Chapter-4

MONETARY AND CREDIT CONTROL BY RBI

1. General
The pattern of Central Banking in India was based on the Bank of England. England had a
highly developed banking system in which the functioning of the Central Bank as a banker's
bank and their regulation of money supply set the pattern. The Central Bank's function as ‘a
lender of last resort’ was on the condition that the banks maintain stable cash reserve ratios as
prescribed from time to time. The effective functioning of the British model depends on an
active securities market where open market operations can be conducted at the discount rate.
The effectiveness of open market operations, however, depends on the member bank’s
dependence on the Central Bank and the influence it wields on interest rates. Later models,
especially those in developing countries showed that Central Banks play an advisory role and
render technical services in the field, of foreign exchange, foster the growth of a sound
financial system and act as a banker to government.1

2. Credit Control: Meaning

Credit Control means the regulation of the creation and contraction of credit in the economy.
It is an important function of central bank of any country. The importance of credit control has
increased because of the growth of bank credit and other forms of credit. Commercial banks
increase the total amount of money in circulation in the country through the mechanism of
credit creation. In addition businessmen buy and sell goods and services on credit basis.
Because of these developments, most countries of the world are based on credit economy
rather than money economy.2 Fluctuations in the volume of credit cause fluctuations in the
purchasing power of money. This fact has far reaching economic and social consequences.
That is why, credit control has become an important function of any central bank3.

1. H.R Machiraju “Indian Financial System ’’, (1991), p 4.1 Vikas Pub. House, New Delhi
2. Ne, Thi, Somashekhar “Money Banking International Trade and Public Finance(2004), p. 138
Anmol Publication Pvt. Ltd., N. Delhi.
3. B.R Sharma & R.P. Nainta , “Banking Law and Negotiable Instruments Act”.(2006). p. 21,Allahabad
Law Agency Faridabad,

139
For instance, the preamble of the Bank of Canada Act states that the Bank of Canada will
regulate credit in Canada. In India, the Reserve Bank of India Act, 1934 says that Bank is
“generally to operate the currency and credit system of its country to its advantages.”4 The RBI,
like all other central banks, is conferred by its Act wide powers for this purpose. These powers
are derived by the bank from various provisions of both the Banking Regulation Act, 1949 and
the Reserve Bank of India Act, 1934.5

3. Objectives of Credit Control

The central bank is usually given many weapons to control the volume of credit in the country.
The use of these weapons are guided by the following objectives.
(i) Stability of Internal Price-Level
The commercial bank can create credit because their main task is borrowing and lending.
They creates credit without any increase in cash with them. This leads to increase in the
purchasing power of many people which may lead to an increase in the prices. The
central bank applies its credit control to bring about a proper adjustment between the
supply of credit and measures required to that effect in the country concerned. This helps
in keeping the prices stable under control.6

(ii) Checking Booms and Depressions

The operation of trade cycles causes instability in the country, so the objective of the
credit control should be to reduce the uncertainties caused by these cycles. The central
bank adjusts the operation of the trade cycles by increasing and decreasing the volume of
credit.7

(iii) Promotion of Economic Growth

The objective of credit Control policy in backward and underdeveloped countries should
be to promote economic growth within the shortest possible time. Generally speaking, the
economic development in these countries is retarded on account of lack of financial
resources. Hence, the Central Banks in these countries often try to solve the problems of
financial stringency through planned expansion of bank credit.8

4. Preamble of Reserve Bank of India Act, 1934

5. Supra n.3 p.22
6 Supra n.2
7. Ibid
8. P. Saravanavel “Modern Banking in India <£- Abroad”, (1989), p. 77, Margham Publication, Madras.

140
(iv) To Regulate and Expand Banking
RBI regulates the banking system of the economy. RBI has expanded banking to all parts
of country. Through monetary policy, RBI issues directives to different banks for setting
up rural branches for promoting agricultural credit. Besides it, government has also set up
cooperative banks and regional rural banks. All this has expanded banking in all parts of
country9

(v) Stabilisation of the Money Market

According to some economists the credit control policy of the Central Bank should aim
at the stabilisation of the money market in the country. To achieve this objective, the
Central Bank should neutralize seasonal variations in the demand for funds. It should for
example, provide extra credit in times of emergencies. In fact, the control on credit
should be exercised by the Central Bank in such a manner as to bring about an
equilibrium in the demand and supply of money at all times.10

(vi) Stability in Exchange Rates

This is also an important objective of credit control. Credit control measures certainly
influence the price level in the country. The internal price level affects the volume of
exports and imports of the county which may bring fluctuations in the foreign exchange
rates. While using any measure of credit control, it should be ensured that there will be no
violent fluctuation in the exchange rates.*11

(vii) Preparation for war and other Emergencies

Sometimes the objective of the Central bank is to prepare the country for war through
expansion of credit to enable the Government to meet its financial requirement. Modem
v/ars are so expensive that it is not possible to meet their costs without adequate
expansion of bank credit. During the second world war almost every country resorted to
expansion of credit on a large scale to meet the rising war expenditure

9. T.R. Jain, “Business Environment (2009-10), p. 192, V.K. (India) Enterprises revised Edn., New
Delhi
10. Ibid.
11. Supra n. 2
12. Supra n. 8

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4. Methods of Credit Control in India
Credit control is one of the most important functions of the Reserve Bank of India. The Reserve
Bank controls the credit in the country with the twin objectives of checking inflation and
facilitating economic development. Credit control weapons used by the Reserve Bank may be
either quantitative or qualitative.
The Reserve Bank has been employing both types of weapons to control the credit by
virtue of powers given to it by the Reserve Bank of India Act, 1934 and the Banking Regulation
Act, 1949. The Reserve Bank of India Act confers on the Reserve Bank powers to control credit
quantitatively. These include bank rates or discount rates, open market operations and variable
reserve requirements. The Banking Regulation Act confers on the Reserve Bank vast powers to
control and regulate the entire banking system of the country. The Reserve Bank controls credit
qualitatively by virtue of these powers. The Reserve Bank has the power to issue directions
regarding the rate of interest that they should pay on fixed and savings deposits, the rate of
interest they may charge on types of advances, the types of securities they can accept as
collaterals, the branch expansion programme of the banks and many other matters. Now we
shall discuss in detail the various methods of credit control used by the Reserve Bank.13
The main difference between the general and selective credit control methods is that the
former influence the cost and overall volume of credit granted by banks. They affect credit
granted to the whole economy whereas the selective controls affect the flow of credit to only
specified sector of the economy, wherein speculative tendency, and rising trend of prices, due to
excessive bank credit, noticed.14

(I) Quantitative Methods

Quantitative methods aim at controlling the total volume of credit in the country. They
relate to the volume and cost of bank credit in general, without regard to the particular field of
enterprise or economic activity in which the credit is used or utilised.The important quantitative
or the general methods of credit control are as follows:15

13. T.N. Chhabra, “BanMns Theory & Practice”. (2003), p. 185, Dhanpat Rai & Co. (p) Ltd. Delhi
14. Ibid.
15. Supra nn.2 .6. 11, p. 140

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(A) Bank Rate or Discount Rate Policy
Bank rate Policy or the Discount Rate Policy has been the earliest instrument of quantitative
credit control. It was the bank of England which experimented with the bank rate policy for the
first time as a technique of monetary management. Now almost every central bank has been
endowed with this instrument of credit control.16
(i) Meaning
The bank rate is the ‘minimum rate of interest’ at which the central bank is ready to grant
loans to commercial banks or to rediscount the bills of exchange. Hence the ‘bank rate’ is also
called as the ‘discount rate’17 Section 49 of the Reserve Bank of India Act has defined the bank

rate as the standard rate at which the Reserve Bank is prepared to buy or rediscount bills of
exchange or other commercial papers eligible for purchase under the Act.18 Thus bank rate is the
rate at which the Reserve Bank purchases or rediscounts the specified bills and commercial
papers. But it is significant to note that for a long time there was no bill market in India. So the
rate of interest charged by the Reserve Bank on the advances made by it to the commercial banks
was treated as the bank rate.19

The Reserve Bank regulates credit of commercial banks and the general credit situation of the
country by manipulating the bank rate. The change in the bank rate generally has the effect on
the cost of credit available to the commercial banks from the Reserve Bank.20 If the bank rate is

increased, the cost of the lending rates to the borrowers increases, due to which the level of the
borrowings of the banks is reduced. In effect the increased bank rates results in contraction of
bank credit. Therefore, where the Central Bank of the country increases the bank rates, all other
rates of interests also increase. The policy of raising the bank rate is called the policy of dear
money and the objective of such a policy is to make money scarce and costly, so as to restrict its
use and flow to the deserving purposes only.21

16. Ibid.
17. M.L. Tannan’s “Bankim Law and Practice in India”. (2005), p. 166, 21th, Edn. Wadhwa & Company,
Nagpur.
18. Sec. 49 of the Reserve Bank of India Act, 1934
19. Supra n. 13 p. 186.
20. Avtar Singh , “Laws of Banking and Negotiable Instruments Act”. (2007), p. 61,1st Edn. Eastern Book
Company, Lucknow
21. R.K. Gupta, “Bankim Law & Practice”. (2005), p. 277, vol. 1st, Modem Law Publication.New Delhi

143
(ii) Conducive Conditions for the Bank Rate Policy
The efficacy of bank rate as an instrument of monetary management calls for the
fulfillment of the following conditions:-
(a) Close Relationship between Bank Rate and other Interest Rates
It is necessary that the relationship between bank rate and the other interest in the
economy should be as far as possible close and direct. Changes in the rate should bring
about similar and appropriate changes in the other interest rates in the economy.
Otherwise the efficacy of bank rate will be limited. There is, therefore, the need for the
existence of an integrated interest rate structure in a country.22
(b) Existence of an Elastic Economic System
The success of bank rate requires the existence of an elastic economic structure. That is,
the entire economic system should be perfectly flexible to accommodate itself to
changes in the bank rate. Changes in the bank rate should bring about similar and
desirable changes in prices, costs, wages, output, profits, etc. The existence of a rigid
economic structure of the country reduces the efficacy of bank rate.23

(c) Existence of Short Term Funds Market

Another condition required for the success of bank rate policy is the existence of market
for ‘short- term fiinds’ in the country. Short-term funds helps to handle foreign as well
as domestic funds which comeup on-account-of changes in the interest rates, consequent
to changes in the bank rate. Before the first World War, bank rate policy was very
effective as an instrument of quantitative credit control because, the conditions necessary
for the success of bank rate were conducive then. But after the world war, the
significance of bank rate began to wane because the post - war atmosphere was not
conducive for the smooth and effective operation of the bank rate policy.24

22. Ne. Thi, Somashekhar “Money Banking International Trade and Public Finance(2004), p. 141,
Anmol Publication Pvt. Ltd., N. Delhi.
23. Ibid
24. Id.

144
 (d)Limitation of Bank Rate Policy
The bank rate policy suffers from following limitations
A higher bank rate is intended to act as an anti-inflationary device, because it is
expected to influence the inventory holding through rise in the cost of such holding. But
the efficacy of Bank Rate is not without its limitations. High lending rates push up the
cost of production/cost of maintaining the stocks of the the genuine borrowers, who in
turn raise the selling prices of their products. Thus the cost-push effect of dear money
adversely affects the whole range of industries and trades.25
Intended to be an anti-inflationary step, the high Bank Rate policy, in reality,
proves to be inflationary in character. This seems to be the reason why, the Reserve Bank
has, during recent years, tightened the availability of its accommodation to the banks.26
During the first quarter of year 2001, Reserve Bank of India reduced the Bank Rate
twice-from 8% to 7% on Feb. 16 and further to 7% effective March 1, 2001. At present
the Bank Rate is 6.00 percent; the repo rate under the Liquidity Adjustment Facility
(LAF) is 7.75%, the reserve repo rate 6% cash reserve ratio increased by 50 basic points
to 7.5% and Statutory Liquidity Ratio is 25.0% effective fortnight begning November,
10, 2007.27 On March 30, 2007, just a few weeks before annual credit policy, the RBI,
had raised the CRR_to 6.5%. Accordingly the repo rates were also increased to 7.75%.28
(B) Refinance Policy
Section 17 of the Reserve Bank of India Act, 1934, permits the Reserve Bank to provide
accommodation to commercial banks by way of re-discounting of eligible bills or as
advances against approved securities. But such lending is subject to the policy formulated
by the Bank in this regard; banks cannot claim such facility as a matter of right. The
Reserve Bank of India has restricted the availability of its refinance to banks through the
various methods followed by it from time-to-time since 1960. During recent years, the
Reserve Bank of India provided refinance to banks on a restricted scale as follows:

25. Supra n.3. p.. 23

26. P.N. Varshney,” Banking Law & Practice”, (2003), p. 5.7,20h Edition Sultan Chand & Sons, New
Delhi
27. R.B.I. Governor announced Mid-term Review of Annual Policy for 2007-08 dated 30 Oct 2007.
28. Swahashome “RBI Focusses on Liquidity Management”, Oct. (2007), p. 51, Journal of Professional
Banker, Hydrabad.
29. Supra n. 18. Sec 17

145
(i) Food Credit Refinance
Reserve Bank provided refinance to the banks against food credit provided by them. But
such refinance was restricted to an amount equal to the excess of total food credit by all
the banks, over a minimum level of such credit. Such minimum level of credit was called
the ‘threshold level' which was fixed by the Reserve Bank from time to time. Banks used
to get 100% refinance in respect of their food credit in excess of the threshold level. Food
credit refinance was provided at the Bank Rate. This rate was 11.5% till 5th July, 1991
when it was hiked to 14%. Subsequently, in October 1991, this refinance facility was
withdrawn.30
(ii) Export Credit Refinance
Export refinance is also provided by Reserve Bank, but its quantum is determined on the
basis of the increase in export credit of a bank over the level of such credit reached in the
base year. In the past, such base year has been brought forward from time to time, for
calculating the export refinance limits of banks.31 With effect from April 26, 1997,

Scheduled Commercial Banks are provided export credit refinance to the extent of 100
per cent of the increase in outstanding export credit eligible for refinance over the level of
such credit as on February. 16, 1996. Interest on export credit refinance is charged at the
Bank rate from the borrowers.
(iii) 182 Days Treasury Bills Refinance Facility
Reserve Bank of India introduced this facility in April, 1987. Under this facility refinance
is provided to the extent of 50% of the holding of the bank's 182 Days Treasury Bills.
The rate of interest charged by the Reserve Bank was enhanced from 10.75% p.a. to
11.25% in view of the rise in cut- yields on these bills.33

30. Supra n.. 26, p..5.8

31. Supra n. 23
32. This percentage was reduced to 50% between 17.1.98 and 9.5.98
33. Snpra n. 26, p. 5.9

146
(iv) General Refinance Facility
A new refinance facility has been introduced by Reserve Bank of India effective from April 26,
1997. This facility enables banks to tide over their temporary liquidity shortage. Under this
facility all scheduled commercial banks are provided general refinance equal to 0.25% of each
bank's fortnightly average outstanding aggregate deposits in 1996-97.34
(C) Open Market Operations
Open market operations of a central bank consist of purchase and sale of government and other
securities in the open market with a view to regulate the supply of money. But in India, open
market operations are used by the Reserve Bank more to give support to the government
securities than to regulate the volume of money.35 It was in Germany perhaps for the first-time

‘Open Market Operations’ were conceived as an instrument of quantitative credit control and
later adopted in other countries.36

The Central Bank purchase and sales the Govt. Securities, Gold, Foreign Exchange etc.,
for enlarging or contracting the cash basis of the commercial banks under section 17(8).37 The
reserve Bank of India is authorized to purchase and sale of securities of the central Govt, or State
Govt, for the any maturity period or of such securities of a local authority, as may be specified in
this behalf by Central Govt, on the recommendation of the Central Board to that effect. The
securities fully guaranteed as to principal and interest thereon by any such Govt, authority shall
be deemed to be securities of such Govt, or authority.
The Reserve Bank of India can influence the reserves of commercial banks i.e. the cash
basis of commercial banks buying or selling Govt, securities in Open market.38 If the reserve

Bank of India buys Govt. Securities in the market from commercial Banks, there is a transfer of
cash from the Reserve Bank of India to the commercial banks and this increase the cash base of
the commercial banks enabling them to expand credit and, conversely, if the reserve Bank of
India sales Govt, securities to the commercial banks, the commercial banks transfer cash to the
reserve Bank of India, therefore, their cash base is reduced. Thus adversely effecting the capacity
of commercial banks to expend their credit.39

34. Sec. 17 (3B) of the Banking Regulation Act, 1949

35. Supra n.13, p. 187
36. Supra n. 22, p. 142
37. Supra n. 34, Sec 17(8)
38 Supra n. 17
39. Supra n 20

147
(i) Objectives of Open Market Operations
The main objectives of “open market operations” are:
(a) To eliminate the effects of exports and imports to gold under tile gold standard.
(b) To impose a check on the export of capital.
(c) To remove the shortage of money in the money market.
(d) To make bank rate more effective.
(e) To prevent a 'run on the bank'.40
In order to increase the scope of its open market operations, the Reserve Bank introduce three
bill market schemes first in 1952, the second in 1970 and the third in 1988. The Reserve Bank
has been helping the Government to successfully float the loans and maintain the prices of
government securities stable. When the price of a particular security is falling, it purchases that
security to give support to the price and vice versa. With the help of this tool, the Reserve Bank
also tries to solve problem of seasonal monetary stringency. It purchases the securities during
the busy seasons and sells the securities when there is surplus fund in the market.41
The success of ‘open market operation’ as a technique of credit control depends upon of size of
Govt, securities available, their range in verities and the ability of the market to absorb them.42

As Crowther has very correctly remark, the central bank can put more water before the public
horse put it cannot force it to drink'43

(D) Variable Cash Reserve Ratio

The traditional instruments of quantitative credit control, bank rate policy and open market
operations, suffer from certain inherent defects and have been found unsuitable to serve the
interests of underdeveloped countries 44 Hence, an entirely new and unorthodox instrument of

quantitative credit control, in the form of variable reserve ratio came into vogue, thanks to the

40 Ne. Thi, Somashekhar “Money Banking International Trade and Public Finance(2004), p. 143, Anmol
Publication Pvt. Ltd., N. Delhi.
41. Supra nn 13,19, p. 187
42. Supra n.19
43. M C, Vaish “Money Bankim & International Trade”, (1997), p.301 8th Edn New Age International (P)
Ltd.. New Delhi
44. Supra nn.2, 40, p. 278

148
 Federal Reserve System of the United States. It was, however, Lord Keynes who was
responsible for popularising the use of this novel technique of ‘Monetary Management,5 The
Federal Reserve System became the trend setter by pressing into service variable reserve ratio
for the first time in 1933 as a weapon of quantitative credit control.45
(i) Meaning
Variable Reserve Ratio refers to the percentage of the deposits of the commercial banks to be
maintained with the central bank, being subject to variations by the central bank. In other words,
altering the reserve requirements of the commercial banks is called variable reserve ratio. It is a
well known fact that all the commercial banks are required to keep a certain percentage of their
deposits as cash reserves with the Reserve Bank of India. The Reserve Bank of India is legally
authorized to raise or lower the minimum reserve that the bank must maintain against the total
deposits.46 This reserve requirement is subject to changes by the central bank depending upon the
monetary needs and conditions of the economy.47
In certain countries, like United States and India, there are clear written laws stipulating
the banks to maintain the reserve requirements with the central bank. Such a reserve ratio is
called the ‘Statutory Reserve Ratio.5 But, in England, the banks maintain the reserve ratio as a
matter of custom. Hence this kind of reserve ratio is card the Customary Reserve Ratio.
Anyhow, the central bank, has the authority to vary the reserve requirements of the banks.
Section 42 provides that every scheduled bank shall maintained with the reserve bank an
average daily balance the amount of which shall not be less than 3% of the total demand and
time liabilities in India of such bank. The reserve bank may by notification in the Gazette of
India increase the said rate to such higher rate as may be specified in the notification; so,
however, that the rate shall not be more than 20% of the total of the demand and time
liabilities.49

45. Supra n. 40, p. 144,

46. M.L. Tannan’s “Banking Law and Practice in India”. (2005), p. 166,21th Edn. Wadhwa &
Company, Nagpur
47. Supra n.43, p..302
48. Supra nn.2. 40. p.145.
49. Sec. 42 of the Reserve Bank of India Act, 1934
The reserve bank of India has got the power to use the variable reserve requirements as an
instruments of monitory control.50 This reserve, which is required to be maintained by the
commercial banks with the reserve bank under section 42 of the Reserve Bank of India Act, 1934
is called cash reserve ratio or CRR in short.51
Under the original Act the scheduled banks were required to maintained 5% of their demand and
2% of their time liabilities in deposit with the reserve bank free of interest under the amendment
act 1956 the reserve bank was authorized to vary the required reserve 5% to 20% in respect of
demand liabilities and between 2% and 8% in respect of time liabilities.52
The monetary measures taken in the last few months by the RBI Governor (Y.V. Reddy) have
raised concerns about whether they will chocke the growth although they will certainly control
inflation. In his speech at the central bank of Greece, on April 2, 2007 the Governor highlighted
two major objectives which the RBI undertakes:
1. Maintain price stability53
2. Accelerate growth54
In other words the central bank has to look beyond growth. There have been four
successive hikes in the CRR since December 2006. The last rates indicate the percentage of
deposits that the commercial bank should have as deposits with RBI. The first CRR hike of 0.5%
was announced on feb 12, 2007 with 0.25% increase becoming effective from feb 13, and
another hike 0.25% from march 3, 2007. This took the rates to 6%. On March 30, the market was
not prepared for the next hike by another 0.5%. This was to be done in two stages of 0.25% hike
from April 14 and another 0.25% from April 28. Another change made was that the repo rate
was increased to 7.75% widening the corridor between repo and reserve repo to 175 basis points.
The rate of interest which had to be paid on the excess CRR above 3% was also cut from 1% to
0.5%

50. Avtar Singh, “Laws of Banking and Negotiable Instruments Act”. (2006), p. 62, ls: Edn. Eastern
Book
Company, Lucknow
51. R.K. Gupta, “Banking Law & Practice”. (2005), p. 277 vol. 1st, Modem Law Publication.New Delhi
52. Supra n.46
53. RBI Bulletin. May 2007, p.12
54. Ibid.

150
The above data indicates a positive trend in CRR rates since june 14 2006.
Cash Reserve Ratio Effective Date
7.00 04-08-2007
6.50 28-04-2007
6.25 14-04-2007
6.00 03-03-2007
5.75 17-02-2007
5.50 08-12-2006
5.00 02-10-2004
4.75 18-09-2004
4.50 14-06-2003
4.75 16-11-2002
5.00 1-06-2002

Trends of Repo rate and cash Reserve Ratio show that from Jan 2007 to March 2009. The CRR
and Repo rate continue to increase from Jan, 2007 to Sept. 2008 and fall down to Nov. 2008 to
March 2009.
55. Shome Swaha, “RBI Focusses on Liquidity Management.” Journal ofProfessional banker. Oct. 2007,.52
ICFAI Uni Press, Hyderabad

151
The annual monitory policy 2009-10 review announced a 25bps cut in both repo and reverse
repo rates, primarily to signal a further moderation in deposit and lending rates in the banking
system. The policy stance has softened considerably as inflation concerns have abated. Broadly,
RBI is expected to maintain a monetary and interest rate regime which is supportive of price
stability and financial stability, taking into account the developments from the global financial
crisis. Ensure a policy environment that will enable credit expansion at viable rates, while
preserving credit quality so as to support the economy to return to a high growth path. RBI to
provide further clarity on presence of foreign banks in India, once the global financial system
stabilizes, for the time being, current policy and procedures governing the presence of foreign
banks in India is to be continued.56

ii) Penalty for not maintaining proper CRR by the bank

In terms of Section 42(3) Reserve Bank of India Act, if the average daily balance held at the
Reserve Bank by a scheduled bank during any fortnight is below the minimum prescribed by or
under sub section (1) or sub-section (IA).57 Such scheduled bank shall be liable to pay the
Reserve Bank in respect of that fortnight penal interest at a rate of three per cent above the bank
rate on the amount by which such balance with the Reserve Bank falls short of the prescribed
minimum and during the next succeeding fortnight , such average daily balance is still below the
prescribed minimum, the rates of penal interest shall be increased to a rate of five per cent above
the bank rate in respect of that fortnight and each subsequent fortnight during which the default
continues on the amount by which such balance at the Reserve Bank falls short of the prescribed
• ,lm 58
minimum.
E) Statutory Liquidity Requirement (SLR)
Section 24 of the Banking Regulation Act, 1949 contains a statutory requirement regarding he
maintenance of liquid assets by banks in India. This Section was amended by the Banking Laws
(Amendment) Act, 1983. Before such amendment every banking company was required to
maintain in India in cash, gold or unencumbered approved securities an amount which shall

56. Annual Monetary Policy ofRBI March 2009 .www.rbi.ore.in

57. Sec. 42 (3) of the Banking Regnlation Act, 1949
58. Supra n. 51, p. 282

152
not at the close of business on any day be less than 25 per cent of the total of its demand and time
liabilities in India. After the amendment, the Reserve Bank has been empowered to step up this
ratio to 40% of the net demand and time liabilities, so as to compel the banks to keep a large
proportion of their deposit liabilities in liquid assets.59 The following points are to be taken into
account while complying with the requirements of this Section:
(i) Basis for Maintenance of S.L.R.
S.L.R. is to be maintained as at the close of business every day. It means that S.L.R. is to
maintained on a daily basis. It should not be less than 25 per cent of the net demand and time
liabilities as obtaining on the last Friday of the second preceding fortnight.60 Section 24 (2A)
which was inserted by the Banking Companies (Amendment) Act, 1962 provides that a
• •! V".
scheduled bank in addition to the average daily balance which it is, or may be, required to
maintain under Section 42 of the Reserve Bank of India Act, 1934 and every other banking
company in addition to the cash reserve which it is required to maintain under Section 18 shall
maintain in India61

(a) in cash, or
(b) in gold valued at a price not exceeding the current market price or in unencumbered
approved securities valued at a price determined in accordance with such one or more of,
combination of, or the following methods of valuation, namely valuation with reference
to cost price, market price, book value or face value, as may be specified by the Reserve
Bank from time to time,62

An amount which shall not at the close of business on any day, be less than twenty-five per cent
or such in other percentage not exceeding forty percent, as the Reserve Bank may, from time to
time by notification the official Gazette specify, of the total of its demand and time liabilities in
India, as on the last Friday of the second preceding fortnight. In computing the amount:

59. Sec. 24 of the Banking Regulation Act 1949.

60. P.N. Varshney,” Banking Law & Practice”. (2003), p. 5.22,20th Edn. Sultan Chand & Sons,
New Delhi
61. Supra n. 51. D. 283
62.Supra n. 60, p. 5.24

153
(i) the deposit required under Section 11(2) to be made with the Reserve Bank by a banking
company incorporated outside India;
(ii) any cash or balances maintained in India by a banking Company other than a scheduled
bank with itself or with the Reserve Bank or by way of net balance in current account in
excess of the aggregate of the cash or balance or net balance required to be maintained
under Section 18;
(iii) any balances maintained by a scheduled bank with the Reserve Bank in excess of the
balance required to be maintained by it under Section 42 of the Reserve Bank of India
Act, 1934;
(iv) the net balance in current accounts maintained in India by a scheduled bank;
(v) any balances maintained by a Regional Rural Bank in call or fixed deposit with its
Sponsor Bank, shall be deemed to be cash maintained in India.
The market price of an approved security shall be the price as on the date of the issue of the
notification or as on any earlier or later date as may be notified from time to time by the Reserve
Bank in respect of any class or classes of securities.63
(ii) Submission of Monthly Return on Form VIII
Every banking company shall submit to the Reserve Bank a monthly return showing
particulars of its assets maintained in accordance with this Section and its demand and time
liabilities in India at the close of business on each alternate Friday during the month. This return
shall be submitted within 20 days after the end of the month. Besides, the Reserve Bank may
also require a banking company to submit a return showing these figures on each day of
month.64

(iii) Penalties for Default in Maintenance of Liquid Assets

The clause relating to imposition of penalties was inserted in 1983. Now, for calculating the
amount of liquid assets, the base shall be the figures of demand and time liabilities in India as on
the last Friday of the second preceding fortnight. If on any alternate Friday (or preceding
working day if Friday is a holiday), the amount maintained by a banking company at the close of
business on that day falls below the minimum prescribed under this Section, such banking

63 .Supra n. 61
64.Supra n. 62

154
Company shall be liable to pay to the Reserve Bank, in respect of that day's default, penal
interest for that day at the rate of 3% per annum above the Bank Rate on the amount of
shortfall.65

If default occurs again on the next succeeding alternate Friday and continues on succeeding
alternate Fridays, the rate of penal interest shall be increased to 5% per annum above the Bank
Rate on each short-fall in respect of that alternate Friday and each succeeding alternate Friday on
which the default continues.66

Even after penal interest at 5% above Bank Rate becomes payable, if the default still occurs,
every director, manager or secretary of the banking company, who is knowingly and wilfully a
party to the default, shall be punishable with fine up to Rs. 500 and with a further fine which
may extend to Rs. 500/- for each subsequent alternate Friday on which the default continues.
Reserve Bank is also empowered not to charge penal interest if it is satisfied with the reason for
default.67

(JJ) Qualitative or Selective Credit Controls

The selective credit control is used to prevent speculative hoarding of commodities like
foodgrains so as to prevent or control inflationary pressures in these areas. Sections 21, 35 and
36 of particular the Banking Regulation Act, 1949 empower the Reserve Bank to determine the
policy in relation to advances to be followed by banking companies generally or by any banking
company in particular, if it is satisfied that it is necessary or expedient in the public interest or
in the interest of depositors. When the policy has been so determined, all banking companies or
the banking company concerned as the case may be, shall be bound to follow the policy as so
/JQ

determined.

65. Sec. 24 (4) A of the Banking Regulation Act 1949.

66. IWd Sea 24 (4) b
67. Ibid Sea 24 (7)
68 Supra nn. 51,61 p. 285

155
(i) Objectives
The following are the broad objectives of selective instruments of credit:
(a) To divert the flow of credit from undesirable and speculative uses to more
desirable and economically more productive and urgent uses.
(b) To regulate a particular sector of the economy without affecting the economy as a
whole.
(c) To regulate the supply of consumer credit.
(d) To stabilise the prices of those goods very much sensitive to inflation.
(e) To stabilise the value of securities.
(f) To correct an unfavourable balance of payments of the country.
(g) To bring under the control of the central bank credit created by non banking
financial intermediaries.
(h) To exercise control upon the lending operations of the commercial banks.69
(ii) Tools of Selective Credit Control
The main instruments of selective credit control in India are:
(a) Fixation of Party-Wise Ceiling on Credit
The ceilings are fixed keeping in view the crop prospects, supply position and price trends. After
the the fixation of ceiling of credit on a party-wise basis since November, 1972, banks are
required to seek prior permission of the Reserve Bank for (i) granting loans to new borrowers,
and (ii) or increasing the credit limits in case of existing borrowers. Thus one bank cannot take
over a commodity account which is subject to credit control from another bank without seeking
prior approval of the Reserve Bank.70

(b) Regulation of Minimum Margin

In case of advances against commodities subject to selective control, higher margins are
prescribed in order to restrict the borrowing capacity of the borrowers. With higher margin, a
borrower can get less credit from banks against a certain quantity of stock and thus can finance

69. Ne. Thi, Somashekhar “Money Bankine International Trade and Public Finance”. (2004), p. 147
Anmol Publication Pvt. Ltd., N. Delhi.
70. Supra nn. 26,60, p. 5.29.

156
only a smaller part of it through bank finance. Moreover, different margins may be prescribed for
different types of borrowers against the security of the same commodity. A higher margin is
generally fixed for those borrowers whose need for credit is not so urgent or larger flow of credit
to whom is likely to aggravate the price situation. For example, minimum margins were
prescribed for advances against foodgrains, pulses and oilseeds (w.e.f. 19th October, 1987) at
45% for processing units or mills and against warehouse receipts and at 60% for others.71
The regulation of margin requirement on security lonas was first introduced in America
in 1934 when under the Securities Exchange, Act the Federal Reserve System was empowered
to practise selective credit control. This instrument of selective credit control was designed to
assert the Federal Reserve system in controlling the volume of credit used for speculation in
securities. In 1936, the Board of Governors employed this method to restrain the activities of
the bears by fixing the margin requirements of 50 per cent short sales. This method is quite an
effective means of controlling the volume of credit in a speculation-minded country like
America. According Goldenweiser the “margin requirements have served a useful purpose, and,
some light has been thrown upon their possibilities and their limitations as an instrument of
credit policy.”72

Although theoretically the method of regulation of margin requirements is quite

capable of being used as a prompt and effective means of checking speculation in securities,
in practice, however, it throws an enormous responsibility on the central bank and causes the
later to be singled out, more than ever, for the role of arch-scapegoat. Explaining the
shortcoming of the method, Burgess says that "the legislation has placed upon the
Reserve System a responsibility which is likely to prove onerous, for the System will find
itself at times required by circumstances to take action which will directly and immediately
influence the profits and even solvency of considerable groups of people”73

71. Ibid.
72. A. Goldenweiser, “Banking Studies”, by Members of Staff of the Board
Governors, p. 406.
73. WR Burgess, “Reserve Banks and the Money Market”, revised Edn., pp.263-264

157
 (c) Fixation of Minimum Lending Rate
Though the Reserve Bank had prescribed the interest rates on various categories of commercial
bank advances (which include the maximum rates of interest to be charged in certain cases), the
minimum lending rate was prescribed for advances for commodities subject to selective
controls.74 In order to make selective credit controls more effective, clean credit facilities are not
allowed to any borrower affected by selective credit controls. Appropriate exemptions from the
requirements of the selective credit controls are, however, India granted so as to avoid unneces­
sary hardship to the deserving borrowers. For example, advances granted to certain categories of
borrowers, e.g., State agencies like the Food Corporation of India and State Trading Corporation,
are exempted from the application of the directives. Exports are exempted from the purview of
selective controls. These restrictions are generally less severe in respect of credit granted to the
manufacturing and processing units and are tighter in case of traders. Similarly advance against
the security of or by way of purchase of demand documentary bills drawn in connection with the
movement of goods subject to selective controls are exempted, while usance bills are not.75

(d) Issue of Directives

Section 21 of the Banking Regulation Act, 1949 provides that the Reserve Bank may give
directions to banking companies, either generally or to any banking company or group of
banking companies in particular as to:
(i) the purpose for which advance may or may not be made;
(ii) the margins to be maintained in respect of secured advances ;
(iii) the maximum amount of advances or other financial accommodation which having
regard to the paid-up capital, reserves any deposits of a banking company and other
relevant considerations, may be made by that banking company, to any one company,
firm, association of persons or individual;

74. P.N. Varshney,” Banking Law & Practice”. (2003), p. 5.29,20th Edn. Sultan Chand & Sons, New Delhi
75. Ibid. p. 5.30

158
 (iv) the maximum amount upto which, having regard to the considerations referred to in
clause (c), guarantees may be given by a banking company on behalf of any one
company, firm, association of persons or individual; and
(v) the rate of interest and other terms and conditions on which advances or other financial
accommodation may be made or guarantees may be given.
Every banking company shall be bound to comply with any directions given to it under
Section 21 76

The power conferred on the reserve bank under this section had been greatly enlarged with the
amendment of the Banking regulation Act with effect from Feb,1964. Prior to the amendment,
the reserve bank could issue directions to banks only as to the purposes of their advances and the
margins and rate of interest there on.77
In Reserve Bank of India case, held that In exercise of powers conferred by sections 21 and
35A of the Act, the Reserve Bank can issue directions having statutory force of law, prohibiting
inter alia, payment of interest on current accounts.
*7Q
In Johny Kuruvilla Case, interpreting ss. 20,21,&35 and dealing with power of the RBI
to issue circulars, it was held to be a measure to curb the possible misuse of position of persons
at the helms of affairs of urban bank and there was no Jurisdiction of the court to prove into the
deliberation. It was also held, that classification of a group of persons as relatives of Directors
could not be considered as objectionable arbitratry.
In Gulabchand Laxmichand Bhutada Case,80 where it was proved that bank had

charged interest at a higher rate than prescribed by RBI directives or had charged compound
interest on a loan to agriculturist contrary to RBI directives, it was held that banking company

76. Sec. 21 of the Banking Regulation Act 1949.

77. M.L. Tannan’s “Banking Law and Practice in India”. (2005), p. 553,21th Edn. Wadhwa &
Company, Nagpur
78. Reserve Bank ofIndia v. State Bank ofIndia, (1996) 85 Comp.Cas. 554
79. Johny Kuruvilla v. Reserve Bank ofIndia, 2004 (2) KLT 693 Kerla
80. Gulabchand Laxmichand Bhutada v. Central Bank ofIndia, 1992 (1) Mh.L.J. 68 Bombay

159
 would be bound to comply with the RBI directions regarding interest, and court could give
appropriate relief as per such directives.
In the broder context of Supervision over the functioning of the banking system, sub­
section (1) of section 35A81 also gives power to the Reserve Bank to issue directions to banks
generally or to any bank in particular in circumstances where the Reserve Bank considers it
necessary in public interest, to prevent the affair of any bank being conducted in a manner
detrimental to the interests of the depositors or on manner prejudicial to the interests of the bank
or to secure, the proper management of any bank generally. The Reserve Bank may also caution
or prohibit banks or any particular bank against from entering into any particular transaction or
O'}

class of transaction, and generally give advice to any bank

In B.O.I. Finance Ltd.Case,83 the use of the words "caution or prohibit" in Section
36(1 )(a) clearly implies that when the Reserve Bank of India prohibits Banking Companies from
entering into any particular transaction, then such a direction which is issued would be binding on
Banks and has to be complied with. While the Reserve Bank of India has the power, under
Section 36(1) (a) of the Act, to give advice or to caution Banking Companies which may not be
binding on Banking Companies, when the Reserve Bank prohibits Banking Companies against their
entering into any particular transaction or class of transactions, the said prohibition has to be
regarded as being binding. The power to prohibit, given by Section 36, will be meaningless, if
it was not meant to be binding on the Banking Companies. The word "advised" cannot be read
in isolated. Reading the said circular, as a whole, it can leave no doubt in any one's mind that what
was stated in the said document was meant to be binding on Banking Companies and was
not merely and “advice” or a “caution” which could be ignored.
The powers of the Reserve Bank to issue directions have to be exercised with bonafide
intentions, as held by the Gujarat High Court in Reserve Bank of India Case 84 In that case
the Court considered the power of the Reserve Bank to issue directions for superseding the
board of a co-operative bank for securing its proper management and upheld the action taken

81 .Supra n. 65 Sec35-A (1)

82 Ibid Sec 36 (la)
83. B.O.I. Finance Ltd. v. Custodian, AIR 1997 SC 1952: 1997 Bank J 501 : H1997 BC172 :(1997)
10 SCC 488 : JT 1997 (4) SC 15.
84. RBIv. Harisidh Co-op. Bank Ltd., AIR 1988 Guj 107.

160
by the Reserve Bank on the finding that it was without mala fide. In the case of Mulraj
Jayantilal Sheth,85 held that where the banking policy framed by RBI regarding interest rates,

etc., was not patently arbitrary, the H.C could not interfere with merits thereof in writ
jurisdiction. In the case of A.K. Merton*5* held that, all banks are bound to follow the directions

or orders of or prohibition of RBI even though it is not a directive or order under section 21 and
36-A yet a prohibition under section 36 A. All such directions, order or prohibitions are equally
binding.
(e) Moral suasion

"Moral suasion" means persuasion of commercial banks to follow certain policies, impressing
upon them the necessity to do. There is no legal compulsion in this regard by the Reserve Bank
or Government of India and therefore the success of these measures depends upon the co­
operation of the commercial banks.86 Through the instrument of Moral Suasion, the approach is
informal rather than formal.87 In advance countries like USA, this method is used by the Central

bank controlling the credit. In this direction, after the devaluation of rupee 1949, the Reserve
Bank advised all banks to restrict advances to genuine trade requirements and not to grant
accommodation for any speculative purposes. The Reserve Bank further advised the commercial
banks in June 1957, to reduce their advances particularly against agricultural commodities
without effecting their magnitude to industries. Similarly by a letter dated 8th January, 1971 to
Chairmen and Chief Excutive Officers of the commercial banks, the Governor of the Reserve
Bank emphasized the need for credit restraint and asked the banks to minimize the resort to
borrowings from the Reserve Bank and to step up their efforts at deposit mobilization. The
Governor has been meeting with the Chairmen and Chief Executive Officers of the banks and
writing personal letters to them advising them to resort to credit control. These persuasions have
given satisfactory results.

85. Mulraj Jayantilal Sheth v. Governor RBI, AIR 2003 Bom. 318 (DB
%5&A.K. Menon v. Fair Growth Financial Service Ltd., (1994) 81 Comp. Cas 508.
86. R.K. Gupta, “Banking Law & Practice”. (2005), p. 286, vol. 1st, Modem Law Publication'New Delhi
87. M C, Vaish “Money Banking & International Trade” , (1997 ), p.302,8* Edn New Age International (P)
Ltd.. New Delhi

161
(f) Rationing of Credit

Under this method, the central bank controls credit by rationing it among its various uses. It
also seeks to control the allocation of bank credit among the various categories of borrowers. The
Reserve Bank has been authorised to secure distribution of credit in conformity with the national
priorities. As required by the Central Government, the Reserve Bank has issued directives to the
commercial banks that at least 40% of their credit must be disbursed among the priority
sectors of the economy such as agriculture, small industries, artisans, education, housing, etc.
Rationing of credit can play a significant role in a planned economy by diverting
financial resources into the priority sectors. But it cannot be denied that it curtails the freedom
of the commercial banks. The commercial banks cannot follow an independent policy because
oo
the channels of investment are determined in advance by the Reserve Bank.
(g) Credit Authorisation Scheme (CAS)
This scheme was introduced by RBI in 1965. Under this scheme, the banks were to take
authorisation of RBI before sanctioning any fresh loan of Rs 1 crore or more to any single party.
The amount of this limit has been changed from time to time. It was raised in 1986 to Rs 6
crore. This scheme has been abolished by RBI in 1988.89

(h) Credit Monetary Arrangements

Under these arrangements RBI monitors and scrutinises all sanctions of bank loan exceeding Rs
5 crores to any single party for working capital requirements. RBI will scrutinize all such loans
after these are sanctioned by commercial banks.90

(i) Direct Action

The Central Bank may take action against banks which are pursuing unsound credit policies.
This may take the form of charging a penal rate of interest or refusing to grant further
rediscounting facilities to the banks who are violating the rules and directives of the Central
Bank. The element of force associated with it is not conducive to the attainment of positive
results. Direct action would result in a division of responsibility between the Central Bank and

88. T.N. Chhabra, “Banking Theory & Practice(2003), p. 190, Dhanpat Rai & Co. (p) Ltd. Delhi
89. T.N. Hajela, “ Money Banking and International Trade “ (2009), p. 429, Ane Books Pvt. Ltd., New Delhi
90. T.R. Jain, “Business Environment”. (2009-10), p. 195, V.K. (India) Enterprises revised Edn, New Delhi

162
the Commercial Bank. The banks constantly feel that the ultimate responsibility rests with the
Central Bank and until some action is taken they extend credit. This confusion resulting from
the evasion of regulations by some banks and their observance by other are fraught with grave
dangers to the financial welfare of the community.91
(j) Publicity
Under this method, the central bank gives wide publicity regarding the probable credit
control policy it may resort to by publishing facts and figures about the various economic and
monetary condition of the economy. The central bank brings out this publicity in its bulletin,
periodicals, report etc.92

(k) Post sanction supervision, control and monitoring of credit

The objective of bank of providing credit being, purpose oriented, the post sanction
supervision, control and monitoring of credit becomes very important. The banks should ensure
that the utilisation of credit is in accordance with the purpose for which the same was granted
and the funds are not diverted for any other purpose. The banks have also to see that the
security obtained by the bank against the loan granted by it is safe and adequate. It has also to
be seen by the banks that the terms and conditions for the grant of loans are being complied
with by the borrowers. The supervision, control and monitoring of credit may be divided into
following categories :
(i) Legal Control
Legal control on the credit may be undertaken by executing proper documents, complying
with the legal requirement full for creation of security and keeping the document in force,
complying with the directive of Reserve Bank and instructions issued by the bank’s Central
Office.
(ii) Physical Control

Inspection of the securities to the bank, verification of books of account, inspection of the
godown to verify the stock and name plate near the hypothecated stocks, inspection of
factory, is done to ensure that the borrower is carrying its business in a rightful manner.

91. P. Saravanavel “Modem Banking in India & Abroad” ("1989), p. 80, Margham Publication, Madras.
92. Ne. Thi, Somashekhar “Money Banking International Trade and Public Finance(2004), p. 149, Anmol
Publication Pvt. Ltd., N. Delhi.
93. R.K. Gupta, “Banking Law & Practice”. (2005 ), p. 700, vol. 1st, Modem Law Publication.New Delhi

163
(iii) Financial Control

Evaluation of performance of borrower is done from the financial statements submitted by it,
monitoring the utilisation of limits, through statements, comprehensive review of credit
account etc.

(iv) Off-site and on-site inspection and supervision.

The inspection and supervision of accounts of the borrower may be undertaken off-site or on­
site. Off-site supervision means the supervision undertaken at bank's desk level by calling
periodical statements and returns, whereas the on-site inspection is undertaken by the bank's
staff at the borrower's place of business.

(v) Off-site supervision by banks

The bank undertakes off-site supervision of the borrower by calling the periodical statements
and returns from the borrowers and analyse the same to judge the performance of the borrower.
Some of the tools of off -site supervision and control have been prescribed by the Reserve bank,
whereas some of the methods are evolved by the bunks themselves.94

5. Limitations of Selective Credit Controls

(i) The selective controls embrace the commercial banks only and hence the non­
banking financial institutions are not covered by these controls.
(ii) It is very difficult to control the ultimate use of credit by the borrowers.
(iii) It is rather difficult to draw a line of distinction between the productive and
unproductive uses of credit.
(iv) It is quite possible that the banks themselves through manipulation advance
loans, for unproductive purposes.
(v) Selective controls do not have much scope under a system of unit banking.
(vi) Development of alternative methods of business financing has reduced the
importance of selective controls.

94. Ibid., d. 701

164
 From the above discussion, we arrive at the conclusion that the two types of credit control
measures, quantitative as well as qualitative, are not rivals, but, on the contrary, they
supplement each other. For successful monetary management, the central bank should combine
the two methods of credit control iii appropriate proportions. In fact, a judicious and a skilful
combination of general and selective credit control measures is the right policy to follow for the
central bank of a country. It must, however, be pointed out that the various methods, whether
quantitative or qualitative, cannot ensure perfect credit control in an economy in view of the
several limitations form which they suffer, and other complexities involved in the situation.
At last we can say that the central bank of a country acts as the leader of the money
market, supervising, controlling and regulating the activities of commercial banks and other
financial institutions. It acts as a bank of issue and is in close touch with the government, as
banker, agent and advisor to the latter.95

6. Monetary Policy : Meaning

The Monetary and Credit Policy is the policy statement, traditionally announced twice a year,
through which the Reserve Bank of India seeks to ensure price stability for the economy.
Monetary Policy of India is formulated and executed by Reserve Bank of India to achieve
specific objectives. It refers to that policy by which central bank of the country controls (i) the
supply of money, and (ii) cost of money or rate of interest, with a view to achieve particular
objectives. In the words of D.C. Rowan. "The monetary policy is defined as discretionary act
undertaken by the authorities designed to influence (a) the supply of money, (b) cost of money or
rate of interest, and (c) the availability of money for achieving specific objectives." Thus,
monetary policy of India refers to that policy which is concerned with the measures taken to
regulate the volume of credit created by the banks, to regulate the expansion of money supply
and money circulation in the country. Main objectives of monetary policy are to achieve price
stability, financial stability and adequate availability of credit for growth. Following are the Main
elements of the monetary policy of India:
(i) It regulates the stock and the growth rate of money supply.
(ii) It regulates the entire banking system of the economy.

95.Supra n. 92, p. 150

165
 (iii) It regulates the level and structure of interest rates directly in organised sector and
indirectly in unorganised sector.
(iv) It determines the allocation of loans among different sectors.
(v) It provides incentives to promote savings and to raise the savings-income ratio.
(vi) It ensures adequate availability of credit for growth and tries to achieve price stability.96

7. Features of Monetary Policy of the Reserve Bank of India

Following are the main features of the monetary policy of the Reserve Batik of India:
/

(i) Active Policy

Before the advent of planning in India in 1951, monetary policy of RBI was a passive
policy. RBI did not use the measures of monetary policy to regulate the availability of
credit. For example from 1935 to 1951, the bank rate remained stable at 3%. But since
1951, RBI has been following an active monetary policy- It has been using all the measures
of credit control.
(ii) Controlled Money Supply
Monetary supply of RBI has been achieving contradictory objectives of economic growth
and controlling inflation. For promoting economic growth, more money supply is needed,
while to control inflation money supply has to be curbed. If RBI feels that more credit is
required for economic growth, then it expands credit. But if RBI feels that inflation is rising
then it restricts credit. Thus, RBI controls money supply to achieve these contradictory
objectives.97

(iii) Seasonal Variations

The monetary policy is characterised by the changing behaviour of busy and slack
seasons. These seasons are tied to the agricultural seasons. In the busy season, there is an
expansion of funds on account of the seasonal needs of financing production, and
inventory building of agricultural commodities. On the other hand, during slack season,
there is less demand for funds. Thus, during the busy season the Reserve Bank expands
credit, and during the slack season, RBI contracts credit

96. T.R. Jain, “Business Environment”. (2009-10) p. 192, V.K. (India) Enterprises revised Edn, New Delhi.
97. Ibid., p. 195

166
(iv) Flexible
Monetary policy has been changed according to change in market conditions and
requirements. If, there is more requirement of funds in the market, then RBI follows
liberal monetary policy by lowering bank rate, CRR, repo rates, interest rates, etc. For
example, at present, economy needs more funds for economic growth, so RBI has given
liberal monetary policy. On the other hand, when inflation is very high, then RBI
decreases supply of money (to check inflation) by adopting tight monetary policy.98
(v) Investment and Saving Oriented
To encourage investment, rate of interest on loan should be low, while to encourage
saving rate of interest on deposits should be high. The monetary policy adopted by
Reserve Bank is both investment and saying oriented. To encourage investment, adequate
funds and loans are made available for productive purposes at reasonably low rates of
interest. The Reserve Bank has also kept the interest on deposits at a reasonably high rate
to attract savings.
(vi) Wide Range of Methods of Credit Control
The Reserve Bank has used a wide range of instruments of credit control. It has adopted all
the measures of quantitative and qualitative credit controls to regulate credit as per the
needs and requirements of the economy.99

8. Limitations of Monetary Policy of India

The following are the main limitations of the monetary policy adopted by the Reserve
Bank:-
(i) Limited Scope of Monetary Policy in Economic Development:
In reality the monetary policy has been assigned only a minor role in the process of
economic development. The Reserve Bank is not given any predominant role in the
process of economic development. The Reserve Bank is just expected to see that the
process of economic development should not be hindered for want of availability of
adequate funds. The decision regarding currency to be printed is dictated by finance
ministry to RBI. So RBI has little control over the supply of money.100

98 Ibid., p. 196
99. Ibid. p. 196
lOO.Ibid.. p.197

167
(ii) Limited Role in Controlling Prices
The monetary policy of Reserve Bank has played only a limited role in controlling the
inflationary pressure. Prices are affected by many factors. Money supply is only one of
them. Other factors are beyond the control of monetary policy.
(iii) Poor Banking Habits
An important limitation of monetary policy is poor banking habits of Indian masses.
People in India prefer to make use of cash rather than cheques. A major portion of cash
generally continues to circulate in the economy without coming to the banks in the form
of deposits. This reduces the credit creation capacity of the banks. Due to high proportion
of currency in circulation of total money supply, banks face the problem of large-
withdrawals of currency every time they create credit.
(iv) Underdeveloped Money Market
Money market is the market where government securities, treasury bills, RBI's securities,
etc. are purchased and sold. The weak money market limits the efficient working of the
monetary policy. The money market comprises of two parts, the organised money market
and unorganised money market. The monetary policy works only in organised money
market. It fails to achieve the desired results in unorganised money market.
(v) Existence of Black Money

The existence of black money in the economy limits the working of the monetary policy.
The black money is not recorded since the borrowers and lenders keep their transactions
secret. Government cannot regulate the black money in accordance with the objectives of
monetary policy. So effectiveness of monetary policy is reduced.
(vi) Conflicting Objectives
An important limitation of monetary policy arises from its conflicting objectives. To
achieve the objective of economic development the monetary policy is to be expansionary,
i.e. money supply has to be increased, but contrary to it to achieve the objective of price
stability or to curb inflation money supply has to be contracted. The monetary policy
generally tails to achieve a proper balance between these two conflicting objectives.101
101. Ibid.

168
(vii) Lack of Coordination with Fiscal Policy
If monetary policy and fiscal policy are not coordinated with each other, they may go
against the objectives of each other. If fiscal policy involves huge deficit financing,
efforts of monetary policy to control money supply will fail. Deficit financing here means
printing of more notes by RBI to give loans to government. Printing of more notes leads
to increase in money supply. RBI cannot regulate deficit financing, which affects money
supply considerably.
(viii) Limitations of Monetary Instruments
An important limitation of monetary policy is related to the inherent limitations of
various instruments of credit control. The margin requirements of loans are already so
high, that the scope for further increase in them is limited. If CRR and SLR are fixed
high, then it will badly affect the profitability of banks as banks will be left with less
surplus funds to lend, and thus cannot lend much. Similarly if CRR and SLR are kept low
then it will increase the risk of banks; because due to less liquid funds banks may not be
able to pay back demand deposits to deposit holders. These limitations of monetary
instruments hamper the smooth working of monetary policy.
(ix) Lack of Banking Facilities
Banking facilities are not available in some rural and remote areas of the country. So
monetary policy cannot regulate credit in such areas. In such areas indigenous banks
operate which are not regulated by monetary policy.
(x) Persuasive-Policy
Some qualitative instruments of credit control like moral persuasion, loans for priority
sector, loans for weaker sections, etc. are only persuasive and not compulsive in nature.
The banks do not consider these measures seriously.
(xi) Imbalance in Credit Allocation
The monetary policy ignores the interest of agriculture sector and small-scale industries.
Agriculture does not get the required institutional finance because of lack of sufficient
security. Consequently, it has to depend upon indigenous money lenders for its credit needs.
Farmers have to pay high rate interest to the indigenous bankers. Even in case of industrial
sector large part of funds flow to large industries. Small industries cannot get much from
banks, because of lack of security. Thus monetary policy has resulted in imbalance in

169
 credit allocation.

(xii) Poor Implementation

Banks do not cooperate with RBI in implementing the monetary policy, so it hinders the
success of monetary policy. In short, the monetary policy of the Reserve Bank suffers

from many limitations. It requires improvements in many directions. Successful

application of monetary policy is not merely a question of availability of instruments of

credit control. It is also a question of judgement with regard to timing and the degree of

control required or relaxation needed. However, past experience shows that Reserve Bank
credit restrictions have always fallen short of the required extent of control.102

8. Suggestions for Improvement of Monetary Policy and Recommendations of the

Chakravarty Committee

Reserve Bank of India appointed a committee to review the working of monetary system

under the chairmanship of Shri S. Chakravarty in 1982. The committee submitted its

report in 1985. The main recommendations of the committee for smooth functioning of

monetary policy were as follows:

(i) Price Stability

The committee recommended that price stability should be the main objective of the

monetary policy. Reserve Bank's credit to the government should be restricted and RBI

should control the amount of credit in such a way that price stability objective can be

achieved.

(ii) Coordination of Monetary and Fiscal Policies

The committee has suggested various ways to coordinate monetary and fiscal policies.

(iii) Flexible Rate of Interest

The committee recommended that banks should have greater freedom in determining

their rate of interest.

(iv) Strengthening Money Market

The committee was of the view that money market in India should be strengthened so as

to make it more efficient.

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 (v) Monetary Targeting
RBI should fix monetary targets for the growth of money supply. These targets should be
reviewed between the year to accommodate changes in market conditions like credit
requirements in the economy.
(vi) Credit Planning
The committee recommended that desired sectoral credit allocation should be in line with
plan priorities. RBI should give guidelines for credit allocation to different sectors, viz.,
agriculture, industry and service sector, etc. The credit allocation should be in line with
the plan priorities. Commercial banks should be directed to give loans according to these
guidelines.
;.-'v
(vii) Proper Implementation
For achieving objectives of monetary policy, it should be strictly implemented. Strong
action should be taken against the commercial banks which do not follow the guidelines
of RBI. During the year, RBI should review the implementation of monetary policy by
1HT
various commercial banks.

10. New Monetary Policy of the RBI

The new monetary policy has been announced to meet the growing demands of credit with the
increase in growth rate of economy. GDP is projected to grow at the rate of 6.5% in 2009-
10. Achieving price stability, financial stability and adequate availability of credit for growth are
the key objectives of new monetary policy. Following are the important measures of the new
monetary policy:
(i) Reduction in Cash Reserve Ratio (CRR)
RBI has reduced cash reserve ratio to increase liquidity in the market. CRR has been
reduced to maintain growth rate in the economy. In April 2009, CRR was kept at 5 per
cent.
(ii) Bank Rate
It is considered desirable to leave the bank rate unchanged at 6 per cent. The matter,
however, will be kept under constant review. In monetary policy for 2009-10, bank rate is
(iii) Repo Rate and Reverse-Repo Rates
Repo and Reverse-Repo rates are constantly reviewed by RBI. RBI reduced 'Repo' and
'Reverse-Repo' rates for the year 2009-10. Now repo rate has been fixed at 4.75 per cent
and reverse-repo rate at 3.25 per cent. This will lead to reduction in interest rates in the
economy.
(iv) Statutory Liquidity Ratio of Regional Rural Banks (RRBs)
All RRBs have been allowed to maintain their entire SLR holdings in government and other
approved securities with themselves. Earlier RRBs had to keep their SLR deposits with
their sponsor banks (parent banks).
(v) Interest Rate Flexibility
In order to impart flexibility in interest rate structure, following measures need to be
considered as early as possible:
(a) Upto some extent banks should have freedom to fix interest rates.
(b) Introduction of flexible interest rate system for all new deposits which will be
reviewed at six-monthly intervals. It means interest rates can be revised after six
months. But the existing term deposits will continue to get the agreed interest rate.
(c) Banks should devise schemes to encourage the depositors for short-term deposits
rather than long-term deposits. For this, the difference in interest rate for long-term
deposits and short-term deposits should be reduced.
(vi) Transparency in the Interest Rate
In the interest of customer and to promote fair competition, it is necessary to have a
greater degree of transparency in regard to actual interest rates for depositors as well as
borrowers. In this direction, the following measures are proposed:
(a) Banks should provide information about deposit rates for various deposits and
effective annualised return to the depositors. This information should be made available to
RBI also, so that RBI can put a consolidated and comparative picture for all banks on its
website. It will enable the depositors to compare interest rates of different banks.
(b) Banks should provide information to RBI about maximum and minimum interest rates
charged by them from their borrowers. RBI will put this information in public reach,
through media or through its website. It will enable the borrowers to compare interest
rates of different banks.

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 (c) Banks are urged to switch over to "all cost" concept for borrowers by clearly declaring
the processing charges, service charges, etc. charged from borrowers. It means banks
should clearly give details about extra service charges, processing charges (in addition to
interest) to the prospective client and should not keep him in dark.105
(vii) Low Interest Rate on Export Credit
Interest rate on export credit is being reduced. According to new monetary policy,
interest cost to exporters will come down. Banks will have to inform RBI of the maximum
and minimum lending rates charged from exporters. On April 2004, Gold Card Scheme
was launched for creditworthy exporters.
(viii) Abolition of Minimum Lending Rate for Cooperative Banks
Earlier RBI used to fix minimum lending rates for cooperative banks but now in order to
provide greater flexibility to cooperative banks in a competitive environment, it is proposed
to withdraw the stipulation of Minimum Lending Rate (MLR) for all cooperative banks.
Cooperative banks will now be free to determine their lending rates considering their cost of
funds, transaction cost, etc. with the approval of their managing committee.
(ix) Liberalisation of Investment Norms
The banks are now permitted to invest their deposits in long term fixed income
instruments, subject to the condition that these instruments should have an appropriate
rating prescribed for the money market instruments. Thus, banks have been given more
freedom to invest their money. The restrictions on the investment by the banks have been
liberalised.
(x) Relaxation on Borrowings from Overseas Markets by Banks
The new monetary policy has relaxed the conditions of borrowings in overseas markets by
banks. The borrowing limit has been increased from 15 per cent to 25 per cent (of paid up
capital and free reserves). It may be mentioned here that in foreign markets, loans are
available at lower interest rates. The increased borrowing limit would enable banks to get
cheaper funds from overseas markets and help them to have adequate resources and thus
reduce the cost of funds for the banks.

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173
(xi) Priority Sector Lending
In order to improve credit delivery mechanism for the priority sector, the new monetary
policy has introduced the following concessions:
(a) In order to help the farmers, credit limit against crops is being increased from Rs 5
lakh to Rs 10 lakh. It means farmers can get loan upto Rs 10 lakh against their crops.
(b) The small-scale industries can get loans upto Rs 15 lakh in place of Rs 5 lakh
without any collateral security.
(c) The overall loan limit for small-scale industries has been raised from Rs 50 lakh to
Rs 1 crore. Domestic banks and foreign banks are required to provide 40 per cent and
32 per cent respectively of the total bank credit to the priority sector. Any shortfall of this
limit by domestic banks is to be deposited into Rural Infrastructure Development Fund
with NABARD, and shortfall of foreign banks is to be deposited with Small Industries
Development Bank of India (SIDBI).106

(xii) Kisan Credit Cards (KCCs)

KCC is a credit card which is issued by banks to farmers for availing credit facility as
per their requirements. The Reserve Bank has advised all banks to issue Kisan Credit
Cards to the farmers. Upto August 2008, banks have issued 7.57 crore Kisan Credit
Cards.
(xiii) Micro-Credit
In the new monetary policy, banks have been advised to provide maximum support to
Self-Help Groups (SHGs). SHG refers to group of persons engaged in self-employment.
The scheme of micro-credit througn Self Help Groups (SHGs) is progressing well.
(xiv) Lending and Borrowings from Call Money Market
(a) Scheduled commercial banks can give loans in the call money market, on a daily
basis, but it should not exceed 25 per cent of their owned funds (paid up capital plus
reserves).
(b) Borrowings by scheduled commercial banks in the call money market, on a daily
basis should not exceed 100 per cent of their owned funds.

106. Ibid., p. 200

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(xv) Prime Lending Rate
Prime Lending Rate (PLR) is determined by RBI. It sets broad guidelines for the banks to fix their
lending rates. For the year 2009-10, prime lending rate of public sector banks is fixed at 11.50% to
13.50 % and for private sector banks this rate is fixed at 12.50 % to 16.75 %. Banks decide then-
lending rate on the basis of prime lending rate. In monetary policy 2009-10, it was stated that the
present Benchmark Prime Lending Rate (BPLR) would be reviewed so that when interest rate
comes down, it is not only for new borrowers but also for existing borrowers, i.e. if interest rate falls
down, its benefit will be given to existing loans also.
(xvi) Urban Cooperative Banks
It has been decided in the new monetary policy that a separate supervisory authority should be
formed for regulating and controlling cooperative banks. This authority should have
representatives of centre, state and local bodies. Such a body can then be
exclusivelyresponsible for efficient functioning of the cooperative institutions and also take
responsibility for ensuring the safety of public deposits in cooperative institutions.
(xvii) Credit to Women
Public Sector Banks are required to lend at least 5 per cent of their total bank credit to women,
(xviii) Customer Service Department
In order to improve the customer services, a customer service department was set up in July
2006. Customers can send their complaints with this department. This department is managed
with the help of Banking Ombudsman. Banking Ombudsman is a regulatory body on banks to
ensure better customer service and to solve customer complaints. Now customers can even send
their complaints online.
(xix) Automated Teller Machines (ATMs)
The coverage of the Automated Teller Machines (ATM) network and the facilities provided by
the banks through ATMs are increasing. At present, there are around 28.000 ATMs across the
country.
All banks were directed to allow customers to use their ATM card on Bank's own ATM or
on any other Bank's ATM free of any cost with effect from 1 April, 2009; i.e. from 1st April 2009

175
onwards ATM holder of any bank can operate his ATM card free of any extra cost at Bank's own
ATM or at any other Bank's ATM.107
(xx) Core Banking Solution (CBS)
The CBS enables the customers of banks to undertake their transactions from any branch of a bank
instead of being attached to a particular branch. It will ensure better customer services by the bank.
At the end of March 2007, 45 per cent of the branches of the public sector banks were interlinked
using CBS.
(xxi) Financial Inclusion
Financial inclusion means delivery of banking services at very low cost to vast sections of
disadvantaged and low income groups. For this, banks have been urged to open 'no frills' account
either with nil balance or with very minimum balance. The purpose of these accounts is to provide
banking facility to low income persons.
(xxii) Financial Education
RBI has started a special project named 'Financial Literacy'. The objective of this project is to
provide information about general banking concepts and working to school and college going
students, women, rural and urban poor and senior citizens. For this, banks have been directed
to make available all printed materials used by retail customers in regional language.
(xxiii) Certificate of Deposits (CDs)
The CDs are issued by banks in multiple of Rs 1 lakh. The maturity of CD is between 3 months
and one year. CDs are freely transferable and are issued at a discount on face-value. Amount of
discount is treated as income by the person who purchases CD. For example, a person buys 3
months CD of face-value of Rs 1,00,000 from bank at a discount of Rs 5,000 for Rs 95,000. After
3 months, he will get Rs 1,00,000 from bank for this CD. So the person earns income of Rs 5,000
on this CD.
(xxiv) Interest on Saving Bank Accounts
Method of computing interest rate on saving bank accounts is to be changed with effect from 1
April, 2010. In this system depositors will be paid interest on their saving bank accounts on a daily
product basis instead of present system of computing interest on lowest balance between 10th and
30th of the month. This change will benefit saving account holders.108

107. Ibid.
108. Ibid.

176
(xxv) Prepaid Cards
Banks are directed to issue prepaid cards. In these cards, an individual pays money to the issuer
(bank), gets a card of that denomination, uses it to buy groceries or pay his bills and
refills the card by again paying money to the card issuer.
Other Features:
(a) Improvement in payment and settlement system.
(b) Development of government security market, money market and debt market.
(c) Reduction in non-performing assets of banks (Loans given by banks on which interest is
not received regularly are called non-performing assets).
(d) More lending to priority sector.
(e) Electronic Funds Transfer system would be implemented for all net worked (on - line)
branches (connected through internet) of all banks all over the country. Awareness
about electronic clearing, viz., Electronic Clearing Service (ECS), National Electronic
Funds Transfer (NEFT) and Real Time Gross Settlement (RTGS) should be spread.
Besides all these, effective fiscal policy is also required for effective implementation of
monetary policy.
11. Monetary Policy for the Year 2009-10
Sh. D. Subbarao, Governor RBI has announced Monetary Policy for the year 2009-10 on
21st April 2009. Following are the main highlights of this policy:109

(i) Bank rate is kept unchanged at 6 per cent.

(ii) Cash Reserve Ratio (CRR) is reduced to 5 per cent.
(iii) Repo Rate and Reverse-Repo Rate are kept at 4.75 per cent and 3.25 per cent
respectively.
(iv) The expansion of money supply is projected at around 17 per cent during 2009-10.
(v) Inflation rate for the year 2009-10 is expected to be 4 per cent.
(vi) GDP growth rate for the year 2009-10 is estimated around 6.5 per cent.
(vii) Bank credit is projected to increase by around 20 per cent during 2009-10.
(viii) Credit Guarantee Scheme has been started for distressed farmers.
(ix) To meet credit requirements in the economy, appropriate liquidity will be maintained
along with the objective of price stability.
109. Monetary Policy for the year 2009-10

177
(x) To focus on credit requirements of export sector, liberal finance will be made available to
exporters.
(xi) The growth in aggregate deposits is projected at 18 % in the year 2009-10.
(xii) Banks to display and update, in their offices/branches as also on their websites, the
details of various service charges in a format which is approved by the Reserve Bank.
(xiii) Limit on investment in foreign countries by Indian companies is increased from 300 per
cent to 400 per cent of their net worth, annum to US $ 5 billion per annum.
(xiv) Indian companies limit for portfolio investment abroad in listed overseas
companies is enhanced from 35 per cent to 50 per cent of net worth.
(xv) Interest rates on loan upto Rs. 1 lakh against gold and silver ornaments are reduced.
(xvi) Interest rates on residential housing loans upto Rs. 30 lakh to individuals are reduced,
(xvii) Prime lending rate for public sector banks is fixed at 11.50 per cent to 13.50 per cent
and for private sector banks, this rate is fixed at 12.50 per cent to 16.75 per cent. Prime
Lending Rate is determined by RBI. It sets broad guidelines for the banks to fix their fendng
rates. Bank decided their lending rates on the basis of this rate.
(xviii) A simplified procedure for granting crop loan upto Rs 50,000 is started. In this scheme,
bank will provide credit to landless labourers, crop-sharers, tenant farmers by
accepting an affidavit giving details of lands tilled/crops grown by such person. Banks
will encourage Self-Help-Group (SHG) mode of lending to such persons.
(xix) In order to provide better customer services, a scheme of incentives and penalties
has been started by RBI for bank branche to exchange notes.
(xx) All transactions of Rs one crore and above must be routed through electronic payment
system.
(xxi) Loans upto Rs 1 crore against NRI deposits have been permitted, earlier this limit
was Rs 20 lakh.
(xxii) Export credit refinance limit for commercial banks has been increased from 15% to
50% of outstanding export credit.
(xxiii) Branch expansion policy is relaxed to allow more penetration and competition among
banks in India.
(xxiv) Setting of more ATMs is made easier.

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In new monetary policy, it was recognised that keeping in view the global financial crisis, our
banks and financial institutions should be more vigilant.
12. Review

The main function of the Reserve Bank, as of all the other central banks, is to formulate and
administer monetary policy. Monetary policy refers to the use of instruments within the control
of the Central Bank to influence the level of aggregate demand for goods and services by
regulation of the total money supply and credit. The total expansion of money supply
depends on the creation of high powered money (reserve base) and the multiplier acting upon
it. Through the various instruments available, the Reserve Bank seeks to control both
dimensions of money supply change.110

The authority of the Reserve Bank of India for the control of the credit system is
embodied in the Reserve Bank of India Act, 1934 and the Banking Regulation Act, 1949. The
former Act confers on the Reserve Bank the traditional powers of general credit control while the
latter Act provides special powers of direct regulation of the operations of commercial banks and
cooperative banks.*111 One of the main functions of the Reserve Bank of India, as the central

bank of the country, is to control credit granted by commercial banks. The Reserve Bank of
India, like all other central banks, is conferred with wide powers for this purpose. The Reserve
Bank of India has made use of the general or quantitative credit control measures in combination
with the selective credit control measures. The general credit control measures include variations
in the bank rate,113 Refinance Policy 114 open market operations and changes in the reserve
requirements.115 All these measures operate through their effect on the level of bank reserves
because bank’s capacity to provide credit largely depends on their cash reserves.116 Selective

credit control measures relate to the distribution or direction of available credit supplies. These
measures are meant to curb excesses in selected areas and channelise the credit to the desired
areas, without effecting each other. Selective credit control measures are considered as a useful
supplement to general credit control measures. They are used to regulate areas which do not

110. Manmohan Singh, “Reserve Bank ofIndia: Function and Working(1983), p. 44,4 * Edn., Bombay
111. T N Chharbra, “Banking Theory and Practice”. Dhanpat Rai and Co.(P) Ltd. 2003 P. 192 Delhi
112. Supra n. 3,5,48, p. 26.
113. Supra nn. 16-25.27-28
114. Supra nn. 29-34
115. Supra nn. 35-43
116. Supra nn. 44-63

179
respond to measures of general credit control and their effectiveness is considerably ir
when they are used in combination with general credit control measures.117 During the
of 1950 and 1960, RBI made use of selective credit controls, open market operations ai
rate; in the decade of 1970, the RBI added CRR and SLR in its armoury; in 1980, the R
CRR, SLR and selective credit controls; in the 1990s the RBI mostly used SLR and C
occasionally used bank rate and open market operations and in the current decade the ]
used CRR, open market operations, bank rate and Repos and Reverse Repo auction
Liquidity Adjustment Facility and Market Stabilisation Scheme.118

117. Supra nn. 68-69

118. T.N. Hajela “Money Banking and International Trade". (2009), p. 423 ,Ane book. Co. New Dell

180