Functions of Central Bank (RBI)

The central bank of the country is the Reserve Bank of India (RBI). It was established in April
1935 with a share capital of Rs.5 crores on the basis of the recommendations of the Hilton
Young Commission. The share capital was divided into shares of Rs.100 each fully paid which
was entirely owned by private shareholders in the beginning. The Government held shares of
nominal value of Rs.2, 20,000.

Reserve Bank of India was nationalised in the year 1949. The general superintendence and
direction of the Bank is entrusted to Central Board of Directors of 20 members, the Governor
and four Deputy Governors, one Government official from the Ministry of Finance, ten
nominated Directors by the Government to give representation to important elements in the
economic life of the country, and four nominated Directors by the Central Government to
represent the four local Boards with the headquarters at Mumbai, Kolkata, Chennai and New
Delhi. Local Boards consist of five members each Central Government appointed for a term of
four years to represent territorial and economic interests and the interests of co-operative and
indigenous banks.

The Reserve Bank of India Act, 1934 was commenced on April 1, 1935. The Act, 1934 (II of
1934) provides the statutory basis of the functioning of the Bank.

The Bank was constituted for the need of following:

 To operate the credit and currency system of the country to its advantage.

Functions of Reserve Bank of India

The Reserve Bank of India Act of 1934 entrust all the important functions of a central bank the
Reserve Bank of India.

Bank of Issue

Under Section 22 of the Reserve Bank of India Act, the Bank has the sole right to issue bank
notes of all denominations. The distribution of one rupee notes and coins and small coins all over
the country is undertaken by the Reserve Bank as agent of the Government. The Reserve Bank
has a separate Issue Department which is entrusted with the issue of currency notes. The assets
and liabilities of the Issue Department are kept separate from those of the Banking Department.
Originally, the assets of the Issue Department were to consist of not less than two-fifths of gold
coin, gold bullion or sterling securities provided the amount of gold was not less than Rs. 40
crores in value. The remaining three-fifths of the assets might be held in rupee coins,
Government of India rupee securities, eligible bills of exchange and promissory notes payable in
India. Due to the exigencies of the Second World War and the post-war period, these provisions
were considerably modified. Since 1957, the Reserve Bank of India is required to maintain gold
and foreign exchange reserves of Ra. 200 crores, of which at least Rs. 115 crores should be in
gold. The system as it exists today is known as the minimum reserve system.
Banker to Government

The second important function of the Reserve Bank of India is to act as Government banker,
agent and adviser. The Reserve Bank is agent of Central Government and of all State
Governments in India excepting that of Jammu and Kashmir. The Reserve Bank has the
obligation to transact Government business, via. to keep the cash balances as deposits free of
interest, to receive and to make payments on behalf of the Government and to carry out their
exchange remittances and other banking operations. The Reserve Bank of India helps the
Government - both the Union and the States to float new loans and to manage public debt. The
Bank makes ways and means advances to the Governments for 90 days. It makes loans and
advances to the States and local authorities. It acts as adviser to the Government on all monetary
and banking matters.

Bankers' Bank and Lender of the Last Resort

The Reserve Bank of India acts as the bankers' bank. According to the provisions of the Banking
Companies Act of 1949, every scheduled bank was required to maintain with the Reserve Bank a
cash balance equivalent to 5% of its demand liabilities and 2 per cent of its time liabilities in
India. By an amendment of 1962, the distinction between demand and time liabilities was
abolished and banks have been asked to keep cash reserves equal to 3 per cent of their aggregate
deposit liabilities. The minimum cash requirements can be changed by the Reserve Bank of
India.

The scheduled banks can borrow from the Reserve Bank of India on the basis of eligible
securities or get financial accommodation in times of need or stringency by rediscounting bills of
exchange. Since commercial banks can always expect the Reserve Bank of India to come to their
help in times of banking crisis the Reserve Bank becomes not only the banker's bank but also the
lender of the last resort.

Controller of Credit

The Reserve Bank of India is the controller of credit i.e. it has the power to influence the volume
of credit created by banks in India. It can do so through changing the Bank rate or through open
market operations. According to the Banking Regulation Act of 1949, the Reserve Bank of India
can ask any particular bank or the whole banking system not to lend to particular groups or
persons on the basis of certain types of securities. Since 1956, selective controls of credit are
increasingly being used by the Reserve Bank.

The Reserve Bank of India is armed with many more powers to control the Indian money
market. Every bank has to get a licence from the Reserve Bank of India to do banking business
within India, the licence can be cancelled by the Reserve Bank of certain stipulated conditions
are not fulfilled. Every bank will have to get the permission of the Reserve Bank before it can
open a new branch. Each scheduled bank must send a weekly return to the Reserve Bank
showing, in detail, its assets and liabilities. This power of the Bank to call for information is also
intended to give it effective control of the credit system. The Reserve Bank has also the power to
inspect the accounts of any commercial bank.

As supreme banking authority in the country, the Reserve Bank of India, therefore, has the
following powers:

(a) It holds the cash reserves of all the scheduled banks.

(b) It controls the credit operations of banks through quantitative and qualitative controls.

(c) It controls the banking system through the system of licensing, inspection and calling for
information.

(d) It acts as the lender of the last resort by providing rediscount facilities to scheduled banks.

What is Bank rate?   Bank Rate is the rate at which central bank of the country (in India it is
RBI) allows finance to commercial banks. Bank Rate is a tool, which central bank uses for short-
term purposes. Any upward revision in Bank Rate by central bank is an indication that banks
should also increase deposit rates as well as Prime Lending Rate. Thus any revision in the Bank
rate indicates could mean more or less interest on your deposits and also an increase or decrease
in your EMI. Bank rate of 9% was continuing since 17/04/2012. Bank rate is now changed to
8.75% with effect from close of business of 29/01/2013.

What is Bank Rate? (For Non Bankers): This is the rate at which central bank (RBI) lends
money to other banks or financial institutions.   If the bank rate goes up, long-term interest rates
also tend to move up, and vice-versa. Thus, it can said that in case bank rate  is hiked,  in all
likelihood banks will hikes their own lending rates to ensure and they continue to make a profit.

What is CRR?    The Reserve Bank of India (Amendment) Bill, 2006 has been enacted and has
come into force with its gazette notification. Consequent upon amendment to sub-Section 42(1),
the Reserve Bank, having regard to the needs of securing the monetary stability in the country,
can prescribe Cash Reserve Ratio (CRR) for scheduled banks without any floor rate or ceiling
rate.  [Before the enactment of this amendment, in terms of Section 42(1) of the RBI Act, the
Reserve Bank could prescribe CRR for scheduled banks between 3 per cent and 20 per cent of
total of their demand and time liabilities].

RBI uses CRR either to drain excess liquidity or to release funds needed for the economy from
time to time. Increase in CRR means that banks have fewer funds available and money is sucked
out of circulation. Thus we can say that this serves duel purposes i.e. it not only ensures that a
portion of bank deposits is totally risk-free, but also enables RBI to  control liquidity in the
system, and thereby, inflation by tying the  hands of the banks in lending money. CRR of 4.25%
was continuing since 30/10/2012. CRR is now decreased to 4% with effect from 09/02/2013.

What is CRR (For Non Bankers): CRR means Cash Reserve Ratio.  Banks in India are
required to hold a certain proportion of their deposits in the form of cash.  However, actually
Banks don’t hold these as cash with themselves, but deposit such case with Reserve Bank of
India (RBI) / currency chests, which is considered as equivalent to holding cash with them.
This minimum ratio (that is the part of the total deposits to be held as cash) is stipulated by
the RBI and is known as the CRR or Cash Reserve Ratio.  Thus, When a bank’s deposits
increase by Rs100, and if the cash reserve ratio is 9%, the banks will have to hold additional
Rs 9 with RBI and Bank will be able to use only Rs 91 for investments and lending / credit
purpose. Therefore, higher the ratio (i.e. CRR), the lower is the amount that banks will be
able to use for lending and investment.  This power of RBI to reduce the lendable amount by
increasing the CRR makes it an instrument in the hands of a central bank through which it can
control the amount that banks lend.  Thus, it is a tool used by RBI to control liquidity in the
banking system.

What is SLR? Every bank is required to maintain at the close of business every day, a minimum
proportion of their Net Demand and Time Liabilities as liquid assets in the form of cash, gold
and un-encumbered approved securities. The ratio of liquid assets to demand and time liabilities
is known as Statutory Liquidity Ratio (SLR). CRR of 24% was continuing since 18/12/2010.
Now SLR is decreased to 23% with effect from 11/08/2012. RBI is empowered to increase this
ratio up to 40%.  An increase in SLR also restricts the bank’s leverage position to pump more
money into the economy.

What is SLR? (For Non Bankers): SLR stands for Statutory Liquidity Ratio. This term is
used by bankers and indicates the minimum percentage of deposits that the bank has to
maintain in form of gold, cash or other approved securities.  Thus, we can say that it is ratio
of cash and some other approved to liabilities (deposits). It regulates the credit growth in
India.

What are Repo rate and Reverse Repo rate?

Repo (Repurchase) rate is the rate at which the RBI lends shot-term money to the banks. When
the repo rate increases borrowing from RBI becomes more expensive.  Therefore, we can say
that in case, RBI wants to make it more expensive for the banks to borrow money, it increases
the repo rate; similarly, if it wants to make it cheaper for banks to borrow money, it reduces the
repo rate. Repo rate of 8% was continuing since 17/04/2012. It is now decreased to 7.75% with
effect from 29/01/2013.

Reverse Repo rate is the rate at which banks park their short-term excess liquidity with the RBI. 
The RBI uses this tool when it feels there is too much money floating in the banking system.  An
increase in the reverse repo rate means that the RBI will borrow money from the banks at a
higher rate of interest. As a result, banks would prefer to keep their money with the RBI.

The central bank has recently increased (as on March, 2011) the repo rate by 25 basis points
from 6.5% to 6.75 per cent and the reverse repo rate by 25 basis points from 5.5% to 5.75% with
immediate effect. Reserve repo of 7% was continuing since 17/04/2012. It is now decreased to
6.75% with effect from 29/01/2013.

The relationship between percentage changes and basis points can be summarised as follows:

1% change = 100 basis points and 0.01% = 1 basis point.

So, a bond whose yield increases from 5% to 5.5% is said to increase by 50 basis points; or
interest rates that have risen 1% are said to have increased by 100 basis points.
Thus, we can conclude that Repo Rate signifies the rate at which liquidity is injected
in the banking system by RBI, whereas Reverse repo rate signifies the rate at which
the central bank absorbs liquidity from the banks.

Marginal Standing Facility (MSF):

It is the rate at which scheduled banks could borrow funds overnight from the RBI against
approved government securities. Banks can borrow funds through MSF during acute cash
shortage (considerable shortfall of liquidity). This measure has been introduced by RBI to
regulate short-term asset liability mismatches more effectively. MSF is pegged 100 bps or 1%
above the repo rate. To provide greater liquidity cushion the RBI introduced MSF. RBI
introduced the introduction of MSF on May 3, 2011 and it was made effective from May 9,
2011. Marginal Standing rate was 9% since 17/04/2012 and now it is decreased to 8.75% with
effect from 29/01/2013.

Custodian of Foreign Reserves

The Reserve Bank of India has the responsibility to maintain the official rate of exchange.
According to the Reserve Bank of India Act of 1934, the Bank was required to buy and sell at
fixed rates any amount of sterling in lots of not less than Rs.10,000. The rate of exchange fixed
was Re. 1 = sh. 6d. Since 1935 the Bank was able to maintain the exchange rate fixed at lsh.6d,
though there were periods of extreme pressure in favour of or against the rupee. After India
became a member of the International Monetary Fund in 1946, the Reserve Bank has the
responsibility of maintaining fixed exchange rates with all other member countries of the I.M.F.

Besides maintaining the rate of exchange of the rupee, the Reserve Bank has to act as the
custodian of India's reserve of international currencies. The vast sterling balances were acquired
and managed by the Bank. Further, the RBI has the responsibility of administering the exchange
controls of the country.

Supervisory functions

In addition to its traditional central banking functions, the Reserve bank has certain non-
monetary functions of the nature of supervision of banks and promotion of sound banking in
India. The Reserve Bank Act, 1934, and the Banking Regulation Act, 1949 have given the RBI
wide powers of supervision and control over commercial and co-operative banks, relating to
licensing and establishments, branch expansion, liquidity of their assets, management and
methods of working, amalgamation, reconstruction, and liquidation. The RBI is authorised to
carry out periodical inspections of the banks and to call for returns and necessary information
from them. The nationalisation of 14 major Indian scheduled banks in July 1969 has imposed
new responsibilities on the RBI for directing the growth of banking and credit policies towards
more rapid development of the economy and realisation of certain desired social objectives. The
supervisory functions of the RBI have helped a great deal in improving the standard of banking
in India to develop on sound lines and to improve the methods of their operation.
Promotional functions

With economic growth assuming a new urgency since Independence, the range of the Reserve
Bank's functions has steadily widened. The Bank now performs a variety of developmental and
promotional functions, which, at one time, were regarded as outside the normal scope of central
banking. The Reserve Bank was asked to promote banking habit, extend banking facilities to
rural and semi-urban areas, and establish and promote new specialised financing agencies.
Accordingly, the Reserve Bank has helped in the setting up of the IFCI and the SFC; it set up the
Deposit Insurance Corporation in 1962, the Unit Trust of India in 1964, the Industrial
Development Bank of India also in 1964, the Agricultural Refinance Corporation of India in
1963 and the Industrial Reconstruction Corporation of India in 1972. These institutions were set
up directly or indirectly by the Reserve Bank to promote saving habit and to mobilise savings,
and to provide industrial finance as well as agricultural finance. As far back as 1935, the Reserve
Bank of India set up the Agricultural Credit Department to provide agricultural credit. But only
since 1951 the Bank's role in this field has become extremely important. The Bank has developed
the co-operative credit movement to encourage saving, to eliminate moneylenders from the
villages and to route its short term credit to agriculture. The RBI has set up the Agricultural
Refinance and Development Corporation to provide long-term finance to farmers.

Classification of RBIs functions

The monetary functions also known as the central banking functions of the RBI are related to
control and regulation of money and credit, i.e., issue of currency, control of bank credit, control
of foreign exchange operations, banker to the Government and to the money market. Monetary
functions of the RBI are significant as they control and regulate the volume of money and credit
in the country.

Equally important, however, are the non-monetary functions of the RBI in the context of India's
economic backwardness. The supervisory function of the RBI may be regarded as a non-
monetary function (though many consider this a monetary function). The promotion of sound
banking in India is an important goal of the RBI, the RBI has been given wide and drastic
powers, under the Banking Regulation Act of 1949 - these powers relate to licencing of banks,
branch expansion, liquidity of their assets, management and methods of working, inspection,
amalgamation, reconstruction and liquidation. Under the RBI's supervision and inspection, the
working of banks has greatly improved. Commercial banks have developed into financially and
operationally sound and viable units. The RBI's powers of supervision have now been extended
to non-banking financial intermediaries. Since independence, particularly after its nationalisation
1949, the RBI has followed the promotional functions vigorously and has been responsible for
strong financial support to industrial and agricultural development in the country.