RBI as Monetary Authority of India: Role as Controller of Money Supply; Credit control tools; Changes - how it impacts Indian economy

Thursday, June 06 2019
RBI as Monetary Authority of India
RBI has reduced the Repo rate again by 25 points on June 6, 2019. Now the Repo rate is 5.75%. Reserve Bank of India (RBI) as Central Bank of the country is the monetary authority and the major Role of RBI is of a controller of credit. Since the role of RBI is expanding day by day, it has become one of the favourite GD topics in top MBA colleges and the questions on RBI also figure in GK section of various MBA entrance exams like IIFT, XAT, CMAT, SNAP among others.

Recent changes in RBI monetary policy announced for 2019, change in RBI leadership and changes in the rates of its various credit control tools, have again brought RBI in the lime light of discussion at various economic and business forums especially at the top B-schools where a slight change in RBI Monetary policy becomes a point of analysis as it impacts the economy of the country.

Reserve Bank of India plays multi-facet role by executing multiple functions such as overseeing monetary policy, issuing currency, managing foreign exchange, working as a bank of government, this article shares the key aspects related to RBI role, changes in the Bank Rate, CRR, Repo Rate, SLR and other key functions performed by the RBI

RBI: Favourite GD & GK Topic
One of the most favourite GD and GK topics on which questions are asked almost in every exam whether MBA, Civil Services, Bank PO or others is the Role of Reserve Bank of India as Monetary Authority and controller of money supply in India.

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Credit Control by RBI: Most Discussed Topic
In fact these are the credit control measures adopted by Reserve Bank of India, which form GD Discussion and also source of GK questions in entrance exams including MBA entrance tests.  

RBI brings timely changes in its credit control measures and sometimes uses more Quantitative Credit control measures and sometimes Qualitative Credit Control measures as per the economic requirement. The measure tools to regulate the credit control are Bank Rate, Cash Reserve Ratio, Statutory Liquidity Ratio, Repo Rate among others.

RBI: Recent Changes
RBI has slashed rates of various monetary control measures:

Bank Rate: 6.25%
CRR: 4%
SLR: 19%
Repo Rate: 5.75%
Reverse Repo Rate: 5.75%
MSF: 6.25% 

While GD carries a weightage of 10 to 20 percent in final selection process, the questions on GK or General Awareness form an important section with a weightage of 15 to 25% in almost all the national level MBA entrance tests including XAT, IIFT, SNAP. They are also the source of discussion during GD, PI, WAT, Extempore topics for MBA admission in IIMs, FMS, MDI, SPJIMR, XLRI and other highly ranked institutes.

This article by MBAUniverse.com shares all about the Role of Reserve Bank of India as the Bank of the Banks, Government’s Bank, its credit control measures and other policies that regulate the money supply in India and control the foreign exchange flow in the economy.

Reserve Bank of India: How different from other banks
Reserve Bank of India (RBI) is the Central Bank of the country. Role of RBI differs from other banks since it does not get engaged in day to day retail banking; does not do micro or macro regular financing. On the contrary, it is the Bankers’ Bank and formulates monetary guidelines and policies which are to be followed by all the banks operating in the country.

The Reserve Bank of India was established in 1935 with the provision of Reserve Bank of India Act, 1934. Till 1949 RBI was privately owned and was nationalised in 1949. Since then RBI is fully owned by the Government of India.

Role of RBI
Reserve Bank of India (RBI) is India's Central bank. It plays multi-facet role by executing multiple functions such as overseeing monetary policy, issuing currency, managing foreign exchange, working as a bank of government and as banker of scheduled commercial banks, among others. It also works for overall economic growth of the country.

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Key functions of RBI
The preamble of the Reserve Bank of India describes its main functions as ‘to regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage’.

Currency Issue
Reserve bank of India is the only authority who is authorized to issue currency in India. While coins are minted by Government of India (GoI), the RBI works as an agent of GoI for distributing and handling of coins. Upto Re.1 coins are minted by GoI although RBI ensures their distribution in the country.

RBI also works to prevent counterfeiting of currency by regularly upgrading security features of currency. RBI prints currency at its 4 currency printing facilities at Dewas, Nasik, Mysore and Hyderabad. The RBI is authorized to issue notes up to the value of Rupees 10,000 (Ten thousand).

Banker to Government
Like individuals, firms and companies who need a bank to carry out their financial transactions effectively & efficiently, Governments also need a bank to carry out their financial transactions. RBI serves this purpose for the Government of India (GoI). As a banker to the GoI, RBI maintains its accounts, receive in and make payments out of these accounts. RBI also helps GoI to raise money from public via issuing bonds and government approved securities.

Supervisor of Banks: Bankers’ Bank
RBI also works as banker to all the scheduled commercial banks. All the banks in India maintain accounts with RBI which help them in clearing & settling inter-bank transactions and customer transactions smoothly & swiftly. Maintaining accounts with RBI help banks to maintain statutory reserve requirements. RBI also acts as lender of last resort for all the banks.

RBI has the responsibility of regulating the nation's financial system. As a regulator and supervisor of the Indian banking system it ensures financial stability & public confidence in the banking system. RBI uses methods like On-site inspections, off-site surveillance, scrutiny & periodic meetings to supervise new bank licenses, setting capital requirements and regulating interest rates in specific areas. RBI is currently focused on implementing Basel-III norms to regulate the hidden Non Performing Assets (NPAs) in Banking system.

RBI as Country’s Foreign Exchange Manager
RBI has an important role to play in regulating & managing Foreign Exchange of the country. It manages forex and gold reserves of the nation.

On a given day, the foreign exchange rate reflects the demand for and supply of foreign exchange arising from trade and capital transactions. The RBI’s Financial Markets Department (FMD) participates in the foreign exchange market by undertaking sales / purchases of foreign currency to ease volatility in periods of excess demand for/supply of foreign currency.

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RBI as Controller of Credit: Regulator of Money supply
RBI formulates and implements the Monetary Policy of India to keep the economy on growth path. Monetary Policy refers to the process employed by RBI to control availability & cost of currency and thus keeping Inflationary & deflationary trends low and stable. RBI adopts various measures to regulate the flow of credit in the country. The measures adopted by RBI can broadly be categorized as Quantitative & Qualitative tools.

1.      Quantitative Tools
Quantitative measures of credit control are applicable to entire money and banking system without discriminations. They broadly refer to reserve ratios, bank rate policy etc. Reserve ratios are the share of net demand & time liabilities (NDTL) which banks have to keep aside to ensure that they have sufficient cash to cover customer withdrawals.

A. Cash Reserve Ratio (CRR): 
CRR is one of the most commonly used by RBI as quantitative tool of credit control. The ratio specifies minimum fraction of the total deposits of customers, which commercial banks have to hold as reserves either in cash or as deposits with the central bank. CRR is set according to the guidelines of the central bank of a country. RBI is empowered to vary CRR between 3 percent and 15 percent.

Present situation
Current CRR is 4% in India.  Cash Reserve Ratio was quoted at 4 percent in its recently announced Sixth bi-monthly Monetary Policy Statement 2019-20. Earlier, the Cash Reserve Ratio in India averaged 5.67 percent from 1999 until 2016, reaching an all time high of 10.50 percent in March of 1999 and a record low of 4 percent in February of 2013.

CRR: Impact of Increase & decrease 
CRR is the share of Net Demand and Time Liabilities (NDTL) that banks must maintain as cash with RBI. The RBI has set CRR at 4%. So if a bank has 200 Crore of NDTL then it has to keep Rs. 8 Crore in cash with RBI. RBI pays no interest on CRR.

For example – if we assume that economy is showing inflationary trends & RBI wants to control this situation by adjusting SLR & CRR. If RBI increases SLR to 50% and CRR to 20% then bank will be left only with Rs. 60 crore for operations. Now it will be very difficult for bank to maintain profitability with such small capital. Bank will be left with no choice but to raise interest rate which will make borrowing costly. This will in turn reduce the overall demand & hence price will come down eventually.

B. Statutory Liquidity Ratio (SLR)
The current SLR announced by RBI is 19% of NDTL as announced by RBI in May 2019. The share of net demand and time liabilities that banks must maintain in safe and liquid assets, such as government securities, cash and gold is SLR.

C. Bank Rate
Current Bank rate is 6.25% . When banks want to borrow long term funds from RBI, it is the interest rate which RBI charges from them. The bank rate is not used to control money supply these days although it provides the basis of arriving at lending and deposit rates. However, if a bank fails to keep SLR or CRR, RBI will then impose penalty & it will be 300 basis points above bank rate.

D. Repo Rate
Present Repo rate is 5.75% with effect from June 6, 2019. If banks want to borrow money (for short term, usually overnight) from RBI, the banks have to pay this interest rate. Banks have to pledge government securities as collateral. This kind of deal happens through a repurchase agreement. If a bank wants to borrow Rs. 100 crores, it has to provide government securities at least worth Rs. 100 crore (could be more because of margin requirement which is 5%-10% of loan amount) and agree to repurchase them at Rs. 106.50 crore at the end of borrowing period. So the bank has paid Rs. 6.50 crore as interest. This is the reason it is called repo rate. The government securities which are provided by banks as collateral cannot come from SLR quota (otherwise the SLR will go below 21.5% of NDTL and attract penalty). Banks have to provide these securities additionally.

To curb inflation, RBI increases Repo rate which will make borrowing costly for banks. Banks will pass this increased cost to their customers which make borrowing costly in whole economy. Fewer people will apply for loan and aggregate demand will get reduced. This will result in inflation coming down. RBI does the opposite to fight deflation. Although when RBI reduces Repo rate, banks are not legally required to reduce their base rate.

Current situation
The Reserve Bank of India on Thursday June 6, 2019, cut its benchmark repo rate by 25 basis points to 5.75%. This is the third rate cut in 2019. The change in repo rate is likely to lower interest rates on new bank loans.

E. Reverse Repo Rate
At present,reverse repo rate is 5.75% with effect from May 2019. Reverse repo rate is just the opposite of repo rate. If a bank has surplus money, they can park this excess liquidity with RBI and central bank will pay interest on this. This interest rate is called reverse repo rate.

F. Open Market Operation (OMO)
Open market operation is the activity of buying and selling of government securities in open market to control the supply of money in banking system. When there is excess supply of money, RBI sells government securities thereby taking away excess liquidity. Similarly, when economy needs more liquidity, RBI buys government securities and infuses more money supply into the economy.

G. Marginal Standing Facility (MSF)
This scheme was introduced in May, 2011 and all the scheduled commercial banks can participate in this scheme. Banks can borrow up to 2.5% of their respective Net Demand and Time Liabilities. RBI receives application under this facility for a minimum amount of Rs. 1 crore and in multiples of Rs. 1 crore thereafter. The important difference with repo rate is that bank can pledge government securities from SLR quota (up to 1%). Current MSF rate is 6.25%.

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Qualitative Tools of Money Control
Qualitative measures of credit control are discriminatory in nature and are applied for specific purpose or to specific financial organization, bank or others which RBI thinks are violating the monetary policy norms.

A. Loan to Value LTV or Margin Requirements
Loan to Value is the ratio of loan amount to the actual value of asset purchased. RBI regulates this ratio so as to control the amount bank can lend to its customers. For example, if an individual wants to buy a car from borrowed money and the car value is Rs. 10 Lac, he can only avail a loan amount of Rs. 7 Lac if the LTV is set to 70%. RBI can decrease or increase to curb inflation or deflation respectively.

B. Selective credit control
RBI can specifically instruct banks not to give loans to traders of certain commodities. This prevents speculations/ hoarding of commodities using money borrowed from banks.

C. Moral Suasion
RBI persuades bank through meetings, conferences, media statements to do specific things under certain economic trends. An example of this measure is to ask banks to reduce their Non-performing assets (NPAs).

Regulates and Supervises the Payment and Settlement Systems
The Payment and Settlement Systems Act of 2007 (PSS Act) gives the Reserve Bank oversight authority, including regulation and supervision, for the payment and settlement systems in the country. In this role, the RBI focuses on the development and functioning of safe, secure and efficient payment and settlement mechanisms. Two payment systems National Electronic Fund Transfer (NEFT) and Real Time Gross Settlement (RTGS) allow individuals, companies and firms to transfer funds from one bank to another. These facilities can only be used for transferring money within the country.

Emerging GK questions from the Text

  • Abbreviations: CRR; LTV; MSF; NEFT; RTGS
  • What is the current CRR, Bank Rate and Repo rate?
  • Re 1 is a currency note or a coin? Who prints/mints it?
  • What is the maximum amount of currency note that can be printed by RBI?
  • CRR is qualitative or quantitative method of credit control?
  • When was RBI established?
  • What is the minimum and maximum limit of CRR which can be exercised by RBI?

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