Semester III

Banking Theory Law and Practice

Course code: 19BCM3IB0

Unit I
Introduction to banking – Types of Banks – Functions - Banking Regulations Act, 1949 –
Reserve Bank of India (RBI) - Organisational structure – Functions of Commercial Banks –
Credit Creations of RBI – Credit Control Measures – Monetary Policy and its objectives -
Relationship between RBI and Commercial Banks.
Introduction to banking
Meaning of Bank
The word ‘Bank’ has been derived from the Latin word ‘bancus’ or ‘banque’. The
meaning of it in English is a bench. The early bankers transacted their business at benches in a
market place.
A bank is a financial institution and a financial intermediary that accepts deposits and
channels those deposits into lending activities, either directly by loaning or indirectly through
capital markets.
The services banks offer to customers have to do almost entirely with handling money or
finances for other people.
In simple word, a bank is a financial institution licensed to receive deposits and make
loans.
Definition:
According to F.E. Perry, “The bank is an establishment which deals in money, receiving
it on deposit from customers, honoring customer‘s drawings against such deposits on demand,
collecting cheques for customs and lending or investing surplus deposits until they are required
for repayment.
Two of the most common types of banks are
• Commercial/retail - a bank may also provide various financial services ranging
from providing safe deposit boxes and currency exchange to retirement and
wealth management and
• Investment banks - Investment banks gear their services toward corporate clients.
They provide services such as merger and acquisition activity and underwriting
among other investment services.
Meaning of banking
Banking is defined as the business activity of accepting and safeguarding money owned
by other individuals and entities, and then lending out this money in order to conduct economic
activities such as making profit or simply covering operating expenses.
Definition
 Section 5 (b) of the Banking Regulation Act 1949 defines “Banking” as “Accepting for
the purpose of lending and investment, deposits of money from the public repayable on demand
or otherwise and withdraw able by cheque, draft, order or otherwise”
Evolution of Banking in India
Modern banking as evolved in England was introduced by the British during their rule in
India. Naturally, today’s Indian banking is similar to British banking. However, it does not mean
that banking was unknown to India.
The essence of banking is lending for productive purposes.
In fact, India was a major partner in international trading and was a big producer of steel,
cloth, pieces and luxurious articles. There are references to rate of interest, security of the loans
in the Manusmrity. Kautilya in the ‘Artha Shastra’ mentions regulation of interest rates, deposits
and even discounting of bills. They were called ‘Hundies’.
The big merchants, traders and moneylenders called ‘Sresthis’ or “Nagarseths” occupied
important positions in the Mughal and Maratha courts.
They had efficient courier system, extensive branches all over India and they gave loans
to the kings also. However, modern banking with its double-entry accounting system and
insistence on deposit mobilization was introduced by the British.
As the British rule extended all over the country, the stages in evolution in Banking in
India. Modern banking also spread driving out the indigenous banking.

Stages in the Evolution of Banking in India :

Some important stages in the evolution of modern banking in India are as follows :
1) Agency Houses :
• When the English traders came to India, they had problem of raising working capital due to
the language barrier.
• Therefore, they established Agency Houses which combined trading with banking.
• One agency house established the first bank in India called the Bank of Hindustan in 1770.
Later on, many banks were established.
• But they disappeared as fast as they were born. Anybody could then start a bank. The field
was free for all.
2) Presidency Banks :
• The East India Co., the ruler of lndia, took initiative in establishing Presidency Banks by
contributing 20% of their share capital to meet its own demand for funds.
• Accordingly, Bank of Bengal, Bank of Bombay and Bank of Madras were established in
1806,
1840 and 1943 respectively.
3) Joint Stock Banks :
• In 1884, banks were allowed to be established on the principle of limited liability.
• In due course, this encouraged establishment of banks.
 • By the turn of the century, many banks with the initiative of Indians were established.
Punjab National Bank, Allahabad Bank, Bank of Baroda are some of the banks then
established.
• Many foreigners also came in the field of Indian banking.
4) Imperial Bank of India :
• To meet the competition of foreign banks, the three Presidency Banks were amalgamated
and a powerful Imperial Bank of India was established in 1921 with its network of
branches all over the country.
• This bank was later nationalized in 1955 and it is today’s State Bank of India.
• This is a prestigious bank as the Government is its customer.
5) Establishment of the Reserve Bank of India :
• Though there was boom in banking, due to absence of any regulation and facility of
timely assistance there were recurrent bank failures.
• This resulted in suspicion about banks in the minds of the people.
• They stayed away from banks.
• The need for a separate Central Bank was emphasised by the HiltonYoung Commission.
• Accordingly, the RBI was established in1935 to perform all the functions of a Central
Bank.
• It was modeled on the pattern of the Bank of England.
• But it did not have much power of regulation.
• The period was also critical one due to the great depression and the subsequent Second
World War. The RBI could not do much about banking.
6) Nationalisation of the RBI and the Banking Regulation Act :
• These two important steps were taken in 1949.
• Immediately after independence wide powers of regulation and control were given to the
RBI and by making use of those powers the RBI was successful in making Indian
banking trustworthy.
• Soon, bank failures became a thing of the past and India’s banks progressed under the
guidance of the RBI.
• Many malpractices, deficiencies and drawbacks were sought to be removed by the RBI.
7) Nationalisation of Banks in 1969 and 1980 :
• Another significant step was taken in 1969 by nationalising 14 big Indian banks.
• Then six more banks were nationalised in 1980.
• The nationalisation of banks brought about a sea-change in the policies, attitudes,
procedures, functions and coverage of banks.
• Indian banks are now being prepared to become international players.
• These are the stages through which Indian banking developed.
8) Recent developments
 ➢ Public Sector Banks (PSBs) are a major type of bank in India, where a majority stake (i.e.
more than 50%) is held by the government.
➢ In April 2019, Vijaya Bank and Dena Bank were merged with Bank of Baroda.
➢ On 30 August 2019, Union Finance Minister Nirmala Sitaraman announced merger of six
public sector banks (PSBs) with four better performing anchor banks in order to
streamline their operation and size, two banks were amalgamated to strengthen national
presence and four were amalgamated to strengthen regional focuses. Subsequently, the
number of public sector bank has been reduced to 12 from 27. This new amalgamation
came effective from 1 April 20
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Types of Banks
Banks are classified into classified into four categories :
• Commercial Banks
• Small Finance Banks
• Payments Banks
• Co-operative Banks
1. Commercial Banks
• Commercial Banks are regulated under the Banking Regulation Act, 1949 and their
business model is designed to make profit.
• Their primary function is to accept deposits and grant loans to the general public,
corporate and government.
• Commercial Banks can be further classified into public sector banks, private sector
banks,
foreign banks and Regional Rural Banks (RRB).
• On the other hand, cooperative banks are classified into urban and rural.
• Apart from these, a fairly new addition to the structure is payments bank.
a) Public Sector Banks
• These are the nationalised banks and account for more than 75 per cent of the total
banking business in the country.
• Majority of stakes in these banks are held by the government. In terms of volume,
SBI is the largest public sector bank in India and after its merger with its 5 associate
banks (as on 1st April 2017) it has got a position among the top 50 banks of the
world. There are a total of 20 nationalised banks in the country.
b)Private Sector Banks
• These include banks in which major stake or equity is held by private shareholders.
• All the banking rules and regulations laid down by the RBI will be applicable on
private sector banks as well.
c) Foreign Bank
• A foreign bank is one that has its headquarters in a foreign country but operates in
 India as a private entity.
• These banks are under the obligation to follow the regulations of its home country as
well as the country in which they are operating.
d) Regional Rural Bank
• These are also scheduled commercial banks but they are established with the main
objective of providing credit to weaker sections of the society like agricultural
labourers, marginal farmers and small enterprises.
• They usually operate at regional levels in different states of India and may have
branches in selected urban areas as well. Other important functions carried out by
RRBs include-
• Providing banking and financial services to rural and semi-urban areas
• Government operations like disbursement of wages of MGNREGA workers,
distribution of pensions, etc.
• Para-Banking facilities like debit cards, credit cards and locker facilities
2. Small Finance Banks
• This is a niche banking segment in the country and is aimed to provide financial
inclusion to sections of the society that are not served by other banks.
• The main customers of small finance banks include micro industries, small and
marginal farmers, unorganized sector entities and small business units.
• These are licensed under Section 22 of the Banking Regulation Act, 1949 and are
governed by the provisions of RBI Act, 1934 and FEMA.
3. Payment Bank
• This is a relatively new model of bank in the Indian Banking industry.
• It was conceptualised by the RBI and is allowed to accept a restricted deposit.
• The amount is currently limited to Rs. 1 Lakh per customer.
• They also offer services like ATM cards, debit cards, net- banking and mobile-
banking.
4.Corporative Bank
• Co-operative banks are registered under the Cooperative Societies Act, 1912 and
they are run by an elected managing committee.
• These work on no-profit no-loss basis and mainly serve entrepreneurs, small
businesses, industries and self-employment in urban areas.
• In rural areas, they mainly finance agriculture-based activities like farming,
livestock and hatcheries.
a) Urban Co-operative Banks
•Urban Co-operative Banks refer to the primary cooperative banks located in urban
and semi-urban areas.
• These banks essentially lent to small borrowers and businesses centered around
communities, localities work place groups.
• According to the RBI, on 31st March, 2003 there were 2,104 Urban Co-operative
 Banks of which 56 were scheduled banks.
• About 79% of these are located in five states, – Andhra Pradesh, Gujarat,
Karnataka, Maharashtra and Tamil Nadu.

b) State Co-operative Banks

A State Cooperative Bank is a federation of the central cooperative bank which acts
as custodian of the cooperative banking structure in the State.

5.Scheduled Banks
Scheduled banks are covered under the 2nd Schedule of the Reserve Bank of India Act,
1934. To qualify as a scheduled bank, the bank should conform to the following conditions:
• A bank that has a paid-up capital of Rs. 5 Lakh and above qualifies for the schedule
bank category
• A bank requires to satisfy the central bank that its affairs are not carried out in a way
that causes harm to the interest of the depositors
• A bank should be a corporation rather than a sole-proprietorship or partnership firm.
6.Non-Scheduled Banks
• Non-scheduled banks refer to the local area banks which are not listed in the Second
Schedule of Reserve Bank of India.
• Non-Scheduled Banks are also required to maintain the cash reserve requirement,
not with the RBI, but with them.
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Functions of Banks
The functions of commercial banks are of two types.
I. Primary Function
a. Accepting deposits b. Giving loans
c. Overdraft d. Discounting of Bills of Exchange
e. Investment of funds
II.Secondary functions.
I. Primary Function
a) Accepting Deposit
1. Saving Deposit
• Saving deposit account meant for those people who wants to save for future needs and
• uncertainties.
• There is no restriction on number and amount of withdrawals.
• Bank provides cheque book, ATM cum debit card and Internet banking facility.
Depositors need to maintain minimum balance which varies across different banks
2. Fixed Deposit or Term Deposit
• In fixed deposit account, money is deposited for a fixed tenure.
 • Banks issues a deposit certificate which contains name, address, deposit amount,
withdrawal date, depositor signatures and other important information.
• Depositor can't withdraw money during this period.
• In case depositor want to withdraw before maturity, banks levy pre-mature withdrawal
penalty.
3. Current Account
• Current accounts are normally opened by businesses.
• Banks provide overdraft facility for these accounts by which account holder can
withdraw more money than available bank balance.
• This act as a short term loan to meet urgent needs. Bank charges high rate on interest
and charges for overdraft facility because bank need to maintain a reserve for unknown
demands for overdraft
4. Recurring Deposit
• In this type of account depositors deposits certain sum of money at regular period of time.
• Benefit of recurring account is that it provides benefit of compounded rate of interest and
enables depositors to collect big sum of money.
b) Granting Loans and Advances
1) Cash Credit
• In this type of credit scheme, banks advance loans to its customers on the basis of bonds,
inventories and other approved securities.
• Under this scheme, banks enter into an agreement with its customers to which money can
be withdrawn many times during a year.
• Under this set up banks open accounts of their customers and deposit the loan money.
With this type of loan, credit is created.
2) Demand loans:
• These are such loans that can be recalled on demand by the banks.
• The entire loan amount is paid in lump sum by crediting it to the loan account of the
borrower, and thus entire loan becomes chargeable to interest with immediate effect.
3) Short-term loan:
• These loans may be given as personal loans, loans to finance working capital or as
priority sector advances.
• These are made against some security and entire loan amount is transferred to the loan
account of the borrower.
c) Overdraft
Bank provides this facility to current account holders. Account holder can
withdraw money anytime up to the provided limit.
 d) Discounting Bills of exchange
• I n normal day to day business, sellers send bills to buyer whenever they sell their p
roducts and it is mentioned in bill to make payment in stipulated time. Let’s take it 30
days. In such conditions seller may discount the bill from bank for some fees. In such
situation bill
• discounting acts as short term loan. In case the buyer or the drawer defaults, bank
send the bill back to seller to drawer so that he may take legal action against drawee
or buyer.
e) Investment of Funds:
• The banks invest their surplus funds in three types of securities—Government
securities, other approved securities and other securities. Government securities
include both, central and state governments, such as treasury bills, national savings
certificate etc.
• Other securities include securities of state associated bodies like electricity boards,
housing boards, debentures of Land Development Banks units of UTI, shares of
Regional Rural banks etc.
II . Secondary Function
(i) Transfer of Funds:
Banks provide the facility of economical and easy remittance of funds from place-to-
place with the help of instruments like demand drafts, mail transfers, etc.
(ii) Collection and Payment of Various Items:
Commercial banks collect cheques, bills,’ interest, dividends, subscriptions, rents and
other periodical receipts on behalf of their customers and also make payments of taxes, insurance
premium, etc. on standing instructions of their clients.
(iii) Purchase and Sale of Foreign Exchange:
Some commercial banks are authorized by the central bank to deal in foreign exchange.
They buy and sell foreign exchange on behalf of their customers and help in promoting
international trade.
(iv) Purchase and Sale of Securities:
Commercial banks buy and sell stocks and shares of private companies as well as
government securities on behalf of their customers.
(v) Income Tax Consultancy:
They also give advice to their customers on matters relating to income tax and even
prepare their income tax returns.
(vi) Trustee and Executor:
Commercial banks preserve the wills of their customers as trustees and execute them
after their death as executors.
(vii) Letters of Reference:
They give information about the economic position of their customers to traders and
provide the similar information about other traders to their customers.
2. General Utility Functions:
Commercial banks render some general utility services like:
(i) Locker Facility:
Commercial banks provide facility of safety vaults or lockers to keep valuable articles of
customers in safe custody.
(ii) Traveller’s Cheques:
Commercial banks issue traveler’s cheques to their customers to avoid risk of taking cash
during their journey.
(iii) Letter of Credit:
They also issue letters of credit to their customers to certify their creditworthiness.
(iv) Underwriting Securities:
Commercial banks also undertake the task of underwriting securities. As public has full
faith in the creditworthiness of banks, public do not hesitate in buying the securities underwritten
by banks.
(v) Collection of Statistics:
Banks collect and publish statistics relating to trade, commerce and industry. Hence, they
advice customers on financial matters. Commercial banks receive deposits from the public and
use these deposits to give loans. However, loans offered are many times more than the deposits
received by banks. This function of banks is known as ‘Money Creation’.
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Banking Regulations Act, 1949

Principal Provisions of Banking Regulation Act, 1949

1. Prohibition of Trading (Sec. 8):
• According to Sec. 8 of the Banking Regulation Act, a banking company cannot
directly or indirectly deal in buying or selling or bartering of goods.
• But it may, however, buy, sell or barter the transactions relating to bills of exchange
received for collection or negotiation.
2. Non-Banking Assets (Sec. 9):
• According to Sec. 9 “A banking company cannot hold any immovable
property, howsoever acquired, except for its own use, for any period exceeding seven years
from the date of acquisition thereof.The company is permitted, within the period of seven
years, to deal or trade in any such property for facilitating its disposal”.
The Reserve Bank of India may, in the interest of depositors, extend the period of
seven years by any period not exceeding five years
3. Management (Sec. 10):
Sec. 10 (a) states that not less than 51% of the total number of members of the Board
of Directors of a banking company shall consist of persons who have special knowledge or
practical experience in one or more of the following fields:
(a) Accountancy;
 (b) Agriculture and Rural Economy;
(c) Banking;
(d) Cooperative;
(e) Economics;
(f) Finance;
(g) Law;
(h) Small Scale Industry.
The Section also states that at least not less than two directors should have special
knowledge or practical experience relating to agriculture and rural economy and
cooperative. Sec. 10(b) (1) further states that every banking company shall have one of its
directors as Chairman of its Board of Directors.
4. Minimum Capital and Reserves (Sec. 11):
Sec. 11 (2) of the Banking Regulation Act, 1949, provides that no banking company
shall commence or carry on business in India, unless it has minimum paid-up capital and
reserve of such aggregate value as is noted below:
(a) Foreign Banking Companies:
In case of banking company incorporated outside India, aggregate value of its paid-
up capital and reserve shall not be less than Rs. 15 lakhs and, if it has a place of business in
Mumbai or Kolkata or in both, Rs. 20 lakhs.
It must deposit and keep with the R.B.I, either in Cash or in unencumbered approved
securities:
(i) The amount as required above, and
(ii) After the expiry of each calendar year, an amount equal to 20% of its profits
for the year in respect of its Indian business.
(b) Indian Banking Companies:
In case of an Indian banking company, the sum of its paid-up capital and reserves
shall not be less than the amount stated below:
(i) If it has places of business in more than one State, Rs. 5 lakhs, and if any such
place of business is in Mumbai or Kolkata or in both, Rs. 10 lakhs.
(ii) If it has all its places of business in one State, none of which is in Mumbai or
Kolkata, Rs. 1 lakh in respect of its principal place of business plus Rs. 10,000 in respect of
each of its other places of business in the same district in which it has its principal place of
business, plus Rs. 25,000 in respect of each place of business elsewhere in the State. No
such banking company shall be required to have paid-up capital and reserves exceeding Rs.
5 lakhs and no such banking company which has only one place of business shall be
required to have paid- up capital and reserves exceeding Rs. 50,000.In case of any such
banking company which commences business for the first time after 16th September 1962,
the amount of its paid- up capital shall not be less than Rs. 5 lakhs.
(iii) If it has all its places of business in one State, one or more of which are in
Mumbai or Kolkata, Rs. 5 lakhs plus Rs. 25,000 in respect of each place of business outside
Mumbai or Kolkata? No such banking company shall be required to have paid-up capital
and reserve excluding Rs. 10 lakhs.
5. Capital Structure (Sec. 12):
According to Sec. 12, no banking company can carry on business in India, unless it
satisfies the following conditions:
(a) Its subscribed capital is not less than half of its authorized capital, and its paid-up capital
is not less than half of its subscribed capital.
(b) Its capital consists of ordinary shares only or ordinary or equity shares and such
preference shares as may have been issued prior to 1st April 1944. This restriction does not
apply to a banking company incorporated before 15th January 1937.
(c) The voting right of any shareholder shall not exceed 5% of the total voting right of all
the shareholders of the company.
6. Payment of Commission, Brokerage etc. (Sec. 13):
According to Sec. 13, a banking company is not permitted to pay directly or
indirectly by way of commission, brokerage, discount or remuneration on issues of its
shares in excess of 2½% of the paid-up value of such shares.
7. Payment of Dividend (Sec. 15):
According to Sec. 15, no banking company shall pay any dividend on its shares until
all its capital expenses (including preliminary expenses, organisation expenses, share
selling commission, brokerage, amount of losses incurred and other items of expenditure
not represented by tangible assets) have been completely written-off.
But Banking Company need not:
(a) Write-off depreciation in the value of its investments in approved securities in any case
where such depreciation has not actually been capitalized or otherwise accounted for as a
loss;
(b) Write-off depreciation in the value of its investments in shares, debentures or bonds
(other than approved securities) in any case where adequate provision for such depreciation
has been made to the satisfaction of the auditor;
(c) Write-off bad debts in any case where adequate provision for such debts has been made
to the satisfaction of the auditors of the banking company.
Floating Charges:
A floating charge on the undertaking or any property of a banking company can be
created only if RBI certifies in writing that it is not detrimental to the interest of depositors
— Sec. 14A. Similarly, any charge created by a banking company on unpaid capital is
invalid — Sec. 14.
8. Reserve Fund/Statutory Reserve (Sec. 17):
According to Sec. 17, every banking company incorporated in India shall, before
declaring a dividend, transfer a sum equal to 20% of the net profits of each year (as
disclosed by its Profit and Loss Account) to a Reserve Fund.
The Central Government may, however, on the recommendation of RBI, exempt it
from this requirement for a specified period. The exemption is granted if its existing reserve
fund together with Securities Premium Account is not less than its paid-up capital.
If it appropriates any sum from the reserve fund or the securities premium account,
it shall, within 21 days from the date of such appropriation, report the fact to the Reserve
Bank, explaining the circumstances relating to such appropriation. Moreover, banks are
required to transfer 20% of the Net Profit to Statutory Reserve.
9. Cash Reserve (Sec. 18):
Under Sec. 18, every banking company (not being a Scheduled Bank) shall, if
Indian, maintain in India, by way of a cash reserve in Cash, with itself or in current account
with the Reserve Bank or the State Bank of India or any other bank notified by the Central
Government in this behalf, a sum equal to at least 3% of its time and demand liabilities in
India.
The Reserve Bank has the power to regulate the percentage also between 3% and
15% (in case of Scheduled Banks). Besides the above, they are to maintain a minimum of
25% of its total time and demand liabilities in cash, gold or unencumbered approved
securities. But every banking company’s asset in India should not be less than 75% of its
time and demand liabilities in India at the close of last Friday of every quarter.
10. Liquidity Norms or Statutory Liquidity Ratio (SLR) (Sec. 24):
According to Sec. 24 of the Act, in addition to maintaining CRR, banking
companies must maintain sufficient liquid assets in the normal course of business. The
section states that every banking company has to maintain in cash, gold or unencumbered
approved securities, an amount not less than 25% of its demand and time liabilities in India.
This percentage may be changed by the RBI from time to time according to
economic circumstances of the country. This is in addition to the average daily balance
maintained by a bank.
Again, as per Sec. 24 of the Banking Regulation Act, 1949, every scheduled bank
has to maintain 31.5% on domestic liabilities up to the level outstanding on 30.9.1994 and
25% on any increase in such liabilities over and above the said level as on the said date.
But w.e.f. 26.4.1997 fortnight the maintenance of SLR for inter-bank liabilities was
exempted. It must be remembered that at the start of the preceding fortnights, SLR must be
maintained for outstanding liabilities.
11. Restrictions on Loans and Advances (Sec. 20):
After the Amendment of the Act in 1968, a bank cannot:
(i) Grant loans or advances on the security of its own shares, and
(ii) Grant or agree to grant a loan or advance to or on behalf of:
(a) Any of its directors;
(b) Any firm in which any of its directors is interested as partner, manager or
guarantor;
(c) Any company of which any of its directors is a director, manager, employee or
guarantor, or in which he holds substantial interest; or
(d) Any individual in respect of whom any of its directors is a partner or guarantor.
12. Accounts and Audit (Sees. 29 to 34A):
• The above Sections of the Banking Regulation Act deal with the accounts and audit.
• Every banking company, incorporated in India, at the end of a financial year
expiring after a period of 12 months as the Central Government may by notification
 in the Official Gazette specify, must prepare a Balance Sheet and a Profit and Loss
Account as on the last working day of that year, or, according to the Third Schedule,
or, as circumstances permit.
• At the same time, every banking company, which is incorporated outside India, is
required to prepare a Balance Sheet and also a Profit and Loss Account relating to
its branch in India also.
• We know that Form A of the Third Schedule deals with form of Balance Sheet and
Form B of the Third Schedule deals with form of Profit and Loss Account.
• It is interesting to note that a revised set of forms have been prescribed for Balance
Sheet and Profit and Loss Account of the banking company and RBI has also issued
guidelines to follow the revised forms with effect from 31st March 1992.
• According to Sec. 30 of the Banking Regulation Act, the Balance Sheet and Profit
and Loss Account should be prepared according to Sec. 29, and the same must be
audited by a qualified person known as auditor.
• Every banking company must take previous permission from RBI before appointing,
reappointing or removing any auditor. RBI can also order special audit for public
interest of depositors.
Moreover, every banking company must furnish their copies of accounts and
Balance Sheet prepared according to Sec. 29 along with the auditor’s report to the RBI and
also the Registers of companies within three months from the end of the accounting period.
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Reserve Bank of India (RBI)
Establishment
• The Reserve Bank of India was established on April 1, 1935 in accordance with the
provisions of the Reserve Bank of India Act, 1934.
• The Central Office of the Reserve Bank was initially established in Calcutta but was
permanently moved to Mumbai in 1937.
• The Central Office is where the Governor sits and where policies are formulated.
• Though originally privately owned, since Nationalization in 1949, the Reserve Bank
is fully owned by the Government of India.
Preamble
The Preamble of the Reserve Bank of India describes the basic functions of the
Reserve Bank 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; to have a modern monetary policy framework to
meet the challenge of an increasingly complex economy, to maintain price stability while
keeping in mind the objective of growth."
Organizational Structure
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Functions of Commercial Banks
A commercial bank is a type of financial institution that provides services like accepting
deposits, making business loans, and offering basic investment products. The term commercial
bank can also refer to a bank, or a division of a large bank, which precisely deals with deposits
and loan services provided to corporations or large or middle-sized enterprises as opposed to
individual members of the public or small enterprises. For example, Retail banking, or Merchant
banks.
Primary Functions of Commercial Banks
The primary functions of a commercial bank are as follows:
1. Accepting Deposits
Commercial banks accept deposits from people, businesses, and other entities in the form of:
• Savings deposits – The commercial bank accepts small deposits, from households or
persons, in order to encourage savings in the economy.
• Time deposits – The bank accept deposits for a fixed time and carry a higher rate of
interest as compared to savings deposits.
• Current deposits – These accounts do not offer any interest. Further, most current
accounts offer overdrafts up to a pre-specified limit. The bank, therefore, undertakes
the obligation of paying all cheques against deposits subject to the availability of
sufficient funds in the account.
2. Lending of Funds
• Another important activity is lending funds to customers in the form of loans and
advances, cash credit, overdraft and discounting of bills, etc.
• Loans are advances that a bank extends to his customers with or without security for a
 specified time and at an agreed rate of interest.
• Further, the bank credits the loan amount in the customers’ account which he
withdraws as per his needs.
• Under the cash credit facility, the bank offers its customers a facility to borrow cash up
to a certain limit against the security of goods
• Further, an overdraft is an arrangement that a bank offers to customers wherein a
temporary facility is offered to overdraw from the current account without any security.
• The limit is pre-specified.
• Additionally, banks also discount and purchase bills. In both of these cases, a bank credits
the amount of the bill in the customer’s account after deducting discounts and
commissions. Subsequently, this amount is recovered from the debtors on the maturity of
the instrument.
Secondary Functions of Commercial Banks
The secondary functions of a commercial bank are as follows:
Bank as an Agent
A bank acts as an agent to its customers for various services like:
• Collecting bills, draft, cheques, etc.
• Paying the insurance premium, rent, loan installments, etc.
• Working as a representative of a customer for purchasing or redeeming securities, etc.
in the stock exchange.
• Acting as an executor, administrator, or trustee of the estate of a customer
• Also, preparing income tax returns, claiming tax refunds, etc.
General Utility Services
There are several general utility services that commercial banks offer like:
• Issuing traveler cheques
• Offering locker facilities for keeping valuables in safe custody
• Also, issuing debit cards and credit cards, etc.

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Credit Controls of RBI
• Credit control is an important tool used by Reserve Bank of India, a major weapon
of the monetary policy used to control the demand and supply of money (liquidity)
in the economy. Central Bank administers control over the credit that the
commercial banks grant.
• Such a method is used by RBI to bring "Economic Development with Stability".
• It means that banks will not only control inflationary trends in the economy but also
boost economic growth which would ultimately lead to increase in real national
income stability.
• In view of its functions such as issuing notes and custodian of cash reserves, credit
not being controlled by RBI would lead to Social and Economic instability in the
 country.

Need for Credit Control

Controlling credit in the economy is amongst the most important functions of the Reserve Bank of India.
The basic and important needs of credit control in the economy are-

• To encourage the overall growth of the "priority sector" i.e. those sectors of the
economy which is recognized by the government as "prioritized" depending upon their
economic condition or government interest. These sectors broadly totals to around 15 in
number.[1]
• To keep a check over the channelization of credit so that credit is not delivered for
undesirable purposes.
• To achieve the objective of controlling inflation as well as deflation.
• To boost the economy by facilitating the flow of adequate volume of bank credit to
different sectors.
• To develop the economy.
Objectives of Credit Control
The broad objectives of credit control policy in India have been-
• Ensure an adequate level of liquidity enough to attain high economic growth rate along
with maximum utilisation of resource but without generating high inflationary pressure.
• Attain stability in the exchange rate and money market of the country.
• Meeting the financial requirement during a slump in the economy and in the normal
times as well.
• Control business cycle and meet business needs

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Credit Control Measures/Methods of Credit Controls
I. Quantitative or General Methods:
1. Bank Rate Policy:
• The bank rate is the rate at which the Central Bank of a country is prepared to re-
discount the first class securities.
• It means the bank is prepared to advance loans on approved securities to its member
banks.
• As the Central Bank is only the lender of the last resort the bank rate is normally
higher than the market rate
For Example
• If the Central Bank wants to control credit, it will raise the bank rate.
• As a result, the market rate and other lending rates in the money-market will go up.
Borrowing will be discouraged.
• The raising of bank rate will lead to contraction of credit.
Similarly, a fall in bank rate mil lowers the lending rates in the money market which in
turn will stimulate commercial and industrial activity, for which more credit will be required
from the banks. Thus, there will be expansion of the volume of bank Credit.
2.Open Market Operations
• In narrow sense—the Central Bank starts the purchase and sale of Government
securities in the money
• But in the Broad Sense—the Central Bank purchases and sale not only Government
securities but also of other proper and eligible securities like bills and securities of
private concerns.
• When the banks and the private individuals purchase these securities they have to
make payments for these securities to the Central Bank.
• This gives result in the fall in the cash reserves of the Commercial Banks, which in
turn reduces the ability of create credit. Through this way of working the Central Bank
is able to exercise a check on the expansion of credit.
• Further, if there is deflationary situation and the Commercial Banks are not creating as
much credit as is desirable in the interest of the economy. Then in such situation the
Central Bank will start purchasing securities in the open market from Commercial
Banks and private individuals.
• With this activity the cash will now move from the Central Bank to the Commercial
Banks. With this increased cash reserves the Commercial Banks will be in a position to
create more credit with the result that the volume of bank credit will expand in the
economy.
3. Variable Cash Reserve Ratio:
• Under this system the Central Bank controls credit by changing the Cash Reserves
Ratio. For example—If the Commercial Banks have excessive cash reserves on the
basis of which they are creating too much of credit which is harmful for the larger
interest of the economy. So it will raise the cash reserve ratio which the Commercial
Banks are required to maintain with the Central Bank.
• This activity of the Central Bank will force the Commercial Banks to curtail the
creation of credit in the economy.
• In this way by raising the cash reserve ratio of the Commercial Banks the Central Bank
will be able to put an effective check on the inflationary expansion of credit in the
economy.
• Similarly, when the Central Bank desires that the Commercial Banks should increase
the volume of credit in order to bring about an economic revival in the country.
• The Central Bank will lower down the Cash Reserve ratio with a view to expand the
cash reserves of the Commercial Banks.
• With this, the Commercial Banks will now be in a position to create more credit than
what they were doing before.
• Thus, by varying the cash reserve ratio, the Central Bank can influence the creation of
credit.
II. Qualitative or Selective Method of Credit Control
1. Rationing of Credit:
• Under this method the credit is rationed by limiting the amount available to each
applicant.
• The Central Bank puts restrictions on demands for accommodations made upon it
during times of monetary stringency.
• In this the Central Bank discourages the granting of loans to stock exchanges by
refusing to re-discount the papers of the bank which have extended liberal loans to the
speculators.
• This is an important method of credit control and this policy has been adopted by a
number of countries like Russia and Germany.
2. Direct Action:
• Under this method if the Commercial Banks do not follow the policy of the Central
Bank, then the Central Bank has the only recourse to direct action.
• This method can be used to enforce both quantitatively and qualitatively credit controls
by the Central Banks.
• This method is not used in isolation; it is used as a supplement to other methods of
credit control.
• Direct action may take the form either of a refusal on the part of the Central Bank to
re- discount for banks whose credit policy is regarded as being inconsistent with the
maintenance of sound credit conditions.
• Even then the Commercial Banks do not fall in line, the Central Bank has the
constitutional power to order for their closure.
• This method can be successful only when the Central Bank is powerful enough and
has cordial relations with the Commercial Banks.
• Mostly such circumstances are rare when the Central Bank is forced to resist to such
measures.
3. Moral Persuasion:
• This method is frequently adopted by the Central Bank to exercise control over the
Commercial Banks.
• Under this method Central Bank gives advice, then request and persuasion to the
Commercial Banks to co-operate with the Central Bank is implementing its credit
policies.
• If the Commercial Banks do not follow or do not abide by the advice or request of the
Central Bank no gross action is taken against them.
• The Central Bank merely was its moral influence and pressure with the Commercial
Banks to prevail upon them to accept and follow the policies.
4. Method of Publicity:
• In modern times, Central Bank in order to make their policies successful, take the
course of the medium of publicity.
 • A policy can be effectively successful only when an effective public opinion is created
in its favour.
• Its officials through news-papers, journals, conferences and seminar’s present a correct
picture of the economic conditions of the country before the public and give a
prospective economic policies.
• In developed countries Commercial Banks automatically change their credit creation
policy.
• But in developing countries Commercial Banks being lured by regional gains. Even
the Reserve Bank of India follows this policy.
5. Regulation of Consumer’s Credit:
• Under this method consumers are given credit in a little quantity and this period is fixed
for 18 months; consequently credit creation expanded within the limit.
• This method was originally adopted by the U.S.A. as a protective and defensive
measure, there after it has been used and adopted by various other countries.
6. Changes in the Marginal Requirements on Security Loans:
• This system is mostly followed in U.S.A.
• Under this system, the Board of Governors of the Federal Reserve System has been
given the power to prescribe margin requirements for the purpose of preventing an
excessive use of credit for stock exchange speculation.
• This system is specially intended to help the Central Bank in controlling the volume of
credit used for speculation in securities under the Securities Exchange Act, 1934.

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Monetary Policy
Introduction
• Monetary policy refers to the policy of the central bank with regard to the use of
monetary instruments under its control to achieve the goals specified in the Act.
• It involves management of money supply and interest rate and is the demand side
economic policy used by the government of a country to achieve macroeconomic
objectives like inflation, consumption, growth and liquidity.
• The Reserve Bank of India (RBI) is vested with the responsibility of conducting
monetary policy.
• This responsibility is explicitly mandated under the Reserve Bank of India Act, 1934.
Instruments of Monetary Policy
There are several direct and indirect instruments that are used for implementing monetary
policy.
▪ Repo Rate:
The (fixed) interest rate at which the Reserve Bank provides overnight liquidity to
banks against the collateral of government and other approved securities under the
liquidity adjustment facility (LAF).
▪ Reverse Repo Rate:
The (fixed) interest rate at which the Reserve Bank absorbs liquidity, on an overnight
basis, from banks against the collateral of eligible government securities under the LAF.
▪ Liquidity Adjustment Facility (LAF):
➢ The LAF consists of overnight as well as term repo auctions.
➢ Progressively, the Reserve Bank has increased the proportion of liquidity injected
under fine-tuning variable rate repo auctions of range of tenors.
➢ The aim of term repo is to help develop the inter-bank term money market, which
in turn can set market based benchmarks for pricing of loans and deposits, and
hence improve transmission of monetary policy.
➢ The Reserve Bank also conducts variable interest rate reverse repo auctions, as
necessitated under the market conditions.
▪ Marginal Standing Facility (MSF):
➢ A facility under which scheduled commercial banks can borrow additional
amount of overnight money from the Reserve Bank by dipping into their
Statutory Liquidity Ratio (SLR) portfolio up to a limit at a penal rate of interest.
➢ This provides a safety valve against unanticipated liquidity shocks to the banking
system.
▪ Corridor:
The MSF rate and reverse repo rate determine the corridor for the daily movement in
the weighted average call money rate.
▪ Bank Rate:
➢ It is the rate at which the Reserve Bank is ready to buy or rediscount bills of exchange
or other commercial papers.
➢ The Bank Rate is published under Section 49 of the Reserve Bank of India Act, 1934.
➢ This rate has been aligned to the MSF rate and, therefore, changes automatically as
and when the MSF rate changes alongside policy repo rate changes.
▪ Cash Reserve Ratio (CRR):
➢ The average daily balance that a bank is required to maintain with the Reserve Bank
as a share of such per cent of its Net demand and time liabilities (NDTL) that the
Reserve Bank may notify from time to time in the Gazette of India.
▪ Statutory Liquidity Ratio (SLR):
➢ The share of NDTL that a bank is required to maintain in safe and liquid assets, such
as, unencumbered government securities, cash and gold.
➢ Changes in SLR often influence the availability of resources in the banking system
for lending to the private sector.
▪ Open Market Operations (OMOs):
These include both, outright purchase and sale of government securities, for injection
and absorption of durable liquidity, respectively.
▪ Market Stabilization Scheme (MSS):
➢ This instrument for monetary management was introduced in 2004.
➢ Surplus liquidity of a more enduring nature arising from large capital inflows is
absorbed through sale of short-dated government securities and treasury bills.
➢ The cash so mobilized is held in a separate government account with the Reserve
Bank.
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Objectives of Monetary Policy
1. Neutrality of Money:
• Monetary authority should aim at neutrality of money in the economy.
• Any monetary change is the root cause of all economic fluctuations.
• According to neutralists, the monetary change causes distortion and disturbances in the
proper operation of the economic system of the country .
• They are of the confirmed view that if somehow neutral monetary policy is followed,
there will be no cyclical fluctuations, no trade cycle, no inflation and no deflation in
the economy.
• Under this system, money is kept stable by the monetary authority.
• It means that quantity of money should be perfectly stable.
• It is not expected to influence or discourage consumption and production in the
economy.
2. Stabilising the Business Cycle:
• Monetary policy has an important effect on both actual GDP and potential GDP.
• Industrially advanced countries rely on monetary policy to stabilise the economy by
controlling business. But it becomes impotent in deep recessions.
Keynes pointed out that monetary policy loses its effectiveness during economic
downturn for two reasons:
(i) The existence of liquidity trap situation (i.e., infinite elasticity of demand for
money)
(ii) Low interest elasticity of (autonomous) investment.
3.Reasonable Price Stability:
• Price stability is perhaps the most important goal which can be pursued most
effectively by using monetary policy.
• In a developing country like India the acceleration of investment activity in the face of
a fall in agricultural output creates excessive pressure on prices.
• The food inflation in India is a proof of this. In such a situation, monetary policy has
much to contribute to short-run price stability.
4.Faster Economic Growth:
• Monetary policy can promote faster economic growth by making credit cheaper and
more readily available.
• Industry and agriculture require two types of credit—short-term credit to meet working
capital needs and long-term credit to meet fixed capital needs.
• The need for these two types of credit can be met through commercial banks and
development banks.
• Easy availability of credit at low rates of interest stimulates investment or expansion of
society’s production capacity. \
 • This in its turn, enables the economy to grow faster than before.
5.Exchange Rate Stability:
• In an ‘open economy’—that is, one whose borders are open to goods, services, and
financial flows— the exchange-rate system is also a central part of monetary policy.
• In order to prevent large depreciation or appreciation of the rupee in terms of the US
dollar and other foreign currencies under the present system of floating exchange rate
the central bank has to adopt suitable monetary measures. India by the Reserve
6.Full Employment:
• During world depression, the problem of unemployment had increased rapidly
• It was regarded as socially dangerous, economically wasteful and morally deplorable.
Thus, full employment assumed as the main goal of monetary policy.
• In recent times, it is argued that the achievement of full employment automatically
includes prices and exchange stability.
7.Equilibrium in the Balance of Payments:
• Equilibrium in the balance of payments is another objective of monetary policy which
emerged significant in the post war years.
• This is simply due to the problem of international liquidity on account of the growth of
world trade at a faster speed than the world liquidity.
• It was felt that increasing of deficit in the balance of payments reduces the ability of an
economy to achieve other objectives.
• As a result, many less developed countries have to curtail their imports which
adversely effects development activities.
• Therefore, monetary authority makes efforts that equilibrium should be maintained in
the balance of payments.
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Relationship between RBI and Commercial Banks
By virtue of the powers conferred upon it by the Reserve Bank of India Act 1934, and the
Banking regulation Act, 1949 the relationship between the Reserve Bank of India and the
scheduled commercial banks is very close and of varied nature.
As Supervisory and Controlling Authority over Banks
The Baking Regulation Act, 1949 confers wide powers upon the Reserve bank to supervise and
control the affairs of banking companies as follows:
1. Licensing of banking Companies:
➢ Section 22 requires every banking company to hold a license from the Reserve bank to
carry on the business of banking in India.
➢ The Reserve bank is empowered to conduct an inspection of the books of the banking
company for this purpose, and to issue a license if it is satisfied that the following
conditions are fulfilled:
(a) The company is or will be in a position to pay its present or future depositors in full as their
claims accrue;
(b) That the affairs of the company are not being or are not likely to be conducted in a manner
detrimental to the interests of its present or future depositors;
(c) That the general character of the proposed management of the company will not be
prejudicial to the public interest or the interests of its depositors;
(d) That the company has adequate capital structure and earning prospects;
(e) That the public interest will be served by the grant of a license to the company to carry on
banking business in India;
(f) That the grant of license would not be prejudicial the operation and consolidation of the
banking system consistent with monetary stability and economic growth.
Thus a license can be granted if the company has satisfactory financial position.
In case of a foreign bank, the Reserve Bank must also be satisfied about the fact that
(1) the carrying of banking business by such bank in India will be in the public interests
(2) that the government or law of the country of its origin does not discriminate against banking
companies registered in India, and
(3) that the company complies with all the provisions of the Act applicable to such companies.
The Reserve Bank is also empowered it cancel the license granted to a banking company.
2. Permission for opening branches:
➢ Sec. 23 requires every banking company to take Reserve bank’s prior permission for
opening a new place of business in India or to change the location of an existing place of
business in India or outside.
➢ The Reserve bank takes into account the financial position, the history, the general
character of management and adequacy of its capital structure and earning prospects and
the fact whether public interest will be served or not before granting permission.
3. Power it Inspect Baking companies:
➢ Under Section 35, the Reserve Bank may either at its own initiative or at the instance of
the Central Government, inspect any banking company’s books of accounts.
➢ If on the basis of the section report submitted by the Reserve bank, the Central
Government is of the opinion that the affairs of the banking company are being
conducted to the detriment of interests on its depositors, it may be order in writing
prohibit the banking company from receiving fresh deposits, or direct the Reserve bank to
apply for the winding up of the banking company.
4. Power to Issue Directions:
➢ Sections 35-A confers powers on the Reserve Bank to issue directions to a banking
company or companies in the public interest or in the interests of banking policy or to
prevent the affairs of the banking company being conducted in a manner detrimental to
the interests of the depositors or in manner prejudicial to the interest of the banking
company or to secure proper management of the banking company.
➢ Section 36 confers powers on the Reserve Bank to caution or prohibit banking companies
against entering into any particular transaction, and generally gave advice to any banking
company.
 ➢ It may pass orders requiring the banks to carry out the specified instructions.
5. Control over Top management:
➢ The Reserve Bank of India has wide powers of overall control over the top Management
of banks Reserve Bank’s prior approval is necessary for appointment or re-appointment
or termination of appointment of a chairman, managing director manager or chief
executive officer.
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