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F2: FINANCIAL MARKETS AND INTERMEDIARIES

MODULE-1

THE NATURE AND ROLE OF A FINANCIAL SYSTEM

The word system in the term Financial system implies a set of complex and closely connected or
intermixed instructions, agents, practices, markets transactions claims and liabilities in the
economy. Finance is the study of money, its nature, creation, behavior, regulations and
administration. Therefore, financial system includes all those activities dealing in finance,
organized into a system. Financial system plays a crucial role in the functioning of the economy
because it allows transfer of resources from savers to investors. The financial system consists of
financial institutions, financial markets, financial instruments and the services provided by the
financial institutions.

Definition of a Financial System: ‘The financial system consists of a variety of institutions, markets
and instruments related in a systematic manner and provide the principal means by which savings
are transformed into investments’-Prasanna Chandra

‘The financial system is a set of institutional arrangements through which financial surpluses
available in the economy are mobilized’-Prof.S.B.Gupta

As stated earlier, the financial system comprises of 4 major components. These components are:

a) Financial Institutions
b) Financial Markets
c) Financial Instruments
d) Financial Services

Financial Institutions mobilize the savings either directly or indirectly through financial markets, by
using various financial instruments and in the process utilizing the services of various financial
services providers. A brief discussion of the components of the financial system is as follows:

1. Financial Institutions: These are institutions which mobilize and transfer the savings or
funds from surplus funds to deficit units. These institutions can be classified into regulatory,
intermediaries, non intermediaries and others. These institutions unlike commercial
organizations deal with only financial assets like deposits, securities, loans.etc .They
participate in financial markets and mobilize the savings from the surplus units either
directly or indirectly.
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2. Financial Markets: This is a place or mechanism where funds or savings are transferred
from surplus units to deficit units. These markets can be broadly classified into money
markets and capital markets. Money market deals with short term claims or financial assets
whereas capital markets deal with those financial assets which have maturity period of
more than a year. This classification is artificial as both these markets perform the same
function of transferring surplus funds to needy units. Another classification could be
primary markets and secondary markets. Primary markets deal in new issues of securities
whereas secondary markets deal with securities which are already issued and available in
the market. Primary markets deal in new issue of securities whereas secondary markets
deal with the securities which are already issued and available in the market. Primary
markets by issuing new securities mobilize the savings directly. Secondary markets
provide liquidity to the securities and thereby indirectly help in mobilize the savings.
3. Financial Instruments: The commodities that are traded or dealt in a financial market are
financial assets or securities or financial instruments. There is a variety of securities in the
financial markets as the requirements of lenders and borrowers are varied. Financial asset
represent a claim on the repayment of principal at a future date and/or a payment of a
periodic or terminal sum in the form of interest or dividend. Ex: Shares, Bonds, Debentures
4. Financial services: Financial services include the services offered by both types of
companies-Asset management companies and Liability Management Companies. The
former includes the leasing companies, mutual funds, merchant banks, issue/portfolio
managers. The latter includes the bill discounting houses and acceptance houses. The
financial services help not only to raise the required mix and extend their services up to the
stage of servicing of lenders. Besides banking and insurance, this sector comprises of
credit rating, venture capital, lease financing, factoring, merchant banking, etc and are
regulated by SEBI, RBI and the Department of Banking and Insurance.

Functions of the Financial System: Some of the functions of the financial system are as
follows:-
 Provision of Liquidity- Financial markets provide a mechanism for an investor to sell
a financial asset. Because of this feature it is said that a financial market offers
liquidity, an attractive feature when circumstances either force or motivate an
investor to sell. In India, RBI is considered as the leader of the financial system and
hence it has to control the regulation of money supply in the country keeping in
mind the best interest of the nation. It has to shoulder the responsibility of
developing a sound financial system by strengthening the institutional structure and
by promoting savings and investment in the country.
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 Mobilization of savings: The most important function of the financial system is to

mobilize the savings and channelize them into productive activities. The financial
system should offer better incentives to attract the savings of the investors and
invest these funds for productive ventures.
 Size Transformation function-Every investor may not be able to invest a large
amount of money, in contrast there many be small investors also who cannot find
any fruitful avenue for their investment. Banks and other financial intermediaries
perform this size transformation function by collecting deposits from a vast majority
of small customers and giving them loan of a sizeable quantity.
 Maturity Transformation function: The financial intermediaries and commercial
banks accept deposits from the general public in different maturities according to
their liquidity preferences and lend them to the borrowers for different maturity dates
and promote the economic activities of a country.
 Risk transformation function- Many of the small investors are risk averse and they
hesitate to invest in the stock market directly. This maybe because of the previous
mistakes they have committed or due to lack of knowledge of the stock market
itself. So the financial intermediaries collect the savings of the individual savers and
distribute them over different investment units with their high knowledge and
expertise. Thus the risk of the individual investors are distributed.

Financial System and Economic Development

The role of financial system in the economic development of the country has been a much
discussed topic amongst the economists. The importance of finance in the development depends
upon the desired nature of development. The larger the proposition of the financial assets(money
and monetary assets) to real assets(physical goods and services) the greater the scope for
economic growth in the longs run. To achieve this growth, investment is necessary which flows
from the financial system. But in the less developed countries, it is a scarce factor of production. So
finance plays a crucial role in these economies. The growth objective of the financial system is to
achieve the structure and rate of growth of various financial assets and liabilities in consonance
with the optimal characteristics of real capital cost. Increasing rate of savings correlates well with
the increase in proposition of savings held in the form of financial assets relative to tangible assets.
Investment in the real sector depends on the functioning of the financial sector as the latter collects
and channels savings into investment which is necessary for growth. Another aspect of financial
system which is relevant to the growth the absorption of liquidity and its use for productive
purposes. A well developed financial system with adequate institution would not only promote
savings but encourage these savings to flow into financial Assets as against physical assets.
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Indian Financial System: Some of the marked characteristics of the Indian financial system during
the past 50 years are continuous inflation increasing internal and external deficits industrialization,
urbanization and significant structural transformation. During the time of Indian independence there
was no strong financial institution in our country. There was absence of issuing institutions and
non participation of intermediary financial institutions. The industrial sector also had no access to
the savings of the community. The capital market also was in a very primitive state. Our Indian
Government adopted the mixed economic system and this paved the way for a different financial
system and fulfill the socio-economic and political objectives. Several important developments
took place in the Indian scenario and a few of them are as follows:

 RBI is the leader of the financial system and was established in 1935 followed by its
nationalization in 1948. This was followed by the nationalization and the renaming of the
Imperial Bank of India to State Bank of India.245 Life Insurance companies were brought
under the control of LIC. Another significant development was the nationalization of 14
major commercial banks in the 1969 and this was further increased to 20 in 1980.
 In 1964 the UTI was established as public sector institution to collect the savings of the
people and make them available for the productive ventures in the country. It is considered
as one of the oldest and largest mutual fund in India and is governed by its own rules and
regulations. But since 1994 the schemes of UTI has to be approved by SEBI. Several open
ended and closed ended schemes have been introduced and repurchase facility of units of
the various income schemes has also been started. It has also started its own subsidiaries
like the UTI Bank, UTI Investor Service Limited, UTI Security Exchange Ltd.
 Many development banks were established not only to extend credit services but also
advisory services. These banks act as multipurpose institutions which provide medium and
long term credit to industrial undertakings, discover investment projects, preparation of
project reports, provide technical advice and managerial services and assist in the
management of industrial units
 Further the IFCI was set up in 1948 with the objective of providing industrial credit to the
industries where they could not meet the normal banking requirements or capital issue was
impracticable.
 SFC’S was established with the intention of providing small and medium term loans to the
medium and small industries .
 The IDBI was established on July1,1964 and is considered as an apex institution in the
area of development banking and it has to co-ordinate the activities of other financial
institutions.
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 The industrial Reconstruction Corporation of India was set up by the IDBI and the LIC with
the main objective of industrial reconstruction and rehabilitation of sick industrial
undertakings.
 The SIDBI was established on April2,1990 and has been vested with the responsibility of
the Small Industries Development Fund and the National Equity Fund.
 The Agricultural Refinance and Development Corporation was set up to provide refinance
support to banks to finance major development projects, dairy development, minor irrigation
projects. etc. However on 1982 it was merged with the NABARD
 The EXIM Bank was set up on January 1,1982 and its main objective is to provide
financial assistance to exporters and importers. The major work of this institution is to co-
ordinate the working of the other institutions engaged in the foreign trade.
 The National Housing Bank was set up on July9,1988 as an apex institution to mobilize
resources for the housing sector and the promotion of the financial institutions for housing
both at the state and the regional levels.
 The Stock Holding Corporation of India was set up jointly by the IDBI,LIC ,IFCI,ICICI,
GIC,UTI & RBI. Its main objective was to provide quick share transfer facilities, clearing
services, depository services, management information services to investors both
individuals and the corporate.
 Mutual funds were set up as they provide investment avenues for small investors who
cannot participate in the equities of big companies. Mutual funs have been floated by some
public sector banks ,LIC, GIC and the private sector also.
 Venture capital is another form of financing in the form of equity financing which can be
considered as along term risk capital to finance high technology projects. Several venture
capital firms like the IDBI Venture Capital Fund, Indus Venture Capital Fund, Credit Capital
Venture Capital Fund etc have been formed.
 Credit rating has also been introduced and has been made compulsory for all debt
instruments. This has been established to help the investor to make a decision of their
investment in various ventures and protect them from risky ventures. Some of the credit
rating agencies are CRISIL, CARE, IICRA, etc.
 A number of financial instruments have been introduced by LIC, UTI, Post office savings,
Provident Funds, NSC, Indra Vikas Patra to meet the diversified requirements of the
investors.
 A number of acts and laws have been passed by the Government for the smooth
functioning of the financial system . The Indian Companies Act, Securities Contracts Act,
MRTP Act, FEMA are some of the acts which have been passed by the Indian
Government. With the introduction of the New Economic Policy several acts have been
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amended and suitable changes have been introduced in the rules and regulations and the
working of the various departments ion the country

SEBI-Securities and Exchange Board of India.-Financial liberalization is important to have a

healthy market. IN order to ensure the benefits of liberalization strong measures for investor
protection is necessary for the society as a whole. Without strict regulation the investors will else
the confidence in the market and there will be no investment which will ultimately lead to under
developed economy. In order to protect the interest of the investors the Controller of Capital Issues
was set up, and the Securities contracts (regulations) act was also passed. But due to the failure of
the controller of capital issues and the Securities Contracts act, the SEBI was established as a
non-statutoty body in1988. In 1992, the SEBI Act of 1992, was passed and it was conferred with
comprehensive powers of all the capital market operations.

The main objectives of SEBI are as follows:

a)To protect the interest of investors so that there is a steady flow of savings into the capital
market.

b)To regulate the securities market and ensure fair practices by the issuers of securities so that
they can raise resources at minimum cost.

c)To promote efficient services by brokers, merchant bankers and other intermediaries so that they
become competitive and professional.

Investor protection is the major responsibility of the SEBI. For this purpose the draft prospectus is
scrutinized for full and fair disclosure and guidelines have been given in the form of a code of
conduct for all the players in the capital market. Merchant bankers are held responsible for fair
disclosure of the companies in the new issue market. Prospectus is graded and penal points are
awarded on the lapses of the merchant bankers. Similarly licensing and registration of all the
intermediaries in the capital markets including underwriters, registrars, portfolio managers was also
completed. In particular registration and regulation of all brokers and sub brokers of stock market,
control of insider trading, inspection and audit of stock exchange and their members were taken up
in full swing.

Powers, Scope and Functions of the SEBI: The SEBI is empowered to regulate depositories,
custodians, merchant bankers, debenture trustees, insider trading, mutual funds, portfolio
managers, investment advisors, venture capital funds, bankers to issues.etc. The SEBI can also
issue guidelines in respect of information disclosure, pricing of issues, bonus issues, preferential
issues, financial instruments, firm allotment and transfer of shares among promoters. The SEBI is
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also empowered to register any agency, intermediary who may be associated with the securities
market and none of them shall buy, sell or deal in securities except under the conditions of a
certificate of registration issued with the SEBI. But the Government of India is empowered to
cancel any person or class of person’s registration issued by the SEBI. The SEBI is also
empowered to lay down the civil and criminal penalties for contravention of the Act, cancel any
person’s registration who tries to abate any provisions of the Act and is punishable with fine or
imprisonment or both.

SEBI’s recent Reforms: The stock exchanges have been directed to follow a uniform procedure for
maintenance of Arbitration Record and Listing records. A uniform policy is made applicable with
regard to listing by establishment of a central listing authority in 2003. But the stock exchanges are
free to charge listing fees, as they deem necessary. During 2003-04 the SEBI in consultation with
the RBI and the Government has allowed the electronic trading in interest rate derivatives on the
notional Government security and 91 days treasury Bills. Banks have been allowed to trade in
interest rate derivatives in the addition to FII, NRI.etc Currency derivatives trading was also started
on NSE in 2008.

The Sebi has also streamlined the guidelines under Disclosure and Investor Protection for
Initial Public Offers through Bok Building process by unlisted companies, and those disclosure
norms for bulk deals. The Clause 49 of the Listing Agreement was amended to improve corporate
governance. The Stock exchange were directed to inspect every year at least 20% of the active
brokers instead of 10% as used to be earlier. The RBI has also directed that only FIIs and BRIs
can trade in derivatives and not OCBs. The Securities brokers are allowed to participate in the
commodity markets as also the selected banks as per the guidelines of the Funds Management
company but security brokers have to set up separate units for this purpose. The SEBI insisted on
the demutualization of all stock exchanges on a uniform basis failing which they would be
derecognized.

Limitations of SEBI: The following are the limitations in the functioning of SEBI.

a) Lack of professional experience among the officials

b) Limited transparency for functioning
c) The administration is bureaucratic.
d) The procedures are complex and mechanical
e) There is a minimum accountability.
f) Certain activities are fraudulent and the legislation is very weak.
g) There is lack of confidence of all players in the capital market specially in the small
investors.
h) The officials enjoy only limited powers.
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i) The officials enjoy only limited powers.

j) Serious approach towards the investors needs is lacking.
k) The regulations are counter productive.

Financial Sector Reforms: Immediately after the announcement of New Economic Policy the
government had appointed a high level committee on financial system to examine all the
aspects relating to the structure, organizations , functions and procedures of the financial
system. The need for financial reforms has arisen because the financial institutions and
markets were in a bad shape. The banking sector suffered from lack of competition, low capital
base, low productivity and high intermediation costs. The role of technology was minimal and
the quality of service did not receive adequate attention. So, the reforms have been introduced
with a bad sweep and covered all the matters relating to operations, banking, primary and
capital and secondary capital markets. Some of the reforms are as follows:

A. Systemic and policy reforms:

 Interest rates in the economy was deregulated, a beginning to move towards market
rates on government securities, the system of administered interest rates was
greatly dismantled and the structure of the interest rates was greatly simplified.
 Until now the banks resources was valued through SLR but now it is valued at the
market rates.
 Capital adequacy norms was introduced for banks, financial institutions and virtually
all market intermediaries was introduced.
 A separate board for financial supervision with an advisory council and an
independent department of supervision was established by the RBI.
 Recovery of Debts Act was passed in 1993 and a special Recovery Tribunal was
established to facilitate the quicker recovery of loan arrears.
 Ways and means advances took the place of adhoc treasury bills as this was
abolished from 1st April 1997 onwards.
 Private sector was allowed to set up banks, mutual funds, money market mutual
funds, insurance companies.etc The public sector banks was permitted to diversify
ownership by law subject to 51% holding by the Government. SBI, IFCI,IRBI was
converted into public limited companies.
 SEBI was made a statutory body in Feb.1992 and armed with necessary authority
and powers for regulations and reform the capital markets.
 Convertibility clause is no longer obligatory in the case of assistance sanctioned by
term lending institutions.
 RBI(Amendment ) Act of 1997 was passed requiring all non banking financial
companies with net owned funds of Rs.25 lakhs or more to register with RBI.
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 Over the Counter Exchange of India(OTCEI) and National stock exchange with
nation wide stock trading, electronic display, clearing and settlement facilities was
established and made operational.
B. Banking reforms:
 Interest rates on deposits and advances of all co-operative banks including urban co-
operative banks was deregulated. Similarly interest rates on commercial banks loans above
Rs.2.00 lakhs and on domestic term deposits was decontrolled.
 SBI and other nationalized banks was enabled to access the capital markets for debt and
equity.
 Prudential norms for income recognition, classification of assets and provisions for bad
debts for commercial banks including regional rural banks and financial institutions was
introduced .
 The performance obligations and commitments was obtained from the RBI from each bank.
This was obtained to ensure a high level of portfolio quality so that problems such as heavy
losses, low profits, erosion of equity do not occur.
 Banks have to maintain their balance sheets ion fully transparent manner and full
disclosures as per the International Accounts Standard committee has to be made.
 Banks are given greater freedom to open, shift and swap branches and also open
extension counters.
 Budgetary support was extended to recapitalization of the weak public sector banks.
 Banking Ombudsman Scheme was introduced to resolve customer grievances in a quick
and inexpensive manner.
C. Primary and Secondary Stock Market Reforms:
 As per the listing requirements, 5 shareholders for every Rs.1.00 lakhs of fresh issue
of capital and 10 shareholders for every Rs.1.00 lakhs for existing companies is
considered a criteria for listing.
 Payment of any direct , indirect disclosures commissions to persons receiving from
allotment was prohibited.
 Debt issued not accompanied by any equity component was permitted to be sold
entirely under the book building process.
 Housing finance could be registered for issue purpose if they were eligible for
refinance from National Housing Bank.
 Issuers were allowed to list debt securities on stock exchanges without their equity
securities being listed.
 Mutual funds were permitted to underwrite public issues.
 Before beginning a carry forward session, stock exchanges are required to disclose
the carry forward position scrip wise and broker wise.
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 A ceiling of Rs.10 crores was imposed on stock market members doing business of
financing carry forward transactions.
 Depositories Act 1996, was passed to provide a legal framework for the
establishment of depositories and facilitate dematerialization of hares. In 1997, an
amendment was passed for this act and banks, mutual funds and IDBI were allowed
to dematerialize their scrips.
 Stock lending scheme without attracting capital gains was introduced.
 Stock exchange were asked to modify listing agreement in order to provide the
payment of interest by companies to investors from the 30th day of closure of public
issue.
 All stock exchanges are required to institute the buy in or auction process.
 The stock exchanges are being modernized. Many of thema have introduced
electronic Trading system-Bombay Online Trading system.
D. Government Securities Market Reforms:
 A 364 day treasury Bill replaced the 182 bills and is being sold continuously since
April 1992.
 Auction of 91 days treasury Bill commenced from January 1993.
 Maturity period for new issued of Central Government securities was shortened from
20 to 10 years and State Government from 15 to 10 years.
 6 new instruments was introduced viz., zero coupon bonds tap stock*, partly paid
Govt. stock , instrument bonds, instruments combining the features of tap stock and
partly paid stocks, floating rate bonds, capital index bonds.(*Meaning of tap stock-
When markets are rising, what a saver might make in 3 years from a savings a/c can
be made in a year or even in months in stock markets./ Thus the reward for taking
risk can tempt the small investor to invest in shares. Companies should therefore
make every effort to tap this potential)
 State Govt. and provident funds were allowed to participate in 91 days treasury bills
auction on a non-competitive basis.
 A scheme for auction of Govt. securities from RBI’s own portfolio as part of its open
market operations was announced.
 Institution for primary dealers in government securities market was established and
guidelines was issued.
 Reverse repo facility with RBI in government dated securities was extende3d to
Discount and Finance House of India and Securities Trading Corporation of India.
E. External Finance Market Reforms:
 Flexible exchange rate system was introduced and exchange controls was largely
dismantled.
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 Foreign Institutional Investors were allowed access to Indian capital market on

registration with SEBI. FII’s were permitted to invest up to 10% in equity of any
company.
 Indian companies permitted to access international capital market through various
instruments including euro-equity issues.
 FERA was replaces with FEMA to facilitate easy capital flows.
 Rupee was made convertible on current account and 100% convertibility on
current account was introduced.
 Rate of long term capital gains tax on portfolios, investment by NRI’s was reduced
from 20% to 10%.
 NRI’s, FII’s were allowed to invest up to 24% in equities of Indian companies
engaged in all activities except those of agriculture and plantation.
 Companies were permitted to retain euro issues proceeds as foreign currency
deposit with banks and public financial institutions in India.
 RBI made a single window agency for receipt and disposal of proposals for
overseas investments by Indian Companies.
 The foreign Investment Promotion Board was reconstituted and the foreign
Investment Promotion Council was set up to promote foreign direct investment in
India.

RESERVE BANK OF INDIA(RBI)-www.rbi.org.in

The RBI is the Central Bank of the Country. It was established on the
recommendations of the Hilton Young commissi0on. It has been established as a body
corporate under the RBI Act,1934 which came into effect from 1st April 1935. On
establishment it took over the function of the management of currency from the
Government of India and power of credit control from the Imperial Bank of India. The
RBI was nationalized in 1948 soon after the independence. The RBI Act has been
amended from time to time and it carries on it operations based on the provision of RBI
Act 1934.

Organization and the Management of the RBI-The provision relating to organization of

the RBI are as follows:

1. Central Board: The general superintendence and direction of the bank’s affairs is
in the hands of the Central Board of Directors. It comprises of a Governor, 4
Deputy Governors and 15directors. All these persons are appointed/nominated by
the Central Government. The Governor and Deputy Governors hold office for such
periods not exceeding 5 years as may be fixed by the central Govt at the time of
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their appointment and are eligible for reappointment. As a matter of practical

convenience the Board has delegated some of its functions to a committee called
the committee of the Central Board, consisting of the Governor, Deputy Governor,
the directors representing or resident in the area in which the meeting is held, the
Govt. Director and other directors as may be present at the place at the relevant
time. The committee meets once a week generally on Wednesday at the office of
the bank at which the Governor has his headquarters for the time being to attend
the business of the bank.
2. Local Board: There is a local board with headquarters at Mumbai, Kolkata, New
Delhi and Chennai for each of the regional areas of the country. The local boards
consists of 5 members each appointed by the central Govt for 4 years. The main
functions of the local boards are to advise the central board on such matters as
may generally be referred to them and to perform such duties as the Central
Board may delegate to them.

Internal Organization and Management of the RBI-The governor is the chief executive
authority and the chairman of the central board of directors of the Bank. He has the
powers of general superintendence and direction of the affairs and business of the
bank. At present, the Governor is assisted by 4 deputy governors and 4 executive
directors in the performance of his duties. The executive directors come in between
the deputy governors and the chief manager. They are not members of the central
board but attend board meeting b y invitation. Central Board of Directors must hold at
least 6 meeting in a year and at least 1 meeting in 3 months. The head office of the
bank is located in Mumbai. The bank has 14 branch offices located at Kanpur,
Ahmedabad, Hyderabad, Nagpur, Jaipur, Bhubaneswar, Chandigarh, Bangalore,
Patna, Indore, Gauhati, Trivandrum.etc.

Functions of the RBI: The main function of the RBI is to regulate the monetary system of the
country in such a way that the balance of economic growth of the country is achieved along with
economic stability. According to the Preamble of RBI Act, 1934” the main functions of the bank are
to regulate the issue of bank notes and keeping of reserve with view to securing monetary stability
in India and generally to operate the currency and credit system of the country to its advantage”.

The functions of the RBI can be classified into A) Traditional functions (B) Development
Functions

A.Traditional Functions: The traditional functions of the RBI are further divided into 3 types:

I. Central Banking functions

II. General Banking functions
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III. Prohibitory functions

1.Central Banking functions: Reserve Bank of India is the central Bank of India.Its central Banking
functions are as under-

a) Issue of paper currency- RBI has the sole right to issue bank note of all the denominations
except one rupee note is issued by the Govt of India .RBI issues notes of the denomination
of Rs.2,5,10,20,50,100,500 and 1000.The bank follows the “Minimum Reserve System” for
issue of bank notes. The minimum reserve system maintained at Rs.200 crores is in the
form of gold and foreign exchange reserves. However Rs.115 crores must be in the form of
gold. The RBI(amendment) Act,1991 provides for the revaluation of the gold held by the
RBI at the international market price. The revaluation of gold with RBI was considered
necessary to ensure realistic reflection of the levels of foreign exchange reserves position
including gold stocks in view of the impact of the developments in Gulf on them. The RBI
has made adequate arrangements for the holding and distributing of currency notes and
coins. It is maintaining currency chests all over the country.
b) Regulation of Credit: refers to the control over the credit policy o f the commercial banks .
As the central bank, RBI controls the creation of credit by the commercial banks. According
to the RBI Act, the RBI can adopt different methods of credit control such as bank rate,
open market operations, change in CRR and selective methods to control the credit of
commercial banks.
c) Banker’s bank: The RBI acts as the bank of all the banks in the country. The scheduled
banks are required to main with the RBI as balance certain percentage of their time and
demand liabilities. It acts as a lender of last resort to them. The scheduled banks an borrow
money from the RBI on the basis of eligible securities or get financial accommodation oat
the time of need or stringency by discounting the bills of exchange. So RBI gives loans to
the commercial banks during the time of emergency.
d) Banker of the Govt: The RBI acts as the banker to Govt. It accepts money for the account
of Union and State Govt. in India, makes payment on their behalf, carries out their
exchange remittances and other banking operations and manages the public debt. It makes
ways and means advances to the Govt for 90 days. It advises the Govt on all monetary and
banking matters.
e) Regulation of Foreign exchange: The RBI has been entrusted with the responsibility of
maintaining the external value of the rupee and for this purpose the bank holds most of the
foreign exchange reserves. Since India is a member of the IMF , the RBI has to maintain
fixed exchange rates with all other member countries of the Fund. It sells and buys foreign
exchange to and from authorized persons at rates fixed by the Govt.
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f) Other functions: Apart from the above mentioned functions the RBI performs certain other
functions like 1)providing direct and indirect foreign assistance to exports,(2)clearing of
interbank obligation(3)conversion of big notes into small coins (4) transfer of
currency(5)supervision and control over commercial banks(6)training to bank employees
through the bankers training college, college of agricultural banking, RBI staff college,
National Institute of Bank Management.

II. General Banking functions

a) Accepting Deposits: RBI accepts deposits from Central Govt, state Govt and
private individual without paying of any interest on these deposits.
b) Bills Discounting: Reserve banks buys, sells, and rediscounts the 90 days
duration bills, promissory Notes.etc .
c) Advancing Loans: RBI gives loans to the Central and State Govt for a period of
90 days.
d) Deal in Foreign Securities: RBI also deals in all such foreign securities which
are encashable within 10 days from the date of purchase.
e) Deal in Costly metals: RBI deals in the sale and purchase of gold, silver as well
as the coins of these metals.
f) Deal with other countries banks: RBI establishes business relations with the
banks of other member countries being a member of the IMF.

III. Prohibitory functions-RBI Act prohibits this bank from performing certain other functions
which are as follows-
1.The bank cannot participate in trade, commerce, or industrial activities of the country

2.RBI cannot purchase its own shares or shares of any other bank or a company. It cannot also grant loan on shares.

3.It cannot give any loan against the security of any immovable property It also cannot purchase immovable property
beyond its needs.

4.RBI cannot pay any interest on its deposits

5.Bank cannot advance loans without securities.

B. Developmental Functions of RBI- RBI also performs certain developmental functions to promote
the economic growth of the country. They are as follows:

1.Promotion of agricultural finance- RBI has an agricultural credit department to conduct research
regarding various problems of agricultural credit. RBI also advises the central Govt, state Govt and
co-operative societies on the various aspects of agricultural growth on the various aspects of
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agricultural growth. A major step of development in this aspect is the Agricultural Refinance and
Development Corporation, a subsidiary of the RBI , establishment of the Regional Rural Banks and
the establishment of the NABARD.

2.Promotion of Industrial Finance-RBI provides financial help for the development of the
economy/\. The commercial banks, the setting up of the Industrial Developmental Bank of
India(IDBI),Industrial Finance Corporation of India(IFCI), State finance corporation, Small scale
Industrial Development corporations are some of the important steps taken by the RBI for meeting
the growing need of finance for the industries.

3.Promotion of finance for exports-Export finance is provided through various schemes viz., Bill
Market scheme, Duty drawback scheme.etc. The establishment of the EXIM Bank is to provide
finance for the export import trade in the country.

Monetary Policy: Monetary Policy refers to that policy through which the central bank of the country
controls (a) the supply of money( b)the availability of money (c)rate of interest in order to achieve
a set of objectives oriented towards the growth and stability of the country. Therefore a monetary
policy refers to the use of official instrument under the control of the RBI to regulate the availability,
cost and use of money and credit with the aim of establishing optimum levels of output and
employment, price stability, balance of payments equilibrium or any goals set by the Government.

Measures of Monetary Policy: In order to carry out the monetary policy of controlled expansion the
RBI has adopted the following measures

a) Bank Rate: According to Sec.49 of RBI Act of 1934 the bank rate is the standard rate at
which the RBI is prepared to buy or rediscount bills of exchange or other commercial paper
eligible for purchase under the Act.
b) Open Market Operations: It means that Bank controls the flow of credit through sale and
purchase of securities in the open market.
c) Variable Cash Reserve Ratio-Banks also controls the cash by changing the Cash Reserve
Ratio of the commercial Bank. In 1956, RBI was granted the right to increase the
percentage of the Demand Deposit up to 20% and that of Time deposits up to 8%.
d) Margin requirements-Changing the margin requirements is another for controlling the credit
adopted by the RBI. Under this arrangement the Reserve Bank fixes the higher margin
while accepting a commodity as a security in order to decrease the flow of credit and vice
versa.
e) Credit Rationing: The credit rationing is the situation where a bank limits the supply of
loans, although it has enough funds to lend and the supply of loans has not yet equaled the
demand of the prospective buyers.
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f) Moral Suasion-This is general persuasion and request by the central bank to the
commercial banks. Many policies are implemented by the central banks with a personal
friendly contacts with the commercial banks.

For latest monetary policy of RBI 2010-11-printed version already distributed .Please refer to it.