November 30, 2012

MA0036 [Financial Systems and Commercial Banking] Set2 Q3

Q3. What are the functions of the Reserve Bank of India?

Ans:

Main Functions


Monetary authority
The Reserve Bank of India is the main monetary authority of the country and beside that the central bank acts as the bank of the national and state governments. It formulates, implements and monitors the monetary policy as well as it has to ensure an adequate flow of credit to productive sectors. Objectives are maintaining price stability and ensuring adequate flow of credit to productive sectors. The national economy depends on the public sector and the central bank promotes an expansive monetary policy to push the private sector since the financial market reforms of the 1990s. 

The institution is also the regulator and supervisor of the financial system and prescribes broad parameters of banking operations within which the country's banking and financial system functions. Objectives are to maintain public confidence in the system, protect depositors' interest and provide cost-effective banking services to the public. The Banking Ombudsman Scheme has been formulated by the Reserve Bank of India (RBI) for effective addressing of complaints by bank customers. The RBI controls the monetary supply, monitors economic indicators like the gross domestic product and has to decide the design of the rupee banknotes as well as coins.

Manager of exchange control
The central bank manages to reach the goals of the Foreign Exchange Management Act, 1999. Objective: to facilitate external trade and payment and promote orderly development and maintenance of foreign exchange market in India.

Issuer of currency
The bank issues and exchanges or destroys currency and coins not fit for circulation. The objectives are giving the public adequate supply of currency of good quality and to provide loans to commercial banks to maintain or improve the GDP. The basic objectives of RBI are to issue bank notes, to maintain the currency and credit system of the country to utilize it in its best advantage, and to maintain the reserves. RBI maintains the economic structure of the country so that it can achieve the objective of price stability as well as economic development, because both objectives are diverse in themselves.

Developmental role
The central bank has to perform a wide range of promotional functions to support national objectives and industries. The RBI faces a lot of inter-sectoral and local inflation-related problems. Some of these problems are results of the dominant part of the public sector. 

Related functions
The RBI is also a banker to the government and performs merchant banking function for the central and the state governments. It also acts as their banker. The National Housing Bank (NHB) was established in 1988 to promote private real estate acquisition. The institution maintains banking accounts of all scheduled banks, too.

There is now an international consensus about the need to focus the tasks of a central bank upon central banking. RBI is far out of touch with such a principle, owing to the sprawling mandate described above. The recent financial turmoil world-over, has however, vindicated the Reserve Bank's role in maintaining financial stability in India.

Bank Rate: RBI lends to the commercial banks through its discount window to help the banks meet depositor’s demands and reserve requirements. The interest rate the RBI charges the banks for this purpose is called bank rate. If the RBI wants to increase the liquidity and money supply in the market, it will decrease the bank rate and if it wants to reduce the liquidity and money supply in the system, it will increase the bank rate. As of 5 May, 2011 the bank rate was 6%.

Cash Reserve Ratio (CRR): Every commercial bank has to keep certain minimum cash reserves with RBI. RBI can vary this rate between 3% and 15%. RBI uses this tool to increase or decrease the reserve requirement depending on whether it wants to affect a decrease or an increase in the money supply. An increase in Cash Reserve Ratio (CRR) will make it mandatory on the part of the banks to hold a large proportion of their deposits in the form of deposits with the RBI. This will reduce the size of their deposits and they will lend less. This will in turn decrease the money supply. The current rate is 6%.

Statutory Liquidity Ratio (SLR): Apart from the CRR, banks are required to maintain liquid assets in the form of gold, cash and approved securities. Higher liquidity ratio forces commercial banks to maintain a larger proportion of their resources in liquid form and thus reduces their capacity to grant loans and advances, thus it is an anti-inflationary impact. A higher liquidity ratio diverts the bank funds from loans and advances to investment in government and approved securities.

In well developed economies, central banks use open market operations--buying and selling of eligible securities by central bank in the money market--to influence the volume of cash reserves with commercial banks and thus influence the volume of loans and advances they can make to the commercial and industrial sectors. In the open money market, government securities are traded at market related rates of interest. The RBI is resorting more to open market operations in the more recent years.

Generally RBI uses three kinds of selective credit controls:
1. Minimum margins for lending against specific securities.
2. Ceiling on the amounts of credit for certain purposes.
3. Discriminatory rate of interest charged on certain types of advances.

Direct credit controls in India are of three types:
1. Part of the interest rate structure i.e. on small savings and provident funds, are administratively set.
2. Banks are mandatory required to keep 25% of their deposits in the form of government securities.
3. Banks are required to lend to the priority sectors to the extent of 40% of their advances.

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