CONTENTS

CENTRAL BANKING
1 2 3 4 5 6 7 8 Overview of Central Banking Indian Banking System Monetary Policy Public Debt Management Forex Reserve Management Issues in Indian Rural Sector Payment and Settlement System Financial Stability

OVERVIEW OF CENTRAL BANKING

Central banks have been in existence since the second half of the 17th century and over the years these have developed into organizations that are central to not only monetary policy making but also to development and regulation of financial system. Central Banks have evolved worldwide on a continuous basis in response to changing political and economic forces around them. Central banks are viewed as multi-function entities performing the tasks of wideranging activities, which are special in nature. The functions of central bank generally include currency management, banker to the government, regulation and supervision of financial institution, managing payment and settlement system and formulating monetary policy for the development of the economy. According to Bank for International Settlements, the bank in any country which has been entrusted with the duty of regulating the volume of currency and credit in that country can be called as central bank . The mandate of central banks has undergone a complete metamorphosis. Expansion of the financial system led to refinements in regulatory and supervisory framework and growth of clearing systems. Monetary policy assumed critical importance in the conduct of central banking with the emergence of concerns about inflation. Similarly, many developing countries have entrusted their central banks with the objective of economic growth along with price stability. The central banks in developed countries came into existence to support and supervise the banking system that was already in place, whereas the central banks in developing countries had to first develop the banking system and financial markets and thereafter put in place the regulatory framework for the efficient oversight and supervision The development of global financial markets and proliferation of financial instruments coupled with episodes of financial crises brought to the fore central banks concern for price stability, financial stability and risk management. The recent global financial crisis has brought to the fore the need for enhanced role for central banks in matters relating to financial stability as well, in addition to various other functions. Establishment of central banks in the world can be traced to the early

central banks founded in Europe the Swedish Riksbank in 1668 and subsequently after some years, the establishment of Bank of England in 1694. In the early stages of establishment of central banks, they were not intended to perform the functions of a modern central bank but were entrusted the task of taking care of government financial transactions and support to governments on financial matters. But subsequently with the evolving financial system, central banks' function encompassed monetary management, regulation and supervision of the banking system, etc. There were only two central banks till 1800 i.e., Riksbank and Bank of England. Till 1873, the number of central banks globally remained in single digit. Establishment of central bank, which started in the late 19th century, got strengthened in 20th century and presently nearly every sovereign nation has established its own central bank. Setting up of each central bank has a

distinctive origin. For instance, Bank of England was established to lend money to the Government whereas, the Federal Reserve Board which came into being in 1914 mainly for a nation-wide payment and depository system. German central bank was set up in 1875 with a view to restore and to maintain a stable currency. Need for a Central Bank Need for a central bank arises due to the following factors: need for strengthening financial sector and ensuring its development for fostering growth. internationalisation of financial markets - making an institutional mechanism like central bank to oversee and take regulatory measures to ensure the process of market development is set in place in an efficient manner. growth of financial innovations having implications for liquidity position and rate changes, the two aspects, which form the essence of monetary policy. high growth of trade in goods and services due to opening up, necessitating the use of funds for settlement through the central banks.

Functions of the Central Bank The functions of central bank vary from country to country and consist of not only creation of money or monetary management, but also broadly cover management of public debt of Government, regulation and supervision of banking entities, financing of developmental activities and other associated functions. Hence, we may broadly classify the functions of central bank as follows: Monetary functions Traditional functions Quasi fiscal functions Monetary function in a Central bank can be further classified into broadly four sub functions: (a) Money supply management (b) credit policy, (c) price stability and (d) exchange rate stability. Under money supply management, the central bank tries to ensure that supply of money for various activities in the economy is according to the demand by trying to ensure balanced development of the economy. Policies are formulated to absorb excess supply of money hanging in the system and injection of funds to the system when genuinely required and thereby keeping the money supply within policy bound based on the expected growth and inflation.

Traditional functions cover banker to the Government, banker to banks, lender of last resort, regulation and supervision of financial system and payment and settlement system. While these functions are performed by central banks generally, in the developed countries some of these functions have been separated (e.g., regulation and supervision) or are not performed due to moral hazard problems (e.g., lender of last resort). Central banks have traditionally supervised commercial banks and other financial institutions. However, since central banks are also regulators in many economies and are consequently in a position to influence the behaviour of market participants, supervision conducted by central banks may pose a moral hazard problem. The idea of a separate supervisory authority has, therefore, gathered some momentum of late. There are various arguments for having the supervisory tasks performed

only by central banks. First, central banks collect enormous amount of data on the financial sector and real sector alike and are, therefore, in a good position to form relatively objective views on market expectations and the need to act when necessary. Second, most central banks provide payment and settlement services and are in a position to quickly monitor the liquidity position of the system. Third, being considered as a lender-of-the-last-resort, a central bank will get prior intimation about the borrowing requirements of the financial sector, which would provide clues about their liquidity requirements. On the other hand, the main arguments for not entrusting the supervisory functions with the central bank are related to the moral hazard problem. The moral hazard problem arises when both depositors and creditors of institutions supervised by the central bank expect that in the event of failure of an institution, they would be salvaged and as such there is an incentive to take unwarranted risks. In an effort to address the moral hazard problem, some countries have set up a separate body to undertake supervisory function the most notable being the United Kingdom where the Financial Supervisory Authority (FSA) was created in 1998.

Under

quasi-fiscal

function,

central

bank

is

discharging

its

responsibilities as a public debt manager. It is very much important to note that the function of debt management is essentially performed by a central bank as an agent of the Government and hence the issue of autonomy does not arise. Many central banks have evolved from the need to have an institution that would manage the finances of their governments. The need to manage government debt was a function that required the central banks to undertake a variety of fiscal transactions and consequently led to evolution of an institutional structure to take care of all the associated functions. While some provision of liquidity to the respective governments is required to smoothen the temporary mismatches in revenues and expenditures, financing the persistent deficits is being increasingly avoided. Some countries have passed legislations prohibiting credit to their governments and enhancing their monetary policy independence. Thus, the governments are increasingly financed by the private sector.

A growing trend the world over has been that of separation of debt management function from the monetary management function, though the actual structure differs across countries. While some OECD countries like Germany and the UK have opted for an autonomous debt management office to improve operational efficiency, some other countries like Australia, France and the US have a separate office working under the aegis of Ministry of Finance. As regards the ideal model for developing countries, opinions vary. Some experts have argued that the separate office can be initially placed under the Ministry of Finance, while there is also a view that in countries where fiscal deficits are high and financial markets are underdeveloped, a separate debt management office may be unsuitable for overall policy effectiveness of debt management.

Central banks in emerging economies take initiatives to perform certain developmental role for smooth conduct of its policies. It assumes the role as a facilitator for financial market developments. It also takes initiatives in the introduction of information technology in the functioning of the various institutional mechanisms in the financial system for quick and smooth operations. Central banks in several developing countries have taken initiatives for financial sector reforms. This role is undertaken as it is increasingly evident that competitive financial markets are necessary for efficient allocation of resources and failures in the financial markets have serious costs in terms of output. In developing countries, central banks have contributed towards the development of the banking and financial sectors and made efforts to bring them at par with their counterparts in the developed world. For this, they have fostered the growth of their markets and institutions. The central banks nowadays are also active in strengthening international financial architecture.

What is Central Bank Independence? Central bank independence basically relates to three areas viz., personnel matters, financial aspects, and conduct of monetary policy. Personnel independence refers to the extent to which the Government

distances itself from appointment, term of office and dismissal procedures of top central bank officials and the governing board. Also, it includes the extent and nature of representation of the Government in the governing body of the central bank. On the other hand, financial independence relates to the freedom of the central bank to decide the extent to which Government expenditure is either directly or indirectly financed via central bank credits. Direct or automatic access of Government to central bank credits would naturally imply that monetary policy is subordinated to fiscal policy. Policy independence relates to the flexibility given to the central bank in the formulation and execution of monetary policy. Another school of thought looks at central bank independence from the view of goal independence vs. instrument independence. Goal independence refers to a situation where the central bank itself can choose the policy priorities of stabilizing output or prices at any given point of time, thus setting the goal of monetary policy. Instrument independence implies that the central bank is only free to choose the means to achieve the objective set by the Government. Many arguments have been put forth in favour as well as against central bank independence for a variety of reasons. First, an independent central bank operates on a longer time scale and thus may be more inclined to adopt a more prudent long-term perspective. Second, the priorities of the fiscal policies may conflict with the monetary policy objectives. For example, while the government would like to keep the cost of debt service low, the monetary authorities may like to vary the interest rates in order to maintain price stability. An independent central bank may be in a better position to address and resolve this conflict. Third, in countries where debt markets are not well developed, central banks that do not enjoy adequate independence may be forced to finance the budget deficit by printing money, thereby interfering with the objective of price stability. The view that central banks should be largely independent of political power is generally believed to have emerged only in the twentieth century. The recent revival of interest in the independence of central banks reflects several factors, viz., the reforms in centrally planned economies, the establishment of new European central banking arrangements and the importance of price stability in a world characterised by substantial cross border financial flows.

As against this, there are also contrary views.

Firstly, the detractors of

autonomy argue that an independent central bank lacks democratic legitimacy. In this context, the views of Milton Friedman that money is too important an issue to be left to the whims of central bankers will have to be considered. Secondly, independence may lead to frictions between the fiscal and the monetary authorities and the resulting costs of these frictions between monetary and fiscal policy may be somewhat costly for society, thus inhibiting the development process. Thirdly, it is possible that the priorities between a strong central bank and society may differ which would perhaps hamper the growth process or economic welfare of the society. In this context, the opinions differ widely on the relative importance between growth vis--vis inflation as objectives of monetary policy. Ultimately everything boils down to the issue of a responsible central bank to societal concerns.

Global Financial Crisis and Central Banks The financial crisis which surfaced in USA in mid-2007 transformed itself into a global financial crisis and then into a global economic crisis. The crisis has attracted the attention of policy makers, academicians and analysts. The global financial crisis has been attributed to a number of micro and macroeconomic factors role of easy money, financial innovations and global imbalances on the one hand to regulatory loopholes both at the national and global level on the other. The crisis has necessitated the need to revisit the global regulatory and supervisory structures and perimeters against the backdrop of rapid financial innovations. In the backdrop of large scale disruptions in international financial markets and deteriorating macroeconomic conditions, the national Governments and central banks in several countries resorted concomitantly with a variety of both conventional and unconventional policy actions to contain systemic risk to shore up the confidence in the financial system and arrest the economic slowdown. The policy responses -regulatory, supervisory, monetary and fiscal- during the crisis have been unparalleled in terms of their scale, magnitude and exceptional coordination across various jurisdictions. The responses included varying combinations of monetary and fiscal measures,

deposit guarantees, debt guarantees, capital injections and asset purchases, which were coordinated globally. Monetary authorities in the industrial world were the first to initiate action by resorting to an aggressive monetary easing resulting in record low policy rates. To contain the crisis of confidence and ease financial conditions, central banks ventured even further by using their balance sheets in unconventional ways. In the context of the crisis, a number of important issues have emerged relating to the prevention and management of crises which allows us to draw relevant lessons for both market participants and policy makers. The analysis of underlying factors whether macroeconomic or microeconomic in nature responsible for evolving and intensifying the crisis have raised issues about the role of public authorities, viz, central banks, supervisor/regulators and governments in safeguarding financial stability. The central banks played a decisive and active role in limiting the impact of the crisis by taking rapid and innovative policy decisions, sometimes in cooperation with other central banks. Experience of crisis shows that there is a good case for bringing financial stability higher in the priorities of central banks. Thus, it is widely perceived that there is a need to revisit and redefine the role of central banks. In this context, the following issues have attracted attention in policy discussions.

Asset Prices and the Role of Monetary Policy The recent financial crisis motivated a review of financial stability frameworks and, within that, the role of central banks in financial stability. An important lesson of the crisis is that the single-minded focus on price stability may have yielded low and stable inflation in terms of prices of goods and services, but the lowering of returns in the commodity/service producing sectors could have diverted the search for yields to the financial sector. Although there are contrasting arguments regarding the role of monetary policy in pricking asset bubbles, it has been increasingly emphasised that the relationship between monetary policy and asset prices needs to be revisited. Despite these contrasting arguments, it is realised that the policy of neglect of asset price build-up has failed and price stability does not necessarily deliver financial stability. Therefore, it is increasingly felt that the mandate of monetary policy

should include macro financial stability and not just price stability. The central banks need to continuously monitor the nature of asset price booms and decide whether monetary policy has any role in minimising the risks associated with booms of a speculative nature.

Adequate Provision of Liquidity as a Lender of Last Resort In addition to the conduct of monetary policy, a vital responsibility of central banks in most countries is to perform the role of lender of last resort (LOLR). At its core, the LOLR function is to prevent and mitigate financial instability through the provision of liquidity support either to markets or individual financial institutions. However, the recent crisis has brought to the fore the issue of the efficacy of central banks as LOLR and raised the question of whether the tools available with them are sufficient for confronting the challenges posed by a crisis

Communication with the Market Another issue that recent global developments have highlighted pertains to the communication of central banks with the market. Due to lack of

comprehensiveness on various policy responses, particularly in advanced economies, credit and financial markets remained unconvinced about the policy measures and did not react positively for some time. This underscores the importance of communication by policy authorities, including central banks, with the markets. Not only central bank policy measures need to be clearly communicated, the dissemination of information on economic outlook by central banks is also important. During crisis, it becomes important for central banks to ensure that their communication with the market is clear enough to add certainty and predictability.

Lessons for Financial Regulation and Supervision With regard to financial regulation and supervision, the following aspects are being emphasised: Importance of System-wide Approach, Policies to Mitigate Pro-Cyclicality in Regulation and Accounting, Enhancing Transparency and Disclosure, Effective Regulation of Cross-border Institutions, Resolution

Mechanism for Non-banking Financial Institutions, Mixing Commercial and Investment Banking, Compensation Structure, Efficacy of Financial

Innovations, etc The other important aspects of the effective functioning of central banks are their credibility and transparency. Credibility of a central bank implies that it has a reputation for pursuing price stability and financial stability consistently and persistently. If a central bank is viewed as both committed to and effective at maintaining low inflation, then inflation expectations are lower, eventually leading to movements in prices and wages that are consistent with low and stable inflation. Conversely, the lack of credibility leads to inflation expectations becoming self-fulfilling. Central bank transparency is crucial for achieving the objectives of monetary policy. Information about the objectives of central bank and the details of conduct of monetary policy like changes in interest rates are important as they help to anchor the public expectations. The central banks face many challenges in the context of the global economic crisis. These are : (i) Managing Monetary Policy in a Globalizing Environment (ii) Redefining the Mandate of Central Banks , (iii) Responsibility of Central Banks Towards Financial Stability, (iv) Managing the Costs and Benefits of Regulation, (v) Managing the Balance Between the Autonomy and Accountability of Central Banks.

************************************* References: Reddy, Y.V. 2001 Autonomy of the Central Bank: Changing Contours in India RBI Bulletin, October 2001. Mohan, Rakesh 2006 Evolution of Central Banking in India RBI Bulletin, Mumbai, May 2006. Fuhrer, Jeffrey C. 1997 Central Bank Independence and Inflation Targeting: Monetary Policy Paradigms for the Next Millennium? New England Economic Review, January/February 1997. Reserve Bank of India, Report on Currency and Finance, 2007 Reserve Bank of India, Report on Currency and Finance, 2010

Subbarao, D (2010) `Challenges for Central Banks in the Context of the Crisis, RBI Bulletin, March 2010 (Prepared by S. Arunachalaramanan, MoF, RBSC: Revised by BN Anantha Swamy, MoF, RBSC)

Indian Banking System

Commercial Banking An Overview Commercial banks play a very important role in the economy. A well developed banking system is a prerequisite for ensuring sustainable economic growth. Commercial banks accept deposits for the purposes of lending and investment. In the process, they channelize money from savers to borrowers and transform the maturity. This intermediary function is the main lubricant in a well oiled economy. The very nature of their role brings in inherent risks. As they deal with public deposits, these are to be returned to the depositors as and when they fall due. It is, therefore, necessary that whatever money they lend or invest is monitored carefully so as to ensure that there is no or negligible impairment. The risk of default by some borrowers in meeting their obligations is generally termed as credit risk. Further, as there is a likelihood of impairment in the money that is lent / invested, there is a need to have a reasonable cushion against unexpected losses so that the chance of depositors losing their money is minimised. This brings in the need for adequate capital in running the business of banking. This is generally ensured by prescribing a minimum capital for banks in absolute terms as well as a minimum capital adequacy ratio to be maintained by banks on an ongoing basis. As banks typically accept shorter duration deposits and lend it for longer duration (maturity transformation), there is a potential that they may not be able to meet the obligations to the depositors as and when they fall due, if the maturity of assets and liabilities are not managed effectively. Liquidity risk management is very important for banks. This brings in the need for appropriate asset liability management by banks.

Banks also are affected by certain macro variables like interest rates, exchange rates etc. The risk arising on account of changes in the interest rate, exchange rate, equity price and commodity price are generally termed as market risk. This also demands that banks maintain adequate cushion in the form of capital. Further, as the size of the bank

grows, the volume they transact increases, the products they offer become much more complex and their geographical spread widens significantly, operational risk management assumes importance. The potential loss arising on account of people, processes and systems is generally termed as operational risk.

Banks deal with public deposits and the public repose enormous trust on banks. It is imperative that the affairs of the banks are managed in a manner not detrimental to the public interest. This brings in the need for having a good corporate governance framework in banks. On account of the special role played by the banks in the economy and in order to protect the interests of the depositors, banks are tightly regulated world over. Regulators prescribe prudential standards to be followed by the banks and it is enforced with authority so as to keep the confidence in the banking system intact.

Deposits are the key source of funds for banks and all the banks vie for mobilising more and more stable deposits. This nudges them to offer good customer service and suitable products. With fierce competition amongst banks, it is the quality of customer service that can determine the winners and losers. Banks just cannot afford to ignore their customers.

With economies of the world integrating at a much faster rate in the recent time, the demand on the banking sector also has grown significantly. This has led to several product innovations, remittance schemes, derivative products etc.

2. Evolution of banking in India The pre-independence period of Indian banking was largely characterized by the existence of private banks organized as joint stock companies. Most banks were small and had private shareholding of the closely held variety. They were largely localized and many of them failed. They came under the purview of the Reserve Bank that was established as central bank for the country in 1935. But the process of regulation and

supervision was limited by the provisions of the Reserve Bank of India Act, 1934 and the Companies Act, 1913. The indigenous bankers and money lenders had remained mainly isolated from the institutional part of the system. The usurious network was still rampant and exploitative. Co-operative credit was the only hope for credit but the

movement was successful only in a few regions. The early years of independence (1947 to 1967) posed several challenges with an underdeveloped economy presenting the classic case of market failure in the rural sector, where information asymmetry limited the foray of banks. Further, the nonavailability of adequate assets made it difficult for people to approach banks. With the transfer of undertaking of Imperial bank of India to State Bank of India(SBI) and its subsequent massive expansion in the under-banked and unbanked centres spread institutional credit into regions which were un-banked heretofore. Proactive measures like credit guarantee and deposit insurance promoted the spread of credit and savings habits to the rural areas. There were, however, problems of connected lending as many of the banks were under the control of business houses. The period from 1967 to 1991 was characterized by major developments like social control of banks in 1967 and the nationalization of banks in 1969 and in 1980. The nationalization of banks was an attempt to use the scarce resources of the banking system for the purpose of planned development. The task of maintaining a large

number of small accounts was not profitable for the banks as a result of which they had limited lending in the rural sector. The problem of lopsided distribution of banks and the lack of explicit articulation of the need to channel credit to certain priority sectors was sought to be achieved first by social control of banks and then by nationalization of banks in 1969 and 1980. The lead bank scheme provided the blue print of further bank branch expansion. The course of evolution of the banking sector in India since 1969 has been dominated by the nationalization of banks. This period was characterized by rapid branch expansion that helped to draw the channels of monetary transmission far and wide across the country. The share of unorganized credit fell sharply and the economy seemed to come out of the low level of equilibrium trap. However, the stipulations that made this possible and helped spread institutional credit

and nurture the financial system, also led to distortions in the process.

The

administered interest rates and the burden of directed lending constrained the banking sector significantly. There was very little operational flexibility for commercial banks. Profitability occupied back seat. Banks also suffered from poor governance. The period beginning from the early 1990s witnessed the transformation of the banking sector as a result of financial sector reforms that were introduced as a part of structural reforms introduced /initiated in 1991. The reform process in the financial sector was undertaken with the prime objective of having a strong and resilient banking system. The progress that was achieved in the areas of strengthening the regulatory and supervisory norms ushered in greater accountability and market discipline amongst the participants. The RBI made sustained efforts towards adoption of international benchmarks in a gradual manner, as appropriate to the Indian conditions, in various areas such as prudential norms, risk management, supervision, corporate governance and transparency and disclosures. The reform process helped in taking the management of the banking sector to the level, where the RBI ceased to micro-manage commercial banks and focused largely on macro goals. The focus on deregulation and liberalization coupled with enhanced responsibilities for banks made the banking sector resilient and capable of facing several newer global challenges. In India, the commercial banks could be categorised broadly into Public Sector Banks (which term includes Nationalised Banks, State Bank of India and its Associates and IDBI Bank), new generation private sector banks, old generation private sector banks and foreign banks. Regional Rural Banks set up in seventies and Local Area Banks around the millennium are also commercial banks. The other entities of Indias banking system are Urban co-operative banks, District Central Co-operative banks and State cooperative banks. In respect of banks, the RBI derives its powers from the provisions of the Banking Regulation Act, 1949, and certain select provisions of RBI Act, 1934. As of March 31, 2009, the Indian Banking System comprised 27 public sector banks, 7 new private sector banks, and 15 old private sector banks, 31 foreign banks, 86 Regional Rural Banks (RRBs), 4 Local Area Banks (LABs), 1721 Urban Co-operative Banks, 31 State co-operative banks and 371 district central co-operative banks. The all

India weighted average population coverage by a commercial bank branch was 13, 400 as on June 30, 2010. 3. Public Sector Banks Even before nationalisation of banks by the Government of India after obtaining independence, India had several banks promoted or controlled by Governments of princely states. State Bank of India and Associates In its report submitted in 1954, the All India Rural Credit Survey Committee recommended the creation of one strong, integrated, State -sponsored, State-partnered commercial banking institution with an effective machinery of branches spread over the whole country. Keeping in view the above recommendation, State Bank of India was established under State Bank of India Act, 1955 which acquired the Imperial Bank of India. Nationalisation of Imperial Bank of India was the beginning of Public Sector Banks in Independent India. State Bank of India was required to promote banking habit in rural areas, introduce new services to the community and provide adequate credit facilities for the productive sectors of the economy. It was also expected to assist the Reserve Bank of India in ensuring the flow of credit in accordance with the national priorities as set out in Five Year Plans. A substantial portion of the shareholding was taken by Reserve Bank of India. Later under State Bank of India (Subsidiary Banks) Act, 1959, eight State-associated banks were taken over by the State Bank of India as its subsidiaries, later named as Associates. The names of the banks which were taken over was as under: Sl No 1 2 3 4 5 6 Name of the Bank State Bank of Jaipur State Bank of Bikaner State Bank of Hyderabad State Bank of Indore State Bank of Mysore State Bank of Patiala Established in Year 1943 1944 1941 1920 1913 1917 Remarks These two banks amalgamated to form SBBJ in 1963 Merged with SBI recently

Sl No 7 8

Name of the Bank State Bank of Saurashtra State Bank of Travancore

Established in Year 1950 1945

Remarks Merged with SBI

First phase of nationalisation Even after State Bank of India and its Associates were taken under Government control, there was a widespread feeling that other Indian commercial banks were not discharging their responsibilities keeping in view the socialistic democratic principles adopted by the State. There have been numerous complaints that these banks are not advancing to sectors like Agriculture, Small Scale Industries etc. In December 1967, the Government initiated the scheme of social control on Indian commercial banks. The arrangements were enforced through a legislative measure on February 1, 1969. However, the scheme was found to be unsatisfactory and inadequate. As a result, on July 19, 1969, 14 banks with deposits above Rs.50 crores were nationalised in order to serve better the needs of development of the economy in conformity with the national policy and objectives. Some of the objectives of nationalisation of banks were as under: To ensure provision of adequate credit to the neglected sectors such as agriculture, cottage and small scale industries, retail trade, exports, artisans and self-employed persons, To prevent the diversion of bank finance to anti-social, less productive, lowpriorities sector and to big industrialists and businessmen, Giving a professional bent to bank management, Reduction of regional imbalances in banking facilities by opening of branches in rural / remote and unbanked areas, Development of banking habits among people, Equitable distribution of economic power by removal of control of banks by a few big industrialists and business houses and Provision of adequate training as well as reasonable terms of service for bank staff.

Since the nationalisation of fourteen major banks, the geographical and functional coverage of commercial banks have increased at a rate that is unprecedented in the world. Mass banking from class banking was the motto. Second phase of nationalisation In order to enhance the capacity of the banking system to meet more effectively the needs of the developing economy and to promote effectively the needs of the developing economy and to promote the welfare of the people in conformity with the national policy, by promulgating an ordinance on April 15, 1980, six more banks with the deposits of Rs.200 crore and above were nationalised. Andhra Bank, New Bank of India, Vijaya Bank, Punjab and Sind Bank, Corporation Bank and Oriental Bank of Commerce were nationalised in the second phase. As a result of nationalisation, there was a rapid expansion of branches of commercial banks not only in metropolitan and urban areas but also in the rural and semi-urban areas that were hitherto neglected by the commercial banks. Mobilisation of substantial deposits and spreading the habit of banking has been the other significant achievements of the nationalised banks. IDBI Bank IDBI was established by an Act of Parliament in July 1964. IDBI also had promoted a new generation private sector bank in the name IDBI Bank Ltd along with SIDBI. It was decided that the IDBI Bank Ltd would be merged with IDBI and the new entity would be named as IDBI Bank Ltd. The final approval from RBI for the merger was given on April 1, 2005. 4. Private Sector Banks For well over two decades, after the nationalisation of 14 larger banks in 1969, no banks have been allowed to be set up in the private sector. Progressively, over this period, public sector banks have expanded their branch network considerably and catered to the socio-economic needs of large masses of population especially the weaker section and those in the rural areas. When financial sector reforms were initiated in India in the early nineties, guidelines for licensing of new banks in the private sector were

issued in January 1993 and subsequently revised in January 2001. The objective was to instil greater competition in the banking system to increase productivity and efficiency. The initial minimum paid up capital was prescribed at Rs. 200 crore to be raised to Rs. 300 crore within three years of commencement of business. Detailed guidelines/requirements have been prescribed with regard to registration, licensing, capital, ceiling on voting rights, priority sector lending, setting up of subsidies, etc. With financial inclusion getting much sharper focus, the demand for licensing few more banks has gained ground. Reserve Bank of India has announced a draft policy paper for licensing more banks on August 11, 2010 seeking opinion by September 2010 from public. The final policy would be articulated taking into account the various suggestions received from members of public, aspiring institutions, academia etc.

5. Foreign Banks In India the presence of foreign banks dates back to the pre-independence period. Various Committees on financial sector reforms recommended further opening up of the Indian banking sector to augment competition and efficiency. Furthermore, a window for expansion of foreign banks was opened in India under the General Agreement on Trade and Services(GATS) of World Trade Organisation(WTO)As of now, along with allowing more branches of foreign banks, giving them more flexibility in their

operations, India has gone beyond the WTO commitment of 12 branches. In fact, number of branches allowed each year has already been higher than WTO commitments. Initially foreign banks in India were allowed to enter and expand by branches-mode only and were not permitted to own controlling stakes in domestic banks. Subsequently, the aggregate foreign investment from all sources was allowed up to a maximum of 74 per cent of the paid-up capital of a private bank. In February 2005 Government of India and the RBI released the Roadmap for presence of Foreign banks in India, laying out a two -track, i.e., consolidation of the domestic banking system(both in private sector and public sector) and foreign banks in a synchronised gradual The

enhancement of the presence of

manner.

roadmap was divided into two phases, the first phase spanning the period March 2005March 2009, and the second phase beginning April 2009 after a review of the experience gained in the first phase. In the first phase, foreign banks are permitted to establish presence by way of

WOS(Wholly-Owned Subsidiary) or conversion of the existing branches into a WOS following the one mode presence criterion. The WOS are treated on par with the existing branches of foreign banks for branch expansion in India. So far, however, no bank has applied for a WOS presence. In view of the current global financial sector turmoil, and its aftermath evolving regulatory and supervisory scenario it has been decided, for the time being, to continue with the current policy and procedures governing the presence of foreign banks in India. 6. Local Area Banks (LABs) The Local Area Bank Scheme was introduced in August 1996 pursuant to the announcement made in the Union Budget of that year. The idea behind setting up of new private local banks with jurisdiction over two or three contiguous districts was to help the mobilisation of rural savings by local institutions and make them available in local areas The guidelines for setting up of LABs in the private sector were announced by the RBI in August 1996. There were four LABs as at end-March 2009. 7. Rural financing Institutions (i) Rural cooperative banks Rural cooperatives occupy an important position in the Indian Financial System. These were the first formal institutions established to purvey credit to rural India. Thus far, cooperatives have been key instrument of financial inclusion in reaching out to the last mile in rural areas. Cooperative banks are registered under the respective State Cooperative Societies Acts or Multi State Cooperative Societies Act, 2002 and governed by the provisions of the respective acts. The legal character, ownership, management, clientele and the role of state governments in the functioning of the cooperative banks make these institutions distinctively different from commercial banks. The distinctive feature of the cooperative credit structure in India is its heterogeneity.

Structure of Rural Cooperative Credit Instructions Rural cooperative structure is bifurcated into short-term and long-term structure. The short-term cooperative structure is a three-tier structure with State Cooperative

Banks(StCBs) at the apex(State) level, District Central Cooperative Banks(DCCBs) at the intermediate(district) level and Primary Agricultural Credit Societies(PACS) at the ground (village) level. The short-term structure caters primarily to the various

short/medium-term production and marketing credit needs for agriculture. The long-term cooperative structure has the State Cooperative Agriculture and Rural Development Banks(SCARDBs) at the apex level and the Primary Cooperative Agriculture and Rural Development Banks (PCARDBs) at the district or block level. These institutions were conceived with the objective of meeting long-term credit needs in agriculture. Regulatory and supervisory framework While regulation of State Cooperative Banks and District Central Cooperative Banks vests with Reserve Bank, their supervision is carried out by National Bank for Agriculture and Rural Development(NABARD). The Board of Supervision, a Committee of the Board of Directors of NABARD, gives directions and guidance in respect of policies and matter relating to supervision and inspection of StCBs, DCCBs. A large number of StCBs as well as DCCBs are unlicensed and are allowed to function as banks till they are either granted licence or their application for licence are rejected. The Committee on Financial Sector Assessment had observed that there is need for roadmap to ensure that only licenced banks operative in the cooperative space and that banks which fail to obtain a licence by 2010 should not be allowed to operate, to expedite the process of consolidation and weeding out of nonviable entities from the cooperative space. A road map has been put in place to achieve this position. (ii)Regional Rural Banks (RRBs) Regional Rural banks were set up under the Regional Rural Banks Act, 1976 with a view to developing the rural economy by providing credit and other facilities,

particularly to the small and marginal farmers, agricultural labourers, artisans and small entrepreneurs. Being local level institutions, RRBs together with commercial and

co-operative banks, were assigned a critical role to play in the delivery of agriculture and rural credit. The equity of the RRBs was contributed by the Central Government, concerned State Government and the sponsor bank in the proportion of 50:15:35. As of March 31, 2009, there were 86 RRBs having a total of 15107 branches. The function of financial

regulation over RRBs is exercised by RBI and the supervisory powers have been vested with NABARD. CRAR norms are not applicable to RRBs. However, income recognition, asset classification and provisioning norms as applicable to commercial banks are applicable to RRBs. 8. Urban Cooperative Banks (UCBs) UCBs play a significant role in providing banking services to the middle and lower income groups of society in urban and semi urban areas. The Primary (Urban) Cooperative Banks(UCBs), like other co-operative societies, are registered under the respective State Co-operative Societies Acts or Multi State Cooperative Societies Act, 2002 and governed by the provisions of the respective Acts. With a view to bringing primary(urban) co-operative banks under the purview of the Banking Regulation Act, 1949,(B R Act) certain provisions of the B R Act were made applicable to co-operative banks effective March 01, 1966. With this, these banks came under the dual control of respective State Governments/Central Government and the Reserve Bank. While the non-banking aspects like registration, management, administration and recruitment, amalgamation and liquidation are regulated by

State/Central Governments, matters related to banking are regulated and supervised by the RBI under the B R Act (as applicable to co-operative societies). As of March 31, 2009 there were 1721 Primary (Urban) Co-operative banks including 53 scheduled banks. The UCBs are largely concentrated in a few States such as, Andhra Pradesh, Gujarat, Karnataka, Maharashtra and Tamil Nadu. Apart from a few large banks, most of the UCBs are often functioning as a unit bank.

9. Looking ahead Commercial banks; Focus is on implementing Basel II norms, which will require improved capital planning and risk management skills. Urban cooperative banks: Focus is on profitability, professional management and technology enhancement. Regional rural banks: Focus is on enhancing capability through IT and HR for serving the rural areas. Rural cooperative banks: Focus is on ensuring that they meet minimum prudential standards.

MONETARY POLICY
One of the important functions of the Reserve Bank is to formulate and implement monetary policy. The term monetary policy refers to the use of instruments within the purview of the central bank to influence the cost and availability of money in order to achieve certain objectives such as price stability, growth, financial stability, etc,. Through monetary policy measures, the central bank attempts to control the overall liquidity in the financial system for ensuring adequate flow of credit for productive sectors of the economy. Till recently, The Reserve Bank of India was announcing the policy review on a quarterly basis. Since, September 2010, Reserve Bank is coming out with a Mid-Quarter Review which takes into account developments in between the quarterly announcements. The stance of monetary policy and the rationale are communicated to the public in a variety of ways, the most important being the Governors quarterly monetary policy statements. Further, the policy measures are analysed in various publications, speeches and press releases. Information on areas relating to the economy, banking and financial sector is released with stringent standards of quality and timeliness. The following discussions deal with various aspects of monetary policy formulation in India.

Objectives

The preamble to the Reserve Bank of India Act, 1934 sets out the objectives of the Bank as 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. Although there is no explicit mandate for price stability, the objectives of monetary policy in India have evolved as those of maintaining price stability and ensuring adequate flow of credit to the productive sectors of the economy. In essence, monetary policy aims to maintain a judicious balance between price stability and economic growth. Of late, considerations of financial stability have assumed greater importance in view of

increasing openness of the Indian economy and financial reforms. In the Indian context, financial stability could be interpreted to include three aspects, viz., (a) ensuring uninterrupted financial transactions, (b) maintenance of a level of confidence in the financial system amongst all the participants and stakeholders, and (c) absence of excess volatility that unduly and adversely affects real economic activity. It is the endeavour of the Reserve Bank to ensure all these aspects of financial stability. Since the late 1980s, there has been an enhanced emphasis by many central banks on securing operational freedom for monetary policy and investing it with a single goal, best embodied in the growing independence of central banks and inflation targeting as an operational framework for monetary policy, which has important implications for transmission channels. In this context, the specific features of the Indian economy have led to the emergence of a somewhat contrarian view: In India, adoption of inflation targeting has not been favoured , while keeping the attainment of low inflation as a central objective of monetary policy, along with that of high and sustained growth that is so important for a developing economy. Apart from the legitimate concern regarding growth as a key objective, there are other factors that suggest that inflation targeting may not be appropriate for India. First, unlike many other developing countries we have had a record of moderate inflation, with double digit inflation being the exception, and largely socially unacceptable. Second, adoption of inflation targeting requires the existence of an efficient monetary transmission mechanism through the operation of efficient financial markets and absence of interest rate distortions. In India, although the money market, government debt and forex markets have indeed developed in recent years, they still have some way to go, whereas the corporate debt market is still to develop. Though interest rate deregulation has largely been accomplished, some administered interest rates still persist. Third, inflationary pressures still often emanate from significant supply shocks related to the effect of the monsoon on agriculture, where monetary policy action may have little role. Finally, in an economy as large as that of India, with various regional differences, and continued existence of market imperfections in factor and product markets

between regions, the choice of a universally acceptable measure of inflation is also difficult.

The objectives of monetary policy differ across countries. During the 1990s, there was a convergence around the world in the goals and methods used to conduct monetary policy. A number of factors were responsible for this development. First, during the 1970s and 1980s, many countries experienced very high levels of inflation. This led to a clear consensus that even moderate levels of inflation damage real growth and that low inflation must therefore be a primary objective of monetary policy. Second, evidence showed that in most countries, short-run money demand functions are unstable and that meaningful measures of money, such as M2 or M3, are very difficult cult to control. As a result, monetary targeting alone was no longer viewed as a viable strategy for stabilizing prices. Finally, excessive exchange rate volatility was seen as damaging. Following this, many countries redesigned their policies and adopted inflation targeting. New Zealand in 1988 became the first industrialized country to adopt an explicit / hard inflation target; Canada, Chile, and Israel adopted inflation targeting in 1991; the United Kingdom, Australia and Sweden also changed their policy frames and adopted inflation targeting. However, countries such as USA and India have other objectives as well.

Framework and Instruments

In India, monetary policy framework has undergone significant transformation over time. In the 1960s, as inflation was considered to be structural and inflation volatility was mainly caused by agricultural failures, there was greater reliance on selective credit controls. The aim was to regulate bank advances to sensitive commodities to influence production outlays, on the one hand and to limit possibilities of speculation, on the other. In the 1970s, there was a surge in inflation on account of monetary expansion induced by expansionary fiscal policies besides the oil price shocks. By the early 1980s, there was a broad agreement on

the primary causes of inflation. It was argued that while fluctuations in agricultural prices and oil price shocks did affect prices, sustained inflation since the early 1960s could not have occurred unless it was supported by the continuous excessive monetary expansion generated by the large-scale monetisation of the fiscal deficit. Against the backdrop, the Committee to Review the Working of the Monetary System (Chairman: Prof. Sukhamoy Chakravarty; 1985), set up by the Reserve Bank, recommended a monetary targeting framework to target an acceptable order of inflation in line with desired output growth

Over the period from 1985 to 1997, India followed a monetary policy framework that could broadly be characterised as one of loose and flexible monetary targeting with feedback . Under this approach, growth in broad money supply (M3) was projected in a manner consistent with expected GDP growth and a tolerable level of inflation. The M3 growth thus worked out was considered a nominal anchor for policy. Reserve money (RM) was used as the operating target and bank reserves as the operating instrument. As deregulation increased the role of market forces in the determination of interest rates and the exchange rate, monetary targeting, even in its flexible mode, came under stress. Capital flows increased liquidity exogenously, put upward pressure on the money supply, prices and the exchange rates. While most studies in India showed that money demand functions had been fairly stable, it was increasingly felt that financial innovations and technology had systematically eroded the predictive potential of money demand estimations relative to the past. Interest rates gained relative influence on the decision to hold money. Accordingly, the Monetary policy framework was reviewed towards the late 1990s, and the Reserve Bank switched over to a more broad-based multiple indicator approach from 1998-99. In this approach, policy perspectives are obtained by juxtaposing interest rates and other rates of return in different markets (money, capital and government securities markets), which are available at high frequency with medium and low frequency variables such as currency, credit extended by banks and financial institutions, the fiscal position, trade and capital flows, inflation rate, exchange rate, refinancing and transactions in foreign

exchange and output. Such a shift was a logical outcome of measures taken over the reform period since the early 1990s. The switchover to a multiple indicator approach provided necessary flexibility to respond to changes in domestic and international economic environment and financial market conditions more effectively. The multiple indicators approach, conceptualized in 1998, has since been augmented by forward looking indicators from surveys and a panel of time series models.

Some of the important factors that shaped the changes in monetary policy framework and operating procedures in India during the 1990s were deregulation of interest rates, and development of the financial markets with reduced segmentation through better linkages and development of appropriate trading, payments and settlement systems along with technological infrastructure. Another important development in the direction of providing safeguards to monetary policy from the consequences of expansionary fiscal policy and ensuring a degree of de facto autonomy of the RBI was the delinking of budget deficit from its automatic monetization by the Reserve Bank. The system of automatic monetisation through ad hoc Treasury Bills was replaced with Ways and Means Advances in 1997, because of which the Government resorted to increased market borrowings to finance its deficit. With the enactment of the Fiscal Responsibility and Budget Management Act in 2003, the Reserve Bank cannot participate in the primary issues of Central Government securities with effect from April 2006.

In its monetary policy operations, the Reserve Bank uses multiple instruments to ensure that appropriate liquidity is maintained in the system so that all legitimate requirements of credit are met, consistent with the objective of price stability. Towards this end, the Bank pursues a policy of active management of liquidity through OMO including LAF, MSS and CRR, and using the policy instruments at its disposal flexibly, as and when the situation warrants. The recent legislative amendments enable a flexible use of the CRR for monetary management, without being constrained by a statutory floor or ceiling on the level

of the CRR. The amendments also enable the lowering of the Statutory Liquidity Ratio (SLR) to the levels below the pre-amendment statutory minimum of 25 per cent of net demand and time liabilities of banks

In the Indian context, reforms in the monetary policy operating framework, which were initiated in the late 1980s crystallised into the Liquidity Adjustment Facility (LAF) in 2000. Under the LAF, the Reserve Bank sets its policy rates, i.e., repo and reverse repo rates and carries out repo/reverse repo operations, thereby providing corridor for overnight money market rates. The introduction of LAF has had several advantages. First and foremost, it made possible the transition from direct instruments of monetary control to indirect instruments. Since LAF

operations enabled reduction in CRR without loss of monetary control. Second, LAF has provided monetary authorities with greater flexibility in determining both the quantum of adjustment as well as the rates by responding to the needs of the system on a daily basis. Third and most importantly, though there is no formal targeting of a point overnight interest rate,

The instruments to manage, in the context of large capital flows and sterilisation, has been strengthened through Market Stabilisation Scheme (MSS), which was introduced in April 2004. As the stock of government securities available with the Reserve Bank declined progressively and the burden of sterilization increasingly fell on LAF operations. the Reserve Bank signed in March 2004, a memorandum of understanding (MoU) with the Government of India for issuance of Treasury Bills and dated government securities under the Market Stabilisation Scheme (MSS). The intention of MSS is essentially to differentiate the liquidity absorption of a more enduring nature by way of sterilisation from the dayto-day normal liquidity management operations. The ceiling on the outstanding obligations of the Government under MSS has been initially indicated but is subject to revision through mutual consultation. The issuances under MSS are matched by an equivalent cash balance held by the Government in a separate identifiable cash account maintained and operated by the Reserve Bank. While

these issuances do not provide budgetary support to the Government, interest costs are borne by the Government. These securities are also traded in the secondary market.

There are occasions when the medium-term goals, say reduction in cash reserve ratios for banks, conflict with short-term compulsions of monetary management requiring actions in both directions. Drawing a distinction between medium term reform goals and flexibility in short-term management is considered something critical in the Indian policy environment. The success of a framework that relies on indirect instruments of monetary management such as interest rates is contingent upon the extent and speed with which changes in the central bank's policy rate are transmitted to the spectrum of market interest rates and exchange rate in the economy and onward to the real sector. Clearly, monetary transmission cannot take place without efficient price discovery, particularly, with respect to interest rates and exchange rates. Therefore, in the efficient functioning of financial markets, the corresponding development of the full financial market spectrum becomes necessary. In addition, the growing integration of the Indian economy with the rest of the world has to be recognized and provided for. Accordingly, reforms focused on improving operational effectiveness of monetary policy have been put in process, while simultaneously strengthening the regulatory role of the Reserve Bank, tightening the prudential and supervisory norms, improving the credit delivery system and developing the technological and institutional framework of the financial sector.

Institutional Mechanism

Monetary policy formulation is carried out by the Reserve Bank through a consultative process. The Monetary Policy Department holds meetings with select major banks and financial institutions, which provide a consultative platform for issues concerning monetary, credit, regulatory and supervisory policies of the Bank. Decisions on day-to-day market operations, including management of

liquidity, are taken by a Financial Markets Committee (FMC), which includes senior officials of the Bank responsible for monetary policy and related operations in money, government securities and foreign exchange markets. The Deputy Governor, Executive Director(s) and heads of four departments in charge of monetary policy and related market operations meet every morning as financial markets open for trading. They also meet more than once during a day, if such a need arises. In addition, a Technical Advisory Committee on Money, Foreign Exchange and Government Securities Markets comprising academics and financial market experts, including those from depositories and credit rating agencies, provides support to the consultative process. Besides FMC meetings, Monetary Policy Strategy Meetings take place regularly. The strategy meetings take a relatively medium-term view of the monetary policy and consider key projections and parameters that can affect the stance of the monetary policy. In pursuance of the objective of further strengthening the consultative process in monetary policy, a Technical Advisory Committee (TAC) on Monetary Policy has been set up with Governor as Chairman and Deputy Governor in charge of monetary policy as Vice Chairman, three Deputy Governors, two Members of the Committee of the Central Board and five specialists drawn from the areas of monetary economics, central banking, financial markets and public finance, as Members. The TAC meets ahead of the Annual Policy and the quarterly reviews of annual policy. The TAC reviews macroeconomic and monetary developments and advises on the stance of monetary policy. Reforms in monetary policy framework are listed in Annex. I.

Monetary Policy Response in India to the Global Financial Crisis

The world economy today seems to be recovering from the most severe crisis since the Great Depression of the 1930s. The financial crisis is also dubbed as the greatest crisis in the history of financial capitalism because of the way it simultaneously propagated to other countries. The impact of the crisis can be gauged from the sharp upward revisions to the estimates of possible write-downs

by banks and other financial institutions from about US$ 500 billion in March 2008 to about US$ 3.5 trillion in October 2009. More than the financial cost, the adverse impact on the real economy has been severe: in 2009, the world GDP is estimated by the IMF to have contracted by 0.8 per cent and the world trade volume is estimated to have declined by 12 per cent.

How was India Impacted?

Post-Lehman, the impact of the global financial crisis was first felt through reversal of capital flows and fall in equity prices in the domestic stock markets on the back of large scale sell-off by the foreign institutional investors (FIIs) as a part of the global deleveraging process. Simultaneously, there was reduced access to external sources of funding by Indian entities due to the tightening of credit conditions in international markets. This shortage of dollar liquidity put significant pressures on the domestic foreign exchange market, which was reflected in downward pressures on the Indian rupee along with its increased volatility. Simultaneously, there was a substitution of overseas financing by domestic financing, which brought both money market and credit market under pressure. The transmission of this external demand shocks was swift and severe on Indias export growth, which turned negative in October 2008. Imports too started declining by December 2008 as domestic activity slowed. The overall impact was reflected in a fall in investment demand and sharp deceleration in the growth of Indian economy in the second half of 2008-09 which persisted through the first quarter of 2009-10.

Policy Response in India

In order to limit the adverse impact of the contagion on the Indian financial markets and the broader economy, the Reserve Bank, took a number of conventional and unconventional measures. These included augmenting domestic and foreign exchange liquidity and sharp reduction in the policy rates. The

Reserve Bank used multiple instruments such as the liquidity adjustment facility (LAF), open market operations (OMO), cash reserve ratio (CRR) and securities under the market stabilization scheme (MSS) to augment the liquidity in the system. In a span of seven months between October 2008 and April 2009, there was unprecedented policy activism. For example: (i) the repo rate was reduced by 425 basis points to 4.75 per cent, (ii) the reverse repo rate was reduced by 275 basis points to 3.25 per cent, (iii) the CRR was reduced by a cumulative 400 basis points to 5.0 per cent, and (iv) the actual/potential provision of primary liquidity was of the order of Rs. 5.6 trillion (10.5 per cent of GDP). These measures were effective in ensuring speedy restoration of orderly conditions in the financial markets over a short time span. These measures were supported by fiscal stimulus packages during 2008-09 in the form of tax cuts, investment in infrastructure and increased expenditure on government consumption. The expansionary fiscal stance continues during 2009-10 to support aggregate demand. While the magnitude of the crisis was global in nature, the policy responses were adapted to domestic growth outlook, inflation conditions and financial stability considerations. The important among the many unconventional measures taken by the Reserve Bank of India were rupee-dollar swap facility for Indian banks to give them comfort in managing their short-term foreign funding requirements, an exclusive refinance window as also a special purpose vehicle for supporting nonbanking financial companies, and expanding the lendable resources available to apex finance institutions for refinancing credit extended to small industries, housing and exports.

Current Policy Stance The Reserve Bank pursued an accommodative monetary policy beginning mid-September 2008 in order to mitigate the adverse impact of the global financial crisis on the Indian economy. The measures taken instilled confidence in market participants and helped cushion the spillover of the global financial crisis on to our economy. However, In October 2009, in view of rising food inflation and the risk of it impinging on inflationary expectations, the Reserve Bank announced the first

phase of exit from the expansionary monetary policy by terminating some sectorspecific facilities and restoring the statutory liquidity ratio (SLR) of scheduled commercial banks to its pre-crisis level in the Second Quarter Review of October 2009. Since then, the Reserve Bank raised the cash reserve ratio (CRR) points, and the repo and reverse repo rates. In the Second Quarter Review of the

Monetary Policy announced on November 2, 2010, the stance of monetary policy was intended to: (i) contain inflation and anchor inflationary expectations, while being prepared to respond to any further build-up of inflationary pressures; (ii) maintain an interest rate regime consistent with price, output and financial stability and (iii) actively manage liquidity to ensure that it remains broadly in balance, with neither a surplus diluting monetary transmission nor a deficit choking off fund flows. Following this, reverse repo rate was raised by 25 basis points to 5.25 per cent. Similarly, repo rates were also raised by 25 basis points to 6.25 per cent. Cash reserve ratio was retained at 6.0 per cent. Movement in key policy rates since October 2008 is presented in Annex 2.

Overall Assessment The monetary policy framework in India has undergone significant shifts from a monetary targeting regime to a multiple indicators regime. Such a transition was conditioned by the developments of financial markets, increasing integration of the Indian economy with the global economy and changing transmission of monetary policy. The multiple indicators approach, conceptualized in 1998, has since been augmented by forward looking indicators from surveys and a panel of time series models. Moreover, the multiple indicators approach continues to evolve. Though the multiple indicators approach is subject to criticism for the absence of a clearly defined anchor, in the wake of the recent global financial crisis there is recognition of the usefulness of a broad indicators-based assessment of monetary policy. Based on the comparison of the relative performance of the monetary regimes in terms of key macroeconomic variables over three periods: (i) the decade preceding the monetary targeting period (1976-85); (ii) monetary targeting period

(1986-98) and (iii) multiple indicators period so far (1999-2009), the following broad conclusions can be drawn. First, real GDP growth, on an average, has improved successively from 4.6 per cent in the decade prior to the monetary targeting period to 5.5 per cent in the monetary targeting period and further to 7.1 per cent in the multiple indicators period. Not only growth has improved but it has become more stable under the multiple indicators approach. Second, headline WPI inflation, on an average, increased during the monetary targeting regime alongside significant increase in fiscal deficit, although there was a reduction in volatility in inflation. Under the multiple indicators approach, both WPI and CPI inflation fell significantly. The fall in inflation was accompanied by substantial reduction in fiscal deficit. This underscores the importance of fiscal consolidation to sustain higher levels of growth with price stability. Third, while the volatility of WPI inflation reduced during the multiple indicators period, it increased for CPI inflation reflecting higher volatility in food prices. This underlines the importance of supply management and a greater focus on agricultural development to contain food price inflation. Fourth, money supply (M3) growth declined over the regimes though volatility of M3 increased slightly during the multiple indicators regime reflecting emerging importance of interest rate in monetary transmission. The shift in operating objective to stabilise overnight interest rate so that it transmits through the term structure is reflected in a discernible reduction in the overnight interest rate with lower volatility. Fifth, exchange rate, on an average, has depreciated successively both in nominal and real terms. However, it has become more stable during the multiple indicators approach than the monetary targeting regime. This could be partly attributed to accumulation of reserves and management of exchange rate to contain volatility.

Sixth, the improved performance of monetary policy was facilitated by supportive fiscal policy discontinuation of the practice of automatic monetisation and rule-based deficit reduction programme under the Fiscal Responsibility and Budget Management (FRBM) Act which enhanced instrument independence of the Reserve Bank. Finally, the recent overall improvement in macroeconomic performance cannot be ascribed to monetary policy alone. Apart from a rule-based fiscal policy, productivity enhancing structural reforms, sharp increase in saving and investment, increasing integration with the global economy, a low global inflation environment and the unleashing of the entrepreneurial spirit of the private sector played an important role. Conclusions

With the changing framework of monetary policy in Indian from monetary targeting to an augmented multiple indictors approach, the operating targets and processes have also undergone a change. There has been a shift from quantitative intermediate targets to interest rates, as the development of financial markets enabled transmission of policy signals through the interest rate channel. At the same time, availability of multiple instruments such as CRR, OMO including LAF and MSS has provided necessary flexibility to monetary operations. While monetary policy formulation is a technical process, it has become more consultative and participative with the involvement of market participant, academics and experts. The internal process has also been re-engineered with more technical analysis and market orientation. In order to enhance transparency in communication the focus has been on dissemination of information and analysis to the public through the Governors monetary policy statements and also through regular sharing of policy research and macroeconomic and financial information.

(Prepared by Dr. BN Ananthaswamy, MoF) ********************************

Annex I: Reforms in the Monetary Policy Framework Objectives Twin objectives of maintaining price stability and ensuring availability of adequate credit to productive sectors of the economy to support growth continue to govern the stance of monetary policy, though the relative emphasis on these objectives has varied depending on the importance of maintaining an appropriate balance. Reflecting the increasing development of financial market and greater liberalisation, use of broad money as an intermediate target has been deemphasised and a multiple indicator approach has been adopted. Emphasis has been put on development of multiple instruments to transmit liquidity and interest rate signals in the short-term in a flexible and bi-directional manner. Increase of the interlinkage between various segments of the financial market including money, government security and forex markets. Financial stability has emerged as one of the objectives of monetary policy in recent years. Instruments Move from direct instruments (such as, administered interest rates, reserve requirements, selective credit control) to indirect instruments (such as, open market operations, purchase and repurchase of government securities) for the conduct of monetary policy. Introduction of Liquidity Adjustment Facility (LAF), which operates through repo and reverse repo auctions, effectively provide a corridor for short-term interest rate. LAF has emerged as the tool for both liquidity management and also as a signalling devise for interest rate in the overnight market. Use of open market operations to deal with overall market liquidity situation especially those emanating from capital flows. Introduction of Market Stabilisation Scheme (MSS) as an additional instrument to deal with enduring capital inflows without affecting short-term liquidity management role of LAF. Developmental Measures Discontinuation of automatic monetisation through an agreement between the Government and the Reserve Bank. Rationalisation of Treasury Bill market. Introduction of delivery versus payment system and deepening of inter-bank repo market. Introduction of Primary Dealers in the government securities market to play the role of market maker. Amendment of Securities Contracts Regulation Act (SCRA), to create the regulatory framework. Deepening of government securities market by making the interest rates on such securities market related. Introduction of auction of government securities. Development of a risk-free credible yield curve in the government securities market as a benchmark for related markets.Development of pure inter-bank call money market. Non-bank participants to participate in other money market instruments.

Introduction of automated screen-based trading in government securities through Negotiated Dealing System (NDS). Setting up of risk-free payments and system in government securities through Clearing Corporation of India Limited (CCIL). Phased introduction of Real Time Gross Settlement (RTGS) System. Deepening of forex market and increased autonomy of Authorised Dealers. Institutional Measures Setting up of Technical Advisory Committee on Monetary Policy with outside experts to review macroeconomic and monetary developments and advise the Reserve Bank on the stance of monetary policy. Creation of a separate Financial Market Department within the RBI

Annex 2: Movements in Key Policy Rates in India (Per cent)

Effective since April 26, 2008 May 10, 2008 May 24, 2008 June 12, 2008 June 25, 2008 July 5, 2008 Effective since July 19, 2008 July 30, 2008 August 30, 2008 October 11, 2008 October 20, 2008 October 25, 2008 November 3, 2008 November 8, 2008 December 8, 2008 January 5, 2009 January 17, 2009 March 4, 2009 April 21, 2009 February 13, 2010 February 27, 2010 March 19, 2010 Reverse Repo 6.00 6.00 6.00 6.00 6.00 6.00 Reverse Repo 6.00 6.00 6.00 6.00 6.00 6.00 6.00 6.00 5.00 (-1.00) 4.00 (-1.00) 4.00 3.50 (-0.50) 3.25 (-0.25) 3.25 3.25 3.50 (+0.25) Repo Rate 7.75 7.75 7.75 8.00 (+0.25) 8.50 (+0.50) 8.50 Repo Rate 8.50 9.00 (+0.50) 9.00 9.00 8.00 (1.00) 8.00 7.50 (0.50) 7.50 6.50 (1.00) 5.50 (1.00) 5.50 5.00 (-0.50) 4.75 (-0.25) 4.75 4.75 5.00 (+0.25) Cash Reserve Ratio 7.75 (+0.25) 8.00 (+0.25) 8.25 (+0.25) 8.25 8.25 8.50 (+0.25) Cash Reserve Ratio 8.75 (+0.25) 8.75 9.00 (+0.25) 6.50 (2.50) 6.50 6.00 (0.50) 6.00 5.50 (0.50) 5.50 5.50 5.00 (0.50) 5.00 5.00 5.50 (+0.50) 5.75 (+0.25) 5.75

April 20, 2010 April 24, 2010 July 2, 2010 July 27, 2010 September 16, 2010 November 2, 2010

3.75 (+0.25) 3.75 4.00 (+0.25) 4.50 (+0.50) 5.00 (+0.50) 5.25 (+0..25 )

5.25 (+0.25) 5.25 5.50 (+0.25) 5.75 (+0.25) 6.00 (+0.25) 6.25 (+0..25 )

5.75 6.00 (+0.25) 6.00 6.00 6.00 6.00

Note: 1. Reverse repo indicates absorption of liquidity and repo indicates injection of liquidity. 2. Figures in parentheses indicate change in policy rates in per cent.

PUBLIC DEBT MANAGEMENT

Introduction The Reserve Bank of India, by virtue of its Act derives the right to manage the public debt of the Central Government as well as issue of new loans, the operational aspects of which will be governed by the agreement between the Bank and the GOI for this purpose. As regards management of public debt for the State Governments, the RBI Act 1934 stipulates that the Bank may undertake this task by way an agreement with each State. The procedural aspects in debt management operations are governed by the Government Securities Act, 2006. It should be noted here that, though the term public debt includes various items of internal as well as external liabilities of the Government, the RBI acts as the debt manager to the Government only for marketable internal debt. As a debt manager for both the Central and State Governments, RBI in consultation with the Government, manages the timing of issue, composition of debt, maturity profile and the type of instruments issued. While these functions pertain to its advisory role, operationally RBI deals with the issue, servicing and repayment of government debt. In this context, the objective of debt management policy has undergone changes over the years in line with the change in RBIs role from passive to active debt manager. Initially, the debt management policy focused on the cost of borrowing, but at present, the objective is minimizing the cost of borrowing over the long run taking into account the refinancing risk involved, while ensuring that debt management policy is consistent with monetary policy. Since RBI is also responsible for monetary management, there is a need for coordination between the monetary and debt management policies, especially in view of the large market borrowing program of the Government to be undertaken at market related rates year after year. The interactions of the Financial Markets Committee within the RBI, the Standing Committee on Cash and Debt Management with representation from both RBI and the GOI, and the pre-budget interaction between the RBI and GOI help in achieving the necessary coordination between debt management, fiscal policy and monetary policy. In view of the conflicting roles that RBI has to play as monetary manager and debt manager, it is proposed to remove the mandatory nature of public debt management by the RBI by way of amendment to RBI Act. Organisational Structure for Debt Management Within the RBI, the Internal Debt Management Department (IDMD) performs the debt management function. Earlier, the Secretarys Department was looking after the work relating to debt management. In October 1992, the Internal Debt Management Cell was constituted as an inter-disciplinary unit with the objective of evolving appropriate policies relating to internal debt management as part of overall monetary policy and to manage operations such as market borrowing, Open Market Operations (OMO), Ways and Means Advances (WMA) and other related matters, as also to promote the development of an

efficient government securities market. The Cell attained the status of a full-fledged department in May 2003. The main functions of IDMD comprise formulation of a core calendar for primary issuance, deciding the maturity profile of debt, designing the instruments and methods of raising resources, deciding the size and timing of issuances. These critical decisions are taken after considering governments needs, market conditions and preferences of various investor segments, etc while at the same time ensuring that the entire strategy is consistent with the overall monetary policy objectives. The actual operations related to the raising of market loans such as acceptance of bids and applications, settlement of securities are undertaken at the Public Debt Offices (PDO) of the RBI. PDO also manages the registry and depository functions in relation to debt management of the government. The Department of Government and Bank Accounts (DGBA) maintains the central accounts regarding the market debt and also liaises with the Government and the PDOs in matters relating to reconciliation of accounts etc. Debt Management Policy - Changes Prior to 1991-92, the fiscal policy compulsions rendered the internal debt management policy passive. In order to ensure that the cost of borrowing for the government remained low, the interest rates on government securities were administered rates which were not in alignment with real interest rates in the market place. Such a policy of borrowing at artificially fixed interest rates was facilitated in a captive market of banks, insurance companies and provident funds that were statutorily required to invest in government securities. In view of the rising requirements of the government, RBIs monetary management too was dominated by a regime of rising CRR and SLR prescriptions. At the same time, till early 1990s, the volume of short term debt of the government also expanded due to automatic accommodation by the RBI through the mechanism of Ad-hoc Treasury bills. It is against this backdrop, and in the context of overall economic and financial sector reforms, that the debt management policy underwent a change. The abolition of ad-hoc treasury bills from April 1997, was a watershed in the relationship of the Bank as banker to the Government. From public debt management point of view, it meant that the Government would need to approach the market for its short term requirement of funds as well. In addition to this, the financial sector reforms underway since the early 1990s, also brought in deregulation in the interest rates on government securities. This happened through the introduction of auction method for price determination by the market. Consequent to the above changes, the focus of debt management also underwent certain changes and the objective now is minimizing the cost of borrowing over the long run taking into account the refinancing risk involved, while ensuring that debt management policy is consistent with monetary policy. Another equally important objective is the development of the government securities market so as to enable separation of debt management from monetary management in the long run. With increasingly active debt management policy

coming into being, the role of RBI as adviser to the Government also began to focus on maturity profile of debt, timing of issuances and types of instruments depending on market conditions. Debt management objectives Minimization of Cost One of the objectives of debt management has always been to ensure that the cost of borrowing is kept low for the government. However, this objective has not always been easy to achieve because RBIs policy has been constrained by the needs of the government. Consequently, RBI had to take private placement or devolvement on itself so as to ensure that the cost is not too high for the government especially when the market sentiment is uncertain or when liquidity conditions were not appropriate. Securities thus acquired were later off-loaded in the market through Open Market Operations. Gradually, there has been awareness that such a support system by RBI could be detrimental to the development of the government securities market and hence, the system of Primary Dealers (PDs) was introduced in 1995-96 to strengthen the institutional infrastructure. In addition, with the formation of the Cash and Debt Management Committee the liaison between the Government and the RBI enabled the RBI to follow a strategy of timing the issues of government loans to coincide with favourable liquidity and yield environment. After the Fiscal Responsibility and Budget Management (FRBM) Act, 2003, RBI has stopped participating in the primary issue of G-Secs and the PDs underwrite 100% of the primary auctions. Refinancing / Rollover Risk In the early nineties, with the introduction of auction mechanism, interest rates on government securities began to be market determined. These were expected to be certainly higher than the administered interest rates existing till then. Hence, in order to ensure that governments cost structure was not unduly high for a longer period of time, the maturity of new loans issued was reduced to just around 10 years. As a result, repayment obligations began to be bunched up bringing with it the possibility of refinancing or rollover risk (risk that government may not be able to raise the requisite amount of resources at the time of repayment or may be able to raise the resources only at higher cost). In order to maintain such rollover risk at acceptable levels, the RBI subsequently followed a strategy of gradually elongating the maturity profile of governments loans through issuance of long term G-Secs. Gradually G-Secs of maturity of even up to 30 years were issued. This was also made to coincide with timing the issues when liquidity conditions are positive. As a result, the weighted average maturity of outstanding loans has increased while the weighted average yield on outstanding stock of government securities has reduced.

Development of government securities market As is often stated, one of the important preconditions for a successful separation of debt management from monetary management is the existence of a well-developed and efficient market for government securities. In this direction, the RBI has made a lot of efforts by bringing in reforms in the following areas: Issuance methods As market determination of prices has become the order of the day, different auction mechanisms have been tried out for different types of issues such as price based auctions and yield based auctions with both uniform price (where all the bidders will pay the same cut-off price irrespective of the actual price which they have bid) and multiple price (where each bidder will pay the price he has bid for which may be higher than the actual cut-off price). Though the benefits of one method over the other cannot be categorically stated for all conditions, it has more or less become a norm for treasury bills to be issued on a multiple price auction while dated securities are issued on a yield-basis (for completely new issues) or price-basis (in case of reissues) as the case may be. Another important factor has been the practice of consolidation of new issues through the process of reopenings or reissues of existing securities. This strategy helped to reduce the number of securities / loans in the market, and at the same time helped to increase the available quantum of securities of a particular loan to facilitate better trading in the secondary market, ultimately paving the way for STRIPS. Instruments An important development to improve the breadth and depth of government securities market has been the introduction of a variety of instruments such as Floating Rate Bonds, Capital Indexed Bonds, Zero Coupon Bonds, etc in addition to treasury bills of various durations as also dated securities. The features of these instruments are dealt with in detail in the chapter relating to Government Securities Market. The main objective of this strategy has been to provide different types of instrument to choose from for different types of investors with different investment requirements. Transparency In order to provide some transparency with respect to timing and size of issues, the Bank has started issuing an indicative calendar for issuance of government securities on a half-yearly basis that indicates the likely dates, size, duration of the issue, type of security and the issue mechanism. This is in addition to the Calendar for regular auction of GOI Treasury Bills. Besides the above steps, the Bank has also begun to make available a lot of information through the medium of its website (such as on-line data on market trades, data on daily LAF operations, details of auction outcomes, data on money market and SGL transactions etc.,) so as to enable informed decision-making by the participants in the market place. Widening Investor Base in order to encourage wider retail holding of government securities, the following steps have been taken (a) introduction of non-competitive bidding

in all auctions wherein the small investors can also participate and take advantage of a finer price in the primary issuance rather than invest through the secondary market. For this purpose, in every dated GoI security auction and State Development Loan (SDL) auction, 5% and 10% respectively of the notified amount is kept reserved for non-competitive bidders. (b) introduction of retail trading in government securities on the stock exchanges in the same manner as capital market scrips and settlement through demat holding of government securities with a Depository Participant. (c) permitting retail investors to hold government securities in a gilt account with a constituent SGL account holder so that the investor need not be bothered with physical holding of securities. Market infrastructure In addition to the establishment of the primary dealer system, improvements in the market infrastructure has been brought about through (a) the provision of an electronic trading platform in the form of Negotiated Dealing System to enable screenbased trading in government securities as also facilitate on-line price discovery and data dissemination to not only market participants but also general public (while maintaining necessary confidentiality), (b) improved settlement systems through the introduction of Delivery-versus-Payment (DvP) mechanism which helps to mitigate credit risk in the market, (c) the operationalisation of the Clearing Corporation of India Limited (CCIL) which performs the role of a Central Counterparty to the transactions by NDS members in government securities and also provides settlement guarantee thereby reducing the settlement risk in the market (d) facilitating the setting up of the self regulatory organization called as FIMMDA Fixed Income Money Market and Derivatives Association which has facilitated the RBI in putting in place market ethics, best practices, guidelines, accounting norms etc in so far as they relate to the government securities market. Some of these areas are dealt in greater detail in the chapter on government securities market. Management of State Government Debt Under its statute, the RBI may by agreement with the respective State Governments undertake the work of being their banker as well as manager of their public debt. However, over the years it has been a challenging task for the Bank to ensure that the market borrowing programme for the States get completed successfully. Despite the efforts of the Bank, the response to States market borrowing programme has been lukewarm due to (1) some states being perceived as financially weak (2) low liquidity of state government securities (3) poor track record of a few state governments in respect of bonds guaranteed by them and servicing of loans by state owned enterprises and (4) reduced levels of SLR. As a result, different methods of issuance such as tap tranche method (where many state governments go in for the issue together which is available on tap for a few days but individual state amounts are not revealed to the market) as well as auction method (generally 5 35% of market borrowing is allowed) have been tried in addition to the traditional tranche

method. In order to improve investor response, the RBI has also provided technical assistance in the preparation of model fiscal responsibility legislation for the State Governments in addition to engaging the state governments attention with regard to policy measures required for enhancing the secondary market liquidity of state government securities. Issues concerning Debt Management Debt sustainability The level and composition of public debt have a significant bearing on the countrys economic development and its ability to withstand shocks and crises. Large borrowing by the Government crowds out private investment because both Government and private sector approach the same pool of savings for their resources. It also increases tax burden of future generations (repayment obligations in future) and interest rates making private investment more expensive (because demand for resources would be greater than its supply). Moreover, the cost of debt servicing would lead to lower government expenditure on desirable social infrastructure. Thus, it is very essential for RBI, as a debt manager and the central bank, to ensure that public debt is kept within sustainable limits. Fiscal Responsibility and Budget Management (FRBM) Act 2003 This Act came into existence in 2003 with the objective of ensuring inter-generational equity in fiscal management (so that future generations do not have to bear a higher tax burden to facilitate repayment of loans acquired by the Government in the past, the fruits of which they may not be able to enjoy), long term macro-economic stability by achieving sufficient surplus, fiscal sustainability through limits on Central Government Borrowings, debt and deficit and to remove fiscal impediments in effective conduct of monetary policy. Under the FRBM Act targets have been set for the GOI to reduce its revenue deficit and completely eliminate it by March 2009 and thereafter build revenue surplus. The FRBM Rules framed in July 2004 also specify annual targets for reduction of Gross Fiscal Deficit. Most importantly, the FRBM Act prohibits the direct borrowing by GOI from the RBI except under exceptional grounds and hence, with effect from April 1, 2006, RBIs participation in the primary issuance of government securities has stopped. This posed a great challenge to the Bank as the debt manager to ensure successful completion of market borrowing programme of the Government without its participation. As such, envisaging that Open Market Operations (OMO) will become a more active instrument for the RBI, an Internal Technical Group on Central Government Securities Market was constituted to study, among other things, the implications of RBIs withdrawal under the FRBM Act for the conduct of debt management function and to make recommendations on the modifications required to the primary auction process, redefining the role of Primary Dealers so as to ensure that RBI s debt management objectives will be fully met. The Group recommended that RBI should retain the option to participate in secondary

market as considered appropriate, greater participation by Primary Dealers through 100 per cent underwriting commitment, minimum bidding obligation, permitting selective exclusivity to the PDs in primary auctions, etc. Government Securities Act, 2006 In order to provide a legal framework which meets the requirements of the current market place and technological advancements, the Bank submitted a proposal to the GoI to replace the earlier Public Debt Act, 1944 by a new Act. Accordingly, the Government Securities Act, 2006 not only simplifies the procedure for transactions in government securities, but also allow for nomination, lien marking / pledging of securities, transfer of ownership in electronic form, creation of STRIPS etc.

(Prepared by Shri Radha Shyam Ratho, GM & MoF, RBSC, Chennai)

FOREX EXCHANGE RESERVES MANAGEMENT

The debt crisis in some of the developing countries in the early nineties, the East Asian crisis in 1997, currency crisis of Argentina, Russia and the recent global financial crisis have clearly highlighted the importance of conservative forex reserve management policies for a nation and the need to build a comfortable level of forex reserves as an insurance against capital outflows, higher oil and commodity prices, etc.

Meaning of Forex Reserves Conceptually, a unique definition of forex reserves is not available as there has been divergence of views in terms of coverage of items, ownership of assets, liquidity aspects and need for a distinction between owned and non-owned reserves. Nevertheless, for policy and operational purposes, most countries have adopted the definition suggested by the International Monetary Fund (Balance of Payments Manual, and Guidelines on Foreign Exchange Reserve Management, 2001); which defines reserves as external assets that are readily available to and controlled by monetary authorities for direct financing of external payments imbalances, for indirectly regulating the magnitudes of such imbalances through intervention in exchange markets to affect the currency exchange rate, and/or for other purposes. In India, the Reserve Bank of India Act 1934 contains the enabling provisions for the RBI to act as the custodian of foreign reserves, and manage reserves with defined objectives. The power of being the custodian of foreign reserves is enshrined, in the first instance, in the preamble of the Act. The reserves refer to both foreign reserves in the form of gold assets in the Banking Department and foreign securities held by the Issue Department, and domestic reserves in the form of bank reserves. The composition of foreign reserves is indicated, a minimum reserve system is set out, and the instruments and securities in which the countrys reserves could be deployed are spelt out in the relevant Sections of the RBI Act.

In brief, in India, what constitutes forex reserves; who is the custodian and how it should be deployed are laid out clearly in the Statute, and in an extremely conservative fashion as far as management of reserves is concerned. In substantive terms, RBI functions as the custodian and manager of forex reserves, and operates within the overall policy framework agreed upon with Government of India. Why do we need to hold Forex Reserves? Technically, it is possible to consider three motives i.e., transaction, speculative and precautionary motives for holding reserves. International trade gives rise to currency flows, which are assumed to be handled by private banks driven by the transaction motive. Similarly, speculative motive is left to individual or corporates. Central bank reserves, however, are characterized primarily as a last resort stock of foreign currency for unpredictable flows, which is consistent with precautionary motive for holding foreign assets. Precautionary motive for holding foreign currency, like the demand for money, can be positively related to wealth and the cost of covering unplanned deficit, and negatively related to the return from alternative assets. From a policy perspective, it is clear that the country benefits through economies of scale by pooling the transaction reserves, while sub-serving the precautionary motive of keeping official reserves as a war chest. Furthermore, forex reserves are instruments to maintain or manage the exchange rate, while enabling orderly absorption of international money and capital flows. In brief, official reserves are held for precautionary and transaction motives keeping in view the aggregate of national interests, to achieve balance between demand for and supply of foreign currencies, for intervention, and to preserve confidence in the countrys ability to carry out external transactions. Reserve assets could be defined with respect to assets of monetary authority as the custodian, or of sovereign government as the principal. For the monetary authority, the motives for holding reserves may not deviate from the monetary policy objectives, while for government, the objectives of holding reserves may go beyond that of the monetary authorities. In other words, the final expression of the

objective of holding reserve assets would be influenced by the reconciliation of objectives of the monetary authority as the custodian and the government as principal. There are cases, however, when reserves are used as a convenient mechanism for government purchases of goods and services, servicing foreign currency debt of government, insurance against emergencies, and in respect of a few, as a source of income.

What are the dominant policy objectives in regard to forex reserves in India? The objectives in broader terms may be encapsulated as (a) maintaining confidence in monetary and exchange rate policies, (b) enhancing capacity to intervene in forex markets, (c) limiting external vulnerability by maintaining foreign currency liquidity to absorb shocks during times of crisis including national disasters or emergencies; (d) providing confidence to the markets especially credit rating agencies that external obligations can always be met, thus reducing the overall costs at which forex resources are available to all the market participants, and (e) incidentally adding to the comfort of the market participants, by demonstrating the backing of domestic currency by external assets. At a formal level, the objective of reserve management in India could be found in the RBI Act, where the relevant part of the preamble reads as to use the currency system to the countrys advantage and with a view to securing monetary stability. This statement may be interpreted to hold that monetary stability means internal as well as external stability; implying stable exchange rate as the overall objective of the reserve management policy. While internal stability implies that reserve management cannot be isolated from domestic macroeconomic stability and economic growth, the phrase to use the currency system to the countrys advantage implies that maximum gains for the country as a whole or economy in general could be derived in the process of reserve management, which not only provides for considerable flexibility to reserve management practice, but also warrants a very dynamic view of what the country needs and how best to meet the requirements. In other words, the financial return or trade off between financial

costs and benefits of holding and maintaining reserves is not the only or the predominant objective in management of reserves.

Evolution of Reserve Management Policy in India Indias approach to reserve management, until the balance of payments crisis of 1991 was essentially based on the traditional approach, i.e., to maintain an appropriate level of import cover defined in terms of number of months of imports equivalent to reserves. For example, the RBIs Annual Report 1990 -91 stated that the import cover of reserves shrank to 3 weeks of imports by the end of December 1990, and the emphasis on import cover constituted the primary concern say, till 1993-94. The approach to reserve management, as part of exchange rate management, and indeed external sector policy underwent a paradigm shift with the adoption of the recommendations of the High Level Committee on Balance of Payments (Chairman: Dr. C. Rangarajan). The Report articulated an integrated view of the issues and made specific recommendations on foreign currency reserves. The relevant extracts are: It has traditionally been the practice to view the level of desirable reserves as a percentage of the annual imports-say reserves to meet three months imports or four months imports. However, this approach would be inadequate when a large number of transactions and payment liabilities arise in areas other than import of commodities. Thus, liabilities may arise either for discharging short-term debt obligations or servicing of medium-term debt, both interest and principal. The Committee recommends that while determining the target level of reserve, due attention should be paid to the payment obligations in addition to the level of imports. The Committee, recommends that the foreign exchange reserves targets be fixed in such a way that they are generally in a position to accommodate imports of three months. (Paragraph 6.3) In the view of the Committee, the factors that are to be taken into consideration in determining the desirable level of reserves are: the need to ensure a reasonable level of confidence in the international financial and trading communities about the capacity of the country to honour its obligations and maintain trade and financial

flows; the need to take care of the seasonal factors in any balance of payments transaction with reference to the possible uncertainties in the monsoon conditions of India; the amount of foreign currency reserves required to counter speculative tendencies or anticipatory actions amongst players in the foreign exchange market; and the capacity to maintain the reserves so that the cost of carrying liquidity is minimal. (Paragraph 6.4) With the introduction of market determined exchange rate as mentioned in the RBIs Annual Report, 1995-96 a change in the approach to reserve management was warranted and the emphasis on import cover had to be supplemented with the objective of smoothening out the volatility in the exchange rate, which has been reflective of the underlying market condition. Against the backdrop of currency crises in East-Asian countries, and in the light of country experiences of volatile cross-border capital flows, the Reserve Banks Annual Report 1997-98 reiterated the need to take into consideration a host of factors, but is noteworthy for bringing to the fore the shift in the pattern of leads and lags in payments/receipts during exchange market uncertainties and emphasized that besides the size of reserves, the quality of reserves also assume importance. Highlighting this, the Report stated that unencumbered reserve assets (defined as reserve assets net of encumbrances such as forward commitments, lines of credit to domestic entities, guarantees and other contingent liabilities) must be available at any point of time to the authorities for fulfilling various objectives assigned to reserves. As a part of prudent management of external liabilities, the RBI policy is to keep forward liabilities at a relatively low level as a proportion of gross reserves and the emphasis on prudent reserve management i.e., keeping forward liabilities within manageable limits, was highlighted in the RBIs Annual Report, 1998-99. The RBI Annual Report, 1999-2000 stated that the overall approach to management of Indias foreign exchange reserves reflects the changing composition of balance of payments and liquidity risks associated with different types of flows and other requirements and the introduction of the concept of liquidity risks is noteworthy. The policy for reserve management is built upon a

host of identifiable factors and other contingencies, including, inter alia, the size of the current account deficit and short-term liabilities (including current repayment obligations on long term loans), the possible variability in portfolio investment, and other types of capital flows, the unanticipated pressures on the balance of payments arising out of external shocks and movements in repatriable foreign currency deposits of non-resident Indians. (Paragraph 6.30) While focusing on prudent management of foreign exchange reserves in recent years, RBIs Annual Report 2000-01 elaborated on liquidity risk associated with different types of flows. The Report stated that with the changing profile of capital flows, the traditional approach of assessing reserve adequacy in terms of import cover has been broadened to include a number of parameters which take into account the size, composition, and risk profiles of various types of capital flows as well as the types of external shocks to which the economy is vulnerable. The then Governor Jalans statement on Monetary and Credit Policy (April 29, 2002) provided a comprehensive view on the approach to reserve management and of special significance was the statement: a sufficiently high level of reserves is necessary to ensure that even if there is prolonged uncertainty, reserves can cover the liquidity at risk on all accounts over a fairly long period. Taking these considerations into account, Indias foreign exchange reserves are now very comfortable. (Paragraph 23).the prevalent national security environment further underscores the need for strong reserves. We must continue to ensure that, leaving aside short-term variations in reserves level, the quantum of reserves in the long run is in line with the growth of the economy, the size of risk-adjusted capital flows and national security requirements. This will provide us with greater security against unfavourable or unanticipated developments, which can occur quite suddenly. (Paragraph 24). The above discussion points to evolving considerations and indeed a paradigm shift in Indias approach to reserve management. The shift has occurred from a single indicator to a menu or multiple indicators approach. Furthermore, the policy of reserve management is built upon a host of factors, some of them are not

quantifiable, and in any case, weights attached to each of them do change from time to time.

Objectives of the Reserves Management The guiding objectives of foreign exchange reserves management in India are similar to those of many central banks in the world. The demands placed on the foreign exchange reserves may vary widely depending upon a variety of factors including the exchange rate regime adopted by the country, the extent of openness of the economy, the size of the external sector in a country's GDP and the nature of markets operating in the country. Even within this divergent framework, most countries have adopted preservation of the long term value of the reserves in terms of purchasing power and the need to minimize risk and volatility in returns as the primary objectives of reserve management. While liquidity and safety constitute the twin objectives of reserve management in India, return optimisation becomes an embedded strategy within this framework.

Legal Framework and Policies The Reserve Bank of India Act, 1934 provides the overarching legal framework for deployment of reserves in different foreign currency assets (FCA) and gold within the broad parameters of currencies, instruments, issuers and counterparties. The essential legal framework for reserves management is provided in sub-sections 17 (6A), 17(12), 17(12A), 17(13) and 33 (6) of the above Act. In brief, the law broadly permits the following investment categories: (i) deposits with other central banks and the Bank for International Settlements (BIS); (ii) deposits with foreign commercial banks; (iii) debt instruments representing sovereign/sovereign-guaranteed liability with residual maturity for the debt papers not exceeding 10 years; (iv) other instruments / institutions as approved by the Central Board of the Reserve Bank in accordance with the provisions of the Act; and (v) dealing in certain types of derivatives.

RBI has framed appropriate guidelines stipulating stringent criteria for issuers / counterparties / investments with a view to enhancing the safety and liquidity aspects of the reserves.

Growth of Forex Reserves since 1991 Indias foreign exchange reserves have grown significantly since 1991. The reserves, which stood at USD 5.8 billion at end-March 1991 increased gradually to USD 54.1 billion by end-March 2002, after which rose steadily reaching a level of USD 309.7 billion in March 2008. The reserves declined to USD 252.0 billion in March 2009. The reserves stood at USD 279.1 billion as on March 31, 2010 compared to USD 281.3 billion as on September 30, 2009. (Table 1). At end October 2010 our reserves stood at roughly $298 bn. Although both US dollar and Euro are intervention currencies and the FCA are maintained in major currencies like US Dollar, Euro, Pound Sterling, Japanese Yen etc., the foreign exchange reserves are denominated and expressed in US Dollar only. Movements in the FCA occur mainly on account of purchases and sales of foreign exchange by RBI in the foreign exchange market in India. In addition, income arising out of the deployment of foreign exchange reserves and external aid receipts of the Central Government also flow into the reserves. The movement of the US dollar against other currencies in which FCA are held also impact the level of reserves in US dollar terms. Table 1: Movement in Foreign Exchange Reserves
Date FCA SDR Gold RTP (USD million) Forex Reserves

31-Mar-07 30-Sep-07 31-Mar-08 30-Sep-08 31-Mar-09 30-Sep-09

191,924 239,954 299,230 277,300 241,426 264,373

2 (1) 2 (1) 18 (11) 4 (2) 1 (1) 5224 (3297)

6,784 7,367 10,039 8,565 9,577 10,316

469 438 436 467 981 1365

199,179 247,761 309,723 286,336 251,985 281,278

31-Mar-10

254,685

5006 (3297)

17,986

1380

279,057

Notes: 1. FCA (Foreign Currency Assets): FCAs are maintained as a multi-currency portfolio comprising major currencies, such as, US dollar, Euro, Pound sterling, Japanese yen, etc. and are valued in terms of US dollars. 2. FCA exclude USD 250.0 million invested in foreign currency denominated bonds issued by IIFC (UK) since March 20, 2009. 3. SDR (Special Drawing Rights): Values in SDR have been indicated in parentheses. They include SDRs 3082.5 million (equivalent to USD 4883 million) allocated under general allocation and SDRs 214.6 million (equivalent to USD 340 million) allocated under special allocation by the IMF on August 28, 2009 and September 9, 2009, respectively. 4. Gold: Gold includes USD 6699 million reflecting the purchase of 200 metric tonnes of gold from IMF during October 1930 2009. The physical stock of gold which was 357.75 as at end September 2009, increased to 557.75 as at end March 2010. 5. RTP refers to the Reserve Tranche Position in the IMF.

Sources of Accretion to the Reserves Table 2 details the major sources of accretion to foreign exchange reserves during the period from March 1991 to end-March 2010.
Table 2: Sources of Accretion to Foreign Exchange Reserves since 1991 (USD billion) Items A B.I. B.II. a. Of which: (i) FDI (ii) FII b. c. d. e. B.III. NRI Deposits External Assistance External Commercial Borrowings Other items in Capital Account* Valuation Change 96.0 80.7 37.0 20.7 70.5 47.3 9.7 279.1 Reserves as at end-March 1991 Current Account Balance Capital Account (net) (a to e) Foreign Investment 1991-92 to 2009-10 5.8 -117.6 381.1 205.7

Reserves as at end-March 2010 (A+BI+BII+BIII)

* : Include errors and omissions.

Table 3 provides details of sources of variation in foreign exchange reserves during 2009-10 vis--vis the corresponding period of the previous year. On balance of payments basis (i.e., excluding valuation effects), the foreign exchange reserves increased by USD 13,441 million during 2009-10 as against a decline of USD 20,080 million during 2008-09. The valuation gain, reflecting the depreciation of the US dollar against the major international currencies, accounted for USD 13,631 million during 2009-10 as compared with a valuation loss of USD 37,658 million during 2008-09. Accordingly, valuation gain during 2009-10 accounts for 50.2 per cent of the total increase in foreign exchange reserves. Besides the valuation gain, inflows under foreign investments and Non-Resident Indian deposits and SDR allocations by the IMF have contributed to the increase in foreign exchange reserves during 2009-10. The IMF allocated SDR 3,082.5 million (equivalent to USD 4,883 million) under general allocation on August 28, 2009 and SDR 214.6 million (equivalent to USD 340 million) under special allocation on September 9, 2009. The allocations were made by the IMF as a part of the Fund's efforts to provide liquidity to the global economic system by supplementing the Fund's member countries' foreign exchange reserves.
Table 3: Sources of Variation in Foreign Exchange Reserves (USD billion) Items I. Current Account Balance Capital Account (net) (a to f) Foreign Investment (i+ii) 2008-09
(-)28.7

2009-10 (-) 38.4

II.

8.6

51.9

a.

3.5 17.5

52.1 19.7

(i) Foreign Direct Investment

(ii) Portfolio Investment Of which: FIIs ADRs/GDRs b. External Commercial Borrowings Banking Capital

(-)14.0

32.4

(-)15.0 1.2 7.9

29.0 3.3 2.5

c.

-3.2 4.3 -1.9

2.1 2.9 7.7

of which: NRI Deposits d. Short-Term Trade Credit External Assistance Other items in capital account Valuation Change

e. f.

2.6 (-) 0.2

2.0 (-) 14.6

III.

(-) 37.7 (-) 57.7

13.6 27.1

Total (I+II+III)

Notes: (i) Other items in capital account apart from Errors and Omissions, include SDR allocations, leads and lags in exports, funds held abroad, advances received pending issue of shares under FDI and transactions of capital receipts not included elsewhere. (ii) Increase in reserves (+) / Decrease in reserves (-).

An analysis of the sources of reserves accretion during the entire reform period from 1991 onwards reveals that increase in net foreign direct investment (FDI) from USD 129 million in 1991-92 to USD 19.7 billion in 2009-10 and cumulative net FII investments from USD 1 million at end-March 1993 to USD 80.7 billion at end-March 2010 largely contributed to the increase in foreign exchange reserves. The net inflows of USD 29.0 billion by FIIs in 2009-10 led to an increase in cumulative portfolio stock to USD 109.7 billion at end-March 2010 from USD 77.3 billion at end-March 2009. Outstanding NRI deposits increased from USD 14.0

billion at end-March 1991 to USD 41.6 billion as at end-March 2009. As at endMarch 2010, the outstanding NRI deposits stood at USD 47.9 billion. On the current account, Indias exports, which were USD 18.3 billion during 1991 92 increased to USD 182.2 billion in 2009-10. However, as compared to the export of USD 189.0 billion during 2008-09, there has been marginal decline during the year 2009-10. Indias imports which were USD 24.1 billion in 1991-92 increased to USD 299.5 billion in 2009-10 (USD 307.7 billion in 2008-09). Invisibles, in particular, private remittances have contributed significantly to the current account. Net invisibles inflows, comprising mainly of private transfer remittances and services, increased from USD 1.6 billion in 1991-92 to USD 78.9 billion in 2009-10. Indias current account balance which was in deficit at 3.0 per cent of GDP in 1990-91 turned into a surplus during the period 2001-02 to 2003-04. However, this could not be sustained in the subsequent years. In the aftermath of the global financial crisis, the current account deficit increased from 1.3 per cent of GDP in 2007-08 to 2.4 per cent of GDP in 2008-09 and further to 2.9 per cent in 2009-10.

Adequacy of Reserves Adequacy of reserves has emerged as an important parameter in gauging the ability to absorb external shocks. With the changing profile of capital flows, the traditional approach of assessing reserve adequacy in terms of import cover has been broadened to include a number of parameters which take into account the size, composition and risk profiles of various types of capital flows as well as the types of external shocks to which the economy is vulnerable. The High Level Committee on Balance of Payments, which was chaired by Dr. C. Rangarajan, erstwhile Governor of the Reserve Bank of India, had suggested that, while determining the adequacy of reserves, due attention should be paid to payment obligations, in addition to the traditional measure of import cover of 3 to 4 months. In 1997, the Report of Committee on Capital Account Convertibility under the chairmanship of Shri S.S.Tarapore, erstwhile Deputy Governor of the Reserve Bank of India suggested alternative measures of adequacy of reserves which, in

addition to trade-based indicators, also included money-based and debt-based indicators. Similar views have been held by the Committee on Fuller Capital Account Convertibility (Chairman: Shri S.S.Tarapore, July 2006). In the recent period, assessment of reserve adequacy has been influenced by the introduction of new measures. One such measure requires that the usable foreign exchange reserves should exceed scheduled amortisation of foreign currency debts (assuming no rollovers) during the following year. The other one is based on a 'Liquidity at Risk' rule that takes into account the foreseeable risks that a country could face. This approach requires that a country's foreign exchange liquidity position could be calculated under a range of possible outcomes for relevant financial variables, such as, exchange rates, commodity prices, credit spreads etc. Reserve Bank of India has been undertaking exercises based on intuition and risk models to estimate 'Liquidity at Risk (LAR) of the reserves. The traditional trade-based indicator of reserve adequacy, viz, import cover of reserves, which fell to a low of three weeks of imports at end-December 1990 reached a peak of 16.9 months of imports at the end of March 2004. At the end of
1

March 2010, the import cover stands at 11.2 months. The ratio of short-term debt to the foreign exchange reserves declined from 146.5 per cent at end-March 1991 to 12.5 per cent as at end-March 2005, but increased slightly to 12.9 per cent as at end-March 2006. However, with expansion in the coverage of short-term debt, the ratio increased to 14.8 per cent at end-March 2008, to 17.2 per cent at end-March 2009 and 18.8 per cent at end-March 2010. The ratio of volatile capital flows (defined to include cumulative portfolio inflows and short-term debt) to the reserves declined from 146.6 per cent as at end-March 1991 to 47.9 per cent at end-March 2009, but increased to 58.1 per cent as at end-March 2010. Management of International Reserves In the recent years, for several reasons, increasing attention is being paid to management of international reserves. First, advent of the Euro as an alternate currency to US dollar; second, movement of many central banks out of gold; third, changes in exchange rate regimes; fourth, changing views on reserve adequacy

and its role in crisis prevention; and fifth, operational use of reserve targets in calculating financing gaps by IMF. The attention to the subject is evidenced by increasing emphasis on transparency, accountability in various fora, and more recently, the issue of IMF guidelines on the subject. Operationally, reserve management is a process that ensures that adequate official public sector foreign assets are readily available to and controlled by the authorities for meeting a defined range of objectives for a country. A reserve management entity is normally made responsible for the management of reserves and associated risks. Invariably, the reserve management entity is the central bank and hence the objectives of reserve management tend to be critical as they would encompass the objectives of the monetary authority and the objectives of a portfolio manager or the custodian of reserves. As a monetary authority, a central banks primary objective is to ensure macroeconomic financial stability in general and external stability in particular. As a custodian, the central banks main objectives are to ensure liquidity, safety and yield on deployment of reserves. In considering management of reserves, the benefits and costs of holding reserves are constantly assessed. On the benefits, recent international financial crises have shown that holding and managing sufficient reserves and disclosing adequate information to markets helps a country to prevent external crises, especially those stemming from the capital account. The growing appreciation of the role of reserves in crises prevention and as a buffer to manage exchange market pressures has given reserve management a more central role, now than before, in national economic policies. Maintaining high level of reserves to tide over external shocks, however, involves opportunity cost. The opportunity cost of holding reserves is the foregone investment because resources have been used to purchase reserves instead of increasing domestic capital. The marginal productivity of domestic capital is the opportunity cost of holding reserves and reserves management seeks to minimize the opportunity costs against the benefits that accrue from holding reserves.

The objectives of reserve management vary across countries, and a recent survey of reserve management practices of select countries (IMF guidelines, 2001) provide good insights on the subject. First, most countries hold reserves to support monetary policy. While ensuring liquidity in foreign exchange market to smooth out undue short-term fluctuations in exchange markets constitutes the primary objective, some countries take a cautious approach to intervention. Smaller countries, hold reserves mainly for consideration of transaction motives to meet external payment imbalances as well as a store of wealth. Precautionary motive of holding reserves to mitigate adverse external shocks is implicit in most countries objectives though among a few, it finds explicit mention. Few countries explicitly use international reserves as the backing for monetary base and to maintain the stability and integrity of the monetary and financial system. From a policy perspective, the objective of holding reserves to support monetary policy is common to most countries and the objective of holding reserves in regard to many emerging economies is primarily to maintain international confidence about its short-term payment obligations as well as confidence in monetary and financial polices. Secondly, most countries have informal coordination between debt management and reserve management policies. As part of informal coordination, most countries take into account external debt indicators, particularly the maturity composition of short-term and long-term debt, as part of reserve management. Thirdly, in regard to transparency and disclosure standards, many countries adhere to the IMFs Special Data Dissemination Standards (SDDS) requirement. Most countries publish data on external debt and reserves on an annual basis in either their central bank annual reports or other reports of Government. Fourthly, liquidity and safety (low risks) prevail upon reserve management entities in most countries as part of objective of reserve management. The yield objective is secondary to most countries in reserve management. Fifthly, most countries use benchmarks for managing currency composition of reserves though information to the public about the benchmarks for the underlying currency composition of reserves is generally not made available. Information

about the underlying norms for adopting the benchmarks are, however available in a number of countries. Risk Management Sound risk management is an integral part of efficient foreign exchange reserves management. The strategy for reserves management places emphasis on managing and controlling the exposure to financial and operational risks associated with deployment of reserves. The broad strategy for reserve management including currency composition and investment policy is decided in consultation with the Government of India. The risk management functions are aimed at ensuring development of sound governance structure in line with the best international practices, improved accountability, a culture of risk awareness across all operations and efficient allocation of resources for development of in-house skills and expertise. The risks attendant on deployment of reserves, viz., credit risk, market risk, liquidity risk and operational risk and the systems employed to manage these risks are detailed in the following paragraphs. Credit Risk Credit risk is defined as the potential that a borrower or counterparty will fail to meet its obligation in accordance with agreed terms. The Reserve Bank has been extremely sensitive to the credit risk it faces on the investment of foreign exchange reserves in the international markets. The Reserve Bank's investments in bonds/treasury bills represent debt obligations of highly rated sovereigns and supranational entities. Further, deposits are placed with the Bank for International Settlements (BIS) and other central banks. Transactions in foreign exchange and bonds/treasury bills with commercial banks/investment banks and other securities firms give rise to credit risk. Credit risks arising from investments are monitored as mentioned below. Credit risk has been in focus since the onset of the credit crisis in the US financial markets and its contagion effect on other economies leading to global financial crisis during the second half of 2008 and during 2009. The Reserve Bank continues to apply stringent criteria for selection of counterparties. Credit exposure vis--vis sanctioned limit in respect of approved counterparties is monitored

continuously. Developments regarding counterparties are constantly under watch. Sovereign risk is also being monitored. The basic objective of such an on-going exercise is to assess whether counterparty's credit quality is under potential threat. Market Risk Market risk arises on account of exchange rate and interest rate movements. These are detailed as under: Currency Risk: Currency risk arises due to uncertainty in exchange rates. Decisions are taken regarding the long-term exposure on different currencies depending on the likely movements in exchange rate and other considerations in the medium and long-term (e.g., maintenance of major portion of reserves in the intervention currency, the approximate currency profile of the reserves in line with the changing external trade profile of the country, benefit of diversification, etc.). The decision making procedure is supported by reviews of the strategy on a regular basis. Interest Rate Risk: The crucial aspect of the management of interest rate risk is to protect the value of the investments as much as possible from the adverse impact of the interest rate movements. The interest rate sensitivity of the reserves portfolio is identified in terms of benchmark duration and the permitted deviation from the benchmark. The focus of the investment strategy revolves around the overwhelming need to keep the interest rate risk of the portfolio reasonably low with a view to minimising losses arising out of adverse interest rate movements, if any. This approach is warranted as reserves are viewed as a market stabilising force in an uncertain environment. Liquidity Risk Liquidity risk involves the risk of not being able to sell an instrument or close a position when required without facing significant costs. The reserves need to have a high level of liquidity at all times in order to be able to meet any unforeseen and emergency needs. Any adverse development has to be met with reserves and, hence, the need for a highly liquid portfolio is a necessary constraint in the investment strategy. The choice of instruments determines the liquidity of the portfolio. For example, in some markets, treasury securities could be liquidated in

large volumes without much distortion to the price in the market and, thus, can be considered as liquid. In fact, excepting fixed deposits with the BIS, foreign commercial banks and central banks and securities issued by supranationals, almost all other types of investments are in highly liquid instruments which could be converted into cash at short notice. The Reserve Bank closely monitors the portion of the reserves which could be converted into cash at a very short notice to meet any unforeseen / emergent needs. Operational Risk and Control System In tune with the global trend, considerable attention is paid to strengthen the operational risk control arrangements. Key operational procedures are

documented. Internally, there is total separation of the front office and back office functions and the internal control systems ensure several checks at the stages of deal capture, deal processing and settlement. There is a separate set-up responsible for risk measurement and monitoring, performance evaluation and concurrent audit. The deal processing and settlement system is also subject to internal control guidelines based on the principle of one point data entry and powers are delegated to officers at various levels for generation of payment instructions. There is a system of concurrent audit for monitoring compliance in respect of all the internal control guidelines. Further, reconciliation of accounts is done regularly. In addition to annual inspection by the internal machinery of the Reserve Bank for this purpose and statutory audit of accounts by external auditors, there is a system of appointing special external auditors to audit the dealing room transactions. The main objective of the special audit is to ensure that risk management systems and internal control guidelines are adhered to. There is a comprehensive reporting mechanism covering significant areas of activity / operations relating to reserve management. These are being provided to the senior management periodically, viz., on daily, weekly, monthly, quarterly, halfyearly and yearly intervals, depending on the type and sensitivity of information. The Reserve Bank uses SWIFT as the messaging platform to settle its trades and send financial messages to its counterparties, banks with whom nostro accounts are maintained, custodians of securities and other business partners.

Evolution of Reserve Management Policy in India Indias approach to reserve management, until the BoP crisis of 1991 was essentially based on the traditional approach, i.e. to maintain an appropriate level of import cover defined in terms of number of months of imports equivalent to reserves. The approach to reserve management, as part of exchange rate management and external sector policy underwent a paradigm shift with the adoption of the recommendations of the High Level Committee on Balance of Payments (Chairman: Dr. C. Rangarajan). As a part of prudent management of external liabilities, RBIs policy is to keep forward liabilities at a relatively low level as a proportion of gross reserves. The policy for reserve management is built upon a host of identifiable factors and other contingencies, including, inter-alia, the size of the current account deficit and short term liabilities (including current repayment obligations on long term loans), the possible variability in portfolio investment, and other types of capital flows, the unanticipated pressures on the balance of payments arising out of external shocks and movements in repatriable foreign currency deposits of non-resident Indians. Transparency & Disclosure Based on a review undertaken in 2003 of the policy and operational matters relating to the management of the reserves, the Reserve Bank of India had decided to compile and make public half-yearly reports on management of foreign exchange reserves for bringing about more transparency and enhancing the level of disclosure. The first such report with reference to the position as on September 30, 2003 was placed in the public domain on February 3, 2004. These reports are
st

now being prepared half yearly with reference to the position as of 31 March and
th

30 September each year with a time lag of about three months. The Reserve Bank has also been making available in the public domain data relating to foreign exchange reserves, its operations in foreign exchange market, position of the countrys external assets and liabilities and earnings from deployment of foreign currency assets and gold through periodic press releases of its Weekly Statistical Supplements, monthly Bulletins, Annual Reports, etc. The Reserve Bank's approach with regard to transparency and disclosure closely follows international

best practices in this regard. The Reserve Bank is among the 68 central banks across the globe which has adopted the Special Data Dissemination Standards (SDDS) template of the IMF for publication of the detailed data on foreign exchange reserves. Such data are made available on monthly basis on the Reserve Bank's website.

References 1. Excerpts from the Special Lecture by Dr.Y.V.Reddy, Deputy Governor, Reserve Bank of India, at National Council of Applied Economic Research, New Delhi on May 10, 2002 2. Half-Yearly Report on Management of Foreign Exchange Reserves 2009-

10 (Covering period up to March 2010)

(Prepared by Shri Brij Raj, Member of Faculty) ***

Issues in Indian Rural Sector

Introduction India is a country of two halves: the Urban India and the Rural India. Quite often, we get to read and hear about the happenings in Urban India but not much is written or known in the mainstream media on our rural economy even though most Indians reside there. As policymakers, it is critical for us to develop a clear understanding about our rural economy, life in rural India and the issues and challenges facing our rural economy so that our approach is well-informed and we frame and implement policies in an effective manner. This write-up seeks to provide an insight into our rural economy and is based on insights from working in the rural planning policy sphere within the Bank, teaching rural finance and above all years of interaction with rural people. 1. Agriculture Though it is acknowledged that agriculture forms the bedrock of our economy and more so for rural India, the share of agriculture in our countrys GDP has been steadily declining over the past five decades. For example, the share of agriculture in our GDP, which stood at 50% in 1951, has come down to about 15% in 2010. Whereas during the same period, the population dependent on agriculture for sustenance continued to be around 60%. If one accounts for the sizeable increase in our population in the last six decades, we can conclude that the absolute number of Indians dependent on agriculture has more than doubled if not trebled during this period. This continues to be so because, we have not succeeded as yet in siphoning off excess population dependent on agriculture to non-farm activities. Dry land in our country is used to cultivate oils, pulses, etc. (Approximately 13 Million Hectares for Pulses and 13 Million Hectares for Oils, but produce is around 26 million tones, which is stagnant for years) and the share of dry land is roughly two thirds of the land under cultivation in our country. Therefore, while our GDP has been growing around 8.5% agriculture growth has been lagging behind often struggling to be at least 4%. The problem of fragmented land holdings and tenancy farming has become chronic. If India has to successfully meet the challenge of food security for its 1.2 billion (and rapidly growing) citizens, there is a clear need for an evergreen revolution. Agricultural productivity in the country has to go up significantly to optimally meet the growing requirements for food and particularly protein-rich-cum-nutritious food in the country.

At the same time, the country cannot afford to ignore the rising and visible threats to crop productivity from global warming. Studies around the world have estimated that for every 1% rise in temperatures, crop yields could decline by about 10-15%. There is scientific evidence that the earth is now already 0.5 degree centigrade hotter over the last century. There is a 50% chance of a rise by 5 degrees centigrade by the end of this century. The consequences on crop yields and weather patterns would be disastrous as per early indications of the effects of global warming. Erratic weather patterns, especially in a country like India where most farmers depend on the monsoons for their crops could play havoc with the farm output. The Government has been encouraging the setting up of Mandis and dissemination of prices to farmers, yet the presence of middlemen ensure that the farmer community still gets the short shrift in respect of their crop produce. The increasing penetration of mobile telephony, contract farming on behalf of corporate entities and an increase in the number of Mandis in various states have helped somewhat alleviate this problem. The above discussion, therefore, points to a need for far greater need for policy attention and action in the area of agriculture. There is a clear need for a quantum leap in public investment in agriculture, setting up of many more Mandis, rising need to encourage contract farming and tie-ups with urban retail chains, etc., encouraging agriculture exports, use of genetically engineered seeds, use of drought-resistant / disease resistant seeds, subsidizing the use of modern irrigation equipment and to fully tap the potential for organic farming.

2. Rural Banking The Reserve Bank has statutory responsibility in respect of rural credit. In Section 54 of the RBI Act, 1934 it is stated as under: To maintain an expert staff to study various aspects of rural credit and development and in particular it may: (a) Tender expert guidance and assistance to National Bank (b) Conduct special studies in such areas as it may consider necessary to do so for promoting integrated rural development Keeping in view the above mandate, RBI and GOI have taken several steps towards development of the rural sector in the country, of which the following are fairly successful ventures: i. ii. Implementation of the Lead Bank Scheme / Priority Sector Lending Encouraging setting up of Rural Self Employment Training Institutes by commercial banks (RSETIs) iii. Encouraging commercial banks to set up Regional Rural Banks in collaboration with governments

iv. v.

Setting up of the Rural Infrastructure Development Fund (RIDF) Smooth implementation of the Mahatma Gandhi National Rural Employment Guarantee Act

vi.

Banks and Self-Help Group Linkages

Pursuant to the announcement in the mid-term review of Annual Policy for the year 2007-08, a High Level Committee was constituted under the chairpersonship of Smt. Usha Thorat, then Deputy Governor, Reserve Bank of India to review the Lead Bank Scheme with focus on financial inclusion and recent developments in the banking sector. The Committees recommendations are now being implemented.

3. Institutional Penetration of Credit in India Table I below gives a snapshot of the change in the institutional penetration of credit in India over the past six decades. Table I - Institutional Penetration of Credit in India
Year Institution 1951 Government / Miscellaneous Co-Operatives Banks Total
*Approximate figures (Authors estimate)

1981 Nil 20%* 21%* 41%*

2001 2% 22%* 24%* 48%

3% 3% 1% 7%

The above table clearly demonstrates that banks clearly need to do much more for Rural Banking to succeed in our country. The rural posting, although mandatory for Bank Officers, is seen by most as a punishment posting and they, accordingly, work in a half-hearted manner. One, therefore, notes with bitterness that the concept of Rural Banker has not picked up. There are problems on several fronts in the rural banking sphere. For instance, the Regional Rural Banks started off with a low-cost structure but now with pay parity with public sector banks, their operations have now become high cost which has added to their problems. The Co-operative sector has its contribution in select sectors no doubt but due to excessive bureaucratic control, rather than by members themselves, has had limited success. Rural infrastructure in most places is poor and requires investments running into billions of dollars.

4. Financial Inclusion Financial inclusion in the Indian context has been defined as the provision of affordable financial services, viz., access to payments and remittance facilities, savings, loans and insurance services by the formal financial system to those who tend to be excluded. Financial inclusion is important for the poor as it provides them opportunities to build savings, avail credit, make investments and equips them to meet emergencies. Out of the 600,000 habitations in the country, only about 5% have a commercial bank branch. Just about 40% of the population across the country has bank accounts and this ratio is much lower in the north-east region of the country. World Bank studies commissioned in 2006 and 2008 have shown that countries with a large population excluded from the formal financial system also show higher poverty ratios and high inequality Financial Inclusion & Development indicators - Recent data shows that countries with large proportion of population excluded from the formal financial system also show higher poverty ratios and high inequality. Table II below provides information on a composite index of financial inclusion and the proportion of population below the poverty line in select countries. For instance, at the beginning of this decade India with only 48% of its population with access to financial services had about 28.6% of its population below the poverty line. Also from the Table it can be observed that India ranks low on the index vis--vis several of its Asian peers. Further, the proportion of people below the poverty line is higher compared to the BRIC countries. These figures highlight the urgent need to fast-track financial inclusion in the country to be competitive vis--vis our Asian and BRIC peers. Table II - Financial Inclusion and Development Indicator Composite index of financial inclusion (percent of population with access to financial services 48 32 43 42 40 63 60 26 59 59 Poverty (percent of population below poverty line) 28.6 (1999-00) 49.8(2000) 22.0(1998) 4.6(1998) 27.1(1999) 15.5(1989) 36.8(1997) 25.0(1995-96) 13.1(1992)

Country India Bangladesh Brazil China Indonesia Korean Republic Malaysia Philippines Sri Lanka Thailand

Source: World Bank (2006) and (2008)

Various technological and financial services and initiatives need to be dovetailed for this. Keeping these aspects is in mind, the Reserve Bank and Government of India have put

financial inclusion process into mission mode, given that it can effectively help in addressing the concern of inclusive growth. The Government of India (GOI) and Reserve Bank of India (RBI) have set a target of March 31, 2012 for provision of banking service either through bank branches or through business correspondents/business facilitators to all villages in the country with a population of 2000 and above. Banks have already submitted their Financial Inclusion plans to the RBI and are currently making all out efforts to meet the above deadline. Commercial banks were permitted in 2006 to use the Business Correspondent / Business Facilitators model for spreading financial inclusion in the country. These are IT-enabled financial inclusion initiatives. In a significant change, banks were also permitted in September 2010 to appoint for-profit entities as Business Correspondent / Business Facilitators. It may be noted that till date, RBI has not permitted the NBFCs to act as BCs citing role conflict. The introduction of UID from mid-2010 would help customers to fulfill KYC requirements and banks in quickly completing documentation requirements and opening bank accounts and disbursing credit. These two initiatives are being seen as game changers in spreading financial inclusion in the country. It may, however, be important to recall that financial inclusion is not a new concept in India and several steps have been taken in the past to pursue this cause. Some milestones in this regard are given in Table III below:

Table III - Milestones on the road to financial inclusion in the country

Year 1904 1969 1975 1990s 2006 2010 2010

Event Setting up of Rural Co-Operatives Nationalization of banks (Phase II in 1980) Setting up of Regional Rural Banks Setting Up of Self-Help Groups Business Correspondents / Business Facilitators Introduction of Aadhaar - The Universal Identification for every Indian Allowing For-Profit Entities to act as Business Correspondents / Business Facilitators

The reason why financial inclusion has become a policy imperative now is we as policy makers have realized that unless financial inclusion is pursued with zeal and all seriousness, economic growth in the country may not be sustainable and inequitable growth may lead to social discord and tension in the country. Financial inclusion to be sustainable has to be a viable business proposition per se. The GOI and State Governments have been attempting to alleviate the problems of rural India through several schemes. Although, these programmes have been criticized for leakages and pilferages, programmes such as the Mahatma Gandhi National Rural Employment Guarantee Act have been a success. NREGA and higher Minimum Support Prices (MSPs) for crops are also ensuring that more money is pushed into the rural areas, which are under-banked. The flip side of MGNREGA has been that rural wages have been going up, farm labour has become more expensive and so have carpenters, masons, construction labour, etc. There is anecdotal evidence that there is a slowdown in the migration of people from rural areas to urban areas in search of jobs. There are credit linked government sponsored schemes, with different degrees of success, viz. i. ii. iii. iv. Swarnajayanti Gram Swarozgar Yojana (SGSY) Swarna Jayanti Sahakari Rozgar Yojana (SJSRY) Self-Employment Scheme for Rehabilitation of Manual Scavengers (SRMS) Differential Rate of Interest (DRI) Scheme

5. Focusing on Financial Literacy - the need of the hour It has been often acknowledged that financial literacy is the key to financial inclusion and a necessary pre-condition for success in the ongoing financial inclusion drive in our country. RBI had earlier advised the convenor bank of each State Level Bankers Committee to set up a FLCCC in any one district on a pilot basis and based on that experience, to extend the facility to other districts in due course. An FLCC can educate people about proper financial management tools, inculcate saving habits and generate demand for financial products and services, which in turn will boost financial inclusion. The establishment of FLCCCs is, therefore, an important milestone in furthering financial inclusion. Up to March 31, 2010 banks had reported setting up 135 credit counselling centres in various states of the country. These centres are expected to provide free financial education to people in rural and urban areas on the various financial products and services, while maintaining an arms length relationship within the parent bank. In its efforts to spread financial literacy in the country, the Reserve Bank has initiated Project Financial Literacy with the objective of disseminating information regarding the central bank and general banking concepts to various target groups. A link titled financial education has

been created on our website which offers the basics of banking, finance and central banking for children of all ages. Our website has also available in 13 languages. RBI has also published easy to understand comic books to explain complexities of banking, finance and central banking in a simple and interesting way to children. The Reserve Bank is also collaborating with state governments across the country to include financial literacy curriculum in the school syllabus. We have launched a pilot project in Karnataka by providing material on banking and personal finance. The Karnataka Government has adapted, translated and included much of this material in the school curriculum and this has already gone on stream from the current academic year which began in June 2010. Based on this experience, the Reserve Bank is looking to replicate this initiative across the country. The RBI as a part of its outreach activities last year has adopted 160 villages all over the country and would be developing them as model villages for financial inclusion. Governor has also recently announced that banks would be also encouraged to open more Financial Literacy Centres to boost financial literacy programmes.

Conclusion The Indian economy cannot grow in a sustainable manner without the contribution of rural India. There is a need for greater policy attention to rural India. The efforts by various stakeholders in our rural economy are in the right direction but much more needs to be done to bridge the urban-rural divide, ensure rural India grows in a sustained manner in the coming decades and makes India a force to reckon with in the global arena.

(Prepared by Dr. J. Sadakkadulla, Principal, RBSC, Chennai. Assistance of Shri Brij Raj, MoF, RBSC in preparing this paper is gratefully acknowledged.)

PAYMENT AND SETTLEMENT SYSTEMS

Introduction Payment Systems encompass a set of instruments and means generally acceptable in making payments, the institutional and organisational framework governing such payment arrangements and the operating procedures and communication network used to initiate and transmit payment information from payer to payee and to settle payments. Payment system facilitates the exchange of goods and services between economic agents using an accepted medium of exchange. A modern payment system typically has a range of specialized sub-systems developed to serve particular sets of customers; some of these clear and settle small payments, some large payments, while some cover both large and retail settlements. As such, payment systems may be classified as large-value systems and retail value systems on the basis of value of individual transactions put through the system. Similarly, payment systems can be classified as gross settlement systems and net settlement systems on the basis of settlement modality, and real-time systems and deferred systems on the basis of settlement timing.

Overview of Payment Systems in India Payment transactions in India have been predominantly paper-based to include cheques, drafts, payment orders, at par instruments (interest / dividend warrants, refund orders, gift cheques, etc., payable at any city). The statutory basis for these instruments is provided by the Negotiable Instruments Act, 1881 (NI Act).

The dominant feature of the Indian banking system is the large geographic spread and branch-centered banking. The vast network of branches implies that the logistics of collection and delivery of paper instruments is formidable. This significant aspect of the banking structure has

185

always been kept in mind while evolving payment system- features and products in the country.

Clearing Operations Computerisation of clearing operations was the first major step towards modernisation of the payments system, the aim being to reduce the long time taken in Clearing, balancing and settlement due to differences and errors in manual balancing, apart from providing accuracy in the final settlement.

The next important milestone was mechanization of the clearing operations with the introduction of Magnetic Ink Character Recognition (MICR) based cheque-processing technology using High Speed Reader Sorter Systems (HSRS).

The MICR Clearing Systems: Reserve Bank of India introduced mechanised clearing in the four metro cities of Mumbai, New Delhi, Kolkata and Chennai from 1986 based on the recommendations of Damle Committee (1983). The technology chosen was MICR technology. MICR stands for Magnetic Ink Character Recognition. Under the MICR technology the information that is necessary for processing is encoded, using special ink containing magnetic properties, in the MICR band in the lower part of the instrument. The MICR cheque contains five fields. On the extreme left is the six digit serial or cheque number. The next field is a nine-digit sort code; the first three digits represent the city code (the first three digits of the Postal Pin code, eg.400 for Mumbai, 600 for Chennai etc); the next three digits represent the Bank code which is allotted by Department of Payment and Settlement Systems, Central office. The last three digits represent the branch code which is allotted by the RBI Regional Offices (NCCs). The fourth field is the six-digit account number of the customer. This is an optional field. The next two-digit field is the transaction code that defines the nature of the instrument viz; savings, current, draft etc. (In case of government account cheques, the account number filed is of length 7 and the transaction code field is length 3 which is together read by the

system as a ten digit government account code). The last field is the thirteen-digit amount field where the last two digits represent the amount in 186

paise. Except the amount field, the others are pre- printed fields; pre-printed by the drawee bank. The presenting bank is required to encode the amount field at the time of presentation of the instruments to the clearing house using an encoding machine.

All the instruments received at the NCC are processed on the ReaderSorter machines through a process known as prime pass. The instruments are read, the information on the MICR band is captured, an item sequence number is sprayed on the reverse side of the instrument and the instrument sorted at a speed of 2400 documents per minute. At the end of processing the settlement register is generated along with various other reports. The cheques are once again run in the Reader-Sorter in a process called Fine Sort in which the cheques are sorted bank- wise, branch- wise and, within a branch transaction codewise. The cheques are then packed and sent to the drawee banks along with a listing of the cheques.

Cheque Truncation System (CTS): This was introduced in the National Capital Territory of New Delhi during February 2008. This has been a strategic decision to invest in a world-class image-based clearing solution that eliminates the physical movement of cheques, providing a more secure and efficient method for clearing cheques. CTS also allows banks to maintain electronic data to address customer queries within the shortest possible time. With all member banks of the New Delhi Bankers Clearing House participating in the CTS, effective from July 1, 2009 the separate MICR clearing has been discontinued.

High Value Clearing: To facilitate faster clearing of large-value cheques (of value Rupees 1, 00,000 and above), the Bank facilitated the introduction of HighValue Clearing (HVC) at the clearing houses, covering select branches of the banks for same day settlement. The HVC continued to remain hugely popular for over two decades, until the recent decision to reduce the risks arising out of use of paper-based instruments for clearing and settlement of large-value transactions. In a bid to encourage customers to move from paper187

based modes to electronic products, in April 2009, the clearing houses have been advised to increase the threshold amount of cheques eligible to be presented in HVC from Rs.1 lakh to Rs.10 lakh and gradually discontinue the use thereof in an undisruptive manner over a period of next one year.

In addition, the Computerised Cheque Clearing Process has been further consolidated through the introduction of magnetic media based input settlement as an intermediate step towards complete automation of cheque clearing through MICR processing.

Electronic Clearing Service (ECS): By the early 90s, though the MICR computerised cheque clearing operations had stabilised, the volumes in cheque clearing continued to reflect an upward trend, creating considerable pressure on the existing work flow processes. A closer analysis revealed that at par items such as dividend and interest warrants (system of paying interest / dividend to the beneficiaries through paper instruments) issued by various companies were contributing significantly to the volumes in clearing. The need was, therefore, felt for the introduction of a cost-effective system which would serve as an alternate method of effecting bulk, low value, recurring payment transactions, thereby obviating the need to issue and handle paper instruments.

The Electronic

Clearing

Service

(ECS)

Credit

scheme was

introduced whereby a series of electronic payment instructions are generated to replace paper instruments. The system works on the basis of one single debit transaction and multiple credits to the beneficiary accounts without issue of paper instruments. This scheme is very cost-effective for companies paying interest and dividend to a large number of beneficiaries. Further, the scheme is being used by the Government of India and a number of other government undertakings for salary payments etc.

The success of ECS-Credit service resulted in the introduction of Electronic Clearing Service - Debit. This scheme facilitates payment of charges 188

to utility services such as electricity/telephone companies, payment of insurance premia and loan instalments etc. by electronic debit to customer accounts. ECS Debit envisages a large number of debits resulting in a single credit simultaneously. ECS Debit works on the principle of pre- authorised debit system under which the account holders account is debited on the appointed date and the amounts are passed on to the utility companies. The payment details, in electronic form, are submitted by the institution to the RBI at the clearing houses through their sponsoring bank. RBI processes the data and prepares branch-wise advices which are delivered through the clearing system.

To encourage the use of these products, these products are offered free of cost by the processing centre to member banks.

Further, during September 2008, the Bank launched a new service known as National Electronic Clearing Service (NECS), at National Clearing Cell (NCC), Mumbai. NECS (Credit) facilitates multiple credits to beneficiary accounts with destination branches against a single debit of the account of the sponsor bank. NECS (Debit) when launched would facilitate multiple debits to destination account holders against a single credit to the sponsor bank. The system has a pan-India characteristic leveraging on Core Banking Solutions (CBS) of member banks, facilitating all CBS bank branches to participate in the system, irrespective of their location. As at the end of September 2009, as many as 114 banks with 30,780 branches participate in NECS.

Electronic Funds Transfer (EFT): Another development that took place in the payments system scenario was the introduction of the Electronic Funds Transfer Scheme which is a retail funds transfer system and enables an account holder of a bank to transfer funds to another person having an account with any of the participating banks, without any physical movement of instruments from one center to another. The EFT system enables both intra and inter-bank funds transfer, within a city and between cities.

The process under the EFT scheme involves submission of the transfer 189

request by the remitting customer to his banker giving details of the beneficiary such as name, account number, bank and branch name, amount and type of account etc. The remitting bank captures this information (using the software developed and maintained by RBI) and forwards the same to the NCC at the originating centre before the cut-off time. The NCC will consolidate the files received from various remitting banks, process and sort them centre-wise and upload the outward files to the destination centres through INFINET at each settlement time. At the receiving centre, the NCC will download the data, process and sort them bank-wise and send them to the service branches of the respective banks. The service branches in turn prepare the branch-wise advices and transmit / send them to the concerned branches. The branches will then pass on the credit to the beneficiarys account and also advise the fact to their service branch. The service branches prepare an acknowledgement file using the same EFT software and send it back to the NCC at the destination centre, which will be transmitted to the originating centre. The NCC at the originating center will in turn acknowledge the same to the sending bank. In case of any discrepancies or under certain conditions the destination branch will return the transaction without crediting the customers account.

A new scheme named National Electronic Funds Transfer (NEFT) has been introduced since 2005 to phase out EFT. However, EFT settlement will continue to be once a day, till it is phased out completely.

National Electronic Funds Transfer System: National Electronic Funds Transfer (NEFT) system is a nation-wide electronic funds transfer system to facilitate transfer of funds from any bank branch to any other bank branch. It is an improvement over the EFT system in the following ways:

Only bank branches which are connected over a computer network can
be members of the NEFT scheme thus there are no delays

All the transactions under the NEFT scheme are processed at Mumbai
only. This means that all the transactions from all the cities in the country flow to Mumbai and flow out of Mumbai and the funds settlement takes place at DAD, RBI, Mumbai 190

 NEFT uses the secure message transmission methodology i.e. Public

Key Infrastructure (PKI) and Digital Signature which are as per the IT Act, 2000.

93 banks with over 61,000 branches are participating in NEFT as at end -- October 2009. NEFT has as many as 6 settlements in a day, thus enabling near real-time transfer of funds between banks. Steps are being taken to widen the coverage both in terms of banks and branches. The individual branches participating in NEFT could be located anywhere across the country. The beneficiary accounts are credited on the same day or the next day depending on the time of settlement.

Inter-Bank Payments

Any settlement system may involve settlement of transactions on a Net basis (setting-off of credits against debits) or Gross basis (transaction by transaction on an individual basis). Netting of transactions again can be on bilateral basis or multilateral basis. The settlement of netted obligations can also take place at designated time intervals or at the end of the day and not necessarily immediately after the netting obligations are arrived at. Final payments under netting systems are generally deferred till a definite period of time called the settlement period (called as Deferred Net Settlement). Netting systems no doubt reduces the number of payments to be effected, but it also introduces certain risks into the system especially for large-value transactions and for systemically important payment systems.

Sources of Risk include the time lag between execution of transaction and its final completion and the time lag between completion of two legs of a transaction. The extent of these risks can be reduced by gross settlement of transactions where final settlement of the transaction occurs on a continuous basis during the processing day. Such a settlement system, which ensures the settlement of transactions on a real time basis, is called as the Real Time Gross Settlement System. 191

Real Time Gross Settlement System: The RTGS system is operational in India since March 2004. It settles all interbank payments and customer transactions above Rs.1 lakh. There are 110 direct participants in RTGS. Participants include banks, financial institutions, primary dealers and clearing entities. All systemically important payments including securities settlement, forex settlement and money market settlements are processed in the RTGS system. The service window for customer transactions is available from 09.00 hours to 16.30 hours on weekdays (up to 13.30 hours on Saturdays) and for inter-bank transactions, up to 18.00 hours on week days (15.00 hours on Saturdays). The number of RTGS enabled bank branches has crossed 60,000. The peak daily volume processed by RTGS stood at 179,933 transactions on 29 September 2009 for Rs.3468.57 billion. RTGS settles 120,000 transactions daily on an average and the volume is growing very fast. Between September 2008 and September 2009, the RTGS volume has increased almost three folds. The Bank provides intraday liquidity to participants free of cost. The liquidity support is fully collateralized. Reserve Bank also commissioned an external assessment of the RTGS system by a team of experts from the Swiss National Bank. These experts viewed that the RTGS system in India is compliant with all the Core Principles, except the one on efficiency.

Some salient features of the RTGS system are:

Each participant will access the RTGS system via a Participant

Interface, which will support high-value payments and associated nonvalue functions such as enquiries, queue management, reporting as well security, resilience and recovery requirements.

The RTGS system will be based on Y-Topology. One of the critical components of the RTGS system is the Interbank
Funds Transfer Processor (IFTP). The IFTP receives and dispatches the RTGS messages, validates them and determines the processing path of transactions. It strips and stores all the information not required for settlement and only the settlement information sent further for accounting. After successful completion of settlement, the IFTP forwards 192

full payment instructions to the receiving participant.

Queuing System: Whenever a transaction is received in the RTGS but cannot be

settled immediately due to shortage of funds in the sender's account, the payment instruction / message is put into a queue. At frequent intervals, the instruction is taken from the queue and tested for funds availability, and is settled if funds are available. RTGS as well as IFTP will maintain queues and queue management facilities. The settlement queues will be logically segmented so that each participant effectively has its own queue of payments awaiting settlement. Participants can see their own outward queue and manage the queue priorities of their own payments. Transactions that fail a funds availability test will be returned to the respective queue and the transaction is retested periodically as per the queue processing/ sequencing algorithms.

Intraday Liquidity Provision: In case funds are not available in the

settlement account of the paying bank, intra-day liquidity (IDL) to participants is provided by the Bank against 100 per cent collateral. Only specific types of transactions will be eligible for such IDL support. Participants have to earmark the eligible securities available as collateral for IDL purposes in the Securities Settlement System (SSS) for this purpose so that the RTGS can communicate with the SSS for the operation of IDL.

Interaction with Net Settlement Systems: A range of payment

systems will continue to operate outside the RTGS environment. Some of these systems will generate financial obligations between

participants of RTGS that need to be settled. The underlying transactions are typically low-value and high-volume and would not be suited for gross settlement. Consequently, net settlement obligations, will be periodically submitted for settlement over RTGS using a Multilateral Net Settlement Batch (MNSB) facility. The MNSB will be a separate transaction type allowing multiple counterparties to the transaction. The MNSB will be submitted by authorized clearing entities and this batch will have priority over other transactions awaiting settlement held in the queue. The funds availability test for the batch 193

will ensure that the batch cannot proceed unless all debits to participants accounts in the batch can be passed. In the event of an unsuccessful funds availability test, processing of the batch will be suspended. The batch will be re-submitted periodically for funds availability testing.

Centralised

Funds

Management

System:

The

Centralised

Funds

Management System facilitates Centralised funds enquiry and management of the accounts maintained by the banks with Reserve Bank of India. The CFMS inter-connects the Deposit Accounts Departments (DAD) at the various offices of the bank and provides interface to RBI member institutions. The basic features of the CFMS are:

A Centralised Funds Enquiry System (CFES) based on the consolidation

of accounts maintained at the different DADs at CFMS.

A Centralised Funds Transfer System (CFTS) to enable movement of

funds across various DADs (typically, intra-bank inter-DAD). The system aims to integrate the various DADs into a single virtual DAD for member banks using the system.

Reserve Bank of India, being the bankers bank to scheduled commercial banks, state co-operative banks and other quasi-government institutions (besides being the banker to Central and State Governments), maintains the current account of the above mentioned organizations. The major aim of the system is to have a centralised facility where each constituent bank can obtain all possible information on these accounts and make authorized updates. This would facilitate the funds management at the banks by the treasury manager by accessing information of their balances maintained across different DADs from a single location. The CFMS carries out all its processing on the IBM Z9 Mainframe at the Data Centres, which would act as the Apex Level Server (ALS). At the DADs, there is the Local Funds Management System (LFMS), while at the Bank Level Server (BLS) there is the 194

Bank Level Fund Management systems (BLFMS) and the Local Bank Node (LBN) would be equipped with the Local Bank Fund Management System (LBFMS). CFMS at the ALS would process queries from the banks BLS/ LBN/ DADs and offer facilities for:

Providing final consolidated balances at that instance with officewise,

account-wise break-up

Viewing the office-wise, transaction-wise details for a given day. Viewing the office-wise, transaction-wise for a given time period within a
day

Providing facility to view old data from the available on-line data Minimum account-wise balances for each center and account The transaction details which are in the queue at each DAD Providing the facility to originate funds transfer messages by the Funds
manager to operate on the accounts at any DAD, through the BLS and also providing the facility to originate funds transfer messages by the LBN to operate on the accounts at the local DADs

Negotiated Dealing System: One of the measures that was instituted by Reserve Bank of India in order to develop the infrastructural arrangements facilitating the secondary market operations in Government Securities has been the introduction of a screen-based trading platform called as the Negotiated Dealing System (NDS). The NDS, which went live from 15 February 2002, is the q u o t e - d r i v e n electronic trading a n d r e p o r t i n g platform through which the deals in the secondary market for government securities are finalized by the participants, and the deal information is taken up for settlement directly from the system without necessitating submission of physical transfer forms by the participants. Apart from facilitating the dealing process (by way of quotes and negotiations), the NDS also provides for electronic reporting of trades, online information dissemination (thereby aiding price and volume discovery), centralised SGL system. The NDS application also provides for electronic submission of bids / applications in the primary issuance of government securities through auction / floatation as the case may be. This has obviated the 195

need for physical applications by the participants.

With effect from August 2005, another platform has been made available through the medium of CCIL called as the NDS-OM (Order Matching) system. This system is an anonymous order matching system as the name suggests. The members put in their orders for purchase and sale of government securities and the system matches the trades on a price/time priority basis (just like the stock exchange mechanism). Irrespective of whether the trade has taken place over the NDS or NDS-OM, the information is made available to CCIL for further processing as given below.

Clearing Corporation of India Limited: The Clearing Corporation of India Limited (CCIL), set up in April 2001 by banks, financial institutions and primary dealers, functions as an industry service organisation for clearing and settlement of trades in foreign exchange, government securities and other debt instruments. Any component of the payment system is open to certain risks such as credit risk, liquidity risk, replacement cost risk etc., which in turn can lead to systemic risks. The Clearing Corporation plays the role of a Central Counter Party (CCP) to all transactions and guarantees settlement of trade executed through its rules and regulations thus eliminating counter party risk. In turn, this will help to mitigate the other risks in the securities and foreign exchange settlement systems. CCIL provides guarantee to the settlement of securities and foreign exchange transactions of the counter parties by interposing itself as the central counter party to all trades by a process called as Novation. By this means, the counter party risk is not eliminated but is managed by redistribution. Players bilateral risk is replaced by standard risk to the CCP. In order to provide such guarantee and also minimise the risks that it exposes itself to, the CCIL follows specific risk management practices, which are also international best practices.

Role of CCIL in settlement of government securities transactions: CCIL commenced operations in this segment for both outright and repo transactions from 15th February 2002 along with the operationalisation of the Negotiated Dealing System. Guaranteed settlement was extended from April 2002. 196

Settlement of securities (Mumbai PDO) and funds (Mumbai DAD) is done through the DVP-III (effective April 2004) mechanism (that is, both funds and securities are settled on a net basis). In the process of clearing and arriving at settlement obligations as above, the transactions are taken into the system at CCIL and necessary risk management procedures adopted to verify the members exposure limits are carried out and calls for additional margins are sent out to the members where required. Thereafter, the final settlement obligation information is sent to Mumbai PDO for initiating the process of settlement. Since CCIL acts as a Central Counter Party and steps in to provide guaranteed settlement where shortages occur (provided the member has fulfilled its share of obligations in terms of margin requirements etc), it has entered into Securities Line of Credit and Funds Line of Credit with a few members so that it has access to securities and funds which can be used for taking care of shortages. Whenever CCIL provides the necessary securities in case of any shortfall, it will withhold the payment of requisite funds to the defaulting member/s. Similarly, securities are withheld from members who default on funds.

Collateralised Borrowing and Lending Obligation (CBLO): This is a discounted money market instrument available in electronic book entry form. It is similar to a tripartite Repo transaction involving CCIL as third party, which functions as the common counter party to borrower as well as lender. The borrower has an obligation to return the money borrowed, at a specified future date. The lender has the authority to receive money lent, at a specified future date with an option / privilege to transfer the authority to another person for value received. There is an underlying charge on securities held in custody (with CCIL) for the amount borrowed / lent. CBLOs are available for the maturity period ranging from one day to one year. The membership of CBLO segment is extended to banks, primary dealers, mutual funds, financial institutions and insurance companies, who are members of the NDS. Membership is also extended to institutions such as NBFCs, Provident Funds and Corporates who do not have access to NDS. These members access CBLO through CCILs web based CBLO application, Internet Gateway to CBLO Trading System. Such members are called Associate members. 197

Associate members are required to open current accounts with one of CCILs designated settlement banks to enable funds settlement.

Role of CCIL in settlement of foreign exchange transactions: CCIL commenced the settlement of inter-bank Re-Dollar spot and forward transactions from 8th November 2002 (for value date 12th November 2002). Authorised dealers who have a reasonable turnover in the forex market, are financially sound and satisfy the capital adequacy norms imposed from time to time by RBI with adequate risk management systems in place are eligible to become members of CCIL. All members must have a current account with RBI for settlement of transactions in INR funds. As part of its risk management practice, CCIL sets a Net Debit Cap (NDC) for each member which is a limit set in dollars and the member would not be allowed to run a net sold position is excess of this limit on any given day. Individual members are required to deposit a margin contribution (which is a function of the members NDC and the stipulated margin factor) to the CCILs Settlement Guarantee Fund (SGF). These contributions, in dollar terms, will be held in the nostro account of CCIL with its settlement bank at New York, USA (ABN AMRO bank) and will be invested by CCIL in approved investment avenues. They will be used as collateral to enter into Line of Credit arrangements with the settlement bank both at New York as well as RBI.

The deal information will be received by CCIL through the Forex Deal Reporting utility that will be used by all the members to report the transactions to CCIL in various batches throughout the day. The trades received will be matched upto specified time limits and unmatched trades will be rejected. CCIL has also introduced FX-Clear an electronic trading platform for members to trade in the foreign exchange market from 7th August 2003. It will provide straight through processing for all trades in USD-INR as they will be taken up directly for settlement by the CCIL forex-clearing segment. Members net liability in both Rupee and Dollar terms will be advised to them before a specified time so that they can make arrangements to ensure that dollar funds are paid out by their correspondents to the credit of CCIL account on 198

settlement day. In case of default on either the Rupee leg or the Dollar leg by any member, CCIL ensures that the settlement is completed by utilization of the respective Line of Credit facility. The corresponding pay-in to the member is withheld by the CCIL and will be released only when the member makes good his default and also pays the charges for utilization of the line of credit funds. If, however, the member does not repair the default within the stipulated period of time, the loss allocation procedure will be invoked wherein the members contribution to the SGF will be first utilized to meet the default. In case of shortfall, the loss will be borne by all the members in proportion to their exposure to the defaulting member for that settlement.

Continuous Linked Settlement (CLS): CCIL also provides Continuous Linked Settlement (CLS) services for banks in India by availing of third party services of ABN Amro Bank. Using this facility banks in India can settle their crosscurrency deals through the CLS. Banks participating in this segment of CCIL report their cross currency trades to Settlement Bank directly or through CCIL. The settlement is made through the nostro accounts of CCIL with the settlement bank, in CLS settlement currencies (of 17 CLS settlement currencies CCIL provides services only in 14 currencies).

CLS settlement is not a guaranteed settlement and it only ensures that the settlement happens on a Payment Versus Payment (PVP) basis. CCIL only facilitates the CLS settlement, it neither novates nor guarantees settlement for this segment. CCIL, therefore, is not exposed to principal risk but only to market risk.

Oversight of the Payment and Settlement Systems Legal Framework: The Payment and Settlement Systems Act, 2007 (PSS Act) was legislated in December 2007 and the PSS Act as well as Regulations framed under the PSS Act came into effect from August 12, 2008. This Act provides for the regulation and supervision of payment systems in India and designates RBI as the authority for the purpose. As per the Act only payment systems authorized by RBI can be operated in the country. The person who 199

operates the system (system provider) would operate the payments in accordance with the provisions of the Act and conditions of authorization. The Act also provides for the settlement effected under the rules and procedures of the system provider to be treated as final and irrevocable.

The Act provides:

Legal Framework for Payment Systems Provide for separate roles of the Reserve Bank as a Regulator,
Operator, System Provider and Participant

Legality for net settlements Separation of operation functionalities Provision for multiple players
Institutional Framework RBI has put in place an institutional framework and structure for oversight of the payment systems.

Board for Regulation and Supervision of Payment and Settlement Systems (BPSS): In 2005, the Bank created a Board for Regulation and Supervision of Payment and Settlement Systems (BPSS) as a Committee of the Central Board of the Bank, to prescribe policies relating to the regulation & supervision of all types of payment and settlement systems, set standards for existing and future systems, authorize the payment and settlement systems, determine criteria for membership to these systems, including continuation and termination of membership. The Board was re-constituted in 2008 in accordance with the provisions of the Board for Regulation and Supervision of Payment and Settlement Systems Regulations, 2008.

The National Payments Council (NPC) was formed in 1999 as the Apex body to provide general policy directions and guidelines for reforms in the payment and settlement systems of the country. The NPC had members from banking and financial sector. After the constitution of the Board for Regulation and Supervision of Payment and Settlement Systems in 2005, the Apex body 200

for regulation and supervision of payment and settlement systems, the role of the NPC was to act as an advisory body to BPSS. The BPSS is now the apex and statutory body and has been re-constituted in 2008 in accordance with the provisions of the Payment and Settlement System Act. The BPSS Regulations, 2008 provides for constitution of sub-committees or Advisory Committee for providing assistance or advice in the performance of its functions as and when required. As such the need for NPC to function on a continuous basis was not felt and moreover the BPSS is monitoring the developments in PSS on a regular basis. Thus the NPC which was earlier designated to act as the advisory body has been wound up. National Payments Corporation of India (NPCI): The Reserve Bank encouraged the setting up of National Payments Corporation of India (NPCI) to act as an umbrella organisation for operating the various retail payment systems in India. NPCI has since become functional. Certificate of authorisation under the Act have been issued to NPCI for take-over of National Financial Switch (NFS) from IDRBT. A road map for take-over of the existing retails payment systems and deployment of new payment systems has been communicated to NPCI by RBI. NPCI is expected to bring greater efficiency by way of uniformity and standardization in retail payments, expansion of reach and innovative payment products to augment customer convenience. The NPCI is an entity registered under the Section 25 of the Companies Act and owned by banks and financial institutions. The ownership of the company would be diversified in such a manner that no bank or group of banks shall have a shareholding exceeding 10 per cent of the total shareholding. Being a Section 25 company, NPCI will not distribute its profits as dividend, but will plough it back for the improvement of the retail payment system- infrastructure.

Department of Payment and Settlement Systems (DPSS): In order to assist the BPSS in performing its functions the Bank constituted a new Department called the Department of Payment and Settlement Systems (DPSS).The DPSS commenced its functioning from March 07, 2005. The department was created by carving out certain functions of the Department of Information Technology (DIT). 201

DPSS implements the policy decisions directed by the BPSS. The Department currently operates only at the Central Office level. At the Regional Office level, the National Clearing Cells assist DPSS in its functions. The Payment and Settlement Systems Act, 2007 (PSS Act) was legislated in December 2007 and the PSS Act as well as Regulations framed under the PSS Act came into effect from August 12, 2008. This Act gives explicit authority to the Reserve Bank of India for regulating the payment systems in the country.

Systemically Important Payment Systems in India: The classification of certain payment systems as systemically important based on, inter-alia whether the participants are banks or not, whether the settlement takes place in the books of Central bank or not, whether the individual value of payments is typically small or not, whether the transactions relate to financial markets or not, whether the failure of one or more participants has a cascading and contagion effect on other participants and other systems. The systems identified as SIPS are:

High Value Clearing System Securities Settlement System Foreign Exchange Clearing Systems Real Time Gross Settlement System
Recognizing the importance of payments in the financial fabric of the country, for financial stability, for efficient transmission of monetary policy and so on, and also recognizing the risks that can disrupt the payment systems if not adequately protected, the Committee on Payment and Settlement Systems (CPSS) of Bank for International Settlements (BIS) has recommended Core Principles for Systemically Important Payment Systems (SIPS). SIPS are a major channel by which shocks can be transmitted across domestic and international financial systems and markets. The Core Principles as well as the corresponding responsibilities of the Central Bank as defined by the CPSS report are given below. 202

Core Principles for systemically important payment systems 1. The system should have a well-founded legal basis under all relevant jurisdictions. 2. The systems rules and procedures should enable participants to have a clear understanding of the systems impact on each of the financial risks they incur through participation in it. 3. The system should have clearly defined procedures for the management of credit risks and liquidity risks, which specify the respective responsibilities of the system operator and the participants and which provide appropriate incentives to manage and contain those risks. 4. The system should provide prompt final settlement on the day of value, preferably during the day and at a minimum at the end of the day. 5. A system in which multilateral netting takes place should, at a minimum, be capable of ensuring the timely completion of daily settlements in the event of an inability to settle by the participant with the largest single settlement obligation. 6. Assets used for settlement should preferably be a claim on the central bank; where other assets are used, they should carry little or no credit risk and little or no liquidity risk. 7. The system should ensure a high degree of security and operational reliability and should have contingency arrangements for timely completion of daily processing. 8. The system should provide a means of making payments which is practical for its users and efficient for the economy. 9. The system should have objective and publicly disclosed criteria for participation, which permit fair and open access. 10. The systems governance arrangements should be effective,

accountable and transparent.

Responsibilities of the central bank in applying the Core Principles A. The central bank should define clearly its payment system objectives and should disclose publicly its role and major policies with respect to systemically important payment systems. 203

B. The central bank should ensure that the systems it operates comply with the Core Principles. C. The central bank should oversee compliance with the Core Principles by systems it does not operate and it should have the ability to carry out this oversight. D. The central bank, in promoting payment system safety and efficiency through the Core Principles, should cooperate with other central banks and with any other relevant domestic or foreign authorities.

As the payment and settlement systems constitute the backbone of any financial economy, and with the objective of ensuring efficient and faster flow of funds among various constituents of the financial sector, Reserve Bank of India has taken up the work of reforms in the payment and settlement systems for the country. While the driving force behind all the initiatives has been technology, it has been ensured that all the other major covenants of a safe, efficient and secure payment and settlement system are fully met with.

Development, Consolidation and Integration of payment systems In order to usher in and establish a modern, robust payment and settlement system infrastructure consistent with international best practices, the Reserve Bank has adopted a three-pronged strategy of Consolidation of existing Payment Systems, Development of Payment Systems and Integration of the Payment and Settlement System. The consolidation of the existing payment systems revolves around strengthening Computerized Cheque clearing and expanding the reach of the existing payment system products by providing for systems with the latest levels of technology. The elements in the developmental strategy include introduction of clearing process in new locations, mechanized cheque processing, image based cheque processing systems, interconnection of the clearing houses, and optimizing the deployment of resources by banks, while integrating all these into a seamless system in due course. Vision Document

204

The Bank has prepared the Payment Systems Vision Document in the area of Payment and Settlement Systems listing the achievements in the area of payment systems during the preceding three years and detailing the action plan with definite milestones to be reached in the next few years. The mission statement of the vision document (2009-12) is To ensure that all the payment and settlement systems operating in the country are safe, secure, sound, efficient, accessible and authorized.

The components of the Payments System objectives of the Bank have been defined as Safety, Security, Soundness, Efficiency, Accessibility and Authorisation.

Recent Developments

Prepaid card systems:

Pre-paid

payment

instruments

are

payment

instruments that facilitate purchase of goods and services against the value stored on such instruments. The value stored on such instruments represents the value paid for by the holders by cash, by debit to a bank account, or by credit card. The pre-paid instruments can be issued as smart cards, magnetic stripe cards, internet accounts, internet wallets, mobile accounts, mobile wallets, paper vouchers and any such instrument which can be used to access the pre-paid amount. Pre-paid payment instruments provide a safe means of payment. They facilitate online transactions as unlike credit cards the amount of loss to the customers is limited. Different types of cards provide different utility to the holders. The usage and availability of pre-paid instruments in India have been limited. Prior to notification of the Payment and Settlement Systems Act, 2007 (PSS Act), banks and non-bank entities were issuing pre-paid payment instruments in the country. Only banks proposing to issue pre-paid payment instruments were approaching DBOD, Reserve Bank for authorization and - issuing pre-paid payment instruments like gift cards, payroll cards, travel cards, payroll cards etc. The regulatory guidelines issued to banks in case of such cards specifies 205

the need for identification of the beneficiary, caps on the value loaded, restrictions on re-loading, cash withdrawal, etc.

Subsequent to the notification of the PSS Act, to ensure protection of public interest it became necessary to lay down the policy relating to regulation of the issue and operation of pre-paid instruments in India and give directions to every system provider, system participant and any other person proposing to issue pre-paid payment instruments. Accordingly, the guidelines for prepaid payment instruments were issued on April 27, 2009 (with an amendment in Aug 2009).

These guidelines cover both banks and non-bank persons and lays down the basic eligibility criteria and the conditions for operating such payment systems in the country. The pre-paid payment instruments that can be issued in the country are classified under three categories viz. (i) Closed system payment instruments (ii) Semi-closed system payment instruments and (iii) Open system payment instruments.

Mobile banking systems: Mobile phones as a medium for providing banking services, have been attaining greater importance. In order to ensure a level playing field and considering that the technology is relatively new, Reserve Bank has brought out a set of operating guidelines for adoption by banks in October 2008. The guidelines permit only banks which are licensed and supervised in India and have a physical presence in India to offer mobile banking services in the country. The guidelines mandate validation through a two factor authentication and end to end encryption. Inter-bank transfer arrangements can be only through RBI authorized systems. As per the revised guidelines issued in December 2009, banks are now permitted to offer this service to their customers subject to a daily cap of Rs 50,000/- per customer for both funds transfer and transactions involving purchase of goods/services

On the technology front the objective is to enable the development of inter-operable standards so as to facilitate funds transfer from account in one 206

bank to any other account in the same or any other bank on a real time basis irrespective of the mobile network a customer has subscribed to.

Only banks who have received one time approval from the Reserve Bank are permitted to provide this facility to customers. Till October 31, 2009, 32 banks have been granted permission to operate Mobile Banking in India, of which 7 relate to SBI and its associates, 12 are nationalised banks and 13 are private / foreign banks.

National Financial Switch: In recent years, the usage of cards (debit, credit and smart cards) has increased manifold. Within this, the growth of debit cards has been higher than that of credit cards. At the same time, use of Automated Teller Machine (ATM) cards are also on the rise necessitating optimization of investment made by banks as a whole. This has brought in a need for sharing of resources where banks have begun to share their ATM networks with one another. ATM networks use Switches wherein ATM transactions are validated against account information, processed and recorded at a central location. Where banks are sharing their ATM networks, it calls for inter-operability or compatibility between the Switches used at national level. In order to facilitate such inter-operability, the Institute for Development and Research in Banking Technology (IDRBT), Hyderabad has set up a National Financial Switch (NFS) at the apex level. The NFS became operational from August 2004. ATMs whose ATM transactions are routed from their respective Switches to the NFS and from the NFS, the inter-bank obligations for settlement are calculated and sent to the CCIL at Mumbai. The settlement is finally effected in the accounts of the

member banks maintained at DAD, Mumbai. The National Financial Switch (NFS) is a system that is a significant step towards facilitating convenience banking to the people of the country.

Institute for Development And Research In Banking Technology (IDRBT) The committee on Technology Upgradation in the Payment Systems (1994), had recommended development of a variety of payment applications which can be implemented with appropriate technology upgradation and development of a reliable communication network. The committee had also 207

suggested setting up of an Information Technology Institute for the purpose of Research and Development as well as Consultancy in the application of technology to the Banking and Financial sector of the country. As recommended by the Committee, the Institute for Development & Research in Banking Technology [IDRBT] was established by the Reserve Bank of India in 1999 as an Autonomous Centre for Development and Research in Banking Technology.

Since its inception, IDRBT is playing a vital role in providing the advantage of developments in computer and communications technology to the Indian banking and financial sector. In addition to its contribution in the field of education and research, the following have been very important contributions of IDRBT:

The INdian FInancial NETwork [INFINET] which is the communication backbone for the Indian Banking and Financial Sector has been set up and maintained by IDRBT. All Banks Public Sector, Private Sector,

Cooperative, etc., - and the premier Financial Institutions in the country are members of the INFINET. The INFINET provides the communication platform through which most of the payment system products in the country are working. The INFINET earlier used leased line technology with ISDN and VSAT as backup. Now, the network has migrated to the latest technology of Multi Protocol Labeled Switching-Virtual Private Network (MPLS-VPN).

Structured Financial Messaging System (SFMS): This system, launched in December 2001, is a secure and common messaging solution that serves as the basic platform for intra- bank and inter-bank applications, and fulfills the requirements of domestic financial messaging. The SFMS, built on the lines of SWIFT, can be used practically for all purposes of secure communication within the bank and between banks. The intra-bank part of SFMS, which is most important, can be used by the banks to take full advantage of the secure messaging facility it provides as also the fact that use of SFMS is not restricted to fully or partially computerized branches.

208

References:

1. Payment Systems in India - Vision 2009-12-RBI Publication 2. Core Principles for Systemically Important Payment Systems (SIPS) Publication of the Committee on Payment and Settlement System of Bank for International Settlement. 3. RBI Annual Report 2008-09

(Updated by Shri R.Vanaraja, Member of Faculty, RBSC, Chennai)

209

Financial stability

Global crisis and financial stability Increasing global imbalances, build-up of excessive leverage and mismatches in financial intermediaries, weaknesses in the regulatory and supervisory system and complexities in financial products arising out of financial innovation have been some of the factors leading to the global crisis. The crisis triggered unprecedented panic and uncertainty about the extent of risk in the system which was reflected in the sudden and massive break down of trust across the entire financial system. While the banks tended to hold liquidity, the credit, bond and equity markets witnessed reversal. In view of the sudden preference for safety, yields on

government securities plunged while spreads over risk free government securities surged across market segments. Massive deleveraging drove down asset prices, setting off a vicious cycle, and several venerable financial institutions came to the brink of collapse. While the epicenter of the crisis lay in the advanced economies originating from the US, it soon spread from the financial sector to the real sector in advanced economies. Concomitantly, the crisis spread geographically from the advanced economies to the emerging market economies and soon engulfed the global economy.

(ii) Post-crisis, financial stability has emerged as an important objective for central banks across countries in the world. The central banks have learnt that financial stability can be jeopardized even if there is price stability and macroeconomic stability. Even as the crisis is not fully behind us, several lessons are clear. Central banks should: take countercyclical policy actions to prevent build up of imbalances; and explicitly include financial stability as a goal. Further, financial stability needs to be understood and addressed both from the micro and macro perspectives.

(iii) Not only

have individual

regulators adopted

a host of measures in their

respective countries, but even the global community as a whole has been making concerted efforts to reform the existing international financial architecture and help prevent such crisis in future. The key aspects of the emerging financial stability frameworks in different countries are the following:

supervision of individual firms from systemic perspective vesting with the sectoral regulators; greater involvement of the central banks, where not already there, in

supervision of systemically important entities; a collegial body of government/central bank/regulators to monitor and coordinate response to systemic risks the role of government as the ultimate absorber of solvency risk demonstrated in the recent crisis; and reorientation of regulatory mandates of all regulators to also take into account a systemic perspective. of financial institutions has been

(iv) A lot of issues are being debated under the institutional framework to make the financial system safer, less vulnerable to crises of the recent kind and more focused towards the needs of the real sector, under the institutional framework of the G-20, the Financial Stability Board(FSB) and the Basel Committee on Banking

Supervision(BCBS). Some of the significant actions already taken to bolster the resilience of the international financial system are as below: roadmap for strengthening the quality, quantity, consistency and transparency of the capital base of banks (Basel III); setting strong risk management standards for banks and financial institutions on governance, management and disclosure of testing; introducing supplementary leverage ratio and global standards; integrating sound compensation principles in the Basel capital framework; introducing central counterparties for derivatives trading; developing new accounting standards special purpose vehicles; and Preparation of internationally agreed principles for the oversight of hedge funds. Initiatives under progress are: developing global liquidity standards; strengthening the supervision of cross-border entities; to enhance the consolidation of minimum liquidity liquidity risk and stress

strengthening the macroprudential framework, inter alia, countercyclical capital framework and more forward-looking provisioning; reviewing the international accounting standards; extending the perimeter of regulation to non-banks; strengthening the oversight of credit rating agencies; and rationalizing compensation structures.

2. Central banks and financial stability (i) Role of central banks in the crisis The main failures attributed to central banks leading to the build up of the crisis are: exclusive focus on price stability; failure to prevent asset price bubbles; and lightness of regulation. It is not as if the risks to financial stability were brewing silently. Several international forums for a while were discussing growing threats from macroeconomic

imbalances, asset price build up, credit expansion and depressed risk premia, and some had even issued alerts and warnings about the impending crisis. But central banks largely refrained from strong corrective action for a variety of reasons

including, inter alia: the perceived inefficiency of monetary policy to address asset price bubble; separation of monetary and regulatory policies; and misplaced faith in the self-correcting forces of financial markets. The net result was financial

stability failed to receive central bank attention it warranted.

(ii) Linkage between monetary and financial stability Two main objectives of the central banks around the world relate to the maintenance of monetary and financial stability. While the monetary stability is generally the explicit objective, financial stability is usually an implicit objective. Both monetary stability and financial stability are intimately linked. Monetary stability supports sound investment and sustainable growth, which in turn is conducive for financial stability. Since the fragility of banks and their counterparties tends to be heightened when prices are unstable, the pursuit of monetary stability can be seen as a crucial contribution to financial stability. Similarly maintaining financial stability also contributes to monetary stability in the long run.

(iii) System-wide assessment Central banks also assess on a system-wide basis taking into consideration the linkages between the real economy and financial markets as well as among financial institutions. Such assessment becomes the basis for policy actions regarding financial system stability. 3. Indias approach to financial stability (i) Perspectives The role of financial stability has been recognized, inter alia, from three principal perspectives. Stability of the financial system has critical influence on price stability and sustained growth, which constitute the principal objectives of policy. A stable financial system facilitates efficient transmission of monetary policy actions. From the perspective of regulation and supervision, safeguarding depositors interest and ensuring stability of the financial system, in particular, the banking sector, is the mandate of the Reserve Bank.

(ii) Response to the global financial crisis The nature and intensity of the impact of the global financial crisis on India was very different from those in some of the developed economies. The Indian financial

sector remained resilient and functioning, despite some volatility. There was neither material stress on the balance sheets nor solvency issues of banks and NBFCs, requiring direct financial support from the Government.

The major elements of the prudential policy framework for institutions and markets that protected the Indian financial system from the crisis are: prudential framework for banks addressing, inter alia, leverage, liquidity and counterparty risk concentrations; recognition of large NBFCs as systemically important and extension of the regulatory perimeter to such entities; an active capital account management framework, particularly in regard to the debt flows into the economy; and

explicit regulation of key derivative markets.

In the Indian context, the multiple indicator approach to monetary policy as well as prudent financial sector management have ensured financial stability. Even as the pace and intensity of financial system liberalization gained momentum through the development of financial markets, financial institutions and financial infrastructure, the broader underpinnings of financial stability were not lost sight of. This was

made possible on account of the synergies between the twin roles of the Reserve Bank as the monetary authority as well as the regulator of banks, financial institutions, NBFCs and key financial markets.

(iii) Measures initiated prior to 2008 Monetary measures The conduct of monetary policy by the Bank has been guided by multiple objectives and multiple instruments. The utility of a broad-based approach to monetary policy, augmented by forward looking indicators, has been immense, especially in uncertain economic environments. Monitoring a number of macroeconomic indicators in the conduct of monetary policy has aided the Bank in interpreting asset market developments and in general, shaping economic and financial policy over the years.

Management of the capital account The liquidity implications of measured interventions in the foreign exchange market were managed through the judicious use of the CRR and MSS. Management of the capital account has been buttressed through the imposition of prudential safeguards in respect of access of foreign entities to the domestic debt markets and on foreign exchange borrowings by domestic corporate. A cap on the amount that can be invested by FIIs in Indias government and corporate bond markets and the policy frameworks for NRI deposits and ECB are important instruments for capital account management.

Compliance with international standards From the outset, India has resolved to attain standards of international best practices in the financial sector, but the endeavour has been to fine tune the process keeping in view the underlying structural, institutional and operational considerations. For

example, a three-track approach, prescribing varying levels of stringency of capital adequacy norms for commercial banks, co-operative banks and Regional Rural Banks has been prescribed.

Prudential framework In the case of systemically important non-deposit taking NBFCs(NBFCs-ND-SI), a gradually calibrated regulatory framework liquidity management, in the form of capital requirements, and reporting requirements has been

exposure norms,

extended, which has limited their capacity to leverage and space for regulatory arbitrage. The Reserve Bank has fixed limits on banks exposure to the capital market as well as to individual and group borrowers with reference to a banks capital. Limits on inter-bank exposures have also been placed. Banks are further encouraged to place internal caps on their sectoral exposures, their exposures to commercial real estate and to unsecured exposures. Caps on banks investments in non-SLR securities and prohibitions on investment in unrated non-SLR securities have been imposed. Systemic interconnectedness has been addressed by introducing prudential norms on banks exposures to NBFCs and to related entities. Restriction on bank financing to NBFCs for certain purposes including financing against collateral of shares or for on-lending to capital market intermediaries are in place.

Counter-cyclical measures The adverse impact of high credit growth in some sectors and asset price fluctuations on banks balance sheets at various points of time were contained through pre-emptive counter-cyclical provisioning and differentiated risk weights for certain sensitive sectors. Banks have been advised to augment their provisioning coverage to a minimum of 70 per cent by end September 2010.

Liquidity management The requirement of a statutory liquidity ratio (SLR) for banks acts as a buffer for both liquidity and solvency of banks. Asset-liability management stipulations for management of liquidity risks have been put in place. Liquidity ratios focusing on funding and market liquidity are monitored on an ongoing basis. The introduction of Liquidity Adjustment Facility(LAF) and restricting access to banks and Primary

Dealers (PDs) have facilitated maintenance of stability in the money market and restricting access to the unsecured overnight market funds, respectively.

Prudential limits are in place to address the extent to which banks and primary dealers can borrow and lend in the unsecured call money market in relation to the net worth. Limits have been placed on purchased inter-bank liabilities (IBL).

Financial markets Statutorily, the Reserve Bank has the regulatory mandate over the foreign exchange, credit, money and government securities market as well as the OTC interest rate markets, including derivatives thereon. The key aspects of the Banks regulation of financial markets encompass product specifications, nature of participants, prudential safeguards, reporting requirements, etc. Under the RBI Act 1934, the validity of any OTC derivative contract is contingent on one of the parties to the transaction being a RBI regulated entity. Access to derivative product is essentially permitted for the purpose of hedging underlying exposure. For interest rate derivatives, there is an additional leeway to undertake derivative transactions for transformation of risk exposure, as specifically permitted by the Bank. To ensure that securitization is value adding, banks have to adhere to elaborate guidelines on true sale and credit enhancements and liquidity support are subject to capital regulations. Profit from sale of assets to SPVs to be amortised over the life of the securities issued. Structured derivative products are permitted only as long as these are a

combination of two or more of the generic instruments permitted by the Bank and do not contain any derivative, not allowed on a standalone basis. Comprehensive guidelines on derivatives have been issued emphasizing the need for a proper risk management framework and appropriate governance practices with regard to the use of derivatives and also focusing on the suitability and appropriateness of customers for various derivative products. The responsibility for assessment of customer suitability and appropriateness rests with the market maker. As early as 2001, the Clearing Corporation of India (CCIL) began to act as a central counterparty in the foreign exchange, government securities and money markets in a phased manner. Screen based order matching and automated settlement systems for the money and government securities markets were also put in place. A Real Time Gross Settlement System to address systemic risks in inter-bank settlement was

implemented in 2004.

In order to increase transparency, various initiatives for

improving dissemination of market information, especially with regard to OTC markets, have been taken by the Bank.

(iv) Measures initiated by the Bank in response to global crisis The Reserve Banks policy response was aimed at containing the contagion from the outside to keep the domestic money and credit markets functioning normally and see that the liquidity stress did not trigger solvency cascades. In particular, three objectives were targeted: to maintain a comfortable rupee liquidity position; to augment foreign exchange liquidity; and to maintain a policy framework that would keep credit delivery on track so as to arrest moderation in growth. Policy initiatives in this direction were judicious mix of conventional and the un-conventional. These were implemented in packages starting mid-September 2008, on occasion in response to unanticipated global developments, and at other times, in anticipation of the impact of potential global developments on the Indian markets. The Bank also suitably recalibrated various sector specific counter cyclical regulatory measures involving risk weights and provisioning. Regulatory guidance was given for restructuring of viable loan accounts for ensuring continued flow of credit to productive sectors of the economy, with a view to arresting slowdown in growth.

(v) Present status of the measures initiated during the crisis The domestic markets returned to normalcy much ahead of the global markets with a significant reduction in risk and a rebound in market activity. The process of monetary policy exist had already begun. Sector-specific liquidity facilities were discontinued and the SLR of scheduled banks was restored to the pre-crisis level. The non-standard refinance facilities for scheduled commercial banks were discontinued.

(vi) Measures initiated after the crisis Financial markets In order to promote transparency in the secondary market for CDs and CPs, the Reserve Bank has introduced a reporting platform, similar to corporate bonds platform being operated by FIMMDA, for all secondary market transactions in CDs and CPs.

As a measure aimed at development of the corporate bond market, the Reserve Bank permitted repo in corporate bonds from March 1, 2010. All repo trades in corporate bonds have to be reported to the FIMMDA reporting platform for real time dissemination of price/yield information to the market participants. To bring repo/ reverse repo transactions onto the balance sheet to reflect their true economic sense and enhance transparency the accounting guidelines have been reviewed and the revised guidelines came into effect from April 01, 2010. Finalizing the guidelines on introduction of Credit Default Swaps (CDSs) for corporate bonds. Regulatory measures Prescribing the loan to value (LTV) ratio in respect of housing loans. Stipulating prudential limits to regulate the investments of banks in companies engaged in forms of business other than financial services. Implementing the recommendations of the Internal Group on supervision of Financial Conglomerates(FCs)on: capital adequacy for FCs; and intra-group transactions and exposures in FCs. Taking appropriate steps to fully align the corporate governance practices in banks in India with the principles enunciated by the BCBS. Issuing final guidelines on compensation practices by banks. Finanlising the guidelines on licensing of new banks. Conversion of balance sheets of scheduled commercial banks in compliance with the accounting standards converged with IFRS.

4. Challenges on the way forward

(i) How to define and measure financial stability? Despite widespread usage, financial stability is difficult to define let alone measure. Policymakers and analysts are actively engaged in fleshing out the definition so that it is precise, measurable and comprehensive.

Ideally, an effective framework for managing financial stability involves not only the identification and monitoring the sources of risks from various segments of the financial system(i.e., financial institutions, markets, payments, settlements and

clearing system) and preempting them from snowballing into a systemic crisis, but also creating conditions for a sound financial environment in normal times. This requires that all the principal segments of the financial system should be jointly capable of absorbing smoothly both anticipated and unanticipated shocks of any nature and magnitude, thereby facilitating an efficient reallocation of financial

resources from savers to investors through adequate pricing of risk.

Hence, some critical elements of any financial stability framework, aspects that need to inform the definition of financial stability are the following: excessive volatility of macro-variables, both global and domestic, and market trends such as interest rates, exchange rates and asset prices, which have direct impact on the real economy; build up of significant leverage in financial, corporate and household sector balance sheets; the moral hazard risks posed by institutions that have become too -big-to-fail or too interconnected or complex to resolve; internal systemic buffers within the financial sector, both at the institution and systemic levels, to counter potential shocks to the economy; strong policy and institutional mechanisms to lean against the wind even as the music is playing; and prevalence of unregulated nodes in the financial sector which, through their interconnectedness with the formal regulated system, can breed systemic vulnerabilities.

(ii) Whether financial stability is the exclusive responsibility of the Central Bank or a shared responsibility with the Government? Natural synergies between the roles of the Reserve Bank as monetary policy authority, regulator and supervisor of institutions(banks and NBFCs) and markets(money market, government securities market, foreign exchange market and credit market) and Lender of Last Resort provide the Bank with the requisite

means and competence to play an integral role in addressing the objectives of financial stability. This model, however, raises fresh questions. Can the Central Bank have exclusive responsibility for financial stability? Conversely, can the government completely delegate the responsibility to the Central Bank under a principal-agent model? If it is a shared responsibility, how should it be shared? What should be the protocol for decision making? Who should prevail, and under what circumstances, in the event of a deadlock? (iii) Growth and financial stability managing the trade-offs In order to safeguard financial stability a variety of prudential measures have been traditionally used such as specifying exposure norms and preemptive tightening of risk weights and provisioning requirements. But these measures are not always costless. For instance, excessive, premature or unnecessary tightening could blunt growth. Similarly, exposure norms could restrict viability of credit for important growth sectors. Thus, the central banks, as in the face of price stability, face the challenge of managing trade off between financial stability and growth. It needs to be recognized that after a crisis, with the benefit of hindsight, all conservative policies appear safe. But excessive conservatism in order to be prepared to ride out a potential crisis could thwart growth and financial innovation. The question is, what price we are willing to pay to prevent a crisis? Or, what potential benefits are we willing to give up to prevent a crisis?

(iv) Reforming regulatory architecture A high Level Coordination Committee on Financial Markets(HLCCFM) exists for addressing inter-regulatory and other policy related issues and for monitoring the systemically important institutions(financial conglomerates). The Committee is

headed by the Governor, RBI, and has representations from the Government and other major financial sector regulators, i.e., SEBI, IRDA and PFRDA. There are

separate sub-committees under the HLCCFM with specific focus on entities regulated by the RBI, SEBI and IRDA. Other than the above sub-committees, there is an RBI-SEBI Technical Committee to harmonise banking regulations and capital market regulations.

Two separate Committees of the Banks Central Board, i.e., the Board for Financial Supervision(BFS) and the Board for Payment and Settlement Systems(BPSS) are responsible for focused regulation and supervision of financial institutions regulated by the Bank and the payment and settlement infrastructure, respectively. The Government has also announced arrangement for financial stability the establishment of an institutional

in the form of

a Financial stability and

Development Council(FSDC), without prejudice to the autonomy of regulators, to monitor macroprudential supervision of the economy, including the functioning of large financial conglomerates, and address inter- regulatory co-ordination issues. It will also focus on financial literacy and financial inclusion. A key issue to be addressed is the nature of relationship of the FSDC with the existing HLCCFM.

5. Financial Stability Unit (FSU) The Reserve Bank has set up a dedicated inter-disciplinary Financial Stability Unit, on July 17, 2009, with the remit to assess the health of the financial system with a focus on identifying and analyzing potential risks to systemic stability and carrying out stress tests. The FSU will also prepare half-yearly reports based on its continuous assessments, crystallizing the potential areas which need to be addressed from a financial stability perspective. The first such report was published in March 2010.

Sources 1. Financial Stability Report Reserve Bank of India March 2010 2. Financial Stability: Issues and Challenges Valedictory address by Dr. Duvvuri Subbarao, Governor, Reserve Bank of India at the FICCI-IBA Annual Conference on Global Banking: Paradigm Shift organized jointly by FICCI and IBA on September 10, 2009 in Mumbai 3. RBI Annual Report 2009 10 4. The Second quarter review of Monetary policy for 2010-11

(Prepared by B Sivakumar, MoF, RBSC)