Role and Functions of Reserve Bank of India (RBI)

The Reserve Bank of India is the central bank of India, was established on April 1, 1935 during the British-Raj in accordance with the provisions of the Reserve Bank of India Act, 1934. The Reserve Bank of India was set up on the recommendations of the Hilton Young Commission. The commission submitted its report in the year 1926, though the bank was not set up for nine years. The Central Office of the Reserve Bank was initially established in Kolkata, Bengal, but was permanently moved to Mumbai in 1937. Though originally privately owned, the RBI has been fully owned by the Government of India since nationalization in 1949. The Preamble of the Reserve Bank of India describes the basic functions of the Reserve Bank as to regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage.

The Reserve Bank of India performs various traditional central banking functions as well as undertakes different promotional and developmental measures to meet the dynamic requirements of the Indian economy.

role of reserve bank of india in indian economy

Traditional Functions

Traditional functions are those functions which every central bank of each nation performs all over the world. Basically these functions are in line with the objectives with which the bank is set up. It includes fundamental functions of the Reserve Bank.

1. Note Issue

The system of note issue as it exists today is known as the minimum reserve system. The currency notes issued by the Bank arid legal tender everywhere in India without any limit. At present, the Bank issues notes in the following denominations: Rs. 2, 5, 10, 20, 50, 100, and 500. The responsibility of the Bank is not only to put currency into, or withdraw it from, the circulation but also to exchange notes and coins of one denomination into those of other denominations as demanded by the public. All affairs of the Bank relating to note issue are conducted through its Issue Department.

In terms of Section 22 of the Reserve Bank of India Act, the RBI has been given the statutory function of note issue on a monopoly basis. The note issue in India was originally based upon “Proportional Reserve System”. When it became difficult to maintain the re ­serve proportionately, it was replaced by “Minimum Reserve System “. According to the RBI Amendment Act of 1957, the bank should now maintain a minimum reserve of Rs.200 crore worth of gold coins, gold bullion and foreign securities of which the value of gold coin and bullion should be not less than Rs.115 crore.

The Government of India issues rupee coins in the denomination of Rs.1, 2, and 5 to public. These coins are required to be circulated to public only through Reserve Bank un ­der Section 38 of the RBI Act. The RBI presently issues notes of denominations Rs.10 and above.

RBI manages circulation of money through currency chests. Currency Chests are receptacles in which stocks of issuable and new notes are stored along with rupee coins. Currency Chests are repositories run by RBI, SBI, subsidiaries of SBI, public sector banks, Government Treasuries and Sub treasuries. Currency Chests help in expansion and contraction of currency in the country.

Originally RBI issued currency notes of Rs.2 and above. However, due to higher cost of printing small denomination notes these denominations are now coincides and issued by Government.

2. Banker, Agent and Financial  Adviser  to the State

The RBI acts as banker to the Government under Section 20 of RBI Act. Section 21 provides that Government should entrust its money remittance, exchange and banking transactions in India to RBI. Under Section 21A RBI has to conduct similar transactions for State Governments also.

RBI earns no income by conducting those functions but earns com ­missions for managing the government’s public debt. Where RBI has no branch, SBI or its subsidiaries are appointed as agents and sub-agents under Section 45 of the RBI Act. Agency Banks receive commission on all transactions conducted on turnover basis.

The RBI extends ‘ ways and means ‘ advances to Central and State Governments. “Ways and Means Advances” (WMA) is not a commercial bank credit. It is a system under which the RBI provides credit to Central and State Gov ­ernments for meeting temporary shortfall in government revenues as compared to the monthly expenditures. In other words, this facility is provided to meet temporary mismatches between revenue collections and revenue expenditures of governments. The maximum volume and period of such advances are governed by agreements between RBI and the concerned government.

RBI also acts as adviser to Government on economic and financial matters. In brief, as a banker to the Government the RBI renders the following functions:

  • Collects taxes and makes payments on behalf of the Government
  • Accepts deposits from the Government
  • Collects cheques and drafts deposited in the Government accounts.
  • Provides short-term loans to the Government
  • Provides foreign exchange resources to the Government.
  • Keep the accounts of various Government Department.
  • Maintains currency chests in treasuries at some importance places for the convenience of the government.
  • Advises governments on their borrowing programmes.
  • Maintains and operates Central Government’s IMF accounts.

3. Banker to the Banks

Reserve Bank  acts as a guardian for the commercial banks.  The RBI being an apex monitory institution has obligatory powers to guide, help and direct other commercial banks in the country. The RBI can control the volumes of banks reserves and allow other banks to create credit in that proportion.  

The Reserve Bank acts as the banker’s bank in the following respects:

  1. Every Bank is under the statutory obligation to keep a certain minimum of cash reserves with the Reserve Bank. The purpose of these reserves is to enable the Reserve Bank to extend financial assistance to the scheduled banks in times of emergency and thus to act as the lender of the last resort. According to the Banking Regulation Act, 1949, all scheduled banks are required to maintain with the Reserve Bank minimum cash reserves of 5% of their demand liabilities and 2% of their time liabilities. The Reserve Bank (Amendment) Act, 1956 empowered the Reserve Bank to raise the cash reserve ratio to 20% in the case of demand deposits and to 8% in case of time deposits. Due to the difficulty of classifying deposits into demand and time categories, the amendment to the Banking Regulation Act in September 1972 changed the provision of reserves to 3% of aggregate deposit liabilities, which can be raised to 15% if the Reserve Bank considers it necessary,
  2. The Reserve Bank provide financial assistance to the scheduled banks by discounting their eligible bilk and through loans and advances against approved securities,
  3. Under the Banking Regulation Act,1949 and its various amendments, the Reserve Bank has been given extensive powers of supervision and control over the banking system. These regulatory powers relate to the licensing of banks and their branch expansion; liquidity of assets of the banks; management and methods of working of the banks; amalgamation, reconstruction and liquidation of banks; inspection of banks; etc.

4. Custodian of Foreign Exchange Reserves

It is the responsibility of the Reserve bank to stabilize the external value of the national currency. The Reserve Bank keeps golds and foreign currencies as reserves against note issue and also meets adverse balance of payments with other counties. It also manages foreign currency in accordance with the controls imposed by the government.

As far as the external sector is concerned, the task of the RBI has the following dimensions:

  • To administer the foreign exchange control;
  • To choose the exchange rate system and fix or manages the exchange rate between the rupee and other currencies;
  • To manage exchange reserves;
  • To interact or negotiate with the monetary authorities of the Sterling Area, Asian Clearing Union, and other countries, and with International financial institutions such as the IMF, World Bank, and Asian Development Bank.

The RBI is the custodian of the country’s foreign exchange reserves, id it is vested with the responsibility of managing the investment and utilization of the reserves in the most advantageous manner. The RBI achieves this through buying and selling of foreign exchange market, from and to schedule banks, which, are the authorized dealers in the Indian foreign exchange market. The Reserve Bank manages the investment of reserves in gold counts abroad and the shares and securities issued by foreign governments and international banks or financial institutions.

5. Bank of Central Clearance, Settlement and Transfer

In India RBI acts as the clearing house for settlement of banking transactions. This function of clearing house enables the other banks to settle their interbank claims easily. Further it facilitates the settlement economically. Where the RBI has no offices of its own, the function of clearing house is carried out in the premises of the State Bank of India. The entire clearing house operations carried on by RBI are computerized. The inter-bank cheque clearing settlement is done twice a day. There is a separate route for clearing high value cheques of Rs.1.00 lakh and above. Cheques drawn on banks in metropolitan cities are cleared on the same day.

The RBI carries out this function through a cell known as National Clearing Cell. In 1998, there were in all 860 clearing houses in operation of which 14 were run by RBI, 578 by SBI and others by public sector banks.

The RBI acts as a lender of last resort or emergency fund provider to the other member banks. As such, if the commercial banks are not able to get financial assistance from any other sources, then as a last resort, they can approach the RBI for the necessary financial assistance. In such situations, the RBI provides credit facilities to the commercial banks on eligible securities including genuine trade bills which are usually made available at Bank Rate. RBI rediscounts bills under Section 17 (2) and 17 (3) and grants advances against securities under Section 17 (4) of RBI Act. However, many of these transactions are practically carried out through separate agencies like DHFI, Securities Trading Corporation of India, primary dealers.

6. Controller of Credit

As the central bank of the country, the Reserve Bank undertakes the responsibility of controlling credit in order to ensure internal price stability and promote economic growth. Through this function, the Reserve Bank attempts to achieve price stability in the country and avoids inflationary and deflationary tendencies in the country. Price stability is essential for economic development. The Reserve Bank regulates the money supply in accordance with the changing requirements of the economy. The Reserve Bank makes extensive use of various quantitative and qualitative techniques to effectively control and regulate credit in the country.  Quantitative controls include the bank rate policy, the open market operations, and the variable reserve ratio. Qualitative or selective credit control, on the other hand includes rationing of credit, margin requirements, direct action, moral suasion publicity, etc.

Supervisory Functions:

In addition to its traditional central banking functions, the Reserve Bank has certain non- monetary functions of the nature of supervision of banks and promotion of sound banking in India. The supervisory functions of the RBI have helped a great deal in improving the methods of their operation. By these functions it controls and administers the entire financial and banking systems of the country.

1. Granting License to Banks

The RBI grants license to the banks, which like to commence their business in India. Licenses are also required to open new branches or closure of branches. With this power

RBI can ensure avoidance of unnecessary competitions among banks in particular location evenly growth of banks in different regions, adequate banking facility to various regions, etc. This power also helps RBI to weed out undesirable people from starting banking business.

2. Function of Inspection and Enquiry

RBI inspects and makes enquiry in respect of various matters covered under Banking Regulations Act and RBI Act. The inspection of commercial banks and financial institu ­tions are conducted in terms of the provisions contained in Banking Regulation Act.

These refer to their banking operations like loans and advances, deposits, investment functions and other banking services. Under such inspection RBI ensures that the banks and finan ­cial institutions carry on their operations in a prudential manner, without taking undue risk but aiming at profit maximization within the existing rules and regulations.

This type of inspection is carried on periodically once a year or two covering all branches of banks. Banks are obliged to take remedial measures on the lapses / deficiencies pointed out dur ­ing inspection. In addition RBI also calls for periodical information concerning certain assets and liabilities of the banks to verify that the banks continue to remain in good health.

This type of inspection / verification is known as off- site inspection. The RBI team visiting bank offices to conduct verification of books and records is known as on- site inspection. RBI inspects banks under RBI Act only when there is a threat to close down a bank for mismanagement and there is a need to verify the fulfillment of conditions for the status of ‘scheduled bank’.

RBI presently conducts inspection of commercial banks, Development Financial Institutions like IDBI, NABARD, etc. Urban Co- operative Banks and non banking financial companies like Lease Financing Companies, Loan Companies.

3. Implementing the Deposit Insurance Scheme

RBI Implements the Deposit Insurance Scheme for the benefit of bank depositors. This supervisory function has improved the standard of banking in India due to this confidence building exercise. Under this system, deposits up to Rs.1.00 lakh with the bank branch are guaranteed for payment. Deposits with the banking system alone are covered under the scheme.

For this purpose banking system include accounts maintained with commercial banks, co- operative banks and RRBs. Fixed Deposits with other financial institutions like ICICI, IDBI, etc. and those with financial companies are not covered under the scheme. ICICI is since merged with ICICI Bank Ltd. and IDBI is getting converted into a bank.

4. Periodical Review of the Working of the Commercial Banks

The RBI periodically reviews the work done by commercial banks. It takes suitable steps to enhance the efficiency of the banks and make various policy changes and imple ­ment programmes for the well-being of the nation and for improving the banking system as a whole.

5. Controls the Non-Banking Financial Corporations

RBI issues necessary directions to the Non-Banking financial corporations and con ­ducts inspections through which it exercises control over such institutions. Deposit taking NBFCs require permission from RBI for their operations.

Promotional Role

Along with the routine traditional functions, central banks especially in the developing country like India have to perform numerous promotional functions. These functions are country specific functions and can change according to the requirements of that country. The RBI has been performing as a promoter of the financial system since its inception.  These special functions are non-monetary functions. They include the following:

1.  Promotion of Banking Habits

The RBI institutionalizes saving through the promotion of banking habit and expan ­sion of the banking system territorially and functionally.

Accordingly RBI has set up De ­posit Insurance Corporation in 1962, Unit Trust of India in 1964, the IDBI in 1964, the Agri ­cultural Refinance Corporation in 1963, Industrial Reconstruction Corporation of India in 1972, NABARD in 1982 and the National Housing Bank in 1988, etc.

It has helped to bring into existence several industrial finance corporations such as Industrial Finance Corpora ­tion of India, Industrial Credit and Investment Corporation of India for industrialization of the country. Similarly sector specific corporations took care of development in their respec ­tive spheres of activity.

2.  Provides Refinance for Export Promotion

The RBI takes the initiative for widening facilities for the provision of finance for for ­eign trade particularly of exports.

The Export Credit and Guarantee Corporation (ECGC) and Exim Bank render useful functions on this line. To encourage exports the RBI is providing refinance facilities for export credit given by commercial banks. Further the rate of interest on export credits con ­tinues to be prescribed by RBI at a lower rate.

The ECGC provides an insurance cover on Export receivables. EXIM Bank extends long term finance to project exporters and foreign currency credit for promotion of Indian exports.

3. Facilities for Agriculture

The RBI extends indirect financial facilities to agriculture regularly. Through NABARD it provides short-term and long-term financial facilities to agriculture and allied activities. It established NABARD for the overall administration of agricultural and rural credit. Indian agriculture would have starved of a cheap credit but for the institutionalization of rural credit by RBI.

The Reserve Bank was extending financial assistance to the rural sector mainly through contributions to the National Rural Credit Funds being operated by NABARD. RBI pres ­ently makes only a symbolic contribution of Rs.1.00 crore.

It, however, extends cheap indi ­rect financial assistance to the agricultural sector by providing large sums of money through General Line of Credit to NABARD. The loans and advances extended to NABARD by RBI and outstanding as on June 1999 amounted to Rs.5073 crore.

4. Facilities to Small Scale Industries

The RBI takes active steps to increase the supply of credit to small industries. It gives directives to the commercial banks regarding the extension of credit facilities to small scale industries. It encourages commercial banks to provide guarantee services to SSI sector. Banks advances to SSI sector are classified under priority sector advances.

SSI sector contributes to a very great extent to employment opportunities and for Indian Exports. Keeping this in view, RBI has directed commercial banks to open specialized SSI bank branches to provide adequate financial and technical assistance to SSI branches. There are around 30 lakh SSI units operating in India. Meeting their financial needs is one of the prime concerns of RBI.

5. Helps Co-operative Sector

RBI extends indirect financing to State Co-operative Banks thereby connects the co ­operative sector with the main banking system of the country. The finance is mostly, is routed through NABARD. This way the financial needs of agricultural sector are taken care of by RBI.

6. Prescription of Minimum Statutory Requirements for Banks

The RBI prescribes the minimum statutory requirements such as, paid up capital, r ­serves, cash reserves, liquid assets, etc. RBI prescribes reserves requirements both under Banking Regulation Act and RBI Act to ensure different objectives.

For example, SLR pre ­scription is done to ensure liquidity position of the bank. CRR prescription is done to have effective monetary control and money supply. Statutory Reserves Appropriation is done to ensure sound banking system, etc.

It also asks banks to set aside provisions against pos ­sible bad loans. With these functions, it exercises control over the monetary and banking systems of the country to ensure growth, price stability and sound banking practices.

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