01 Reserve Bank of India as a Banking Regulator

RESERVE BANK OF India was set up in 1935 under the Reserve Bank of India Act. 1934
and is the monetary authority and central bank of the country with responsibilities to
overview, develop and regulate the financial system.
CENTRAL BANKING FUNCTIONS
1. Reserve Bank. as Note-Issuing Authority Section 38 of the RBI Act
The currency of our country consists of one-rupee notes and coins (including subsidiary
coins) issued by the Government of India and bank notes issued by RBI. As required by Government puts into circulation one-rupee coins and notes through RBI only. RBI has the
sole right to issue bank notes in India. The notes issued by RBI and the one-rupee notes and
coins issued by the Government are unlimited legal tender. RBI also bears the responsibility
of exchanging notes and coins into those of other denominations as required by the public.
2. Reserve Bank as Banker to Government Section 20 and 21 of RBI Act,
RBI acts as banker to the Central and State Governments to transact government business
including the management of the public debt of the Central Government. Section 21 requires
the Central Government to entrust RBI all its money, remittance, exchange and banking
transactions in India and, in particular deposit free of interest all its cash balances with RBI.
RBI performs similar functions on behalf of the State Governments also. The Bank has entered
into agreements with the Central and State Governments for carrying on these functions. For
conducting ordinary banking business of the Central Government, RBI is not entitled to any
remuneration; it holds cash balances of the Government free of interest. For the management of
public debt, RBI is entitled to charge a commission. RBI is also required to maintain currency
chests of its Issue Department at places prescribed by the Government and to maintain
sufficient notes and coins therein.
Reserve Bank of India has also been entrusted with the task of managing the public debt
of the Central and State Governments. It undertakes auctions for the treasury bills and
Government dated securities are issued by it on behalf of the Government. It is entitled to
charge a commission for managing public debt. It may also purchase and sell securities of
Central and State Governments.
RBI is also authorized to make to the Central and State Governments ways and means
advances which are repayable within 3 months from the date of making the advance. RBI also
acts as adviser to the Government on important economic and financial matters.
3. Reserve Bank as Bankers' Bank (2nd Schedule to the RBI Act, 1934)
RBI is the banker to the banks-that is, to all commercial. cooperative and Regional Rural
Banks (RRBs).
A 'Scheduled Bank' means a' bank included in the Second Schedule to the Reserve Bank
of India Act, 1934. The Reserve Bank is empowered to include in the Second Schedule the
name of a bank which carries on the business of banking in India and which satisfies the
conditions laid down in Section 42(b).

(i) It must have a paid up capital and reserves of an aggregate value of not less than Rs.5Iakh;
(ii) It must satisfy the Reserve Bank that its affairs are not being conducted in a manner
detrimental to the interests of its depositors; and
(iii) must have any of the following structure:
(i)Commercial banks-Indian and foreign. (ii) Public Sector Banks, (iii) State Cooperative Banks,
(iv) Urban Cooperative Banks, and
(v) Regional Rural Banks.
The status of "Scheduled Bank" confers certain privileges e.g .. they become eligible for
availing of the facilities of accommodation from RBI. A scheduled bank. on the other hand.
has to fulfill the obligation to maintain statutory reserves with RBI.
4. Reserve Bank as Lender of the Last Resort
As the banker to the banks. RBI acts as the lender of the last resort and grants accommodation
to the scheduled banks in the following manner:
(a) Re-discounting or purchase of eligible bills (Section 17(2) and (3)
(b) Loans and Advances. Section 17(4) enables the RBI to grant loans and
advances to the scheduled banks. repayable on demand or on the expiry of
fixed periods not exceeding 90 days against the security of the following:
(i) Stocks. funds and securities (other than immovable property) in which a trustee is
authorised to invest trust money.
(ii) Gold or silver or documents of title to the same.
(iii) Such bills of exchange and promissory notes as are eligible for purchase or re- discount
by the RBI (stated above) or those guaranteed by the State Government as
to repayment of the principal and interest.
(iv) Promissory notes of any scheduled bank or State Cooperative Bank supported by
documents of title to goods (such documents having been transferred. assigned or
pledged to any other bank as securtty for a loan or advance made of bona fide
commercial or trade transactions or for the purpose of financing agricultural
operations or the marketing of crops).
Section 17(3-A) enables the banks to secure accommodation from the RBI on easier terms in
connection with export finance provided by them. The RBI may make loans and
advances to any scheduled bank against the promissory note of the latter repayable on demand
or on the expiry of a fixed period not exceeding 180 days.
Emergency Advances
The commercial banks and cooperative banks may be granted emergency advances by RBI
under Section 18 on such special occasions when RBI is satisfied that the grant of such loans
Is necessary for the purpose of regulating credit in the interests of Indian trade and commerce,
industry and agriculture. Such emergency advances may be given notwithstanding any
limitation contained in Section 17 and 18.
5. As Controller of Credit
Reserve Bank of India exercises control over the credit granted by the commercial banks
through various powers conferred upon it for this purpose. The methods of credit control are
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as follows:
(a) Statutory Cash Reserve Ratio (CRR). Under Section 42 of RBI Act. 1934. every
scheduled bank is under an obligation to keep a cash reserve with RBI called the Statutory
Cash Reserve Ratio (CRR). Every scheduled bank is required to maintain with RBI an
average daily balance equal to -a prescribed percentage of its demand and time liabilities
Average daily balance means the average of balances held at the close of business on each
day of a fortnight. Liabilities of a scheduled bank exclude its paid-up capital an reserves
and inter bank liabilities. Section 42(3) of RBI Act. 1934 prescribes penalties for not
complying with the above mentioned requirements. Currently prescribed CRR is 4%
(b) Statutory Liquidity Requirement (SLR,-) (under Section 24 of RBI Act., apart from
statutory cash reserve which the scheduled banks have to keep with RBI. All banks have
to main tam liquid assets at also in the form of cash, gold and unencumbered
approved securities. Curent SLR is 23%
Reserve Bank of India gradually revised this requirement during 1970's and 1980's till it
reached the highest level of 38.5 per cent in January 1988. RBI had stepped up the liquidity
ratio for three reasons :
(a) A higher liquidity requirement forces scheduled banks to maintain- a larger
proportion of their resources in liquid form and thus reduces their capacity to grant
loans and advances to business and industry. Thus it is anti-inflationary in its
impact; and
(b) A higher liquidity ratio diverts banks' funds from loans and advances granted to industry
and trade to investment in government and other approved securities.
(c) The higher liquidity ratio is a method of raising funds for the Government and for
the public sector financial institutions at a rate lower than the market rate of interest.
It may be mentioned here that the effect of stepping up cash reserve ratio (CRR) and the
statutory liquidity requirement (SLR) is the same, viz., they force banks to keep large
volume of funds in liquid form, reduce their capacity to extend credit to business and
industry and thus act as anti-inflationary measures.
,
(c) Selective Credit Controls. Under Section 21 of the Banking Regulation Act, 1949,
RBI has been vested with wide powers to control advances by individual banks or by the
banking system as a whole and to issue directives for :
(i) The purpose for which advances may or may not be made;
(ii)The margins to be maintained on secured loans;
(iii)The maximum amount of advances to any firm or company; and
(iv) The rate of interest to be charged by banks and other terms and conditions for granting
advances.
Advances against (a) food grains, (b) cotton and kappas, (c) oilseeds and oil, (d) vanaspati,
(e) sugar. khandsari and gur. and (f) cotton textiles. Including yarn. were subject to selective
controls. Under the system of selective credit controls. whose need for credit may not be so
urgent or larger flow of credit to whom is likely to aggravate the price situation. RBI does not
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allow granting of clean credit facilities to any borrower subject to selective credit controls.
RBI makes certain exemptions also from the selective credit controls-for example. State
agencies such as the Food Corporation of India (FCI) and State Trading Corporation (STC)
are exempted. Banks generally conform to the selective control directives issued by RBI.
(d) Bank Rate Policy. Bank rate is the rate at which Reserve Bank of India grants loans to
the commercial banks and re-discounts the bills of exchange. By changing the Bank rate.
Reserve Bank of India varies the cost of funds which the banks may borrow from Reserve
Bank of India. In turn they also increase their lending rates. At present Bank rate is 8. 25%.
(e) Liquidity Adjustment Facility.
Reserve Bank of India has introduced the Liquidity Adjustment facility to provide short term
liquidity to the banks and also to absorb excess Liquidity from the banking system. Under this
facility fixed rate repo auctions are conducted on a daily basis. Commercial banks which are
in need of funds for a very short period bid for funds under this scheme.
Funds are made available to them by way of purchase of approved securities by the Reserve
Bank. This is subject to a commitment by the borrowing bank to repurchase the same
security after the specified period is over. say one. three or seven days at the price specified
by the Reserve Bank. This is called Repo transaction. The repo rate is fixed by Reserve Bank
of India.
When the commercial banks possess excess liquidity and the Reserve Bank feels the
necessity of absorbing such Liquidity, it conducts reverse repo auctions. under which Reserve
Bank sells the approved securities to the banks with the commitment to repurchase the same
after a specified period. This is called Reverse Repo. Its rate is also fixed by Reserve Bank of
India.
6. To Undertake Transactions in Foreign Exchange
Section 40 of Reserve Bank of India Act authorities the Reserve Bank of India to undertake
transactions in foreign exchange. The Bank sells to and buys from any authorized dealer in
foreign exchange. foreign currencies on conditions prescribed by the Government. The
authorised dealers-are those who are entitled to buy or sell foreign exchange under the
Foreign Exchange Management Act. 1999. Moreover. Reserve Bank of India holds India's
reserves (currently approx. USD285 Bn) of international currencies and administers theexchange control system in the country.
7. Collection and Furnishing of Credit Information
Reserve Bank of India is empowered to collect credit information from Banking companies
and to furnish such information in a consolidated form to any banking company applying for
the same along with the prescribed fee.
Section 17 of the Reserve Bank of India Act. 1934 has been amended in 2006 to include
the following business which may be undertaken by Reserve Bank of India:
(a) Dealing in derivatives. and, with the approval of the Central Government, in any other
financial instrument. "
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(b) Lending or borrowing of securities of the Central Government or a State Government or

of such securities of a local authority as may be specified by the Central
Government, or foreign securities.
(c) Dealing in repo or reverse repo (without any limitation on lending or borrowing of
funds).
The newly inserted Section 45W authorises the Reserve Bank to determine the policy
relating to interest rates or interest rate products and may give directions in that behalf to all
agencies or any of them. dealing in securities, money market instruments, foreign exchange,
derivatives or other instruments of like nature as the bank may specify from time to time. But
such directions shall not relate to the procedure for execution or settlement of the trades in
respect of the transactions of the Stock Exchanges
REGULATORY AND SUPERVISORY FUNCTIONS Banking Regulation Act 1949
Reserve Bank of India Act and the Banking Regulation Act confer wide powers on Reserve
Bank of India to regulate and supervise the affairs of banking institutions in India. Important
powers of the Reserve Bank of India are as follows :
1. Licensing of Banking Companies. Section 22 of Banking Regulation Act, 1949
requires every banking company to hold a licence from the Reserve Bank to carry on the
business of banking in India. The Reserve Bank is empowered to conduct an inspection of the
books of the banking company for this purpose, and to issue a licence if it is satisfied that the
necessary conditions are fulfilled.
2. Permission for Opening Branches. Section 23 requires every banking company to take
Reserve Bank's prior permission for opening a new place of business in India or to change
the location of an existing place of business in India or outside. The Reserve Bank takes into
account the financial position, the history, the general character of management and adequacy
of its capital structure and earning prospects and the fact whether public inter~st will be
served or not, before granting permission.
3. Power to Inspect Banking Companies under Section 35, the Reserve Bank may, either
at its own initiative or at the instance of the Central Government, inspect any banking
company and its books and accounts. If on the basis of the inspection report submitted by the
Reserve Bank, the Central Government is of the opinion that the affairs of the banking
company are being conducted to the detriment of interests of its depositors. it may by order
in writing prohibit the banking company from receiving fresh deposits, or direct the Reserve
Bank to apply for the winding up of the banking company.
4. Power to Issue Directions. Section 35.A confers powers on the Reserve Bank to issue
directions to a banking company or companies in the public interest or in the interest of
banking policy or to prevent the affairs of the banking company being conducted in a manner
detrimental to the interests of the depositors. Section 36 confers powers on the Reserve Bank
to caution or prohibit banking companies against entering into any particular transaction and
generally give advice to any banking company. It may pass orders requiring the banks to
carry out the specified instructions.
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5. Control over Top Management.

Reserve Bank's prior approval is necessary for appointment or re-appointment or termination
of appointment of a chairman, managing director, manager or chief executive officer.
Section 36-AA empowers the bank to remove from office any chairman, director, chief
executive officer or other officer or employee of a bank, if it considers it necessary or
desirable. The Bank may appoint any other suitable person in place of the person removed by
it. The Reserve Bank can appoint one or more additional directors on the Board of Directors
of banks, if it considers it necessary in the interest of banking policy or in the public interest
in the interests of the bank or its depositors.
BANKING REGULATIONS ACT 1949
Summary of some important sections is provided hereunder. The section no. is given at the end of each
item. For details, kindly refer the bare Act.
1) Banking means accepting for the purpose of lending or investment of deposits of money from

public repayable on demand or otherwise and withdraw able by cheque, drafts order or otherwise
(5 (i) (b)).
2) Banking company means any company which transacts the business of banking (5(i)(c)
3) Transact banking business in India (5 (i) (e).
4) Demand liabilities are the liabilities which must be met on demand and time liabilities means

liabilities which are not demand liabilities (5(i)(f)

5) Secured loan or advances means a loan or advance made on the security of asset the market

value of which is not at any time less than the amount of such loan or advances and unsecured
loan or advances means a loan or advance not secured (5(i)(h).
6) Defines allied business activities a banking company may be engaged in like borrowing,

lockers, letter of credit, traveller cheques, mortgages etc (6(1).

7) States that no company shall engage in any form of business other than those referred in Section

6(1) (6(2).
8) For banking companies carrying on banking business in India to use at least one word bank,

banking, banking company in its name (7).

9) Restrictions on business of certain kinds such as trading of goods etc. (8)
10) Prohibits banks from holding any immovable property howsoever acquired except as acquired

for its own use for a period exceeding 7 years from acquisition of the property. RBI may extend
this period by five years (9)
11) Paid up capital, reserves and rules relating to these (11 & 12)
12) Banks not to pay any commission, brokerage, discount etc. more than 2.5% of paid up value

of one share (13)

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13) Prohibits a banking company from creating a charge upon any unpaid capital of the

company. (14) Section 14(A) prohibits a banking company from creating a floating charge on the
undertaking or any property of the company without the RBI permission.
14) Prohibits payment of dividend by any bank until all of its capitalized expenses have been

completely written off (15)

15) To create reserve fund and 20% of the profits should be transferred to this fund before any

dividend is declared (17 (1))

16) Permits banks to form subsidiary company for certain purposes (19)
17) No banking company shall hold shares in any company, whether as pledgee, mortgagee or

absolute owners of any amount exceeding 30% of its own paid up share capital + reserves or
30% of the paid up share capital of that company whichever is less. (19(2).
18) Restrictions on banks to grant loan to person interested in management of the bank (20)
19) Every bank has to publish its balance sheet as on March 31st (29).Balance sheet is to be got

audited from qualified auditors (30 (i))Publish balance sheet and auditors report within 3 months
from the end of period to which they refer. RBI may extend the period by further three month
(31)Prevents banks from producing any confidential information to any authority under Industrial
Disputes Act. (34A)
20) Amendments carried in the Act during 1983 empowers Central Govt to frame rules specifying

the period for which a bank shall preserve its books (45-y), nomination facilities (45ZA to ZF)
and return a paid instrument to a customer by keeping a true copy (45Z).
21) Certain returns are required to be sent to RBI by banks such a monthly return of liquid assets

and liabilities (24-3), quarterly return of assets and liabilities in India (25) return o unclaimed
deposits i.e 10 years and above (26) and monthly return of assets and liabilities (27-1)
Board for Financial Supervision
It comprises of four directors of the central Board of Directors of the Reserve Bank of India.
The Board is entrusted with the supervision of commercial banks, selected financial
institutions and non-banking finance companies. The focus of supervisory strategy is on the
following aspects:
(a) Off-site surveillance system.
(b) On-site inspection.
(c) Monitoring asset quality, capital adequacy and other prudential norms of banks.
(d) Extending the task of supervision to strengthen internal control, management
information system and fraud monitoring procedures within the above mentioned
institutions.

01 B Review Questions on Banking Regulator :

1.

What do you under stand by a Scheduled bank?

a. A bank which is in the schedule VI of the Companies Act -1956
b. A bank that qualifies to be included in 2nd Schedule of RBI Act-1935

c.
d.
e.
2.

A bank that qualifies to be included in 2nd Schedule of Banking Regulation Act 1949
All of the above
None of the above

Which is not condition that need not be satisfied by a bank to become a scheduled bank?
(i) It must have a paid up capital and reserves of aggregate value of not less than Rs.5Iakh;
(ii) It must satisfy the Reserve Bank that its affairs are not being conducted in a manner detrimental
to the interests of its depositors; and
(iii) must have any of the following structure: Commercial banks-Indian and foreign, Public Sector
Banks, State Cooperative Banks, Urban Cooperative Banks, Regional Rural Banks.
iv) all of the above
v) none of the above

3.

What is the necessity of exercising control over credit created by banks.

4.

What is the ceiling on shares a bank can hold in any company whether as pledgee, mortgagee or
absolute owner?
What do you understand by Cash Reserve Ratio? Why is it maintained? What is current CRR?

5.
6.

What do you understand by Statutory Liquidity Requirement? What purpose does it serve? What is
current SLR?

7. Describe the Liquidity Adjustment facility provided by Reserve Bank of India. What is Repo and
reverse repo transaction?