9/7/2008

CENTRAL BANK
• It is the APEX monetary institute in the money market
which acts as the monetary authority of the country
and serves as the Government’s bank as well as the
bankers’ bank.
• In brief, we may say that the central bank is an
organ of the Government which, by reason of its
operations influences the working of the FIs of the
country.

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Central Bank as the apex body

Central Bank
(RBI)

Commercial Cooperative Other

Banks Societies Institutions

Land
Public Pvt. State Pub Pvt.
Sector Sector Coop.
Dev Gov Sector Sector
Banks

SBI & As Foreign Banks NSC, PO, EPF

Nationalised Non-Scheduled
Banks Banks Chits, Nidhis,
LIC, GIC, UTI, Corporate
RRBs EXIM Bank, IDBI, bodies, Hire
IFCI, IRBI, Purch Cos.,
NABARD, SFC, Investment Cos,
SIDBI, STCI, etc. Merchant
Banks,

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How does the Central Bank differ from

other banks?
 Is a Government Organ
 It does not exist to secure maximum profit
 Has a special controlling relationship with the
commercial banks

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THE
RESERVE BANK OF INDIA

Mint Road, Mumbai

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Historical Perspective
• The origin of RBI in 1935 was the culmination of a long series of efforts.

• The earliest effort to set up a central bank dates back to 1773 when Warren
Hastings, the Governor of Bengal recommended the establishment of a “General
Bank in Bengal and Bihar.”

• The next attempt was made in 1807-08 when Robert Richards, a member of the
Bombay Government submitted a scheme for a General Bank… but the Governor
General was not impressed.

• Again in 1931, John Maynard Keynes – A member of Royal Commission on Indian

Finance and Currency submitted a memorandum entitled “Proposal for the
establishment of a State Bank of India” which was to perform both Central
Banking and Commercial Banking in India. But due to the outbreak of the First
World War this could not be implemented.

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Bank of Bombay 1840-1921 Bank of Madras 1843-1921

Bank of Bengal 1806-1921

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History Continued:
•The First Major step was taken in 1921 when the three Presidency Banks were
amalgamated to form the Imperial Bank of India. It was primarily a commercial
bank but also performed certain central banking functions.(But note issue and
Foreign exchange were the direct responsibility of the Central Govt.)

•In 1926 the Hilton Young Commission recommended that the dichotomy of the
functions and divisions of responsibility should be ended. It suggested the
establishment of a central bank to be called as RBI.

•Accordingly the gold standard and the RBI Bill was introduced in the legislative
assembly in Jan 1927 but was dropped on account of sharp differences.

•The Indian Constitutional Reforms in 1933 made it obligatory that the transfer
of responsibility from the British Govt. in India to Indian hands was dependent
on the establishment of the RBI. These events led to the introduction of a fresh
bill in Sept. 1933

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• The Governor General gave his accent on 6th March 1934 and
RBI was constituted in accordance with the provisions of the Act
containing 58 sections and was inaugurated on 1st of April 1935.
• The RBI was constituted as a shareholder’s bank with a fully paid
up capital of Rs. 5 Crores divided into shares of Rs. 100 each. Of
these 5 lakh shares, 2200 shares were subscribed by the directors
of the bank and the remaining by the Pvt. Shareholders.
• In view of the need for close integration between bank’s policy
and those of the government, the question of state ownership
surfaced time and again. But it was only after independence that
the decision to Nationalise the bank was taken. In terms of RBI
(Transfer to Public Ownership) Act, 1948, its entire paid up
capital was transferred to Central Govt. on 1st of January 1949
when it became a state owned institution.

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Its Organization Structure and

Management.
• The OS of the RBI consists of the central board and the local boards.
• Central Board: The central board is appointed or nominated by the CG for a
period of 4 yrs. It consists of Official Directors and Non official directors:
• Official Directors: The Governor and not more than 4 deputy governors are full time
official directors.
• Non-official Directors: They are 15 in no. 10 directors from various fields and one
Govt. official are nominated by the Govt. While 4 directors from 4 local boards are
nominated as non-official directors.
• The RBI is managed by the Central Board of Directors comprising 14 non
executive independent members. There is one Governor who is the executive
head and is assisted by 4 Deputy Govs. They are all appointed by the GOI for
a period of 5 years. The function of the Central Board are general
superintendence and direction of the bank’s affairs
• Local Boards: There are 4 local boards, one each from the four regions of the
country in Mumbai, Kolkata, Chennai and New Delhi. The membership of each
local boards consists of 5 members appointed by the CG for a term of 4 years.
The function of the local board is to advise the central board on local matters
and interests.

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• The Govt. official and the 4 Deputy Gov. do not have the right to vote in
the meetings of the board. All powers of the bank is vested on the central
board of directors.
• It must hold at least 6 meetings in year and at least 1 in 3 months.
• There are 4 local boards with headquarters at Mumbai, Delhi, Kolkata &
Chennai representing Western, Northern, Easters & Southern regions
respectively. The Central Govt. nominates 5 members on each local board
for a period of 4 years. The chairman is elected from among the members
and the manager of the RBI office in a region acts as the ex-officio
Secretary of the local board.
• The RBI has 22 regional officers most of them in state capitals.
 The head office of the RBI is at Mumbai having 16 departments such as the
banking, Issue, Currency management, Exchange Control, Industrial Credit,
Agricultural Credit etc..
 The bank has 15 offices and 2 branches in different parts of the country.
Where the RBI has no office or branch, the SBI and its 7 associates acts as
its agent or sub agent.

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Umbrella Acts:
Legal Framework •RBI Act 1934 (Governs RBI functions)
•Banking Regulation Act 1949
(Governs the financial sector)

 Acts Governing Specific Functions:

 Public Debt Act 1944/ Govt. Securities Act
 Securities contract Regulation Act, 1956
 Indian Coinage Act, 1906
 FEMA, 1999

 Acts Governing Banking Operation

 Companies Act, 1956
 Banking Cos Acq & Trf Act 1970/80
 Banker’s Books Evidence Act
 Banking Secrecy Act
 Negotiable Instruments Act, 1881

 Acts Governing Individual Institution

 State Bank of India Act, 1954
 IDBI Act, IFCI Act, NABARD Act, National Housing Bank Act, The Deposit
ins & Cr Guarantee Corp Act

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The Preamble basically prescribes two main

objectives of RBI that of 1) Price Stability and 2)
Credit availability

 To Promote monetisation and monetary integration of the economy.

 To manage currency and regulate foreign exchange
 To institutionalise savings through promotion of banking habits
 To build up a sound and adequate banking and credit structure.
 To evolve a well differentiated structure of institution purveying
credit for agriculture and allied activities.
 To set up or promote several specialised FIs at all India and regional
levels to widen facilities for term finance to industry
 To lend support to planning authorities and Govt. in their effort to
accelerate the pace of economic development.

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The Main Function of Central

Bank is to Regulate the

Functions of RBI Monetary Mechanism

comprising of currency,
banking and credit system.

• Traditional Function
– Issue of Currency (200crg+Fex-115g) 1. To formulate, implement and monitor
– Banker to Government (
the monetary policy
– Banker’s Bank
2. To prescribe broad parameters of
– Exchange Management and control
banking operations
– Control of Credit
3. To facilitate external trade and
payment and promote orderly
– Collection and Publication of Data and Report
development and maintenance of
– Training Facilities
foreign exchange market
• Promotional & Developmental Functions
4. To issue, exchange or destroy currency
Agricultural Finance
–
notes and coins not fit for circulation.
Industrial Finance
–
5. To perform wide range of promotional
– Export Credit function to support national objective
– Credit to priority sector 6. To perform merchant banking function
– Bill market scheme for central and the state Govt.
– Development and regulation of banking system 7. To maintain banking accounts for all
• Other Functions scheduled banks
– Purchase and Selling of Gold
– Banking function with other Central Banks Worldwide
– Can borrow money from a scheduled bank in India or outside
– Issues DDs made payable at its own offices and agencies, and makes issues and circulates banks post
bills

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1. Issue of Currency
 Monopoly in notes issue
 1 Re notes and coins not issued by RBI
 Issued on the basis of minimum currency reserve system. By RB
Amendment Act 1956, a provision was made for a minimum
reserve in foreign exchange. And in gold in absolute terms.
400 Cr in Foreign Reserves and a min of 115 cr in Gold. A
total of 515 cr. (FOREX Rsv: Foreign currency deposits and
bonds held by central banks)
 Operates through Currency Chests at 15 offices & 2 Branches
all over India supported by SBI where there is no
representation.

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2. Banker to the Government

• Maintains and operates the cash balances of the central and state Govt. on
the current a/c deposit on which it pays no interest.
• It receives and makes payment on behalf of the central and state govt.
• It carries out exchange, remittance, and other banking operations on behalf
of these Govts.
• It buys and sells Govt. Sec. in the market
• It manages the public debt by issuing Govt. loans and paying interest and
principal
• It also sells T bills through tender on behalf of the Govt.
• It makes ways and means advances to the central & State Govts. by
purchasing T bills from them for a period not exceeding 91 days.
• It advises the Govt. on all banking and financial matters.
• It acts as an agent of the Central & the State Govt. in their dealings with
the IMF and World Bank, IFCA and IDA.

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3. Bankers’ Bank
 Under the Banking Reg. Act 1949 every bank is required to keep
between 3% to 15% of the total of its time and demand liabilities
with the RBI as CRR which is interest free. (Ap.07-6.5%)
 Every bank is also required to maintain with the RBI between 25%
to 40% of its net time and demand liabilities as SLR. (25%)
 RBI also regulates, supervises and controls the working of the banks :
Issuing of license for opening and branch exp. Calling for returns
and statements and books of accounts. Issue of directions concerning
terms and conditions for loans and advances.
 RBI acts as clearing house for banks
 RBI provides refinance facilities to commercial banks for export
credit, against 364 days T bills.

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4. Exchange Mgt. Control

 Under FERA, 1973 The RBI had to control the
receipts and payments of foreign currencies.
 The RBI determines the external value of rupee in
relation to the weighted basket of India's major
trading partners with pound sterling as the
intervention currency.

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5. Credit Control
 The RBI controls the money supply and credit to
ensure price stability and meet the varying economic
conditions of the country. For this purpose it uses the
various credit control measures such as variations in
interest rates, open market operations, changes in
CRR and SLR, selective credit controls etc.

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6. Collection and Publication of Data

and Reports
• The RBI has a division of Reports, Reviews and
publications under its department of Economic
analysis and policy which collects data on economic
matters such as money, credit, finance, agriculture
and industrial production, balance of payments,
prices etc. and publishes them in various
publiocations like RBI Bulletin, Weekly Statistical
Supplements, Annual Report on Currency and
Finance. etc.

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7. Training Facilities
• The RBI has set up a no. of training colleges and
centers to provide training to the banking personnel
at different levels:
– Banker’s Training College (BTC) Mumbai
– Reserve Bank Staff College (RSBC) Madras
– College of Agricultural Banking (CAB) Pune
– Zonal Training Centres (ZTC) M,K,C,D
– Indira Gandhi Institute of Development Research
– Training in Computer Technology

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8.Promotional & Development

Functions.
 AGRICULTURAL FINANCE
 INDUSTRIAL FINANCE
 EXPORT CREDIT
 CREDIT TO PRIORITY SECTOR AND WEAKER
SECTIONS
 BILL MARKET
 DEVELOPMENT AND REGULATION OF BANKING
SYSTEM

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Agricultural Finance
 RBI extended Assistance to the cooperative credit
institutions for agricultural dev and allied rural
activities right from its inception in the year 1935
 For this it set up an agricultural credit department
to provide long and medium term financing to these
sectors. The department was taken by NABARD in
the year 1982

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INDUSTRIAL FINANCE
 An industrial credit department was set up in the
year 1957 to advice and help the bank in
providing financial assistance to industries and in
setting up financial institutions like IDBI, IFCI, ICICI
etc.
 It also established the National Industrial Credit
Fund in 1964 to provide financial assistance to
large scale industries.

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EXPORT CREDIT
 The RBI provides concessional credit , refinance
facilities and guarantee to commercial banks for
export.
 It also has setup the EXIM bank to finance export
trade.

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Credit to Priority Sector and Weaker

Sections
 Under its differential Rate of interest scheme the RBI
provides concessional finance to priority sector and
weaker sections of the society.
 Eg: Lead Bank Scheme Rate of int 4%

Bill Market Scheme

• The RBI has been instrumental in developing
the Bill market

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Objectives of Credit Control

 To Stabilize Internal Price Level
 To Stabilize the rate of Foreign Exchange
 To Protect the outflow of Gold
 To Control Business Cycle
 To Meet business needs
 To Ensure Growth with Stability

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ROLE OF RBI
 Monetary Authority of the Country:
 Monetary policy making is the central function of the
RBI

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Detailed Discussion:
 To Stabilise Internal Price Levels:
 Frequent Change in Price Adversely effects the economy
 Inflation and Deflation trends needs to be prevented
 And all these could be done by adopting a suitable Credit Control Policy.
 To Stabilize the rate of Foreign Exchange
 Change in internal price level effects the level of exports and imports in the
country
 If Prices (Exports and Imports ) therefore value of Domestic currency
in the foreign market and its exchange rate ( And vice-versa)

 To Protect the outflow of Gold

 Expansion of bank credit leads to Rise in Prices thereby decreasing Export
and Increasing Import. As a result an Unfavourable Balance of Payment
Situation.
 Bank Cr Prices will & thus Exports will & Imports will
 [ Gold Std-Brt Wd 44—70- d&S ]

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 To Control Business Cycle

 Are a common phenomenon of a capitalist country and
 Are characterised by alternating periods of Prosperity and Depression
 During Prosperity ,Vol of Credit Expands leading to Rise in Prod and
Employment and thus Rise in Price
 So , there should be Control of Bank credit in Boom Period and
Expansion in Lean Period
 To Meet business needs
 When Business Expands more credit is required and less credit is absorbed
during lean periods
 Industry Life Cycle
 To Ensure Growth with Stability
 And not only price stability or forex stability.

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Methods of Credit Control

Quantitative Qualitative

Controls the Use and

Aims at controlling the Cost
and Quantity of Credit
1) Bank rate or Discount
rate policy
2) Open Market Operations
3) Variable Reserve Ratio
Direction of Credit (Selective
Credit Control Measures)
1) Regulation of Margin
Requirement
2) Regulation of Consumer
Credit
3) Rationing o Credit
4) Direct Action
5) Moral Suasion
6) Publicity

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Quantitative Methods
1. Bank Rate Policy

 Bank Rate Policy: The bank rate or discount rate is

the rate fixed by the CB at which it rediscounts First
Class bills & Government Securities. (It is the rate of
interest charged by the CB at which it provides
rediscount to banks through the discount window)
 If CB lowers Bank Rate Borrowing becomes cheaper
= So Commercial Banks will borrow more = Advances
will be available at a lower cost = More Demand =
More Business = Encourages rise in price.

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Limitations of Bank Rate Policy

 Market rates do not match with bank rates
 Wages, Costs & Prices are not elastic. (If bank rate goes
up wages, costs and prices should change which does not.)
 Commercial Banks do not always approach Central Bank
(Because they often keep large amount of liquid assets
with them)
 Bills of Exchange are not frequently used
 Pessimism or Optimism: Depends on waves of P/O among
business men. At times even at increased bank rate
borrowers continue to borrow. They are mostly driven by
Business Considerations.

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 Power to Control Deflation is Limited: Lowering the

bank rate below 3% (for eg) will not necessarily
lead to a decline of 3% or below in the market
rates.
 It is non discriminatory: It doesn't distinguish between
productive and unproductive activities.
 It is not successful in controlling BOP disequilibrium:
Because there is a requirement for removal of all
restrictions on foreign exchange and movements in
international capital – which is not possible.

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2. Open Market Operations:

 This method refers to the sell and purchase of

securities, bills and bonds of Govt. as well as Pvt.
Financial Institutions by the Central Bank.
 There are 2 principal motives of open market
operations:
1) One is to influence the reserve of the commercial
banks in order to control their power of credit
creation
2) To effect the market rates of interest so as to control
the commercial banks’s credit.

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 Suppose Central Bank wants to control Expansion of

Credit by Commercial Banks (Say in case of
Inflation) It will sell Govt. Securities – say worth Rs.
10Cr.

Individuals having accounts with

Commercial banks will also purchase
various commercial banks will purchase

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Limitations:
 Lack of well organised securities market.
 CRR is not stable
 Penal Bank Rate
 Banks Act Differently
 Pessimistic or optimistic Attitude
 Velocity of Credit money is not constant.

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3.Variable Reserve Ratio:

 It was first suggested by Keynes in 1930 and was

adopted by the Federal Rsv. Sys in the US (in the year
1935)
 Every Commercial Bank is required by the law to maintain
a minimum % of its Deposit with the Central Bank… (it
may either be a % of its term and demand deposits
separately or Total Deposits.)
 Whatever amount of money remaining with the
Commercial Banks over and above the minimum reserve is
called excess reserve.
 When Central Bank Raises the ratio it means more money
it to be kept with the Central Bank and thus less resources
are available for credit creation.

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Limitations:

 Excess Reserve
 Clumsy method: Lacks definiteness and is inexact and uncertain.
(Amount of Reserve and Place)
 Discriminatory: Effects different bank differently.
 Inflexible: is applicable all over the country universally whereas
different regions have different requirements

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SELECTIVE CREDIT CONTROL

METHODS
 Selective or qualitative methods are meant to
regulate and control the supply of credit among its
possible users and uses.
 Selective instruments do not effect the total amount
of credit but the amount that is put to use in a
particular sector in the economy.
 The aim of selective credit control is to channelize
the Flow of bank credit from speculative and other
undesirable purposes to socially desirable and
economical avenues.

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1. Regulation of Margin

 This method is employed to prevent excessive use of credit

to purchase or carry securities by speculators.
 The Central Bank fixes minimum margin required on loans
for purchasing security or carrying security. (in other words
the minimum value of loans which a borrower can have from
banks on the basis of securities/ collaterals.)
 Eg: Suppose CB fixes 10% margin on value of securities
worth Rs. 1000. So it can lend only Rs. 900 and keep Rs.
100. If it raises to 25% then commercial banks can now lend
only Rs. 750 against a security of Rs. 1000. So if the
Central Bank wants to curb speculation it will raise the
margin requirement.

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Merits & Demerits:

 Merits: 1) Non Discriminating (It applies equally to both
borrowers and lenders thus it limits both supply and
demand) 2) it is equally applicable to banks and NBFCs
3) It increases the supply of credit for more productive uses.
4) It is very effective anti-inflationary device because it
controls expansion of credit in those sectors of the economy
which breeds inflation. 5) It is simple to administer

 Demerits: 1) A borrower may not show any interest to

purchase stocks with borrowed funds by pledging other
assets or securities for loan… he may purchase them through
some other sources. 2) He may purchase stock for cash which
he would have used for purchasing supplies and materials
and then borrow for those supplies and later pledge them.

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2. Regulation of Consumer Credit

 Aims to regulate Consumer Credit through :

 Installmentcredit
 Hire Purchase Finance

 The main objective is to regulate demand for

Durable Consumer Goods
Minimum Down Maximum Period
payments for Repayment
 If the Central Bank finds a slump in a particular sector
then it can effectively introduce this mechanism to
rectify the situation
 Say the Automotive Sector faces a slump (then down payment requirements may be
reduced and Max. period of repayment can be increased. Therefore there will be
increased demand and also the allied industries will develop like rubber, plastic, spare
parts etc.

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Merits and Demerits

 Merits: 1) Effective in both boom and slump periods.
Here, General Credit Control Methods fail because it
operates with a time lag whereas consumer credit
control method doesn't. 2) It is interest inelastic: because
consumers are interested to buy under the influence of
DEMONSTRATION EFFECT and rate of interest has little
consideration.

 Demerits: 1) It is applicable to a particular class of

borrowers only, therefore it discriminates among
different types of borrowers.

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3. Rationing of Credit: (4 Types)

1. Variable Portfolio Ceiling: Here, CB fixes a ceiling on

aggregate portfolios of Comm banks and they can’t
advance loans beyond their ceiling.
2. Variable Capital Asset Ratio: this is the ratio which the
CB fixes in relation to capital of a commercial bank to
its total assets.
3. Discrimination against larger Banks
4. Rationing Credit for Selective Purposes: here, Central
Bank ceases to be lender of the last Resort. (Done
only in case of extreme inflationary situations.)

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4. Direct Action

 It is done in the form of issuance of “ Directives” It is

done from time to time to follow a particular policy
which the CB wants to enforce immediately.
 Used in case of ERRING banks

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5. Moral Suasion

 It is a method of persuasion or request, or informal

suggestion or advice.
 Here, the executive head of the CB calls a meeting
of Commercial Banks and explains them the need
for adoption of a certain policy.

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6. Publicity

 The annual repots and other allied financial data of

all Commercial banks are regularly published by
the RBI, this forces the commercial banks to perform
in accordance to the prescribed norms and
requirements.

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CONCLUSION
 Selective credit controls are not used to the total
exclusion of general credit controls. In fact they are
an adjunct to general quantitative control. They are
meant to supplement the later and are regarded only
as the ‘second line instrument.’
 The vital point is not the question of general vs.
selective credit control or the assessment of the
general pros and cons between the two methods but
of their integration. Indeed the co-ordination of
selective and general controls appears to be more
effective then the use of any one of them singly or in
isolation.

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Frequently Used Terminologies

 CRR [Cash Reserve Ratio] - CRR is the rate at which
banks are required to maintain their reserves with
the central bank on a fortnightly basis. [In recent
times it has been around 4 to 4.75%]
 SLR [Statutory Liquidity Ratio] – SLR refers to the
rate at which banks are required to maintain their
reserves in government securities.

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Repo Rate, Bank Rate, Reverse Repo

Rate:
• Repo Rate & Bank Rate: The Repo rate is the rate at which RBI borrows from
the bank while the bank rate is the rate at which the banks borrow from the
RBI. (It is the rate at which RBI rediscounts certain defined bills.) The bank rate
is currently around 6%. Any revision on the bank rate by the RBI is a signal to
commercial banks to revise deposit rates as well as the PLR.

Repo Rate (RBI borrowing

from Commercial Banks)
Comm RBI
Banks Bank Rate (COMB
borrowing from RBI)
• What is the reverse repo rate? It is the interest rate that a bank earns for
lending money to the Reserve Bank of India in exchange for government
securities.

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