UNIVERSITY OF MUMBAI

PROJECT REPORT ON
WORKING OF RESERVE BANK OF INDIA,
COMMERCIAL BANKS, CENTRAL BANKS & STATE BANK OF INDIA.

IN PARTIAL FULLFILMENT FOR

MASTERS OF COMMERCE
2023-24

PROJECT GUIDE
DR. RANJIT THAKUR

SUBMITTED BY
ABBAS MAQBOOL HAMDULAY

NCRD’S
STERLING COLLEGE OF ARTS, COMMERCE & SCIENCE
NERUL, NAVI MUMBAI
 UNIVERSITY OF MUMBAI
NCRD’S
STERLING COLLEGE OF ARTS,
COMMERCE & SCIENCE
NERUL, NAVI MUMBAI

CERTIFICATE

To whom so ever it may concern

This is to certify that the work of ABBAS MAQBOOL HAMDULAY SEM IV, M.com,
Part II have successfully completed a project report on,“WORKING OF RESERVE
BANK OF INDIA, COMMERCIAL BANKS, CENTRAL BANKS & STATE BANK OF INDIA “
terms of the academic year 2023-24 in the collage norms laid down by college
authority.

Project Guide;
DR. RANJIT THAKUR Principal (Commerce)

External Examiner
Submission Date: 10/04/2024
Viva Date:
 DECLARATION

I, ABBAS MAQBOOL HAMDULAY student of “SEM IV, M.com, Part

II”, NCRD’S, STERLING COLLEGE OF ARTS, COMMERCE &SCIENCE”, hereby declare
that I have completed the project report on “WORKING OF RESERVE BANK OF
INDIA, COMMERCIAL BANKS, CENTRAL BANKS & STATE BANK OF INDIA” in the
academic year 2023-24 with guidance of DR. RANJIT THAKUR.

The information submitted by me is true & original to the best of my

knowledge.

Submitted By – ABBAS MAQBOOL HAMDULAY

 ACKNOWLEDGEMENT

Written words have an unfortunate tendency to degenerate gratitude into a stilted

formality. However this is the only way to record permanently one’s gratitude.

I take this opportunity to express my thanks to DR. RANJIT THAKUR for

constant support and especially her valuable suggestion in helping me to complete
the project on due time. I also thank office staff member of Pillai’s College who
were involved in providing with the information required to make this project.

I also express my thanks to all teaching and non-teaching staff who directly and in-
directly guided me with moral support to complete this project. I would also like to
thank the librarian who helped me towards providing the needed reference books,
which has been an immense value for collection of the information.

Last but not the least I am thankful to my parents and my friends for their
encouragement and co-operation during the time of my work.
 TABLE OF CONTENTS

Sr.no. Particulars Page no.

1 NAME PAGE 01

2 Certificate 02

3 Declaration 03

4 Acknowledgement 04

5 TABLE OF CONTENTS 05

6 Preface 06

7 Review of Literature 07

8 Research methodology 09

9 Contents of Main Project 14

10 Main Project 17

11 Bibliography 99
There are many excellent text books on Banking written by well-known British and American
Writers. However, none of these can claim to cover the entire course of study prescribed by
The Indian Universities. Moreover, most of these books are above the understanding of an
Average Indian student of Commerce and Economics. The present book is a humble effort
in this direction.

On account of the growing importance of the banking industry, most of the Indian
Universities have introduced a special paper on banking for their degree students. The
Present volume has been made to cover the syllabi of B.Com, B.B.M., M.B.A., M.Com. M.A.,
L.L.B., etc. In addition, I hope, it will also be of benefit to candidates appearing for various
Competitive examinations such as I.A.S., I.E.S., C.A., N.E.T., and I.I.B. examinations. The
Present volume contains 19 chapters devoted mainly to the study of Commercial Banks,
Central Bank, Reserve Bank of India, State Bank of India, Money and Capital Markets,
Indian Banking Systems, Banker and Customer Relationship, Operation of Bank Accounts,
Collection and Payment of Cheques, Loans and Advances, Types of Securities, Modes of
Creating Charge, Guarantee, Letter of Credit, Accounts and Audit of Banks. The last chapter
contains multiple choice and short-type questions for the benefit of the candidates who want
a deeper insight into Banking.

While preparing this book, I have collected the relevant material from government
publications, published and unpublished sources, books, journals and articles by eminent
scholars. My Principal, colleagues and friends have offered me valuable suggestions in the
preparation of the manuscript. My sincere thanks are due to all of them.

Last, but not the least, I acknowledge with a sense of gratitude person who not only left no
stone unturned in providing me a congenial atmosphere for studies at home, but also relieved
me from a number of family responsibilities and even more, at times, directly helped me in my
work. Any suggestion for enhancing the value of the book from students and teachers, would
be most welcome and would be kept in view at the time of bringing out the second edition.
With these words, I present this book to students, who alone will judge its worth.
 REVIEW OF LITERATURE
Introduction

Banks are important in mobilizing and allocating savings in an economy and can solve important
moral hazard and adverse selection problems by monitoring and screening borrowers and depositors.
Besides, banks are important in directing funds where they are most needed in an efficient manner and
have direct implications on capital allocation, industrial expansion, and economic growth (Berger,
Demirguc-Kunt, and Haubrich 2003; Levine 1997). Banks also play an important role in diminishing
informational asymmetries and risks in the financial system. Hence, the study of the banking industry
and its impact on the economy is of the utmost importance. The effects of concentration and
competition on bank performance are pertinent since they have important policy implications. A recent
global trend of consolidation in the banking sector has intensified, generating important debates on its
effects on the profitability of banks, consumer costs, the efficiency in allocating resources in an
economy, and on overall financial stability.
In this chapter we present and overview of this literature, starting with a brief survey of the
industrial organization theories of the market power and efficient-structure hypotheses that have been
put forward to explain the relationship between the structure of the banking sector and its performance
in section 2.2. Then, section 2.3 is dedicated to discussing the measurement of banks’ efficiency, which
is key in the proper assessment of the structure and profitability of the banking industry and, ultimately,
of competition conditions. Two main methodologies, parametric and nonparametric, are discussed and
analyzed as well as various examples of the empirical literature. Furthermore, banking productivity is
presented following the efficiency discussion. The nonparametric Malmquist productivity index is
detailed followed by some empirical evidence in the literature. The discussion of the studies about
competition in banking follows in section 2.4; here again two broad categories are distinguished;
structural models S. G. Castellanos et al., Competition and Efficiency in the Mexican Banking Industry ©
Sara G. Castellanos, Gustavo A. Del Ángel and Jesús G. Garza-García 2016 10 COMPETITION AND
EFFICIENCY that follow the market power and efficient structure theories and nonstructural models in
line with the new industrial organization theory. Some of the latter models are discussed in this section.
Section 2.5 covers some of the most representative empirical studies of this vast and growing literature,
which spans various time periods and geographical areas. However, we defer the discussion of the
studies for the Mexican banking sector to chapter 4. Section 2.6 deals with a more recent but growing
literature strand on the relationship between bank competition and financial stability; akin to the
market power and efficient structure models of the relationship between banking structure and profits,
two opposing views of the effect of competition among banks and stability of the banking system have
been posed, namely the “competition-stability” and “competition-fragility” views, giving place to
growing academic discussions. Some conclusions are presented in the final section 2.7.

S. G. Castellanos et al., Competition and Efficiency in the Mexican Banking Industry © Sara G.
Castellanos, Gustavo A. Del Ángel and Jesús G. Garza-García 2016
 Market Power versus Efficiency

Industrial organization studies have for long analyzed the concentration– profitability
relationship in banking to assess if the structural features of a market influence the
performance of banks in setting above-competitive prices, such as higher loan rates and lower
deposit rates. The traditional structure-conduct-performance (SCP) hypothesis, first proposed
by Bain (1956), posits that market power has a direct relationship with profitability, in which
firms can set less favorable prices to consumers in more concentrated markets as a result of
anti-competitive behavior (Berger and Hannan 1989). According to the SCP hypothesis, the
characteristics of the structure of the market are relevant to determine the conduct of the main
market participants. Therefore, the number and types of firms in a market, entry barriers,
market share and market concentration, and competition and regulatory policies become
relevant to analyze the structure of the market. According to the market power hypotheses a
direct link between structure and conduct (profitability and performance) can be established.
The analysis of bank performance has important social and economic impacts since the efficient
and optimal allocation of resources through intermediation can produce welfare optimization
(Dansby and Willig 1979). A related theory is the so-called relative-market power hypothesis
(RMP), in which firms with large market shares and well-differentiated products exert pricing
advantages and earn profits above competitive levels (Berger 1995). The first studies that
investigated these hypotheses found a positive relationship between concentration and profits,
conducive of collusion (see Gilbert 1984; Rhoades 1977, 1982, among others).
 RESEARCH METHODOLOGY
Methods of Data Collection:-

A. Primary Data: -
For my project I decided to take an interview of a Banker of

1. What are your career goals? Where do you see yourself five years from now?
Ten years?
Most importantly be realistic Blue sky stuff brands you as immature. One or two
management jumps in three to five years is a reasonable goal. If your track indicates you
are on line for senior management in ten years it’s okay to mention. However if you have
had a rocky road it’s better to be introspective.

2. Have you applied to any other areas apart from banking?

Here of course your answer will hold some other finance or sales and marketing careers -
insurance or accountancy, altogether these careers should have skills related to banking.
Here of course because banking sector whose booming sector even though in cessation our
banking sector perform well and its give good shape to your career

3. Why do you want to work here?

If you have done your homework about this organization now is the time to use that
knowledge. Remember even as a recruited candidate some facilities will want to understand
why you would select them. If you are a recruited candidate remind them that you were not
looking when you were contacted but that the challenge sounded intriguing and that a solid
opportunity for career advancement is important to you.

5. If any interviewer asks if you get more salary other than my company will you
go for that?
As an aspirant for successful professional, i think it is the experience not the salary that
matters to get the peak. Besides, this company is on a high growth trajectory. Hence if i am
eligible it is an honor to grow with my company.

6. Describe your gaps in employment frequent job changes or your being asked to
leave your last position?
Addressing mistakes in choices you made in the past will demonstrate maturity. Being
unable to do so will cost you the job. From commuting issues to re-engineering there are
people who never expected job loss or changes to be a problem to address. Be able to
address each issue clearly with solid information. This is an opportunity to grow with new
challenges. Convey why you can and are ready to settle down now and your ability to make
a contribution to a new organization. If you have taken time off between positions it is OK
to let them know that you were not looking for another job. Let the interviewer know with
increased responsibility and your broadened experience you will be an asset to their team.
If you had offers and did not accept them, let them know you are looking for the perfect
organization theirs Be positive introspective and honest but do not dwell on the question.

7. Why banking that also clerk after MBA.

My passion is to be in a banking sector .So that I can start my career with bank and attain
good position

8. What do you consider your Most Significant Strengths?

Be prepared by knowing your four or five key strengths. Be able to discuss each with a
specific example. Select those attributes that are most compatible with the job opening.
Some people say management or good inter-personal skills in answer to this. Do not answer
this way unless you can describe with specific examples the characteristics of management
(planning organizing results staffing etc.) or how your relationship skills have proven critical
to your success.

9. Describe your Typical Day?

The interviewer is looking for your organizational skills and the functions you handle to
determine if you can address their problems. Before the interview review what you do daily
weekly and monthly. Being energetic planned able to set goals and willing to be flexible are
all important aspects of successfully managing your new responsibilities. Extensive
discussion about putting out fires may signal a problem with your ability to plan or
anticipate problems. The interviewer wants to know whether you are a responsible person
or not .You have to impress him by narrating your day in such a way that he gets a glimpse
of your responsibility, efficiency, hardworking nature, & above all you are putting all efforts
to reach your goal.

10. Why do you Believe that you are Qualified for this Position?
Be certain you know the specifics of the question do they need a person to maintain the
status quo or make major changes Do they want staff development a hands-on manager or
an administrator to facilitate policies with upper administration. Pick two or three main
factors about the job and about you that are most relevant. Provide specific details. Select a
clinical or technical skill or a specific management skill (organizing staffing planning) and
combine it with a personal success attribute. Have you ever accomplished something you
didn’t think you could the interviewer is trying to determine your goal orientation work ethic
personal commitment and integrity. Provide a good example where you overcame numerous
difficulties to succeed. Prove you are not a quitter and that you will get going when the
going gets tough. Specify all your strengths and relate them to the position you are
applying.

11. What do you like dislike most about your current position? What will you miss
most about your current position?
The interviewer is trying to determine compatibility with the open position. If you have an
interest in the position be careful. Stating that you dislike overtime or detail work can cost
you the position. There is nothing wrong with liking challenges pressure situations
opportunities to grow or a dislike for bureaucracy or frustrating situations. Again be positive
about your current position.

12. Describe the Difference between being a Manager and a Leader and a
Follower?
Your answer will tell the interviewer about your understanding of hiring motivating and
retaining staff. Following directions thinking outside of the box empowering people or just
doing what needs to be done all of these management approaches have their time. It’s OK
to be a manager certain situations require it. Being a leader is the next level of managerial
development, so convey what is appropriate for you. Manager in the sense of manages the
management. It includes planning, coordinating, controlling, all these thinks. Leader is
nothing but to lead the team. It mainly concentrates to avoid any speculation of work and
follow the managerial activities of above. Followers is just like follow to who are giving one
work should be clearly fulfils that.

13. What significant trends do you see in the future for our industry?
This is your chance to shine. You will be fully familiar with the economic situation as it
relates to banking or how recent legislation affects it. How will you be familiar? Because you
will have done your research and preparation properly. You will have talked to people about
the employer, you will have been reading trade magazines, journals and newspapers, and
you will have poured over company brochures, annual reports or anything else you can get
your hands on direct from the employer. You could talk about tele-banking, the limited
range of services now being offered by the supermarket banks, the effects of technology
and competition and much more. The Employment Files in the Careers Service library are an
obvious first place to look. The Internet is also an excellent source of information. Be ready
to have more than one significant trend to discuss. The most significant trends is to
maintain relationships with client, provide them best services at earliest, application of new
technologies, reach out to remote areas, educating customer the benefits of banks.

14. Describe your involvement in re-engineering down-sizing or cost containment

processes?

Healthcare continues to go through major changes. Describe in a positive way what changes
you led facilitated or were involved in as a participant. Use examples where you specifically
made changes and describe the outcome.

15. Why do you choose banking sector?

Banking sector has evolved tremendously in the past decade. It is not just limited to its
basic role of lending money taking deposits. This scope has been widened. There has been
development of adequate professional management and modern managerial techniques and
practices in banking. Banking operations now also serve a large social purpose. Such highly
evolved booming as well as challenging sector requires upbeat and enthusiastic workers
with strong interpersonal skills.
16. What is probability officer and its duties and responsibilities?
The Main role of Probationary officer in banking is to maintain the operation in all levels of
banking and he holds the position period up to the bank's rule. After Completion of training
only you have the Responsibilities under which u have to be promoted. Post in banking
system is to maintain al the activities related to bank. Works like castor oriented as created
deposit from the custor,giving loan to the customers, opening any type of a/increasing the
customer by convincing it,maintaning the cash in the drawer,voucher authoriation,day to
day generating the reports,npa recovery, telling government scheme to the customers and
many more like all the branch operation.
17. How do you Handle Pressure?
High achievers tend to perform well in high pressure situations. These questions also could
imply that the position is pressure packed. If you do perform well under stress provide an
example with details giving an overview of the stressful situation. Let the interviewer feel
the stress by your description. In such a stressful situation first you would try to be focused
and strategically plan to arrive at the best and logical decision, which the situation would
require.

18. Where have you saved money handled more with less or found other ways to
cut cost or increase productivity?

Describe your actions with a positive can-do attitude. Most organizations face these same
issues and your proven success will make a good impression. Be specific and describe your
successes in quantifiable terms. Share those achievements where you increased revenue
reduced costs improved quality of care or otherwise improved the bottom line. Know the
positive impact you have made for your current and past organizations. Well-articulated,
these answers can land your next opportunity.

19. What are the challenges for banking sector of India?

As it is banking sector, it has to face social and economic factors which leads to economic
growth for developed and under developed countries. Mainly banking is solid foundation and
meet needs of industry and commerce. Every sector has its own kind of challenges to face
when it comes to banking sector its challenges are very high. If you see some development
in India it's because of banking sector because its contribution to economy is maximum.

20. Who are our major competitors and what differences do you notice in our
Banking’s products?

The company will be expecting that you have done your research on the industry generally.
You should be familiar with the bank's products and services - literature on these can be
picked up at any branch. Read the banks brochures and annual reports - these may be in
the careers information room. Be aware of current trends in the market and try to find out
what each bank is doing in these areas. Insurance and Mutual Fund sectors are competitors
to banking industry. Banking products are different than those products as banking products
assure rewards on investment where as others can't gave any assurance.
Secondary Data:-
I have preferred to collect secondary data from my previous
researched project with some help of primary data.
Preface 1

CHAPTER -1: COMMERCIAL BANKING 1-26

INTRODUCTION 1
Meaning 1
Definition of a Bank 1
TYPES OF BANKS 2
FUNCTIONS OF COMMERCIAL BANKS 4
SOURCES OF BANK’S INCOME 9
INVESTMENT POLICY OF BANKS 10
BALANCE SHEET OF THE BANK 12
Liabilities 12
Assets 14
CREDIT CREATION 15
Basis of Credit Creation 15
Process of Credit Creation 16
Leaf and Cannon Criticism 18
Limitation on Credit Creation 18
UNIT BANKING VS BRANCH BANKING 20
A. Unit Banking 20
B. Branch Banking System 22
COMMERCIAL BANKS AND ECONOMIC DEVELOPMENT 24
Conclusion 26
CHAPTER-2: CENTRAL BANKING 27-45
INTRODUCTION 27
Meaning of Central Bank 27
Definition of Central Bank 27
Functions of the Central Bank 28
CREDIT CONTROL 31
Objectives of Credit Control 32
Methods of Credit Control 32
Meaning 33
Theory of Bank Rate 33
Working of Bank Rate 34
The Process of Bank Rate Influence 34
Bank Rate under the Gold Standard 34
Conditions for the Success of the Bank Rate Policy 34
Limitations 35
Meaning 36
Theory of Open Market Operations 36
Objectives of Open Market Operations 37
Conditions for the Success of Open Market Operations 37
Popularity of Open Market Operations 38
A. Variable Cash Reserve Ratio 39
Meaning 39
B. Theory of Variable Reserve Ratio 39
Working of Variable Reserve Ratio 40
Limitations 41
Selective or Qualitative Methods 41
Objectives 42
Measures of Selective Credit Control 42
Conclusion 45

CHAPTER-3: RESERVE BANK OF INDIA 47-75

INTRODUCTION 47
Capital 48
Organisation 48
Offices of the Bank 49
Departments of the Reserve Bank 50
Functions of the Reserve Bank 51
CREDIT CONTROL 58
Weapons of Credit Control 58
METHODS OF SELECTIVE CREDIT CONTROLS ADOPTED BY RESERVE BANK 61
Limitations of Selective Controls in India 63
MONETARY POLICY OF THE RESERVE BANK OF INDIA 64
Reserve Bank of India and Monetary Controls 64
Limitations of Monetary Policy 66
Chakravarthy Report on the Working of the Monetary System 67
The Narasimham Committee Report (1991) 68
Recommendations of the Committee 68
The Goiporia Committee Report (1991) 70
Recommendations of Goiporia Committee 70
The Narasimham Committee Report (1998) 71
ROLE OF RBI IN ECONOMIC DEVELOPMENT 71
Contribution to Economic Development 72
Conclusion 75

CHAPTER-4: STATE BANK OF INDIA 77-81

INTRODUCTION 77
Capital 77
Management 77
Functions 78
Role of the State Bank in Economic Development 79
Conclusion 80
INTRODUCTION

Banking occupies one of the most important positions in the modern economic world.
It is necessary for trade and industry. Hence it is one of the great agencies of commerce.
Although banking in one form or another has been in existence from very early times,
modern banking is of recent origin. It is one of the results of the Industrial Revolution and
the child of economic necessity. Its presence is very helpful to the economic activity and
industrial progress of a country.

Meaning

A commercial bank is a profit-seeking business firm, dealing in money and credit. It is a

financial institution dealing in money in the sense that it accepts deposits of money from the
public to keep them in its custody for safety. So also, it deals in credit, i.e., it creates credit by
making advances out of the funds received as deposits to needy people. It thus, functions as a
mobiliser of saving in the economy. A bank is, therefore like a reservoir into which flow the
savings, the idle surplus money of households and from which loans are given on interest to
businessmen and others who need them for investment or productive uses.

Definition of a Bank

The term ‘Bank’ has been defined in different ways by different economists. A few definitions
are:

According to Walter Leaf “A bank is a person or corporation which holds itself out to
receive from the public, deposits payable on demand by cheque.” Horace White has defined
a bank, “as a manufacture of credit and a machine for facilitating exchange.”

According to Prof. Kinley, “A bank is an establishment which makes to individuals such

advances of money as may be required and safely made, and to which individuals entrust
money when not required by them for use.”

The Banking Companies Act of India defines Bank as “A Bank is a financial institution
which accepts money from the public for the purpose of lending or investment repayable on
demand or otherwise withdrawable by cheques, drafts or order or otherwise.”
Thus, we can say that a bank is a financial institution which deals in debts and credits.
It accepts deposits, lends money and also creates money. It bridges the gap between the
savers and borrowers. Banks are not merely traders in money but also in an important sense
manufacturers of money.

TYPES OF BANKS

Broadly speaking, banks can be classified into commercial banks and central bank.
Commercial banks are those which provide banking services for profit. The central bank has
the function of controlling commercial banks and various other economic activities. There
are many types of commercial banks such as deposit banks, industrial banks, savings banks,
agricultural banks, exchange banks, and miscellaneous banks.

Types of Commercial Banks

1. Deposit Banks: The most important type of deposit banks is the commercial banks.
They have connection with the commercial class of people. These banks accept
deposits from the public and lend them to needy parties. Since their deposits are
for short period only, these banks extend loans only for a short period. Ordinarily
these banks lend money for a period between 3 to 6 months. They do not like to lend
money for long periods or to invest their funds in any way in long term securities.

2. Industrial Banks: Industries require a huge capital for a long period to buy machinery
and equipment. Industrial banks help such industrialists. They provide long term loans
to industries. Besides, they buy shares and debentures of companies, and enable them
to have fixed capital. Sometimes, they even underwrite the debentures and shares of big
industrial concerns. The important functions of industrial banks are:

1. They accept long term deposits.

2. They meet the credit requirements of industries by extending long term loans.
3. These banks advise the industrial firms regarding the sale and purchase of shares
and debentures.
The industrial banks play a vital role in accelerating industrial development. In
India, after attainment of independence, several industrial banks were started with
large paid up capital. They are, The Industrial Finance Corporation (I.F.C.), The
State Financial Corporations (S.F.C.), Industrial Credit and Investment Corporation
of India (ICICI) and Industrial Development Bank of India (IDBI) etc.

3. Savings Banks: These banks were specially established to encourage thrift among
small savers and therefore, they were willing to accept small sums as deposits. They
encourage savings of the poor and middle class people. In India we do not have such
special institutions, but post offices perform such functions. After nationalisation
most of the nationalised banks accept the saving deposits.

4. Agricultural Banks: Agriculture has its own problems and hence there are separate
banks to finance it. These banks are organised on co-operative lines and therefore
do not work on the principle of maximum profit for the shareholders. These banks
meet the credit requirements of the farmers through term loans, viz., short, medium
and long term loans. There are two types of agricultural banks,

(a) Agricultural Co-operative Banks, and

(b) Land Mortgage Banks.

Co-operative Banks are mainly for short periods. For long

periods there are Land Mortgage Banks. Both these types of banks are performing
useful functions in India.

5. Exchange Banks: These banks finance mostly for the foreign trade of a country.
Their main function is to discount, accept and collect foreign bills of exchange. They
buy and sell foreign currency and thus help businessmen in their transactions. They
also carry on the ordinary banking business.

In India, there are some commercial banks which are branches of foreign banks.
These banks facilitate for the conversion of Indian currency into foreign currency
to make payments to foreign exporters. They purchase bills from exporters and sell
their proceeds to importers. They purchase and sell “forward exchange” too and
thus minimise the difference in exchange rates between different periods, and also
protect merchants from losses arising out of exchange fluctuations by bearing the
risk. The industrial and commercial development of a country depends these days,
largely upon the efficiency of these institutions.

6. Miscellaneous Banks: There are certain kinds of banks which have arisen in due
course to meet the specialised needs of the people. In England and America, there are
investment banks whose object is to control the distribution of capital into several uses.
American Trade Unions have got labour banks, where the savings of the labourers are
pooled together. In London, there are the London Discount House whose business is “to
go about the city seeking for bills to discount.” There are numerous types of different
banks in the world, carrying on one or the other banking business.
 FUNCTION OF COMMERCIAL BANKING
Commercial banks have to perform a variety of functions which are common to both
developed and developing countries. These are known as ‘General Banking’ functions of the
commercial banks. The modern banks perform a variety of functions. These can be broadly
divided into two categories: (a) Primary functions and (b) Secondary functions.
 Primary Functions

Primary banking functions of the commercial banks include:

1. Acceptance of deposits
2. Advancing loans
3. Creation of credit
4. Clearing of cheques
5. Financing foreign trade
6. Remittance of funds

1. Acceptance of Deposits: Accepting deposits is the primary function of a commercial

bank mobilise savings of the household sector. Banks generally accept three types of
deposits viz., (a) Current Deposits (b) Savings Deposits, and (c) Fixed Deposits.

(a) Current Deposits: These deposits are also known as demand deposits. These
deposits can be withdrawn at any time. Generally, no interest is allowed on
current deposits, and in case, the customer is required to leave a minimum
balance undrawn with the bank. Cheques are used to withdraw the amount.
These deposits are kept by businessmen and industrialists who receive and make
large payments through banks. The bank levies certain incidental charges on the
customer for the services rendered by it.

(b) Savings Deposits: This is meant mainly for professional men and middle class
people to help them deposit their small savings. It can be opened without any
introduction. Money can be deposited at any time but the maximum cannot go
beyond a certain limit. There is a restriction on the amount that can be withdrawn
at a particular time or during a week. If the customer wishes to withdraw more
than the specified amount at any one time, he has to give prior notice. Interest is
allowed on the credit balance of this account. The rate of interest is greater than
the rate of interest on the current deposits and less than that on fixed deposit.
This system greatly encourages the habit of thrift or savings.

(c) Fixed Deposits: These deposits are also known as time deposits. These deposits
cannot be withdrawn before the expiry of the period for which they are deposited
or without giving a prior notice for withdrawal. If the depositor is in need of
money, he has to borrow on the security of this account and pay a slightly higher
rate of interest to the bank. They are attracted by the payment of interest which
is usually higher for longer period. Fixed deposits are liked by depositors both for
their safety and as well as for their interest. In India, they are accepted between
three months and ten years.

2. Advancing Loans: The second primary function of a commercial bank is to

make loans and advances to all types of persons, particularly to businessmen and
entrepreneurs. Loans are made against personal security, gold and silver, stocks of
goods and other assets. The most common way of lending is by:
(a) Overdraft Facilities: In this case, the depositor in a current account is allowed to draw
over and above his account up to a previously agreed limit. Suppose a businessman
has only Rs. 30,000/- in his current account in a bank but requires Rs. 60,000/- to
meet his expenses. He may approach his bank and borrow the additional amount
of Rs. 30,000/-. The bank allows the customer to overdraw his account through
cheques. The bank, however, charges interest only on the amount overdrawn from
the account. This type of loan is very popular with the Indian businessmen.

(b) Cash Credit: Under this account, the bank gives loans to the borrowers against
certain security. But the entire loan is not given at one particular time, instead the
amount is credited into his account in the bank; but under emergency cash will
be given. The borrower is required to pay interest only on the amount of credit
availed to him. He will be allowed to withdraw small sums of money according to
his requirements through cheques, but he cannot exceed the credit limit allowed
to him. Besides, the bank can also give specified loan to a person, for a firm
against some collateral security. The bank can recall such loans at its option.

(c) Discounting Bills of Exchange: This is another type of lending which is very
popular with the modern banks. The holder of a bill can get it discounted by the
bank, when he is in need of money. After deducting its commission, the bank
pays the present price of the bill to the holder. Such bills form good investment
for a bank. They provide a very liquid asset which can be quickly turned into
cash. The commercial banks can rediscount, the discounted bills with the central
banks when they are in need of money. These bills are safe and secured bills.
When the bill matures the bank can secure its payment from the party which had
accepted the bill.

(d) Money at Call: Bank also grant loans for a very short period, generally not
exceeding 7 days to the borrowers, usually dealers or brokers in stock exchange
markets against collateral securities like stock or equity shares, debentures, etc.,
offered by them. Such advances are repayable immediately at short notice hence,
they are described as money at call or call money.

(e) Term Loans: Banks give term loans to traders, industrialists and now to agriculturists
also against some collateral securities. Term loans are so-called because their maturity
period varies between 1 to 10 years. Term loans, as such provide intermediate or
working capital funds to the borrowers. Sometimes, two or more banks may jointly
provide large term loans to the borrower against a common security. Such loans are
called participation loans or consortium finance.

(f) Consumer Credit: Banks also grant credit to households in a limited amount to
buy some durable consumer goods such as television sets, refrigerators, etc., or
to meet some personal needs like payment of hospital bills etc. Such consumer
credit is made in a lump sum and is repayable in instalments in a short time. Under
the 20-point programme, the scope of consumer credit has been extended to
cover expenses on marriage, funeral etc., as well.

(g) Miscellaneous Advances: Among other forms of bank advances there are packing
credits given to exporters for a short duration, export bills purchased/discounted,
import finance-advances against import bills, finance to the self employed, credit
to the public sector, credit to the cooperative sector and above all, credit to the
weaker sections of the community at concessional rates.
3. Creation of Credit: A unique function of the bank is to create credit. Banks supply
money to traders and manufacturers. They also create or manufacture money. Bank
deposits are regarded as money. They are as good as cash. The reason is they can be
used for the purchase of goods and services and also in payment of debts. When a
bank grants a loan to its customer, it does not pay cash. It simply credits the account
of the borrower. He can withdraw the amount whenever he wants by a cheque. In
this case, bank has created a deposit without receiving cash. That is, banks are said
to have created credit. Sayers says “banks are not merely purveyors of money, but
also in an important sense, manufacturers of money.”

4. Promote the Use of Cheques: The commercial banks render an important service by
providing to their customers a cheap medium of exchange like cheques. It is found much
more convenient to settle debts through cheques rather than through the use of cash.
The cheque is the most developed type of credit instrument in the money market.

5. Financing Internal and Foreign Trade: The bank finances internal and foreign
trade through discounting of exchange bills. Sometimes, the bank gives short-term
loans to traders on the security of commercial papers. This discounting business
greatly facilitates the movement of internal and external trade.

6. Remittance of Funds: Commercial banks, on account of their network of branches

throughout the country, also provide facilities to remit funds from one place to another
for their customers by issuing bank drafts, mail transfers or telegraphic transfers
on nominal commission charges. As compared to the postal money orders or other
instruments, bank drafts have proved to be a much cheaper mode of transferring
money and has helped the business community considerably.
 Secondary Functions

Secondary banking functions of the commercial banks include:

1. Agency Services
2. General Utility Services
These are discussed below.

1. Agency Services: Banks also perform certain agency functions for and on behalf
of their customers. The agency services are of immense value to the people at large.
The various agency services rendered by banks are as follows:

(a) Collection and Payment of Credit Instruments: Banks collect and pay various credit
instruments like cheques, bills of exchange, promissory notes etc., on behalf of
their customers.

(b) Purchase and Sale of Securities: Banks purchase and sell various securities like
shares, stocks, bonds, debentures on behalf of their customers.

(c) Collection of Dividends on Shares: Banks collect dividends and interest on shares
and debentures of their customers and credit them to their accounts.

(d) Acts as Correspondent: Sometimes banks act as representative and correspondents

of their customers. They get passports, traveller’s tickets and even secure air and
sea passages for their customers.

(e) Income-tax Consultancy: Banks may also employ income tax experts to prepare
income tax returns for their customers and to help them to get refund of income
tax.

(f) Execution of Standing Orders: Banks execute the standing instructions of their
customers for making various periodic payments. They pay subscriptions, rents,
insurance premia etc., on behalf of their customers.

(g) Acts as Trustee and Executor: Banks preserve the ‘Wills’ of their customers and
execute them after their death.

2. General Utility Services: In addition to agency services, the modern banks provide
many general utility services for the community as given.

(a) Locker Facility: Bank provide locker facility to their customers. The customers can
keep their valuables, such as gold and silver ornaments, important documents;
shares and debentures in these lockers for safe custody.

(b) Traveller’s Cheques and Credit Cards: Banks issue traveller’s cheques to help their
customers to travel without the fear of theft or loss of money. With this facility,
the customers need not take the risk of carrying cash with them during their
travels.
(c) Letter of Credit: Letters of credit are issued by the banks to their customers
certifying their credit worthiness. Letters of credit are very useful in foreign
trade.

(d) Collection of Statistics: Banks collect statistics giving important information relating
to trade, commerce, industries, money and banking. They also publish valuable
journals and bulletins containing articles on economic and financial matters.

(e) Acting Referee: Banks may act as referees with respect to the financial standing,
business reputation and respectability of customers.

(f) Underwriting Securities: Banks underwrite the shares and debentures issued by
the Government, public or private companies.

(g) Gift Cheques: Some banks issue cheques of various denominations to be used on
auspicious occasions.

(h) Accepting Bills of Exchange on Behalf of Customers: Sometimes, banks accept bills
of exchange, internal as well as foreign, on behalf of their customers. It enables
customers to import goods.

(i) Merchant Banking: Some commercial banks have opened merchant banking
divisions to provide merchant banking services.

A. Fulfillment of Socio-Economic Objectives

In recent years, commercial banks, particularly in developing countries, have been called
upon to help achieve certain socio-economic objectives laid down by the state. For example,
the nationalized banks in India have framed special innovative schemes of credit to help
small agriculturists, village and cottage industries, retailers, artisans, the self employed
persons through loans and advances at concessional rates of interest. Under the Differential
Interest Scheme (D.I.S.) the nationalized banks in India advance loans to persons belonging
to scheduled tribes, tailors, rickshaw-walas, shoe-makers at the concessional rate of 4 per cent
per annum. This does not cover even the cost of the funds made available to these priority
sectors. Banking is, thus, being used to subserve the national policy objectives of reducing
inequalities of income and wealth, removal of poverty and elimination of unemployment in
the country.

It is clear from the above that banks help development of trade and industry in the country.
They encourage habits of thrift and saving. They help capital formation in the country. They
lend money to traders and manufacturers. In the modern world, banks are to be considered
not merely as dealers in money but also the leaders in economic development.
 SOURCES OF BANK’S INCOME

SOURCES OF BANK’S INCOME

A bank is a business organisation engaged in the business of borrowing and lending money.
A bank can earn income only if it borrows at a lower rate and lends at a higher rate. The
difference between the two rates will represent the costs incurred by the bank and the profit.
Bank also provides a number of services to its customers for which it charges commission.
This is also an important source of income. The followings are the various sources of a
bank’s profit:

1. Interest on Loans: The main function of a commercial bank is to borrow money for
the purpose of lending at a higher rate of interest. Bank grants various types of loans to
the industrialists and traders. The yields from loans constitute the major portion of the
income of a bank. The banks grant loans generally for short periods. But now the banks
also advance call loans which can be called at a very short notice. Such loans are granted
to share brokers and other banks. These assets are highly liquid because they can be
called at any time. Moreover, they are source of income to the bank.

2. Interest on Investments: Banks also invest an important portion of their resources

in government and other first class industrial securities. The interest and dividend
received from time to time on these investments is a source of income for the banks.
Bank also earn some income when the market prices of these securities rise.

3. Discounts: Commercial banks invest a part of their funds in bills of exchange by

discounting them. Banks discount both foreign and inland bills of exchange, or in
other words, they purchase the bills at discount and receive the full amount at the
date of maturity. For instance, if a bill of Rs. 1000 is discounted for Rs. 975, the
bank earns a discount of Rs. 25 because bank pays Rs. 975 today, but will get Rs.
1000 on the due date. Discount, as a matter of fact, is the interest on the amount
paid for the remaining period of the bill. The rate of discount on bills of exchange is
slightly lower than the interest rate charged on loans and advances because bills are
considered to be highly liquid assets.

4. Commission, Brokerage, etc.: Banks perform numerous services to their

customers and charge commission, etc., for such services. Banks collect cheques,
rents, dividends, etc., accepts bills of exchange, issue drafts and letters of credit
and collect pensions and salaries on behalf of their customers. They pay insurance
premiums, rents, taxes etc., on behalf of their customers. For all these services banks
charge their commission. They also earn locker rents for providing safety vaults to
their customers. Recently the banks have also started underwriting the shares and
debentures issued by the joint stock companies for which they receive underwriting
commission.
Commercial banks also deal in foreign exchange. They sell demand drafts, issue letters of
credit and help remittance of funds in foreign countries. They also act as brokers in foreign
exchange. Banks earn income out of these operations.
 INVESTMENT POLICY OF BANK
The financial position of a commercial bank is reflected in its balance sheet. The balance
sheet is a statement of the assets and liabilities of the bank. The assets of the bank are
distributed in accordance with certain guiding principles. These principles underline the
investment policy of the bank. They are discussed below:

1. Liquidity: In the context of the balance sheet of a bank the term liquidity has two
interpretations. First, it refers to the ability of the bank to honour the claims of the
depositors. Second, it connotes the ability of the bank to convert its non-cash assets
into cash easily and without loss.

It is a well known fact that a bank deals in funds belonging to the public. Hence,
the bank should always be on its guard in handling these funds. The bank should
always have enough cash to meet the demands of the depositors. In fact, the success
of a bank depends to a considerable extent upon the degree of confidence it can instill
in the minds of its depositors. If the depositors lose confidence in the integrity of
their bank, the very existence of the bank will be at stake. So, the bank should always
be prepared to meet the claims of the depositors by having enough cash. Among the
various items on the assets side of the balance sheet, cash on hand represents the
most liquid asset. Next comes cash with other banks and the central bank. The order
of liquidity goes on descending.

Liquidity also means the ability of the bank to convert its non-cash assets into
cash easily and without loss. The bank cannot have all its assets in the form of cash
because each is an idle asset which does not fetch any return to the bank. So some of
the assets of the bank, money at call and short notice, bills discounted, etc. could be
made liquid easily and without loss.

2. Profitability: A commercial bank by definition, is a profit hunting institution. The

bank has to earn profit to earn income to pay salaries to the staff, interest to the
depositors, dividend to the shareholders and to meet the day-to-day expenditure.
Since cash is the least profitable asset to the bank, there is no point in keeping all the
assets in the form of cash on hand. The bank has got to earn income. Hence, some
of the items on the assets side are profit yielding assets. They include money at call
and short notice, bills discounted, investments, loans and advances, etc. Loans and
advances, though the least liquid asset, constitute the most profitable asset to the
bank. Much of the income of the bank accrues by way of interest charged on loans
and advances. But, the bank has to be highly discreet while advancing loans.

3. Safety or Security: Apart from liquidity and profitability, the bank should look
to the principle of safety of its funds also for its smooth working. While advancing
loans, it is necessary that the bank should consider the three ‘C’ s of credit character,
capacity and the collateral of the borrower. The bank cannot afford to invest its funds
recklessly without considering the principle of safety. The loans and investments
made by the bank should be adequately secured. For this purpose, the bank should
always insist on security of the borrower. Of late, somehow or other the banks have
not been paying adequate importance to safety, particularly in India.
4. Diversity: The bank should invest its funds in such a way as to secure for itself
an adequate and permanent return. And while investing its funds, the bank should
not keep all its eggs in the same basket. Diversification of investment is necessary
to avoid the dangerous consequences of investing in one or two channels. If the
bank invest its funds in different types of securities or makes loans and advances
to different objectives and enterprises, it shall ensure for itself a regular flow of
income.

5. Saleability of Securities: Further, the bank should invest its funds in such types
of securities as can be easily marketed at a time of emergency. The bank cannot
afford to invest its funds in very long term securities or those securities which are
unsaleable. It is necessary for the bank to invest its funds in government or in first
class securities or in debentures of reputed firms. It should also advance loans against
stocks which can be easily sold.

6. Stability in the Value of Investments: The bank should invest its funds in those
stocks and securities the prices of which are more or less stable. The bank cannot
afford to invest its funds in securities, the prices of which are subject to frequent
fluctuations.

7. Principles of Tax-Exemption of Investments: Finally, the investment policy of

a bank should be based on the principle of tax exemption of investments. The bank
should invest in those government securities which are exempted from income and
other taxes. This will help the bank to increase its profits.

Of late, there has been a controversy regarding the relative importance of the
various principles influencing the investment policy of a bank particularly between
liquidity and profitability. It is interesting to examine this controversy.
Let us examine what happens if the bank sticks to the principle of liquidity only. It is
true that if the bank pays importance to liquidity, it can easily meet the demands of the
depositors. The bank should have adequate cash to meet the claims of the depositors. It
is true that a successful banking business calls for installing confidence in the minds of
the depositors. But, it should be noted that accepting deposits is not the only function of a
bank. Moreover, the bank cannot afford to forget the fact that it has to earn income to pay
salaries to the staff, interest to the depositors, dividend to the shareholders and meet the
day-to-day expenditure. If the bank keeps all its resources in liquid form, it will not
be able to earn even a rupee. But profitability is a must for the bank. Though cash on
hand is the most liquid asset, it is the least profitable asset as well. Cash is an idle asset.
Hence, the banker cannot concentrate on liquidity only.

If the bank attaches importance to profitability only, it would be equally

disastrous to the very survival of a bank. It is true that a bank needs income to
meet its expenditure and pay returns to the depositors and shareholders. The bank
cannot undermine the interests of the depositors. If the bank lends out all its funds,
it will be left with no cash at all to meet the claims of the depositors. It should be
noted that the bank should have cash to honour the obligations of the depositors.
Otherwise, there will be a ‘run’ on the bank. A run on the bank would be suicidal to
the very existence of the bank. Loans and advances, though the most profitable asset,
constitute the least liquid asset.
It follows from the above that the choice is between liquidity and profitability.
The constant tug of war between liquidity and profitability is the feature of the assets
side.

According to Crowther, liquidity and profitability are opposing or conflicting

considerations. The secret of successful banking lies in striking a balance between
the two.
BALANCE SHEET OF THE BANK

The balance sheet of a commercial bank is a statement of its assets and liabilities. Assets
are what others owe the bank, and what the bank owes others constitutes its liabilities. The
business of a bank is reflected in its balance sheet and hence its financial position as well.
The balance sheet is issued usually at the end of every financial year of the bank.
The balance sheet of the bank comprises of two sides; the assets side and the liabilities
side. It is customary to record liabilities on the left side and assets on the right side. The
following is the proforma of a balance sheet of the bank.
Liabilities
Liabilities are those items on account of which the bank is liable to pay others. They
denote other’s claims on the bank. Now we have to analyse the various items on the
liabilities side.

1. Capital: The bank has to raise capital before commencing its business. Authorised
capital is the maximum capital upto which the bank is empowered to raise capital by
the Memorandum of Association. Generally, the entire authorised capital is not raised
from the public. That part of authorised capital which is issued in the form of shares
for public subscription is called the issued capital. Subscribed capital represents that
part of issued capital which is actually subscribed by the public. Finally, paid-up
capital is that part of the subscribed capital which the subscribers are actually called
upon to pay.

2. Reserve Fund: Reserve fund is the accumulated undistributed profits of the bank.
The bank maintains reserve fund to tide over any crisis. But, it belongs to the
shareholders and hence a liability on the bank. In India, the commercial bank is
required by law to transfer 20 per cent of its annual profits to the Reserve fund.

3. Deposits: The deposits of the public like demand deposits, savings deposits and
fixed deposits constitute an important item on the liabilities side of the balance sheet.
The success of any banking business depends to a large extent upon the degree of
confidence it can instill in the minds of the depositors. The bank can never afford to
forget the claims of the depositors. Hence, the bank should always have enough cash
to honour the obligations of the depositors.
4. Borrowings from Other Banks: Under this head, the bank shows those loans it
has taken from other banks. The bank takes loans from other banks, especially the
central bank, in certain extraordinary circumstances.

5. Bills Payable: These include the unpaid bank drafts and telegraphic transfers issued
by the bank. These drafts and telegraphic transfers are paid to the holders thereof by
the bank’s branches, agents and correspondents who are reimbursed by the bank.

6. Acceptances and Endorsements: This item appears as a contra item on both the
sides of the balance sheet. It represents the liability of the bank in respect of bills
accepted or endorsed on behalf of its customers and also letters of credit issued and
guarantees given on their behalf. For rendering this service, a commission is charged
and the customers to whom this service is extended are liable to the bank for full
payment of the bills. Hence, this item is shown on both sides of the balance sheet.

7. Contingent Liabilities: Contingent liabilities comprise of those liabilities which are

not known in advance and are unforeseeable. Every bank makes some provision for
contingent liabilities.

8. Profit and Loss Account: The profit earned by the bank in the course of the year
is shown under this head. Since the profit is payable to the shareholders it represents
a liability on the bank.
9. Bills for Collection: This item also appears on both the sides of the balance sheet.
It consists of drafts and hundies drawn by sellers of goods on their customers and are
sent to the bank for collection, against delivery documents like railway receipt, bill
of lading, etc., attached thereto. All such bills in hand at the date of the balance sheet
are shown on both the sides of the balance sheet because they form an asset of the
bank, since the bank will receive payment in due course, it is also a liability because
the bank will have to account for them to its customers.

Assets
According to Crowther, the assets side of the balance sheet is more complicated and
interesting. Assets are the claims of the bank on others. In the distribution of its assets,
the bank is governed by certain well defined principles. These principles constitute the
principles of the investment policy of the bank or the principles underlying the distribution
of the assets of the bank. The most important guiding principles of the distribution of assets
of the bank are liquidity, profitability and safety or security. In fact, the various items on the
assets side are distributed according to the descending order of liquidity and the ascending
order of profitability.
Now, we have to analyse the various items on the assets side.

1. Cash: Here we can distinguish cash on hand from cash with central bank and other
banks cash on hand refers to cash in the vaults of the bank. It constitutes the most
liquid asset which can be immediately used to meet the obligations of the depositors.
Cash on hand is called the first line of defence to the bank.
In addition to cash on hand, the bank also keeps some money with the central bank
or other commercial banks. This represents the second line of defence to the bank.

2. Money at Call and Short Notice: Money at call and short notice includes loans
to the brokers in the stock market, dealers in the discount market and to other
banks. These loans could be quickly converted into cash and without loss, as and
when the bank requires. At the same time, this item yields income to the bank. The
significance of money at call and short notice is that it is used by the banks to effect
desirable adjustments in the balance sheet. This process is called ‘Window Dressing’.
This item constitutes the ‘third line of defence’ to the bank.

3. Bills Discounted: The commercial banks invest in short term bills consisting of bills
of exchange and treasury bills which are self-liquidating in character. These short
term bills are highly negotiable and they satisfy the twin objectives of liquidity and
profitability. If a commercial bank requires additional funds, it can easily rediscount
the bills in the bill market and it can also rediscount the bills with the central bank.

4. Bills for Collection: As mentioned earlier, this item appears on both sides of the
balance sheet.

5. Investments: This item includes the total amount of the profit yielding assets of
the bank. The bank invests a part of its funds in government and non-government
securities.
6. Loans and Advances: Loans and advances constitute the most profitable asset to
the bank. The very survival of the bank depends upon the extent of income it can
earn by advancing loans. But, this item is the least liquid asset as well. The bank
earns quite a sizeable interest from the loans and advances it gives to the private
individuals and commercial firms.

7. Acceptances and Endorsements: As discussed earlier, this item appears as a

contra item on both sides of the balance sheet.

8. Fixed Assets: Fixed assets include building, furniture and other property owned
by the bank. This item includes the total volume of the movable and immovable
property of the bank. Fixed assets are referred to as ‘dead stocks’. The bank generally
undervalues this item deliberately in the balance sheet. The intention here is to
build up secret reserves which can be used at times of crisis.

Balance sheet of a bank acts as a mirror of its policies, operations and achievements.
The liabilities indicate the sources of its funds; the assets are the various kinds of
debts incurred by a bank to its customers. Thus, the balance sheet is a complete
picture of the size and nature of operations of a bank.
 CREDIT CREATION
An important function performed by the commercial banks is the creation of credit. The
process of banking must be considered in terms of monetary flows, that is, continuous
depositing and withdrawal of cash from the bank. It is only this activity which has enabled
the bank to manufacture money. Therefore the banks are not only the purveyors of money
but manufacturers of money.

Basis of Credit Creation

The basis of credit money is the bank deposits. The bank deposits are of two kinds viz.,
(1) Primary deposits, and (2) Derivative deposits.

1. Primary Deposits: Primary deposits arise or formed when cash or cheque is

deposited by customers. When a person deposits money or cheque, the bank will
credit his account. The customer is free to withdraw the amount whenever he wants
by cheques. These deposits are called “primary deposits” or “cash deposits.” It is out
of these primary deposits that the bank makes loans and advances to its customers.
The initiative is taken by the customers themselves. In this case, the role of the bank
is passive. So these deposits are also called “passive deposits.” These deposits merely
convert currency money into deposit money. They do not create money. They do not
make any net addition to the stock of money. In other words, there is no increase in
the supply of money.

2. Derivative Deposits: Bank deposits also arise when a loan is granted or when
a bank discounts a bill or purchase government securities. Deposits which arise
on account of granting loan or purchase of assets by a bank are called “derivative
deposits.” Since the bank play an active role in the creation of such deposits, they are
also known as “active deposits.” When the banker sanctions a loan to a customer,
a deposit account is opened in the name of the customer and the sum is credited to
his account. The bank does not pay him cash. The customer is free to withdraw the
amount whenever he wants by cheques. Thus the banker lends money in the form
of deposit credit. The creation of a derivative deposit does result in a net increase in
the total supply of money in the economy,

Hartly Withers says “every loan createsa deposit.” It may also be said “loans make deposits”
or “loans create deposits.” It is rightly said that “deposits are the children of loans, and credit is
the creation of bank clerk’s pen.”

Granting a loan is not the only method of creating deposit or credit. Deposits
also arise when a bank discounts a bill or purchase government securities. When
the bank buys government securities, it does not pay the purchase price at once in
cash. It simply credits the account of the government with the purchase price. The
government is free to withdraw the amount whenever it wants by cheque. Similarly,
when a bank purchase a bill of exchange or discounts a bill of exchange, the proceeds
of the bill of exchange is credited to the account of the seller and promises to pay the
amount whenever he wants. Thus asset acquired by a bank creates an equivalent bank
deposit. It is perfectly correct to state that “bank loans create deposits.” The derivate
deposits are regarded as bank money or credit. Thus the power of commercial banks
to expand deposits through loans, advances and investments is known as “credit
creation.”
Thus, credit creation implies multiplication of bank deposits. Credit creation may
be defined as “the expansion of bank deposits through the process of more loans and
advances and investments.”

Process of Credit Creation

An important aspect of the credit creating function of the commercial banks is the process
of multiple-expansion of credit. The banking system as a whole can create credit which
is several times more than the original increase in the deposits of a bank. This process is
called the multiple-expansion or multiple-creation of credit. Similarly, if there is withdrawal
from any one bank, it leads to the process of multiple-contraction of credit. The process of
multiple credit-expansion can be illustrated by assuming

(a) The existence of a number of banks, A, B, C etc., each with different sets of
depositors.

(b) Every bank has to keep 10% of cash reserves, according to law, and,

(c) A new deposit of Rs. 1,000 has been made with bank A to start with.

Suppose, a person deposits Rs. 1,000 cash in Bank A. As a result, the deposits of bank
A increase by Rs. 1,000 and cash also increases by Rs. 1,000. The balance sheet of the bank
is as follows:
Balance Sheet of Bank A

Liabilities ₨ Assets ₨
New Deposit 1,000 New Cash 1,000
Total 1,000 Total 1,000

Under the double entry system, the amount of Rs. 1,000 is shown on both sides.
The deposit of Rs. 1,000 is a liability for the bank and it is also an asset to the bank. Bank A
has to keep only 10% cash reserve, i.e., Rs. 100 against its new deposit and it has a surplus of
Rs. 900 which it can profitably employ in the assets like loans. Suppose bank A gives a loan to
X, who uses the amount to pay off his creditors. After the loan has been made and the amount
so withdrawn by X to pay off his creditors, the balance sheet of bank A will be as follows:

Balance Sheet of Bank A

Liabilities ₨ Assets ₨
Deposit 1,000 New Cash 100
Loan to MR. X 900
Total 1,000 Total 1,000
Suppose X purchase goods of the value of Rs. 900 from Y and pay cash. Y deposits the
amount with Bank B. The deposits of Bank B now increase by Rs. 900 and its cash also
increases by Rs. 900. After keeping a cash reserve of Rs. 90, Bank B is free to lend the
balance of Rs. 810 to any one. Suppose bank B lends Rs. 810 to Z, who uses the amount to
pay off his creditors. The balance sheet of bank B will be as follows:

Balance Sheet of Bank B

Liabilities ₨ Assets ₨
Deposit 900 Cash 90
Loan to MR. Z 810
Total 900 Total 900

Suppose Z purchases goods of the value of Rs. 810 from S and pays the amount. S deposits
the amount of Rs. 810 in bank C. Bank C now keeps 10% as reserve (Rs. 81) and lends
Rs. 729 to a merchant. The balance sheet of bank C will be as follows:

Balance Sheet of Bank C

Liabilities ₨ Assets ₨
Deposit 810 Cash 81
Loan to MR. Z 729
Total 810 Total 810

Thus looking at the banking system as a whole, the position will be as follow:

Name of Deposit Cash Reserve Loan

Bank ₨ ₨ ₨
Bank A 1,000 100 900
Bank B 900 90 810
Bank C 810 81 729

Total 2710 271 2439

It is clear from the above that out of the initial primary deposit, bank advanced Rs. 900
as a loan. It formed the primary deposit of bank B, which in turn advanced Rs. 810 as loan.
This sum again formed, the primary deposit of bank C, which in turn advanced Rs. 729 as
loan. Thus the inital primary deposit of Rs. 1,000 resulted in bank credit of Rs. 2439 in
three banks. There will be many banks in the country and the above process of credit
expansion will come to an end when no bank has an excess reserve to lend. In the
above example, there will be 10 fold increase in credit because the cash ratio is 10%.
The total volume of credit created in the banking system depends on the cash ratio. If
the cash ratio is 10% there will be 10 fold increase. If it is 20%, there will be 5 fold
increase. When the banking system receives an additional primary deposit, there will be
multiple expansion of credit. When the banking system loses cash, there will be multiple
contraction of credit.

The extent to which the banks can create credit together could be found out with the
help of the credit multiplier formula. The formula is:

𝟏
K=
𝒓
Where K is the credit multiplier, and r, the required reserves. If the reserve ratio is 10%
the size of credit multiplier will be:
𝟏 𝟏
K =
= = 𝟏𝟎
𝒓 𝟏.𝟎
It means that the banking system can create credit together which is ten times more
than the original increase in the deposits. It should be noted here that the size of credit
multiplier is inversely related to the percentage of cash reserves the banks have to maintain.
If the reserve ratio increases, the size of credit multiplier is reduced and if the reserve ratio
is reduced, the size of credit multiplier will increase.

Leaf and Cannon Criticism

Walter Leaf and Edwin Cannon objected to the theory of credit creation. According to them,
the commercial bank cannot lend anything more than what it receives as cash from deposits.
But the contention of Leaf and Cannon that banks cannot create credit is wrong due to the
following reasons:

(a) A single bank may not be able to create derivative deposits in excess of its cash
reserves. But the banking system as a whole can do what a single bank cannot do.

(b) As Crowther points out that the total net deposits of commercial banks are for in
excess of their cash reserves. It means they can create credit.

Limitation on Credit Creation

The commercial banks do not have unlimited power of credit creation. Their power to
create credit is limited by the following factors:

1. Amount of Cash: The power to create credit depends on the cash received by banks.
If banks receive more cash, they can create more credit. If they receive less cash they
can create less credit. Cash supply is controlled by the central bank of the country.

2. Cash Reserve Ratio: All deposits cannot be used for credit creation. Banks must
keep certain percentage of deposits in cash as reserve. The volume of bank credit
depends also on the cash reserve ratio the banks have to keep. If the cash reserve
ratio is increased, the volume of credit that the banks can create will fall. If the cash
reserve ratio is lowered, the bank credit will increase. The Central Bank has the
power to prescribe and change the cash reserve ratio to be kept by the commercial
banks. Thus the central bank can change the volume of credit by changing the cash
reserve ratio.
3. Banking Habits of the People: The loan advanced to a customer should again come
back into banks as primary deposit. Then only there can be multiple expansion. This
will happen only when the banking habit among the people is well developed. They
should keep their money in the banks as deposits and use cheques for the settlement
of transactions.

4. Nature of Business Conditions in the Economy: Credit creation will depend

upon the nature of business conditions. Credit creation will be large during a
period of prosperity, while it will be smaller during a depression. During periods
of prosperity, there will be more demand for loans and advances for investment
purposes. Many people approach banks for loans and advances. Hence, the volume
of bank credit will be high. During periods of business depression, the amount of
loans and advances will be small because businessmen and industrialists may not
come to borrow. Hence the volume of bank credit will be low.

5. Leakages in Credit-Creation: There may be some leakages in the process of credit

creation. The funds may not flow smoothly from one bank to another. Some people
may keep a portion of their amount as idle cash.

6. Sound Securities: A bank creates credit in the process of acquiring sound and
profitable assets, like bills, and government securities. If people cannot offer sound
securities, a bank cannot create credit. Crowther says “a bank cannot create money
out of thin air. It transmutes other forms of wealth into money.”

7. Liquidity Preference: If people desire to hold more cash, the power of banks to
create credit is reduced.

8. Monetary Policy of the Central Bank: The extent of credit creation will largely
depend upon the monetary policy of the Central Bank of the country. The Central
Bank has the power to influence the volume of money in circulation and through
this it can influence the volume of credit created by the banks. The Central Bank has
also certain powerful weapons, like the bank rate, open market operations with the
help of which it can exercise control on the expansion and contraction of credit by
the commercial bank.

Thus, the ability of the bank to create credit is subject to various limitations.
Still, one should not undermine the importance of the function of credit creation
of the banks. This function has far-reaching effect on the working of the economy,
especially on the business activity. Bank credit is the oil which lubricates the wheels
of the business machine.
 UNIT BANING V/S BRANCH BANKING
The banking system in different countries vary substantially from one another. Broadly
speaking, however, there are two important types of banking systems, viz., unit banking and
branch banking.

A. Unit Banking

‘Unit banking’ means a system of banking under which banking services are provided by a
single banking organisation. Such a bank has a single office or place of work. It has its own
governing body or board of directors. It functions independently and is not controlled by any
other individual, firm or body corporate. It also does not control any other bank. Such banks
can become member of the clearing house and also of the Banker’s Association. Unit banking
system originated and grew in the U.S.A. Different unit banks in the U.S.A. are linked with
each other and with other financial centres in the country through “correspondent banks.”

Advantages of Unit Banking

Following are the main advantages of unit banking:

1. Efficient Management: One of the most important advantages of unit banking

system is that it can be managed efficiently because of its size and work. Co-ordination
and control becomes effective. There is no communication gap between the persons
making decisions and those executing such decisions.

2. Better Service: Unit banks can render efficient service to their customers. Their area
of operation being limited, they can concentrate well on that limited area and provide
best possible service. Moreover, they can take care of all banking requirements
of a particular area.

3. Close Customer-banker Relations: Since the area of operation is limited the

customers can have direct contact. Their grievances can be redressed then and
there.

4. No Evil Effects Due to Strikes or Closure: In case there is a strike or closure of

a unit, it does not have much impact on the trade and industry because of its small
size. It does not affect the entire banking system.

5. No Monopolistic Practices: Since the size of the bank and area of its operation are
limited, it is difficult for the bank to adopt monopolistic practices. Moreover, there is free
competition. It will not be possible for the bank to indulge in monopolistic practices.

6. No Risks of Fraud: Due to small size of the bank, there is stricter and closer
control of management. Therefore, the employees will not be able to commit fraud.

7. Closure of Inefficient Banks: Inefficient banks will be automatically closed as

they would not be able to satisfy their customers by providing efficient service.
8. Local Development: Unit banking is localised banking. The unit bank has the
specialised knowledge of the local problems and serves the requirement of the local
people in a better manner than branch banking. The funds of the locality are utilised
for the local development and are not transferred to other areas.

9. Promotes Regional Balance: Under unit banking system, there is no transfer

of resources from rural and backward areas to the big industrial and commercial
centres. This tends to reduce regional imbalance.

Disadvantages of Unit Banking

1. No Economies of Large Scale: Since the size of a unit bank is small, it cannot reap
the advantages of large scale viz., division of labour and specialisation.

2. Lack of Uniformity in Interest Rates: In unit banking system there will be large
number of banks in operation. There will be lack of control and therefore their rates
of interest would differ widely from place to place. Moreover, transfer of funds will
be difficult and costly.

3. Lack of Control: Since the number of unit banks is very large, their co-ordination
and control would become very difficult.

4. Risks of Bank’s Failure: Unit banks are more exposed to closure risks. Bigger unit
can compensate their losses at some branches against profits at the others. This is not
possible in case of smaller banks. Hence, they have to face closure sooner or later.

5. Limited Resources: Under unit banking system the size of bank is small.
Consequently its resources are also limited. Hence, they cannot meet the requirements
of large scale industries.

6. Unhealthy Competition: A number of unit banks come into existence at an

important business centre. In order to attract customers they indulge in unhealthy
competition.

7. Wastage of National Resources: Unit banks concentrate in big metropolitan cities

whereas they do not have their places of work in rural areas. Consequently there is
uneven and unbalanced growth of banking facilities.

8. No Banking Development in Backward Areas: Unit banks, because of their

limited resources, cannot afford to open uneconomic branches in smaller towns and
rural areas. As such, these areas remain unbanked.

9. Local Pressure: Since unit banks are highly localised in their business, local
pressures and interferences generally disrupt their normal functioning.
B. Branch Banking System

It means a system of banking in which a banking organisation works at more than one place.
The main place of business is called head office and the other places of business are called
branches. The head office controls and co-ordinates the work at branches. The day-to-day
operations are performed by the branch manager as per the policies and directions issued
from time to time by the head office.

This system of banking is prevalent throughout the world. In India also, all the major
banks have been operating under branch banking system.

Advantages of Branch Banking

1. Better Banking Services: Such banks, because of their large size can enjoy the
economies of large scale viz., division of work and specialisation. These banks can
also afford to have the specialised services of bank personnel which the unit banks
can hardly afford.

2. Extensive Service: Branch banking can provide extensive service to cover large
area. They can open their branches throughout the country and even in foreign
countries.

3. Decentralisation of Risks: In branch banking system branches are not concentrated

at one place or in one industry. These are decentralised at different places and in
different industries. Hence the risks are also distributed.

4. Uniform Rates of Interest: In branch banking, there is better control and coordination
of the central bank. Consequently interest rates can be uniform.

5. Better Cash Management: In branch banking there can be better cash management
as cash easily be transferred from one branch to another. Therefore, there will be
lesser need to keep the cash idle for meeting contingencies.

6. Better Training Facilities to Employees: Under branch banking the size of the
bank is quite large. Therefore, such banks can afford to provide better training
facilities to their employees. Almost every nationalised bank in India has its separate
training college.

7. Easy and Economical Transfer of Funds: Under branch banking, a bank has
a widespread of branches. Therefore, it is easier and economical to transfer funds
from one branch to the other.

8. Better Investment of Funds: Such bank can afford the services of specialised and
expert staff. Therefore they invest their funds in such industries where they get the
highest return and appreciation without sacrificing the safety and liquidity of funds.

9. Effective Central Bank Control: Under branch banking, the central bank has to
deal only with a few big banks controlling a large number of branches. It is always
easier and more convenient to the central bank to regulate and control the credit
policies of a few big banks, than to regulate and control the activities of a large number
of small unit banks. This ensures better implementation of monetary policy.
10. Contacts with the Whole Country: Under branch banking, the bank maintains
continual contacts with all parts of the country. This helps it to acquire correct
and reliable knowledge about economic conditions in various parts of the country.
This knowledge enables the bank to make a proper and profitable investment of its
surplus funds.

11. Greater Public Confidence: A bank, with huge financial resources and number
of branches spread throughout the country, can command greater public confidence
than a small unit bank with limited resources and one or a few branches.

Disadvantages of Branch Banking

Following are the disadvantages of branch banking:

1. Difficulties of Management, Supervision and Control: Since there are hundreds

of branches of a bank under this system, management, supervision and control
became more inconvenient and difficult. There are possibilities of mismanagement
in branches. Branch managers may misuse their position and misappropriate funds.
There is great scope for fraud. Thus there are possibilities of fraud and irregularities
in the financial management of the bank.

2. Lack of Initiative: The branches of the bank under this system suffer from a
complete lack of initiative on important banking problems confronting them. No
branch of the bank can take decision on important problems without consulting the
head office. Consequently, the branches of the bank find themselves unable to carry
on banking activities in accordance with the requirements of the local situation.
This makes the banking system rigid and inelastic in its functioning. This also leads
to “red-tapism” which means “official delay.”

3. Monopolistic Tendencies: Branch banking encourages monopolistic tendencies

in the banking system. A few big banks dominate and control the whole banking
system of the country through their branches. This can lead to the concentration of
resources in the hands of a small number of men. Such a monopoly power is a source
of danger to the community, whose goal is a socialistic pattern of society.

4. Regional Imbalances: Under the branch banking system, the financial resources
collected in the smaller and backward regions are transferred to the bigger industrial
centres. This encourages regional imbalances in the country.

5. Continuance of Non-profitable Branches: Under branch banking, the weak and

unprofitable branches continue to operate under the protection cover of the stronger
and profitable branches.

6. Unnecessary Competition: Branch banking is delocalised banking, under branch

banking system, the branches of different banks get concentrated at certain places,
particularly in big towns and cities. This gives rise to unnecessary and unhealthy
competition among them. The branches of the competing banks try to tempt
customers by offering extra inducements and facilities to them. This naturally
increases the banking expenditure.
7. Expensiveness: Branch banking system is much more expensive than the unit
banking system. When a bank opens a number of branches at different places, then
there arises the problem of co-ordinating their activities with others. This necessitates
the employment of expensive staff by the bank.

8. Losses by Some Branches Affect Others: When some branches suffer losses due
to certain reasons, this has its repercussions on other branches of the bank.

Thus branch banking system as well as unit banking system suffer from defects
and drawbacks. But the branch banking system is, on the whole, better than the
unit banking system. In fact, the branch banking system has proved more suitable
for backward and developing countries like India. Branch banking is very popular
and successful in India. A comparison between unit banking and branch banking is
essentially a comparison between small-scale and large-scale operations.
 COMMERCIAL BANKS & ECONOMIC DEVELOPMENT
Commercial banks are considered not merely as dealers in money but also the leaders in
economic development. They are not only the store houses of the country’s wealth but also
the reservoirs of resources necessary for economic development. They play an important role
in the economic development of a country. A well-developed banking system is essential
for the economic development of a country. The “Industrial Revolution” in Europe in the
19th century would not have been possible without a sound system of commercial banking.
In case of developing countries like India, the commercial banks are considered to be the
backbone of the economy. Commercial banks can contribute to a country’s economic
development in the following ways :

1. Accelerating the Rate of Capital Formation: Capital formation is the most

important determinant of economic development. The basic problem of a developing
economy is slow rate of capital formation. Banks promote capital formation.
They encourage the habit of saving among people. They mobilise idle resources
for production purposes. Economic development depends upon the diversion of
economic resources from consumption to capital formation. Banks help in this
direction by encouraging saving and mobilising them for productive uses.

2. Provision of Finance and Credit: Commercial banks are a very important source
of finance and credit for industry and trade. Credit is a pillar of development. Credit
lubricates all commerce and trade. Banks become the nerve centre of all commerce
and trade. Banks are instruments for developing internal as well as external trade.

3. Monetisation of Economy: An underdeveloped economy is characterised by the

existence of a large non-monetised sector. The existence of this non-monetised sector
is a hindrance in the economic development of the country. The banks, by opening
branches in rural and backward areas can promote the process of monetisation
(conversion of debt into money) in the economy.

4. Innovations: Innovations are an essential prerequisite for economic development.

These innovations are mostly financed by bank credit in the developed countries. But
in underdeveloped countries, entrepreneurs hesitate to invest in new ventures and
undertake innovations largely due to lack of funds. Facilities of bank loans enable
the entrepreneurs to step up their investment on innovational activities, adopt new
methods of production and increase productive capacity of the economy.

5. Implementation of Monetary Policy: Economic development need an appropriate

monetary policy. But a well-developed banking is a necessary pre-condition for the
effective implementation of the monetary policy. Control and regulation of credit
by the monetary authority is not possible without the active co-operation of the
banking system in the country.

6. Encouragement to Right Type of Industries: Banks generally provide financial

resources to the right type of industries to secure the necessary material, machines
and other inputs. In this way they influence the nature and volume of industrial
production.
7. Development of Agriculture: Underdeveloped economies are primarily agricultural
economies. Majority of the population in these economies live in rural areas.
Therefore, economic development in these economies requires the development of
agriculture and small scale industries in rural areas. So far banks in underdeveloped
countries have been paying more attention to trade and commerce and have almost
neglected agriculture and industry. Banks must provide loans to agriculture for
development and modernisation of agriculture. In recent years, the State Bank of
India and other commercial banks are granting short term, medium-term and longterm
loans to agriculture and small-scale industries.

8. Regional Development: Banks can also play an important role in achieving

balanced development in different regions of the country. They transfer surplus
capital from the developed regions to the less developed regions, where it is scarce
and most needed. This reallocation of funds between regions will promote economic
development in underdeveloped areas of the country.

9. Promote Industrial Development: Industrial development needs finance. In

some countries, commercial banks encouraged industrial development by granting
long-term loans also. Loan or credit is a pillar to development. In underdeveloped
countries like India, commercial banks are granting short-term and medium-term
loans to industries. They are also underwriting the issue of shares and debentures
by industrial concerns. This helps industrial concerns to secure adequate capital for
their establishment, expansion and modernisation. Commercial banks are also
helping manufacturers to secure machinery and equipment from foreign countries
under instalment system by guaranteeing deferred payments. Thus, banks promote
or encourage industrial development.

10. Promote Commercial Virtues: The businessmen are more afraid of a banker than
a preacher. The businessmen should have certain business qualities like industry,
forethought, honesty and punctuality. These qualities are called “commercial virtues”
which are essential for rapid economic progress. The banker is in a better position
to promote commercial virtues. Banks are called “public conservators of commercial
virtues.”

11. Fulfillment of Socio-economic Objectives: In recent years, commercial banks,

particularly in developing countries, have been called upon to help achieve certain
socio-economic objectives laid down by the state. For example, nationalised bank in
India have framed special innovative schemes of credit to help small agriculturists,
self-employed persons and retailers through loans and advances at concessional
rates of interest. Banking is thus used to achieve the national policy objectives of
reducing inequalities of income and wealth, removal of poverty and elimination of
unemployment in the country.

Thus, banks in a developing country have to play a dynamic role. Economic development
places heavy demand on the resources and ingenuity of the banking system. It has to respond
to the multifarious economic needs of a developing country. Traditional views and methods
may have to be discarded. “An Institution, such as the banking system, which touches and
should touch the lives of millions, has necessarily to be inspired by a larger social purpose
and has to subserve national priorities and objectives.” A well-developed banking system
provides a firm and durable foundation for the economic development of the country.
Conclusion
From the above discussion, undoubtedly, we can say that, commercial banks form the most
important part of financial intermediaries. It accepts deposits from the general public and
extends loans to the households, firms and the government. Banks form a significant part of the
infrastructure essential for breaking vicious circle of poverty and promoting economic growth.
 CENTRAL BANKING
INTRODUCTION

A central bank is an ‘apex institution’ in the banking structure of a country. It supervises,

controls and regulates the activities of commercial banks and acts as a banker to them. It also
acts as a banker, agent and adviser to the government in all financial and monetary matters.
A central bank is also the custodian of the foreign balances of the country and is responsible to
maintain the rate of exchange fixed by the government and manages exchange control. The
most important function of a central bank is to regulate the volume of currency and credit in
a country. It will be no exaggeration to say that a modern central bank is the central arch to
the monetary and fiscal framework in almost all the countries developed or developing in the
world. In developing economies, the central bank has also to perform certain promotional
and developmental functions to accelerate the pace of economic growth.

Meaning of Central Bank

In every country there is one bank which acts as the leader of the money market, supervising,
controlling and regulating the activities of commercial banks and other financial institutions.
It acts as a bank of issue and is in close touch with the government, as banker, agent and
adviser to the latter. Such a bank is known as the central bank of the country.

Definition of Central Bank

A banking institution can more easily be identified by the functions that it performs.

According to Vera Smith, “the primary definition of central banking is a banking system in
which a single bank has either a complete or residuary monopoly in the note issue.”

Kisch and Elkin believe that “the essential function of a central bank is the maintenance of the
stability of the monetary standard.” In the statutes of the Bank for International Settlements
a central bank is defined as “the bank of the country to which has been entrusted the duty
of regulating the volume of currency and credit in that country.”

De Kock gives a very comprehensive definition of central bank. According to De Kock, a central
bank is a bankwhich constitutes the apex of the monetary and banking structure of its country
and whichperforms, best it can in the national economic interest, the following functions:

(a) The regulation of currency in accordance with the requirements of business and the
general public, for which purpose it is granted either the sole right of note issue or at
least a partial monopoly thereof.
(b) The performance of general banking and agency services for the state.
(c) The custody of cash reserves of the commercial banks.
(d) The custody and management of the nation’s reserves of international currency.
(e) The granting of accommodation, in the form of rediscounts, or collateral advances,
to commercial banks, bill brokers and dealers, or other financial institutions, and the
general acceptance of the responsibility of lender of last resort.
(f) The settlement of clearances between the banks.
(g) The control of credit in accordance with the needs of business and with a view to
 carrying out the broad monetary policy adopted by the state.

The nature of function of a central bank differs in a developed economy as compared to

those in a developing economy.

Objectives of the
Central Banking

Maintain internal
value of currency
Promote financial
institutions

Preserve the external Promote economic

value of rupee growth

Ensure price
stability

Functions of the Central Bank

The functions of the central bank differ from country to country in accordance with the
prevailing economic situation. But there are certain functions which are commonly performed
by the central bank in all countries. According to De Kock, there are six functions which are
performed by the central bank in almost all countries.

Functions of Central Banking

Monopoly of Note Issue

Custodian of Exchange Reserves

Banker to the Government

Banker to Commercial Banks

Controller of Credit

Promoter of Economic Development

1. Monopoly of Note Issue: The issue of money was always the prerogative of the
government. Keeping the minting of coins with itself, the government delegated the
right of printing currency notes to the central bank. In fact the right and privilege of
note issue was always associated with the origin and development of central banks
which were originally called as banks of issue. Nowadays, central banks everywhere
enjoy the exclusive monopoly of note issue and the currency notes issued by the
central banks are declared unlimited legal tender throughout the country. At one
time, even commercial banks could issue currency notes but there were certain evils
in such a system such as lack of uniformity in note issue, possibility of over-issue
by individual banks and profits of note issue being enjoyed only by a few private
shareholders. But concentration of note issue in the central bank brings about
uniformity in note issue, which, in turn, facilitates trade and exchange within the
country, attaches distinctive prestige to the currency notes, enables the central bank
to influence and control the credit creation of commercial banks, avoids the overissue
of notes and, lastly, enables the government to appropriate partly or fully the
profits of note issue. The central bank keeps three considerations in view as regards
issue of notes-uniformity, elasticity (amount according to the need for money), and
safety.

2. Custodian of Exchange Reserves: The central bank holds all foreign exchange
reserves-key currencies such as U.S. dollars, British pounds and other prominent
currencies, gold stock, gold bullion, and other such reserves-in its custody. This
right of the central bank enables it to exercise a reasonable control over foreign
exchange, for example, to maintain the country’s international liquidity position at
a safe margin and to maintain the external value of the country’s currency in terms
of key foreign currencies.

3. Banker to the Government: Central banks everywhere perform the functions of

banker, agent and adviser to the government. As a banker to the government, the
central bank of the country keeps the banking accounts of the government both of the
Centre and of the States performs the same functions as a commercial bank ordinarily
does for its customers. As a banker and agent to the government, the central bank
makes and receives payments on behalf of the government. It helps the government
with short-term loans and advances (known as ways and means advances) to tide
over temporary difficulties and also floats public loans for the government. It also
manages the public debt (i.e., floats services and redeems government loans). It
advises the government on monetary and economic matters.

4. Banker to Commercial Banks: Broadly speaking, the central bank acts as the
banker’s bank in three different capacities: (a) It acts as the custodian of the cash
reserves of the commercial banks (b) It acts as the lender of the last resort (c) It is the
bank of central clearance, settlement and transfer. We shall now discuss these three
functions one by one.

(a) It acts as the custodian of the cash reserves of commercial banks: Commercial banks
keep part of their cash balances as deposits with the central bank of a country
known as centralisation of cash reserves. Part of these balances are meant for
clearing purposes, that is, payment by one bank to another will be simple book
entry adjustment in the books of the central bank. There are many advantages
when all banks keep part of their cash reserves with the central bank of the
country. In the first place, with the same amount of cash reserves, a large amount
of credit creation is possible. Secondly, centralised cash reserves will enable
commercial banks to meet crises and emergencies. Thirdly, it enables the central
bank to provide additional funds to those banking institutions which are in
temporary difficulties. Lastly, it enables the central bank to influence and control
the credit creation of commercial banks by making the cash reserves of the latter
more or less.

(b) Lender of the last resort: As the banker’s bank, the central bank can never refuse to
accommodate commercial banks. Any commercial bank wanting accommodation
from the central bank can do so by rediscounting (selling) eligible securities with
the central bank or can borrow from the central bank against eligible securities.
By lender of the last resort, it is implied that the latter assumes the responsibility
of meeting directly or indirectly all reasonable demands for accommodation by
commercial banks in times of difficulties and crisis.

(c) Clearing agent: As the central bank becomes the custodian of cash reserves of
commercial banks, it is but logical for it to act as a settlement bank or a clearing
house for other banks. As all banks have their accounts with the central bank,
the claims of banks against each other are settled by simple transfers from and
to their accounts. This method of settling accounts through the central bank,
apart from being convenient, is economical as regards the use of cash. Since
claims are adjusted through accounts, there is usually no need for cash. It also
strengthens the banking system by reducing withdrawals of cash in times of crisis.
Furthermore, it keeps the central bank of informed about the state of liquidity of
commercial banks in regard to their assets.

5. Controller of Credit: Probably the most important of all the functions performed
by a central bank is that of controlling the credit operations of commercial banks. In
modern times, bank credit has become the most important source of money in the
country, relegating coins and currency notes to a minor position. Moreover, it
is possible, as we have pointed out in a previous chapter, for commercial banks to
expand credit and thus intensify inflationary pressure or contract credit and thus
contribute to a deflationary situation. It is, thus, of great importance that there should
be some authority which will control the credit creation by commercial banks. As
controller of credit, the central bank attempts to influence and control the volume of
bank credit and also to stabilise business conditions in the country.

6. Promoter of Economic Development: In developing economies the central bank

has to play a very important part in the economic development of the country. Its
monetary policy is carried out with the object of serving as an instrument of planned
economic development with stability. The central bank performs the function of
developing long-term financial institutions, also known as development banks,
to make available adequate investible funds for the development of agriculture,
industry, foreign trade, and other sectors of the economy. The central bank has also
to develop money and capital markets.
In addition, the central bank may also undertake miscellaneous functions such
as providing assistance to farmers through co-operative societies by subscribing to
their share capital, promoting finance corporations with a view to providing loans
to large-scale and small-scale industries and publishing statistical reports on tends
in the money and capital markets. In short, a central bank is an institution which
always works in the best economic interests of the nation as a whole. In view of all
these functions, as discussed above, it follows that a modern central bank is much
more than a Bank of Issue.

CREDIT CONTROL

It means the regulation of the creation and contraction of credit in the economy. It is an
important function of central bank of any country. The importance of credit control has
increased because of the growth of bank credit and other forms of credit. Commercial banks
increase the total amount of money in circulation in the country through the mechanism
of credit creation. In addition, businessmen buy and sell goods and services on credit basis.
Because of these developments, most countries of the world are based on credit economy
rather than money economy.

Fluctuations in the volume of credit cause fluctuations in the purchasing power

of money. This fact has far reaching economic and social consequences. That is
why, credit control has become an important function of any central bank. For
instance, the preamble to the Bank of Canada Act states that the Bank of Canada will
regulate credit in Canada. In India, the Reserve Bank has been given wide powers
to control credit creation and contraction by commercial banks. Before we discuss
the techniques of credit control, it is desirable to understand the objectives of credit
control.

Objectives of Credit Control

The central bank is usually given many weapons to control the volume of credit in the
country. The use of these weapons is guided by the following objectives:

(a) Stability of Internal Price-level: The commercial bank can create credit because their
main task is borrowing and lending. They create credit without any increase in cash
with them. This leads to increase in the purchasing power of many people which may
lead to an increase in the prices. The central bank applies its credit control to bring
about a proper adjustment between the supply of credit and measures requirements
of credit in the country. This will help in keeping the prices stable.

(b) Checking Booms and Depressions: The operation of trade cycles causes instability in
the country. So the objective of the credit control should be to reduce the uncertainties
caused by these cycles. The central bank adjusts the operation of the trade cycles by
increasing and decreasing the volume of credit.

(c) Promotion of Economic Development: The objective of credit control should be to promote
economic development and employment in the country. When there is lack of money,
its supply should be increased so that there are more and more economic activities and
more and more people may get employment. While resorting to credit squeeze, the
central bank should see that these objectives are not affected adversely.
(d) Stability of the Money Market: The central bank should operate its weapons of credit
control so as to neutralise the seasonal variations in the demand for funds in the
country. It should liberalise credit in terms of financial stringencies to bring about
stability in the money market.

(e) Stability in Exchange Rates: This is also an important objective of credit control.
Credit control measures certainly influence the price level in the country. The
internal price level affects the volume of exports and imports of the country which
may bring fluctuations in the foreign exchange rates. While using any measure of
credit control, it should be ensured that there will be no violent fluctuation in the
exchange rates.

Methods of Credit Control

The various methods employed by the central bank to control credit creation power of the
commercial banks can be classified in two groups viz., quantitative controls, and qualitative
controls.

Quantitative controls are designed to regulate the volume of credit created by the
banking system. These measures work through influencing the demand and supply of credit.
Quantitative measures, on the other hand, are designed to regulate the flow of credit in
specific uses.

1. Quantitative Methods: Quantitative methods aim at controlling the total volume

of credit in the country. They relate to the volume and cost of bank credit in general,
without regard to the particular field of enterprise or economic activity in which the
credit is used.
The important quantitative or general methods of credit control are as follows:

A. Bank Rate or Discount Rate Policy

Bank Rate Policy or the Discount Rate Policy has been the earliest instrument of quantitative
credit control. It was the Bank of England which experimented with the bank rate policy
for the first time as a technique of monetary management. Now every central bank has been
endowed with this instrument of credit control.

Meaning

Bank rate refers to the official minimum lending rate of interest of the central bank. It is
the rate at which the central bank advances loans to the commercial banks by rediscounting
the approved first class bills of exchange of the banks. Hence, bank rate is also called as the
discount rate.

Theory of Bank Rate

The theory underlying the operation of bank rate is that by manipulating the bank rate, the
central bank is in a position to exercise influence upon the supply of credit in the economy.
According to the theory of bank rate an increase or a decrease in the bank rate leads to a
reduction or an increase in the supply of credit in the economy. This is possible because
changes in the bank rate bring about changes in the other rates of interest in the economy.

Working of Bank Rate

As mentioned above, by manipulating the bank rate it is possible to effect changes in the
supply of credit in the economy. During a period of inflation, to arrest the rise in the price
level, the central bank raises the bank rate. When the bank rate is raised, all other interest
rates in the economy also go up. As a result, the commercial bank also raise their lending
rates. The consequence is an increase in the cost of credit. This discourages borrowing and
hence investment activity is curbed in the economy. This will bring about a reduction in the
supply of credit and money in the economy and therefore in the level of prices.
On the other hand, during a period of deflation, the central bank will lower the bank rate
in order to encourage business activity in the economy. When the bank rate is lowered, all
other interest rates in the economy also come down. The banks increase the supply of credit
by reducing their lending rates. A reduction in the bank rate stimulates investment and the
fall in the price level is arrested.

The Process of Bank Rate Influence

Regarding the process through which changes in the bank rate influence the supply of credit,
the level of business activity and the price level, we can distinguish two approaches. One put
forth by R.G. Hawtrey and the other one associated with J.M. Keynes.
In the opinion of Hawtrey, changes in the bank rate operate through changes in the short
term rates of interest. These changes in the short term interest rates, in their turn, influence
the cost of borrowing by businessmen and industrialists.
But, according to Lord Keynes, changes in bank rate become effective through changes
in the long term interest rates as reflected by changes in the capital value of long term
securities.
But, it should be noted that there is not much difference between the two approaches
and hence they are complementary to each other.

Bank Rate Under the Gold Standard

Under the gold standard, bank rate was used primarily to set right the disequilibrium in the
balance of payments of the country. When there was a deficit in the balance of payments and
hence an outflow of gold, bank rate was raised to check the outflow of gold. This was done by
attracting the inflow of short term capital into the country.

Conditions for the Success of the Bank Rate Policy

The efficacy of bank rate as an instrument of monetary management calls for the fulfillment
of the following conditions:

(a) Close relationship between bank rate and other interest rates: It is necessary that the
relationship between bank rate and the other interest in the economy should be
close and direct. Changes in the rate should bring about similar and appropriate
changes in the other interest rates in the economy. Otherwise the efficacy of bank
rate will be limited. There is, therefore, the need for the existence of an integrated
interest rate structure.

(b) Existence of an elastic economic system: The success of bank rate requires the existence
of an elastic economic structure. That is, the entire economic system should be
perfectly flexible to accommodate itself to changes in the bank rate. Changes in the
bank rate should bring about similar and desirable changes in prices, costs, wages,
output, profits, etc. The existence of a rigid economic structure will reduce the
efficacy of bank rate.

(c) Existence of short term funds market: Another condition required for the success of
bank rate policy is the existence of market for short term funds in the country. This
will help to handle foreign as well as domestic funds that come up on account of
changes in the interest rates, following changes in the bank rate.

Before the First World War, bank rate policy was very effective as an instrument of
quantitative credit control because, the conditions necessary for the success of bank rate
were there. But, after the war, the significance of bank rate began to wane because the
post-war atmosphere was not conducive for the smooth and effective operation of the bank
rate policy.

Limitations

The Bank Rate Policy suffers from the following limitations:

(a) It has been argued that bank rate proves ineffective to combat boom and depression.
During a period of boom, investment is interest inelastic. Even if the bank rate is
raised to any extent, investment activity will not be curbed, because during a period
of boom, the marginal efficiency of capital will be very high and the entire business
community will be caught in a sweep of optimism. During depression, bank rate
becomes ineffective following the general psychology of diffidence and pessimism
among the business circles.
(b) The growth of non-banking financial intermediaries has proved an effective threat to
the effectiveness of bank rate policy. It has been adequately established by the study
of the Redcliffe Report and Gurley-Shaw, that the mushroom growth of non-banking
financial intermediaries has belittled the significance of bank rate. This is because
changes in the bank rate immediately affect the rates of interest of the commercial
banks only and the non-banking financial institutions are not subject to the direct
control of the central bank. Hence, it is said that “the good boy is punished for
the actions of a bad boy.”

(c) The decline in the use of bills of exchange as credit instruments also has been
responsible for the decline in the importance of bank rate.

(d) Further, of late, businessmen have found out alternative methods of business
financing, self-financing, ploughing back the profits, public deposits, etc. Indeed, the
role of commercial banks as suppliers of loanable funds has been decreasing in
importance.

(e) Moreover, the economic structure has not been adequately responding itself to
changes in the bank rate. After the war, all kinds of rigidities have crept into the
economic system.

(f) The invention of alternative instruments of credit control also has accounted for the
decline in the popularity of bank rate.

(g) Further, the dependence of the commercial bank on the central bank for loans also
has decreased leading to the decline in getting the bills of exchange rediscounted by
the central bank. In addition, there has been an increased liquidity in the assets of
banks.

(h) Finally, the increase in the importance of fiscal policy following the Great Depression
of 1930’s has also reduced the importance of bank take policy as a technique of credit
control.

However, in spite of the above limitations that the bank rate policy is subject to, it
would be wrong to undermine the significance of bank rate as a tool monetary management.
Though, by itself, it may not yield the desirable results, but will certainly prove effective
when used with other instruments of credit control. The scope for the use of bank rate by the
central bank, therefore, cannot be completely ruled out. The bank rate has undergone a
significant revival. Its significance in controlling inflation cannot be undermined.
B. Open Market Operations

After the First World War, bank rate policy as a tool of monetary management began to loose
its significance following the invention of alternative techniques of credit control. Among
the alternative instruments of quantitative credit control invented in the post-war period,
open market operations assumed significance.

Meaning
Open market operations refer to the purchase and sale of securities by the central bank. In
its broader sense, the term includes the purchase and sale of both government and private
securities. But, in its narrow connotation, open market operations embrace the purchase
and sale of government securities only. It was in Germany that open market operations took
its birth as an instrument of quantitative credit control.

Theory of Open Market Operations

The theory underlying the operation of open market operations is that by the purchase
and sale of securities, the central bank is in a position to increase or decrease the cash
reserves of the commercial banks and therefore increase or decrease the supply of credit in
the economy.

The modus operandi of open market operations can now be explained. During a period
of inflation, the central bank seeks to reduce the supply of credit in the economy. Hence,
it sells the securities to the banks, public and others. As a result of the sale of securities by
the central bank, there will be a transfer of cash from the buyers to the central bank. This
will reduce the cash reserves of the commercial banks. The public has to withdraw money
from their accounts in the banks to pay for the securities purchased from the central bank.
And the commercial banks themselves will have to transfer some amount to the central
bank for having purchased the securities. All this shrinks the volume of cash in the vaults
of the banks. As a result the banks will be unable to expand the supply of credit. When the
supply of credit is reduced by the banking system, the consequences on the economy will be
obvious. Investment activity is discouraged ultimately leading to a fall in the price level.
On the other hand, during a period of deflation, in order to inject more and more credit
in to the economy, the central bank purchases the securities. This will have an encouraging
effect on investment because the banks supply more credit following an increase in their
cash reserves. Thus, the central bank seeks to combat deflation in the economy.

Objectives of Open Market Operations

The main objectives of open market operations are:

(a) To eliminate the effects of exports and imports to gold under the gold standard.
(b) To impose a check on the export of capital.
(c) To remove the shortage of money in the money market.
(d) To make bank rate more effective.
(e) To prevent a ‘run on the bank’.
Conditions for the Success of Open Market Operations

The efficacy of open market operations as a tool of quantitative credit control requires the
fulfillment of certain conditions discussed below.

1. Institutional Framework: The success of open market operations requires the

existence of an institutional framework, that is, the existence of a well-knit and well
developed securities market. The absence of a matured money market constitutes a
serious impediment to the development of open market operations as an effective
instrument of monetary control. In fact, in the under developed countries, the scope
for open market operations is limited because of the absence of the institutional
framework referred to above.

2. Legal Framework: The effective and meaningful functioning of open market

operations calls for a suitable legal setting. The legal setting is that there should
be no legal restrictions on the holding of securities by the central bank. It has
been found that in some countries the governments have imposed ceilings on the
holdings of government securities by central banks. Such legal restrictions obviously
circumscribe the efficacy of open market operations.

3. Maintenance of a Definite Cash Reserve Ratio: Another condition that should

be fulfilled for the success of open market operations is that the cash reserves of the
banks should change in accordance with the purchase and sale of securities by the
central bank. When the central bank purchases the securities, the cash reserves
of the banks should increase and when the central bank sells the securities, the
cash reserves of the banks should fall. This means that the banks should maintain a
definite cash reserve ratio. But, if the banks keep the cash reserves in excess of the
fixed ratio or have other secret reserves, the very purpose of open market operations
will be defeated.

4. Non-operation of Extraneous Factors: Due to the operation of certain

extraneous factors the cash reserves of the banks may not change in accordance
with the requirement of open market operations. For example, when the central
bank purchases the securities in order to inject more credit into the economy, this
objective may be defeated by an outflow of money due to unfavourable balance of
payments or the public may hoard a part of the additional cash put into circulation.

5. Non-existence of Direct Access of Commercial Banks to the Central Bank:

Another important condition for the smooth working of the open market operations
is that the commercial banks should not have direct access to the central bank for
financial accommodation. In case the banks have direct accommodation to the
central bank, then the reduction in their cash reserves through open market sale of
securities by the central bank may be neutralised by these banks by borrowing from
the central bank.

It should be noted here that the above conditions necessary for the success of open
market operations constitute by themselves the limitations of the open market
operations. In fact, in many countries, particularly in the less developed countries,
the success of open market operations is limited because the above conditions are
not fulfilled.
Popularity of Open Market Operations

Despite the limitations of open market operations, it has been argued that this technique of
credit control is superior to the bank rate policy. The superiority of open market operations
stem from the following points:

(a) The discount rate policy seeks to regulate credit in an indirect way, whereas open
market operations have a more direct and effective influence on the regulation of
credit by the central bank.

(b) The influence of bank rate is on short term interest rates only. The long term interest
rates are influenced only indirectly by changes in bank rate. But, the policy of open
market operations has a direct bearing on the prices of long term securities and hence
on the long term interest rates. It has a direct and immediate effect on the quantity of
money and credit and hence on the market interest rates. It is on this score that the
policy of open market operations is now increasingly used to influence the interest rates
as well as the prices of government securities in the money market.

But, the above two points of the superiority of the policy of open market operations
should not make us blind to the fact that the policy of open market operations will itself help
to achieve the desired results. It is necessary to combine both bank rate and open market
operations judiciously to achieve the desired results. Wherever possible, open market
operations will have to be supplemented by the bank rate policy. This will go a long way in
producing effective results in regulating the volume of credit in the economy.

A. Variable Cash Reserve Ratio

The traditional instruments of quantitative credit control, bank rate policy and open market
operations, suffer from certain inherent defects and have been found unsuitable to serve the
interests of underdeveloped countries. Hence, an entirely new and unorthodox instrument
of quantitative credit control, in the form of variable reserve ratio, came into vogue, thanks to
the Federal Reserve System of the United States. It was, however, Lord Keynes who was
responsible for popularising the use of this novel technique of monetary management. The
Federal Reserve System became the trendsetter by pressing into service variable reserve ratio
for the first time in 1933 as a weapon of quantitative credit control.

Meaning

Variable Reserve Ratio refers to the percentage of the deposits of the commercial banks
to be maintained with the central bank, being subject to variations by the central bank.
In other words, altering the reserve requirements of the commercial banks is called
variable reserve ratio.

It is a well-known fact that all the commercial banks have to maintain a certain percentage
of their deposits as cash reserves with the central bank. The central bank, therefore, acts as
the custodian of the cash reserve of the commercial banks. By doing so, the central bank
imparts liquidity and confidence into the system. This reserve requirement is subject to
changes by the central bank depending upon the monetary needs and conditions of the
economy.
In certain countries, like United States and India, there are clear written laws stipulating
the banks to maintain the reserve requirements with the central bank. Such a reserve ratio is
called the Statutory Reserve Ratio. But, in England, the banks maintain the reserve ratio as
a matter of custom. Hence this kind of reserve ratio is called the Customary Reserve Ratio.
Anyhow, the central bank has the authority to vary the reserve requirements of the banks.

B. Theory of Variable Reserve Ratio

The theory underlying the mechanism of variable reserve ratio is that by varying the reserve
requirements of the banks, the central bank is in a position to influence the size of credit
multiplier of the banks and therefore the supply of credit in the economy. An increase or
decrease in the reserve requirements will have a contractionist or expansionary influence
respectively on the supply of credit by the banking system.

Working of Variable Reserve Ratio

It is interesting to examine the working of variable reserve ratio as a technique of quantitative

credit control. During a period of inflation, the central bank raises the reserve ratio in order
to reduce the supply of credit in the economy and therefore to reduce the price level. When the
reserve requirements of the banks are raised, the excess reserves of the banks shrink and
hence the size of their credit multiplier decreases. It should be noted that the size of credit
multiplier is inversely related to the reserve ratio prescribed by the central bank. An increase
in the reserve ratio, therefore, discourages the commercial banks from expanding the supply
of credit.

On the contrary during a period of deflation, the central bank lowers the reserve
requirements of the banks in order to inject more purchasing power into the economy. When
the reserve ratio is lowered, the excess reserves with the banks increase and hence the size of
credit multiplier increases. This will have an encouraging effect on the ability of the banks
to create credit. Thus, the central bank seeks to combat deflation in the economy.
Another variant of Variable Reserve Ratio is the method of Statutory Liquidity Ratio
(S.L.R.) which is being used by the Reserve Bank of India. In this case, every scheduled bank
in India is required under law to maintain certain liquid assets to meet its liabilities. These
liquid assets comprise cash reserves with the central bank, balances with other banks in
current account and investment in government securities. By varying the S.L.R., the central
bank seeks to influence the credit creating capacity of the commercial banks. This method is
known as the method of Secondary Reserve Requirements, and is being extensively used in
western countries, like France, the U.S., Sweden, etc.

Other variants of Variable Reserve Ratio include the supplementary Reserve

Requirements, Special Accounts System, Special Deposits System, etc.
There is a substantial measure of agreement that variable reserve ratio can be appropriately
pressed into service when a country is experiencing large and sudden movements in its
gold and foreign exchange assets, especially as a result of speculative international capital
movements. The effects of large inflows and outflows of foreign capital can be counteracted
smoothly and effectively by changes in the reserve requirements. Again, by varying the
reserve ratio, it is possible to meet the minor fluctuations and shifts in the balance of
payments position.
Though variable reserve ratio also has been a tool of quantitative credit control. It should
be sharply distinguished from the traditional instruments of the bank rate and open market
operations which belong to the same group. While the bank rate policy and open market
operations alter the volume of free reserves of the banks indirectly by influencing the total
amount of reserves, the variable reserve ratio does so directly. “Whereas the other two
methods are designed to bring about an actual quantitative change in reserve holdings and
thereby in free reserves a change in reserve requirements serves to create or destroy free
reserves by a stroke of pen.”

Limitations

The following constitute the limitations of variable reserve ratio:

(a) In the first place, variable reserve ratio has been considered to be a blunt and harsh
instrument of credit control.

(b) As compared with the open market operations, it is inexact and uncertain as regards
changes not only in the amount of reserves, but also the place where these changes
can be made effective.

(c) Variable reserve ratio is accused of being discriminatory in its effect. It affects
different banks differently. Banks with a large margin of excess reserves would be
hardly affected whereas banks with small excess reserves would be hard pressed.

(d) Variable Reserve Ratio is considered to be inflexible. It lacks flexibility in that

changes in reserve requirements would not be well adjusted to meet small or localized
situations of reserve stringency or superfluity.

(e) This method of credit control is likely to create a panic among the banks and the investors.
(f) Maintaining the reserve ratio with the central bank imposes a burden on the banks
because no interest is allowed on these cash reserves by the central bank.

(g) In the event of the commercial banks having huge foreign funds, the method of
variable reserve ratio proves ineffective.

In view of the above limitations, according to De Kock, variable reserve ratio should be
used “with moderation and discretion and only under abnormal conditions.”

Yet, the case for variable reserve ratio is stronger than for bank rate policy and open
market operations. Variable reserve ratio has the merit of being applied universally. It is
considered to be the battery of the most improved type that the central bank has added to
its armoury of the instruments of credit control. The technique of variable reserve ratio has
been found extremely popular among the central banks of the less developed and the
developing countries. As mentioned earlier, while the success of bank rate and open market
operations calls for the fulfillment of certain conditions, in the case of variable reserve ratio,
the desired results can be achieved just ‘by a stroke of pen’.

From the above, we should not draw the conclusion that any of the three methods is
preferable to the others. The right attitude should be not to accept this method or that
method but to combine all the three methods in right proportions in order to secure effective
results in the field of credit creation. The three methods, as we have seen above, have their
own merits and demerits, and hence, no method, taken alone, can be successful in producing
the desired results. Therefore, a judicious and skilful combination of all the three methods
is essential in order to realize the objectives of credit control. These three methods may be
combined in varying proportions to achieve effective results in the field of credit.

Selective or Qualitative Methods

The central bank may assume that the inflationary pressure in the country is due to artificial
scarcities created by speculators and hoarders who may hoard and black market essential
goods through the use of bank credit. Accordingly, the central bank may not regulate and
control the volume of credit but central the use of credit or the person’s security, etc. Such
controls are known as selective or direct controls. The special features of selective or
qualitative controls are:

(a) They distinguish between essential and non-essential uses of bank credit.

(b) Only non-essential uses are brought under the scope of central bank controls.

(c) They affect not only the lenders but also the borrowers.

Selective controls attempt to cut down the credit extended for non-essential purposes or
uses. Loans extended to speculators to hoard goods or bank credit to consumers to raise their
demand for such durable goods as refrigerators, cars, etc., will prove to be inflationary when
there is already excessive demand as compared to the limited supply. Essentially, therefore,
selective controls are meant to control inflationary pressure in a country.

Objectives

The following are the broad objectives of selective instruments of credit control:
(a) To divert the flow of credit from undesirable and speculative uses to more desirable
and economically more productive and urgent uses.
(b) To regulate a particular sector of the economy without affecting the economy as a
whole.
(c) To regulate the supply of consumer credit.
(d) To stabilise the prices of those goods very much sensitive to inflation.
(e) To stabilise the value of securities.
(f) To correct an unfavourable balance of payments of the country.
(g) To bring under the control of the central bank credit created by non-banking financial
intermediaries.
(h) To exercise control upon the lending operations of the commercial banks.

Measures of Selective Credit Control

For the purpose of selective credit control, the central bank generally uses the following
forms of control, from time to time.

1. Margin Requirements: Banks are required by law to keep a safety margin against
securities on which they lend. The central bank may direct banks to raise or reduce
the margin. In the U.S.A. before World War II, the Federal Reserve Board fixed a
margin of 40 per cent (i.e., a bank could lend up to 60 per cent of the value of
security). But during the war and later, the margin requirements were raised from
40 per cent to 50 per cent, then to 75 per cent and in 1946 to 100 per cent in some
cases. When the margin was raised to 75 per cent one could borrow only 25 per cent
of the value of the security and when the margin requirement was fixed at 100 per
cent one could borrow nothing. Thus by raising the margin requirement, the central
bank could reduce the volume of bank credit which a commercial bank can grant
and a party can borrow. Margin requirement is a good tool to reduce the degree and
extent of speculation in commodity market and stock exchanges.

2. Regulation of Consumer Credit: During the Second World War an acute scarcity of
goods was felt in the U.S.A., and the position was worsened by the system of bank credit
to consumers to enable them to buy durable and semi-durable consumer goods through
instalment buying. The Federal Reserve Banks of the U.S.A., were authorised to regulate
the terms and conditions under which consumer credit was extended by commercial
banks. The restraints under these regulations were two-fold: (a) They limited the amount
of credit that might be granted for the purchase of any article listed in the regulations; and
(b) they limited the time that might be agreed upon for repaying the obligation. Suppose a
buyer was required to make a down-payment of one-third of the purchase price of a car
and the balance to be paid in 15 monthly instalments. Under the regulations restraining
consumer credit, the down-payment was made larger and the time allowed was made
shorter. The result was a reduction in the amount of credit extended for the purchase
of cars and the time it was allowed to run; and the ultimate result was the restriction,
in the demand for consumer goods at a time when there was a shortage in supply and
when there was a necessity for restriction on consumer spending. This measure was a
success in America in controlling inflationary pressures there. In the past-war period, it
has been extensively adopted in all those countries where the system of consumer credit
is common.

3. Rationing of Credit: Rationing of credit, as a tool of selective credit control,

originated in England in the closing years of the 18th century. Rationing of credit
implies two things. First, it means that the central bank fixes a limit upon its
rediscounting facilities for any particular bank. Second, it means that the central
bank fixes the quota of every affiliated bank for financial accommodation from the
central bank.

Rationing of credit occupies an important place in Russian Economic Planning.

The central bank of the Russian Federation allocates the available funds among
different banks in accordance with a definite credit plan formulated by the Planning
Commission.

But the criticism of rationing of credit is that it comes into conflict with the function
of the central bank as a lender of the last resort. When the central bank acts as a
lender of the last resort it cannot deny accommodation to any bank through it has
borrowed in excess of its quota. Moreover, this method proves effective only when
the demand for credit exceeds the supply of it.

4. Control through Directives: In the post-war period, most central banks have been
vested with the direct power of controlling bank advances either by statute or by
mutual consent between the central bank and commercial banks. For instance, the
Banking Regulation Act of India in 1949 specifically empowered the Reserve Bank
of India to give directions to commercial banks in respect of their lending policies,
the purposes for which advances may or may not be made and the margins to be
maintained in respect of secured loans. In England, the commercial banks have
been asked to submit to the Capital Issue Committee all loan applications in
excess of £ 50,000. There is no uniformity in the use of directives to control bank
advances. On the one extreme, the central bank may express concern over credit
developments; the concern may be combined with mild threat to avoid increase or
decrease in the existing level of bank loans. On the extreme, there can be a clear and
open threat to the commercial banks financing certain types of activities.

5. Moral Suation: This is a form of control through directive. In a period of depression,

the central bank may persuade commercial banks to expand their loans and advances,
to accept inferior types of securities which they may not normally accept,
fix lower margins and in general provide favourable conditions to stimulate bank
credit and investment. In a period of inflationary pressure, the central bank may
persuade commercial banks not to apply for further accommodation or not to use the
accommodation already obtained for financing speculative or non-essential activities
lest inflationary pressure should be further worsened. The Bank of England has
used this method with a fair measure of success. But this has been mainly because of
a high degree of co-operation which it always gets from the commercial banks.

6. Direct Action: Direct action or control is one of the extensively used methods of
selective control, by almost all banks at sometime or the other. In a broad sense, it
includes the other methods of selective credit controls. But more specifically, direct
action refers to controls and directions which the central bank may enforce on all
banks or any bank in particular concerning lending and investment. The Reserve
Bank of India issued a directive in 1958 to the entire banking system to refrain from
excessive lending against commodities in general and forbidding commercial banks
granting loans in excess of Rs. 50,000 to individual parties against paddy and wheat.
There is no doubt about the effectiveness of such direct action but then the element
of force associated with direct action is resented by the commercial banks.

7. Publicity: Under this method, the central bank gives wide publicity regarding the
probable credit control policy it may resort to by publishing facts and figures about
the various economic and monetary condition of the economy. The central bank
brings out this publicity in its bulletins, periodicals, reports etc.

Limitations of Selective Credit Controls

(a) The selective controls embrace the commercial banks only and hence the nonbanking
financial institutions are not covered by these controls.
(b) It is very difficult to control the ultimate use of credit by the borrowers.
(c) It is rather difficult to draw a line of distinction between the productive and
unproductive uses of credit.
(d) It is quite possible that the banks themselves through manipulations advance loans
for unproductive purposes.
(e) Selective controls do not have much scope under a system of unit banking.
(f) Development of alternative methods of business financing has reduced the
importance of selective controls.
From the above discussion, we arrive at the conclusion that the two types of credit
control measures, quantitative as well as qualitative, are not rivals, but, on the contrary,
they supplement each other. For successful monetary management, the central bank should
combine the two methods of credit control in appropriate proportions. In fact, a judicious
and a skilful combination of general and selective credit control measures is the right policy
to follow for the central bank of a country. It must, however, be pointed out that the various
methods, whether quantitative or qualitative, cannot ensure perfect credit control in an
economy in view of the several limitations from which they suffer, and other complexities
involved in the situation.

Conclusion
To conclude, the central bank of a country acts as the leader of the money market, supervising,
controlling and regulating the activities of commercial banks and other financial institutions.
It acts as a bank of issue and is in close touch with the government, as banker, agent and
adviser to the latter.
Several attempts were made from time to time to set up a Central Bank in India prior to 1934.
But unfortunately these attempts failed to bear any fruit. In 1921, the Government of India
established the Imperial Bank of India to serve as the Central Bank of the country. But the
Imperial Bank did not achieve any appreciable success in its functioning as the Central Bank of
the country. In 1925, the Hilton Young Commission was asked by the Government to express its
views on the subject. The commission made out a forceful case for the establishment of a brand
new Central Bank in the country. According to the Commission, it was not desirable to keep the
control of currency and credit in the hands of two separate agencies. The Government of India
controlled currency while the Imperial Bank regulated credit prior to the establishment of the
Reserve Bank of India in April 1st, 1935. The Hilton Young Commission did not consider this
double control on currency and credit as a desirable feature of the Indian monetary system. It
was on this account that the Commission recommended the transfer of the control of currency
and credit to a new Central Bank to be set up in the country. It was on this account that the
Commission recommended the establishment of the Reserve Bank of India as the Central Bank
of the country. The Government of India while accepting the recommendations of the
Commission brought forward a Bill before the Central Legislature. But the Bill could not be
passed on account of differences amongst the members of the legislature. The Government of
India, therefore, postponed the idea of a new Central Bank for sometime. In 1929, the Central
Banking Enquiry Committee again made a forceful plea for the establishment of the Reserve
Bank. Consequently, the Reserve Bank of India Act was passed in 1934, and the Reserve Bank
started functioning from 1st April, 1935.
The Reserve Bank of India is the kingpin of the Indian money market. It issues notes,
buys and sells government securities, regulates the volume, direction and cost of credit,
manages foreign exchange and acts as banker to the government and banking institutions.
The Reserve Bank is playing an active role in the development activities by helping the
establishment and working of specialised institutions, providing term finance to agriculture,
industry, housing and foreign trade. In spite of many criticisms, it has successfully controlled
commercial banks in India and has helped in evolving a strong banking system. A study of the
Reserve Bank of India will be useful, not only for the examination, but also for understanding
the working of the supreme monetary and banking authority in the country.
Capital

Originally, the Reserve Bank was constituted as a shareholders bank, based on the model
of leading foreign central banks of those days. The bank’s fully paid-up share capital was
Rs. 5 crores divided into shares of Rs. 100 each. Of this, Rs. 4,97,80,000 were subscribed
by the private shareholders and Rs. 2,20,000 were subscribed by the Central Government
for disposal of 2,200 shares at part to the Directors of the Bank (including members of the
Local Boards) seeking the minimum share qualification. The share capital of the bank has
remained unchanged until today. The Reserve Bank also had a Reserve Fund of Rs. 150
crores in 1982. It was nationalised in January 1949 and since then it is functioning as the
State-owned bank and acting as the premier institution in India’s banking structure.

Organisation

As per the Reserve Bank of India Act, the organisational structure of the Reserve Bank
comprises:
(A) Central Board
(B) Local Boards

(A) Central Board

The Central Board of Directors is the leading governing body of the bank. It is entrusted
with the responsibility of general superintendence and direction of the affairs and business
of the Reserve Bank.

The Central Board of Directors consists of 20 members as follows:

1. One Governor and four Deputy Governors: They are appointed by the
Government of India for a period of five years. Their salaries, allowances and other
perquisites are determined by the Central Board of Directors in consultation with
the Government of India.

2. Four Directors Nominated from the Local Boards: There are four local Boards
of Directors in addition to the Central Board of Directors. They are located at
Mumbai, Kolkata, Chennai and New Delhi. The Government of India nominates
one member each from these local Boards. The tenure of these directors is also
for a period of five years.

3. Ten other Directors: The ten other directors of the Central Board of Directors are
also nominated by the Government of India. Their tenure is four years.

4. One Government Official: The Government of India also appoints one Government
Official to attend the meetings of the Central Board of Directors. This official can
continue for any number of years with the consent of the Government, but he does
not enjoy the right to vote in the meetings of the Central Board.

The Central Board of Directors exercises all the powers of the bank. The Central
Board should meet at least six times in each year and at least once in three months.
Usually, the Central Board keeps a meeting in March every year at New Delhi so as
to discuss the budget with the Finance Minister after its presentation in parliament.
Similarly, it keeps a meeting in August at Mumbai in order to pass the Bank’s annual
report and accounts.
For all practical purposes, however, the committee set-up by the Central Board
looks after the bank’s current affairs. The committee consists of the Governor, the
Deputy Governors and such other Directors as may be present. The committee
meets once a week. Two sub-committees have also been appointed to assist the
committee of the Central Board. Of these, one is called the Building Sub-Committee
which deals with matters relating to building projects. The other is called the Staff
Sub-Committee which is concerned with staff and other matters.

The Governor is the highest official of the Reserve Bank. There are four Deputy
Governors to help and advise him. Each Deputy Governor is allotted a particular job
to do, and he is fully held responsible for the proper execution of the job.

(B) Local Boards

The Reserve Bank of India is divided into four regions : the Western, the Eastern, the
Northern and the Southern regions. For each of these regions, there is a Local Board, with
headquarters in Mumbai, Kolkata, New Delhi and Chennai.

Each Local Board consists of five members appointed by the Central Government for four
years. They represent territorial and economic interests and the interests of co-operative
and indigenous banks in their respective areas. In each Local Board, a chairman is elected
from amongst their members. Managers in-charge of the Reserve Bank’s offices in Mumbai,
Kolkata, Chennai and New Delhi are ex-officio Secretaries of the respective Local Boards at
these places.

The Local Boards carry out the functions of advising the Central Board of Directors
on such matters of local importance as may be generally or specifically referred to them or
performing such duties which may be assigned to them. Generally, a Local Board deals with
the management of regional commercial transactions.

Offices of the Bank

The headquarters of the Reserve Bank is located at Mumbai. But for the efficient performance
of its functions, the Bank has opened local offices at New Delhi, Kolkata, Chennai, Bangalore,
Kanpur, Ahmedabad, Hyderabad, Patna and Nagpur. The Bank can open its office at any
other place with the prior consent of the Central Government. The State Bank of India acts
as the agent of the Reserve Bank at those places where the latter does not maintain its own
offices. The regional offices of the exchange control department of the Reserve Bank are
located at New Delhi, Kanpur, Kolkata and Chennai.

The Reserve Bank has three training establishments viz., (a) Bankers Training College,
Mumbai, (b) College of Agricultural Banking, Pune and (c) Reserve Bank Staff College,
Chennai.

The organisational set-up of the Reserve Bank of India is depicted in following chart.
Departments of the Reserve Bank

To carry out its functions/operations smoothly and efficiently, the Reserve Bank of India has
the following departments:
1. Issue Department.
2. Banking Department.
3. Department of Banking Development.
4. Department of Banking Operations.
5. Agricultural Credit Department.
6. Exchange Control Department.
7. Industrial Finance Department.
8. Non-Banking Companies Department.
9. Legal Department.
10. Department of Research and Statistics.
11. Department of Government and Bank Accounts.
12. Department of Currency Management.
Reserve Bank of India 51
13. Department of Expenditure of Budgetary Control.
14. Rural Planning and Credit Department.
15. Credit Planning Cell.
16. Department of Economic Analysis and Policy.
17. Inspection Department.
18. Department of Administration and Personnel.
19. Premises Department.
20. Management Services Department.
21. Reserve Bank of India Service Board.
22. Central Records and Documentation Centre.
23. Secretary’s Department.
24. Training Establishments.

There are also Zonal Training Centres situated in Mumbai, Kolkata, Chennai and New
Delhi for conducting induction, functional and short-term preparatory courses for the
clerical staff.

Functions of the Reserve Bank

According to the preamble of the Reserve Bank of India Act, the main functions of the bank
is “to regulate the issue of bank notes and the 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.” The various functions performed by the RBI can be conveniently
classified in three parts as follows:

A. Traditional Central Banking Functions

The Reserve Bank of India discharges all those functions which are performed by a central
bank. Among these the more important functions are as follows:

1. Monopoly of Note Issue: Under Section 22 of the Reserve Bank of India Act, the
Bank has the sole right to issue bank notes of all denomination. 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 Rs. 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.
2. Banker to the Government: The Reserve Bank of India serves as a banker to the
Central Government and the State Governments. It is its obligatory function as a central
bank. It provides a full range of banking services to these Governments, such as:

(a) Maintaining and operating of deposit accounts of the Central and State
Government.
(b) Receipts and collection of payments to the Central and State Government.
(c) Making payments on behalf of the Central and State Government.
(d) Transfer of funds and remittance facilities of the Central and State
Governments.
(e) Managing the public debt and issue of new loans and Treasury Bills of the Central
Government.
(f) Providing ways and means advances to the Central and State governments to
bridge the interval between expenditure and flow of receipts of revenue. Such
advances are to be repaid by the government within three months from the date
of borrowal.
(g) Advising the Central/State governments on financial matters, such as the
quantum, timing and terms of issue of new loans. For ensuring the success
of government loan operations, the RBI plays an active role in the gilt-edged
market.
(h) The bank also tenders advice to the government on policies concerning banking
and financial issues, planning as resource mobilisation. The Government of India
consults the Reserve Bank on certain aspects of formulation of the country’s Five
Year Plans, such as financing pattern, mobilisation of resources, institutional
arrangements regarding banking and credit matters. The government also seeks
the bank’s advice on policies regarding international finance, foreign trade and
foreign exchange of the country.
The Reserve Bank has constituted a sound research and statistical organisation
to carry out its advisory functions effectively.
(i) The Reserve Bank represents the Government of India as member of the
International Monetary Fund and World Bank.

3. Banker’s Bank: The Reserve Bank has the right of controlling the activities of the
banks in the country. All the commercial banks, co-operative banks and foreign
banks in the country have to open accounts with the bank and are required to keep
a certain portion of their deposits as reserves with the Reserve Bank. Cash reserves
are not to be less than 3% of the demand and time liabilities of the bank. The
Reserve Bank has the power to increase this ratio upto 15%. Through this, Reserve
Bank is able to regulate and control the credit created by the commercial banks. In
addition to this, the scheduled banks are also required to submit to the Reserve Bank
a number of returns every Friday.

4. Lender of the Last Resort: The scheduled banks can borrow from the Reserve Bank
on the basis of eligible securities. They can also get the bills of exchange rediscounted.
The Reserve Bank acts as the clearing house of all the banks. It adjusts the debits
and credits of various banks by merely passing the book entries. The Bank also
provides free remittance facilities to the banks. Thus, it acts as the banker’s bank.
The Reserve Bank also acts as the lender of the last resort and an emergency bank.
It grants short-term loans to scheduled commercial banks against eligible securities
in time of need. Similarly, it rediscounts the eligible bills of exchange brought by the
commercial banks.
5. National Clearing House: The Reserve Bank acts as the national clearing house
and helps the member banks to settle their mutual indebtedness without physically
transferring cash from place to place. The Reserve Bank is managing many clearing
houses in the country with the help of which cheques worth crores of rupees are
cleared every year. The ultimate balances are settled by the banks throught cheques
on the Reserve Bank.

6. Credit Control: The Reserve Bank of India is the controller of credit, i.e., it has
the power to influence the volume of credit created by bank in India. It can do so
through changing the bank rate or through open market operation. 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
if 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 bank.
(b) It controls the credit operation 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.

7. Custodian of Foreign Exchange Reserves: The Reserve Bank has the responsibility
of maintaining the external value of the rupee. There is centralisation of the entire
foreign exchange reserves of the country with the Reserve Bank to avoid fluctuations
in the exchange rate.

The RBI has the authority to enter into foreign exchange transactions both on its
own account and on behalf of government. The bank is also empowered to buy and
sell foreign exchange from and to scheduled banks in amounts of not less than the
equivalent of Rs. 1 lakh.

As the custodian of the nation’s foreign exchange reserves, the RBI also administers
exchange controls of the country, and enforces the provision of the Foreign Exchange
Regulation Act, 1973.
8. Collection of Data and Publications: The Reserve Bank of India collects statistical
data and economic information through its research departments. It compiles data on
the working of commercial and co-operative banks, on balance of payments, company
and government finances, security markets, price tends, and credit measures.
The bank is the principal source of certain financial statistics and banking data.
It publishes a monthly bulletin, with weekly statistical supplements and annual
reports which present a good deal of periodical reviews and comments pertaining
to general economic, financial, and banking developments, including the bank’s
monetary policies and measures, adopted for the qualitative and quantitative
monetary management.

The followings are the regular publications of the Bank:

(a) Reserve Bank of India Bulletin (monthly) and its weekly statistical
supplements.
(b) Report of the Central Board of Directors (Annual).
(c) Report on Trend and progress of Banking in India (Annual).
(d) Report on Currency and Finance (Annual).
(e) Review of the Co-operative Movement in India (Published once in two years).
(f) Banking Statistics (Basic Statistical Returns).
(g) Statistical Tables Relating to Banks in India.
(h) Statistical Statements Relating to the Co-operative Movement in India.
(i) Adboc Export Committee’s Reports and Monographs.
(j) Results of surveys conducted by the bank, such as the survey of India, Foreign
Liabilities and Assets, All-India Debt and Investment Survey 1971-72, etc.
(k) History of the Reserve Bank of India (1935-51).
(l) Functions and Working of the Reserve Bank of India.
(m) Banking and Monetary Statistics of India and its Supplements.
(n) Reserve Bank of India Occasional Paper (Bi-annual).

B. Promotional Functions

The scope of the functions performed by the Reserve Bank has further widened after the
introduction of economic planning in the country. The bank now performs a variety of
promotional and developmental functions. The bank’s responsibilities include, apart from
monetary functions, the institutionalisation of savings through the promotion of banking
habit and the expansion of banking system territorially and functionally. The RBI has to
provide facilities for agricultural and industrial finance.

(a) Reserve Bank of India and Agricultural Credit: The bank’s responsibility in
this field has been occasioned by the predominantly agricultural basis of the Indian
economy and the urgent need to expand and coordinate the credit facilities available
to the rural sector. The RBI has set up a separate agricultural department to maintain
an expert staff to study all questions of agricultural credit and coordinate the operation
of the bank with other agencies providing agricultural finance. The RBI does not
provide finance directly to the agriculturists, but through agencies like cooperative
banks, land development banks, commercial bank etc. After the establishment of
the National Bank for Agriculture and Rural Development (NABARD) on July 12,
1982, all the functions of the RBI relating to rural credit have been transferred to
this new agency.
(b) Reserve Bank of India and Industrial Finance: The Reserve Bank of India has
taken initiative in setting up statutory corporations at the all-India and regional levels
to function as specialised institutions for term lending. The first of these institutions
was the Industrial Finance Corporation of India set up in 1948. Followed by the
State Finance Corporations in each of the state from 1953 onwards. The RBI has
also helped in the establishment of other financial institutions such as the Industrial
Development Bank of India, the Industrial Reconstruction Bank of India, Small
Industries Development Bank of India, Unit Trust of India, etc. For the promotion
of foreign trade the Reserve Bank has established the Export and Import Bank of
India. Similarly, for the development of the housing industry the RBI has established
the National Housing Bank.

Furthermore, the Deposit Insurance and Credit Guarantee Corporation (DICGC),

a wholly owned subsidiary of the Reserve Bank, operates credit guarantee schemes
with the objective of providing cover against defaults in repayment of loans made to
small borrowers, including small-scale industrial borrowers, in order that credit flow
to them is enlarged.

C. Supervisory Functions

Over the years, extensive powers have been conferred on the Reserve Bank of India for
supervision and control of banking institutions. The Banking Regulation Act 1949, provides
wide powers to the Reserve Bank to regulate and control the activities of Banks to safeguard
the interests of depositors. Amendment Act passed in 1963, and effective from February 1,
1964, provided further powers to the Reserve Bank, particularly to restrain control exercised
by particular groups of persons over the affairs of bank and to restrict loans and advances as
well as guarantees given by the bank to or on behalf of any one company, firm, association
of persons, and gave greater control to the Reserve Bank over the appointment and removal
of bank’s executive personnel.

The various aspects of the supervisory/regulatory functions exercised by the Reserve

Bank may be briefly mentioned as under:

1. Licensing of Banks: There is a statutory provision that a company starting banking

business in India has first to obtain a licence from the Reserve Bank. If the Reserve
Bank is dissatisfied on account of the defective features of the proposed company, it
can refuse to grant the licence. The bank is also empowered to cancel the license of
a bank when it will cease to carry on banking business in India.

2. Approval of Capital, Reserves and Liquid Assets of Bank: The Reserve Bank
examines whether the minimum requirements of capital, reserve and liquid assets
are fulfilled by the banks and approves them.

3. Branch Licensing Policy: The Reserve Bank exercises its control over expansion
of branches by the banks through its branch licensing policy.

In September 1978, the RBI formulated a comprehensive branch licensing policy

with a view to accelerate the pace of expansion of bank offices in the rural areas. This
was meant to correct regional imbalance of the banking coverage in the country.
4. Inspection of Banks: The Reserve Bank is empowered to conduct inspection of
banks. The inspection may relate to various aspects such as the bank’s organisational
structure, branch expansion, mobilisation of deposits, investments, credit portfolio
management, credit appraisal profit planning, manpower planning, as well as
assessment of the performance of banks in developmental areas such as deployment
of credit to the priority sectors, etc. The bank may conduct investigation whenever
there are complain about major irregularities or frauds by certain banks. The
inspections are basically meant to improve the working of the banks and safeguard the
interests of depositors and thereby develop a sound banking system in the country.

5. Control Over Management: The Reserve Bank also looks into the management
side of the banks. The appointments, re-appointment or termination of appointment
of the chairman and chief executive officer of a private sector bank is to be approved
by the Reserve Bank. The bank’s approval is also required for the remuneration,
perquisites and post retirement benefits given by a bank to its chairman and chief
executive officer.

The Boards of the public sector banks are to be constituted by the Central
Government in consultation with the Reserve Bank.

6. Control Over Methods: The Reserve Bank exercises strict control over the methods
of operation of the banks to ensure that no improver investment and injudicious
advances made by them.

7. Audit: Banks are required to get their balance sheets and profits and loss accounts
duly audited by the auditors approved by the Reserve Bank. In the case of the SBI,
the auditors are appointed by the Reserve Bank.

8. Credit Information Service: The Reserve Bank is empowered to collect information

about credit facilities granted by individual bank and supply the relevant information
in a consolidated manner to the bank and other financial institutions seeking such
information.

9. Control Over Amalgamation and Liquidation: The banks have to obtain the
sanction of the Reserve Bank for any voluntary amalgamation. The Reserve Bank in
consultation with the central government can also suggest compulsory reconstruction
or amalgamation of a bank. It also supervises banks in liquidation. The liquidation have
to submit to the Reserve Bank returns showing their positions. The Reserve Bank keeps
a watch on the progress of liquidation proceedings and the expenses of liquidation.

10. Deposit Insurance: To protect the interest of depositors, banks are required to
insure their deposits with the Deposit Insurance Corporation. The Reserve Bank of

India has promoted such a corporation in 1962, which has been renamed in 1978 as
the Deposit Insurance and Credit Guarantee Corporation.
11. Training and Banking Education: The RBI has played an active role in making
institutional arrangement for providing training and banking education to the bank
personnel, with a view to improve their efficiency.
In brief, the Reserve Bank of India is performing both traditional central
banking functions and developmental functions for the steady growth of the Indian
economy.

Commercial banks grant loans and advances to merchants and manufacturers. They create
credit or bank deposits in the process of granting loans. In modern times, bank deposits
are regarded as money. They are as good as cash. They can be used for the purchase of
goods or in payment of debts. But excessive creation of credit by commercial bank leads to
inflation. Inflation has serious social and economic consequence. For instance, people with
fixed incomes, workers and salaried persons suffer greatly on account of rising prices. So, a
Central Bank must control the credit created by commercial banks in order to maintain the
value of money at a stable level. Similarly, excessive contraction of credit leads to deflation.
Deflation leads to unemployment and suffering among workers. Under such circumstances
the central bank should encourage credit creation. Hence it is essential that the creation of
credit is kept within reasonable limits by the central bank. The central bank has to control
and regulate the availability of credit, the cost of cost and the use of credit flow in the
economy. Credit control is an important function of the central bank. The central bank is in
a position to control credit in its capacity as the bank of issue and the custodian of the cash
reserves of the commercial bank.

Weapons of Credit Control

Various weapons or methods or instruments are available to the Reserve Bank of India to
control credit creation or contraction by commercial banks. These methods are divided into
two categories:

(A) Quantitative or general methods or instruments.

(B) Qualitative or selective methods or instruments.
A. Quantitative or General Methods

These are traditional methods of credit control. These methods have only a quantitative
effect on the supply of credit. They are used for either increasing or reducing the volume
of credit. They cannot control credit for its quality. The important quantitative methods or
instruments of credit control are as follows:

1. Bank Rate: The bank rate is the rate of interest at which the Reserve Bank of India
makes advances to the commercial banks against approved securities or rediscounts the
eligible bills of exchange and other commercial papers. The Reserve Bank of India Act,
1934 defines the bank rate as “the standard rate at which it (the Bank) is prepared to buy
or rediscount bills of exchange or other commercial paper eligible for purchase under the
Act.” The change in the bank rate leads to changes in the market rates of interest i.e.,
short-term as well as long-term interest rates. If bank rate is raised rates of interest in
the money market including the lending rates of commercial banks also rise. So the cost
of credit rises. The demand for bank loans generally falls and so the demand for goods
will also fall. Thus inflation can be checked or controlled by raising bank rate. Similarly,
deflation (i.e., state of falling prices) can be checked by lowering the bank rate. So the
bank rate acts as a “pace-setter” in the money market.

The Reserve Bank of India has changed the bank rate from time to time to meet the
changing conditions of the economy. The bank rate was raised for the first time,
from 3 per cent to 3½ per cent, in November 1951, with a view to checking an undue
expansion of bank credit. The bank rate was further raised to 4 per cent on May 16,
1959. In February 1965, the bank rate was further raised to 6 per cent. In March
1968, however, the bank rate was reduced to 5 per cent with a view to stimulating
recovery from the industrial recession of 1967. In January 1971, the bank rate was,
however raised to 6 percent as an anti-inflationary device. Subsequently, the bank
rates was raised to 10 per cent in July 1981 and to 12 per cent in October 1991. The
bank rate was, however, reduced to 10 per cent in June 1997. The increases in the
bank rate were adopted to reduce bank credit and control inflationary pressures.
The Reserve Bank of India has made only a modest use of this instrument.

2. Open Market Operations: Open market operations consist of buying and selling
of government securities by the Reserve Bank. Open market operations have a
direct effect on the availability and cost of credit. When the central bank purchases
securities from the banks, it increases their cash reserve position and hence, their
credit creation capacity. On the other hand, when the central bank sells securities to
the banks, it reduces their cash reserves and the credit creation capacity. The
Reserve Bank of India did not rely much on open market operations to control credit.
It was not used for influencing the availability of credit. Due to under-developed
security market, the open market operations of the Reserve Bank are restricted to
Government securities. These operations have also been used as a tool of public
debt management. They assist the Indian government to raise borrowings. During
1951-52 the sale of securities was more. But in 1961 the purchases were more. This
proves that it is not used to credit restraint only.

In India, the open market operations of the Reserve Bank has not been so effective
because of the following reasons:
(a) Open market operations are restricted to government securities.
(b) Gift-edged market is narrow.
(c) Most of the open market operations are in the nature of “switch operations”
(i.e., purchasing one loan against the other).

3. Cash-Reserve Requirement (CRR): The central bank of a country can change

the cash-reserve requirement of the commercial banks in order to affect their credit
creation capacity. An increase in the cash-reserve ratio reduces the excess reserves of
the banks and a decrease in the cash-reserve ratio increases their excess reserves. The
variability in cash-reserve ratios directly affects the availability and cost of credit.
Originally, the Reserve Bank of India Act, 1934 required the commercial banks
to keep with the Reserve Bank a minimum cash reserve of 5% of their demand
liabilities and 2% of time liabilities. The amendment of the Act in 1962 removes the
distinction between demand and time deposits and authorises the Reserve Bank to
change cash reserve ratio between 3 and 15%. The method of variable cash-reserve
ratio is the most direct, immediate and the most effective method to credit control.
The Reserve Bank of India used the technique of variable cash reserve ratio for
the first time in June, 1973. It raised the cash reserve ratio from 3 to 5% in June
1973. The cash-reserve ratio was further raised to 7% in September 1973. Since
then, the Reserve Bank has raised or reduced the cash reserve ratio many times.
Recently, the cash reserve ratio was raised to 11% effective from July 30, 1988 and
to 15% with effect from July 1989. The present cash-reserve ratio is 13%. This
method is mainly intended to control and stabilise the prices of commodities, stocks
and shares and prevent speculation and hoarding. The Reserve Bank used the CRR
as a drastic measure to curb credit expansion.

4. Statutory Liquidity Ratio (SLR): Under the Banking Regulation Act, 1949, banks
are required to maintain liquid assets in the form of cash, gold and unencumbered
approved securities equal to not less than 25% of their total demand and time
deposits. This minimum statutory liquidity ratio is in addition to the statutory cashreserve
ratio. Maintenance of adequate liquid assets is a basic principle of sound
banking. The Reserve Bank has been empowered to change the minimum liquidity
ratio. Accordingly, the liquidity ratio was raised from 25% to 30% in November
1972, to 32% in 1973, to 35% in October 1981, to 38% in January 1988, and to
38.5% in September 1990. There are two reasons for raising the statutory liquidity
requirements or ratio by the Reserve Bank of India. They are:

(a) It reduces commercial bank’s capacity to create credit and thus helps to check
inflationary pressures.
(b) It makes larger resources available to the government.

In view of the Narasimham committee report, the government decided to reduce the
statutory liquidity ratio in stages over a 3 year period from 38.5% to 25%. As a first
step in this direction, it was reduced to 38% in April 1992. The statutory liquidity
ratio was reduced to 37.75% in March 1993 and to 33.75% in September 1994. The
statutory liquidity ratio was further reduced to 32.75% in April 1997.

B. Qualitative Selective Methods

Selective credit controls are qualitative credit control measures undertaken by the central
bank to divert the flow of credit from speculative and unproductive activities to productive
Reserve Bank of India 61
and more urgent activities. Selective credit controls are better than the quantitative credit
controls in many respects. They encourage credit to essential industries and at the same time
discourage credit to non-essential industries. Similarly, they encourage productive activities
and at the same time discourage speculative activities. In a developing economy like India,
qualitative credit controls are mainly intended for the following purposes:

(a) To prevent anti-social use of credit like speculative hoarding of stock.

(b) To divert credit from unproductive activities to productive activities.
(c) To divert credit from non-essential to essential industries.
(d) To encourage credit for certain sectors like priority sector.
The Banking Regulation Act, 1949, granted wide powers to the Reserve Bank of India to adopt
selective methods of credit control. The Act empowered the Reserve Bank to issue directions
to the banks regarding their advances. These directives may relate to the following:

(a) The purpose for which advances may or may not be made.
(b) The margins to be maintained on secured loans.
(c) The maximum amount of advances to any firm or company, and
(d) The rate of interest to be charged.

The Reserve Bank of India has undertaken the following selective credit controls to
check speculative and inflationary pressures and extend credit to productive activities.

1. Variation of Margin Requirements: The “margin” is the difference between

the “loan value” and the “market value” of securities offered by borrowers against
secured loans. By fixing the margin requirements on secured loans, the central bank
does not permit the commercial banks to lend to their customers the full value of
the securities offered by them, but only a part of their market value. For example,
if the central bank prescribes the margin requirements at 40%, that means that the
commercial banks can lend only 60% of the market value of the securities of the
customers. If the margin is raised to 50%; the banks can lend only 50% of the market
value of the securities to the customers. Thus, by changing the margin requirements,
the amount of loan made by the banks can be changed in accordance with the policy
of the central government. If the central bank raises the margin requirements, the
amount of bank advances against securities will be automatically reduced. As a result
the bank credit will be diverted from the field of speculative activities to the other
fields of productive investments. If, on the contrary, the central bank lowers down
the margin requirements, the amount of bank advances to the customers against
securities can be automatically increased. Thus by altering margin requirements
from time to time, the central bank keeps on changing the volume of bank loans to
the borrowers. This method is an effective way of checking the flow of credit to less
productive and less desirable uses in the economy.

The Reserve Bank of India has been increasingly using this method in recent years
to control bank advances against essential commodities like food-grains, oil-seeds,
sugar etc. The main object is to prevent speculative dealings in such commodities. In
1957, the margin against loans on food-grains was increased to 40% and again to
60% in 1970. In March, 1977, the minimum margin was fixed at 85% on advances
against stocks of groundnut oil, castor oil etc. This was done to check undue rise in
the price of oil-seeds and vanaspathi. The margin requirements were also increased
in the case of pulses, sugar, vanaspathi and oil-seeds in subsequent years. During
1984-85 the maximum margins on bank advances against stocks of food-grains was
45% in the case of mills and 60% in the case of others. Reserve Bank has been using
this method flexibly according to the needs of the situation. The margin requirements
was increased when the prices are going up and decreased when the credit flow has
to be increased.
2. Credit Authorisation Scheme (CAS): Credit Authorisation Scheme is a type of
selective credit control introduced by the Reserve Bank in November, 1965. Under
the scheme, the commercial banks had to obtain Reserve Bank’s authorisation before
sanctioning any fresh credit of Rs. 1 crore or more to any single party. The limit was
later gradually raised to Rs. 6 crores in 1986, in respect of borrowers in private as well
as public sector. Under this scheme, the Reserve Bank requires the commercial banks
to collect, examine and supply detailed information regarding the borrowing concerns.
The main purpose of this scheme is to keep a close watch on the flow of credit to the
borrowers. This scheme requires that the banks should lend to the large borrowing
concerns on the basis of credit appraisal and actual requirements of the borrowers. But
this scheme was abolished in 1982. Though the scheme has been abolished, the Reserve
Bank, however, insists that the banks have to get its approval once the loans have been
sanctioned by them to big borrowers. The Reserve Bank would monitor and scrutinise
all sanctions of bank loans exceeding Rs. 5 crores to any single party for working capital
requirements, and Rs. 2 crores in the case of term loans. This post-sanction scheme has
been called “Credit Monitoring Arrangement (CMA).”

3. Control of Bank Advances: This is also used as selective control method. The
Reserve Bank has fixed from time to time maximum limits for some kinds of
loans and advances. In May 1956, the Reserve Bank issued a directive asking all
the commercial banks in the country to restrict their advances against paddy and
rice. This directive was issued to check speculative hoarding of paddy and rice. In
September 1956, these restrictions were applied to cover food-grains, pulses and
cotton textiles. In 1970, the maximum limit for loans against shares and debentures
was fixed to Rs. 5 lakhs. This was done to prevent speculation in shares with the
help of bank loans.

4. Differential Interest Rates: In 1966, the Reserve Bank announced the policy
of “Selective Liberalisation of Credit.” According to this policy, the Reserve Bank
encouraged credit to defence industries, export industries and food-grains for
procurement by government agencies. The Reserve Bank agreed to provide refinance
at the bank rate in respect of advances to the above industries. At the same time it
made credit dearer for other purposes.

5. Credit Squeeze Policy: Since 1973, the Reserve Bank has adopted a “Credit squeeze
policy” or dear money policy as an anti-inflationary measure. This policy aims at
curbing overall loanable resources of banks and also enhancing the cost or credit of
borrowers from banks.

6. Moral Suasion: This method involves advice, request and persuasion with the
commercial banks to co-operate with the central bank in implementing its credit
policies. The Reserve Bank has also been using moral suasion as a selective credit
control measure from 1956. It has been sending periodic letters to the commercial
banks to use restraint over their credit policies in general and in respect of certain
commodities and unsecured loans in particular. In June 1957, the banks were
advised to reduce advances against agricultural commodities. Regular meetings and
discussions are also held by the Reserve Bank with commercial banks to impress
upon them the need for their co-operation in the effective implementation of the
monetary policy.
Selective credit controls are flexible. They can be tightened, relaxed, withdrawn
and re-imposed according to price situation in the market. For influencing the
purpose and direction of credit. The Reserve Bank has been using various selective
credit controls. It should be noted that qualitative methods are not competitive but
complementary to quantitative methods of credit control. Both methods should be
employed to control credit created by commercial banks.

Limitations of Selective Controls in India

The Reserve Bank implemented various measures of qualitative control to channelise the flow
of credit into productive sectors and restricted the financing of speculative and unproductive
activities. The successful operation of selective credit controls, however, suffers from the
following limitations:

(a) Traders mostly use their own finance for holding stocks of commodities. This selffinancing
or private financing reduces the rate of bank finance and its influence.

(b) Traders may manage to get credit from non-controlled sectors and use it in controlled
sectors. It is very difficult to ensure that the borrowers use the amount for the purpose for
which it is borrowed.

(c) The Reserve Bank has no control over the activities of non-banking financial
institutions as well as indigenous bankers. These institutions and bankers play a
significant role in financing trade and industry in Indian economy.

(d) The Reserve Bank is not fully equipped with tools and powers to control effectively
the inflationary trends in the country. Its general and selective controls are effective
only to the extent to which inflationary pressures are the result of bank finance.
But the Reserve Bank’s credit control measures may not prove effective in case, the
inflationary pressures are caused by deficit financing and shortage of goods.

(e) Existence of large quantity of money in the black market also poses a serious
limitation to the credit policy of the Reserve Bank. Speculation and hoarding are
also carried on with the help of black money. The Reserve Bank could not exercise
its effective control over the expansion of black money in the Indian economy.

The methods of selective control are more suitable for under developed countries
like India. It is essential to divert credit to more essential industries for speedier economic
development. The methods of selective credit control can prove helpful in
the achievement of this objective. If the Reserve Bank has not undertaken different
selective control methods to check inflationary pressures, the price position in the
country might have been some what worse. The selective credit controls, if they are
applied along with quantitative credit control methods, have a great role to play in
our planned economy.
Monetary policy, generally refers to those policy measures of the central bank which are
adopted to control and regulate the volume of currency and credit in a country. According to
Paul Einzig, an ideal monetary policy may be defined “as an effort to reduce to a minimum
the disadvantages and increase the advantages resulting from the existence and operation
of a monetary system.” Broadly speaking, by monetary policy is meant the policy pursued
by the central bank of a country for administering and controlling country’s money supply
including currency and demand deposits and managing the foreign exchange rates:

Reserve Bank of India and Monetary Controls

The main objective of monetary policy pursued by the Reserve Bank of India is that of
‘controlled monetary expansion.’ In order to achieve this objective the Reserve Bank has at
its disposal various instruments, the important among these are as follows:

1. Quantitative requirements, and

2. Qualitative or selective controls.

In a developing country like India, the most important objective of monetary policy
should be that of ‘controlled monetary expansion.’ Controlled monetary expansion implies
two things:

(a) Expansion in the supply of money, and

(b) Restraint on the secondary expansion of credit.

(a) Expansion in the Supply of Money

In a developing country like India, money supply has to be expanded sufficiently to match
the growth of real national income. Although it is difficult to say what relation the rate
of increase in money supply should bear to the rate of growth in national income, more
generally, the rate of increase in money supply should be somewhat higher than the projected
rate of growth of real national income for two reasons.

(i) As incomes grow the demand for money as one of the components of savings tends
to increase.
(ii) Increase in money supply is also necessitated by gradual reduction of non-monetised
sector of the economy.

In India, the rate of increase in money supply has been far in excess of the rate of
growth in real national income. It has resulted, to a large extent, in the creation of
consistent inflationary pressures in the economy.

(b) Restraint on the Secondary Expansion of Credit: Government budgetary deficits

for financing a part of the investment outlays constitute an important source of monetary
expansion in India. It is, therefore essential to restrain the secondary expansion of credit.
While exercising restraints, care should be taken that the legitimate requirements of
agriculture, industry and trade are not adversely affected. The Reserve Bank has also to
channelise credit into the vital sectors of the economy, specially the priority sectors.
In order to achieve the twin goals, it is essential to formulate a monetary policy which
may regulate the flow of credit to desired sectors. So far as the choice of instruments of the
monetary policy is concerned, the Reserve Bank of India has a very limited scope in this
respect. The Reserve Bank has at its disposal both quantitative (traditional) and qualitative
(selective) methods to control credit. In the past, the Reserve Bank has employed bank
rate, open market operations, variable reserves ratio and selective credit controls as the
instruments to restrain the secondary expansion of credit.

The progress of the various methods of credit control, contemplated by the Reserve Bank
of India suggests that the objective of monetary policy i.e., ‘controlled monetary expansion’
has been realised to a limited extent. While the supply of money has increased in a greater
proportion than the national income, the restraints on the expansion of credit have been
rather weak and ineffective. In spite of the various methods employed by the Reserve Bank
to contain the inflationary pressures, the general price level has been showing a rising trend.
It leads up to this inevitable conclusion that there is something wrong with the monetary
policy pursued by the Reserve Bank of India in the recent post. The policy should be that of
‘controlled contraction’ rather than ‘controlled expansion.’

However, if we take into account the nature of the Indian economy and the needs of
developmental finance, it would be a folly on our part to adopt a monetary policy of ‘controlled
contraction’. India is a developing economy, and for the overall development of the various
sectors like agriculture, industry, trade, commerce, transport, and foreign trade, availability
of huge financial resources is essential. With the concept of developmental planning gaining
momentum, the availability of monetary resources in sufficient quantity becomes all the
more essential. With limited supply of money the Indian economy will not be able to achieve
the objective of self-sustained economic growth. Therefore, the RBI will have to continue
with the policy of controlled expansion. The only change that the RBI has to introduce
is that it will have to implement the various restraints on the expansion of credit more
vigorously and with great authority.

Limitations of Monetary Policy

A major failure of the monetary policy in India lies on the price front. The monetary
authorities have not been in a position to curb an inflationary rise in price which has often
taken violent jumps at intervals. A number of causes account for this failure.
(a) Monetary policy, to be effective, should be able to regulate supply and cost of credit.
The Reserve Bank tries to do by controlling the activities of commercial banks and to
some extent of co-operative banks. But the proportion of total credit provided by
non-banking institutions and other agencies is much higher. The impulses generated
by the Reserve Bank have thus a limited impact.

(b) In relation to commercial banks the task of the Reserve Bank is rendered difficult by
the limitations inherent in the various instruments of monetary control.

(c) In part the freedom to curtain Reserve Bank accommodation for banks is also
constrained by the fact that the device of offering preferential facilities has been used
for encouraging banks to lend to such sectors with so many windows opened for
refinance as an adjunct to efforts to change the long-term pattern of bank finance, it
becomes difficult for the Reserve Bank to close these special windows just when the
banks may find it necessary or tempting to use these special facilities.
(d) There is a special consideration that hitherto neglected sectors should be shielded as
far as possible from credit curbs. This makes the task of the monetary policy more
difficult.

(e) The type of the policy the Reserve Bank has pursued so far requires the presence of a
sound statistical and monitoring system. Any defects in this system make it difficult
to bring about a speedy and appropriate turn around in credit trends.

Chakravarthy Report on the Working of the Monetary System

The committee to review the working of the monetary system headed by S. Chakravarthy
submitted its report to the RBI in April 1985. In its terms of reference this committee was
required to provide a review of the monetary system and recommend measures for making
monetary policy more effective. The committee dealt particularly with the objectives of
monetary policy; coordination between monetary policy and fiscal policy; regulation of
money supply; maintenance of price stability; interest rate policy and utilisation of credit.
Its main recommendations are as follows:

(a) The committee had stressed the need to pursue price stability as the primary objective
of the monetary policy. However, it suggested that this objective should not come in
conflict with the other socio-economic goals embodied in the five year plans. The
committee pointed out that the major factor that contributed to colossal increase in
the money supply had been the RBI’s credit to the government. The committee thus
recommended that an appropriate framework for the regulation of the RBI’s credit
to the government should be evolved.

(b) The official concept of budgetary deficit did not allow in the past to clearly know
the monetary impact of fiscal operations. The committee, therefore, suggested a
change in the definition of budgetary deficit. The budgetary deficit of the Central
Government was measured in terms of an increase in treasury bills. In the opinion of
the committee, this overstated the extent of the monetary impact of fiscal operations
because no distinction was made between the absorption of treasury bills and the
increase in the holdings of treasury bills by the RBI.

(c) The committee was of the view that banks should have greater freedom in
determining their lending rates. This would prevent unnecessary use of credit which
presently is possible due to relatively low rates. Further the committee strongly felt
that concessional interest rates as a redistributive device should be used in a very
selective manner.

(d) The committee did not favour continuance of cash credit as the predominant form
of bank credit. In its opinion, certain measures should be undertaken to encourage
loans and bills finance forms of bank credit. It also stressed the importance of credit
system in the area of priority sector lending. This would enable adequate and timely
flow of credit to the priority sectors.

(e) The committee was of the view that the money market in India should be restructured.
In its opinion, in the restructured monetary system the treasury bills market, the
call money market, the commercial bills market and the inter-corporate funds
market should play an important role in the allocation of short term resources. The
committee also recommended that the RBI should adopt all the measures which are
necessary to develop an efficient money market in this country.

The major recommendations of the Chakravarthy Committee were accepted and have
been implemented. The committee had stressed the need for developing aggregate monetary
targets to ensure orderly monetary growth. The government has thus on an experimental basis
carried out an exercise to evolve such targets in consultation with the RBI. The government
has also accepted in principle that increase in entire RBI credit to the government should
be reflected in the budget in addition to the narrowly defined figure of the budget deficit.
Keeping in view the recommendations of the committee the yields on long-term government
securities have been increased and the maturities have been reduced. Moreover, now treasury
bills of 364 days maturity are being issued by the RBI. These short-term instruments with
flexible rates would enable banks to manage their liquidity better and help in evolving an
active secondary market in short term instruments.

The Narasimham Committee Report (1991)

The Government of India set up a nine-member committee under the chairmanship of

M. Narasimham, a former Governor of the Reserve Bank of India, to examine all aspects
relating to the structure, organisation, functions and procedures of the financial system.
This committee on the financial system submitted its report in November 1991. In order
to improve the functioning of the financial sector, particularly the banking sector in India,
Narasimham Committee has suggested wide-ranging measures.
Recommendations of the Committee

Narasimham Committee made a number of recommendations to improve the productivity,

efficiency and profitability of the banking sector. The main recommendations of the
committee are:

1. Structural Reorganisation of the Banking Structure: To bring about greater

efficiency in banking operations, the Narasimham Committee proposed a substantial
reduction in the number of public sector banks through mergers and acquisitions.
According to the committee, the broad pattern should consist of:

(a) 3 or 4 large banks (including the State Bank of India) which could became
international in character.
(b) 8 to 10 national banks with a network of branches throughout the country
engaged in general or universal banking.
(c) Local banks whose operations would be generally confined to a specific region; and
(d) Rural banks including Regional Rural Banks mainly engaged in financing
agriculture and allied activities in rural areas.

2. Licensing of Branches: The committee proposed that the present system of

licensing of branches should be discontinued. Banks should have the freedom to
open branches purely on profitability considerations.

3. Freedom to Foreign Banks to open Offices: The committee recommended

that the Government should allow foreign banks to open offices in India either as
branches or as subsidiaries. Foreign banks and Indian banks should be permitted
to set up joint ventures in regard to merchant and investment banking, leasing and
other forms of financial services.

4. Removal of the Duality of Control of Banks: The committee recommended

that the present system of dual control over the banking system between Reserve
Bank and the Banking Division of the Ministry of Finance should end immediately.
Reserve Bank of India should be the primary agency for the regulations of the
banking system.

5. Setting up of Assets Reconstruction Fund: Narasimaham Committee

recommended the setting up of the “Assets Reconstruction Fund” to take over
from the nationalised banks and financial institutions, a portion of their bad and
doubtful debts at a discount. All bad and doubtful debts of the banks were to be
transferred in a phased manner to ensure smooth and effective functioning of the
Assets Reconstruction Fund.

6. Special Tribunals for Recovery of Loans: Banks at present face many difficulties
in recovering the loans advanced by them. Therefore, the committee recommended
that special tribunals should be set up for recovering loans granted by banks.

7. Directed Credit Programmes: The committee recommended that the system of

directed credit programme should be gradually phased out. The concept of priority
sector should be redefined to include only the weakest section of the rural community.
The directed credit programme for the priority sector should be fixed at 10 per cent
of the aggregate bank credit. The committee argued that the system of directed credit
should be temporary and not a permanent one.
8. Statutory Liquidity Ratio (SLR): The committee recommended that the statutory
liquidity ratio should be gradually reduced from the present 38.5 per cent to 25 per
cent over the next five years.

9. Cash Reserve Ratio (CRR): The committee recommended that CRR should be
progressively reduced from the present high level of 15 per cent to 3 to 5 per cent.

10. De-regulation of Interest Rates: The committee recommended that all controls
and regulations on interest rates on lending and deposit rates of banks and financial
institutions should be removed.

11. Capital Adequacy: The committee proposed that banks should achieve 8 per cent
capital adequacy ratio as recommended by Basle Committee by March 1996.

12. Banks in the Private Sector: The committee recommended that the Reserve Bank
of India should permit the setting up of new banks in the private sector, provided
they satisfy all the conditions and norms prescribed by the Reserve Bank. Further,
there should be no difference in treatment between public sector banks and private
sector banks.

13. Raising Capital Through the Capital Market: Profitable banks and banks with
good reputation should be permitted to raise capital from the public throught the
capital market. Regarding other banks, the government should subscribe to their
capital or give a loan. Which should be treated as a subordinate debt, to meet their
capital requirements.

14. Proper Classification of Assets: The committee recommended that the assets
of bank should be classified into 4 categories:
(a) standard
(b) sub-standard
(c) doubtful, and
(d) loss assets.

Full disclosures of assets and liabilities should be made in the balance-sheets of banks and
financial institutions as per the International Accounting Standards reflecting the real state of
affairs.

15. Free and Autonomous Banks: The committee recommended that the public sector
banks should be free and autonomous.

16. Liberalisation of Capital Market: The committee recommended liberalisation

of the capital market. The office of the “Controller of Capital Issues” should be
abolished. There should be no need to get prior permission from any agency to issue
capital. The capital market should be opened for foreign portfolio investments.
The recommendations of the Narasimham Committee (1991) were revolutionary in
many respects. Most of the recommendations have been accepted by the government
and implemented during the 8th Five year plan.
The Goiporia Committee Report (1991)
Banking in India has made a remarkable progress in its growth and expansion, as well as
business. But the quality of customer service has deteriorated day-by-day. To meet the new
challenges in the changing environment of liberalised financial system. Indian banks have to
be modernised, become more efficient and competitive. The banking sector has to face stiff
competition from mutual funds started by various financial institutions and schemes launched
by the Unit Trust of India. The saving instruments of non-banking financial institutions,
and various small saving schemes of government are more attractive from the investing
public point of view. As a result the annual growth rate in deposits has remained almost
stagnant in recent years. Improving customer service’ is one of the major steps the banks
are required to take for greater deposit mobilisation. The Reserve Bank of India appointed
committees from time to time to make necessary recommendations for improvement in
customer service. In September, 1990, the Reserve Bank of India set up a committee under
the chairmanship of Sri M.N. Goiporia to examine the problem of customer service in banks
and suggest measures to improve the situation.

Recommendations of Goiporia Committee

The committee submitted its report on 6th December, 1991. Main recommendations of the
committee are as follows:

(a) Extension of banking hours for all transactions, except cash.

(b) Change in the commencement of working hour for bank staff to facilitate timely
opening of bank counters.
(c) Immediate credit of outstation cheques upto Rs. 5000/- as against Rs. 2,500/- at
present.
(d) Enhancement of interest rate on saving account.
(e) Introduction of tax benefits against bank deposits.
(f) Full use of discretionary powers vested in the bank staff at all levels.
(g) Expeditious despatch of documents lodged for collection.
(h) Extension of teller’s duties.
(i) Modernisation of banks.
(j) Opening of specialisation branches for different customer groups.
(k) Introduction of a new instrument in the form of bank order.
(l) Introduction of restricted holidays in banks.
Most of the recommendations were accepted by the Reserve Bank of India, and are being
implemented.
The Narasimham Committee Report (1998)
The Finance Ministry of the Government of India set up “Banking Sector Reforms Committee”
under the chairmanship of Mr. M. Narsimham in 1998. This committee submitted its report
in April, 1998 to the Government of India. Important findings and recommendations of the
Narasimham committee (1998) are as follows:

1. Need for a Stronger Banking System: The Narasimham Committee has made
out a strong case for a stronger banking system in the country. For this purpose,
the committee has recommended the merger of strong banks which will have a
“multiplier effect” on industry. The committee has also supported that two or three
large strong banks be given international or global character.
2. Experiment with the Concept of Narrow Banking: The committee has suggested
the adoption of the concept of “narrow banking” to rehabilitate weak banks.

3. Small, Local Banks: The committee has suggested the setting up of small, local
banks, which would be confined to states or cluster of districts in order to serve local
trade, small industry and agriculture.

4. Capital Adequacy Ratio: The committee has suggested higher capital adequacy
requirements for banks. It has also suggested the setting up of an “Asset Reconstruction
Fund” to take over the bad debts of the banks.

5. Review and Update Banking Laws: The Narasimham Committee (1998) has
suggested the urgent need to review and amend the provisions of Reserve Bank of
India Act, Banking Regulation Act, State Bank of India Act and Bank Nationalisation
Act so as to bring them in line with the current needs of the banking industry.
The Reserve Bank is India’s central bank. It occupies a pivotal position in the monetary
and banking structure of our country. It is the apex monetary institution in the country.
It supervises, regulates, controls and develops the monetary and financial system of the
country. It performs all the typical functions of a good central bank. It also performs a
number of developmental and promotional functions. It also assists the government in its
economic planning. The bank’s credit planning is devised and co-ordinated with the Five
year plans. It assists the government in the great task of nation building.

Contribution to Economic Development

Since its inception in 1935, the Reserve Bank of India has functioned with great success, not
only as the apex financial institution in the country but also as the promoter of economic
development. With the introduction of planning in India since 1951, the Reserve Bank
formulated a new monetary policy to aid and speed up economic development. The Reserve
Bank has undertaken several new functions to promote economic development in the country.
The major contributions of the Reserve Bank to economic development are as follows:

1. Promotion of Commercial Banking: A well-developed banking system is a precondition

for economic development. The Reserve Bank has taken several steps to
strengthen the banking system. The Banking Regulation Act, 1949 has given the
Reserve Bank vast powers of supervision and control of commercial banks in the
country. The Reserve Bank has been using these powers:

(a) To strengthen the commercial banking structure through liquidation and

amalgamation of banks, and through improvement in their operational standards
(b) To extend the banking facilities in the semi-urban and rural areas, and
(c) To promote the allocation of credit in favour of priority sectors, such as agriculture,
small-scale industries, exports etc.
The Reserve Bank is also making valuable contribution to the development of
banking system by extending training facilities, to the supervisory staff of the banks
through its ‘Banker’s training colleges.
2. Promotion of Rural Credit: Defective rural credit system and deficient rural
credit facilities are one of the major causes of backwardness of Indian agriculture. In
view of this, the Reserve Bank, ever since its establishment, has been assigned the
responsibility of reforming rural credit system and making provision of adequate
institutional finance for agriculture and other rural activities. The Reserve Bank has
taken the following steps to promote rural credit:

(a) It has set up Agricultural Credit Department to expand and co-ordinate credit
facilities to the rural areas.
(b) It has been taking all necessary measures to strengthen the co-operative credit
system with a view to meet the financial needs of the rural people.
(c) In 1956, the Reserve Bank set-up two funds. Namely, the National Agriculture
Credit (long-term operations) Fund, and the National Agricultural Credit
(stabilisation) Fund, for providing medium-term and long-term loans to the state
co-operative banks.
(d) Regional rural banks have been established to promote agricultural credit.
(e) Some commercial bank have been nationalised mainly to expand bank credit
facilities in rural areas.
(f) The National Bank for Agriculture and Rural Development has been established
in 1982 as the apex institution for agricultural finance.
(g) The Reserve Bank has helped the establishment of many warehouses in the
country.

As a result of the efforts made by the Reserve Bank, the institutional finance for
agriculture has been increasing considerably over the years. The agricultural output
has increased by leaps and bounds. Probably no other central bank in the world is
doing so much to help, develop and finance agricultural credit.

3. Promotion of Co-operative Credit: Promotion of co-operative credit movement is

also the special function of the Reserve Bank. On the recommendations of the Rural
Credit Survey Committee, the Reserve Bank has taken a number of measures to
strengthen the structure of co-operative credit institutions throughout the country.
The Reserve Bank provides financial assistance to the agriculturists through the
co-operative institutions. The Reserve Bank has, thus, infused a new life into the
co-operative credit movement of the country.

4. Promotion of Industrial Finance: Credit or finance is the pillar to industrial

development. The Reserve Bank has been playing an active role in the field of industrial
finance also. In 1957, it has set up a separate Industrial Finance Department which
has rendered useful service in extending financial and organisational assistance to
the institutions providening long-term finance. It made commendable efforts for
broadening the domestic capital market for providing the medium and long-term
finance to the industrial sector. In this regard the Reserve Bank took initiative
in the establishment of a number of statutory corporations for the purpose of
providing finance, especially medium and long-term finance, to industries; Industrial
Development Bank of India, Industrial Finance Corporation of India, State Finance
Corporations, State Industrial Development Corporations and the Industrial
Credit and Investment Corporation of India are some of important corporations
established in the country with the initiative of the Reserve Bank. The Reserve Bank
has contributed to the share capital of these institutions and providing short-term
advances also to some of them. The role of these corporations in providing financial
help to industries is commendable. The Reserve Bank has played an active role in the
establishment of the Unit Trust of India. The Unit Trust of India mobilises the savings
of people belonging to middle and lower income groups and uses these funds for
investment in industries. By mobilising the small savings of the people, the Unit
Trust has been promoting capital formation which is the most important determinant
of economic development. The Reserve Bank also has been encouraging commercial
banks to provide credit to the small-scale industries. It has been encouraging credit
for small industries through its “Credit Guarantee Scheme.” Small-scale industries
have been recognised as a priority sector. The Reserve Bank has also been, acting as
a “developmental agency” for planning, promoting and developing industries to fill
in the gaps in the industrial structure of the country.

5. Promotion of Export Credit: “Export or Perish” has become a slogan for the
developing economies, including India. In recent years, India is keen on expanding
exports. Growth of exports needs liberal and adequate export credit. The Reserve
Bank has undertaken a number of measures for increasing credit to the export sector.
For promoting export financing by the banks, the Reserve Bank has introduced
certain export credit schemes. The Export Bills Credit Scheme, and the Pre-shipment
Credit Scheme are the two important schemes introduced by the Reserve Bank. The
Reserve Bank has been stipulating concessional interest rates on various types of
export credit granted by commercial banks. The Reserve Bank has been instrumental
in the establishment of Export-Import Bank. The Exim Bank is to provide financial
assistance to exporters and importers. The Reserve Bank has authority to grant loans
and advances to the Exim Bank, under certain conditions.

6. Regulation of Credit: The Reserve Bank has been extensively using various credit
control weapons to regulate the cost of credit, the amount of credit, and the purpose
of credit. For regulating the cost and amount of credit the Reserve Bank has been
using the quantitative weapons. For influencing the purpose and direction of credit,
it has been using various selective credit controls. By regulating credit, the Reserve
Bank has been able

(a) To promote economic growth in the country.

(b) To check inflationary trends in the country.
(c) To prevent the financial resources from being used for speculative purposes.
(d) To make financial resources available for productive purposes keeping in view
the priorities of the plans, and
(e) To encourage savings in the country.

7. Credit to Weaker Sections: The Reserve Bank has taken certain measures to
encourage adequate and cheaper credit to the weaker sections of the society. The
“Differential Rate of Interest Scheme” was started in 1972. Under this scheme,
concessional credit is provided to economically and socially backward persons engaged
in productive activities. The Reserve Bank has been encouraging the commercial
banks to give liberal credit to the weaker sections and for self-employment schemes.
The Insurance and Credit Guarantee Corporation of India gives guarantee for loans
given to weaker sections.
8. Development of Bill Market: The Reserve Bank introduced the “Bill Market
Scheme” in 1952, with a view to extend loans to the commercial banks against their
demand promissory notes. The scheme, however, was not based on the genuine
trade bills. In 1970, the Reserve Bank introduced “New Bill Market Scheme” which
covered the genuine trade bills representing sale or despatch of goods. The bill market
scheme has helped a lot in developing the bill market in the country. The bill market
scheme has increased the liquidity of the money market in India.

9. Exchange Controls: The Reserve Bank has been able to maintain the stability of
the exchange value of the “Rupee” even under heavy strains and pressure. It has also
managed “exchange controls” successfully.

Inspite of the limitations under which it has to function in a developing country

like India, the over all performance of the Reserve Bank is quite satisfactory. It
has been able to develop the financial structure of the country consistent with the
national socio-economic objectives and priorities. It has discharged its promotional
and developmental functions satisfactorily and acted as the leader in economic
development of the country.

Conclusion

From the above discussion, it is made clear that the Reserve Bank of India is the kingpin of
the Indian money market. It issues notes, buys and sells government securities, regulates the
volume, direction and cost of credit, manages foreign exchange and acts as banker to the
government and banking institutions. The RBI is playing an active role in the development
activities by helping the establishment and working of specialised institutions, providing
term finance to agriculture, industry housing and foreign trade.
The Reserve Bank of India had been attempting to help the villagers through the state
cooperativebanks but the extent of its assistance was very limited. At the same time, the
need to help the farmers in all possible ways so as to increase agricultural production has
been most pressing since independence. The All India Rural Credit Survey Committee
(AIRCSC) recommended the setting up of a State Bank of India, a commercial banking
institution, with the special purpose of stimulating banking development in rural areas. The
State Bank of India was set up in July 1, 1955, when it took over the assets and liabilities of
the former Imperial Bank of India.

Capital

The State Bank of India has authorised share capital of Rs. 20 crores and an issued share
capital of Rs. 5,625 crores which has been allotted to the Reserve Bank of India. The shares
of the SBI are held by the Reserve Bank of India, insurance companies and the general public
who were formerly shareholders of the Imperial Bank of India. The State Bank of India and
its associate banks are engaged in the economic development of the country through a wide
network of 13,306 (30-6-2000) branches spread over the country. After 1955, there has been
a steady increase in the assets and liabilities of the State Bank of India.

Management

The management of the State Bank vests in a Central Board constituted thus: A Chairman
and a Vice-chairman appointed by the Central Government in consultation with the Reserve
Bank; not more than two Managing Directors appointed by the Central Board with the
approval of the Central Government; six Directors elected by the shareholders other than
the Reserve Bank; eight Directors nominated by the Central Government in consultation
with the Reserve Bank to represent territorial and economic interests, not less than two
of whom shall have special knowledge of the working of co-operative institutions and of
the rural economy; one Director nominated by the Central Government; and one Director
nominated by the Reserve Bank.
Functions

The State Bank of India performs all the functions of a commercial bank and acts as an
agent of the Reserve Bank in those places were the latter has no branch offices. Further it
is required to play a special role in rural credit, namely, promoting banking habits in the
rural areas, mobilising rural savings and catering to their needs. It is expected to look after
the banking development in the country. It provides financial assistance to the small scale
industries and the co-operative institutions.

We can discuss the functions of the State Bank under the following three sub-heads:

A. Central Banking Functions

Though the State Bank is not the Central Bank of the country, yet it acts as the agent of the
Reserve Bank in all those places where the latter does not have its own branches. As agent
to the Reserve Bank, the State Bank performs some very important functions:

1. It acts as the Bankers Bank: It receives deposits from the commercial banks and
also gives loans to them on demand. The State Bank rediscounts the bills of the
commercial banks. It also acts as the clearing-house for the other commercial banks.
In addition to this the State Bank also provides cheap remittance facilities to the
commercial banks.

2. It acts as the Government’s Banker: It collects money from the public on behalf
of the government and also makes payments in accordance with its instructions.
The bank also manages the public debt of the Central and the State Governments.

B. Ordinary Banking Functions

The ordinary banking functions of the State Bank are as follows:

1. Receiving Deposits from the Public: Like other commercial banks, the State
Bank also receives different types of deposits from the public. The total deposits of
the State Bank stood at Rs. 36,188 crores on 29th June, 1990. Of this amount, Rs.
7,105 crores were demand deposits and Rs. 29,083 crores were time deposits.

2. Investment in Securities: Like other commercial banks, the State Bank invests its
surplus funds in the Securities of Government of India, the State Governments, Railway
Securities, Securities of Corporations and Treasury Bills. The total amount invested by
the State Bank in these securities stood at Rs. 9,942 crores on 29th June, 1990.

3. Loans and Advances to Businessmen: The State Bank grants loans and advances
to businessmen against the security of government papers, exchange bills, approved

promissory notes and title deeds. The total advances of the State Bank to businessmen
stood at Rs. 24,047 crores on 29th June, 1990.
4. Foreign Banking: In recent years, the State Bank of India has extended its foreign
banking business. It has opened its branches in important world banking centres,
such as Nassau, Singapore, Hong Kong, London, New York, Frankfurt etc. The Bank’s
foreign business is expanding every year. It has been able to give a new direction to
its foreign business. The State Bank, in collaboration with leading foreign banks, has
also been extending loans to foreign governments.

5. Miscellaneous Work: The miscellaneous functions of the State Bank are as follows:

(a) The State Bank can receive securities, jewels etc. for safe custody.
(b) Sale and purchase of gold, silver, bullion and coins.
(c) Safe custody of the valuables of its customers.
(d) Issuing of credit certificates to the customers.
(e) Issuing drafts on its own as well as the branches of the subsidiary banks.
(f) Telegraphic remittance of funds from one place to another place.
(g) Acting as the agent of the co-operative banks under certain circumstances.
(h) Working as the liquidator of banking companies and doing other miscellaneous
jobs assigned to it by the Reserve Bank.
(i) The State Bank grants special credit facilities to small scale industries and cooperative
societies.

C. Prohibited Business of the State Bank

The State Bank of India Act has enumerated certain business which cannot be done by the
State Bank.

(a) The State Bank cannot grant loans against stocks and shares for a period exceeding
six months. But, according to an amendment of the Act, made in 1957, the State
Bank can grant loans to industries against their assets for a period of 7 years.
(b) The State Bank can purchase no immovable property except for its own offices.
(c) The State Bank cannot re-discount those bills which do not carry at least two good
signatures.
(d) The State Bank could neither discount bills nor extend credit to individuals or firms
above the sanctioned limit.
(e) The State Bank can neither re-discount nor offer loans against the security of those
exchange bills whose period of maturity exceeds six months.

Role of the State Bank in Economic Development

Growth of banking facilities is indispensable for speedy economic development. By helping

in the encouragement of small savings, mobilisation of savings and development of credit into
the priority sectors, the State Bank of India is playing a significant role in India’s economic
development. The role of the SBI can be studied under the following heads:

1. The SBI and Small-scale Industries: State Bank Group has been the most
important single source of institutional finance to small-scale industries in the country.
The SBI has set up several pilot centres, to experiment with financing schemes.
Through its Instalment Credit Scheme the SBI provides finances for the purchase
of equipments and machinery by small and medium size business engaged
in approved manufacturing industries. In 1967, the State Bank introduced the
“Entrepreneur Scheme”, under which credit to the small sector was based on the
ability and competence of the entrepreneurs as well as the technical feasibility and
economic viability of the project.

2. The SBI and Agricultural Credit: The SBI provides direct advances to farmers for
all agricultural operations and indirect loans to Primary Co-operative Credit Societies,
Farmers Service Societies, etc. The SBI Group provides agricultural advances for a
variety of purposes which include loans to co-operative banks, advances to Land
Development Banks, Village Adoption Scheme, Integrated Rural Development,
Financial Assistance to marketing and processing societies, development of
warehousing facilities, etc.

3. The SBI and Small Road and Water Transport: The development of transport
facilities, especially in the rural areas, is very vital for the maximum utilisation of the
localised resources. The SBI provides advances to the small road and water transport
operators at concessional rates.

4. The SBI and Industrial Estates: The State Bank of India has been playing a
significant role in the establishment of industrial estates in the country. The total
advances for setting up of industrial estates have increased to over Rs. 2 crores in
June 1989.

5. The SBI and Export Promotion: The State Bank of India also helps in the export
promotion by providing finances to exporters, maintaining close relationship between
exporters and importers, collecting and disseminating information about market etc.
About 30 per cent of the total export finance of scheduled banks comes from the SBI
Group.

6. The SBI and Regional Development: The SBI is also helping in reducing the
regional disparities by establishing a major portion of its new branches in the rural
and unbanked areas. The Lead Bank Schemes has been very successful in the
integrated development of the rural areas.

In brief, the State Bank of India is playing the role of leading public sector
commercial bank for the speedy economic development of the Indian economy.

Conclusion

Thus, the SBI is truly shaping itself as a national institution of major financial importance.
It has helped in making more effective Government control over the country’s money market.
It has extended appreciably banking facilities to rural and other areas lacking badly in such
facilities. The Bank massive resources are made available to the high priority sectors of the
economy according to the objectives of planned development. To achieve so much in such a
short time is highly creditable indeed.
BIBLOGRAPHY