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CHAPTER-I
SYNOPSIS

1.1. Introduction
Combining the monetary and supervisory functions of a central bank is best attributed to its
concern for the „systemic stability‟ of the financial system and the protection of the payments
system.
It is also argued that banking supervisory information may improve the accuracy of
macroeconomic forecasts and thus help the central bank to conduct monetary policy more
effectively. The central bank‟s involvement in supervision does not necessarily weaken its
stance on monetary policy as a central bank‟s inflation performance and its role in
supervision are two, more or less, separate issues. On the other hand, the combination of
control of monetary policy and the role of Lender of Last Resort (LoLR) at the central bank
has been criticised on the grounds that it raises inflationary concerns.
A central bank committed to price stability will sterilise the injection of liquidity necessary
for the stability of the system in the event of crisis so that there is no undesired increase in the
money supply. If the LoLR function and supervision are combined, an intervention as LoLR
may give rise to confusion in the expectations of the private sector regarding the central
bank‟s monetary policy stance. Concerns have also been expressed that a conflict of interest
may arise between the reputation of the central bank as guarantor of currency and financial
stability. For example, concern for the reputation of the central bank as supervisor may
encourage an excessive use of the LoLR facility so that bank crises do not put its supervisory
capacity in question. It has been argued that the reputation of the central bank is more likely
to suffer, than to benefit, from bank supervision.
1.2. Objective of Research
The objective of research is
1. To analyse the conflicting roles of the RBI as public debt manager and bank
supervisor.
2. To understand the monetary functions of the RBI.
2


1.3. Research Question
Whether the experience of fiscal dominance over monetary policy would have been different
if there had been separation of debt management from monetary management in India?
1.5 Method of Research
Method of research is doctrinal in nature. Secondary sources including books, articles from
journals and newspaper articles are relied upon.
1.6. Survey of Literature
The various articles from the internet have been referenced for the Research work. The
various case laws relating to research questions are examined.
1.7. Chapterization Scheme
The project is divided five chapters. The first chapter forms the introduction which gives the
research question, brief introduction to the research, the methodology of the research, the
survey of literature, bibliographical information etc upon the project. The second chapter
gives an account of the development role of the RBI since its inception, chapter III gives an
account of the relationship of the RBI with the government. Chapter IV gives an account of
1.8. Bibliography
Books:
ML Tannan, Tannans Banking Law and Practice in India, 22
nd
Edition, 2008, LexisNexis
Butterworths Wadhwa.
RK Gupta, Banking Law and Practice in India, 2
nd
Edition, 2012, Universal Law
Publications.
Mark Hapgood QC, Paget‟s Law of Banking, 13
th
ed., 2007, LexisNexis Butterworths
S.N. Gupta, The Banking Law, Universal Publishing Co., 1
st
ed., 2010, New Delhi
Avtar Singh, Banking and Negotiable Instruments, 2011, Eastern Book Co., Lucknow.
Dr. M. Sumathy, Banking Industry in India, 2011, Regal Publications, New Delhi.
Butterworths Banking Law Handbook, 7
th
ed., 2008, LexisNexis.
3


Articles:
Financial Regulation and Supervision, RBI Publications, Available At:
http://rbidocs.rbi.org.in/rdocs/Publications/PDFs/69297.pdf Accessed On: 1/12/2012.
Report of the Working Group on Conflicts of Interest in the Financial Sector, RBI
Publications, Available At: http://rbidocs.rbi.org.in/rdocs/Content/PDFs/68210.pdf Accessed
on: 1/12/2012.
Regulatory and Supervisory Challenges in Banking, RBI Publications, Available At:
http://rbi.org.in/scripts/publicationsview.aspx?id=10497 Accessed on: 1/12/2012.
Dr. Rakesh Mohan, “ Evolution of Central Banking in India”, Deputy Governor at the
seminar organized by the London School of Ecnonomics and the National Institute of Bank
Management at Mumbai on January 24, 2006.













4

CHAPTER – II
DEVELOPMENT ROLE OF THE RBI
As in many developing countries, the central bank is seen as a key institution in bringing
about development and growth in the economy. In the initial years of the RBI before
independence, the banking network was thinly spread and segmented. Foreign banks served
foreign firms, the British army and the civil service. Domestic/Indian banks were linked to
domestic business groups and managing agencies, and primarily did business with their own
groups. The coverage of institutional lending in rural areas was poor despite the cooperative
movement. Overall financial intermediation was weak. In an agrarian economy, where more
than three-fourth of the population lived in the rural areas and contributed more than half of
GDP, a constant and natural concern was agricultural credit. Therefore, almost every few
years a committee was constituted to examine the rural credit mechanism. There has perhaps
been one committee every two or three years for over a hundred years.
1
A clear objective of
the development role of the RBI was to raise the savings ratio to enable the higher investment
necessary for growth, in the absence of efficient financial intermediation and of a well
developed capital market. The view was that the poor were not capable of saving and, given
the small proportion of the population that was well off, the only way to kick start the savings
and investment process in the country was for government to perform both functions.
Thus the RBI was seen to have a legitimate role to assist the government in starting up
several specialized financial institutions in the agricultural and industrial sectors, and to
widen the facilities for term finance and for facilitating the institutionalisation of savings.
Although the Reserve Bank was actively involved in setting up many of these institutions, the
general practice has been to hive them off as they came of age, or if a perception arose of
potential conflict of interest. There can be little doubt that the establishment of these
institutions has helped financial development in the country. It can be argued, of course, that
similar institutional development could have taken place through private sector efforts or by
the Government. The availability of financial sector expertise in the Reserve Bank, however,
was instrumental in these tasks being performed over time by the Reserve Bank.
2


1
Mark Hapgood QC, Paget‟s Law of Banking‟, 13
th
ed., LexisNexis Butterworths, 2007, 349
2
Dr. Rakesh Mohan, “ Evolution of Central Banking in India”, Deputy Governor at the seminar organized by
the London School of Ecnonomics and the National Institute of Bank Management at Mumbai on January 24,
2006.
5

CHAPTER – III
RELATIONSHIP OF RBI WITH THE GOVERNMENT
The RBI is a banker to the Central Government statutorily and to the State Governments by
virtue of specific agreements with each of them.
3.1. Monetary and Fiscal Role of the RBI
It is common for central banks in developing countries to act as debt managers of their
respective governments. Central Banks have typically financed governments through
monetisation as and when the need arose for expansionary fiscal policy which has been often
in developing countries. The Indian experience has been no different and expansionary fiscal
policy was indeed financed by resort to automatic monetization, accompanied by financial
repression and effective loss of central bank autonomy with respect to monetary policy.
3

3.2. Before Liberalization (1991)
In 1951, with the onset of economic planning, the functions of the RBI became more
diversified. As the central bank of a typical developing country emancipated from centuries
old colonial rule, the RBI had to participate in the nation building process. Fiscal policy
assumed the responsibility of triggering a process of economic growth through large public
investment, facilitated by accommodative monetary and conducive debt management
policies. The RBI played a crucial role in bridging the resource gap of the Government in
plan financing by monetising government debt and maintaining interest rates at artificially
low levels for government securities to reduce the cost of government borrowing.
4

The provisions of the Reserve Bank of India Act, 1934 authorizes the RBI to grant advances
to the Government, repayable not later than three months from the date of advance. These
advances, in principle, were to bridge the temporary mismatches in the Government‟s receipt
and expenditure and were mainly intended as tools for Government‟s cash management.
However, in practice, the tool of short-term financing became a permanent source of funds
for the Government through automatic creation of ad hoc Treasury bills whenever

3
Regulatory and Supervisory Challenges in Banking, RBI Publications, Available At:
http://rbi.org.in/scripts/publicationsview.aspx?id=10497 Accessed on: 1/12/2012.
4
Report of the Working Group on Conflicts of Interest in the Financial Sector, RBI Publications, Available At:
http://rbidocs.rbi.org.in/rdocs/Content/PDFs/68210.pdf Accessed on: 1/12/2012.
6

Government‟s balances with the RBI fell below the minimum stipulated balance. This
automatic monetization led to the RBI‟s loss of control over creation of reserve money. In
addition, the RBI also created additional ad hoc Treasury bills whenever funds were required
by the Government. As there was unbridled expansion of fiscal deficits and the Government
was not in a position to redeem the ad hoc Treasury bills, the RBI was saddled with a large
volume of these bills constituting a substantial component of monetized deficit. This process
continued from the 1950s to the 1990s.
By the end of the 1980s a fiscal-monetary-inflation nexus was increasingly becoming evident
whereby excessive monetary expansion on account of monetization of fiscal deficit fuelled
inflation. The RBI endeavoured to restrict the monetary impact of budgetary imbalances by
raising the required reserve ratios to be maintained by banks. As the growth of pre-empted
resources was inadequate to meet the Government‟s requirement, it had to perforce borrow
funds from outside the captive market through postal savings and provident funds, by
offering substantial fiscal incentives and at administered low rates of interest. Thus, the
economy was pushed into financial repression.
5

3.3. Post Liberalization
There was a significant change in thinking regarding overall economic policy during the early
1990s. There were arguments for a reduced role of the Government in the economy which
resulted in a conscious view in favour of fiscal stabilisation and reduction of fiscal deficits
aimed at eliminating the dominance of fiscal policy over monetary policy through the prior
practice of fiscal deficits being financed by automatic monetization. It is this overall
economic policy transformation that has provided greater autonomy to monetary policy
making in the 1990s.
6

In pursuance of the financial sector reforms undertaken in 1991, despite the proactive fiscal
compression and efforts made by the RBI in moderating money supply during the early part
of the 1990s, the continuance of the ad hoc Treasury bills implied that there could not be an
immediate check on the monetized deficit. In order to check this unbridled automatic
monetization of fiscal deficits, the First Supplemental Agreement between the RBI and the

5
Financial Regulation and Supervision, RBI Publications, Available At:
http://rbidocs.rbi.org.in/rdocs/Publications/PDFs/69297.pdf Accessed On: 1/12/2012.
6
ML Tannan, Tannans Banking Law and Practice in India, 22
nd
Edition, 2008, LexisNexis Butterworths
Wadhwa, 226.
7

Government of India on September 9, 1994 set out a system of limits for creation of ad
hoc Treasury bills during the three-year period ending March 1997. In pursuance of the
Second Supplemental Agreement between the RBI and the Government of India on March 6,
1997, the ad hoc Treasury bills were completely phased out by converting the outstanding
amount into special undated securities and were replaced by a system of Way and Means
Advances. The participation by the RBI in primary auctions of the Government has also been
discontinued with effect from April 1, 2006 under the provisions of Fiscal Responsibility and
Budget Management Act, 2003 (FRBM). Other related measures that have been initiated
since 1991 are deregulation of interest rates and lowering of statutory ratios.
The Indian economy has made considerable progress in developing its financial markets,
especially the government securities market since 1991. Furthermore, fiscal dominance in
monetary policy formulation has significantly reduced in recent years. With the onset of a
fiscal consolidation process, withdrawal of the RBI from the primary market of Government
securities and expected legislative changes permitting a reduction in the statutory minimum
Statutory Liquidity Ratio, fiscal dominance would be further diluted.
All of these changes took place despite the continuation of debt management by the Reserve
Bank. Thus, one can argue that effective separation of monetary policy from debt
management is more a consequence of overall economic policy thinking rather than
adherence to a particular view on institutional arrangements.
7

The core issue of the conflict of interest between monetary policy and public debt
management lies in the fact that while the objective of minimizing market borrowing cost for
the Government generates pressures for keeping interest rates low, compulsions of monetary
policy amidst rising inflation expectations may necessitate a tighter monetary policy stance.
Therefore, the argument in favour of separating debt management from monetary policy rests
on the availability of effective autonomy of the central bank, so that it is able to conduct a
completely independent monetary policy even in the face of an expansionary fiscal stance of
the government.
8

However, if this is a realistic possibility rests to be seen. If there is an understanding amongst
policy makers that expansionary fiscal policy that is financed by monetization leads to

7
RK Gupta, Banking Law and Practice in India, 2
nd
Edition, 2012, Universal Law Publications, 317.
8
Mark Hapgood QC, Paget‟s Law of Banking, 13
th
ed., 2007, LexisNexis Butterworths, 442.
8

undesirable results would such a policy be pursued? The Indian experience has itself shown
that as such realisation took place in the 1990s the policy response was to arrive at policy
conventions between the Government and the Reserve Bank that enabled the practice of
independent monetary policy, despite debt management continuing to be housed in the RBI.
3.4. Regulation and Supervision
This issue arose in India primarily because of the predominant Government ownership of
banks after nationalization of banks in 1969 and 1980. By the 1990s, more than 90 per cent of
banking assets were in banks owned by the Government. In this institutional setting there was
a perception given that banks cannot fail and that depositors are effectively fully protected.
Moreover, all management appointments in banks rested with the Government, and hence the
norms of corporate governance in public sector banks. Furthermore, in the presence of
administered deposit and lending rates, credit allocation and other banking decisions that
rested with the government, regulation and supervision of banks also effectively became
subservient to the Government during the 1970s and 1980s.
9

It was only after the change in banking policy in 1991, which emphasized competition along
with interest rate deregulation and elimination of credit allocation that banking regulation and
supervision by the Reserve Bank could became effective.
10

The primary justification for financial regulation and supervision by regulatory authorities is
to prevent systemic risk, avoid financial crises, protect depositors‟ interest and reduce
asymmetry of information between depositors and financial institutions. The business of
banking has a number of attributes that have the potential to generate instability as banks are
much more leveraged than other firms due to their capacity to garner public deposits.
Therefore, the need for establishing an agency to regulate and supervise the banking activity
arose from frequent bank failures in various countries with ramifications for the whole
economy. The central banks had started to focus their attention on ensuring financial stability
and avoiding a financial crisis, since the late nineteenth century.
11


9
S.N. Gupta, The Banking Law, Universal Publishing Co., 1
st
ed., 2010, New Delhi, 537.
10
Id at 539.
11
Avtar Singh, Banking and Negotiable Instruments, 2011, Eastern Book Co., Lucknow, 442.
9

The basic objective of bank supervision is to ensure that banks are financially sound, well
managed and that they do not pose a threat to the interest of their depositors. The emphasis of
supervision has been shifting in the recent period from the traditional Capital, Assets,
Management, Earnings, Liquidity and Interest Rate Sensitivity (CAMELS) approach to a
more risk-based approach. Basel II, which encompasses the risk analysis, uses a „three-pillar‟
concept – minimum capital requirements, supervisory review and market discipline – to
ensure financial stability.
12

Central banks have traditionally regulated and supervised financial institutions, including
commercial banks. However, since central banks are also regulators and influence the
behaviour of market participants, supervision conducted by central banks may pose a moral
hazard problem. Therefore, the idea of a separate supervisory authority has gathered some
momentum in recent years. In addition, as a practicing central banker, I can envisage
situations of conflict between monetary policy, and regulation and supervision, especially in
situations of economic and financial stress. To illustrate a case of conflict, the mounting
inflationary pressures in a country may require interest rates to rise sharply but then banks
would be potentially exposed to write-downs of their asset valuations.
13

The changing role of financial regulation and supervision of the RBI can be characterised by
less stress on „micro‟ regulation but more focus on „prudential‟ supervision, and on risk
assessment and containment. The Indian approach to banking sector reforms has been gradual
and different from many other emerging market economies, where financial sector reforms
resulted in privatization of erstwhile public sector financial intermediaries.







12
S.N. Gupta, The Banking Law, Universal Publishing Co., 1
st
ed., 2010, New Delhi, 547.
13
Dr. M. Sumathy, Banking Industry in India, 2011, Regal Publications, New Delhi. 291.
10

CHAPTER – IV
INTERNATIONAL PERSPECTIVE ON SEPARATION OF SUPERVISION FROM
CENTRAL BANKS
The question of where authority for the supervision of banks and other financial institutions
should reside has become the subject of intense debate. In many countries, responsibility for
banking supervision rests with the central bank, while supervision over other financial
institutions is typically vested with other agencies. However, in recent years, there are several
cases of countries moving away from this model.
Although the early central banks were established primarily to finance commerce, foster
growth of the financial systems and to bring uniformity in the note issue, central banks in
several countries in the 20th century, notably the US, were founded to restore confidence in
the banking systems after repeated bank failures. As the incidence of banking crises started
increasing, the statutory regulation of banks was considered necessary for the protection of
depositors, reduction in asymmetry of information and for ensuring sound development of
banking. In the 19th century, central banks had started focusing their attention on ensuring
financial stability and their role had increasingly come to eliminate financial crises. The Bank
of England used to adjust the discount rate to avoid the effects of crises and this technique
was used by other European central banks as well. In the United States, a series of banking
crises between 1836 and 1914 had led to the establishment of the Federal Reserve System.
The experience of the Great Depression had a profound effect on banking regulation in
several countries and commercial banks were progressively brought under the regulation of
central banks. Thus, the prevention of systemic risk manifested by crises became the basic
reason for central bank‟s involvement with financial regulation and supervision.
14

The experience of some other countries in delegating the responsibility of bank regulation
was totally different. Despite the occurrence of banking crises and the need for central bank‟s
intervention in resolving the crises, some countries established a separate regulatory authority
outside the central bank to supervise the banking system, often several years before or after
the creation of the central bank. The Canadian Government established the Office of the
Inspector General of Banks in 1925 after the collapse of the Home Bank. The Bank of

14
Dr. Rakesh Mohan, “ Evolution of Central Banking in India”, Deputy Governor at the seminar organized by
the London School of Ecnonomics and the National Institute of Bank Management at Mumbai on January 24,
2006.
11

Canada was created nine years later. Canada‟s experience was not unique. A number of other
countries, including Chile, Mexico, Peru, and the Scandinavian countries developed central
banks and bank regulators completely separately. Thus, the experiences of countries in
creating an appropriate structure and entrusting the responsibility of bank regulation and
supervision vary considerably, although the basic motive has been to maintain systemic
stability.
15

The most strongly emphasised argument in favour of assigning supervisory responsibility to
the central bank is that as a bank supervisor, the central bank will have firsthand knowledge
of the condition and performance of banks. The central bank‟s supervisory role makes it
easier to get advance information from banks. This, in turn, can help it identify and respond
to the emergence of a systemic problem in a timely manner. Furthermore, to the extent that
the central bank acts as a lender of the last resort, it may be desirable that some regulatory
and supervisory functions remain with central bank in order to limit moral hazard incentives
and to have an intimate knowledge of the condition of banks, which can be acquired only
through its participation in the supervisory process. This argument assumes that it is not
possible for a third party, responsible for bank supervision, to transfer information effectively
to the LoLR, particularly during financial instability. However, such a conflict of interest may
also exist even when central bank is not the regulator and supervisor for banks as the central
bank will always endeavour to maintain the stability of the financial system. The conflict
could become particularly acute during an economic downturn in that the central bank may
be tempted to pursue a too-loose monetary policy to avoid adverse effects on bank earnings
and credit quality, and/or encourage banks to extend credit more liberally than warranted
based on credit quality conditions to complement an expansionary monetary policy.
In recent years, there has been a trend of passing over banking regulation from the central
banks to other agencies. Under this arrangement, central banks are assigned the task of
monetary policy and also remain lenders of last resort. This phenomenon has occurred in a
few countries, notably Great Britain, Japan and South Korea. Countries which belong to the
European Monetary Union (EMU) have de facto adopted this system since monetary policy is
now carried out at the federal level (the European Central Bank), while banking supervision
is undertaken at the national level.

15
Financial Regulation and Supervision, RBI Publications, Available At:
http://rbidocs.rbi.org.in/rdocs/Publications/PDFs/69297.pdf Accessed On: 1/12/2012.
12

CHAPTER – V
RESERVE BANK OF INDIA: MONETARY POLICY AND INSTRUMENTS
The objectives of the monetary policy are to maintain price stability and ensure
adequate flow of credit to the productive sectors of the economy. Stability for the national
currency (after looking at prevailing economic conditions), growth in employment and
income are also looked into. The monetary policy affects the real sector through long and
variable periods while the financial markets are also impacted through short-term
implications.
The common objective of any kind of monetary policy is the stability in the economy
and price stability. It depends on the prevailing conditions of the country‟s economy, as what
economic policy will be pursued by the RBI, which is the controlling authority of India
through its various instruments. In case of inflationary situation, excess aggregate demand,
contractionary policy is followed, interest rates are being raised and reserve requirements are
being increased to ensure that there is no excess money or demand in the economy leading to
demand pull inflation. In case of deflationary situation or depression, or when there is
situation of cyclical unemployment in the country, expansionary policy is to be followed by
the economy, in which interest rates are kept low to make credit cheap so as to increase the
demand in the economy for the goods and services.
16

Monetary policy instruments: quantitative & qualitative
Principal instruments of monetary policy or credit control of the central bank of a
country are broadly classified as: (a) Qualitative Instruments and (b) Quantitative
Instruments. Qualitative Instruments affects the quantum of money, whereas Qualitative
Instruments focus on the particular areas which are effected by the problems discussed above.
Quantitative Instruments refers to those instruments of monetary policy which affect
overall money supply/credit in the economy. These instruments do not direct or restrict the
flow of credit to some specific sectors of the economy. Few recognized and most used
quantitative instruments are as follows:

16
Report of the Working Group on Conflicts of Interest in the Financial Sector, RBI Publications, Available At:
http://rbidocs.rbi.org.in/rdocs/Content/PDFs/68210.pdf Accessed on: 1/12/2012.
13

a) Interest Rates: The bank rate is the minimum rate at which the central bank of a
country as a lender of last resort is prepared to give credits to the commercial
banks.
17
The increase in bank rate increases the rate of interest and credit becomes
dear. Accordingly, the demand for credit is reduced and thus money power or
purchasing power is reduced. This course of action is under contractionary policy
to handle inflation. On the other hand, decrease in the bank rate lowers the market
rate of interest charged by the commercial banks from their borrowers. Credit
becomes cheap and money becomes easily available to spend and thus demand in
the economy for goods and services increases and controls deflationary situation.
Bank rate is the minimum rate. The related interest rates which are controlled by
the RBI is Repo Rate and Reverse Repo Rate.
Repo Rate is the current rate, not the minimum rate.
18
Funds are taken by the
commercial banks on the Repo Rate for overnight and fortnight requirements to
maintain mandatory cash reserves. The effect and operation of Repo Rate is same
as Bank Rate in regard the monetary policy. Effect of Repo Rate is generally not
shifted to the public in general, it is absorbed, but as it is dependent on Bank Rate,
and Bank Rate is shifted to public through primary function of advancing loan of
the commercial banks.
Reverse Repo Rate is the another form of interest rate, this is the rate at which
central bank pays interest to the money deposited in the central bank by the
commercial banks.
19
If RBI decides to pay more interest, commercial banks would
deposit more money with central bank, which will decrease the availability of
money for the credit to public by commercial banks, resulting in decreasing
money supply.
b) Liquidity Rates: It is humbly submitted that liquidity rates are of two types,
Statutory Liquidity Ratio and Cash Reserve Ratio.
Cash Reserve Ratio (CRR) refers to the minimum percentage of a bank‟s total
deposits required to be kept with central bank.
20
Commercial banks have to keep

17
Instruments of Monetary Policy, Reserve Bank of India, <www.rbi.org.in/basicinfo.com> accessed March 21,
2011.
18
Ibid.
19
Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR), Master Circular, Reserve Bank of India,
2011,<www.mastercircular.rbi.org.in> accessed 18
th
March, 2011.
20
Ibid.
14

with the central bank a certain percentage of their deposits in the form of cash
reserves as a matter of law. For example: If the minimum reserve ratio is 10 per
cent and total deposits of HDFC bank is ` 1000 Crores, it will have to keep `100
crores with RBI bank. Now, HDFC is left with ` 900 Crores to avail for the credit
and to invest. If CRR increases by 5% or decreases by 5%, it will decrease and
increase the availability of credit by ` 50 Crores. There is inverse relationship
between these two. The maximum and minimum limits of CRR is 15 % and 3 %
respectively.
Statutory Liquidity Ratio (SLR): Every bank is required to maintain a fixed
percentage of its assets in the form of cash or other liquid assets.
21
With a view to
reducing the flow of credit in the market, the central bank increases this liquidity
ratio. However, in case of expansion of credit, the liquidity ratio is reduced.
Success of CRR and SLR again depends on the amount of excess reserves with
the commercial banks. CRR and SLR would be rendered meaningless if banks are
used to keeping high excess reserves.
c) Open Market Operations: Open market operations refer to the sale and purchase
of securities in the open market by the central bank.
22
By selling the securities
(like NSC bonds), the central bank withdraws cash balances from within the
economy. And, by buying the securities, the central bank contributes to cash
balances in the economy.
Cash Balances are high powered money on the basis of which commercial banks
create credit. Thus, through open market operations, if cash balances are
increased, flow of credit will increase many times more, and if cash balances are
reduced, the flow of credit will decrease many times more.
Open Market Operations affects the quantity of money supply also by increasing
and decreasing VM (Velocity of Money), which is multiplier while calculating
money supply.
The above discussed were the quantitative measures of monetary policy. Sometimes,
just controlling the money supply or increasing supply does not result in price stability. The
problem with the monetary supply is that they cannot achieve price stability, if the inflation is

21
Ibid.
22
Supra Note 1, p. 82.
15

in one particular sector or part of the economy. It cannot do anything if one bank is not
following the guidelines, sometimes there have to be harsh actions taken by central bank.
a) Margin Requirements: The margin requirement of loan refers to the difference
between the current value of the security offered for loans and the value of loans
granted.
23
Suppose, a person mortgages an article worth ` 100 with bank and bank
gives him loan of ` 70. In this case, 30 % is the margin requirement. If the margin
requirement is increased, it will decrease the availability of credit to a person. If
the margin requirement is decrease, it will enable this person to get more loan for
his assets value worth ` 100.
b) Rationing of Credit: Rationing of credit refers to fixation of credit quotas for
different business activities.
24
Rationing of credit is introduced when the flow of
credit is to be checked particularly for speculative activities in the economy. The
central bank fixes credit quota for different business activities. The commercial
banks cannot exceed the quota limits while granting loans.
For example: Vehicle loans are safe for banks, whereas agricultural loans are
considered unsafe by banks. If there is no rationing of credit, A commercial bank,
if let‟s say Bank has ` 100 Crores to provide for loans. They would provide loans
for safe avenues, and it would create money deficit in Agriculture Sector, which
will create imbalance. Thus there are two types of quotas to be fixed, one is
Minimum and another is maximum, for agriculture there will be minimum and for
vehicle loans, there will be maximum quota to be fixed by RBI.
c) Direct Action and Moral Suasion: The central bank may initiate direct action
against the member banks in case these do not comply with its directives.
25
Direct
action includes derecoginition of a commercial bank as a member of the country‟s
bank system. Sometimes, the central bank makes the member banks agree through
persuasion or pressure to follow its directives with a view to controlling the flow
of credit.
This is hardly taken action due to fear of backlash from union of commercial
banks. But certainly moral suasion is pursued.
Factors affecting monetary policy:

23
Ibid. p. 82.
24
Ibid. p. 83.
25
Supra Note 4, p.145.
16

It is not necessary that whatever the monetary policy will be formulated by
government or RBI will have the desired result, it may not have the desired result. It is
dependent on other factors, such as non-institutionalized or scheduled financing sector,
structure of businesses and mechanism use, and existence of investment market.
Bank Rate is dependent on the commercial banks upon the central bank for loans is
one of the factor, if commercial bank have their own surplus funds which they can utilize for
high credit needs, their dependence will be effected by this. It is important to note that in
India there is structure of financing created by Sahukars etc, which reaches to more public,
even in remote areas of the sector. The interest rates followed by this structure of financing is
totally unrelated. Open market operations are dependant on how the large sector companies
are doing in the market. When money through NSCs goes to RBI, it is presumed to go out of
the circular flow of economy, but when money is invested in PSUs they are considered safe
as well as in the market. If the PSUs and Maha Navratnas Companies are performing good in
the economy, the open market operations would not be launched by the RBI.













17

CHAPTER – V
CONCLUSION
In theory, separation between the two functions would perhaps enhance the efficiency in
monetary policy formulation and debt management, but the debate in the Indian context
needs to recognize certain key dynamics of the fiscal-monetary nexus. First, in India, the joint
policy initiatives by the Government and the RBI have facilitated good co-ordination between
public debt management and monetary policy formulation. Where‟s commitment to fiscal
discipline and reduction in monetized deficit have imparted considerable autonomy to the
operation of monetary policy, the proactive debt management by the RBI also facilitated the
conduct of monetary policy, especially through the use of indirect instruments. In fact, the
substantial stock of Government securities held by the RBI enabled it to sterilize the
monetary impact of capital flows through open market operations since the late 1990s. In
recent years, with the reversal in the interest rate cycle, the RBI was able to prescribe higher
risk weights on assets to protect the balance sheet of the banks. This step certainly ensured
financial stability for the economy. Second, the RBI‟s experience in managing public debt
over the years has equipped it with the requisite technical capacity of efficiently fulfilling the
twin responsibilities of debt and monetary management in tune with requirements of the
Government and market conditions. The RBI has been making efforts to develop the money
and government securities market since 1988 and has gained valuable experience and
knowledge about related markets. This may have been difficult to accomplish if the debt
management function had been effectively separate.
With all of these changes taking place in the monetary fiscal environment in the near future,
there will be great need for a continued high degree of coordination in debt management
between RBI and the Government. In fact, in the U.S., even though debt management is
formally done by the Treasury, the close co-operation that actually exists between the Federal
Reserve Bank of New York and the Treasury is not very different in function from the
relationship between the RBI and the Government in its debt management function.
The evaluation of our experience therefore supports the position that a pragmatic view needs
to be taken on this issue keeping in mind the specific institutional context of a particular
country in mind.

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