Unit - II :

The Regulatory Structure

of Banking

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Contents
01 The Banking Regulation Act 1949

The Central Bank- Functions of a central

02 Bank

03 The Reserve Bank of India Functions and

Powers of RBI

04 RBI-the Monetary Policy and Reserve

Ratio Requirements.
The Indian banking system works
with three acts

1. Reserve bank of India,

2. The Companies Act, and
3. Banking Regulation Act.
The Banking Regulation
Act 1949
An Introduction to the Banking Regulation
Act, 1949

•Companies Act Governance: Before 1949, the Companies Act

governed all banking operations and activities.
•Poor Health of Banks: Prior to the enactment of the Banking
Regulation Act, the health of many banks was poor, primarily due to low
liquidity.
•Complicated Banking Conditions: The banking sector faced
complicated conditions, largely due to the rapid and unchecked growth
of banks.
•Bank Failures and Closures: The period saw numerous bank failures
and closures, contributing to the overall instability of the sector.
Objectives of the Banking Regulation
Act, 1949
• Restrict Non-Banking Activities: The Act aims to restrict trading
business activities to minimize risks associated with non-banking
sectors.
• Protection of Depositors' Interests: It safeguards and protects
the interests of depositors to ensure the safety of their funds.
• Encourage Sound Banking Practices: The Act promotes the
development of multifarious banking institutions in India on sound
financial lines.
• Regulation of Credit System: It adjusts the credit system and
monetary funds to ensure higher payable interest, aligning with
national priorities.
Main sections of the banking
regulation act, 1949

• Section 20A: Defines regulations and rules related to the power

and administration to pardon debts (it implies the power to officially
release an individual or entity from the obligation to repay a debt).
• Section 21: Grants the Reserve Bank of India (RBI) authority to
regulate advances made by banking corporations.
• Section 21A: Specifies that the rate of interest (RoI) assessed by
banking institutions is not subject to scrutiny by Indian courts.
 Amendments to the Banking
Regulation Act, 1949
• 1965 Amendment:
• The Act was amended to extend its applicability to cooperative banks.
• Several other changes were made to strengthen the regulation of banks in India.

• 2011 Amendment:
• Introduction of the Banking Laws (Amendment) Bill.
• The amendment gave the Reserve Bank of India (RBI) the power to replace a
banking company's Board of Directors for up to 12 months if they were found to be
working against the interests of the company and its depositors.

• 2020 Amendment:
• Banking Regulation (Amendment) Bill introduced in the Lok Sabha by Finance
Minister Nirmala Sitharaman on March 3, 2020.
• The amendment aimed to provide the RBI with greater regulatory control over
cooperative banks, including management, capital, audit, and liquidation.
The Central Bank
The Central Bank

A central bank is a government-run institution that

supervises the money supply, or the amount of money in
circulation, and maintains a country's or a group of
countries' currency.

Price stability is a primary goal of many central

banks.
Examples of Central Banks
• Federal Reserve (Fed) - United States:\
• European Central Bank (ECB) - Eurozone
• Bank of England (BoE) - United Kingdom
• Bank of Japan (BoJ) – Japan
• People's Bank of China (PBoC) – China
• Reserve Bank of India (RBI) – India
• Bank of Canada (BoC) - Canada
• Swiss National Bank (SNB) – Switzerland
• Reserve Bank of Australia (RBA) – Australia
• South African Reserve Bank (SARB) - South Africa
 Central Bank
Objectives
1.Regulator of Currency: The central bank, such as the RBI, is exclusively
authorized to print currency notes, playing a pivotal role in managing the
nation’s currency supply.
2.Banker and Advisor to the Government: Functioning as a fiscal agent,
the central bank manages government deposits, executes payments on
behalf of the government, and provides valuable advice on monetary
policies and economic matters.
3.Custodian of Commercial Banks: Mandated by law, commercial banks
maintain reserves, with the central bank acting as a custodian and lender of
cash reserves, facilitating interbank transactions.
4.Custodian and Manager of Foreign Exchange Reserves: The central
bank manages foreign exchange rates by buying and selling currencies
internationally and serves as the official repository of foreign currencies
and gold.
5. Lender of the Last Resort: In times of financial stress, the central bank extends
collateral-based advances or re-discounts to various financial entities, preventing the
collapse of the country’s financial structure.

6. Controller of Credit: The Reserve Bank of India and similar central banks
control how much money banks create using different methods to avoid inflation.

7. Transfer and Settlements: Acting as a clearinghouse, the central bank provides

services for transferring and settling mutual claims among commercial banks,
streamlining the clearing of cheques and facilitating fund transfers.
Functions of a Central Bank
• Monetary Authority: Formulates and implements monetary policy to manage
inflation, stabilize the currency, and achieve sustainable economic growth.

• Issuer of Currency: Sole authority to issue and manage the national currency.

• Regulator of the Financial System: Supervises and regulates banks and other
financial institutions to ensure stability and protect depositors.

• Banker's Bank: Provides banking services to the government, commercial banks,

and other financial institutions, including clearing and settlement of interbank
transactions.

• Custodian of Foreign Exchange: Manages the country’s foreign exchange reserves

and ensures the stability of the exchange rate.

• Developmental Role: Supports economic development through various initiatives,

including financial inclusion and development of financial infrastructure.
The Reserve Bank of India
The Reserve Bank of India (RBI) is the central bank of
India, which began operations on Apr. 1, 1935, under the
Reserve Bank of India Act.
The Reserve Bank of India uses monetary policy to create
financial stability in India, and it is charged with
regulating the country’s currency and credit systems.
Reserve Bank of India (RBI): Origin

• Establishment:
• Formed through the Reserve Bank of India Act
of 1934.
• Established based on the recommendations of
the Hilton Young Commission.
• Initial share capital of Rs. 5 crore.

• Location:
• Central Office initially set up in Kolkata.
• Permanently shifted to Mumbai in 1937.
• Ownership:
• Originally privately owned.
• Nationalized in 1949 and is now fully owned by the
Government of India.
• Historical Role:
• Acted as the central bank for Burma (Myanmar) until
April 1947.
• Acted as the central bank for Pakistan until June 1948.
• Mandate:
• Responsible for controlling, issuing, and maintaining
the supply of currency in India.
• Manages the country’s main payment systems.
 Reserve Bank of India (RBI):
Organization Structure
•The operation of the Reserve Bank of India lies with
a 21-member central board of directors consisting of:
• Governor;
• 4 Deputy Governors;
• 2 Finance Ministry representatives;
• 10 government-nominated directors;
• 4 directors to represent local boards’ headquarters of
RBI.
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 Issue of currency notes by the reserve bank of india
(RBI):

1.Primary Function: Printing and issuing currency notes.

2.Denominations: RBI prints notes of all denominations except the 1 rupee note,
which is issued by the Indian Ministry of Finance.
3.Regulation: Governed by the Minimum Reserve System (MRS), which requires
RBI to maintain a reserve of Rs. 200 crore, with Rs. 120 crore in gold and the
remainder in foreign currency.
4.Denomination Changes: RBI handles the introduction of new denominations
and the discontinuation of old ones, such as during the 2016 demonetization
when old 500 and 1000 rupee notes were replaced with new 2000 and 500 rupee
notes.
 Lender of last resort:

Parent Bank: Acts as the central bank for all primary banks in India.

Lender of Last Resort: Provides emergency financial support to

banks in crisis situations at certain interest rates.

Oversight: Monitors financial transactions of banks to ensure the

security of account holders' funds.
• Policy Repo Rate (6.50%): Central bank’s lending rate to
commercial banks.
• Standing Deposit Facility Rate (6.25%): Rate for parking
excess funds with the central bank without collateral.
• Marginal Standing Facility Rate (6.75%): Rate for
borrowing overnight from the central bank against securities.
• Bank Rate (6.75%): Long-term lending rate by the central
bank.
• Fixed Reverse Repo Rate (3.35%): Rate for parking
surplus funds with the central bank for a fixed period.
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 The power to grant a "moratorium" refers to the authority to provide
a temporary suspension or delay of certain obligations or actions.
In the context of financial and banking regulations, a moratorium
typically involves:

1.Suspension of Payments: Allowing a borrower to temporarily halt

repayments on loans or debts without facing penalties or legal
action.
2.Temporary Relief: Providing relief from specific financial
obligations during periods of financial distress or emergencies.
Monetary Policy of RBI

Monetary policy is the

macroeconomic policy laid down by
the central bank for credit- control.
In the Indian economy, the Reserve
Bank of India (RBI) is the only
monetary institution that controls
monetary supply.
 Monetary Policy
Monetary policy refers to the policy to control the supply
of credit/money in the economy. Its objective is to correct
the economy’s inflation and deflation situations.
It states the use of financial instruments under the control
of the Reserve Bank of India to achieve the ultimate
objective of economic policy mentioned in the Reserve
Bank of India Act, 1934 which is to standardise
magnitudes such as availability of credit, interest rates,
and money supply.
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Recent News
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What is the reserve ratio
requirement?
The reserve ratio is the portion of
reservable liabilities that commercial
banks must hold onto, rather than lend
out or invest. This is a requirement
determined by the country's central
bank,

The RBI has a

government-constituted Moneta
ry Policy Committee (MPC) which
is tasked with framing monetary
policy using tools like the repo
rate, reverse repo rate, bank rate,
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 Quantitative Tools of Monetary Policy
Major instruments coming in this category are explained below:
Bank Rate or Discount Rate
•Bank Rate or Discount Rate is the rate at which the RBI is ready to buy or
rediscount Bills of Exchange or other Commercial Papers from the
Scheduled Commercial Banks (SCBs).
•If the RBI fixes a high Bank Rate, banks would not want to rediscount bills
from the RBI as their profits will be low. This will have the effect of reducing
the money supply in the market.
•Thus, an increase in the Bank Rate results in a tightening of money
supply and vice versa.
Reserve Requirements
• The reserve requirement or required reserve ratio is a bank regulation that sets the
minimum reserves each bank must hold as a part of the deposits.
• It comprises two instruments:
• Cash Reserve Ratio (CRR)
• Cash Reserve Ratio (CRR) is the minimum percentage of a bank’s total Demand and
Time Liabilities (DTL) that a Scheduled Commercial Bank is obligated to deposit with
the RBI in the form of cash.
• RBI does not pay any interest on CRR deposits.
• RBI Act does not prescribe any range (ceiling or floor) for fixing CRR. Thus, RBI has
the freedom to fix the CRR at any rate depending on the macroeconomic conditions.
• If CRR is increased: If the RBI increases the CRR, the commercial banks have to
deposit more money with the RBI and are left with less money to lend to customers.
Thus, the effect is reduced money supply in the economy.
• If CRR is decreased: If the RBI decreases the CRR, the commercial banks have to
deposit less money with the RBI and are left with more money to lend to customers.
Thus, the effect is increased money supply in the economy.
 Statutory Liquidity Ratio (SLR)
•Statutory Liquidity Ratio (SLR) is the percentage of Net Demand and Time Liabilities (NDTL) that a
Scheduled Commercial Bank (SCB) has to keep with itself, in the form of:
• Cash, or
• Gold, or
• SLR Securities (such as government bonds, treasury bills, and any other instrument notified by the
RBI), or
• Any combination of the above three.
•Unlike the CRR, SLR need not be deposited with RBI.
•The range of SLR prescribed by the RBI is from 0 percent to 40 percent.
• If SLR is increased: If the RBI increases the SLR, the commercial banks are left with less money to
lend to customers. Thus, the effect is reduced money supply in the economy.
• If CRR is decreased: If the RBI decreases the SLR, the commercial banks are left with more money
to lend to customers. Thus, the effect is increased money supply in the economy.
•If the bank fails to maintain the required SLR, then it is liable to pay penal interest at (Bank Rate + 3%) per
annum above the bank rate, on the shortfall amount.
• If the shortfall continues for the next succeeding day, penal interest is to be paid at (Bank Rate + 5%).
 Liquidity Adjustment Facility (LAF)
•Liquidity Adjustment Facility (LAF) allows banks to borrow money from
the RBI through repurchase agreements (repos) or to make loans to
RBI through reverse repo agreements.
•It is aimed to aid banks in adjusting the day-to-day mismatches in liquidity.
•It comprises the following 2 sub-instruments:

Repo Rate (Re-purchase Option Rate)

Repo Rate is the rate of interest at which the RBI provides short-term loans to SCBs (
Scheduled Commercial Banks) against approved securities.

Reverse Repo Rate

Reverse Repo Rate is the rate of interest at which the RBI borrows funds from the
SCBs. In other words, it is the rate at which SCBs park their excess funds with the RBI
for a short period of time.
Marginal Standing Facility (MSF)
The Marginal Standing Facility (MSF) is a facility introduced by the RBI in 2011, based on the
Narasimhan Committee's recommendations, to help banks manage short-term liquidity needs.
What is MSF?
A facility where banks can borrow money overnight from the RBI, using government
securities as collateral.
Eligibility:
All Scheduled Commercial Banks (SCBs) with current accounts at the RBI can use this
facility.
Borrowing Limit:
Banks can borrow up to 1% of their Net Demand and Time Liabilities (NDTL), which is
calculated based on the second preceding fortnight (a period of 14 days or two weeks).
Interest Rate:
The interest rate for MSF is 25 basis points (0.25%) higher than the Repo Rate, making it a
penal rate for emergency borrowing.
Minimum Borrowing:
Banks must borrow at least ₹1 crore, and they can only borrow in multiples of ₹1 crore.
MSF helps banks manage sudden cash shortages but comes at a higher cost due to the penal
interest rate.
 "Do you know what a basis point is?"
"Basis points" (often abbreviated as bps) is a unit of measure used in finance to
describe the percentage change in the value or rate of a financial instrument. One
basis point is equivalent to 1/100th of a percentage point, or 0.01%.
Key Points:
•1 basis point = 0.01%
•100 basis points = 1%
Example:
•If an interest rate increases from 5.00% to 5.25%, the increase is 25 basis points.
•Similarly, if a bond yield decreases from 7.50% to 7.45%, the decrease is 5 basis
points.
Basis points are commonly used in contexts where small changes in rates or yields
are significant, such as in interest rates, bond yields, or fees in the financial
industry.
 Open Market Operations (OMOs)

Open Market Operations (OMOs) are actions taken by the Reserve Bank of
India (RBI) to control the amount of money available in the economy by
buying or selling government securities.
•When the RBI wants to increase the money supply: It buys government
securities from banks. This gives banks more money to lend, which
increases the overall money in the economy.
•When the RBI wants to decrease the money supply: It sells government
securities to banks. The banks pay for these securities, which reduces the
cash they have available to lend, lowering the amount of money in the
economy.
This process helps the RBI manage inflation, interest rates, and overall
economic stability.
 Market Stabilization Scheme (MSS)
The Market Stabilization Scheme (MSS) is a tool used by the Reserve Bank of India (RBI) to
manage excess money in the economy.
Key Points:
•What is MSS?
• It involves the RBI selling government bonds to reduce the excess money supply in the
economy.
•How it Works:
• The RBI sells these bonds to financial institutions. When institutions buy these bonds, the
money used to purchase them goes back to the RBI, reducing the cash available in the
economy.
•Purpose:
• This process, known as "sterilization," helps control inflation and stabilize the economy by
reducing excess liquidity.
•Market Stabilization Bonds (MSBs):
• The bonds issued under this scheme are called Market Stabilization Bonds (MSBs) and are
essentially government bonds.
MSS helps the RBI manage the money supply to keep the economy stable.
 Term Repos
•Since October 2013, the RBI has introduced Term Repos (of different
tenors, such as 7/14/28 days), to inject liquidity over a period that is
longer than overnight.
•The aim of Term Repo is to help develop an inter-bank money market,
which in turn can set market-based benchmarks for the pricing of loans
and deposits, and through that improve the transmission of monetary
policy.
Qualitative Tools of Monetary Policy
Major instruments coming in this category are explained below

Margins Requirements

•Margin refers to the difference between the value of securities offered for
loans and the value of loans actually granted.
•If RBI wants to control the flow of credit to a particular sector, it fixes a
high margin for that sector. As a result, customers will take lesser loans for
that sector.
Consumer Credit Regulation

•Credit made available by commercial banks (installments) for the

purchase of consumer durables is known as consumer credit.
•If there is excess demand for certain consumer durables leading to their
high prices, the RBI reduces consumer credit by:
• increasing down payment, and/or
• reducing the number of installments of repayment of such credit.
 Moral Suasion
•Moral Suasion means persuasion and request.
•RBI makes the banks adhere to the policy and directives through
persuasion or pressure in order to maintain a certain level of money
supply in the economy.

Direct Action
The RBI takes direct action such as refusing to rediscount the bills or
charging penal interest rates, etc when a commercial bank does not
co-operate with the central bank in achieving its desirable objectives.
Rationing of Credit or Credit Ceiling
Under this, the RBI fixes a ceiling on the amount of loans that can be
granted by SCBs. As a result, SCBs tighten in advancing loans to the
public.

Priority Sector Lending

Under this, the RBI prescribes the banks to provide a specified portion of
the bank lending to a few specific sectors like agriculture and allied
activities, micro and small enterprises, poor people for housing, etc.
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