The Reserve Bank of India (RBI): A Journey Through Time
- April 2, 2024
- Posted by: OptimizeIAS Team
- Category: DPN Topics
The Reserve Bank of India (RBI): A Journey Through Time
Subject: Economy
Section: Monetary Policy
Establishment and Early Years:
- The Reserve Bank of India is the central bank of the country.
- The Reserve Bank of India was set up on the basis of the recommendations of the Hilton Young Commission. The Reserve Bank of India Act, 1934 (II of 1934) provides the statutory basis of the functioning of the Bank, which commenced operations on April 1, 1935.
- The Bank was constituted to
* Regulate the issue of banknotes
* Maintain reserves with a view to securing monetary stability and
* To operate the credit and currency system of the country to its advantage. - The Bank began its operations by taking over from the Government the functions so far being performed by the Controller of Currency and from the Imperial Bank of India, the management of Government accounts and public debt. The existing currency offices at Calcutta, Bombay, Madras, Rangoon, Karachi, Lahore and Cawnpore (Kanpur) became branches of the Issue Department. Offices of the Banking Department were established in Calcutta, Bombay, Madras, Delhi and Rangoon.
- Burma (Myanmar) seceded from the Indian Union in 1937 but the Reserve Bank continued to act as the Central Bank for Burma till Japanese Occupation of Burma and later upto April, 1947. After the partition of India, the Reserve Bank served as the central bank of Pakistan upto June 1948 when the State Bank of Pakistan commenced operations. The Bank, which was originally set up as a shareholder’s bank, was nationalised in 1949.
- The first Governor was Sir Osborne Arkell Smith, followed by the first Indian Governor, Sir C.D. Deshmukh.
- An interesting feature of the Reserve Bank of India was that at its very inception, the Bank was seen as playing a special role in the context of development, especially Agriculture.
- The Bank was also instrumental in institutional development and helped set up institutions like the Deposit Insurance and Credit Guarantee Corporation of India, the Unit Trust of India, the Industrial Development Bank of India, the National Bank of Agriculture and Rural Development, the Discount and Finance House of India to build the financial infrastructure of the country.
- With liberalisation, the Bank’s focus has shifted back to core central banking functions like Monetary Policy, Bank Supervision and Regulation, and Overseeing the Payments System and onto developing the financial markets.
Being Central bank of India, following functions are performed by RBI
- Issue of Bank Notes: The Reserve Bank of India has the sole right to issue currency notes except one rupee notes which are issued by the Ministry of Finance. Currency notes issued by the Reserve Bank are declared unlimited legal tender throughout the country
- Banker to Government: As banker to the government the Reserve Bank manages the banking needs of the government. It has to-maintain and operate the government’s deposit accounts. It collects receipts of funds and makes payments on behalf of the government. It represents the Government of India as the member of the IMF and the World Bank.
- Custodian of Cash Reserves of Commercial Banks: The commercial banks hold deposits in the Reserve Bank and the latter has the custody of the cash reserves of the commercial banks.
- Custodian of Country’s Foreign Currency Reserves: The Reserve Bank has the custody of the country’s reserves of international currency, and this enables the Reserve Bank to deal with crisis connected with adverse balance of payments position.
- Lender of Last Resort: The commercial banks approach the Reserve Bank in times of emergency to tide over financial difficulties, and the Reserve bank comes to their rescue though it might charge a higher rate of interest.
- Controller of Credit: Since credit money forms the most important part of supply of money, and since the supply of money has important implications for economic stability, the importance of control of credit becomes obvious. Credit is controlled by the Reserve Bank in accordance with the economic priorities of the government through Repo rate, reverse repo rate.
Chronology of Events
1 Apr 1935 | Reserve Bank of India commences operations. Sir Osborne Smith the first Governor of the Bank. The Bank was constituted as a shareholders’ bank. |
5 Jul 1935 | Scheduled banks required to maintain the Cash Reserve Ratio, i.e., hold cash balances with the RBI equivalent to 5% of their Demand Liabilities and 2% of their Time Liabilities. |
1937 | RBI acts as banker to the Government of Burma and also responsible for note issue in Burma. |
1940 | The silver rupee replaced by the quarternary alloy rupee. One Rupee note reintroduced. This note had the status of a rupee coin and represented the introduction of official fiat money in India. |
11 Aug 1943 | Sir C. D. Deshmukh assumes office of Governor. |
30 Jun 1948 | RBI ceased to function as the Central Bank of Pakistan. State Bank of Pakistan commenced operations wef July 1, 1949. |
1 Jan 1949 | Reserve Bank of India nationalised. |
16 Mar 1949 | Coming into force of the Banking Companies Act, 1949. This formed the statutory basis of bank supervision and regulation in India. |
1 Jul 1949 | Sir Benegal Rama Rau assumes office as Governor |
19 Jul 1969 | 14 major Indian Scheduled Commercial Banks with deposits of over Rs 50 crores nationalised ‘ to serve better the needs of development of the economy in conformity with national policy objectives’. On February 10, 1970 the Supreme Court held the Act void mainly on the grounds that it was discriminatory against the 14 banks and that the compensation proposed to be paid by Govt was not fair compensation. |
Dec 1969 | Lead Bank Scheme introduced which envisaged an area approach to banking to meet the credit gaps in the economy. |
Reforms of 1991:
- In response to the economic crisis of 1990, the RBI took significant measures.
- It transferred gold reserves to manage liquidity and devalued the rupee twice.
- Full convertibility of the rupee on trade account was allowed.
- Banking reforms, deregulation of interest rates, and issuing new private bank licenses were key steps.
Manmohan Singh and Pranab Mukherjee Era:
- Manmohan Singh, as Governor, strengthened monetary policy actions and initiated banking reforms.
- Singh had differences with Finance Minister Pranab Mukherjee, notably over licensing foreign banks like Bank of Credit and Commerce International (BCCI)
Subbarao and Urjit Patel vs. Government:
- Subbarao, during his tenure as Governor, had disagreements with Finance Minister P. Chidambaram.
- Urjit Patel faced a feud with the Finance Ministry over surplus dividend income from the RBI.
- Patel resigned after serving two years as Governor.
Handling the 2008 Crisis:
- Under Y.V. Reddy’s leadership, the RBI’s policies against capital inflows pre-crisis were praised.
- Post-crisis, the RBI managed the situation well under D. Subbarao’s liberal accommodative policy.
- Raghuram Rajan introduced plans to internationalize the rupee and boost exports.
Demonetization of 2016:
- The sudden demonetization of high-value currency notes in 2016 led to significant challenges.
- The RBI faced the task of managing liquidity shortages and economic disruptions.
- The pace of remonetization was slow, affecting businesses and GDP growth.
Monetary Policy Committee and Asset Quality Review:
- Patel chaired the first meeting of the Monetary Policy Committee (MPC).
- Despite calls to ease the asset quality review initiated by Rajan, Patel continued the exercise.
- The RBI utilized the Insolvency and Bankruptcy Code (IBC) to address the debt pile of major defaulters.
COVID-19 Pandemic Response:
- Shaktikanta Das, the current Governor, adopted an accommodative monetary policy during the pandemic.
- The repo rate was reduced to 4% to stimulate growth.
- The pandemic accelerated the RBI’s push for digital payments, with the launch of UPI revolutionizing the banking system.
The RBI’s journey over the last 90 years has seen it navigate through various economic challenges, implement crucial reforms, and adapt to evolving financial landscapes, solidifying its role as India’s central bank and a key player in the country’s economic development.
Monetary Policy Committee (MPC) – Overview
The Monetary Policy Committee (MPC) is a statutory body constituted by the Government of India under the amended Reserve Bank of India (RBI) Act, 1934. Its primary objective is to determine the policy rate needed to achieve the inflation target set by the government.
Purpose:
- The MPC is responsible for fixing the benchmark interest rate, also known as the repo rate, which is used to guide other interest rates in the economy.
- It aims to maintain price stability while supporting the objective of economic growth.
Composition:
- Members: The MPC consists of six members:
- RBI Governor (Chairperson)
- Deputy Governor of RBI in charge of monetary policy
- One officer nominated by the RBI Board
- Three members appointed by the Central Government
- Criteria for Appointment:
- Members are appointed based on their expertise and experience in economics, banking, finance, or monetary policy.
- They are expected to have the ability, integrity, and standing in their fields.
Decision Making:
- Voting: The MPC takes decisions on monetary policy by a majority vote.
- Quorum: A minimum of four members must be present, including the Governor or the Deputy Governor.
- Binding Decision: The decision of the MPC is binding on the RBI.
Functions and Instruments of Monetary Policy:
- Repo Rate:
- The rate at which the RBI lends money to commercial banks.
- It influences borrowing and lending rates in the economy.
- Reverse Repo Rate:
- The rate at which the RBI borrows money from commercial banks.
- It affects the liquidity in the banking system.
- Liquidity Adjustment Facility (LAF):
- Consists of repo and reverse repo auctions to manage short-term liquidity.
- Marginal Standing Facility (MSF):
- Banks can borrow overnight funds from the RBI against government securities.
- Bank Rate:
- Rate at which the RBI lends money to commercial banks for longer durations.
- Cash Reserve Ratio (CRR):
- Specifies the percentage of deposits that banks must keep with the RBI.
- Affects the liquidity available to banks for lending.
- Statutory Liquidity Ratio (SLR):
- Mandates banks to maintain a certain percentage of their deposits in specified liquid assets.
- Influences credit availability and liquidity.
- Open Market Operations (OMOs):
- Buying and selling of government securities to manage liquidity.
- Affects money supply and interest rates.
- Market Stabilization Scheme (MSS):
- Used to absorb excess liquidity from the market.
Policy Stances:
- Accommodative:
- Central bank aims to boost economic growth.
- Willingness to cut interest rates and expand money supply.
- Neutral:
- Balanced stance when equal priority is on inflation and growth.
- No bias towards rate hikes or cuts.
- Hawkish:
- Focus on controlling inflation.
- Willingness to raise interest rates to curb inflationary pressures.
- Calibrated Tightening:
- Gradual increase in interest rates over time.
- Indicates a cautious approach towards monetary tightening.
Asset Quality Review (AQR)
An Asset Quality Review (AQR) is a detailed examination or review conducted by a regulatory authority, often a central bank viz. Reserve Bank of India (RBI), to assess the true quality of a bank’s assets, particularly loans. The primary objective of an AQR is to identify and recognize the actual level of bad loans or non-performing assets (NPAs) within the banking system.
Purpose:
- Assessment of Bad Loans: The main aim of an AQR is to evaluate the extent of bad loans or NPAs held by banks.
Criteria for NPAs:
- 90-Day Rule: In India, a loan is classified as a non-performing asset (NPA) if the borrower fails to pay interest or repay the principal for a period of 90 days or more.
Need for AQR:
- Prevention of Crisis: Banks sometimes use technical adjustments to mask or delay the classification of stressed loans as NPAs. This can create a false picture of the bank’s health and lead to a potential crisis.
- Enhanced Transparency: AQRs aim to enhance transparency in the banking system by ensuring that the true state of asset quality is reflected in the books.
Process:
- Thorough Examination: The RBI conducts a thorough and detailed review of the bank’s loan portfolio, scrutinizing each loan account.
- Identification of NPAs: During the AQR, the RBI identifies loans that are not being serviced as per the stipulated criteria.
- Forcing Recognition: Banks are required to recognize these identified NPAs on their balance sheets, reflecting the true state of their asset quality.
Impact:
- Clear Picture: AQRs provide a clear and accurate picture of a bank’s financial health by identifying and recognizing troubled assets.
- Provisioning: Banks are then required to set aside provisions to cover potential losses from these NPAs, affecting their profitability and capital adequacy.
- Market Confidence: A transparent assessment through an AQR can improve investor and market confidence in the banking sector.
Significance:
- Financial Stability: AQRs are crucial for maintaining financial stability by addressing potential risks and vulnerabilities in the banking system.
- Regulatory Vigilance: It reflects the regulator’s vigilance in ensuring that banks adhere to prudential norms and maintain asset quality standards.