INTRODUCTION

Banks in India are highly regulated and have to ensure compliance and reporting to RBI and other
authorities. The principal regulations applicable to banks originate from the Banking Regulation Act
and RBI Act. A detailed knowledge of these are necessary for any student of banking in India.
Keeping this in mind, contents this chapter cover constitution and powers of RBI, monetary control
measures adopted by banks, constitution and control of banks, other regulatory authorities of
banks. These form the broad regulatory frame work of banks in India, the knowledge of which is
essential for a any student on banking. The contents are of Level 1 orientation and will be useful
for equipping oneself with deeper knowledge about how banks are regulated.
Regulatory Framework of Banks
The principal regulatory frame work of Banks in India involves among others, The Reserve Bank of
India Act, 1934 (‘RBI Act’) and Banking Regulation Act 1949 (‘BR Act’). Let us have an over view of
the same. Detailed discussion on various provisions of the same are dealt in various topics of this
chapter that follow later.

RESERVE BANK OF INDIA ACT, 1934 (AN OVERVIEW)

The RBI Act was enacted with an objective of constituting Reserve Bank of India to regulate issue
of bank notes, to keep reserves to ensure monetary stability, to operate currency and credit
system.
This Act is the basis for constitution, powers, and functions of RBI. This act does not regulate
banking directly though section 18 and 42 of RBI Act are used in regulating credit. In broad sense,
RBI Act deals with Incorporation, Capital, Management, Business of RBI itself, Central Banking
Functions, Collection and furnishing of information, Regulating Non-Banking Institution receiving
deposits and financial institutions, Prohibition of Acceptance of deposits by unincorporated bodies,
Regulation of transactions in derivatives, money market instruments, securities etc., Joint
mechanism, Monetary Policy, General Provisions, Penalties along with Schedule I and II.
The RBI Act was amended several times in the past to expand the powers of RBI. The last
amendment to RBI Act was done in February, 2016 to provide for a Monetary Policy Committee
(‘MPC’), to maintain price stability under an overall objective of growth. The task of the MPC would
be fixing the benchmark policy rate (repo rate) to control and contain inflation within the specified
target level. The Committee-based structure is expected to bring in value addition and
transparency in this area of policy decisions. MPC will hold meetings at least four times a year and
publish the decisions after each such meeting.

THE BANKING REGULATION ACT, 1949 (AN OVERVIEW)

The Banking Regulation Act, 1949 applies to the whole of India including Jammu and Kashmir. The
Act was initially brought in to force as the Banking Companies Act, 1949, and later renamed
Banking Regulations Act, 1949 w.e.f. 01.03.1966. The Banking Regulation Act does not apply to
primary agricultural credit societies, non-agricultural primary credit societies and cooperative land
mortgage banks as per section 3. Till 1965 the coverage of this Act was limited to Banking
Companies and later in 1966 Co-operative banks were also brought under its jurisdiction. The
Banking Regulation Act is applicable along other statutory laws applicable, unless specifically
exempted. Therefore provisions of Companies Act are also applicable unless there is an express
special provision in the Banking Regulation Act.
Broadly speaking, the Act regulates the entire activities of banking right from licensing, restrictions
on share holding, directors, voting rights etc.
The Banking Regulation Act further specifies restriction on loans and advances, interest rates to be
charged, maintenance of SLR reserves, Audit, inspection, submission of balance sheet and
accounts. There are also provisions regarding control over managements, apart from liquidation
and winding up as well as penalties. Thus, the Banking Regulation Act tries to regulate the entire
gamut of banking business.

OF RESERVE BANK OF INDIA

The Genesis
Lesson 2 n Regulatory Framework of Banks 35
Till the establishment of Reserve Bank of India (RBI), there was dual control of currency issuance
and credit control by the then Central government (under British rule) and the Imperial Bank of
India respectively. Due to certain developments in the economy, there was a strong view that
currency issuance should be delinked from the Government. The Hilton-Young Commission, which
was appointed to go in to this issue among others, recommended constituting a central bank to be
named as – Reserve Bank of India — which would regulate note issuance and to operate credit
system throughout the country. This is evident in the Preamble to The RBI Act, 1934 which reads
as “ to constitute a Reserve Bank for India 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
any credit system of the country to its advantage”. Hence, the Reserve Bank of India was
constituted with these primary objects.
Constitution of RBI & Management
The main purpose for which RBI was constituted has been stated in Chapter II Section 3 (1) and
(2) of the RBI Act as under -
“(1) A bank to be called the Reserve Bank of India shall be constituted for the purposes of taking
over the management of the currency from the Central Government and of carrying on the
business of banking in accordance with the provisions of this Act.
(2) The Bank shall be a body corporate by the name of the Reserve Bank of India, having
perpetual succession and a common seal, and shall by the said name sue and be sued.”
RBI has been constituted as a body corporate (under the then prevailing Companies Act) in 1935
and continues in the same manner as it was envisaged, with a capital of Rs. 5 crores, which is
wholly owned by the Government of India from January 1, 1949. Prior to 1949 RBI was Private
entity owned by public shareholders.
In terms of sections 7(2) and section 8 of the RBI Act, the general superintendence and direction of
the affairs and business of RBI is vested in Central Board of Directors, consisting of a Governor, 4
Deputy Governors, and 16 Directors (4 from each local boards, 10 nominated directly by Central
Government, 2 Government officials) appointed in terms of the Provisions of RBI Act.
Section 7(1) of RBI Act empowers the Central Government to give directions to the Governor in the
public interest after due consultations. The Governor and Deputy Governors hold office for a period
of five years, the independent director’s tenure is for four years and that of government officials is
at the pleasure of the government. All the board officials are eligible for re-appointment. However,
independent directors’ appointment is restricted to two terms of 4 years each (continuously or
intermittently spread over 8 years). A Deputy Governor and Government officials nominated as
Director may attend any meeting of the Central Board and take part in its deliberations but shall not
be entitled to vote.
However, in the absence of the Governor, and if permitted by Governor in writing, a Deputy
Governor may vote in the meetings of Central Board.
In terms of section 9 of the RBI Act, Four local boards have been constituted for each of four areas
namely Delhi, Mumbai, Kolkata and Chennai. Local board consists of 5 members each appointed
by Central Government to represent, “as far as possible, territorial and economic interests and the
interests of co-operative and indigenous banks.”
RBI Act confers powers to disqualify Directors and members of Local Boards, remove and vacate
them from their office under section 10 & section 11. The Governor has to convene meeting of
Central Board at least six times in a year and at least once in a quarter. If any four Directors
request the Governor to convene the meeting
of Central Board, the Governor has to convene a meeting forthwith.
For the day-to-day conduct of the bank’s business the Central Board, in terms of the powers
vested in it under section 58 of the RBI Act can make such regulations as it may consider
necessary. The regulations so made will be effective only with the prior sanction of the Central
Government. The powers of the Board to make regulations .are fairly wide in that the Board can
make regulations to cover all matters for which provision is necessary or convenient for the
purpose of giving effect to the provisions of the Act including that of internal functioning of RBI.
In particular, the Board is authorised to make regulations in regard to the following matters:
• Conduct of the business of the Central Board/Local Boards and the procedure that may be
followed at meetings;
• Delegation of powers and functions to Central Board to Deputy Governors, Directors, or Officers
of the Bank, Local Boards;
• Formation of committees of the Central Board and delegation of functions and powers to such
committees;
• Constitution and management of staff and superannuation funds
• Execution of contracts binding on RBI, Use of the common seal of the Bank;
• Maintenance of accounts and preparation of balance sheets of RBI;
• Remuneration of Directors;
• The relations of the scheduled banks with the RBI;
• The returns submitted by the scheduled banks to the RBI;
• Conduct and management of clearing houses for scheduled banks;
• Refund of currency notes of the Government of India or bank notes which are lost, stolen,
mutilated or imperfect;
• Any other matter for the efficient conduct of the business of the RBI.
OBJECTIVES OF RBI
The original objectives for which RBI was established were:
• To regulate the issue of Bank notes.
• To keep reserves with a view to securing monetary stability in India.
• To operate the currency and credit system of the country to its advantage.
In addition to the above, due to an amendment in 2016, the following objective was also added viz.
• To operate the monetary policy for maintaining price stability while keeping in mind objective of
growth.
•
FUNCTIONS OF RBI
The functions of the RBI have been enumerated in Chapter III of the RBI Act. The following are
broad functions:
(i) Issue and Management of Currency and distribution of coins
The currency of our country consists of One-rupee notes and coins (including lower denominations
thereof) as well as Bank notes issued by RBI. Issuance of bank notes (currency) is one of the
original central banking functions for which the RBI was established. In terms of section 22, of the
RBI Act, RBI has the sole right to issue bank notes in India. Such bank notes are issued by a
department of RBI known as Issue Department, which is a separate and wholly distinct department
from the Banking Department which is responsible for banking business of the RBI. However the
design, form and material of bank notes are to be approved by the Central Government on the
basis of recommendations of Central Board of the RBI. Every bank note shall be a legal tender at
any place in India. On recommendation of the Central Board, the Central Government may declare
any series of bank notes of any denomination to be not a legal tender.
Under the RBI Act, RBI has the power to recommend to Central Government various
denominations of bank notes, which shall be two rupees, five rupees, ten rupees, twenty rupees,
fifty rupees, one hundred rupees, five hundred rupees, one thousand rupees, five thousand rupees
and ten thousand rupees or other denominations not exceeding ten thousand rupees. The issue
department keeps its assets, which forms the backing for note issuance, distinctly separate from
that of the assets of the banking department.
The assets of the Issue Department against which notes are issued to public consist of gold coin,
gold bullion, foreign securities, rupee coin and rupee securities to such aggregate amount as is not
less than Rs. 200 Crores of rupees out of which the value of Gold coins and bullion are to be not
less than Rs. 115 Crores.
Within RBI, the Department of Currency Management (‘DCM’) has the responsibility of
administering the functions of currency management. Currency management basically relates to
the issue of notes and coins and retrieval of unfit notes from circulation. The currency management
infrastructure consists of a network of 19 issue offices, 4,034 currency chests (including sub-
treasury offices and a currency chest of the Reserve Bank at Kochi), and 3,707 small coin depots
of commercial, cooperative and regional rural banks (‘RRB’s) spread across the country. In order
to improve the currency distribution system by leveraging technology, the RBI adopted a hub-and-
spoke model for the distribution of banknotes across the country. Fresh note remittances are sent
to larger currency chests, which meet the currency needs of a designated area (such as a district).
These chests are identified as hub chests and, in turn, supply notes to smaller currency chests in
their vicinity which act like spokes in the distribution model. Fresh notes are distributed to every
issue office of the RBI as per an allocation plan.
RBI has established a chain of currency chests with several banks in the country. A currency chest
is a place where the RBI keeps all the excess money in the form of cash under the custody of
different banks. Currency chests are designated branches of commercial banks authorised by the
RBI to hold stock of bank notes, rupee notes and coins. These currency chests have the
responsibility for distribution of these notes and coins on behalf of RBI. The currency chests get
their supply of printed notes from RBI, which are later delivered to the respective banks. Currency
chests can be stated to be a depository frame work of the RBI.
The banks which host the currency chests are required to maintain accounts of the chests
independently which is subject to monitoring and scrutiny of RBI. Also through a separate set of
policy and rules RBI exchanges mutilated or torn notes surrendered by customers through bank
branches and currency chests. The bank notes which are issued and circulated by RBI are bearer
promissory notes and they are exempt from payment of stamp duty.
(ii) Banker to the Government
In terms of section 20 of RBI Act, RBI has an obligation to Act as a banker to the central
government. Under this obligation RBI has to accept monies for account of the Central
Government, to make payments up to the amount standing to the credit of Central Government, to
carry out its exchange, remittance and other banking operations, including the management of the
public debt of the Union of India.
Also under section 21 of RBI Act, RBI has a right to transact Government business India which
includes money, remittance, exchange and banking transactions in India; and, the Central
Government to deposit free of interest all its cash balances with the RBI under mutually agreed
terms. The Reserve Bank is also saddled with the responsibility of receiving and paying money on
behalf of the various Government departments. For carrying out its duties as banker to the
Government of India, it is not paid any remuneration. RBI is entitled for a commission for managing
public debt functions. The Government transaction work also includes maintaining currency chests
at places specified by the Central Government. Similarly section 21A of the RBI Act enables RBI to
enter in to agreements with State Governments to transact their businesses.
Under sections 20 and 21(A)(b) of the RBI Act, RBI manages public debt of both Central and State
governments. Float new loans on behalf of Central/State governments, conduct periodical auctions
of Treasury Bills, issue of dated Government securities as well buying and selling the same are
some of the additional work done by RBI in its capacity as a Banker to the Government.
Under the mandate signed with Central Government and State governments RBI extends Ways
and Means Advances up to 90 days at an interest rate 2% over the Repo rate. This is basically to
manage the temporary mismatches in their short term receipts and payments. RBI also provides
investment services by deploying temporary surplus cash balances in Government accounts. RBI
also advises the Government on monetary and banking issues when requested to do so. Also
manages consolidated fund of India, contingency fund and public accounts as these accounts are
maintained by RBI.
(iii) Banker to the Banks
This is a special relationship that is created due to statutory requirements under the RBI Act. Once
the name of a bank is included in the Second Schedule, that Bank is eligible to be called as a
Scheduled Bank. Among other conditions, it is bound to maintain the stipulated Cash reserves
under section 42 in an account with RBI. The Scheduled Bank status to any bank also confers
privileges such as availing financial accommodation from RBI under specified conditions.
Reserve Bank also provides means of transfer and settlement of funds between banks on account
of clearing, remittances, lending and borrowing through such accounts. Thus RBI provides a
platform (iv)
Lesson 2 n Regulatory Framework of Banks 39 for inter-bank financial transactions. Such accounts
of banks are maintained by Deposit Accounts
Department of RBI. Intra-bank funds transfers also takes place through an RBI portal known as e-
Kuber.
Lender of last resort
When banks exhaust all other means for raising funds for their operations, they fall back on RBI as
a source for finance as provided under the RBI Act. Hence RBI is known as Lender of last resort.
RBI grants financial accommodation to banks in terms of section 17(2), (3) and 3 (A) “sale,
purchase and rediscount of eligible bills” as well as loans and to advances banks under section
17(4) of RBI Act.
Rediscount of bills with RBI by banks are confined to the following categories:
(a) Bonafide Commercial bills forming part of commercial or trade transactions drawn on and
payable in India and maturing within 90 days from the date of discount by banks. In case of export
bills relating to export from India the maturity may be 180 days. The other pre-requisite is that such
bills should have two signatures with one among them that of a scheduled bank.
(b) Bills related to financing agriculture operations or marketing of crops: Such bills which are to
mature within 15 months from the date of purchase or discount by banks.
(c) Bills that are associated with Cottage and Small Scale Industries: Such bills that are associated
with production or marketing aspects of these industries maturing within 12 months of its discount
or purchase by banks, drawn and payable within India and having two signatures one of which that
of a State Co-operative Bank or a State Financial Corporation supported by a guarantee from State
Government concerned on repayment of Principal and interest on these bills.
(d) Bills representing holding or trading in Government Securities: Such bills drawn and payable
within India, bearing the signature of a Scheduled Bank and maturing within 90 days from the date
of purchase or re-discount.
(e) A foreign bill: Bills arising out of bonafide export transactions maturing with 180 days drawn in
or on any country outside India, such country being a member of International Monetary Fund. For
other than export bill, the maturity is not to exceed 90 days.
Loans and Advances
Section 17(4) of the RBI Act empowers Reserve Bank to grant loans among others to, Scheduled
Banks, State Co-operative Banks, and State Financial Corporations loans and advances,
repayable on demand or on the expiry of fixed periods not exceeding ninety days.
Such loans and advances are granted against the securities of
• stocks, funds and other (than immovable property) securities, in which there is an authorization to
a trustee to invest monies
• Gold or silver or documents of title to these
• Promissory Notes or Bills of Exchange eligible for purchase or rediscount by RBI or guaranteed
by State Government regarding repayment of principal and interest due on them
• Promissory notes of any scheduled bank or State Co-operative Bank which are supported by
documents of title to goods (which have been already transferred, assigned or pledged to any
other bank as a security for any advance or loan made of bonafide commercial or trade
transactions or those in respect of financing agricultural operations or marketing of crops).
Further by means of Section 17(3-A) of the RBI Act, RBI grants financial accommodation at
concessional rates on export oriented bills, repayable on demand or a fixed period which mature in
not exceeding 180 days based on declarations from banks. For financing under these schemes
RBI had introduced
Bill Market Schemes in 1951 and subsequently modified the same in 1970 as New Bill Market
Scheme.
(vi) Emergency Advances
Also RBI, grants emergency advances to specified banks on special occasions as envisaged in
Section 18 of the said Act in the interest of regulating credit to trade, commerce, agriculture and
industries. This special provision is available despite any restrictions stated under Section 17 and
Section 18 to RBI and extend such financial accommodation to banks on such bills which are not
financeable by RBI, otherwise. Further under Section 18 RBI can make an advance to a State
Cooperative Bank or to a cooperative society based on the recommendations of a State
Cooperative Bank. Such advance is repayable on demand, or on the expiry of fixed period
generally not exceeding 90 days under the terms and conditions specified by RBI.
(vii) Controller of Credit
As Bank credit extended by various banks has its own impact on the economy, one of the key
functions for which RBI was constituted was to manage the credit for the advantage of the country.
RBI exercises control over the credit extended by banks through specific instruments on account of
wide powers granted to it by RBI Act as well as Banking Regulation Act, 1949.
The frame work of credit control are implemented through the following instruments at the
command of RBI. They are-
I. Cash Reserve Ratio
II. Statutory Liquidity Ratio
III. Directives under BR Act
IV. Refinancing of loans
V. Moral suasion
Cash Reserve Ratio (Sec 42 of RBI Act)
Statutory Liquidity Ratio (Sec 24 of BR Act)
Credit Conrtols
Directives
Financial Accomodation
Moral Suasion
Cash Reserve Ratio (CRR)
General Credit Control
Selective Credit Control (BR Act Sec 21 and Sec 35 A)
Rate Policy (Bank Rate & Repo)
Re Discounting/ Refinancing
In terms of Section 42 of the RBI Act every scheduled bank in India is required to maintain an
average daily balance the amount of Cash Reserves with RBI as a percentage of Total Net
Demand and Time Liabilities in India. Reserve Bank notifies the percentage of CRR to be
maintained by banks at regular intervals through gazette notifications.
country.
The main purpose of maintaining CRR by the banks is to secure the monetary stability of the
country. By increasing the CRR or decreasing the CRR the lendable resources of a bank can be
reduced or increased. This would lead to scarcity of availability of funds or increase in availability of
funds in the economy resulting in a deflationary or inflationary effect.
When the RBI Act was introduced, the minimum and maximum floor rates of this ratio to be
maintained by banks was specified between 3% to 20% .This was amended 2006 and floor rates
were abolished, to give RBI the flexibility to decide and announce the percentage of CRR to be
maintained by banks from time to time keeping in view the monetary situation prevailing in the
country. By varying CRR, RBI can expand or contract the credit extended by a bank, thus affecting
the quantum of credit a bank can extend.
All scheduled banks and Non-scheduled banks have to maintain CRR as per Sec 18 of the RBI
Act. Banks have to calculate the CRR on the basis of their respective demand and time liabilities
as on the Friday of second preceding fortnight. Reserve Bank of India has prescribed statutory
returns i.e. Form A Return (for CRR) under section 42(2) of the RBI Act, and Form VIII Return (for
SLR) under section 24 of the Banking Regulation Act, 1949. In addition to the above an
incremental CRR in terms of section 42(1A) also need to be maintained as advised by RBI from
time to time. At present no incremental CRR need to be maintained. Provisional return of Form A
to be submitted by banks within 7 days and final Form A to be submitted within 20 days from expiry
of the relevant fortnight.
As per the latest directions after calculations, each bank has to maintain at least minimum CRR
balances up to 90 per cent with effect from the fortnight beginning April 16, 2016.
According to RBI, the following are liabilities for the purpose of computation of CRR:
a. Liabilities to the banking system computer under Section 42 (1) of the RBI Act.
b. Credit balances on Asian Currency Union (US Dollar) Account.
c. Demand and Time liabilities of the respective banks off-shore units.
With effect from March 31, 2007 RBI has discontinued paying interest on CRR balances
maintained by banks with RBI.
Since June 24, 2006 if a bank defaults in maintaining CRR on daily basis RBI has powers to
recover penal interest at the rate of 3% p.a. over Bank Rate on the amount which falls short of the
balances on that day. If the short fall continues subsequently on succeeding days, the penal rate
will be recovered at a rate of 5% p.a. over Bank Rate.
Presently banks have to maintain 4% of their Net Demand and Time liabilities as CRR.