RBI

Banking Law : 

Banking Law RESERVE BANK OF INDIA

Functions of Central Bank & RBI : 

Functions of Central Bank & RBI Regulation of Currency One of the most important functions of a central bank is the issue and regulation of currency. The central bank everywhere enjoys the monopoly of note issue. The central banks are vested with the monopoly of note issue for the following reasons: to ensure uniformity in the note issue which will facilitate trade and exchange within the country to impart the notes with a distinct prestige,

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to restrict or expand the supply of notes according to the requirements of the economy, to bring stability in the monetary standard and create confidence among the public, to influence and control credit creation by commercial banks.

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2. Banker, Agent and Adviser to the Government The central bank acts as banker, agent and adviser to the government banker to the government, the central bank receives deposits and makes payment on behalf of the government. It buys and sells foreign currencies on behalf government. As an agent, the central bank makes short-term loans to the government period not exceeding 90 days. It undertakes the issue of new loans and bills, redeems old securities and renews them according to market conditions. Thus the central bank manages the public debt programmed. It administers equalisation fund and clearing agreements whenever they are introduced stabilizing exchange rate. The central bank advises the government on economic and monetary devaluation or revaluation or currency, deficit financing, balance of payments etc.

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3. Banker's Bank The central bank acts as banker's bank in three different capacities: (i) Custodian of cash reserve of commercial banks. (ii) Lender of last resort. Bank of central clearance, settlement and transfer. Custodian of the cash reserve of commercial banks: A central bank is the custodian of the cash reserves of the commercial banks operating in the country. All the commercial banks keep a part of their cash reserves with the central bank. practice of keeping cash with the central bank is compulsory in countries like USA and India and customary in England.

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There are many advantages in keeping cash reserve with the central bank: (a) The centralization of reserves is a great source of strength to the banking system in the country. (b) The centralization of reserves serves as the basis of a large and more elastic credit structure. In the absence of such a centralization every individual bank is able to create large credit with the same amount of deposit. (c) The central bank can employ these funds effectively during periods of seasonal demands and to meet financial crisis in the market, (d) The central bank can provide additional funds on a temporary basis to commercial banks to overcome the financial difficulties. (e) It is also an effective tool of credit control.

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(ii) Lender of last resort : When commercial banks are not able to secure financial accommodation from other sources, then as a last resort, they can approach the central bank for necessary facilities. The central bank, in such a case, will be prepared to grant accommodation against eligible securities. By lender of last resort, the central ink assumes the responsibility of meeting directly or indirectly all reasonable demands for funds in times of emergency. This practice benefits the commercial banks in the following ways: The banks can carry on their activities on the basis of small cash reserve. The system helps commercial banks to maintain the liquidity of their financial resources. By this function, the central bank gets an opportunity to establish control over the banking system of the country.

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Bank of clearance, settlement and transfer. The central bank acts as the Bring house for commercial banks keep their accounts and. maintain cash serve with the central bank. So it is easier for the central bank to act as the clearing house of the country. The central-bank settles the claims and counter claims of the banks by making transfer entries in their account. To transfer and lie claims of one bank upon others, the central, bank operates a separate department in big cities and trade centers. This department is known as 'clearing house” The clearing house operations are quite significant. They are of great convenience to the banking system.

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4. Custodian of Foreign Exchange Reserves The central hank keeps and manages the foreign exchange reserves country: Funds coming from and going out to foreign countries are channeled through the central bank. All the incomes in foreign currencies accrued into central bank in the foreign exchange accounts and payments are met from these accounts. All the balances are kept under the custody of the bank. Further the central banks in most countries maintain both gold and foreign currencies reserves against note issue and also to meet adverse balance of payments, it a fixes the exchange rate of domestic currency in terms of foreign currencies a maintain stability in exchange rates. The central bank also manages exchange control operations in accordance with the rules laid down by the government.

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5. Research and Data Collection In addition to the above functions, a modern central bank collects publishes important monetary data pertaining to the working of the banking system and the economy as a whole. It helps to understand the nature and magnitude problems facing the economy and seek solutions thereof.

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6. METHODS OF CREDIT CONTROL The most important function of the central bank is to control credit by commercial banks. Money and credit represent a powerful force for good evil in the economy. Money cannot manage itself. So it is the duty of the central bank to ensure that money and credit is properly managed so that inflation and deflationary pressures can be controlled in the economy. In modern times bank credit has become the important source of money and commercial have unlimited power to expand or contract credit. A central bank has a important of weapons to control credit created by commercial banks. Methods of credit control are broadly divided into two: Quantitative credit control methods. Qualitative or selective credit control methods.

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The quantitative methods aim to control the total quantity and cost of re­created by banks, whereas the qualitative methods control the use and direct of credit. The quantitative methods are traditional and indirect. They include bank rate policy, open market operations and variable reserve ratio. The qualitative controls are direct which consist of regulation of consumer credit, margin requirements, rationing of credit, direct action, moral suasion and publicity

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BANK RATE POLICY Commercial banks rediscount their bills of exchange with the central bank, times of need. Similarly they borrow from the central bank against approved securities. For this service the central bank charges a rate, which is called bank rate. Thus the bank rate or discount rate is the rate at which the central bank prepared to discount the first class bills of exchange and government specific held by the commercial banks. The bank of England was the first to develop bank rate as a weapon to credit control.

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Working of the Bank Rate Policy When the central bank feels that the inflation in the country is on account of excessive creation of credit by commercial banks it raises the banks' rate. Following this, the lending rate of commercial banks go up. A rise in interest rate discourages flesh loans and puts pressure on borrowers to repay their past debts. As a result Business activities are curtailed. Fall in business activities leads to contraction of income and expenditure, reduction in demand for goods and services and ultimately fall in prices. Thus raising of bank rate controls inflations.

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The opposite happens in times of deflation. The central bank reduces the bank rate to expand credit. Following this the commercial banks reduce their lending rates. As the cost of loan is low, businessmen are encouraged to borrow and make investment. Consequently production, employment and price Increase. Thus lowering of the bank rate offsets the deflationary tendencies in the economy.

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Limitations of Bank Rate Policy The efficacy of the bank rate as an instrument of credit control has the following limitations: The success of the bank rate policy depends upon the extent to which other other market rates move in line with the bank rate. If the market rates do not change along with the bank rate, the changes in the bank rate becomes ineffective. Such a relationship is possible only when the money market is fully developed and the banking system of the country is well organized. In countries like UK and USA the bank rate policy has been successful but in underdeveloped countries has not succeeded to that extent. The effectiveness of the bank rate policy depends upon the existence of eligible bills of exchange. Nowadays the use of bills of exchange as an instrument of financing trade and commerce has reduced considerably. The cash credit an overdraft are the most convenient methods of borrowing for businessmen. The absence of rediscounting makes the bank rate policy ineffective instrument credit control.

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The bank rate will not succeed if banks have excess cash reserve. Bank may secure large funds due to deficit financing by the government. The creation of money by government to finance development schemes finds its way to commercial banks and they are in the position to lend more without resorting rediscounting or borrowing from the central bank. Thus the commercial bank are not completely dependent on the central bank and consequently the bank rate is not successful.

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The commercial banks must be in the habit of rediscounting or borrowing from the central bank. In underdeveloped money market the banks do no approach the central bank for borrowing. In the absence of such a practice, bank rate becomes ineffective. The economic system of the country must be elastic for the success of the bank rate policy. That is the cost of production, wages, interest rates etc., should respond to the changes in the bank rate. Nowadays the economic system has become rigid in all the countries. The government's control over wages, price and business etc., has been responsible for the rigidity of the economic system As a result of this, the bank rate policy has become ineffective. The success of the bank rate policy depends on the effect it produces on entrepreneurial activities. In practice the entrepreneurial activities are not adversely affected by the changes in the market rate of interest but by the margin of profit. If they expect higher return they will borrow and invest in spite of the increase in rate of interest. Besides, the investments in public sector are not governed by the changes in the rate of interest. Therefore it is difficult to establish relationship between the rate of interest and investment.

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Open Market Operations Open market operations mean, buying and selling of commercial paper and government securities in the market by the central bank. The method of open market operation is as follows: In periods of inflation, the central bank sells the securities in the market. If he buyers are individual, firms etc., they make payments by withdrawing from heir deposits with the banks. If the buyers are commercial banks their cash holding it the central bank gets reduced. So the banks are forced to stop granting fresh loans and recall loans already granted and the investment activity in the country gets slackened and the inflationary situation reduced. I During the periods of depression the central bank purchases securities in the pen market and pays cash to the sellers of securities. The public deposit their money with the banks. This increases the cash balances of commercial banks which is used to give fresh loans. Consequently the economic activity increases leading to a rise in the level of investment, employment and price.

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Limitations The policy of open market operations has certain limitations. In many countries, especially in underdeveloped countries, the money market is not well organized and developed. They do not have broad and active security market and also bill market. So open market operations are not successful. In a number of countries the cash reserves of commercial banks do not increase or decrease in accordance with the sale of purchase or securities. When the banks maintain higher cash reserves than they are required to do or if then maintain other type of secret reserve, the policy will not be successful. The open market operations can be successful only when commercial banks do not approach the central bank for accommodation. If the banks have direct access to the central bank, the reduction in cash reserve will be neutralized by the banks through borrowing from the central bank. Similarly, commercial banks may repay the loans to the central bank when the cash reserve is increased instead of granting more credit.

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VARIABLE RESERVE RATIO Variable reserve ratio as a method of credit control was suggested by Keynes in 1930. This method was introduced by Federal Reserve System of USA in 1935. Now in almost all countries of the world, the central bank adopts this instrument an effective credit control. Every commercial bank is required by law to maintain certain percentage of Its deposit with the central bank which is called the reserve ratio. The central bank has the power to change the percentage of cash reserves to be kept with it. By changing the reserve requirement the central bank is able to effect the amount cash with the commercial banks and force them to curtail or expand credit.

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LIMITATIONS The variable reserve ratio is subject to a number of limitations. (1) The commercial banks usually possess large excessive cash reserves. When central bank raises the ratio, they transfer a part of the excess reserve. They stick to the legal requirement of cash to deposit and continue to create credit. (2) This method affects different banks differently. Banks having large reserves not suffer much compared to banks having little or no reserves. This policy is also discriminatory in the sense that the non-banking financial intermediary like co-operative societies, development banks etc., are not affected by verification in reserve requirements.

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3. This policy is inflexible in the sense that the reserve ratio is applicable all regions of the country without regard to local situation. More credit ma required in one region and it may be superfluous in the other region. Raising reserve ration is not justified in the former case whereas it is appropriate latter region. 4. It introduces an element of uncertainty in the working of banks. Bar-not know when the reserve ratio will be changed. So Keynes has suggested the reserve ratio should be changed after giving reasonable notice and by as percentage. 5. Variable reserve ratio restricts the freedom of commercial banks. Even sufficient funds are available the banks may not expand credit on account of that the ratio may be raised after sometime.

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6. The employment of this weapon may have depressive effect on securities market. When the central bank suddenly increases the reserve ratio, the banks may be forced to sell the securities to maintain the requirement. This widespread selling of securities may bring down the prices of securities collapse the security market. 7. Finally the success of this system depends on the willingness of businessmen to borrow and invest. During period of inflation, the banks mayreduce credit even though the reserve ratio is raised. Similarly during periods depression banks may not be able to expand credit if the businessmen pessimistic about the future.

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