Money and Banking in India: RBI, Supply and Policy

Money is anything generally accepted in payment for goods and services and in settlement of debt. Banking is the business of accepting such money as deposits, repayable on demand, and lending it out. Between them they decide how much credit an economy has, and in India both are governed by one institution, the Reserve Bank of India. Questions from this chapter are short and definitional, so this note fixes the definitions, the dates and the instruments.

What money does

Money performs four functions. It is a medium of exchange, which removes the need under barter for a double coincidence of wants. It is a measure of value or unit of account, so that prices of unlike goods can be compared. It is a store of value, because it can be held without spoiling. And it is a standard of deferred payment, so that loans and contracts can be written in it. Modern currency is fiat money: it has no metallic backing and is accepted because the state declares it legal tender. Notes and coins are legal tender; a cheque is not, since a creditor may refuse it, so it is called credit money. Time deposits, which can be turned into cash only after notice, are called near money.

Measures of money supply

M1 is the most liquid and M4 the least. M3 is the measure the Reserve Bank watches most closely, and it is the one examiners mean by broad money. Banks add to the money supply by creating credit: a deposit received is partly kept as reserve and the rest lent, the loan returns to the system as a fresh deposit, and the process repeats, so a given quantity of reserve money supports a multiple of deposits.

The Reserve Bank of India

The Reserve Bank was set up on the recommendation of the Hilton Young Commission, formally the Royal Commission on Indian Currency and Finance, which reported in 1926. It was constituted under the Reserve Bank of India Act of 1934 and began work on 1 April 1935, with its central office at Calcutta, moved permanently to Bombay in 1937. It began as a shareholders' bank and was nationalised on 1 January 1949. Its first Governor was Sir Osborne Smith and its first Indian Governor was C. D. Deshmukh, who later became Finance Minister.

Its functions are the classic list of a central bank. It is the monetary authority, framing and operating monetary policy. It is the sole issuer of currency notes above one rupee, which carry the Governor's signature; the one rupee note and all coins are issued by the Government of India and merely circulated by the Reserve Bank, and the one rupee note carries the signature of the Finance Secretary. Notes are issued under the Minimum Reserve System, in force since 1957, under which the Bank must hold a minimum reserve of two hundred crore rupees, of which one hundred and fifteen crore is in gold and the rest in foreign securities. The Reserve Bank is banker to the central and state governments, banker to the banks and lender of last resort, custodian of the country's foreign exchange reserves, and the regulator and supervisor of the banking and payment systems.

Instruments of monetary policy

Quantitative instruments work on the volume of credit. The cash reserve ratio is the share of a bank's net demand and time liabilities that it must keep as cash with the Reserve Bank. The statutory liquidity ratio is the share it must hold in cash, gold or approved securities with itself. The repo rate is the rate at which the Reserve Bank lends to banks for short periods against government securities, and the reverse repo rate is the rate at which it absorbs their surplus funds. The bank rate is the rate at which it lends for longer periods without such repurchase, and the marginal standing facility lets a bank borrow overnight at a rate above the repo rate. Open market operations are the purchase and sale of government securities to add or remove liquidity. Qualitative instruments work on the direction of credit and include margin requirements, credit rationing, consumer credit regulation, moral suasion and direct action. Since the amendment of the Reserve Bank of India Act in 2016 the policy rate is set by a six-member Monetary Policy Committee, three of its members from the Reserve Bank with the Governor as chairperson and three appointed by the central government, the Governor having a casting vote; the government notifies the inflation target for a five-year period in consultation with the Bank.

The structure and milestones of Indian banking

Banks listed in the Second Schedule of the Reserve Bank of India Act are scheduled banks. The commercial banking group covers public sector banks, private sector banks, foreign banks, regional rural banks and the newer small finance banks and payments banks, a payments bank being allowed to take deposits up to a ceiling set by the Reserve Bank but not to lend. Alongside them stand the cooperative banks and the development institutions such as NABARD, set up on 12 July 1982 on the recommendation of the Sivaraman Committee as the apex body for rural and agricultural credit.

The milestones are asked directly. The Bank of Hindustan, founded at Calcutta in 1770, was the first bank in India. The three presidency banks, the Bank of Bengal of 1806, the Bank of Bombay of 1840 and the Bank of Madras of 1843, were merged in 1921 into the Imperial Bank of India, which became the State Bank of India on 1 July 1955. The Punjab National Bank, founded in 1894, was the first bank started with wholly Indian capital and Indian management. Fourteen large commercial banks were nationalised on 19 July 1969 and six more in April 1980. The Lead Bank Scheme, which gives each district a bank responsible for its credit planning, dates from 1969 as well. Under priority sector lending norms a domestic commercial bank must lend a prescribed share of its adjusted net bank credit, forty per cent in the standard norm, to agriculture, small enterprises, education, housing and weaker sections.