stability as the core objec�ve of monetary policy. Since money and
credit are the obverse and reverse of the same coin, credit policy emerges as an adjunct to
monetary policy.
2.2 BANKER TO GOVERNMENT
We had previously discussed the ra�onale underlying the genesis of central banks and it
was observed that one of the primary func�ons of central banks was to finance the
governments. This is because many countries faced problems of financing their budget
deficits. They felt the need to have the support of another agency which could effec�vely
manage the government finances. The central banks are in a unique posi�on to
discharge this func�on.
2.3 BANKER TO BANKS
Another important func�on of the central banks across the globe is to act as bankers to
banks. In this the they are entrusted with the task of maintaining financial stability. They
act as lender of the last resort in �mes of crisis. The financial system in the early days,
asit is now, is essen�ally a bank dominated system; hence the focus of the central banks
is on the financial stability of banks. Lender- of-last-resort func�on was the first financial
stability func�on that central banks performed.
2.4 LENDER-OF-LAST-RESORT
Central banks perform the task of rescuing banks whenever they face crisis situa�ons. A
banking crisis is an event in which many or even all banks in the banking system face
sudden demand from their creditors/depositors and the former is unable to meet their
demands. There are different hypotheses about the origin and propaga�ng channels of
banking crises.
2.5 MONETARY POLICY FUNCTIONS
Monetary policy func�ons form the core of central banking opera�ons and cons�tute
one of the key func�ons of almost all central banks.

Government accounts maintained with the central bank consist of both its deposits and
liabili�es. The deposit balances of government increase whenever the central bank
extends credit to government. The government discharges its payment obliga�ons
towards fiscal opera�ons through issuance of cheques. This cons�tutes the liabili�es of
government with the central bank. The gap between Government Deposit (GD) balances
and its liabili�es (GL) results in net central bank credit to government (GL>GD).
 The net foreign exchange reserves posi�on provides a major backing for the note issue
func�on of the central bank. In other words, the resultant currency expansion could be
traced to the external opera�ons of the country.

The two important factors contribu�ng to monetary expansion are: the net central bank
credit to government and the net foreign exchange reserves posi�on.
A Central Bank Digital Currency (CBDC) would be a digital banknote. Central banks are
exploring whether CBDC could help them to achieve their public good objec�ves, such
as safeguarding public trust in money, maintaining price stability and ensuring safe and
resilient payment systems and infrastructure.

Central bank money is a liability of the central bank. The two types of central bank
money that are presently issued in the United States are (1) physical currency issued by
the Fed Reserve and (2) digital balances held by commercial banks at the Fed Reserve.
Bitcoin and other crypto currencies use distributed ledger technology (DLT) which is an
electronic ledger system.
the Monetary Authority of Singapore (MAS) does not perform the note issuance task.

2.6 CURRENCY ISSUE AND MANAGEMENT

The primary func�on of a central bank is the monopoly of note issues. Before central
banks took over the currency issue func�on, several private banks used to perform this
func�on. This led to the circula�on of numerous currencies with varying degrees of
acceptability. There was no control either on the quantum of currency issue or on the
management of such issue in accordance with the requirements of the economy at large.
Accordingly, this dispensa�on not only created confusion in the minds of people but also
led to loss of credibility with respect to currency validity..
2.7 PAYMENT AND SETTLEMENT SYSTEMS
Payment and setlement systems play an important role in facilita�ng financial
transac�ons. Financial transac�ons involve both receipts as well as payments.
Setlement of transac�ons in cash is never an issue. But the other forms of payment
involve intermediaries and unless both ends of the transac�on are complete, a
transac�on may not be setled.
 the earliest forms of credit funds transfers – the Giro system – evolved out of the postal
system in Europe

Broadly, there are three variants of organiza�onal structure followed wherein;

(a) the en�re gamut of opera�ons viz., the regulatory and opera�onal aspects of
clearing func�on are managed by central banks,
(b) the regulatory aspects are looked a�er by the central banks, the clearing opera�ons
are managed by private en��es and
(c) the regulatory aspects are with the central banks, the clearing opera�ons are shared
by the Central Bank and the par�cipa�ng en��es such as commercial banks etc.

2.8 MAINTAINING INTERNAL VALUE OF CURRENCY

Apart from ac�ng as a medium of exchange and unit of account, money also func�ons
as a standard of deferred payment and as store of value. As a standard of deferred
payment, money acts as a unit of account in terms of which future payments are
s�pulated. This applies to payments of interest, rents, salaries, pensions, insurance
premium etc.
that abandoning the gold standard and its gradual replacement by frac�onal reserve
system led to increased risks to price stability.
The Great Depression exposed the hollowness of the laissez-faire philosophy
Keynes in the General Theory emphasized the role of fiscal policy as a tool of economic
recovery.
The ‘Keynesian’model in fact, had a gap in theory in the sense that the equilibrium level
of aggregate supply and aggregate demand may not result in full employment level of
income. Addi�onal income could bridge this gap.
there is a trade-off between infla�on and growth. This was highlighted by the Phillips
curve. The Phillips Curve no�on that infla�on could be a trade-off for incremental
growth was, however, short lived.

banks remain cap�ve buyers of government securi�es, even if the interest rates on
these borrowings are at sub-market levels.

there is a tendency towards easing these constraints. In terms of (a) inves�ng by banks
in government securi�es at market related rates (b)government ini�a�ves to bring down
the SLR over �me.
 Keynes advocated targe�ng the price level in the 1930s. Sweden was the first to adopt
it a�er the collapse of the gold standard.

Developing countries generally have rela�vely higher rates of infla�on. In these

countries predic�ng future infla�on is o�en uncertain. Hence, missing an infla�on target
is more likely to happen in developing economies than in the developed economies.

2.9 MAINTENANCE OF THE EXTERNAL VALUE OF CURRENCY 2.9.1

In order to ensure credibility in interna�onal transac�ons, some countries started linking
their currencies to gold. In other words, the unit of currency of a country on gold
standard expresses its currency unit in terms a certain quan�ty of gold of certain
fineness.
The Breton Woods Conference in 1944. One of the major objec�ves of the Breton
Woods system was maintenance of stable exchange rates. Members could keep their
exchange rates within one per cent of the agreed par value.
The IMF introduced the facility of Special Drawing Rights (SDRs). The need for crea�on of
SDRs arose in the wake of the inadequacy of the arrangements regarding the borrowing of
hard currencies by deficit countries. The Smithsonian Agreement came in to existence
following the suspension of gold conver�bility by the US. It lasted only for 14 months �ll
June 1972.

2.10 REGULATION, FACILITATION AND SUPERVISION OF FINANCIAL SYSTEM

Central banks started taking over the regulatory and supervisory func�ons of the
financial systems as the banks and other financial en��es play a significant role in
providing finance for developmental purposes and failure of banks due to systemic or
other reasons could cause tremendous damage to the economic system at large. Banks
extend credit to various sectors of the economy based on the quantum of deposits
mobilized by them from the Public.
In pursuing these objec�ves supervisors base their judgments on three aspects, viz., (i)
how much risk each bank is undertaking, (ii) what resources, tangible (e.g., capital,
liquidity) or intangible (e.g., quality of management and control systems) are available to
manage that risk, and (iii) whether the iden�fied level of resources is sufficient to
manage/balance the risk.
there has been a percep�ble shi� from the tradi�onal Capital, Assets, Management,
Earnings, Liquidity, and Interest Rate Sensi�vity (CAMELS) approach to a risk-based
approach.
Risk Assessment, Tools of Supervision, Evalua�on (RATE) and Schedule 3 Compliance
Assessment, Liaison, Evalua�on (SCALE).
2.11 FINANCIAL STABILITY
The concept of financial stability can be defined in a variety of ways. Mishkin defines
financial stability as the ‘prevalence of a financial system, which is able to ensure in a
las�ng way and without major disrup�ons, an efficient alloca�on of savings to
investment opportuni�es’. This broad defini�on is important because of its percep�on
that an individual bank failure or every large swing in asset prices does not necessarily
mean financial instability.

2.12 PROMOTIONAL FUNCTIONS TO SUPPORT GROWTH AND OTHER NATIONAL

OBJECTIVES
Promo�on of growth is at the centre of all economic policies. In the broad sense of the
term, promo�on of growth could qualify as a developmental func�on universally
performed by central banks. This func�on came to be entrusted to the central banks
along with the objec�ve of promo�ng employment in the a�ermath of the Great
Depression
The infla�on-growth trade off, enshrined in the Phillips Curve rela�onship is relevant
only in shorter run, researchers have pointed out that in the medium to long run, if
infla�on exceeds a threshold level then growth suffers.

2.13 DEVELOPMENT OF FINANCIAL MARKETS AND INSTITUTIONS

The challenges before the central banks in developing countries are enormous; first,
they are constrained by the prevailing market condi�ons. Second, as leaders of the
financial sector they have to adapt their policies to suit the changing structure of the
economy and proac�vely modify the financial structure itself to promote development.

Selec�ve credit policies, micro alloca�on of credit, creditsubsidiesto preferred sectors

are instances of ac�vi�es undertaken by central banks to support the governments’
growth ini�a�ves.
However, subsidy based quasi-fiscal regula�ons could distort the markets and sow
seeds of financial repression.
Financial markets generally comprise the money market, bond market, foreign exchange
market and capital market.
 Given the dependence of monetary policy on the financial structure of the economy,
central banks in developing countries should be concerned about macroeconomic
management of the cost and supply of money and credit.
This developmental role requires the Central Bank to work towards promo�on of
ins�tu�ons and instruments. The Reserve Bank of India has also taken many such
ini�a�ves in se�ng up development finance ins�tu�ons (DFIs) such as Industrial
Development Bank of India (IDBI) and Na�onal Bank for Agriculture and Rural
Development (NABARD)

2.14 CENTRAL BANK COMMUNICATION POLICIES 2.14.1 Central banks communicate their
views and policies in the form of monetary and credit policy announcements and various
reports that they publish. The evolu�on of central bank communica�ons, over the years
were enshrined in expressions like ‘monetary mys�que’ and ‘construc�ve ambiguity’.
These expressions in a sense represented central banks stance towards policy
communica�ons.

3.CONTEMPORARY ISSUES IN CENTRAL BANKING

3.1 INTRODUCTION
The ra�onale behind the establishment and the evolu�onary process of central banks
discussed earlier, bear ample tes�mony to the desirability of having a Central Bank at the
apex level of the financial system. However, some countries have provisions for alterna�ve
ins�tu�ons/arrangements in case they (central banks) fail to carry out their responsibili�es
in the wake of a financial break down or in situa�ons of a general economic crisis.

3.2 AUTONOMY AND INDEPENDENCE OF A CENTRAL BANK

In the ini�al years of evolu�on, most central banks were established as private ins�tu�ons
and remained independent of Government control. This situa�on con�nued �ll the outbreak
of the Second World War. Later the func�onal role of central banks has widened. The
rela�onship between the government and the central banks took a new turn, par�cularly in
wake of war financing.
Independence of the central bank in itself is a tool to achieve broader macroeconomic goals.
Precondi�ons for effec�ve independence of a central bank include transparency about its
aims; some form of accountability to the legisla�ve body; and maintaining policy credibility
with a view to overcoming the �me inconsistency problem.
3.3 CREDIBILITY OF A CENTRAL BANK
A credible track record of central banks in terms of maintaining low infla�on or price
stability gains paramount relevance in managing monetary policy. This in a sense shape and
sets the move for adap�ng public percep�ons towards infla�on. Hence, central banks tend
to establish reputa�on for pursuing price stability and financial stability consistently
and persistently

.4 ACCOUNTABILITY OF A CENTRAL BANK

Accountability implies bearing responsibility for monetary policy ac�ons. Central bank
accountability, coupled with autonomy and transparency facilitates price and financial sector
stability, which is conducive to sustainable economic growth. There are few measures of
accountability of monetary policy.
Independence of the central bank in itself is a tool to achieve broader macroeconomic goals.
Precondi�ons for effec�ve independence of a central bank include transparency about its
aims; some form of accountability to the legisla�ve body; and maintaining policy credibility
with a view to overcoming the �me inconsistency problem.

3.5 TRANSPARENCY IN CENTRAL BANK OPERATIONS

Transparency in the case of could be defined as the absence of asymmetric informa�on
between monetary policy makers and other economic agents with a view to reducing the
uncertainty. The need for transparency has emanated from several developments in
the recent years.
The acronym ELRIC stands for five areas, viz., external audit mechanism, legal structure and
independence, financial repor�ng, internal audit mechanism and a system of internal
control.

3.6 CONFLICT WITH FISCAL POLICIES

Central banking is an evolving process responding to poli�cal and economic forces over a
period. In principle, effec�ve coordina�on between the central bank, which formulates
monetary policy, and the government, which is responsible for fiscal policy, is required for
achieving the common set of macroeconomic objec�ves.
Devia�ng from the classical economists’ view that money is just a veil, Keynes integrated the
monetary and the real sectors of the economy by emphasizing the inter-linkage between
the rate of interest and the level of investment in the economy.
Cri�cs contend that the use of this alterna�ve policy op�on is beset with the problem of
crowding out private investment. This implies that (a) funds available for financing of private
investment are in effect transferred the government for financing the deficit and (b)
consequently, the funds available for private investment would reduce.
As the government absorbs a larger chunk of liquidity in the system, there will be a pressure
on the availability of funds in the economy. The pressure is on two counts (a) since the
banks/financial ins�tu�ons mostly absorb these funds, they will be constrained in
conduc�ng their lending opera�ons and (b) to the extent there is a crowding out effect, the
private sectors investment gets adversely affected. Further, such deple�on of funds may
lead to pressure on demand for funds in the market and consequently push up the interest
rates. The rise in interest rates: (a) would reduce the prices of government securi�es and
the value of por�olio, and (b) would push up the loan rates and raise the cost of investment.
A rise in interest rates would also trigger expecta�ons of a further price rise and rendersit
difficult for the central bank to pursue its objec�ve of price stability
New Zealand has established a separate government office to manage government
debt in the late 1980s.
Important reason that calls for separation of debt management from monetary
management is that if both the functions are located in a single body, it is likely that
monetary policy may be so managed as to benefit debt management operations.
This is akin to an insider information problem.

The participants in the Market Borrowing Programme (MBP) are (a) RBI (b)
commercial banks (c) other financial institutions (d) individuals and (e)
Primary Dealers.

Primary dealers are registered entities with the RBI and play role of market
makers in respect of the government securities. They also act as underwriters for
the devolved portion of the government securities issued under the government
borrowing programme.
Devolvement occurs when central banks are not in a position to gauge the liquidity
in the economy appropriately or due to the portfolio behaviour of financial
institutions.
Direct monetization by absorbing the securities, be they bonds or treasury bills,
offered by governments at a certain interest rate is rarely preferred by central banks.
Central banks generally agree for private placement only if they are sure that they
could offload the same within a foreseeable future,say a month, or a quarter, or a
half of a year or a year.

MODULE B: CENTRAL BANKING IN INDIA

4.Reserve Bank of India

4.1 INTRODUCTION
The functions and working of the Reserve Bank of India have continuously evolved
since its inception in 1935, responding to the country’s economic scenarios from time
to time and in line with the theoretical and functional developments at
the global level .

4.2 RESERVE BANK OF INDIA: ORGANIZATIONAL EVOLUTION

It has been stated previously that the two traditional functions of central banks are
the note issue function and acting as a banker to government. The history of central
banking shows that these two functions were either carried out by an existing bank
or by a new bank set up for the purpose, even before such a bank came to be known
as a central bank.

The RBI is a banker to the Central Government statutorily and to the State
Governments by virtue of specific agreements with each of them.
the tool of short-term financing became a permanent source of funds for the
Government through automatic creation of ad hoc Treasury bills whenever
Government’s balances with the RBI fell below the minimum stipulated balance.
This automatic monetization led to the RBI’s loss of control over creation of reserve
money.

4.3 RESERVE BANK OF INDIA: STRUCTURE AND GOVERNANCE

The Preamble to the Reserve Bank of India Act, 1934 stated that the Bank has been
constituted ‘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’. The Reserve Bank of India Act, 1934,
specifies that the Bank is a corporate body with special powers and obligations for
serving national interest.
The Reserve Bank of India Bill (1933) underscored the desirability of entrusting the
control of currency and credit to an independent authority which could act with
continuity. The Bill was adopted as the Reserve Bank of India Act in 1934 in terms of
which the Bank commenced operations in April 1935.

4.4 RESERVE BANK OF INDIA: MAJOR ORGANIZATIONAL AND FUNCTIONAL

DEVELOPMENTS OVER TIME (1950’s ONWARDS)
The organizational changes that occurred in the Reserve Bank over the years
broadly reflect the changing functional role of the Reserve Bank in response to (a)
the changing roles of central banks across the globe, (b) the broad
directions/philosophy of State as enshrined in the Indian Constitution, and (c) the
financial, social and equity requirements of the planning process in India.

4.5 RBI ACT 1934: SALIENT FEATURES AND SOME COMMENTS (AS AMENDED
VIDE FINANCE ACT 2022) 4.5.1 An account of the principal features of the Reserve
Bank of India Act should be of interest. The legislative effort, spread over so many
years, that went into the making of the Act was massive; the product of this effort
deserves careful study.

5.CENTRAL BANKING: INDIAN SPECIFIC ISSUES

5.1 INTRODUCTION
The enactment of the Banking Regulation Act marked an important development in
providing the appropriate statutory backing for the Reserve Bank of India for
effectively discharging its regulatory and supervisory functions. Similarly, the Foreign
Exchange Management Act (FEMA) made new beginning in foreign
exchange management.

5.2 BANKING REGULATION ACT

The need for a comprehensive banking legislation was felt during the war years
which witnessed substantial expansion in the banking network, with an all-round
increase in the number of banks, their branches and deposit resources. However,
the absence of adequate statutory legislation to regulate the establishment and
running of banks had led to various unsound practices.
5.3 FOREIGN EXCHANGE MANAGEMENT ACT (FEMA)
The Report of the High-Level Committee on Balance of Payments (Chairman: C.
Rangarajan, 1993) gave a new focus to the formulation of policies relating to the
external sector. The major recommendations of the Committee which provided the
basic thrust and direction for framing of external sector policies are given below: (a)
introduction of a market-determined exchange rate regime within limits; (b)
liberalization of current account transactions leading to current account convertibility;
(c) compositional shift in capital flows away from debt to non-debt creating flows; (d)
strict regulation of external commercial borrowings, especially short-term debt; (e)
discouraging volatile elements of flows from non-resident Indians; (f) full freedom for
outflows associated with inflows (i.e., principal, interest, dividend, profit and sale
proceeds) and gradual liberalization of other outflows; and (g) the dissociation of the
Government in the intermediation of flow of external assistance

5.4 THE BANKING OMBUDSMAN SCHEME, 2006 (AS AMENDED UP TO 1ST

SEPTEMBER 2022)) Silent Features of the Scheme
An Ombudsman is generally an authority (official) appointed to receive and
investigate on the public grievances against the Government or any other authority
or institution or organization and redress such grievances as a non-adversarial
adjudicator, or an alternative to the adversary system for resolution of disputes. The
position is that of an independent and non-partisan officer who deals with specific
complaints from the public against administrative injustice and mal-administration.

5.5 FINANCIAL SECTOR REFORMS

During the 1980s, the financial markets were highly segmented and controlled. Also
the interest rates in the government securities market and the credit market were
tightly regulated. The banking sector remained dominated by public sector banks
with a significant quantum of non-performing assets. Credit was extended to the
Government by mandating the maintenance of a minimum Statutory Liquidity Ratio
(SLR) whereby commercial banks were required to invest substantial portions of
their liabilities in government securities at below market interest rates.

5.6 OTHER FINANCIAL REGULATORS AND DIVISION OF FUNCTIONS

The financial system covers distinct segments specializing in different areas of
operation, namely, the banking sector, the insurance sector, the capital markets
segment, etc. It is well recognized that the regulation and supervision function
exercised by authorities should eventually ensure the soundness and strength of the
entire financial system.
5.7 INSTITUTIONS SET UP BY RBI
One of the primary tasks of central banks in developing countries is to build a well-
differentiated institutional credit structure. The track record of RBI in this area is
commendable. Historically, one can see that specialized financial institutions have
been built up over time to cater to the requirements of agriculture, industry, and
exports. In this sense RBI ensured that financial support to the growth of these
sectors, as envisaged in the Five Year Plans, was extended.

6. FINANCIAL INCLUSION AND DEVELOPMENT

monetary policy in the best interests of economy.

6.1 INTRODUCTION
Financial inclusion in the sense of access to the formal financial system for basic
financial services at a reasonable cost is now positioned as a policy objective in
more than 60 countries. It is also central to the United Nation’s (UN’s) 2030
Sustainable Development Goals (SDGs) and the G 20’s Action Plan on the
2030Agenda for Sustainable Development. Several direct developmental effects are
attributed to financial inclusion such as greater mobilisation of savings, improving
conditions for remittances, boosting fiscal revenues and improving the effectiveness
of fiscal transfers

6.2 IMPEDIMENTS IN THE PROCESS OF ACHIEVING FINANCIAL INCLUSION

The excluded may live in remote areas or may belong to communities or segments
of society that undertake economic activity informally – they do not maintain records
or have signed contracts or documentation.

6.3 ROLE OF POLICY INTERVENTIONS: MANDATES AND SUBVENTIONS

An important policy decision could be to mandate banks allocate a certain fraction of
their loans to the “priority sector” and that they open 25 percent of their branches in
unbanked areas. There are also interest subventions that are made available for
loans to specific sectors. Furthermore, banks have been urged to open bank
accounts for all under the Pradhan Mantri Jan Dhan Yojana (PMJDY), while today
they are being exhorted to make loans to small businesses under
the Mudra scheme.

6.4 ON BUILDING AN APPROPRIATE INSTITUTIONAL AND FINANCIAL

STRUCTURE BASED ON DIGITAL TECHNOLOGY
The moneylender is particularly effective because he knows the neighbourhood and
its people, and can make a good assessment of who is credit worthy. A large national
bank with a local branch suffers from two infirmities. First, the branch manager has
typically been recruited through an all-India exam, is from a different state, and
typically is not intimately familiar with the local people. While many good branch
managers do indeed learn about the community, some do not.

6.5 FOCUS ON PAYMENT AND SETTLEMENT SYSTEMS VS FOCUS ON

EXTENSION OF CREDIT
We have been trying for decades to expand credit. We have focused much less on
easing payments and remittances, on expanding remunerative savings vehicles, or
on providing easy-to-obtain insurance against crop failures. In the emerging financial
inclusion paradigm, the Government and the RBI are trying to expand inclusion by
encouraging these other products, allowing credit to follow them rather than lead.

6.6 SOME ISSUES AND THEIR POSSIBLE RESOLUTION

Some impediments that the excluded could face relate documents pertaining to
Know your customer requirements. Secondly there is need to promote and
encouraging competition to prevent exploitation. Thirdly, there is need to ensure
some flexibility and forgiveness in financial arrangements. Fourthly, there is need for
skilling and support and finally encouraging financial literacy and ensuring
consumer protection.

6. 7 FINANCIAL INCLUSION
 Financial inclusion acts as a driver of balanced economic growth. The latest
Financial Access Survey (FAS) of the International Monetary Fund (IMF) highlights
the progress made by India in dealing with the last mile problem of financial inclusion
and increasing the popularity of financial products in the previous decade.

6.8 FINANCIAL INCLUSION PLANS

Financial Inclusion Plans (FIPs) were introduced by the Reserve Bank in 2010 with
the objective of encouraging banks to adopt a planned and structured approach
towards financial inclusion. FIP returns submitted by banks show that progress has
been made in the provisioning of banking services in the rural areas and with time,
their usage has also increased.

MODULE – C
MONETARY AND CREDIT POLICIES
Unit 7. Monetary Policy

7.1 INTRODUCTION
This Unit deals with the following aspects of monetary policy formulation of the
Reserve Bank of India: • major objectives of monetary policy and the recent
consensus of Central banks over specific objectives like price stability, growth,
employment, inflation target.

7.2 MONETARY POLICY: THEORETICAL UNDERPINNINGS

Monetary policy is the policy designated to influence changes in the supply of
money with the ultimate objective to promote growth with price stability. Money is the
liability of the government and the central bank. Looked at from another angle, it is
an asset – financial asset – in the hands of the public. It is, therefore, a constituent in
the portfolio of assets held by the public. The public, of course holds an array of
financial and physical assets in its portfolio depending on the relative risk-return
profile of these assets. They constantly re-adjust their portfolios in the wake of
changes in the risk-return profiles of various assets.

7.3 OBJECTIVES OF MONETARY POLICY

What would be the ideal number of ultimate objectives of monetary policy? There is
no definitive answer to this question. Going by the Tinbergen-type of argument, the
number of objectives should not be too many, since it is not always possible to have
an equal number of policy instruments to realize the objectives.

7.4 RECONCILING DUAL OBJECTIVES

Most Central banks pursue the dual objectives of price stability and output
maximization. In pursuing these objectives, they often face problems of
inconsistency in terms of policy choice. In order for Central banks to appropriately
reconcile both the objectives, the objectives have to be quantified. Some Central
banks also pursue full employment as an additional objective. It has, however, been
the experience that it is very difficult to quantify the tolerable level of unemployment
or the full employment level.

7.5 MONETARY POLICY RULES

Rules are generally preferred to discretionary action by Central banks as they serve
as: (a) useful tools for influencing the market expectations and establishing
credibility, (b) they chart Central Bank action in specific directions, (c) Central banks
would have control over the variable/s with reference to which the rules are framed
so as to render the rule effective, and (d) Rule-based behaviour imparts a degree of
transparency to Central Bank policy framework.

7.6 THE VEXED ISSUE: RULES VS DISCRETION

The issue as to whether Central banks should conduct their monetary policy
operations based on rules or they should base their judgments on discretion has
received utmost attention in the central banking literature.
7.7 INDICATORS OF POLICY
All Central banks tend to monitor several macroeconomic indicators on a regular
basis. These indicators cover trends in outputs of major segments of the economy,
nominal, and real wages (depending on their availability), monetary aggregates such
as narrow money, broad money and reserve money, growth in bank credit to private
sector, and a few important economic indicators such as, industrial sales, imports,
private consumption, fiscal position, foreign borrowings, changes in consumer prices
and exchange rates.

7.8 INSTRUMENTS OF POLICY

As explained earlier, the major objective of monetary policy is price stability/price
stability with growth. In recent years, financial stability also emerged as an additional
objective of central banks. For achieving these goals Central banks use monetary
policy tools (as well as regulatory and supervisory mechanisms for achieving the
financial stability objective).

7.9 STATUTORY LIQUIDITY RATIO (SLR)

The banks hold secondary reserve requirements in the form of government and
other specified securities. The secondary reserve requirements, essentially ensure
that the share of loan and investment portfolios in the total asset portfolio of
banks is rebalanced.

7.10 SELECTIVE CREDIT CONTROLS

Central banks play a major role in Emerging Market Economies as controllers of
credit. The monetary and credit policies are closely linked. The regulatory framework
governing both the policies is the same. The credit budget follows the
monetary budget.
7.11 POLICY TRANSMISSIONS MECHANISMS AND CHANNELS
The monetary policy transmission mechanism refers to the mechanism by which
monetary policy impulses are transmitted to the real sectors of the economy. The
presumed channels of transmission were highlighted by the proponents of Quantity
Theory of Money and the Keynesians.

7.12.1 transmission channel

Theoretical developments in explaining transmission channels of monetary policy
identified certain important macro-economic variables, the changes in which would
trigger the transmission of monetary policy changes to the real economy. These
channels of transmission are the money aggregates, the interest rate, the exchange
rate, the asset prices (or wealth effect), the credit or the balance sheet channels.

7.13 AN EVALUATION OF THE TRANSMISSION CHANNELS

The variables to be targeted by monetary policy could be prices or
output/employment or both. The effect of the policy on the variables may entail lags
which may be country specific. There is thus no single transmission mechanism that
is universally applicable as an effective one for all countries, or even for a group of
countries such as the industrial countries or EMEs and for all times to come.

7.14 TRANSPARENCY OF POLICIES

Central banks across the globe endeavour to maintain high degree of transparency
in all areas of their policy action. This is evident from the numerous Reports that
central banks publish. These Reports include the Annual Reports, Quarterly and
Monthly Reports and other Periodical and Special Reports. Besides they publish a
vast amount of statistical data not only relating to their operations but also regarding
the economic conditions in general and financial conditions in particular.
7.15 LAGS IN POLICY
Monetary policy formulation involves two types of lags, viz., the inside lag and the
outside lag. As the monetary authority’s desire to have quick impact of their policy
actions, they take efforts to minimize both the lags.

7.16 PROCESS OF MONETARY POLICY FORMULATION IN INDIA

The discussions above cover a broad canvas for monetary policy formulation.
Obviously, there is no generic formula for monetary policy formulation and each
central bank has to work out its own approach to and modalities for monetary policy,
against the theoretical background.

7.17 CONDUCT OF MONETARY POLICY IN THE WAKE OF NET LARGE CAPITAL

INFLOWS DURING THE 2000s An excellent example of fiscal-monetary co-
ordination During the 2000s, India built up significant foreign exchange reserves,
indicating the absorption of a part of net capital inflows by the Reserve Bank during
this period. Theoretically, the absorption of net capital inflows by the Reserve Bank
creates reserve money, which through the multiplier effect leads to the creation of
M3 in the economy.

7.18 RECENT INITIATIVES FOR FURTHER STRENGTHENING MONETARY

POLICY FORMULATION
The Government of India and the Reserve Bank of India signed the Monetary policy
Framework Agreement (MPFA) on February 20, 2015, and adopted the flexible
inflation target (FIT) (see Box 11). This process of monetary policy formulation based
on inflation targeting approach is in line with the best international practices.
8.CREDIT POLICY

8.1 INTRODUCTION
This Unit broadly covers both the theoretical and practical aspects of credit policy in
India. It explores the mechanisms through which credit policy is inextricably
interwoven into the planning process and explains the role of the Reserve Bank of
India in framing credit policies, simultaneously optimizing the objectives of price
stability and promotion of economic growth.

8.2.THEROTICAL UNDERPINNINGS
It was seen that monetary policy is concerned with the macro dimensions of
changes in money supply. Credit policy is somewhat narrower in approach covering
the impact of changes in the supply of credit on the economy. While the cost of credit
influences investment decisions in the economy, the quantum of credit gains
importance from the point of view of monetary management

8.3 CREDIT POLICY IN PRACTICE

The monetary policy formulation takes in to account several factors affecting money
supply, such as the fiscal considerations (volume of market borrowing programme),
the likely foreign exchange flows, the efficacy of banks in mobilizing deposits, the
extent to which the banks and the financial institutions could contribute to the market
borrowing programme, etc. Based on these parameters, the central bank arrives at a
desirable level of credit expansion during, say, a financial year.

8.4 NOMINAL VERSUS REAL CREDIT

The distinction between nominal and real credit assumes importance from the point
of view of assessing the impact of price rise on the credit. Nominal credit is the credit
measured at current prices while real credit is the credit measured based on a given
base year’s price level. The distinction between these two measures provides a
measure of change in price level.

8.5 CREDIT ALLOCATION MECHANISMS (a) Theoretical Model

The credit allocation mechanism in India follows closely from the physical planning
undertaken under the Five-Year Plans. In each full Plan, sub-plans of investment and
production for each sector are drawn up.

8.6 INSTRUMENTS OF CREDIT CONTROL

For the regulation of credit, the Reserve Bank makes use of two broad types of
credit control generally employed by central banks: (a) Quantitative Credit Control
Measures: These measures, include the Bank Rate, Open Market Operations,
Varying Reserve Ratios and the Statutory Liquidity Ratio. These measures are aimed
at controlling the money supply and through it the credit creation by banks

8.7 MARGIN REQUIRMENTS

The Reserve Bank has issued a number of directives to scheduled banks to restrict
their advances against oil seeds, paddy and rice, gram, pulses, cotton textiles, etc.
For instance, the minimum margins on bank advances against oil seeds and
vegetable oils were raised twice in succession by 15 percentage points each time
across-the-board with effect from May 4, 1990 and July 2, 1990. Subsequently, as
need arose, directives were issued covering other essential commodities. When the
supply situation became easy, these conditions were also relaxed.

8.8 RATIONING OF CREDIT (CREDIT CEILING)

The RBI has been exercising selective credit control by fixing the ceiling for bank
advances against certain commodities. For instance, effective December 30, 1989,
higher ceiling at 100 per cent of peak level of credit based on the three-year period
1984-85, 1985-86 and 1986-87 (November- October) was stipulated for bank
advances against wheat, cotton and kapaas.

8.9 CREDIT PRICING (SETTING BANK’S LENDING RATES)

The Indian financial system is a bank centric system and hence banks are the main
conduits through which monetary impulses are transmitted to the real economy.
However, the issue of transmission from the policy rate to banks’ lending rates has
all along been a matter of concern for the Reserve Bank. Accordingly, strengthening
the design of the bank lending rates has remained an important focus of RBI to
improve the efficacy of the monetary transmission process.
8.10 GUIDELINES ON DIGITAL LENDING RBI
issued guideline vide circular dated September 02, 2022 to all Commercial Banks,
Primary (Urban) Co-operative Banks, State Co-operative Banks, District Central Co-
operative Banks; and Non-Banking Financial Companies (including Housing Finance
Companies) in terms of “Recommendations of the Working Group on Digital Lending
– Implementation” dated August 10, 2022.

9.FISCAL-MONETARY RELATIONS

INTRODUCTION
The major objective of central banks is to ensure price stability with growth. The
price stability objective enables countries to pursue the growth objective in an orderly
and definitive manner. Economic literature suggests that there would be a threshold
rate of inflation at which economic growth is maximized or optimized.

9.2 MONETARY-FISCAL RELATIONS: INDIA

A major contributing factor for monetary expansion has been the fiscal policies
adopted over the years. This is because the State played a major role in the
economy, particularly with the inception of planning in India since 1951. The RBI is a
banker to the Central Government statutorily and to the State Governments by virtue
of specific agreements with each of them.

9.3 STRIKING BALANCE BETWEEN INFLATION AND GROWTH: RECENT

INITIATIVES
 The twin objectives of growth with price stability cannot be met unless there
is better harmonization of ‘monetary and fiscal policies. The ushering in of the
financial sector reforms and the.

9.4 FINANCES OF CENTRAL AND STATE GOVERNMENTS: RECENT

TRENDS
An important factor that brightens the prospects of the recovery is the fiscal
policy stance. The thrust on infrastructure can create conditions for
broadening the revival in activity by exploiting forward and backward linkages
and multiplier effects.

9.5 CENTRAL GOVERNMENT FINANCES IN 2020-21

In the wake of the pandemic, the Union Government announced a series of
economic reform measures which cumulatively amounted to ₹17.2 lakh crore
(9.3). Within a fortnight of COVID-19 being declared a pandemic, i.e., on
March 26, 2020, the government announced the Pradhan Mantri Garib Kalyan
Package (PMGKP) which focused on protecting lives and livelihoods of
vulnerable sections of the population through measures like free foodgrains to
the poor; direct benefit transfers to women ,senior citizens and poor disabled;
and paying both employee and employer contribution to provident fund
corpuses for organised sector workers.

9.6 CENTRAL GOVERNMENT FINANCES IN 2021-22

The Union Budget 2021-22 has set the stage for a strong revival. This is
sought to be achieved by increasing the buoyancy of tax revenue through
improved compliance, and by increased receipts from monetisation of assets.
Efforts at improving tax buoyancy are not reliant on additional taxation. The
budget also aims at better compliance through use of data analytics and
artificial intelligence.

9.7 STATE FINANCES IN 2021-22 9.7.1 As per the information available for
17 state governments, the GFD has been budgeted at 3.2 per cent of GSDP
in 2021-22 as against 4.1 per cent in 2020-21 (RE). This is in line with the
Fifteenth Finance Commission’s (FC-XV) recommendation on the revised
fiscal roadmap for states. The consolidation over the previous year has been
sought to be achieved primarily through enhanced revenue receipts and cut in
revenue expenditure while hiking capex.

9.8 CONSTITUTION OF FINANCE COMMISSION

The Constitution of India provides for the establishment of a Finance
Commission for the purpose of allocation of certain resources of revenue
between the Union and the State Governments. Finance Commission is
established under Article 280 of the Constitution of India by the President of
India for the purpose of devolution of financial resources from the central
government to state governments. The qualifications, powers, and procedures
of the Commission itself are regulated by the Finance Commission
(Miscellaneous Provisions) Act 1951.

9.9 RECOMMENDATIONS OF THE FIFTEENTH FINANCE COMMISSION

9.9.1 There are three aspects to the recommendations in a historical context:
tax devolution, grants, and fiscal roadmap/ rules. The broad recommendations
of the 15th Finance Commission in these areas.

9.10 GRANTS-IN-AID
The FC-XV has made a significant departure from its predecessor in
recommending a historically high share of grants in total transfers.
Compositionally, grants to local bodies have the highest share in finance
commission grants since the FC-XIII, followed by post devolution revenue
deficit grants, both of which have seen their share in total transfers rise
consecutively in the last two finance commission recommendations.
9.11 FISCAL ROADMAP/RULES
Successive finance commissions have recommended debt and deficit targets
as well as institutional changes to make governments accountable and
transparent in the conduct of fiscal policy. The FC-12, the FC-13 and the FC-
14 recommended elimination of revenue deficits and limiting the fiscal deficit
to GDP ratio to 3 per cent at both levels of government.

9.12 FISCAL ROAD MAP RECOMMENDED BY THE 15TH FINANCE

COMMISSION • GFD-GDP ratio glide path from 9.3 per cent in 2021-22 to 6.8
per cent in 2025-26. • Projected Debt/GDP ratio of 85.7 per cent in 2025-26
after peaking at 89.6 per cent in 2022-23 • Restructuring of FRBM and
timetable for achieving debt sustainability to be examined a high powered
inter-departmental group • In the baseline scenario, GFD-GDP ratio glide path
from 6 per cent in 2021-22 to 4 per cent in 2025 – 26.

10.LIQUIDITY MANAGEMENT IN THE SYSTEM

10.1 INTRODUCTION
The implementation of a successful monetary policy requires effective
management of central bank liquidity operations. The sense in which the term
liquidity is used in this Unit refers to central bank liquidity i.e., the reserves
provided by a central bank to the banking system. Banks, in many countries,
are required to maintain a mandated level of balances in their accounts with
the central bank. These balances are referred to as required reserves.

10.2 THEORETICAL FRAME-WORK UNDERLYING LAF

Central bank liquidity is the key element in monetary policy implementation
process and the focal point for liquidity management operations is the banking
system liquidity or system liquidity.

10.3 GENESIS AND EVOLUTION OF LIQUIDITY ADJUSTMENT FACILITY

Having understood the theoretical and operational determinants of liquidity in
the system, as also the objectives and importance of liquidity management in
the system, it would be interesting to trace the evolution of the liquidity
framework through the years in the Reserve Bank of India.

10.4 REVIEW OF LAF BASED ON THE REPORT OF THE EXPERT

COMMITTEE TO REVISE AND STRENGTHEN MONETARY POLICY
FRAMEWORK
The LAF Framework had been further revised following the Report of the
Expert Committee to Revise and Strengthen the Monetary Policy Framework
(Chairman: Dr. Urjit R. Patel; RBI, 2014). The Committee recommended that
excessive reliance of the Reserve Bank on the overnight segment of the
money market should be avoided by de-emphasising overnight repos; and
suggested instead that liquidity management operations should be conducted
through term repos of different tenors.

10.5 REVISED FRAMEWORK OF LAF BASED ON THE

RECOMMENDATIONS OF IWG • Based on the feedback received, it was
decided to fine-tune the existing liquidity management framework. The major
ingredients of the revised framework are as follows: • The weighted average
call rate (WACR) will continue to be the operating target.

10.6 OPERATIONAL STRATEGIES IN MANAGING LAF

Liquidity operations shall take into consideration prevailing conditions, based
on which the required tools will be used to achieve the objectives of the
liquidity management framework. The design of the LAF covers management
both day to day liquidity as well as durable liquidity scenarios.

10.7 UNDERLYING INSTRUMENTS FOR THE CONDUCT OF LAF

• The liquidity framework should have an array of instruments to address
durable liquidity surplus or deficit. While daily overnight operations (or
weekly/fortnightly operations followed by overnight operations) should
address the liquidity needs of the banking system, it is nonetheless possible
that unanticipated shocks (variations in Government cash balances,
fluctuations of CiC, or Forex intervention operations) could lead to liquidity
build-up (positive or negative) that could result in actual liquidity being
different from the desired level.

10.8 GUIDING PRINCIPLES FOR THE CONDUCT OF LAF • The banking

liquidity being kept in deficit or in surplus mode is a design feature of the
liquidity management framework – whether it is the corridor system or the
floor system, or, analogously, whether the policy rate is the repo rate or the
reverse-repo rate.

10.9 STRUCTURING OF OPEN MARKET OPERATIONS • Central banks

appropriately evolve structured OMOs keeping in view the market
requirements of liquidity in terms of duration as well as quantum. For
example, in India, the OMO structures are evolved using Central Government
or State Government Securities of different maturities. The relevant bonds
could range from 1 year to 20/30 years.

10.10 OTHER SALIENT FEATURES OF THE REVISED LAF • The desired

level of system liquidity: The Group observes that the design of the corridor
system, with repo rate as the policy rate, would require the system liquidity to
be in a small deficit of about 0.25 per cent - 0.5 per cent of Net Demand and
Time Liabilities (NDTL) of the banking system. However, if financial conditions
warrant a situation of liquidity surplus, the framework could be used flexibly,
with variable rate operations, to ensure that the call money rate remains close
to the policy repo rate.

10.11 LIQUIDITY MANAGEMENT DURING COVID-19: INITIATIVES

UNDERTAKEN BY THE RESERVE BANK OF INDIA
COVID-19 sent financial markets in India as also the world into a tailspin.
Financial institutions were faced with liquidity stress, loss of access to funding
and tightening of financial conditions amidst disruption of cash flows and
working capital cycles. In response, the Reserve Bank deployed several
conventional and unconventional tools to restore orderly conditions in financial
markets and maintain normal functioning of financial intermediaries.

10.12 MONEY MARKETS: LIQUIDITY CONDITIONS

Money markets have remained flush with surplus liquidity due to the Reserve
Bank’s support through LAF windows. The net LAF position, which was
around ₹3.0 lakh crore on an average, during Q4: 2019-20, increased to an
average of ₹4.7 lakh crore during Q1: 2020-21 (up to June 22, 2020).

10.13 GOVERNMENT SECURITIES MARKET AND THE RISK-FREE CURVE

The first port of call in the transmission of changes in the policy rate is the
inter-bank call money rate, as described earlier. Subsequently, this impulse
gets transmitted to longer term risk-free interest rates and other traded
financial instruments, and finally to loan and deposit rates.
10.14 CORPORATE BOND MARKET: LIQUIDITY CONDITIONS
The corporate bond market is an important source of financing for the private
sector. An active corporate bond market also provides an avenue for
institutional investors such as insurance companies and provident and
pension funds with long term financial assets, to match their
liabilities (RBI, 2016 ).

10.15 EQUITY MARKETS: LIQUIDITY CONDITIONS

Similar to other emerging markets, in March 2020, the Indian equity markets
witnessed record net FPI outflow of ₹62,000 crore (USD 8 billion
approximately). This was followed by an outflow of ₹6,340 crore in April 2020.

10.16 SEVERITY OF THE PANDEMIC AND THE RBI INITIATIVES

COVID-19 has posed a challenge of gargantuan proportions. The halt in
economic activity over several weeks has led to acute risk aversion and
increased demand for precautionary liquidity by individuals, corporations, and
financial agents.

10.17 RECENT MEASURES ANNOUNCED BY RBI ON 08 APRIL, 2022 AS

PART OF MONETARY POLICY The Reserve Bank of India (RBI) announced
the introduction of a standing deposit facility (SDF) at 3.75% which would
serve as the floor for the policy corridor. With this, the width of the policy
corridor was narrowed to 50 basis points (bps) from 65 bps.
MODULE – D

MANAGEMENT OF FOREIGN EXCHANGE RESERVES AND

CONSTITUENTS OF INDIAN FINANCIAL MARKET.

Unit 11. Management of Foreign Exchange Reserves

11.1 INTRODUCTION
The level of foreign exchange reserves is an indicator of the comfort level a
country enjoys in meeting its international obligations in terms of payment for
imports. As the economy becomes more open, external shocks need a
cushion which reserves alone can provide. The volatility of some of the capital
flows needs to be kept in mind.

11.2 LEGAL FRAMEWORK The Reserve Bank of India Act, 1934 provides the
overarching legal framework for deployment of reserves in different foreign
currency assets and gold within the broad parameters of currencies,
instruments, issuers, and counterparties. The essential legal framework for
reserve management is provided in sub-sections 17(6A), 17(12), 17(12A),
17(13) and 33 (6) of the above Act.

11.3.1 The broad strategy for reserve management including currency

composition and investment policy is decided in consultation with the
Government of India. The risk management functions are aimed at ensuring
development of sound governance structure in line with the best international
practices, improved accountability, a culture of risk awareness across all
operations, efficient allocation of resources and development of in-house
skills and expertise.

11.4 OPERATIONAL RISK AND CONTROL SYSTEM

In tune with the global trend, close attention is paid to strengthen the
operational risk control arrangements. Key operational procedures are
documented. Internally, there is total separation of the front office, and the
back-office functions and the internal control systems ensure several checks
at the stages of deal capture, deal processing and settlement.

11.5 TRANSPARENCY AND DISCLOSURES

The Reserve Bank has been making available in the public domain data
relating to Foreign Exchange Reserves, its operations in foreign exchange
market, position of the country’s external assets and liabilities and earnings
from deployment of Foreign Currency Assets and gold through periodic press
releases of its Weekly Statistical Supplements, Monthly Bulletins,
Annual Reports, etc.

11.6 RECENT DEVELOPMENTS IN THE MOVEMENT OF FOREIGN

EXCHANGE RESERVES
The Reserve Bank of India publishes half-yearly reports on management of
foreign exchange reserves as part of its efforts towards enhanced
transparency and levels of disclosure. These reports are prepared half yearly
with reference to the position as at end-March and end-September each year.
The present report is with reference to the position as at end-March 2022.

11.7 SOURCES OF ACCRETION TO FOREIGN EXCHANGE RESERVES

provides details of sources of variation in foreign exchange reserves during
AprilJune 2022. Table 11.3 provides the comparative position of variation of
Reserves between April – June 2021 and April – June 2022 period.

11.8 ADEQUACY OF RESERVES At end of December 2021, foreign

exchange reserves cover of imports (on balance of payments basis) declined
to 13.1 months from 14.6 months at end-September 2021. The ratio of short-
term debt (original maturity) to reserves, which was 16.5 per cent at end-
September 2021, increased to 18.1 per cent at end December 2021.

11.9 MANAGEMENT OF GOLD RESERVES

As at end-March 2022, the Reserve Bank held 760.42 metric tonnes of gold
(including gold deposits of 11.08 metric tonnes). While 453.52 metric tonnes
of gold is held overseas in safe custody with the Bank of England and the
Bank of International Settlements (BIS), 295.82 metric tonnes of gold is
held domestically.

11.10 INVESTMENT PATTERN OF THE FOREIGN CURRENCY ASSETS

(FCA)
The foreign currency assets comprise multi-currency assets that are held in
multi-asset portfolios as per the existing norms, which conform to the best
international practices followed in this regard. As at end-March 2022, out of
the total FCA of USD 540.72 billion, USD 363.03 billion was invested in
securities, USD 140.54 billion was deposited with other central banks and the
BIS and the balance USD 37.16 billion comprised deposits with
commercial banks overseas.

11.11 OTHER RELATED ASPECTS

 Financial Transaction Plan (FTP) of the IMF: During the half year under
review (September 2021-March 2022), there were two Purchase Transactions
aggregating USD 172.15 million and two repurchase transactions aggregating
USD 22.56 million under the FTP of the IMF.

12.CONSTITUENTS OF INDIAN FINANCIAL SYSTEM STRUCTURE

12.1 INTRODUCTION
The importance of developing an appropriate financial infrastructure in
promoting economic growth can be hardly over emphasized. The initiatives
taken by the Reserve Bank of India in developing a well-structured financial
institutional structure for the growth and development of the economy were
discussed in UNIT5.

12.2 GENESIS OF FINANCIAL MARKET DEVELOPMENT

The Chakravarty Committee (1985) was the first to make comprehensive
recommendations for the development of the Indian money market. This was
followed by the Vaghul Committee set up by the Reserve Bank to specifically
examine various aspects for widening and deepening of the money market.

12.3 STRUCTURE AND GROWTH OF FINANCIAL MARKETS IN INDIA

The financial system in India currently comprises financial institutions,
financial markets, and financial instruments. The various segments of the
financial market in India are the money market, the Government securities
market, the foreign exchange market, the capital market, and the
insurance market.
12.4 MONEY MARKET
Money market is the most important segment of the financial system as it
provides the fulcrum for equilibrating short-term demand for and supply of
funds, thereby facilitating the conduct of monetary policy.

12.5 GOVERNMENT SECURITIES MARKET 12.5.1 The Government

securities market in India forms an overwhelming part of the overall debt
market. Interest rates in this market provide benchmarks for other segments
of the financial market. Historically, the impetus for development of the
Government securities market in India has come from the large Government
borrowing requirements while an additional reason during the 1990s was the
increased capital flows and the need for sterilization.

12.6 FOREIGN EXCHANGE MARKET

Since the 1950s, the foreign exchange market in India has witnessed a
significant transformation from a highly controlled regime to a liberal regime.
The forex market basically comprises of banks designated as Authorised
Dealers (ADs), exporters and importers, individuals and the Reserve Bank.
Before 1990s, the market was highly regulated. In view of the scarcity of
foreign exchange reserves, banks, exporters, and individuals had to surrender
the foreign exchange earned/received by them to the Reserve Bank.

12.7 REFORM/POST-REFORM PERIOD (1990s TO 2010)

This phase has been marked by wide-ranging measures to widen and deepen
the market, besides exchange rate liberalization. The impetus for forex market
reform was provided by recommendations of the Rangarajan Committee
(1992), the Sodhani Committee (1995) and the Tarapore Committee (1997).
The importance attached to the forex market is amply evident from the
preamble to the Foreign Exchange Management Act (FEMA, 1999).
12.8 FOREIGN EXCHANGE MARKETS: POST REFORM PERIOD
Foreign exchange market in India has developed significantly in the post-
reforms era following the phased transition from a pegged exchange rate
regime to a market determined exchange rate regime in 1993 and the
subsequent adoption of current account convertibility in 1994. With the
abolition of liberalized exchange rate management system (LERMS) in 1993,
the exchange rate of the rupee became market determined.

12.9 FINANCIAL BENCHMARKS – TRANSPARENCY & GOVERNANCE

FRAMEWORK
Financial benchmarks are indices, values or reference rates used for the
purpose of pricing, settlement and valuation of financial contracts. The
revelations regarding manipulation of LIBOR in June 2012 had shocked the
entire global financial markets.

12.10 ROAD MAP FOR LIBOR TRANSITION RBI has provided a “Road Map
for LIBOR Transition” vide notification dated 8th July, Banks were requested
to frame a Board-approved plan, outlining an assessment of exposures linked
to the London Interbank Offered Rate (LIBOR) and the steps to be taken to
address risks arising from the cessation of LIBOR, including preparation for
the adoption of the Alternative Reference Rates (ARR)
MODULE – E
REGULATION, SUPERVISION AND FINANCIAL STABILITY

Unit 13. Evolution of Regulation and Supervision

13.1 INTRODUCTION Central Bank’s Regulation and Supervision over the

commercial banks and financial institutions is a somewhat recent
phenomenon. The need for regulation and supervision arises on account of
the importance of the banks in managing finance flows.

13.2 GENESIS AND EVOLUTION OF REGULATION AND SUPERVISION:

SOME THEORETICAL UNDERPINNINGS
Central banks regulation and supervision over commercial banks and
financial institutions is a somewhat recent phenomenon. The conduct of
supervision to single out banks as a special category of institution requiring
the attentions of a supervisor implies no special lack of confidence in the
capacity of bankers to manage their own affairs.

13.3 GLOBAL BACKDROP

The history of central banks, contributing to financial stability was one of their
roles in most countries, although to varying degrees. Even when central
banks were assigned a relatively narrow mandate, such as that of inflation
targeting in recent years, they often played a decisive part as soon as
financial instability struck.

13.4 INTERACTIONS OF MONETARY POLICY AND REGULATORY AND

SUPERVISORY POLICIES
It is time to consider how monetary policy and banking supervision are
related. It is therefore imperative at first to discuss the benefits a bank
supervisory role could offer to monetary policy formulation – particularly in
terms of informational advantages – and then by considering some design
features, which are important when tackling the challenges of putting
monetary policy and banking supervision under one roof.

13.5 INTEGRATION VS SEPARATION OF MONETARY, REGULATORY AND

SUPERVISORY FUNCTIONS - RECENT PERSPECTIVES
While the importance of central bank independence for the conduct of
monetary policy has been the subject matter of numerous empirical studies,
relatively little research has been focused on the significance of other aspects
of the structure of the central bank, particularly its role in bank supervision.

13.6 GENESIS OF BANK REGULATION AND SUPERVISION IN INDIA

Indigenous system of banking existed in India for centuries, which met the
requirements of an ancient economy (Rau, 1960).
13.7 CONDUCT OF MONETARY POLICY AND COMPATIBILITY WITH
REGULATORY AND SUPERVISORY ROLE: THE INDIAN PERSPECTIVE
An important debate in the context of a central bank is whether there is any
inherent conflict in discharging both the monetary policy and supervisory
functions simultaneously by the central bank. An important argument for
preserving a financial stability function in a central bank, even when regulation
of financial entities is carried out by another institution, is that monetary and
financial stability policies are intertwined.

14.DEVELOPMENT, REGULATION AND SUPERVISION AND RECENT

PERFORMANCE OF SCHEDULED COMMERCIAL BANKS

14.1 INTRODUCTION
The banking system in India has witnessed steady growth since
independence. The inadequacy of the banking system in terms of its number
and size as well as in the supply of financial products in line with economic
development was realised since the beginning of the planning process since
the 1950s and in the early sixties.

14.2 EVOLUTION AND DEVELOPMENT OF COMMERCIAL BANKS

DURING INITIAL YEARS (1950 TO 1969)
Before 1950, there were several bank failures and the banking sector had not
then evolved fully to meet the requirements of the economy. The supervisory
powers, conferred initially in 1940 vested the Reserve Bank with the right, on
a restricted scale, to inspect banking companies in consultation with the
Government of India.
14.3 STRENGTHENING AND CONSOLIDATION OF COMMERCIAL BANKS
(1969-1991)
The nationalization of 14 major commercial banks on July 19, 1969, was a
turning point in the Indian banking system with the entry of the public sector.
The focus of regulation was, therefore appropriately reoriented to meet the
objectives of the nationalization of banks. In the context of the wider role
assigned to banks following the nationalization, a re-orientation of the system
of bank inspections was called for. The objectives as per the re-orientation of
bank inspections were the evaluation of the overall performance of each bank
in different aspects.

14.4 RAPID STRIDES IN THE DEVELOPMENT THE BANKING SECTOR

FOLLOWING THE FINANCIAL REFORMS PROCESS USHERED IN THE
1990’s
The decade of the 1990s was a watershed in the history of the Indian
financial system in general and the banking system. Notwithstanding the
remarkable progress made by the Indian banking system in achieving social
goals during the 1980s, it experienced certain problems that led to decline in
efficiency and productivity, and erosion of profitability. Factors such as
directed investment and directed credit programs had affected the operational
efficiency of the banking system.

14.5 PRUDENTIAL REQUIREMENTS FOR BANK SUPERVISION

Most central banks have adopted the Basle principles of bank supervision
while specifying the prudential requirements for bank supervision. The areas
on which emphasis is laid are the capital adequacy norms, asset classification
procedures and methods, income recognition principles, market valuation of
assets, and recovery mechanisms to reduce the non-performing
assets of banks.
14.6 SUBMISSION OF RETURNS ON LIQUIDITY RISK, INTEREST RATE
RISK AND CURRENCY RISK
Reserve Bank of India issued the ALM guidelines in 1999 which, inter-alia,
introduced two returns viz. Statements of Structural Liquidity and Interest Rate
Sensitivity in domestic currency covering domestic operations. Banks were
already submitting two other returns viz. Maturity and Position and Interest
Rate Sensitivity in four major foreign currencies (USD, EURO, GBP and JPY).

14.7 RISK MANAGEMENT IN BANKS

Banks perform mainly the financial intermediary function. While performing
this function, they encounter various types of risks, viz., credit risk, market risk
(which includes interest rate risk, foreign exchange risk, liquidity risk, equity
price risk, commodity price risk, etc.), legal risk, regulatory risk, reputational
risk, operational risk, etc.

14.8 REGULATORY POLICIES FOR SCHEDULED COMMERCIAL BANKS

Resolution Framework for Covid-19 Stressed Assets: A window for resolution
of Covid-19-related stressed assets was announced on August 06, 2020,
under the Prudential Framework for Resolution of Stressed Assets introduced
a year earlier. It enabled the implementation of a resolution plan (RP) in
respect of eligible corporate exposures without change in ownership, and
covered personal loans too, while classifying them as standard but subject to
certain conditions.

14.9 SUPERVISION OF SCHEDULED COMMERCIAL BANKS

The Reserve Bank endeavours to constantly improve the efficacy of its
supervisory function, so that the resilience of the regulated entities can be
enhanced. A calibrated supervisory approach is followed to bring in required
modularity and scalability to better focus on risky practices and institutions
and to deploy an appropriate range of tools and technology to achieve our
supervisory objectives.

14.10 RECENT OPERATIONS AND PERFORMANCE OF SCHEDULED

COMMERCIAL BANKS
During 2020-21, scheduled commercial banks (SCBs) reported a discernible
improvement in their asset quality, capital buffers and profitability,
notwithstanding the disruptions of the pandemic. While credit offtake
remained subdued, elevated deposit growth on the liabilities side was
matched by growth in investments on the assets side. Nonetheless, incipient
stress remains in the form of higher restructured advances.

14.11 DEVELOPMENTS IN THE BANKING SECTOR 2021-2022 IN BRIEF

RBI’s Pandemic Response: Stepping out of Oblivion The 2020 pandemic
caused worldwide contagion, and the precipitous loss of lives and livelihood.
By the end of 2021, several advanced economies may have reached or
exceeded pre-pandemic levels of output, but middle income emerging
economies have suffered large losses of output, with the heaviest burden
falling on low income countries.

15.DEVELOPMENT, REGULATION AND SUPERVISION OF CO-

OPERATIVE BANKS

15.1 INTRODUCTION
The agricultural credit system as it has emerged has been a product of both
evolution and intervention and symbolizes the system’s response to the
stimuli from continuing requirement and speedy delivery of rural credit. The
importance of rural credit received the attention while enacting the Reserve
Bank of India Act, 1935 following which the agriculture credit Department as a
department of RBI came into existence.
15.2 GROWTH OF COOPERATIVE BANKING SYSTEM
The Reserve Bank of India Act, 1934 contains specific provisions relating to
agricultural credit. Section 54 of the RBI Act specifically authorized the
creation of an Agricultural Credit Department within the Reserve Bank to deal
not only with the rural credit but also with the long-term finance including
refinance. Section 17 of the RBI Act has empowered it to provide agricultural
credit through state cooperative banks or any other banks engaged in the
business of agricultural credit.

15.3 REGULATORY FRAMEWORK FOR CO-OPERATIVES: DUALITY OF

CONTROL
The ‘duality of control’ over the cooperative institutions is a contentious issue.
The Task Force on Cooperative Credit System (Chairman: Jagdish Capoor,
1999) addressed the issue of duality of control over cooperative credit
institutions and suggested the removal of overlap of controls to endow
functional autonomy and operational freedom to co-operatives.

15.4 STRENGTHENING OF THE FINANCIAL POSITION OF THE UCBs

Keeping in view the weak financial position of many UCBs, the Reserve Bank
has undertaken a series of measures directed towards strengthening of the
UCBs. Since March 31, 1993, the UCBs have been advised to adhere to the
prudential norms, which include the applicability of the capital adequacy
standards, prescribing an asset-liability management framework, enhancing
the proportion of holding of Government and other approved securities for the
purpose of SLR stipulation, restriction on bank finance against the security of
corporate shares and debentures, and limiting the exposure to capital
market investment.
15.5 STRENGTHENING OF THE SUPERVISORY SYSTEM RELATED TO
UCBs
Instances such as the Madhavpura Mercantile Cooperative Bank’s failure
brought to the fore the need to have stringent regulatory control over the
cooperative banking system. To strengthen the supervisory mechanism, the
Reserve Bank extended the Off-site Surveillance System (OSS) to all non-
scheduled UCBs having deposit size of Rs. 100 crore and above. A
supervisory reporting system was introduced for the scheduled UCBs since
March 2001 as a first step towards setting up of OSS for all UCBs.

15.6 COOPERATIVE BANKS: RECENT DEVELOPMENTS

The Reserve Bank continues to play a key role in strengthening the
cooperative banking sector by fortifying the regulatory and supervisory
framework. In this context, the Department took several initiatives in 2020-21
in pursuance of the agenda set in the beginning of the year.

15.7 IMPLEMENTATION STATUS OF GOALS

Discussion Paper on Policy Framework for Consolidation of UCB Sector
Large number of UCBs are community/ region-based which hinders the
process of mergers among UCBs and consolidation in the sector. On a
proposal made by the Reserve Bank, the BR Act, 1949 (as applicable to co-
operative societies) has been amended.

15.8 STRENGTHENING REGULATORY FRAMEWORK Initiatives in this

regard during 2020-21 were as follows:
• The amendment in the BR Act, 1949 (as applicable to cooperative societies -
AACS) has brought in significant changes in the statutory provisions
applicable on cooperative banks. The Department is in the process of
amending the extant instructions and issuing new guidelines
wherever required.
15.9 MAJOR DEVELOPMENTS
System-Based Asset Classification – UCBs: To improve the efficiency,
transparency, and integrity of the asset classification process, UCBs with total
assets of ₹2,000 crore or above as on March 31, 2020, have been advised to
implement the system-based asset classification with effect
from June 30,2021.

15.10 AGENDA FOR 2021-22 The agenda for cooperative banks in 2021-22
would include the following under Utkarsh:
• Setting up of an Umbrella Organisation (UO) for UCBs: National Co-
operative Finance and Development Corporation Ltd. was incorporated on
April 18, 2020, as a non-government public limited company under the
Companies Act 2013, having its registered office in New Delhi. The process of
enrolment of UCBs as shareholder members of the UO is in progress.

16.FINANCIAL STABILITY
16.1 INTRODUCTION
In the aftermath of major crisis situations, central banks have been assigned
financial stability as a major functional responsibility. Conceding that the crisis
situations are unpredictable, it is nevertheless realized that the severity of
crisis situations could be minimized in case the financial
system remains strong.

16.2 GLOBAL ECONOMIC CRISIS AND ITS IMPLICATIONS FOR CENTRAL

BANKS 16.2.1 Before discussing the framework for financial architecture
adopted by central banks across the globe for financial stability, it would be
appropriate to discuss the genesis and causes and consequences of the
global financial crisis of 2008.

16.3 FINANCIAL STABILITY – AN OVERVIEW

There is no single definition of financial stability. Mishkin defines financial
stability in a broad way as the prevalence of a financial system, which can
ensure in a lasting way and without major disruptions, efficient allocation of
savings to investment opportunities. This broad definition is important
because of its perception that an individual bank failure or every large swing
in asset prices does not necessarily mean financial instability.

16.4 RISKS TO FINANCIAL STABILITY

Financial stability would be vulnerable to crisis situations when shifts in policy
regime take place with no trace of transparency. The uncertainties could lead
to deviations in the market behavior of certain participants, especially the big
ones from the normal pattern, the rest of the market participants would tend to
imitate and be a part of the ‘herd’. Such ‘herd behaviour’, if unchecked, could
lead to system-wide crisis.

16.5 EARLY WARNING SIGNALS AND REMEDIAL ACTION

The systemic risks that occurred in the 1990s(in Mexico, Thailand, Korea,
Indonesia, Argentina, Brazil, Russia) were extreme in the sense they were
severe crises. From the point of view of policymaking at the levels of both the
Treasury and central banks, it is important to nip the crisis in bud when
symptoms of crises arise.

16.6 LIQUIDITY MANAGEMENT IN BANKS Introduction

Liquidity, or the ability to fund increases in assets and meet obligations as
they come due, is crucial to the ongoing viability of any banking organization.
Therefore, managing liquidity is among the most important activities
conducted by banks.

16.7 THE BASEL NORMS FOR BANK SUPERVISION

The Basel Committee on Banking Supervision (BCBS) that was established
by the Central Bank Governors of the Group of 10 countries in 1975 after the
Herstatt Bank crisis has formulated 25 basic principles which came to be
known as core principles. These principles have widely been accepted as
providing a benchmark for assessing whether the supervisory system is
effective or not.

16.8 PROGRESS IN THE IMPLEMENTATION OF BASEL II NORMS

Though concurrent efforts are underway in India to refine and upgrade
financial information monitoring, data dissemination and data warehousing in
various banks, the magnitude of the task is huge and appears to be difficult as
there are many commercial banks in India, which are at various
levels of development.

16.9 PROGRESS IN THE IMPLEMENTATION OF BASEL III NORMS

 As from April1,2013, the Basel III capital regulation has been implemented by
the Reserve Bank of India (RBI) in phases and it will be fully implemented as
on March 31, 2019. The Basel III Liquidity Coverage Ratio (LCR) was
implemented by banks in India from January 1, 2015 with full implementation
being effective from January 1, 2019. The Reserve Bank has issued draft
guidelines on implementation of Net Stable Funding Ratio (NSFR).

16.10 RBI PERSPECTIVE ON MOVING TOWARDS BASLE III

IMPLEMENTATION The RBI is moving ahead towards implementation of
Basel III Framework. By far the most important reason is that as India
integrates with the rest of the world, as increasingly Indian banks go abroad
and foreign banks come on to our shores, India cannot afford to have a
regulatory deviation from global standards.

16.11 EFFECT OF LIBERALIZATION AND GLOBALIZATION ON FINANCIAL

STABILITY
A significant feature of the past century has been the rapid evolution in the
role of central banks globally. A paradigm shift in the functions of the central
banks has been brought about by several factors like the liberalization of the
domestic economy and the financial system; and globalization and
technological advances.

16.12 CONDUCT OF MONETARY POLICY IN THE CONTEXT OF

LIBERALIZATION AND GLOBALIZATION
The conduct of monetary policy formulation has undergone significant
change in terms of adapting itself to the changing dynamics of liberalization
and globalization. In India, the Reserve Bank has been continuously
responding to changes in both the domestic and global macroeconomic
conditions and accordingly, the operating procedures have undergone
significant changes.
16.13 GROWING TREND TOWARDS TRANSPARENCY, CO-OPERATION
AND BEST PRACTICES IN A GLOBALIZED ENVIRONMENT
Transparency in market operations is essential for smooth functioning of
financial markets and for ensuring an efficient monetary policy transmission
mechanism. The benefit of transparency is that it reveals information about
current and future behaviour of the central bank and thereby influences
expectation formation and market behaviour. In the context of globalization,
the need for disseminating adequate, timely and quality data relating to
various aspects of the economy such as real sector, interest and exchange
rates and prices, for efficient functioning of markets has gained significance.

16.14 ROLE OF CONSULTATIVE APPROACH

A hallmark of the financial market reform process in India has been the
consensus building, which is operationalized through inter-departmental
working groups, inter-agency committees and Technical Advisory Committees
at the formulation stages and Financial Markets Committee (FMC) at the
monitoring stage. The aim of such exercises is to involve all the stake holders
in the formulation and implementation stages.

16.15 LINKAGE TO INTERNATIONAL FINANCIAL STABILITY

In this section, we endeavour to capture the international dimensions and
linkages of financial stability. When exchange rates are volatile, or when
foreign flows do not follow a steady pattern or when foreign debt incurred by
governments or by firms in EMEs is perceived to be unsustainable, financial
stability would be under severe stress. Most currency and financial crises in
EMEs could be traced to improper sequencing of economic reforms.

16.16 INTERNATIONAL STANDARDS AND CODES

The crisis situations could be triggered due to the failure of non-bank entities
as well. The collapse of the real estate prices caused the failure of non-bank
entities. This reveals that the regulations and supervision should extend
beyond the frontiers of banking to include the other financial
companies as well.

16.17 ROLE OF SUPERVISOR UNDER BASEL II & BASEL III

The Basel Committee on Banking Supervision formulated the Core Principles
for banking supervision and central banks across the world have adopted
these principles with a view to achieving broad convergence of their
supervisory mechanisms with the international norms.

MODULE;-F
NON-BANKING FINANCIAL COMPANIES AND PRIMARY DEALERS

Unit 17. Non-Banking Financial Institutions: Development,

Regulation and Supervision

17.1 INTRODUCTION
Banks are basically financial intermediaries transferring funds from those
sections of society having surplus funds like households and transferring them
to those sectors that need funds like individuals, corporates, government etc.
and transferring the same to those that need funds for carrying out their
economic activities.

17.2 CONDITIONS FOR COMPANIES TO REGISTER AS NBFCs WITH THE

RESERVE BANK OF INDIA
A company has to meet the following requirements before applying to the
Reserve Bank of India for obtaining NBFC License. • The business should be
registered as a company under the Companies Act, 1956, or 2013. • The
minimum capital (Net Owned Fund) requirement is Rs. 2 crore.
• The principal business of the applicant should be financial activities. If the
financial flow of the business is more than 50% of the total capital asset, then
that company can get NBFC registration. • It should have at least 1 Director
from the financial field or a senior banker as a director. • The CIBIL (Credit
Information Bureau Limited) records should be clean.

17.3 NBFCs REGISTERED WITH OTHER REGULATORY BODIES

Some types of NBFCs fall under the regulatory framework of other regulatory
bodies. Therefore, such NBFCs are not required to be registered with the
Reserve Bank of India. These types of NBFCs are listed below: • Insurance
Companies: These are regulated by the Insurance Regulatory and
Development Authority of India (IRDA), • Housing Finance Companies
(HFCs): These are supervised by the National Housing Bank (NHB)

17.4 Types of NBFC

Classification of NBFCs by Activity Type of NBFC Activity

1. Investment and Credit Company (ICC) Lending and investment.
2. NBFC-InfrastructureFinance Company (NBFC-IFC) Financing of
infrastructure sector.
3. Core Investment Company (CIC) Investment in equity shares, preference
shares, debt, or loans of group companies.
4. NBFC-Infrastructure Debt Fund (NBFC-IDF) Facilitation of flow of long-
term debt only into post commencement operations in infrastructure projects
which have completed at least one year of satisfactory performance.
5. NBFC-Micro Finance Institution (NBFC-MFI) Providing collateral free
small ticket loans to economically disadvantaged groups.
6. NBFC-Factor: Acquisition of receivables of an assignor or extending loans
against the security interest of the receivables at a discount.
7. NBFC-Non-Operative Financial Holding Company (NBFC-NOFHC)
Facilitation of promoters/ promoter groups in setting up new banks.
8. Mortgage Guarantee Company (MGC) Undertaking of mortgage
guarantee business.
9. NBFC-Account Aggregator (NBFC-AA) Collecting and providing
information about a customer’s financial assets in a consolidated, organised,
and retrievable manner to the customer or others as specified by the
customer.
10. NBFC–Peer to Peer Lending Platform (NBFC-P2P) Providing an online
platform to bring lenders and borrowers together to help mobilise funds.
11. Housing Finance Company (HFC) Financing for housing.

Layers of NBFC:

The framework is based on a four-layered structure: base layer (NBFC-BL),

middle layer (NBFC-ML), upper layer (NBFC-UL) and top layer, with a
progressive increase in the intensity of regulation.
The base layer consists of non-deposit taking NBFCs (NBFC-NDs) with asset
size below ₹1,000 crore and certain other NBFCs engaged in specific
activities. It aims at increasing transparency by way of greater disclosures
and improved governance standards while not burdening them with higher
level regulations. The middle layer mainly includes all deposit taking NBFCs
and non-deposit taking NBFCs with asset size of ₹1,000 crore and above and
some specialised NBFCs.

17.5 GROWTH OF NBFC SECTOR AND THE NEED FOR PRUDENCE

NBFCs have come a long way in terms of their scale and diversity of
operations. They now play a critical role in financial intermediation and
promoting inclusive growth by providing last-mile access of financial services
to meet the diversified financial needs of less-banked customers. Over the
years, the segment has grown rapidly, with a few of the large NBFCs
becoming comparable in size to some of the private sector banks.

17.6. THE ROLE OF THE RESERVE BANK OF INDIA IN THE

DEVELOPMENT OF NBFCs
The Reserve Bank of India plays an active role in the regulation, promotion,
and development of NBFCs by undertaking the following activities: • Co-
ordination with State Governmentsto pass State Legislations to curb
unauthorized and fraudulent activities • Conducting public awareness
programmes, depositors’ education, conducting workshops/ seminars for
trade and industry organizations .

17.7 REGULATORY POLICIES FOR NON-BANK FINANCIAL COMPANIES

(NBFCs): SCALE-BASED REGULATORY FRAMEWORK
The Reserve Bank came out with a scale-based regulation framework for
NBFCs following the principle of proportionality on October 22,2021.
Currently, capital to risk weighted assets ratio (CRAR) requirement for
NBFCs is 15 per cent of risk weighted assets (RWAs), without any bifurcation
such as Common Equity Tier (CET) 1 or additional Tier I capital.
To enhance the quality of regulatory capital, NBFC-UL will have to maintain
CET- 1 capital of at least 9 per cent of RWAs. Further, large exposure
framework has also been introduced for NBFC-UL.
The extant credit concentration limits prescribed separately for lending and
investments have been merged into a single exposure limit of 25 per cent for
a single borrower and 40 per cent for a group of borrowers in case of NBFC-
ML and NBFCUL. These concentration limits will be determined with
reference to the NBFC’s Tier 1 capital instead of their owned fund.
The extant NPA classification norm has also been changed to the overdue
period of more than 90 days for all categories of NBFCs and a glide path has
been provided to NBFCs-BL to be achieved by March 31, 2026.
Also, with a view to stem financial stability concerns, a ceiling of ₹1 crore per
borrower has been put on financing of subscription to initial public offer (IPO).

IIBF. CENTRAL BANKING (p. 440). Kindle Edition.

17.8 SPECIAL LIQUIDITY SCHEME (SLS) FOR NON-BANK FINANCIAL

COMPANIES (NBFCs)/ HOUSING FINANCE COMPANIES (HFCs)
In July 2020, the Government announced an SLS of ₹30,000 crore to
address short-term liquidity concerns of NBFCs/HFCs. Under the scheme, a
Special Purpose Vehicle (SPV) was set up to purchase investment grade
commercial papers (CPs)/ non-convertible debentures (NCDs) of residual
maturity up to 90 days issued by these institutions.

17.9 ALIGNING REGULATORY FRAMEWORK FOR HFCs WITH NBFCs

Consequent to the transfer of regulation of HFCs from National Housing Bank
(NHB) to the Reserve Bank with effect from August 9, 2019, a revised
regulatory framework was issued on October 22,2020, to ensure smooth
regulatory transition.

17.10 LOWERING OF SECURED DEBT LIMIT FOR NBFCs UNDER

SARFAESI ACT
On February 24, 2020, NBFCs with asset size of ₹100 crore and above were
permitted to take recourse to the SARFAESI Act for enforcement of security
interest in secured debts of ₹50 lakh and above. Subsequently, the
Government further reduced the secured debt limit to ₹20 lakh and above on
February 12, 2021.

17.11 DECLARATION OF DIVIDEND BY NBFCs

Considering the increasing significance of NBFCs in the financial system and
their inter-linkages with different segments, guidelines on their dividend
distribution were issued on June 24, 2021. The eligibility criteria for dividend
pay-out were linked to their capital adequacy and net NPA levels, and a
ceiling on the maximum dividend pay-out ratio was specified.

17.12 SUPERVISORY POLICIES FOR NBFCs

The Reserve Bank endeavours to constantly improve the efficacy of its
supervisory function, so that the resilience of the regulated entities can be
enhanced. A calibrated supervisory approach is followed to bring in required
modularity and scalability to better focus on risky practices and institutions
and to deploy an appropriate range of tools and technology to achieve our
supervisory objectives.

17.13 APPOINTMENT OF AUDITORS IN REGULATED ENTITIES

The Reserve Bank issued guidelines for appointment of Statutory Central
Auditors (SCAs)/ Statutory Auditors(SAs) of SCBs(excluding RRBs), UCBs
and NBFCs(including HFCs) in April 2021. This was the first time when such
guidelines were prescribed for UCBs and NBFCs.

17.14 PROMPT CORRECTIVE ACTION (PCA) FRAMEWORK FOR NBFCs

Given the growing size and interconnectedness of NBFCs with other
segments of the financial system, the Reserve Bank put in place a PCA
framework for them on December14,2021. The PCA framework, which will
strengthen the supervisory tools applicable to NBFCs, will come into effect
from October 1, 2022, based on the financials at end-March 2022.

17.15 IMPACT OF PANDEMIC ON NBFC SECTOR

The pandemic tested the resilience of the NBFC sector. Their balance sheet
expanded in 2020- 21 on the back of credit growth of NBFCs-ND-SI aided by
proactive policy support and revival of the economy.
18.ROLE OF PRIMARY DEALERS IN THE GOVERNMENT SECURITIES
MARKET: EVOLUTION AND DEVELOPMENT,
REGULATION AND SUPERVISION

18.1 INTRODUCTION
Over the years, the PDs presence in the Government securities market has
brought about an element of dynamism, both in the primary and secondary
markets. As on March 31, 2021, there were 21 primary dealers (PDs), of
which 14 function as bank departments and 7 as standalone PDs (SPDs), the
latter registered as NBFCs under section 45 IA of the RBI Act, 1934.

18.2 EVOLUTION OF PDs In 1995, the Reserve Bank of India (RBI)

introduced the system of Primary Dealers (PDs) in the Government Securities
(G-Sec) Market. The objectives of the PD system are to strengthen the
infrastructure in G-Sec market, development of underwriting and market
making capabilities for G-Sec, improve secondary market trading system and
to make PDs an effective conduit for open market operations (OMO).

18.3 ELIGIBILITY CONDITIONS FOR PDs

An applicant will not be eligible for authorisation as a PD if, within the last one
year, it has been subject to litigation or regulatory action or investigation that
the Reserve Bank considers material or otherwise relevant to the business of
PD. In making such determination, RBI may consult with the appropriate
regulators for their views. An entity satisfying the criteria stipulated above
should submit its application to the Chief General Manager, Internal Debt
Management Department (IDMD), RBI, Mumbai.

18.4 ROLE AND RESPONSIBILITIES OF PDs PDs are expected to play an

active role in the G-Sec market, both in its primary and secondary market
segments through various obligations like participating in Primary auction,
market making in G-Secs, predominance of investment in G-Secs, achieving
minimum secondary market turnover ratio, maintaining efficient internal
control system for fair conduct of business etc.

18.5 LIQUIDITY SUPPORT FROM RBI

In addition to access to the RBI’s LAF, standalone PDs are also provided with
liquidity support by the RBI against eligible G-Sec including SDLs. The
parameters based on which liquidity support will be allocated are given below:
• Of the total liquidity support, half of the amount will be divided equally among
all the standalone PDs. The remaining half (i.e. 50%) will be divided in the
ratio of 1:1 based on market performance in primary market and secondary
market. Performance in primary market will be computed on the basis of bids
accepted in the T-Bill/CMB auctions and G-Sec auctions in the proportionate
weights of 1 and 3. Similarly, the secondary market performance will be
judged on the basis of outright turnover in T-Bills/CMBs and G-Sec in the
proportionate weights of 1 and 3.

18.6 OPERATIONS AND PERFORMANCE OF PDs

PDs are financial intermediaries mandated to take part in the all-round
development of the primary and secondary government securities market,
underwrite issuances of government dated securities and participate in
primary auctions. They are also mandated to achieve a minimum success
ratio (bids accepted as a proportion to bidding commitment) of 40 per cent in
primary auctions of T-bills and Cash Management Bills (CMBs), assessed on
a half-yearly basis.
18.7 FINANCIAL PERFORMANCE OF SPDs
A substantial increase was observed in the SPDs’ profit after tax (PAT) in
2020-21 vis-à-vis previous year on account of sharp contraction in interest
expenses. Trading profits also witnessed a substantial increase. Income
remained at almost similar levels whereas expenditure decreased in
comparison with the previous year, resulting in higher profits for the
SPDs during 2020-21.

18.8 OPERATIONAL GUIDELINES, REGULATORY AND SUPERVISORY

PROVISIONS GOVERNING PRIMARY DEALERS
Salient feature of Regulation and Supervision by RBI: Operations of the PDs
are subject to prudential and regulatory guidelines issued by RBI from time to
time. As part of off-site supervision, PDs are required to submit prescribed
periodic returns to RBI. RBI may also prescribe any other return as it may
deem necessary. RBI will have the right to inspect the books, records,
documents, and accounts of a PD.
i. The underwriting commitment on dated securities of Central Government
will be divided into two parts - a) Minimum Underwriting Commitment (MUC),
and b) Additional Competitive Underwriting (ACU). ii. The MUC
The MUC of each PD will be computed to ensure that at least 50 percent of
the notified amount of each issue is mandatorily underwritten equally by all
the PDs.
In the ACU auction, each PD would be required to bid for an amount at least
equal to its share of MUC. A PD cannot bid for more than 30 per cent of the
notified amount in the ACU auction.

18.9 INVESTMENT GUIDELINES

Investment policy - PDs should frame and implement, a Board approved,
investment policy and operational guidelines on securities transactions. The
policy should contain the broad objectives to be followed while undertaking
transactions in securities on their own account and on behalf of clients, clearly
define the authority to put through deals, and lay down procedure to be
followed while putting through deals, various prudential exposure limits, policy
regarding dealings through brokers, systems for management of various risks,
guidelines for valuation of the portfolio and the reporting systems etc.
18.10 CAPITAL ADEQUACY AND RISK MANAGEMENT 18.10.1 The capital
adequacy and risk management guidelines applicable to a bank undertaking
PD activity departmentally, will be as per the extant guidelines applicable to
banks. In other words, for the purpose of assessing the bank’s capital
adequacy requirement and coverage under risk management framework, the
PD activity should also be taken into account.