CONTENTS

Foreword ii Acknowledgements iii Chapters Description Page No. 1 Evolution of Central

Banking Globally and in India 1 2 Legal Framework for Reserve Bank Functions 5 3
Monetary Policy Framework 14 4 Market Operations 22 5 Financial Stability 39 6 Overview
of the Indian Financial System 44 7 Regulation of Commercial Banks 47 8 Supervision of
 Commercial Banks 58 9 Regulation and Supervision of Co-operative Banks in India 70

10 Regulation and Supervision of Non-Banking Financial

79
Companies in India
11 Enforcement in RBI 98 12 Development and Regulation of Financial Markets
103 13 Payment and Settlement Systems 122 14 Currency Management 132 15
Banker to Banks and Governments 148 16 Public Debt Management 157 17
Understanding RBI Balance Sheet 162 18 Foreign Exchange Management 175 19
Foreign Exchange (Forex) Reserves 184 20 Consumer Education and Protection
190 21 Financial Inclusion and Development 197 22 Development of Institutions
207 23 Research, Surveys and Data Dissemination 210

i
Foreword
The importance of central banks has increased manifold in the last decade with such
institutions taking a proactive lead in responding to situations and circumstances that have a
bearing on financial stability, supporting respective economies during the global financial
crisis of 2007-08 and more recently in dealing with the scenario emerging out of Covid-19
pandemic.
The role of Reserve Bank of India (RBI) has also evolved with several dimensions
added (recent addition as regulator for HFCs, for example), several reforms and
reformations, modification and re-designing of functional domains and creation of new
Departments/verticals since its establishment on April 1, 1935. It is in this context that
Reserve Bank Staff College as the premier Training Institution of RBI, has constantly tried to
document the functions and working of RBI in its most current form. Discerning readers and
scholars may recall that the last compilation was brought out in the year 2017, which was an
update on the previous publications brought out in the year 2010.
What has necessitated this review and update are several factors which include some
very rapid developments in central banking activities and reorganization of departments and
divisions within RBI in the intervening period. A case in point are the recent
additions/modifications to functional domains in the form of creation of Enforcement
Department, the new Supervisory and Regulatory verticals etc. Further, the emphasis in the
newer version has shifted more to the functional aspects and thus we have removed
references to certain regulations which have since been over-written by new ones(manner of
resolution of stressed assets, changing norms on Priority Sector Lending etc) so that the
content remains sturdy and stable over longer periods of time. Other significant changes that
have been covered in the revised version include introduction of new rupee liquidity
management tools by RBI, reconstitution of Financial Stability and Development Council
(FSDC), amendments in chapter-III of RBI Act covering changes in provisions related to
NBFCs, transfer of regulation of Housing Finance Companies to RBI, introduction of new
ombudsman schemes, changes in priority sector guidelines, introduction of National
Strategy for Financial Education, etc.
The updated version of this book earlier unveiled by Governor, RBI at RBSC, Chennai
on January 3, 2020 and was subsequently modified in June 2020 through a vetting process by
concerned CO Department(s). To fulfil the obligations under the bank’s Rajbhasha Policy, this
book has since been translated in Hindi as well. We hope that the new updated version will
make for some valuable read and we shall also look forward to suggestions to bring in more
features and updates.
R Kesavan
Principal

ii
ACKNOWLEDGEMENT

Covering a wide range of fully evolved and currently evolving functions and working of
Reserve Bank of India most definitely implies that an intense collaborative effort must be
involved in producing Training Material of this order. Accordingly, we wish to acknowledge
the sincere efforts of all Members of Faculty and all others (more specifically Rajbhasha
Officers from RBSC and RO, Chennai, who worked on the Hindi translation) involved in the
process, without whose help we would not have been able to bring out an updated version
of the book.

2. The meticulous efforts of Members of Faculty of the Reserve Bank Staff College in
updating individual chapters is heartily appreciated. The untiring efforts and hard work
rendered by the editorial team, consisting of R Sathish, Satish Chandra Rath, M K
Subhashree, Edwin Prabu A and Hema Chatterjee are worthy of special mention. But for
their determination, hard work and discipline, this version would not have materialised. Smt
R Suma, Rajbhasha Officer (RBSC), Smt Mayalakshmi, Shri Pandarinath and Shri Shyam
Sunder, Rajbhasha Officers from RO, RBI, Chennai who contributed significantly to the Hindi
version, also deserve our gratitude.

3. Needless to mention, there would be changes and updates in the manner we operate and
function as a full service Central Bank and there would always scope to update further and
improve the effort. We shall, therefore, look forward to reader’s suggestions in this regard
which may be mailed to principalrbsc@[Link].

R Kesavan
 Principal

iii
Chapter 1: Evolution of Central Banking Globally and in India
“THERE have been three great inventions since the beginning of time: fire, the wheel and
central banking” – Will Rogers
The evolution of central banks can be traced back to the seventeenth century when
Riksbank, the Swedish Central Bank was set up in 1668. The Bank of England was founded in
1694. The Central Bank of the United States, the Federal Reserve established in 1914, was
relatively a late entrant to the Central Banking arena. The Reserve Bank of India, India’s
central bank started operations in 1935. At the turn of the twentieth century there were
only eighteen central banks. Today, most of the countries have a central bank.
Central banks are not regular banks. They are unique both in their functions and their
objectives. In the beginning, central banks were established with the primary purpose of
providing finance to the government to meet their war expenses and to manage their debt.
They were initially known as banks of issue with the term central banking coming into
existence only in the nineteenth century. They were founded as “special” commercial banks
and would evolve into public-sector institutions much later. The “special” nature of these
banks was based on government charters, which made them not only the main bankers to
the government but also provided them monopoly privileges to issue notes or currency.
Central banks also held accounts of other banks even as they engaged in normal commercial
banking activities. Given their “special” status and their size, they soon came to serve as
banker to banks facilitating transactions between banks as well as providing them banking
services.
The eighteenth and nineteenth century witnessed several financial panics. Panics are
a serious problem as failure of one bank may lead to failure of others. Banks are susceptible
to panics or “runs” as more popularly known, due to the nature of their balance sheets. Their
liabilities are short-term and liquid (banks’ major liabilities are demand deposits, which
means depositors can ask their money back anytime they want and therefore immediately
payable) and the assets are long-term and illiquid (in the sense that it is not easy to sell them
and convert into cash quickly). Banks engage in this so-called maturity or liquidity
transformation to allocate society’s available pool of resources effectively between savers
and borrowers. The failure of banks and its potential adverse impact on the real economy
was and is a serious concern for all policymakers. In 1873, Walter Bagehot, an editor of the
Economist magazine, published a book titled “Lombard Street” where he clearly articulated
that to avoid panics, central banks should assume the role of “lender of last resort”. The
doctrine, which came to be known as Bagehot’s dictum states that a central bank, in periods
of panics or crisis, should lend freely, against quality collateral and at a penal rate of interest.
The idea being, a bank that is facing a “run” by its depositors or other lenders can tide over
temporary liquidity problem in the stress period, by borrowing from the central bank against
collateral. It can pay off the depositors and buy some time before things calm down. Given
bank runs are self fulfilling prophecies, if the banks can navigate this period without
becoming insolvent, a crisis could be averted. The very fact that the bank was able to meet
the withdrawal demands would

1
comfort the other depositors waiting to withdraw and wean them away. Without the ‘lender
of last resort’ facility, banks must resort to fire-sale of their assets and that too at a deep
discount. Thus, in addition to be a banker to the government and banks, central banks also
became lenders of last resort.
The main mission of a central bank is to maintain macroeconomic stability and
financial stability. Macroeconomic stability refers to achieving stable and sustainable growth
and keeping prices stable, i.e., low and stable inflation. Financial stability on the other hand
refers to keeping the financial system resilient and avoiding financial crisis. The relative
importance of these objectives has varied over time. While the pursuit of sustainable
economic growth and low and stable inflation have been fundamental to central banking
activities since the early nineteenth century with the advent of the gold standard, the
importance of financial stability became more prominent since the Great Depression of the
1930s when the world economy faced large bank failures and deep recession.
To achieve the objectives of macroeconomic stability and financial stability, central
banks have certain tools at their disposal. To achieve economic stability, central banks use
monetary policy. By varying short-term interest rates, i.e., either raising or lowering the
interest rates, they control the supply of and demand for money in the economy and thereby
economic activity and inflation. For example, if the economy is growing fast and inflation is
high, central bank may raise the interest rates it charges the banks to lend money. Higher
interest rates will permeate into other rates, such as housing loan, consumer loan, etc. As
the cost of borrowing increases, it discourages consumption and investment and thus
reduces growth and inflation. On the other hand, if the economy is growing too slow or if
the inflation is too low, the central bank will lower the interest rate. This will feed into other
rates and encourage spending and investment thereby pushing economic growth and
inflation. The trick of the trade is to achieve sustainable growth and low and stable inflation.
Thus, sometimes, central banking is said to be “neither a science nor an art, but a craft”.
To deal with financial stability, central banks main tool is provision of liquidity. This
tool, as explained earlier, is referred to as “lender of last resort”. Some central banks, which
are also the banking regulators in their economies employ another tool, viz., regulation and
supervision, also to foster financial stability. By setting prudent rules and principles and
examining and monitoring banks adherence to these rules and principles, the central banks
aim to create a healthy and robust banking and financial system. A resilient and safer banking
system will reduce the chances of financial crisis in the first place. In many countries the
regulatory and supervisory roles are performed by multiple agencies and therefore may not
be a main function of the central bank.
The internationalization of commercial banking activity brought several risks to the
fore. The failure of two banks in 1974, the Franklin National Bank in the United States and
Bank Herstatt in Germany, which had international implications necessitated international
cooperation and coordination among central banks. The Basel Committee for Banking
Supervision (BCBS) was thus established. The committee sets international regulatory

2
standards, known as Basel Standards that forms the bedrock for all national and
international banking regulations.
Since the outbreak of the financial crisis in 2007-08, the tool box of central banks has
been strengthened. These tools or measures are popularly known as “unconventional
policies”, reflecting their use in extraordinary circumstances. Quantitative or credit easing,
negative interest rates, forward guidance, etc., are some of the tools employed by central
banks to deal with the crisis and its aftermath. The central banks also became “market
makers of last resort” during the crisis as the markets became dysfunctional. These concepts
will be explained in subsequent chapters.
Evolution of the Reserve Bank of India
The origins of the Reserve Bank of India (RBI) can be traced to 1926, when the Royal
Commission on Indian Currency and Finance – also known as the Hilton-Young Commission –
recommended the creation of a central bank for India to separate the control of currency
and credit from the Government and to augment banking facilities throughout the country.
The Reserve Bank of India Act of 1934 established the Reserve Bank and set in motion a
series of actions culminating in the start of operations in 1935. Since then, the Reserve
Bank’s role and functions have evolved, as the nature of the Indian economy and financial
sector changed. Though started as a private shareholders’ bank, the Reserve Bank was
nationalised in 1949.
The Preamble to the Reserve Bank of India Act, 1934, under which it was constituted,
specifies its objective as “to regulate the issue of Bank notes and the keeping of reserves with
a view to securing monetary stability in India and generally to operate the currency and
credit system of the country to its advantage”. The primary role of the RBI, as the Act
suggests, is monetary stability, that is, to sustain confidence in the value of the country’s
money or preserve the purchasing power of the currency. Ultimately, this means low and
stable expectations of inflation, whether that inflation stems from domestic sources or from
changes in the value of the currency, from supply constraints or demand pressures. In
addition, the RBI has two other important mandates; inclusive growth and development, as
well as financial stability.
In a country where a large section of the society is still poor, inclusive growth assumes
great significance. Access to finance is essential for poverty alleviation and reducing income
inequality. One of the core functions of the RBI, therefore, is to promote financial inclusion
that leads to inclusive growth. As the central bank of a developing country, the
responsibilities of the RBI also include the development of financial markets and institutions.
Broadening and deepening financial markets and increasing their liquidity and resilience so
that they can help allocate and absorb the risks entailed in financing India’s growth is a key
objective of the RBI.
India’s financial system is dominated by banks. Their regulation and supervision is
therefore important both from the viewpoint of protecting the depositors’ interest and
preserving financial stability. The RBI, deriving powers from the Banking Regulation Act,
1949, designs and implements the regulatory policy framework for banks operating in India.
Over

3
the years, the purview of regulation and supervision has been expanded to include non
banking entities also.
The global economic uncertainties during and after the Second World War warranted
conservation of scarce foreign exchange by sovereign intervention and allocation. Initially,
the RBI carried out the regulation of foreign exchange transactions under the Defence of
India Rules, 1939 and later, under the Foreign Exchange Regulation Act of 1947. Over the
years, as the economy matured, the role shifted from foreign exchange regulation to foreign
exchange management.
The 1991 balance of payment and foreign exchange crisis was a watershed event in
India’s economic history. Being at the centre of country’s monetary and financial system, the
RBI played a key supporting role in helping the Government manage the crisis and undertake
necessary market and regulatory reforms. The approach under the reform era included a
thrust towards liberalisation, privatisation, globalisation and concerted efforts at
strengthening the existing and emerging institutions and market participants. The Reserve
Bank adopted international best practices in areas, such as, prudential regulation, banking
technology, variety of monetary policy instruments, external sector management and
currency management to make the new policy framework effective.
Central banks are at the heart of a country’s payment and settlement system. “One of
the principal functions of central banks is to be the guardian of public confidence in money,
and this confidence depends crucially on the ability of economic agents to transmit money
and financial instruments smoothly and securely through payment and settlement systems”1.
The RBI has, over the years, taken several initiatives in building a robust and state-of-the-art
payment and settlement system that not only improves the “plumbing” of the financial
system but also its stability.
The last two and a half decades have also seen growing integration of the national
economy and financial system with the world. While rising global integration has its
advantages in terms of expanding the scope and scale of growth of the Indian economy, it
also exposes India to global shocks. The crisis of 2007-08 gave a glimpse of financial
instability in other economies posing threat to our financial stability. Hence, preserving
financial stability has become an even more important mandate for the RBI.

1
Bank oversight of payment and settlement systems, BIS, May 2005

4
Chapter 2: Legal Framework for Reserve Bank Functions
The structure, roles and responsibilities of central banks vary between countries,
which is very much evident from their origins and also the variety of functions they perform.
The statutes governing the establishment and mandate of central banks are also not uniform
even as they play a crucial role in determining the functions of central banks across the
world.
In India, the RBI is the central banking authority constituted by the Reserve Bank of
India Act, 1934 (‘RBI Act’), and its duties and responsibilities flow from that statute. However,
the range of functions, which the RBI is undertaking is not only covered under the RBI Act 2
but is also covered under various other statutes. Thus, the legal backing for the functions of
RBI is spread over a number of statutes. In this chapter, we examine in detail the legal
provisions vis-à-vis the multifarious functions that are conferred on the RBI.
Reserve Bank of India – Legal Background
Pursuant to the recommendation of the Royal Commission on Indian Currency and
Finance, a Bill was introduced in the Legislative Assembly in 1927 to create a central bank for
India, which was later withdrawn due to lack of agreement among various sections of people.
Subsequently, the White Paper on Indian Constitutional Reforms (1933) recommended for
the establishment of a Reserve Bank in India. Accordingly, a fresh Bill was introduced in the
Legislative Assembly, which got passed and received the Governor General’s assent on
March 6, 19343. Consequently, the RBI Act came into existence and the RBI commenced its
operations as the central bank of the country on 1 st April 1935 as a private shareholders’
bank, with a paid-up capital of Rupees five crore.
Aims and Objectives – The Preamble
The purposes for which the RBI has been established as India’s central bank has been
spelt out in the preamble to the RBI Act, which states as follows:
(i) “to regulate the issue of banknotes and the keeping of reserves with a view to securing
 monetary stability in India and generally to operate the currency and credit system of the
country to its advantage; and
(ii) that it is essential to have a modern monetary policy framework to meet the challenge
of an increasingly complex economy and the primary objective of the monetary policy is
to maintain price stability while keeping in mind the objective of growth” 4.

Thus, the Preamble in the RBI Act, as amended by the Finance Act, 2016, provides
that the primary objective of the monetary policy is to maintain price stability, while keeping
in mind the objective of growth, and to meet the challenge of an increasingly complex
economy. However, the functions which the RBI is undertaking is not restricted only within
the provisions of the RBI Act, but also extends to various areas, such as, regulation and
supervision
2
Section 17, RBI Act, 1934
3
Source: RBI Website, ‘History of the Reserve Bank of India’
4
Please read Indian Finance Act, 2016 wherein amendments to RBI Act, 1934 have been brought to amend the Preamble and
also new Chapter III-F

5
of banks, consumer protection, management of foreign exchange, management of
government securities, regulation and supervision of payment systems, etc., for which
powers are drawn from various laws, namely, the Banking Regulation Act, 1949, Foreign
Exchange Management Act, 1999, Government Securities Act, 2006, Payment and
Settlement Systems Act, 2007, etc.
Banking Functions – Legal Background
The general superintendence and direction of the affairs and business of the RBI shall
be entrusted to the Central Board 5 having nominees from the Central Government and
Directors appointed under Section 8 of the RBI Act. The Board of the RBI is headed by the
Governor and assisted by not more than four Deputy Governors 6. The Board exercises all
powers and do all acts and things which may be exercised by the RBI. Section 17 of the RBI
Act enables RBI to do banking business, such as accepting deposits, without interest, from
any person. The other business, which the RBI may transact are also mentioned in the said
provision. It states that the RBI may transact various businesses such as acceptance of
deposits without interest from Central Government and State Governments, purchase, sale
and rediscount of Bills of Exchange, making of short term loans and advances to banks and
other institutions, providing of annual Contributions to National Rural Credit Funds, dealing
in Derivatives, purchase and sale of Government Securities, purchase and sale of shares of
State Bank of India, National Housing Bank, Deposit Insurance and Credit Guarantee
Corporation, etc., keeping of Deposits with SBI for specific purposes, making and issue of
Banknotes, etc7.

Section 18 facilitates the RBI to act as a ‘Lender of Last Resort’. Section 19 lists out the
kinds of businesses which RBI may not transact. The provisions of the RBI Act enable the RBI
to act as banker to Central Government and State Governments. Under Sections 20 and 21 of
the RBI Act, RBI has an obligation and right respectively to accept monies for account of the
Central Government and to make payments up to the amount standing to the credit of its
account, and to carry out its exchange, remittance and other banking operations, including
the management of the public debt of the Union. In the case of State Governments, the said
banking functions may be undertaken by way of an agreement between the RBI and the
State Government concerned, as provided in Section 21-A of the RBI Act. These agreements
made between the RBI and the State Governments are statutory as they are required to be
laid before the Parliament as soon as they are made.
Issue Functions - Legal Background
Issuance of bank notes is one of the key central banking functions the RBI is
authorised and mandated to do8. Section 22 of the RBI Act confers on RBI the sole right to
issue bank notes in India. The issue of bank notes shall be conducted by a department called
the Issue

5
Please read Section 7 of the RBI Act, 1934
6
Please read Section 8 of the RBI Act, 1934
7
Please read Section 17 and other provisions of the RBI Act, 1934 for full details
8
See Chapter III of RBI Act, 1934 for detailed reading

6
Department, which shall be separated and kept wholly distinct from the Banking
Department9. The RBI Act enables RBI to recommend to Central Government the
denomination of bank notes, which can be of 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 rupees10. The design, form and material of bank notes shall be approved by the
Central Government on the recommendations of Central Board of the RBI 11. Every bank note
shall be a legal tender at any place in India, however, on recommendation of the Central
Board, the Central Government may declare any series of bank notes of any denomination to
be not a legal tender12. Another important function is exchange of mutilated or torn notes,
which under the RBI Act is not a matter of right, but of grace 13. The bank notes that are being
issued by the RBI are exempt from payment of stamp duty14.

Monetary Policy Functions - Legal Background

Chapter III-F15 of the RBI Act provides for a statutory basis for the Monetary Policy
Framework and the Monetary Policy Committee. The Central Government, in consultation
with the RBI shall determine the inflation target in terms of the Consumer Price Index, once
in every five years, which needs to be notified in the Official Gazette 16. Similarly, it is the
Central Government that should constitute a Monetary Policy Committee by notification in
the Official Gazette17. The Monetary Policy Committee shall consist of (a) the Governor of the
RBI; (b) Deputy Governor of the RBI in charge of Monetary Policy; (c) one officer of the RBI to
be nominated by the Central Board; and (d) three persons to be appointed by the Central
Government18. The Monetary Policy Committee has been entrusted with the statutory duty
to determine the Policy Rate required to achieve the inflation target. The decision of the
Monetary Policy Committee is binding on the RBI and the RBI shall publish a document
explaining the steps to be taken by it to implement the decisions of the Monetary Policy
Committee19. It has been the objective of the statute that a Committee-based approach will
add lot of value and transparency to monetary policy decisions. The meetings of the MPC
shall be held at least 4 times a year and it shall publicize its decisions after each such
meeting20.

Public Debt Functions – Legal Background

The Parliament of India enacted the Government Securities Act, 2006 (‘GS Act’) with
an objective “to consolidate and amend the law relating to Government securities and its
management by the Reserve Bank of India” 21. The GS Act applies to Government securities

9
Please see Section 23, RBI Act, 1934
10
Please see Section 24, RBI Act, 1934
11
Please see Section 25, RBI Act, 1934
12
Section 26, RBI Act, 1934
13
Section 28, RBI Act, 1934
14
Section 29, RBI Act, 1934
15
Introduced by Finance Act, 2016
16
Section 45-ZA, RBI Act, 1934
17
Section 45-ZB, RBI Act, 1934
18
Section 45-ZB, RBI Act, 1934
19
Section 45-ZJ, RBI Act, 1934
20
Section 45-ZK, RBI Act, 1934
21
Preamble, Government Securities Act, 2006

7
created and issued by the Central Government or a State Government 22. The GS Act
prescribes the procedure and modalities to be followed by the RBI in the management of
the public debt and also confers various powers on the RBI, including the power to
determine the title to a Government security, if there exists any doubt in the opinion of the
RBI23. Further, Section 18 of the GS Act provides that no order made by the RBI under that
Act shall be called in question by any Court for the reasons stated therein. Prior to the
enactment of the GS Act, the said public debt functions of the RBI have been governed by
the provisions of the Public Debt Act, 1944. The enactment of the GS Act has not fully
repealed the Public Debt Act, 1944. This is evident from Section 31 of the GS Act which
states that the Public Debt Act, 1944, shall cease to apply to the Government securities to
which that Act applies and to all matters for which provisions have been made under the GS
Act.
Foreign Exchange Management – Legal Background
The powers and responsibilities with respect to external trades and payments,
development and maintenance of foreign exchange market in India are conferred on the RBI
under the provisions of the Foreign Exchange Management Act, 1999 (‘FEMA"). Section 10 of
the FEMA empowers the RBI to authorize any person to be known as authorized person to
deal in foreign exchange or in foreign securities, as an authorized dealer, money changer or
off-shore banking unit or in any other manner as it deems fit. Similarly, it empowers the RBI
to revoke an authorization issued to an authorized dealer in public interest, or the authorized
person has failed to comply with the conditions subject to which the authorization was
granted or has contravened any of the provisions of the FEMA or any rule, regulation,
notification, direction or order issued by the RBI. However, the revocation of an
authorization may be done by the RBI after following the prescribed procedure in the FEMA
or the Regulations made there under. Section 13 of the FEMA details out the contraventions
and penalties, and the RBI has been empowered to compound certain contraventions under
Section 15 of the FEMA.
Banking Regulation & Supervision – Legal Background
 India has a variety of banks viz., banking companies (banks which are companies and
regulated by the Banking Regulation Act, 1949), State Bank of India (constituted by the State
Bank of India Act, 1955), Nationalised Banks (constituted by the Banking Companies
(Acquisition and Transfer of Undertakings) Act, 1970/ 1980), Regional Rural Banks
(constituted under the Regional Rural Banks Act, 1976) and co-operative banks (constituted
either under the Multi-State Co-operative Societies Act, 2002 or State Co-operative Societies
Acts). Although RBI is entrusted with the task of regulating and supervising all types of banks
in the country, the powers exercisable by it towards different banks are not uniform.
The power to regulate and supervise banking companies has been provided by the
provisions of the Banking Regulation Act, 1949 (BR Act, 1949) to the RBI. Although, the

22
Please see Section 1 of GS Act, 2006
23
Please see Section 12 of GS Act, 2006

8
preamble to the BR Act, 1949, states that it is an Act to consolidate and amend the law
relating to banking. The powers of RBI to formulate banking policy 24, regulate and supervise
banking business etc., are scattered across the BR Act, 1949. Section 5(ca) of the BR Act,
1949, states that banking policy means any policy, which is specified from time to time by
the RBI, in the interest of the banking system or in the interest of monetary stability or
sound economic growth, having due regard to the interests of the depositors, the volume of
deposits and other resources of the bank and the need for equitable allocation and the
efficient use of these deposits and resources. The appointment of chairman and whole-time
directors of a banking company shall not have effect, unless done with the previous approval
of the Reserve Bank25. Similarly, as a part of control over management, Section 36-AB of BR
Act, 1949, empowers RBI to appoint additional directors on the boards of banking
companies. Section 36-AA of the BR Act, 1949 enables RBI to remove executives, officers and
employees of a banking company under certain conditions. Moreover, the RBI has been
empowered under BR Act, 1949, to supersede the boards of banking companies.
Though it is not the role of the Reserve Bank to micro-manage the affairs of banks, it
has powers tor to control advances by banking companies 26. Section 22 of the BR Act, 1949
confers on RBI the power to issue licenses and also to cancel licenses of banking companies.
Another important regulatory power that has been vested in the RBI is the power to issue
directions to banking companies. Under Section 35-A of the BR Act, 1949, RBI has the power
to issue directions to banking companies in public interest or in the interest of banking policy
or to prevent the affairs of any banking company being conducted in a manner detrimental
to the interests of the depositors or in a manner prejudicial to the interests of the banking
company or to secure the proper management of any banking company.
The Banking Regulation (Amendment) Act, 2017 has provided powers to RBI to issue
directions to banking companies in relation to resolution of stressed assets 27. As part of the
supervisory powers, RBI has been empowered to inspect banking companies on its own or at
the instance of Central Government under the provisions of the BR Act, 1949 28. “Thus an
overall responsibility to find out the well-being of a banking company, in improving monetary
stability and economic growth as well as keeping in view the interests of depositors”, has
been left with the Reserve Bank of India29.

Only a few provisions which are mentioned in section 51 of the BR Act will apply to
State Bank of India, Nationalised Banks and Regional Rural Banks. In the case of co-operative
banks, the application of the provisions of the BR Act will be subject to the modifications
mentioned in section 56 of the very same Act.

24
Please see Section 5(ca) of the BR Act, 1949
25
Section 35B of the BR Act, 1949
26
See section 21 of RBR Act
27
Section 35AB of the BR Act.
28
Please see Section 35 of the BR Act, 1949
29
Janata Sahakari Bank Ltd. V/s. State of Maharashtra (AIR 1993 Bombay 252)

9
Regulation and Supervision of NBFCs – Legal Background
The regulation and supervision of non-banks is one of the critical functions that the
RBI has been entrusted with. Section 45-IA of the RBI Act mandates every non-banking
financial company to obtain a certificate of registration from the RBI and to have a net
owned fund as may be specified by the RBI in the Official Gazette, before commencing such
non
banking financial business.30 Further, as a part of regulation and supervision of non-banks,
the RBI has been conferred with the statutory powers to regulate or prohibit issue of
prospectus or advertisements soliciting deposits of money by non-banking financial
companies,31 power to determine policy and issue directions to non-banking financial
32
companies, etc. Further, the RBI has been empowered under Section 45-L of the RBI Act to
call for information and issue directions to non-banking financial companies for the reasons
stated therein. As a part of the supervisory control over the non-banking financial
companies, the RBI has the power to inspect them under Section 45-N of the RBI Act, 1934.
Regulation & Supervision of Co-operative banks – Legal Background
In terms of Article 246 of the Constitution of India, the legislative powers of the Union
and the State are given in three Lists, viz., the Union List the State List and the Concurrent
List respectively of Schedule VII to the Constitution. The entry relating to incorporation,
regulation and winding-up of Cooperative Societies fall in State List 33 whereas the entry
relating to banking fall in the Union List 34. This results in the duality of jurisdiction over
cooperative banks - by the Reserve Bank of India and the Registrar of Cooperative Societies.
In Janata Sahakari Bank Ltd. v. State of Maharashtra35, the Bombay High Court has held that
“though the control over management of Co-operative Society where it is Co-operative
Banking Society or otherwise is vested in the Registrar of Co-operative Societies, but insofar
as banking is concerned, by virtue of S.56 of the Banking Regulation Act, 1949, read with
S.35A of the Banking Regulation Act, 1949, it will be a subject with which the Reserve Bank
of India has full power”.
The Banking Regulation (Amendment) Ordinance, 2020 that was promulgated on
June 27, 2020 seeks to amend the Banking Regulation Act, 1949, with regard to cooperative
banks. The Ordinance states that the BR Act will not apply to primary agricultural credit
societies and cooperative societies whose principal business is long term financing for
agricultural development. Further, these societies shall not use the words ‘bank’, ‘banker’ or
‘banking’ in their name or in connection with their business, and act as an entity that clears
cheques. The Ordinance provides that a cooperative bank may issue equity shares,
preference shares, or special shares on face value or at a premium to its members or to any
other person residing within its area of operation. Further, it may issue unsecured
debentures or bonds or similar

30
Please read Chapter III-B of RBI Act, 1934 for detailed provisions
31
Please see Section 45-J of the RBI Act, 1934
32
Please see Section 45-JA of the RBI Act, 1934
33
Please see Entry No.32 of List II of the VII Schedule to the Constitution of India
34
Please see Entry No.45 of List I of the VII Schedule to the Constitution of India
35
AIR 1993 Bombay 252

10
securities with maturity of ten or more years to such persons subject to the prior approval of
the Reserve Bank of India (RBI), and any other conditions as may be specified by RBI. The
Ordinance adds that in case of a co-operative bank registered with the Registrar of Co
operative Societies of a state, the RBI will supersede the Board of Directors after consultation
with the concerned state government, and within such period as specified by it. However,
RBI may exempt a cooperative bank or a class of cooperative banks from certain provisions
of the Act through notification for such time period and under such conditions as may be
specified by the RBI36.

Regulation of Derivatives and Money Market Instruments – Legal Background

Chapter III-D was inserted in the RBI Act with effect from 9 th January 2007 by way of
an amendment to the RBI Act, 1934. In the said chapter, the Parliament of India thought it as
appropriate to introduce provisions relating to regulation of transactions relating to
derivatives, money market instruments, securities, etc. by the RBI. Sub-section (a) of Section
45U of the RBI Act defines derivative as an instrument to be settled at a future date, whose
value is derived from change in interest rate, foreign exchange rate, credit rating or credit
index, price of securities (also called ‘underlying’), or a combination of more than one of
them and includes interest rate swaps, forward rate agreements, foreign currency swaps,
foreign currency-rupee swaps, foreign currency options, foreign currency rupee options or
such other instruments as may be specified by the RBI from time to time. Similarly, money
market instruments have been defined to include call or notice money, term money, repo,
reverse repo, certificate of deposit, commercial usance bill, commercial paper and such
other debt instrument of original or initial maturity up to one year as the RBI may specify
from time to time. The power of RBI to regulate these money market instruments have been
provided under Section 45W of the RBI Act, which states that the RBI may, in public interest
or to regulate the financial system of the country to its advantage, determine the policy
relating to interest rates or interest rate products and give directions in that behalf to all
agencies or any of them, dealing in securities, money market instruments, foreign exchange,
derivatives, or other instruments of like nature as the RBI may specify from time to time.
Payment and Settlement Functions – Legal Background
 The Parliament of India enacted the Payment and Settlement Systems Act, 2007 (‘PSS
Act, 2007’) with an objective to provide for the regulation and supervision of payment
systems in India and to designate the Reserve Bank of India as the authority for that purpose
and for matters connected therewith or incidental thereto 37. Under Section 4 of the PSS Act,
2007, no person shall commence or operate a payment system except with an authorization
issued by the RBI. Similarly, under Section 8 of the PSS Act, 2007, RBI has the power to
revoke the authorization granted to any person if it contravenes any of the provisions of the
PSS Act or does not comply with regulations or fails to comply with the orders or directions
issued by the RBI or operates the payment system contrary to the conditions subject to
which the
36
[Link]
37
Preamble to the PSS Act, 2007

11
authorization was issued. The regulation and supervision of payment systems has been
conferred on the RBI by virtue of provisions of Chapter IV of the PSS Act, 2007. The
regulatory and supervisory controls include power to determine standards for the
functioning of payment systems38, power to call for returns 39, documents40 or other
information41, power to enter and inspect payment systems 42, power to carry out audit and
inspections43, power to issue directions44, etc.

Credit Information Companies Regulation Functions

Reserve Bank has been entrusted with the task of regulation and supervision of Credit
Information Companies under the Credit Information Companies (Regulation) Act, 2005.
Three institutions form the essential pillars of the Act, viz. the Credit Information Companies,
the Credit Institutions and Specified Users. The Act empowers the Reserve Bank to issue
directions to Credit Information Companies and also to inspect them. The Reserve Bank is
also authorised by the statute to determine policy in relation to functioning of credit
information companies.
Consumer Protection and promotion Functions – Legal Background
Protection of the interests of the depositors is one of the vital mandates of the RBI.
The various provisions in the RBI Act, 1934, BR Act, 1949, etc., are replete with the phrases
like “in the interests of depositors” wherever it entrusts powers to the RBI45. Apart from
depositors, the resolution of grievances of customers who deal with its regulated entities is
also important for the Reserve Bank of India. Reserve Bank of India has formulated three
Ombudsman Schemes for covering operations of banks, NBFCs and payment systems.
Reserve Bank of India attaches high importance to its promotional and
developmental roles. Clause (8AA) of section 17 of the RBI Act states that the promoting,
establishing, supporting or aiding in the promotion, establishment and support of any
financial institution - whether as its subsidiary or otherwise - is a business which can be
transacted by the Reserve Bank. Section 54 of that Act points to the developmental role of
RBI in matters of rural development. It provides that the Reserve Bank may maintain expert
staff to study various aspects of rural credit and development and in particular it may (i)
tender expert guidance and assistance to the National Bank; and (ii) conduct special studies
in such areas as it may consider necessary to do so for promoting integrated rural
development.
Conclusion
The powers and functions of the RBI have further widened consequent upon the
amendments to the Securitisation and Reconstruction of Financial Assets and Enforcement
of

38
Please read Section 10 of the PSS Act, 2007
39
Please read Section 12 of the PSS Act, 2007
40
Please read Section 12 of the PSS Act, 2007
41
Please read Section 12 of the PSS Act, 2007
42
Please read Section 14 of the PSS Act, 2007
43
Please read Section 16 of the PSS Act, 2007
44
Please read Section 17 of the PSS Act, 2007
45
Source: RBI Website

12
Security Interests Act, 2002 and the National Housing Bank Act, 198747. Although, the
46

object and purpose of establishment of the RBI, as could be observed from the preamble to
the RBI Act, 1934, is to regulate the issue of Bank notes and the keeping of reserves with a
view to securing monetary stability and also to formulate monetary policy with an objective
to control inflation,48 the multifarious functions which the RBI has been entrusted with
through various legislations shows that the central bank of the country has much wider
mandates than what have been summarized in the preamble to the RBI Act, 1934. The
regulation and supervision of banks, non-banks, co-operative banks, management of
currency, management of public debt of the Union and the State, management of foreign
exchange, acting as banker to banks, banker to governments, protection of interests of
depositors, spreading of financial literacy, etc., are all part of achieving the common goal as
enshrined in the preamble to the RBI Act, 193449.
46
Enforcement of Security Interest and Recovery of Debts Laws and Miscellaneous Provisions (Amendment) Act, 2016
47
The Finance (No.2) Act, 2019
48
Preamble to the Reserve Bank of India Act, 1934
49
Report of the Commission on FSLRC in the year 2013 by Shri B.N. Srikrishna, Chairman

13
Chapter 3: Monetary Policy Framework
I. Monetary Policy Making in India
Definition, objectives and tools
Central banks derive their objectives from their respective mandates. Monetary
Policy could have either a single objective of price stability or multiple objectives. In the
literature and in practice, price stability is considered as the dominant objective of monetary
policy. For countries, which have adopted inflation targeting framework, price stability is the
core objective. Monetary policy refers to the use of monetary instruments under the control
of the central bank to influence variables, such as interest rates, money supply and
availability of credit, with a view to achieving the objectives of the policy.
Before the amendment of the RBI Act in May 2016, the Preamble read as “to regulate
the issue of Bank notes and keeping of reserves with a view to securing monetary stability in
India and generally to operate the currency and credit system of the country to its
advantage”. Accordingly, the objectives of monetary policy evolved as maintaining price
stability and ensuring adequate flow of credit to the productive sectors of the economy.
With progressive liberalization and increasing globalization of the economy, maintaining
orderly conditions in financial markets emerged as an additional policy objective. Thus, over
time, the role of monetary policy in India evolved to maintain a judicious balance between
price stability, economic growth and financial stability. However, pursuant to the
amendment to RBI Act, 1934, in May 2016, the primary objective of monetary policy is to
maintain price stability while keeping in mind the objective of growth. The amended
Preamble to RBI Act reads, inter alia, as follows:
“to regulate the issue of Bank notes and keeping of reserves with a view to securing
monetary stability in India and generally to operate the currency and credit system of
the country to its advantage”
“AND WHEREAS it is essential to have a modern monetary policy framework to meet
the challenges of an increasing complex economy;
AND WHEREAS the primary objective of the monetary policy is to maintain price
stability while keeping in mind the objective of growth”.

There are various direct and indirect instruments used for implementing monetary
policy including Repo Rate, Reverse Repo Rate, Marginal Standing Facility (MSF) under the
Liquidity Adjustment Facility (LAF), Bank Rate, Cash Reserve Ratio (CRR), , Open Market
Operations (OMOs) and Market Stabilization Scheme (MSS). They are briefly explained
below:
Repo Rate: The (fixed) interest rate at which the Reserve Bank provides overnight liquidity to
banks against the collateral of government and other approved securities under the LAF. It is
the policy rate decided by the Monetary Policy Committee (MPC).

14
Reverse Repo Rate: The (fixed) interest rate at which the Reserve Bank absorbs liquidity, on
an overnight basis, from banks against the collateral of eligible government securities under
the LAF.
Liquidity Adjustment Facility (LAF): The LAF consists of overnight as well as term
repo/reverse repo auctions. Progressively, the Reserve Bank has increased the proportion of
liquidity injected under variable rate repo auctions across the range of tenors. The aim of
term-repo is to help develop the inter-bank term-money market, which in turn can set
market-based benchmarks for pricing of loans and deposits, and hence improve transmission
of monetary policy. The RBI also conducts variable rate repo/reverse-repo auctions, as
necessitated by market conditions.
Marginal Standing Facility (MSF): A facility under which scheduled commercial banks can
borrow additional amount of overnight money from the Reserve Bank against their excess
SLR securities and also by dipping into their SLR portfolio up to a specified limit at a penal
rate of interest. This provides a safety valve against unanticipated liquidity shocks to the
banking system.
Policy Corridor: The MSF rate as the ceiling and the Reverse Repo rate asthe floor
determines the policy corridor. The objective of liquidity management operations is to keep
the WACR closely aligned to the policy repo rate.
Bank Rate: It is the standard rate at which the Reserve Bank is ready to buy or rediscount
bills of exchange or other commercial papers. The Bank Rate is published under Section 49
of the Reserve Bank of India Act, 1934. This rate has been aligned to the MSF rate and,
therefore, changes automatically as and when the MSF rate changes alongside policy repo
rate changes.
Cash Reserve Ratio (CRR): The amount that a bank is required to maintain with the Reserve
Bank as a specified proportion (per cent) of its Net Demand and Time Liabilities (NDTL) for a
fortnight starting from a Saturday till the next reporting Friday. The proportion required to
be maintained is notified by the Reserve Bank from time to time. The maintenance of CRR
balances over a fortnight is on an average daily basis with a stipulated minimum daily
maintenance notified by the Reserve Bank.
Open Market Operations (OMOs): These include both repurchase (repo or reverse repo)
operations and outright purchase and sale of government securities, for injection and
absorption of liquidity, respectively.
Market Stabilisation Scheme (MSS): This instrument for monetary management was
introduced in 2004. Surplus liquidity of a more enduring nature arising from large capital
inflows is absorbed through sale of short-dated government securities and treasury bills.
Depending upon the nature of the surplus liquidity (long term/ short term) the securities
 15
under MSS (long term dated securities/ short term CMBs) are issued. The cash so mobilised
is held in a separate government account with the Reserve Bank50.

II. Evolution of Monetary Policy Framework in India

In order to attain the objectives of monetary policy, it is necessary to have a
consistent policy framework. Broadly, monetary policy framework consists of objectives,
operating procedure and governance arrangements.

• Objectives are the aims of the monetary policy, which are goal variables or nominal
anchors and long-term in scope but are not directly under the control of the central bank. As
a result, central banks strive to achieve these objectives only indirectly by targeting
intermediate and operating targets, which bear a stable relationship with the ultimate
objectives, through instruments which are under their direct control. The choice of the
operating target is crucial as this variable is at the beginning of the monetary transmission
mechanism. Similarly, the selection of intermediate targets is conditional upon the channels
of transmission – the process through which monetary policy actions impact the ultimate
objectives.

• Operating procedure essentially deals with how the central bank intends to influence
the operating target and thereby the intermediate target through its liquidity management
operations. Therefore, the operating procedure is essentially the day-to-day management of
liquidity conditions consistent with the overall stance of the monetary policy. In other words,
operating procedure is also called the nuts and bolts of monetary policy, the “plumbing in
the architecture” (Patra et al., 2016).

• Governance arrangements primarily deal with the process of decision making and
focus on responsibilities, powers and accountability of the monetary authority.
From the perspective of global best practices, historically, bank reserves and short
term interest rates have evolved as the two dominant operating targets. However, the focus
shifted to short-term interest rates in early 1990s, reflecting greater significance of interest
rates in monetary transmission mechanism as markets developed in a deregulated
environment. Consequently, the overnight rate emerged as the most commonly pursued
operating target in the conduct of monetary policy.
India's monetary policy framework has undergone several transformations reflecting
underlying macroeconomic and financial conditions. During 1971-1985, the monetisation of
the fiscal deficit exerted a dominant influence on the conduct of monetary policy. The pre
emption of resources by the public sector and the resultant inflationary consequences of
high public expenditure necessitated frequent recourse to the CRR to neutralize the
secondary
50
Key features of the scheme include, inter alia (i) under the scheme, the Government issues Treasury Bills and/or dated
securities in addition to the normal borrowing requirements, for absorbing liquidity from the system; (ii) the Treasury Bills/dated
securities issued under the MSS have all the attributes of regular Treasury Bills and dated securities. These securities are
eligible for Statutory Liquidity Ratio (SLR), repo and Liquidity Adjustment Facility (LAF); (iii) the amounts raised under the MSS
are held in a separate identifiable cash account titled the Market Stabilisation Scheme Account (MSS Account) maintained and
operated by the Reserve Bank; (iv) the amounts credited into the MSS Account are be appropriated only for the purpose of
redemption and / or buy back of the Treasury Bills and / or dated securities issued under the MSS.
 16
effects of monetary expansion. Financial repression in the form of interest rate prescriptions,
statutory pre-emptions and directed credit partly crowded out the private sector from the
credit market. Against this backdrop, the Committee to Review the Working of the Monetary
System (Chairman: Dr. Sukhamoy Chakravarty) recommended in 1985 a new monetary policy
framework based on monetary targeting with feedback, drawing on empirical evidence of a
stable demand function for money.
Monetary Targeting Framework
Under this framework, broad money became the intermediate target while reserve
money was one of the main operating instruments for achieving control on broad money
growth. Accordingly, monetary (M3) projection was made consistent with the expected real
GDP growth and a tolerable level of inflation. Technically, in a simple form, if expected real
GDP growth was 6 per cent, the income elasticity of demand for money was 1.5 and a
tolerable inflation was 5 per cent, the M3 expansion target was set at 14 per cent [M3
growth = 1.5(6) +5 =14 percent] (Mohanty, 2010). This framework was in operation during
mid-1980s to 1997-98. Analysis of the money growth outcomes during the monetary
targeting regime indicates that targets were rarely met. The biggest impediment to
monetary targeting was lack of control over RBI's credit to the central government, which
accounted for the bulk of reserve money creation.
With economic and financial sector reforms in the 1990s, there was shift in financing
government and the commercial sector with increasing reliance on market-determined
interest rates and exchange rate. RBI was able to move away from direct instruments to
indirect market-based instruments. The SLR and CRR were gradually brought down to 25 per
cent and 9.5 per cent, respectively by 1997. Further, as the pace of trade and financial
liberalization gained momentum in the 1990s, the efficacy of broad money as an
intermediate target was re-assessed. Financial innovations and external shocks emanating
from swings in capital flows, volatility in the exchange rate and global business cycles
imparted instability to the demand for money. There was also increasing evidence of
changes in the underlying transmission mechanism of monetary policy with interest rate and
the exchange rate gaining importance vis-à-vis quantity variables. Against this backdrop, in
India, the search for an alternative monetary framework ended in switching over to Multiple
Indicator Approach in 1998-99.
Multiple Indicator Approach
The RBI adopted a 'multiple indicator approach' in April 1998 with a greater emphasis
on rate channels for monetary policy formulation relative to quantity instruments. Under this
approach, a number of quantity variables such as money, credit, output, trade, capital flows
and fiscal position as well as rate variables such as rates of return in different markets,
inflation rate and exchange rate were analysed for drawing monetary policy perspectives.
The multiple indicator approach was informed by forward looking indicators since the early
2000s drawn from the RBI's surveys of industrial outlook, credit conditions, capacity
utilization,
 17
professional forecasters, inflation expectations and consumer confidence. The RBI continued
to give indicative projections of key monetary aggregates.
The multiple indicator approach seemed to work fairly well from 1998-99 to 2008-09,
as reflected in the average real gross domestic product (GDP) growth rate of 7.1 per cent
associated with average inflation of about 5.5 per cent in terms of both the wholesale price
index (WPI) and the Consumer Price Index (CPI). Subsequently, however, there was a
mounting public censure of the efficacy and even the credibility of this framework as
persistently high inflation and weakening growth co-existed, i.e., visible signs of stagflation.
Use of a large panel of indicators was also not providing a clearly defined nominal anchor for
monetary policy. It also left policy analysts unclear about what the RBI looks at while taking
policy decisions. Since 2007 several high-level Committees in India have highlighted that the
RBI must consider switching over to inflation targeting (RBI, 2014).
Flexible Inflation Targeting
Against this backdrop, the RBI constituted an Expert Committee to Revise and
Strengthen Monetary Policy Framework (Chairman: Dr. Urjit R. Patel) on September 12, 2013
to recommend what needed to be done to revise and strengthen the current monetary
policy framework with a view to, inter alia, making it transparent and predictable. The
Expert Committee submitted its report in January 2014 and set the stage for a move towards
the adoption of a flexible inflation targeting framework for monetary policy in India. In the
flexible inflation targeting framework, the policy (repo) rate is set, based on an assessment
of the current and evolving macroeconomic situation, with the aim of achieving the inflation
target on an average over the business cycle, while accommodating growth concerns in the
short run (RBI, 2014). Once the repo rate is announced, the operating framework designed
by the RBI envisages liquidity management on a day-to-day basis through appropriate
actions, which aim at anchoring the operating target – WACR – around the repo rate. The
details of the operational framework of monetary policy is elaborated in the next chapter
“Market Operations”. These changes in money market rates then get transmitted to the
entire financial system, which, in turn, influences aggregate demand – a key determinant of
inflation and growth.
Prior to the amendment to the RBI Act in May 2016, the flexible inflation targeting
framework, as recommended by the above-mentioned Committee, was governed by an
Agreement between Government of India and Reserve Bank of India in February, 2015. The
amendment of the RBI Act in May 2016 provided the statutory basis for the implementation
of the flexible inflation targeting framework. As per the amended Act, the inflation target
would be defined in terms of all India Consumer Price Index (CPI) and the inflation target
would be set by the Government of India, in consultation with the Reserve Bank, once in
every five years. The failure to achieve the inflation target was defined as when: (a) the
average inflation is more than the upper tolerance level of the inflation target for any three
consecutive quarters; or (b) the average inflation is less than the lower tolerance level for
any three consecutive quarters. In the event of a failure to meet the inflation target, the
Reserve
 18
Bank has to set out in a report to the Central Government: (a) the reasons for failure to
achieve the inflation target; (b) remedial actions proposed to be taken by the Bank; and (c)
an estimate of the time-period within which the inflation target shall be achieved pursuant
to timely implementation of proposed remedial actions. The amended Act requires the
Reserve Bank to publish, once in every six months, a document called the Monetary Policy
Report that explains (a) the sources of inflation; and (b) the forecast of inflation for 6-18
months ahead. The amended RBI Act came into effect in June 2016. In pursuance of the
amended Act, in August 2016, the Central Government notified in the Official Gazette an
inflation target of 4 per cent Consumer Price Index (CPI) inflation for the period from August
5, 2016, to March 31, 2021, with the upper tolerance limit of 6 per cent and the lower
tolerance limit of 2 per cent.
Section 45ZB of the amended RBI Act, 1934 also provides for a six-member Monetary
Policy Committee (MPC) to be constituted by the Central Government by notification in the
Official Gazette. Accordingly, a six-member Monetary Policy Committee (MPC) was
constituted on September 29, 2016, with three internal and three external members, to
determine the policy rate to achieve the inflation target. Under the amended RBI Act, the six
member committee is required to meet at least four times in a year. Three external MPC
members are appointed for a period of 4 years. Each member of the MPC has one vote, and
in the event of an equality of votes, the Governor of the RBI has a second or casting vote. The
resolution adopted by the MPC is published after conclusion of every meeting of the MPC in
accordance with the provisions of Chapter III F of the amended Reserve Bank of India Act,
1934. On the 14th day, the minutes of the proceedings of the MPC meeting are published
which include (a) the resolution adopted by the MPC; (b) the vote of each member on the
resolution, ascribed to such member; and (c) the statement of each member on the
resolution adopted. Till May 2020, the MPC met 23 times since its first meeting in October
2016.
The Reserve Bank's Monetary Policy Department (MPD) assists the MPC in
formulating the monetary policy. Views of key stakeholders in the economy, and analytical
work of the Reserve Bank contribute to the process for arriving at the decision on the policy
repo rate. The Financial Markets Operations Department (FMOD) operationalises the
monetary policy, mainly through day-to-day liquidity management operations. The Financial
Markets Committee (FMC) meets daily to review the liquidity conditions so as to ensure
close alignment of the operating target - the weighted average call money rate (WACR) –
with the policy repo rate.
During the global financial crisis, advanced economies suffered steep and persistent
fall in the real GDP. The advanced economies’ central banks couldn’t rely solely on
conventional monetary policy, i.e., reduction in policy rate due the zero-lower bound (ZLB)
constraint of the policy rate leading them to introduce unconventional monetary policies to
revive the economy. Unconventional monetary policy broadly consists of quantitative easing
(QE) and forward guidance (FG) measures. Quantitative easing measures refer to the asset
purchase programs of the advanced central banks’, which drastically increased the total
assets
 19
as well as altered the composition of assets in the central banks’ balance sheet unlike the
conventional monetary policies, which had negligible impact on the central banks’ balance
sheet. Forward guidance refers to the use of central bank communication to manage
expectations about the future course of policy, thereby attempting to influence the financial
decisions of the household and firms.
The RBI has started implementing some of the unconventional monetary policy
measures from December 2019 onwards to arrest the economic slowdown and improve the
investment cycle in India. The reliance on unconventional monetary policy measures
increased in February 2020 to reduce the impact of Corona virus outbreak on economic
activity. Operation twist is one of the unconventional monetary policy measures adopted by
the RBI since December 2019 under which the RBI simultaneously sells short-term securities
and buys long-term securities through open market operations (OMO). This measure is
aimed at bringing down the long-term benchmark yield rate. RBI has also introduced
measures aimed at durable liquidity injections to the banking system through long-term
repo operations (LTRO) with the tenor of one year and three year at reasonable cost, i.e.,
the repo rate. RBI has also implemented sector-specific measures such as exemptions from
the cash reserve ratio (CRR) for the equivalent of incremental credit disbursed by banks as
loans in certain select areas/segments and targeted LTROs (TLTROs) to provide liquidity to
sectors and entities which are experiencing liquidity constraints and/or hindrances to
market access51.

As explained above, monetary policy making in India has evolved over the years. In
the last three decades, key changes related to the adoption of monetary targeting
framework, transition to multiple indicator approach and adoption of inflation targeting.
III. Monetary Policy Transmission
Monetary transmission is the process through which monetary policy impulses in the
form of policy rate changes by a central bank are transmitted to the entire spectrum of
interest rates such as money market rates, bond yields, bank deposit and lending rates and
asset prices such as stock prices and house prices. Various economic agents such as
households, firms and the government respond to these interest rate changes by adjusting
their spending behaviour. This alters aggregate demand of households and firms and by
aligning it with aggregate supply conditions, the broader macroeconomic policy objectives
such as price stability and sustainable growth of the economy are achieved. The whole
process takes months, sometimes, more than a year.
The empirical evidence for India suggests that monetary policy actions are felt with a
lag of 2-3 quarters on output and with a lag of 3-4 quarters on inflation, and the impact
persists for 8-12 quarters. Transmission takes place through various ‘channels’, namely (i)
interest rate channel, (ii) credit channel, (iii) exchange rate channel, and (iv) asset price
channel52. According to many studies, the interest rate channel has been found to be the

51
Detailed changes in the liquidity management of RBI is provided in the next chapter “Market Operations”.
52
See RBI (2014)
 20
strongest in India. The efficacy of monetary policy depends on the magnitude and the speed
with which policy rate changes are transmitted to the ultimate objectives of monetary policy,
viz., growth and inflation. In a bank dominated system like India, the transmission to banks’
lending rates is the key to the successful implementation of monetary policy. Hence, it has
been the endeavour of the Reserve Bank to strengthen the monetary transmission by
focusing on the design of the lending interest rates of the banking system. However, the
issue of transmission from the policy rate to banks’ lending rates has all along been a matter
of concern. The transmission to banks’ lending rates has been impeded by a variety of
factors and thus the impact of policy change on economic activity and inflation remained
muted.
To address this concern, the Reserve Bank has refined the interest rate setting
methodology of banks from time to time. Effective October 1, 2019, in pursuance of the
recommendations of the Internal Study Group (RBI, 2017), the Reserve Bank, mandated that
all scheduled commercial banks (excluding regional rural banks) should link all new floating
rate personal or retail loans and floating rate loans to Micro and Small Enterprises (MSEs) to
the policy repo rate or 3-month T-bill rate or 6-month T-bill rate or any other benchmark
market interest rate published by Financial Benchmarks India Private Ltd. (FBIL). With a view
to further strengthening monetary transmission, Reserve Bank directed the banks to link
their pricing of loans for the medium enterprises also to an external benchmark effective
April 1, 2020. Under this benchmarking system, banks are free to choose the spread over the
benchmark rate, subject to the condition that the credit risk premium may undergo change
only when the borrower’s credit assessment undergoes a substantial change, as agreed upon
in the loan contract. External benchmarks are transparent as they are available in the public
domain and hence easily accessible to the borrowers. Subsequent to the introduction of an
external benchmark system, monetary transmission has improved to the sectors where new
floating rate loans have been linked to the external benchmark.
References
Acharya, V. V. (2017). “Monetary Transmission in India: Why is it important and why hasn’t it worked
well?”, Inaugural Speech delivered at the Aveek Guha Memorial Lecture organised by Tata Institute of
Fundamental Research (TIFR) at Homi Bhabha Auditorium, Mumbai, November 16. Mohanty. D
(2010). “Monetary Policy framework in India: Experience with Multiple Indicators Approach” RBI
Bulletin, March
Patra M.D., Kapur M., Kavediya R., Lokare S.M. (2016). “Liquidity Management and Monetary Policy:
From Corridor Play to Marksmanship”, in Ghate C., and Kletzer K. (eds) Monetary Policy in India,
Springer, New Delhi, 257-296.
RBI (1985). “Report of the Committee to Review the Working of the Monetary System” (Chairman:
Dr. Sukhamoy Chakravarty).
……. (2006). Report on Currency and Finance 2004-05.
……. (2014). “Report of the Expert Committee to Revise and Strengthen the Monetary Policy
Framework” (Chairman Dr. Urjit R Patel), January.
……. (2017). “Report of the Internal Study Group to Review the Working of the Marginal Cost of
Funds Based Lending Rate System” (Chairman: Dr. Janak Raj), October.
 21
Chapter 4: Market Operations
The objective, framework and implementation of the market operations of the RBI are
discussed in this Chapter, which is divided into two sections. The first section deals with
Monetary Policy Operations and the second section deals with the Foreign Exchange
Operations ofRBI.
I. Monetary Policy Operations
The objective of monetary policy operations isto enable the transmission of monetary
policy to the financial system. The MPC determines the policy interest rate, and the policy
stance to achieve the inflation target. The operating target of monetary policy isthe weighted
average call rate (WACR), which is a volume weighted rate of overnight transactions
undertaken in Call money market (uncollateralized segment of the money market with banks
and primary dealers as participants). By conducting market operations as per the liquidity
management framework designed by it, the RBI endeavours to ensure that the operating
target, i.e., the WACRis aligned topolicyrateonadailybasis.
The liquidity management framework of RBI comprises of Liquidity Adjustment
Facility (LAF) and Marginal Standing Facility (MSF) for management of transient liquidity, i.e.,
liquidity surplus or deficit of temporary nature. LAF includes repos and reverse repos of
various tenors conducted by the RBI. MSF is an additional facility in which banks can borrow
rupee funds from RBI at a higher rate against eligible collateral including by dipping below
the statutory SLR up to a specified limit. For managing liquidity of enduring nature, i.e.,
liquidity surplus or deficit, which is persisting in the banking system for a longer period, due
to various factors, instruments like Long Term Repo/Reverse Repo Operations
(LTROs/LTRROs), Open Market Operations (OMOs) by outright purchase and sale of
government securities, changes in required Cash Reserve Ratio (CRR), Market Stabilisation
Scheme (MSS), USD/INR swaps auctions (Forex Swap Auctions) are used.
The CRR is a direct instrument which immediately impacts the system liquidity. If CRR
is increased, banks must maintain higher balances in their current account with RBI, thereby
creating liquidity deficit in the banking system. Similarly decrease in CRR has the immediate
impact of creating liquidity surplus in the banking system. Other instruments of liquidity
management are detailed in the ensuing paragraphs.
Liquidity Management Framework
An RBI Internal Working Group has reviewed the liquidity management framework and
published its report in September 2019. The Group has continued with the existing objectives
of maintaining the call money rate close and consistent to the policy rate and not
undermining the price discovery in the inter-bank money market. The Group recommended
the continuance of a corridor system with the call money rate as the target rate but with
greater flexibility in deciding about the appropriate level of liquidity deficit or surplus
required in the banking system based on financial conditions. Other recommendations were
regarding
 22
minimizing the number of operations for greater efficiency, discontinuance of assured
liquidity of up to 1% of NDTL, inclusion of longer term repo operations in addition to existing
tools for durable liquidity management and dissemination of more information on liquidity
management.
Based on the recommendations of the above report, RBI has updated its Liquidity
Management Framework vide RBI notification dated February 6, 2020, as tabulated below.
Sl. No. Instrument Quantum Periodicity/Timing

A. Instruments under LAF framework to manage short-term/transient liquidity

1. 14-day variable-rate Auction amount is On reporting Friday

repo/ reverse repo decided by RBI and a (2.30 p.m. to 3.00
auction single auction (either repo p.m.)
or reverse repo) is
(Main operation)
conducted based on the
assessment of liquidity
conditions by RBI.

2. Variable Rate Term Repo/ The auction amount is Discretionary

Reverse Repo auction decided by RBI based on
(Tenor: overnight and up an assessment of the
to 13 days) liquidity conditions.
(Fine-tuning operations)

3. Fixed Rate Reverse Repo No restriction on amount Daily between 5.30

p.m. and 11.59 p.m.*

4. Marginal Standing Individual banks can draw

Facility (MSF) funds up to Excess SLR + 2
per cent below SLR.

5. FX Swaps The amount is decided by Discretionary

RBI, based on the
assessment of the
liquidity conditions.

23
Sl. No. Instrument Quantum Periodicity/Timing
 6. Standing Deposit The operational details are awaited.
Facility (SDF)

B. Instruments to manage durable liquidity

7. Long Term Variable The auction amount is Discretionary

Rate Repo Operation decided by RBI, based on
(LTRO) an assessment of the
liquidity conditions.
Tenor: beyond 14 days

8. Long Term Variable

Rate Reverse Repo
Operation (LTRRO)

Tenor: beyond 14 days

9. FX Swap Auctions The auction amount is Discretionary

decided by RBI, based on
an assessment of the
liquidity conditions.

* The window was extended from 09:00 hrs to 23:59 hrs daily w.e.f. March 31, 2020 as an
interim and temporary measure to provide greater flexibility in liquidity management by
market participants in the wake of the disruptions caused by COVID-19.
Key features of repo/reverse repo/MSF conducted under LAF are summarised
below: Discretion with RBI

While the main operation is a 14-day variable rate repo or reverse repo (depending
upon the prevailing liquidity conditions) at the start of the reporting fortnight under the
revised liquidity framework, RBI has the discretion to conduct overnight/ longer term, repo/
reverse repo auctions at variable/fixed rates depending on market conditions and other
relevant factors. For using this discretion, RBI considers its assessment of the prevailing
liquidity conditions based on available data and forecast of liquidity. The details of this
mechanism are elaborated later in this chapter.
Rate of interest
The rate of interest applicable for repo is the policy rate decided by the MPC from
time to time. The reverse repo rates and the MSF rates are linked to the policy rate and are
decided by RBI from time to time. For variable-rate repo and reverse repo auctions, the
applicable rate of interest will be the cut-off as decided by RBI, based on the bids/offers

24
received.
Securities eligible for collateral
SLR-eligible and unencumbered Government of India dated securities (including oil
bonds)/Treasury Bills and State Development Loans (rated and unrated) are considered as
eligible securities for repo/ MSF and reverse repo operations. The market value of securities
on the day of operation is reckoned to calculate collateral requirement for repo/MSF/reverse
repo operations. The RBI also has the option to revalue securities held as collateral at pre
determined intervals as is currently done for LTROs & TLTROs to ensure that lending remains
adequately collateralised.
Margin Requirement
A margin is applied in respect of the eligible securities, which effectively ensures that
the borrower using the repo or MSF window to borrow Rupee funds has to provide extra
collateral. For example; if the margin is 5 percent and the market participant borrowing from
repo window would have to provide ₹105 crore worth of eligible securities to borrow ₹100
crore Rupees.
Mechanics of operations
• The bid/offer is submitted electronically in the Core Banking System (e- Kuber) ofRBI
by the members within the stipulated time. Settlement of reverse repo/MSF transactions is
automatic and immediate afterthe placement ofthe bid/offerintheCBS.
• For variable rate operations, settlement is done after announcement of results of the
auction. Results of the operations are announced through Press Release on RBI website.
Decision regarding cut-off for Variable-Rate auctions
• Variable-rate repo: There is no restriction on the number of bids by banks. Banks can
bid up to the notified amount. Once the bidding time is over, all the bids are arranged in
descending order of the quoted rates and the cut-off rate is arrived corresponding to the
notified amount of the auction. Successful bidders would be those who have placed their
bids at or above the cut-off rate. If there is more than one successful bid at the cut-off rate,
then pro-rata allotment is done. No bids are accepted at or below the prevailing repo rate.
• Variable-rate reverse repo: The mechanics of a variable-rate reverse-repo auction is
opposite of the mechanics for repo auctions. In this case, no offers areaccepted ator above
theprevailing repo rate.
How does the LAF corridor work?
To ensure that the WACR does not deviate too much from the policy repo rate, a
corridor system with the reverse repo as floor and MSF as ceiling is maintained. By accessing
the MSF window, banks can borrow Rupee funds from RBI by providing acceptable securities

25
as collateral. By accessing the reverse repo window, banks can lend Rupee funds to RBI, in
exchange for collateral securities. The important point to note here is that both MSF and
reverse repo rates are linked to the policy repo rate set by the MPC with MSF rate being
upper bound of the corridor and reverse repo rate being the lower bound of the corridor.
The RBI has the discretion to decide the width of the corridor. Forthe current policy rates
please refer to the RBI website.
Banks can also borrow and lend Rupee funds from other market participants in the
money market. Therefore, before availing the RBI facility, banks would consider the available
options for borrowing and lending in other segments ofthe money marketsuch as call
money, tri-party repo53, market repo, etc. An important factor, which will influence the
decision of the individual banks to borrow or lend shorttermfunds from/to RBIor
othersegments of the money market would be the interest rate. While, banks also consider
various aspects such as the requirement of collateral securities, ease of operations,
availability, tenor, etc., interest rate level is the most important factor which enables
alignment of WACR with the policy repo rate.
Let us understand this with an example. XYZ bank needs to lend its surplus funds. The
bank would try to lend to other participants in money market. In a situation of system level
liquidity surplus (more lenders than borrowers), the rate in the money market will fall.
However, given that banks have the option of deploying their excess funds in the RBI’s
reverse repo facility without any limit, the reverse-repo rate sets a floor to the interbank
rates as a bank will not lend it to another market participant at a rate below the reverse-
repo rate.
Similarly, let us suppose XYZ bank needs to borrow overnight Rupee funds. The bank
would try to borrow from other participants in money market. In a situation of system level
liquidity deficit (more borrowers than lenders), the rates could increase in the market.
However, given that banks have the option of borrowing funds under MSF window of RBI,
the MSF rate sets the ceiling as banks typically would not borrow from other market
participants at a rate higher than the MSF rate. However, the amount of borrowing from
MSF window is restricted by the availability of free collateral securities with the bank i.e.
eligible securities held in excess of SLR requirements plus allowance given to banks to let
their SLR holdings fall below the statutory requirement to the extent permitted by RBI.
Therefore, in a scenario of huge system level liquidity deficit, it is possible that the money
market rates can breach the ceiling and go beyond the MSF rate. However, such a scenario is
only expected in extraordinary circumstances.
A narrow corridor limits the possibility of huge deviations of the money market rates
from the policy Repo rate and helps in anchoring the WACR to the policy repo rate, while a
wider corridor allows greater room for rates to fluctuate and incentivises market
development.

53
Tri-Party Repo is a money market instrument provided by CCIL in which market participants can borrow and lend short term
rupee funds against eligible collateral securities. CBLO segment of the money market has been discontinued and replaced with
Triparty Repo with effect from November 05, 2018

26
How is the WACR aligned to the policy repo rate?
In periods of huge surplus liquidity, the call rates will trend towards lower bound of
the LAF corridor, the reverse repo rate. Similarly, in periods of huge liquidity deficit,the
callrateswill be biasedtowardsthe upper bound, i.e.,MSF rate. To ensure that the WACR is
anchored to the repo rate, RBI uses fine tuning operations, i.e., the discretionary variable-
rate repo and reverse repo auctions. The amount and timing is decided by RBIdepending
upon its assessment
of the liquidity conditions. RBI also continuously monitors the money market rates during
the market hours and conducts fine-tuning operations, as and when needed, to achieve the
objective of keeping the WACR close to the policy rate. For example, if the WACR is close to
the reverse-repo rate, it means that there is surplus in the system liquidity. Let us assume
that liquidity estimation including feedback from the market participants suggests that
about ₹50000 crore has come into the system due to unanticipated government spending.
In such a scenario, the announcement of an additional variable rate reverse repo auction for
about ₹50000 crore, will help in supporting the market rates and pushing them higher,
bringing it closer to the policy repo rate. Similarly, in a situation of a large deficit in the
system, when the WACR is trending towards the MSF Rate, an announcement of an
additional variable-rate repo auction for sufficient amount will pull the WACR lower and align
it with the repo rate. To ascertain the amount, tenor and timing of operations, the
assessment of the system-level liquidity on an ongoing basis is very important.
How is the System level liquidity assessed by RBI?
The important factors considered for assessment of the system level liquidity can be
classified into known factors and unknown factors. On a day-to-day basis, information
aboutthe amount and impact of known factors is readily available with certainty. Some
examples of known factors are reversal of outstanding RBI operations under LAF, settlement
of OMOs, settlement of forex operations of RBI, government bond redemptions, coupon
payments, primary auctions, etc. Information about the amount and impact of unknown
factors is not readily available and it needsto be assessed orforecasted. Some examples of
unknown factors are the extent of banks maintenance of reserves on any given day, changes
in currency in
circulation and expenses by the Central Government. Forecasting, therefore, relies on past
data as well as information gathered from informal communications with
government/banks. For arriving at the net impact on system liquidity, both known and
unknownfactorsmust beconsidered.
The liquidity management framework in India stands on two broad mutually
reinforcing pillars offorward looking assessment54.

• Pillar-I is an assessment of the likely evolution of system-level liquidity demand based

on near-term (four to six weeks) projections of autonomous drivers of liquidity. The core of
Pillar I is near-term forecasts of autonomous drivers of liquidity, particularly demand for

54
Dr. Urjit R. Patel. (2014). Expert Committee to Revise and Strengthen the Monetary Policy Framework. Mumbai: Reserve
Bank of India

27
currency (which reflects behaviour of households), demand for excess reserves (which
reflects behaviour of the banking system), and the central government's balances with the
RBI (which depends on cash flows of the Government). For liquidity management, forex
market intervention is also an autonomous driver of liquidity, but since there cannot be any
near
term forecasts for these interventions, they are considered as and when the information is
available. Using a combination of forward looking information and a backward-looking
assessment of the time series evolution of the determinants of liquidity, projections are
generated on a regular basis to inform the RBI's decisions on discretionary liquidity
management.
• Pillar-II is an assessment of system-level liquidity over a relatively longer time horizon,
focusing on the likely growth in broad money, bank credit and deposits, the corresponding
order of base money expansion and this assessment is then juxtaposed with a breakdown
into autonomous and discretionary drivers of liquidity derived under Pillar I. Thus, Pillar II
becomes the broader information set within which decisions relating to discretionary
liquidity management measures are taken based on PillarIassessment.
Decision regarding discretionary liquidity management operations by RBI
The RBI's discretionary liquidity management operations (primarily in the form of
variable- rate repos/reverse repos and OMOs) are guided by the extent of LAF deficit that is
'reasonable' at any point of time (measured by amount of net outstanding repo, reverse
repo, MSF and standing liquidity facility for primary dealers), and the assessment of the
nature of deficit/surplus, i.e., whether it is transient or durable. For managing liquidity of
transient nature, LAF/MSF windows are used. However, for managing the liquidity condition
of enduring or persistent nature, instruments like LTROs, OMOs, MSS & CRR are used. MSS is
used in situations when use of OMOs may not be desirable and/or RBI's own portfolio of
securities is not adequate to absorb the surplus system liquidity. The mechanics is explained
in the MSS subsection in later paragraph.

Calculation of System Liquidity55

We can determine whether and by how much, the system is in deficit or surplus by
arriving at the net borrowing/lending from RBI from various windows i.e. LAF/ MSF/
standing liquidity facility (for Primary Dealers) or any other windows/schemes. If the net
amount so derived is positive it means banks have borrowed from RBI and system is in
deficit, and vice versa. However, excess reserves maintained by banks must be adjusted to
the net LAF/MSF/SLF to arrive at the system liquidity. The summarised version of system
liquidity is furnished below:

System liquidity = Net borrowing under LAF - Excess reserves maintained by banks
Net borrowing under LAF = Total of all Repo/MSF/SLF borrowings (–) Total of all Reverse
repo deposits

55
Report of the Internal Working Group to Review the Liquidity Management Framework dated September 26, 2019

28
Excess reserves maintained by banks = Actual reserves maintained by banks (–) Required
reserves

Note: If the system liquidity derived above is positive it would indicate that system liquidity is
in deficit and vice-versa.
How to determine whether the liquidity condition is enduring or not?
Persistent high levels of outstanding RBI Repos or Reverse Repos indicate that the
deficit/surplus is of an enduring nature. Durable liquidity or permanent demand for reserves
arises from permanent or long-term changes in the liabilities of the Reserve Bank viz.,
expansion/contraction in currency in circulation, unsterilised Fx intervention operations and
decrease/increase of banking system reserves due to changes in net demand and time
liabilities of the banking system (NDTL). However, reversible changes in demand/supply of
reserves arising from frictional factors such as tax outflows or government expenditure
generate temporary mismatches in the banking system liquidity. For example, if the
government balances have come down from positive balance of ₹10,000 crore to around Nil,
then this would increase the banking system surplus by that amount till such amount flows
back to government account in the form of tax collections and other revenues. Similar kind of
impact can be observed for the deficit also. Considering all the factors, RBI decides on the
nature of the liquidity surplus or deficit and, accordingly, the appropriate instruments are
used.
Instruments of durable liquidity
Traditionally, OMO and MSS operations are used to deal with durable liquidity. The
mechanics of these operations are given in following paragraphs. However, recently, the RBI
has augmented its liquidity management toolkit to meet the durable liquidity needs of the
system through usage of long-term foreign exchange Buy/Sell USDINR swap auctions and
introduction of Long Term Repo Operations (LTROs)/Targeted Long Term Repo Operations
(TLTROs). The first Buy/Sell auction was conducted for USD 5 billion for a tenor of 3 years on
March 26, 2019.
LTROs were introduced in February 2020 to augment the liquidity management toolkit. The
mechanism of LTROs is similar to repos but they are of longer duration from one to three
years. A variant of the same, TLTROs were introduced in March 2020 to provide longer
duration money to specific sectors/instruments. Liquidity availed by banks under TLTROs had
to be deployed in investment grade corporate bonds, commercial paper, and non-convertible
debentures in both primary and secondary markets. In April 2020, RBI announced a Targeted
Long-Term Repo Operations 2.0 (TLTRO 2.0) to channel liquidity to small and mid-sized
corporates, including non-banking financial companies (NBFCs) and micro finance institutions
(MFIs) that had been impacted by COVID-19 disruptions. The funds availed under TLTRO 2.0
had to be deployed in investment grade bonds, commercial paper (CPs) and non-convertible
debentures (NCDs) of Non-Banking Financial Companies (NBFCs). At least 50 percent of the
total funds availed has to be apportioned as given below:

29
i. 10 per cent in securities/instruments issued by Micro Finance Institutions (MFIs);
ii. 15 per cent in securities/instruments issued by NBFCs with asset size of ₹ 500
crore and below; and
iii. 25 per cent in securities/instruments issued by NBFCs with assets size between ₹
 500 crore and ₹ 5,000 crore.
Mechanics of OMO operations
An OMO sale of government securities by the Reserve Bank hasthe impact of
reducing the system liquidity. An OMO purchase of government securities, on the other
hand, has the impact of increasing the system liquidity. OMO purchases will lead to increase
in RBI investments in the government securitieswhileOMOsalesleadto adecrease.
OMOs are conducted by RBI through auction mechanism or by directly undertaking
transactions in the secondary market. Such direct secondary market transactions are
undertaken on NDS-OM (Negotiated Dealing System – Order Matching) platform which is an
anonymous order matching platform for Government securities. The data on total amount
of OMO purchase or sale transactions by the RBI in the secondary market is published with a
lag. For conducting OMO through auction mechanism, announcement is made by RBI
through press releases giving details of the amount, date and time of auction and the choice
of securities. On the day of auction, after the cut-off time for bidding, the bids are
processedand theOMO auctioncommittee in RBI decides on the cut-off yield. The decision is
announced by
way of press release. The frequency of auctions is generally not pre-determined or pre
announced, unlike the primary auctions conducted as part of Government's market
borrowingprogramme. Itdependsonthe evolving liquidity conditions.
One important issue regarding OMOs is the impact on G-Sec yields. Announcement
regarding OMO sales may have a hardening impact on yield due to higher supply of securities
in the system. The selection of securitiesfor OMO auction is an important factor in the
success of the auction. The cut-off yield of the OMO auctions are keenly watched by the
markets as it may indicate RBI's comfortlevelsfortheyields.
Recently, the RBI has conducted special OMOs involving simultaneous sale and
purchase of Government securities, also known as ‘Operation Twist’. These operations are
liquidity neutral at the inception and can be used to have a desired impact on the long-term
and short-term interest rates without altering the liquidity conditions.
Mechanics of MSS operations
Market Stabilisation Scheme (MSS) is another tool used by the RBI to manage the
surplus liquidity in the system. MSS was used in periods when large capital inflows had
necessitated RBI intervention in the forex market to contain volatility. The purchase of
significant amount of dollars and consequent increase in liquidity required sterilisation
operations to prevent inflationary effects of the excessive capital flows. Also, post
demonetization, MSS had been used to deal with huge surplus liquidity condition resulting

30
from increase in deposits by public with the banks. To conduct OMO sales and reverse repos,
the RBI needs sufficient government securities. As OMO sales and Reverse Repos can only be
conducted to the extent of such securities being available with RBI 56, the MSS comes handy
in a situation where OMO sales are not desirable or the available quantum of government
securities with RBI is inadequate to handle the liquidity surplus in the system.
 Under MSS, Government securities (including Cash Management Bills (CMB), T- Bills
and Dated Securities) are auctioned. Unlike normal market borrowing by the government,
the amount raised under MSS is kept in a sequestered account and not available for
spending by the Government. This is essential as government spending would have resulted
in rupee
liquidity again getting transferred back to the banking system, thereby defeating the
purpose for which the instrumentwasused.
In consultation with RBI, the government decides the ceiling and the threshold limit
of MSS for each financial year. After receiving confirmation from the government, the RBI
issues a press release with information regarding the ceiling for gross issuances and the
threshold amount. Once the gross issuances under MSS reach the threshold limit, or there is
an additional requirement, the RBI informs the government of the same, which reviews and
advises the revised ceiling andthreshold limit.
The choice of securities under MSS depends, inter alia, on the estimate regarding the
natureof the surplusliquidity conditions. Ifthe surplusisforecasted to lingerfor a much longer
duration, then government securities of longer tenor would be issued, while if the surplusis
forecasted to be for a shorter tenor, T-Bills or CMBs would be issued. Press release for
conducting the auction is issued by the RBI. During the auction window, the market
participants can place their bids electronically in the core banking system of RBI. Like auction
of other government securities,aninternalauctioncommitteedecidesthecut-offandthe same is
communicated by wayofpressrelease.
The effectiveness of the RBI's operations in the money markets is regularly analysed
and published in the bi-annual Monetary Policy Report (MPR), MPC statements and the
annual report. The operating framework and its components have also been fine-tuned and
revised to support the financial markets, monetary conditions and to fulfil the needs of a
modern economy while ensuring consistency with the monetary policy stance. Regular
efforts have also been taken to improve the accuracy of forecasting through improved
marketintelligence for effectiveliquiditymanagement.
Special operations
Conducting special operations in money markets is necessitated for financial stability
considerations and in view of RBI’s role as lender of last resort. Select special operations are
mentioned below:

56
The Urjit Patel committee of 2014 had recommended the introduction of a Standing Deposit Facility (SDF) which would obviate
the requirement of providing collateral securities by RBI in reverse Repo operations and thus the balance of securities would not
come in the way of liquidity management in such situations. The RBI Act has since been amended for introduction of a SDF.

31
• From October 2008 to October 2009, RBI had conducted special repo auctions with
a view to enabling banks to meet the liquidity requirements of Mutual Funds
(MFs), Non-Banking Financial Companies (NBFCs) and Housing Finance Companies
(HFCs).
 • In April 2020, to deal with liquidity strains on mutual funds (MFs) in the wake of
hredemption pressures related to closure of some debt MFs and potential
contagious effects because of COVID-19 related disruptions, RBI announced a ₹
50,000 crore Special Liquidity Facility for Mutual Funds (SLF-MF). Under this
scheme, RBI conducted repo operations of 90 days tenor at the fixed repo rate.
The SLF-MF was on-tap and open-ended. Funds availed under the SLF-MF had to
be used by banks exclusively for meeting the liquidity requirements of MFs by (1)
extending loans, and (2) undertaking outright purchase of and/or repos against
the collateral of investment grade corporate bonds, commercial papers (CPs),
debentures and certificates of Deposit (CDs) held by MFs.
II. Foreign Exchange Operations of India

Objective57
TheRupee exchange rateisdetermined by the forces ofmarketdemandandsupply. The
objective and purpose of exchange rate management is to ensure that economic
fundamentals are reflected in the external value of the rupee. Subject to this general
objective, the conduct of exchange rate policy is guided by three major objectives: first, to
reduce excess volatility in exchange rates, while ensuring that the market functions in an
orderly fashion; second, to help maintain an adequate level of foreign exchange reserves,
and; third, to facilitate the development of a healthy foreign exchange market. To ensure
orderly conditions, RBI closely monitors the developments in the financial markets at home
and abroad.
Due to India's significant reliance on capital flows, which can be often large and
lumpy and are subject to sudden stops and reversals, viz., bulk demand for oil imports and
bunching up of government payments, the forex market becomes susceptible to bouts of
volatility. Of late, geopolitical events of significant nature such as trade war fears, tensions in
the middle east and severe exogenous shocks (e.g. volatility in markets caused by Covid-19 in
the year 2020) have caused disruptions in the global and domestic forex markets. The sharp
growth in the offshore trading volumes in the Rupee NDF market abroad in recent years,
likely even exceeding the volumes in the onshore markets, have raised concerns around the
forces that are determining the value of the rupee, price discovery in onshore market and
the ability of the RBI to ensure currency stability.
An important aspect of the policy response in India to the various episodes of
volatility has been market intervention combined with monetary and administrative
measures to

57
India's Foreign Exchange Reserves : Policy, Status and Issues (Speech by Dr. Y.V. Reddy, at National Council of Applied
Economic Research, New Delhi on May 10, 2002)

32
addressthe threatsto financial and market stability, while complementary or parallel
recourse has been taken by way of communications through speeches and press releases.
Based on the preparedness andmaturity ofthe foreign exchange market and India's position
on the external front (in terms of reserves, debt, current account deficit, etc.), reform
measures have been progressively undertaken to put in place a liberalized exchange and
payments system for current and capital account transactions with a view to further develop
the foreign exchange market.
While regulatory measures may produce the desired outcomes with a lag, the RBI's
forex intervention has the immediate impact on the prevailing demand and supply of foreign
currency in the market. With the objective of curbing volatility in exchange rate, RBI conducts
sales or purchases of foreign currency in the forex market,to contain the excessive volatility
and/or to smoothen out lumpy outflows/inflows. Such sales and purchases are not governed
by a predetermined target or band around the exchange rate.
Impact of RBI's intervention
RBI's intervention impacts the demand and supply of the foreign currency in the
domestic forex market and helps in curbing volatility of the USDINR currency pair. For
example, consider a scenario of huge capital inflows causing spurt in volatility in dollar-rupee
movement with sharp appreciating pressure on Rupee vis-à-vis dollar. Such flows lead to
appreciation of Rupee because of increase in supply of dollars in the forex market as foreign
investorsselldollarsto investinRupeebondsandequity [Link],mosttimes,the price
adjustment is not smooth. It rather gyrates up and down. In such a scenario, RBI intervention
through buying dollars neutralises the impact of temporary oversupply of dollars. But the
amount of dollars purchased by RBI intervention does not have a one-to-one relationship
with the dollar oversupply. The very hint of RBI intervention impacts the market sentiments,
altering the market dynamics and forcing market players to rebalance themselves to the new
situation.
For example, if Rupee is appreciating sharply against the dollar, the participants (e.g.
importers) who are looking for opportunity to buy dollars at the best possible price would
like to wait to benefit by buying dollars at lower price. If such an importer anticipatesreversal
in Rupee appreciation, then he would immediately like to buy the dollars in the market at
current price. Similarly, the Authorised Dealers 58 (ADs) can undertake proprietary positions
within acceptable limits. The AD banks also take position by buying and selling dollars to
benefit from the price movement. Because the AD banks have superior information about
supply and demand of foreign currency in the market, they swiftly change their position from
dollar overbought to oversold position59 in foreign currency and vice-versa. Thus, RBI's
intervention influences the market participants' behaviour, thereby impacting the short-
term supply and demand of dollars in the domestic forex market and bringing stability in the

58
Authorised Dealers are the banks licensed and authorized by RBI to deal in foreign exchange.
59
When an entity buys and holds dollars, it is considered as long position and when an entity sells dollars it is considered as a
short position.

33
market.
Similarly, to deal with increased volatility during episodes of huge capital outflows
with depreciating pressure on Rupee, RBI sells dollars in the market. This causes the supply
of dollars to go up, thereby stemming the depreciation of Rupee against the dollar. The
market sentiments and behaviour of the market participants are impacted, which ultimately
lead to stabilityinthemarket.
One important aspect of RBI intervention in FX market is that it has a concurrent and
commensurate impact on rupee liquidity conditions. If RBI sells foreign currency, it receives
INR from the market participants and thus the banking system liquidity reduces to that
extent. Similarly, when RBI purchases foreign currency in the forex market, the INR liquidity
goes up in the banking system. To mitigate this impact of forex intervention on the INR
liquidity, the RBI undertakes offsetting transaction via its liquidity management tools. This
process is known as ‘sterlisation’ and such forex intervention sometimes is referred as
‘sterlised intervention.’ However, there is no one to one relationship between both.
Instruments used by RBI for forex intervention
RBI intervenes in the spot, forwards, swaps and futures market. Rupee exchange rate
is determined from transactions in the spot market (T+2 settlement). Rates for forex
forwards (other than spot) are derived from a combination of spot and swap transactions.
The forward transactions impact both spot rate and forward premium, whereas swaps only
impacts the forward premium. The spot, forwards and swaps are traded in over the counter
(OTC) market. One important factor for operating in the forward market is that it provides
manoeuvrability to RBI to modulate the domestic rupee liquidity conditions in consonance
with the prevailing monetary policy stance. For example, when RBI purchases foreign
currency from the forex market and wants to postpone the injection of INR liquidity due to
its forex operation, it can undertake a sell/buy swap to postpone the delivery of foreign
currency to a future date thereby shifting the impact on INR liquidity to a future date.
Currency futures are traded on authorised exchanges such as NSE, BSE, etc., and are a
part ofthe exchange traded segmentofthe [Link] important difference between the
OTC and exchange traded segment is that, while the transactions in the OTC segment is
delivery based (both rupee and dollar legs are settled on due dates), transactions on the
ETCD (Exchange Traded Currency Derivative)segment is cash settled in Rupee terms(only the
profit or loss converted into Rupee terms are settled on due date). Another important
advantage of using the ETCD market isthat it does not alter the level of forex reserves, as
only net amount in Rupee terms is settled and there is no requirement of delivering or taking
deliveryofdollars.
The market operations can be undertaken either directly or through select agency banks,
though the general preference is for indirect intervention through selected banks. Both
approaches have merits and drawbacks. But the indirect approach has the advantage of
maintaining confidentiality of the intervention operations, thereby enhancing their

34
60
effectiveness . The data regarding RBI'sforex intervention operationsis published with some
lag in the RBI Monthly Bulletin and the Special Data Dissemination Standards of the
InternationalMonetary Fund (both are available on RBI website).
Why excessive volatility is bad in forex market?
Exchange rate volatility represents the movement in exchange rate over time. The
larger the magnitude of its change, or the more quickly it changes over time, the more
volatile it is. Standard deviation is a popular measure to determine volatility. Historical
standard deviation is a backward-looking measure of volatility, while implied volatility can be
derived from options traded in the derivative market. Market players use several other
models for forecasting volatility such as ARCH (Autoregressive Conditionally
Heteroscedasticity), Generalized Autoregressive Conditionally Heteroscedasticity (GARCH),
etc. Volatile exchange rates make international trade and investment decisions more
difficult as it increases risks. Exchange rateriskreferstothepotentialtolosemoneybecause
ofachangeintheexchange rate. Some examples of how traders and investors may losemoney
when the exchangeratechanges sharply are asfollows.
Let us consider that an Indian garment manufacturer had received an order to export
1000 pieces of a particular type of garment to a retailerin USA at 10 dollar per item. The cost
of the garment was ₹600 per item for the exporter, and the dollar-rupee was trading at ₹65
per dollar. Accordingly, the exporter was expecting to make a profit of ₹50 per item.
Suppose the shipment is expected to occur in 3 months' time and that the payment for the
shipment neednotbemade until that time. Three months have elapsed and 10,000 dollars
are received in lieu of shipment of the garments. Now, at the end of this three-month
period, suppose Rupeeratehasfallento₹[Link],Rupee amount
comes to only ₹600 per item. This amount is less than the originally expected amount of
₹650 per item. Therefore, the movement in exchange rate has led to a loss of ₹50 per item
worth of expected profit. This is an example of the risk an exporter faces due to change in
the currency value.
Let us consider another example in which an Indian corporate had borrowed one
million-dollar last year from an overseas bank in USA for a one year period to take advantage
of the lower interest rate prevailing abroad at the dollar-rupee exchange rate of ₹65 per
dollar. Consider thattheone-year cost of borrowing in USA was 3% forthat borrower, while
the borrowing rate in India was 10%. The Indian corporate had converted the dollar
proceedsto ₹65,000,000 and used the same in his business. The investor did not hedge the
currency risk. The dollar unexpectedly appreciated against the Rupee and at the time of
repayment it was trading at ₹70 per dollar. So, to refund the borrowed amount with interest,
the Indian corporate needs to buy 1.03 million dollar by spending ₹72,100,000 which
translates into borrowing costs higher than the rate if he had borrowed in India.

60
BIS Paper no. 73 on 'Intervention in foreign exchange markets: the approach of the Reserve Bank of India. by Mr. Rakesh
Tripathy of the Reserve Bank of India under the guidance of Mr. G. Mahalingam and Mr. Harun R. Khan for the Emerging
Markets Deputy Governors' Meeting hosted by the Bank for International Settlements on 21 and 22 February 2013 at Basel.

35
On the flip side, favourable currency movements in both the examples cited, would
haveled to gains. In the first example, had the rupee value changed to ₹70, the shipment
value would have increased in Rupee terms, generating a profit of ₹100 per item. Similarly,
in the second example, had the exchange rate moved to ₹60, it would have further reduced
the cost of his borrowing. Thus, a volatile exchange rate will either lead to unexpected losses
or gains.
There are several methods to hedge and protect oneself from this type of exchange
rate movement (also called currency risk). Some important derivative instruments are
forwards, futures and options, etc. In any case, exchange rate fluctuations lead to either
increase in risk of losses or additional cost to protect againstthose risks.
Adequacy of foreign exchange reserves
Purchase of dollars by RBI through forex market intervention operation hasthe
impact of increase in forex reserves whereas sale of dollars decreases the forex reserves. The
adequacy of forex reserves is assessed based on several parameters, which take into account
the import cover; quantum, composition and risk profile of varioustypes of capital inflows; as
well asthe external shocks to which the economy is vulnerable. Unlike many other countries,
India has not accumulated its reserves by having a surplus current account, but through large
capital inflows. Therefore, one can argue that reserves held by India are nottruly “earned”,
but rather “borrowed” innature,andthattheymaybe required to be “returned” should the
capital flows reverse, as it did during 2008–09. Forex reserves entail a cost because of low
returns
on investments as compared to returns on Rupee investments.
RBI intervention data
The data related to RBI intervention data is published in the RBI monthly bulletin on
trade settlement basis with a lag of one month. The data on purchase, sale and forward
outstanding is given for intervention in OTC markets. A separate table on intervention in
ETCD Market is also provided. In addition, net drains on foreign currency assets related data
with a lag is published in the IMF Special Data Dissemination Standards Template on
International Reserves/Foreign Currency Liquidity.
Special operations in the forex market
With a view to maintaining stable conditions and to restore confidence during periods
of liquidity stress, RBI has undertaken special measuresin the past to augment both rupee
and foreign exchange liquidity. Some important special operationstakeninthepast
arementioned below.
• Post Lehman collapse in 2008, there was global crisisresulting in dollarliquidity
shortage in the international market. In order to give comfort to the Indian banks having
overseas branches or subsidiaries in managing their short-term foreign funding
requirements, a rupee dollartemporary swap
[Link], banks were allowed to swap their
rupee funds for dollar funds for a maximum period of three months.

36
Further, for funding the swaps, banks were also allowed to borrow under the Liquidity
Adjustment Facility (LAF) for the corresponding tenor at the prevailing repo rate. This facility
was subsequently extended to EXIM Bank, for meeting their disbursals under lines of credit
already committed by them. This facility had the net impact of lending dollars for temporary
periods to the eligible entities against the collateral of LAF eligible securities.
• A swap facility for expansion of Export Credit in Foreign Currency was announced on
January 14, 2013 to support the incremental Pre-shipment Export Credit in Foreign Currency
(PCFC) extended by the banks. The swap facility was available to scheduled banks (excluding
RRBs) from January 21, 2013 till June 28, 2013 for fixed tenor of 3/6 months. Banks had the
option to enter into rupee-dollarswaps with RBI and also access rupee refinance to the
extent of the swap under PCFC. During any particular month, the maximum amount of
dollars that banks were eligible to avail of from RBI through swaps was equal to the
incremental PCFC disbursedwith reference toNovember 30, 2012.
• A Forex Swap Window for Public Sector Oil Marketing Companies was announced on
August 28, 2013 to meet the entire daily dollar requirements of three public sector oil
marketing companies(IOC,HPCL and BPCL).Underthe swap facility, RBI entered into sell/buy
USD- INR forex swaps for fixed tenor with the oil marketing companies through designated
banks. This facility had the impact of temporarily supplying dollars against rupees to the oil
companies and thereby taking out a big chunk of demand from the forex market. This
helped in managing the increased volatility of Rupee by taking off the depreciating pressure
fromit.
• A swap window for attracting FCNR (B) dollar funds was announced on September 6, 2013
forscheduled commercial banks(excluding RRBs). The facilityremainedopentillNovember 30,
2013. Under the facility, a US Dollar- Rupee swap window for fresh FCNR (B) deposits in
permitted currencies was allowed for a tenor of 3 to 5 years, in line with the tenor of the
underlying FCNR deposits. The swap facility with RBI was available in US Dollars only and was
undertaken at a fixed rate of 3.5 per cent per annum. In the first leg of the transaction, the
bank sold US Dollars to RBI at RBI Reference Rate. In the reverse leg of the swap transaction,
Rupee funds would have to be returned to RBI along with the swap premium to get the US
Dollars back. The facility had the impact of increasing the dollar availability with RBI for the
swap period. Bulk of the swaps was for the 3-year period, which was extinguished in2016.
• A facility of US Dollar-Rupee swap window was announced for Authorised DealerBanks
on September10,[Link],theCategory-Ibanks werepermittedtoborrowfunds
from their Head Office, overseas branches and correspondents and by overdrafts in Nostro
accounts up to a limit of 100 per cent of their unimpaired Tier I capital (as against the
prevailing limit of 50 per cent) as at the close of the previous quarter or USD 10 million (or its
equivalent), whichever is higher. The banks were then permitted to enter into a swap
transaction with RBI in respect of the fresh borrowings raised with a minimum tenor of one
year and amaximumtenor ofthree years covering the entiretenoroftheborrowing. The swaps
were available at a concessional rate of a 100 bps below the market rate. The swap rate was

37
reset after everyone year from the date of the swap at 100 bps lower than the market rate
prevailing on the date ofreset. The swaps were available only for conversion of
USDequivalent into Rupees. The concessionalswap window was available till November 30,
2013. The facility had the impact of increasing the dollar availability with RBI forthe swap
period. As the facility was for a maximum period of 3 years,the swaps were extinguished by
2016.
• The two swap windows (against fresh FCNR (B) deposits and Banks' overseas
borrowings) mobilized about USD 34 billion that helped in augmenting dollar fundswithRBI.
 • In March 2019, the RBI has inducted forex swap auctions (buy-sell or sell-buy Rupee
Dollar swaps) in its liquidity management toolkit. The first such buy/sell auction (thus
injecting INR liquidity) was conducted for USD 5 billion for tenor of 3 years on March 26,
2019. The US Dollar amount mobilized through this auction was reflected in RBI’s foreign
exchange reserves for the tenor of the swap while also reflecting in RBI’s forward liabilities.
In 2020, the RBI used forex swap auctions to provide USD liquidity (via a sell/buy swap) to
the market. This is a very versatile tool and can be used to inject/absorb both USD and INR
liquidity for a desired long or short-term period.

38
Chapter 5: Financial Stability
A well-functioning financial system – comprising financial markets, financial
intermediaries (such as, banks, insurance companies, non-banking finance companies, etc.)
and financial infrastructure (responsible for payment, clearing and settlement) – is critical for
economic growth, as it ensures the efficient transfer of resources from lenders to borrowers.
If anyone who wants to start a business – a restaurant, a software firm, a consumer
electronics shop – and had to do so only with their hard-earned savings or with the help of
their parents, relatives or friends, many bright ideas would go unrealized. At the same time,
in the absence of avenues for investment, savings will remain idle or be wasted. Similarly, if
you invest in a company and you cannot sell your shares or bonds and invest somewhere
else, you remain invested forever and it would be very hard for promising enterprises to
raise capital and grow. Thus, stable financial systems, by allocating society’s accumulated
savings to the most productive available uses, not only provides access to finance, which is
essential for economic development, but also plays a key role in managing risk and
promoting entrepreneurship.
Finance can be obtained through two channels: directly by issuing securities (shares
or bonds) or indirectly thorough financial intermediaries such as banks and non-bank finance
companies. This is depicted below:

The

two channels are mostly complementary. However, depending upon the nature of
development of financial systems in a country, one channel may play a greater role than the
other. For example, in countries such as the United States or the United Kingdom where
financial markets are more developed, direct or market-based finance is more popular. On
the other hand, in European countries like France and Germany, banks play a dominant role
in the financing of the economy. In India, banks not only are the main source of financing for
households and corporates, but also are the main saving vehicle. In the absence of a healthy

39
financial system, the intermediation process will not happen, and economic development
will stutter.
Financial systems, most of the time, performs its role efficiently. However, when they
do not, it leads to financial instability and episodes of financial crisis. A financial crisis in itself,
if it does not transmit to the real economy, though a cause for concern, is not catastrophic. If
the financial system can absorb the shocks and thereby keep the real economy immune from
the distortions, it is said to be resilient and is well-functioning. However, there have been
many episodes of financial crisis in the modern economy, when the shocks in the financial
system spilled over to the real economy resulting in massive unemployment and recession. In
particular, banks may stop lending or stop rolling over maturing loans either due to losses in
its balance sheet or due to low levels of capital. It could also be due to sudden liquidity
crunch as assets in bank’s balance sheet are generally long-term and illiquid. In a market-
based economy, the lenders may lose trust in the borrower’s ability to repay and would not
be willing to invest in their securities or provide any short-term finance. As a consequence,
financing declines with attendant adverse implications for consumption and investment and
ultimately economic growth. The financial literature categorises such an event as Systemic
risk – the risk wherein “the provision of necessary financial products and services by the
financial system will be impaired to a point where economic growth and welfare may be
materially affected”61.A build-up of systemic risk leads to financial instability. Therefore,
financial stability is a state whereby the build-up of systemic risk is prevented.
The financial crisis of 2007-09 is a manifestation of systemic risk as many economies
fell into recession following the bursting of the housing bubble and failure of large financial
institutions. The crisis brought to light several new risks that must be addressed to prevent
systemic risk. These include, but not limited to, the build-up of leverage, the complexity of
new financial instruments, the opacity of markets and interconnectedness among
institutions. Financial intermediation outside the regulatory perimeter, the so-called Shadow
Banking, and its linkages with the regulated banking system, was also a major catalyst for
the financial crisis.
The build-up of systemic risk has been identified with two dimensions, viz., Time and
Cross-sectional dimensions. Therefore, the objective of financial stability should be to
address the build-up of systemic risk as also to limit the spill over of the consequences of
materialisation of such systemic risk. Spill over of risks arise from interconnectedness of
various segments of the financial sectors. One way of limiting the spill over could be to
restrict the interconnectedness among the various sectors. However, this will come at a cost
of reduced efficiency of the market and substantially enhanced cost of intermediation as
well as a high level of inconvenience to the market entities and ultimate consumers of
financial services. Therefore, the objective of financial stability should be to identify, monitor
and minimise the build-up of systemic risks in financial system and reduce the spill over
effects in

61
European Central Bank

40
the most efficient and effective way. This involves a fine dovetailing between the objectives
of maximum market efficiency, highest consumer protection and minimum systemic risks.
Objectives of financial stability can be achieved by establishing a framework broadly
divided under three categories, viz., (1) establishing an institutional and governance
structure for financial stability (2) measuring and monitoring systemic risk; and, (3)
implementing macroprudential policies to mitigate identified systemic risks.
Institutional and governance structure for financial stability
Post financial crisis of 2007-09, there is recognition of the need to pursue financial
stability as an explicit policy objective by many central banks. However, given that the
financial system is comprised of several financial intermediaries and market segments,
increasingly the responsibility for financial stability is vested with the Government in most of
the countries with the central banks playing a pivotal supporting role. In India, the
Government set up Financial Stability and Development Council (FSDC) in December 2010 as
the apex level forum for strengthening and institutionalizing the mechanism for maintaining
financial stability, enhancing inter-regulatory coordination and promoting financial sector
development. The Chairman of the Council is the Finance Minister and its members include
the heads of financial sector Regulators, viz., Reserve Bank of India (RBI), Securities and
Exchange Board of India (SEBI), Insurance Regulatory and Development Authority of India
(IRDAI), Pension Fund Regulatory and Development Authority (PFRDA), Finance Secretary
and/or Secretary, Department of Economic Affairs (DEA), Secretary, Department of Financial
Services, and Chief Economic Adviser. Later, FSDC was reconstituted in May 2018 to include
additional members such as Minister of State responsible for DEA, Secretary of Department
of Electronics and Information Technology given the importance of digital transactions and
data privacy, Revenue Secretary subsequent of rollout of Goods and Services Tax (GST) and
the Chairperson of the Insolvency and Bankruptcy Board of India (IBBI). The Council can
invite experts to its meeting if required. Without prejudice to the autonomy of regulators,
the Council monitors macro prudential supervision of the economy, including functioning of
large financial conglomerates and addresses inter-regulatory coordination and financial
sector development issues. It also focuses on financial literacy and financial inclusion.
A sub-committee of the FSDC was formed to assist the FSDC, which replaced the
previous High-Level Coordination Committee on Financial Markets. The sub-committee is
headed by the Governor, RBI and has representation from all the members of FSDC. In
addition, Deputy Governors and an Executive Director from RBI are also members of this sub
committee. The sub-committee meets regularly to review the developments in the macro
economy and financial markets to maintain financial stability and monitor macro-prudential
regulation in the country.
Maintaining financial stability has been the main objective of the RBI even prior to
the crisis. The RBI over the years has been pursuing macroprudential policies, without
explicitly labelling them as such, to address systemic risk. The Board for Financial
Supervision and the

41
Board for Payment and Settlement Systems, both committees of the Central Board of
Directors, were constituted to aggregate information pertaining to the financial system as a
whole and take informed decisions to deal with any signs of instability, both at the individual
institution level and at the system level. Prior to the formation of the FSDC, RBI had a record
of using time varying LTV ratios to dampen credit growth in commercial and residential real
estate segment. In addition, the cross-sectional spillovers of financial markets are contained
by imposing a strict exposure limit on equity market participation, tracking of unhedged
foreign currency exposures of counterparties as well as directing banks to have an aggregate
exposure limit on real estate. Similarly, RBI, during times of foreign exchange pressure has
resorted to implementing strict open position limits of banks and has also in co-ordination
with capital markets regulator imposed higher margining norms as well as position limits on
exchange traded currency derivatives. The lender of last resort facility as well as Central Bank
experience in ensuring price and exchange rate stability makes the Central Banks’ role in
maintaining financial stability even more significant.
The financial crisis of 2007-09 reinforced the importance of financial stability for
macroeconomic stability and to strengthen the existing architecture, the RBI set up an
operationally independent Financial Stability Unit (FSU) in August 2009. The FSU prepares
half-yearly financial stability reports, which reflect the collective assessment of the sub
committee of the FSDC on risks to India’s financial stability. The other major functions of the
FSU include, but not limited to, conduct of macro-prudential surveillance of the financial
system on an ongoing basis, carry out periodic systemic stress tests to assess resilience of the
banking system and development of models for assessing financial stability.
Measuring and Monitoring Systemic Risk
Monitoring of systemic risk on an ongoing basis has become a mandate for most of
the Central Banks and Financial Sector regulators. These monitoring are done with the help
of various tools, such as stress tests at micro and macro level, analysis of interconnectedness
among various financial market entities and sectors, use of various indicators such as banking
stability indicator, systemic liquidity indicator, credit-GDP growth trends for the whole
economy as well as for different economic sectors. In most of the jurisdictions, these
indicators and instruments are published in periodic reports called Financial Stability Reports
or Financial Stability Reviews.
Implementing policies to mitigate identified systemic risks
Once the systemic risk has been identified, the next task is to implement the policies
to mitigate such risks. In many modern economies, the regulation and supervision of
financial institutions are distributed among a host of agencies. This made it difficult to
coordinate the supervision of the activities of these institutions and share information that
could pose risk to the system. Therefore, even though financial stability is one of the key
objectives of central banking, the role of Central Bank was limited to provision of liquidity,
i.e., lender of last resort. The financial crisis brought to recognition that the policies and
tools to deal with financial

42
stability issues were inadequate. Focus on micro prudential policies, which are aimed at
safety of individual institutions, was found to be insufficient and macroprudential policies
aimed at safeguarding the stability of the financial system and preventing the build-up of
systemic risk gained prominence.
The objectives of macroprudential policies are twofold:

• To mitigate procyclicality, i.e., prevent the excessive build-up of risk through debt and
leverage, which amplifies boom and bust cycles (time dimension)

• To improve the resilience of the financial system, i.e., its ability to absorb shocks
without major disruptions to the real economy, by limiting contagion (cross-sectional
dimension) and targeting systemically important financial institutions (higher capital levels
for example)
 To achieve the above objectives, many instruments are identified. These instruments
sometimes are standalone macroprudential tools or they can be an overlay on the existing
micro prudential instrument. To achieve the first objective, i.e., to mitigate procyclicality,
leverage ratio (to reduce leverage and thereby curb lending of banks), limiting loan-to-value
ratios (home buyers for example must bring in more of their money), dynamic provisioning,
higher risk-weights on bank loans, etc., are employed. Similarly, long term institutional
investors can be precluded from investing in certain sectors or prescribed not to invest in
instruments below a certain credit rating. At the system level, regulators can prescribe some
across the sector measures such as countercyclical capital buffer when a pre-decided
threshold, say credit to GDP gap, is breached. To enhance the resilience of the financial
system, capital buffers (accumulation of capital as precautionary reserves during economic
upturns to use them in economic downturns), liquidity buffers (presence of significant high
quality liquid assets in the balance sheet), higher capital requirements for systemically
important institutions, stress tests to assess the strength of the balance sheet, etc., are used.

43
Chapter 6: Overview of the Indian Financial System
Indian financial system comprises of institutions (banks, non-banking financial
companies, insurance companies, mutual funds, etc.), financial markets (money market,
Government Securities market, foreign exchange market, etc.) and financial market
infrastructure ably supported by the legal and institutional framework (Fig.1). A well
functioning financial system supports efficient financial intermediation, bringing savers and
borrowers together, facilitates efficient allocation of risk and resources and contributes to
overall economic growth.
Figure 1
Rationale for Financial Regulation
The financial system performs several vital functions: intermediating between savers
and investors, facilitating payments, risk-sharing, providing liquidity, alleviating information
asymmetry between borrowers and lenders, etc. A well-functioning financial system
contributes to economic welfare, whereas a dysfunctional or unstable financial system leads
to economic hardship. The objective of regulation is to ensure that the financial system
performs these vital functions without any adverse impact on the real economy.
The traditional approach of prudential regulation has been to safeguard the stability
of individual institutions. In addition to prudential regulation, regulations aimed at consumer
protection are also in place. Regulations, which examine how individual institutions respond

44
to exogenous shocks and ensure their soundness are called micro prudential regulations. The
focus of regulation has taken a macroprudential character in the aftermath of the global
financial crisis, as it showed that the existing regulatory architecture was inadequate to deal
with the build-up of systemic risk where the financial system as a whole was impaired and
was not in a position to perform intermediation. The current approach therefore is to use a
combination of both micro prudential and macroprudential regulations to make the financial
system resilient and maintain financial stability.
Regulatory and Supervisory structure in India
The regulation and supervision of the financial system in India is carried out by
different regulatory and supervisory authorities. The regulatory role of Reserve Bank covers
commercial banks, co-operative banks and certain categories of Non-Banking Financial
Companies (NBFCs) registered with it. The Ministry of Corporate Affairs (MCA) regulates
other financial companies registered with it. Further, the Finance (No.2) Act, 2019 (23 of
2019) has amended the National Housing Bank Act, 1987 that conferred certain powers for
regulation of Housing Finance Companies (HFCs) with Reserve Bank. In respect of co-
operative sector, there exists a system of dual regulation, wherein the Registrar of Co-
operative Societies (RCS) of the respective States in respect of Single State Co-operative
Banks and the Central Registrar of Co-operative Societies (CRCS) in respect of Multi-State Co-
operative Banks jointly regulates these entities with Reserve Bank. While Reserve Bank is
concerned with the banking function of the co-operative banks, the management control
rests with the RCS/CRCS. This dual control impacts both the regulation and supervision of
the co-operative banks. The Insurance Regulatory and Development Authority of India
(IRDAI) regulates the insurance sector and the capital market, credit rating agencies, etc., are
regulated by Securities and Exchange Board of India (SEBI).
The supervisory role of the Reserve Bank covers commercial banks, urban co-
operative banks (UCBs), some Financial Institutions (FIs) and Non-Banking Financial
Companies (NBFCs) registered with it. The Regional Rural Banks (RRBs), State Co-operative
Banks (StCBs) and District Central Co-operative Banks (DCCBs) are supervised by National
Bank for Agriculture and Rural Development (NABARD), while the Housing Finance
Companies (HFCs) are supervised by National Housing Bank (NHB).
In addition to regulating and supervising financial institutions, RBI also regulates
certain segments of the financial markets and the financial market infrastructure which
would be discussed in the subsequent chapters.
Reorganisation of Regulation and Supervision Departments of RBI
The Central Board of the Reserve Bank of India had in its meeting on May 21, 2019,
approved the creation of the separate supervisory and regulatory cadre. This decision was
taken with a view to having a holistic approach to supervision and regulation of the regulated
entities to address growing complexities, size and inter-connectedness as also to deal more
effectively with potential systemic risk that could arise due to possible supervisory arbitrage

45
and information asymmetry. Accordingly, the RBI decided to integrate the supervision
function into a unified Department of Supervision and regulatory functions into a unified
Department of Regulation with effect from November 01, 2019.
Prior to that, the supervision of financial sector entities was undertaken through
three separate departments, viz., Department of Banking Supervision, Department of Non-
Banking Supervision and Department of Co-operative Bank Supervision. Similarly, the
regulatory functions relating to financial sector entities were carried out through three
separate departments, viz., Department of Banking Regulation, Department of Non-Banking
Regulation and Department of Cooperative Banking Regulation.
This restructuring will:
i. make supervisory and regulatory process more activity based rather than being
segmented purely based on the organizational structure of regulated entities; ii.
bestow graded supervisory approach to all the RBI supervised entities linked to their
size and complexity;
iii. facilitate more effective consolidated supervision of financial conglomerates
 among the RBI supervised entities;
iv. result in more efficient allocation of human resources attending to regulation and
supervision of financial sector entities under the Bank’s purview; and v. help build an
experienced and skilled human resources in regulation and supervision of financial
sector entities.

46
Chapter 7: Regulation of Commercial Banks
The prime rationale for bank regulation can be traced to the special role that banks
play in an economy. The core act of banking – acceptance of deposits which are
withdrawable on demand and using such funds for lending and investing – helps the
economic growth by mobilising savings and encouraging investment and consumption. In
the discharge of their role of financial intermediaries, banks perform transformation
functions – of size, risk, liquidity and maturity, which expose them to significant risks. As
liquidity and maturity transformers, banks fund long term illiquid assets (mortgages, for
example) using short term and liquid instruments such as demand deposits. The resultant
asset-liability mismatch, while being central to banking business, makes banks fragile by
design. Inability, or even the perceived inability, to refund the deposits on demand could
lead to erosion of public confidence resulting in a ‘run’, which can bring down any bank. The
mechanisms put in place to repose public confidence in the banking system - depositor
insurance and provision of liquidity support by the Central Bank - could themselves lead to
other regulatory concerns such as moral hazard. Considering these risks faced by banks, a
well-designed regulatory framework is a sine qua non for ensuring the safety and well-
functioning of the banking system.
 Banks are highly leveraged institutions as they mobilise huge quantum of deposits
and borrowings against a relatively very low quantum of their own equity capital. Since
banks build-up huge leverage using depositors’ funds, protection of depositors’ interests
becomes one of the central reasons for bank regulation. Unsophisticated depositors of
banks may not be able to monitor banks effectively due to asymmetric information.
Asymmetric information arises when one party to the economic transaction has greater
material information than the other party. Even if a depositor could assess the current value
of a bank’s assets vis-à-vis its liabilities, the condition could change as the banking business
is dynamic with banks continuously altering their asset holdings and taking on new
depositors and creditors. For a developing economy like India, there is also much less
tolerance for downside risk among depositors many of whom place their life savings with
the banks. Hence, from a moral, social, political and humane angle, it is imperative that the
banking system is well regulated.
The central role banks occupy in the financial system in facilitation of payment and
settlement services and in the transmission of monetary policy also make the stability of
banking system an uncompromising objective of regulators. Banking crises can adversely
impact the economy by disrupting the payment and settlement systems and making
monetary policy transmission less effective, thus resulting in huge social costs in terms of
output losses and unemployment.
All the above reasons call for a well-designed banking regulation.
What Regulation does not intend to accomplish
While the depositor protection, systemic stability and fostering of competition, etc.,
are goals of regulation, there are several aspects that banking regulation is not intended to

47
62
accomplish . Firstly, preventing the failure of individual banks is not the primary focus of
banking regulation, subject to the condition that depositors are protected, financial stability
is not affected, and adequate banking services are maintained. Secondly, banking regulation
should not substitute banker’s commercial decisions about its operations. Finally, banking
regulation should not favour certain groups over others. Banks also should not be protected
from competition from other institutions.
Legal framework for banking regulation
Prior to the enactment of the Banking Regulation Act, 1949, the provisions of law
relating to banking companies were contained in the Indian Companies Act. Company law
was introduced in India with the Companies Act 43 of 1850, which was based on the English
Companies Act, 1844. When the Reserve Bank of India Act, 1934 came into effect, an
important function of the Reserve Bank was to hold the custody of the cash reserves of
banks, granting them accommodation in a discretionary way and regulating their operations
in accordance with the needs of the economy through instruments of credit control. With
regard to the banking system of the country, the primary role of the Reserve Bank was
conceived as that of the lender-of-last-resort for the purpose of ensuring the liquidity of the
short-term assets of banks. The Banking Regulation (BR) Act was passed on February 17,
1949, which comprehensively deals with several aspects of the banks ranging from setting
up of a bank to amalgamation besides several operational issues.
In addition, the functioning of banks is also covered under various statutes,
depending on their category, e.g., SBI Act 1955, Banking Companies (ATU) Act 1970 and
1980, RRB Act 1976. Further in 1965, Section 56 was inserted in Banking Regulation Act to
regulate functioning of Co-operative banks.
Evolution of Banking Regulation in India
As functions of the Reserve Bank evolved over the years, the regulatory and
supervisory approaches were modified as and when deemed necessary. In tune with the
developments that have taken place from time to time in the Indian economy in general and
the banking system in particular, the objectives and approaches of regulation and
supervision have also changed, while retaining the basic purpose of maintaining the
soundness and stability of the banking system. The focus of the Reserve Bank’s role as a
regulator and supervisor has shifted gradually from micro regulation of banks’ day to day
activities with a view to ensuring that the regulations are adhered to in an environment
where banks’ management are given freedom to take commercial decisions based on their
own judgment.
As the Indian banking system gradually started acquiring global character in recent
years, the regulation and supervision have focused on preventing systemic instability,
fostering competition and improving market practices. While the fundamental objective of
regulation and supervision continued to be “maintaining the soundness and stability of the

62
Report on Currency and Finance (Chapter X), Reserve Bank of India Sep 4, 2008 under Para 10.11 of Chapter X. Regulatory
And Supervisory Challenges in Banking.

48
financial system” all along, regulation and supervision has simultaneously focused on other
objectives such as transparency of balance sheet, protection of depositor interest, meeting
social needs and improving the efficiency, reducing information asymmetries and preventing
money-laundering activities. In sum, with constant changes in the domestic and external
financial environment, the Reserve Bank responded appropriately from time to time, and in a
proactive manner, by fine tuning the focus of its regulatory and supervisory function as the
situation evolved.
Indian Banking System
Commercial Banks
The commercial banking sector in India is quite diverse. Based on the ownership
pattern, banks can be broadly categorised into public sector banks, private sector banks and
foreign banks. While the State Bank of India, nationalised banks and Regional Rural Banks
(RRBs) are constituted under respective enactments of the Parliament, the private sector
banks and foreign banks are considered as banking companies as defined in the Banking
Regulation Act, 1949. Till 2015, only universal banking licenses were being issued. However,
since 2015, licenses for differentiated banks (niche banks) are also being issued alongside
licenses for universal banks.
Regional Rural Banks
Regional Rural Banks (RRBs) were setup with a view to developing the rural economy
by providing credit and other facilities, particularly to the small and marginal farmers,
agricultural labourers, artisans and small entrepreneurs. Being local level institutions, RRBs
together with commercial and co-operative banks, were assigned a critical role to play in the
delivery of agriculture and rural credit. The equity of the RRBs was contributed by the Central
Government, State Government concerned and the sponsor bank in the proportion of
[Link]. The function of financial regulation over RRBs is exercised by Reserve Bank and the
supervisory powers have been vested with NABARD.
Local Area Banks
Local Area Banks (LABs) were conceived as low-cost structures and for providing
efficient and competitive financial intermediation services in their areas of operation in the
rural and semi-urban areas. The Scheme envisaged a Local Area Bank with a minimum capital
of INR 5 Crore and an area of operation comprising three contiguous districts. Further, to
provide LABs an opportunity to grow, in December 2012, they were permitted to expand
their area of operation to two more districts.
Foreign Banks
Foreign banks are permitted to operate in India either as branches or Wholly Owned
Subsidiaries (WOS). Permission for opening of branches by foreign banks in India is guided by
India’s commitment to WTO.

49

Commercial
Banks

Public Sector Private Sector

SBI RRBs
Foreign
Domestic
Nationalised

Universal Differentiated

Local Area Banks (LABs)

Salient banking regulations Payments Banks
Small Finance Banks

Given the special risks faced by banks and, at the same time, the deleterious impact
their failure has on the economy, it is imperative that the banking regulation is
comprehensive and robust. The banking regulation seeks to regulate the entire gamut of
bank's functions starting from their inception to winding up. Broadly the banking regulation
strategies relate to ex-ante strategies such as entry regulations, activity regulations,
prudential regulations, governance regulations, conduct regulations and information
regulations and ex-post regulations such as resolution policies.
Bank licensing
For commencing banking operations in India, whether by an Indian or a foreign bank,
a licence from the Reserve Bank is required. The Banking Regulation Act, 1949 provides that
a company intending to carry on banking business must obtain a license from RBI except
such of the banks (public sector banks and RRBs), which are established under specific
enactments. The RBI issues licence only after ‘tests of entry’ are fulfilled.
The minimum statutory requirements for setting up new banks in India are stipulated
in the Banking Regulation Act, 1949. Ownership in private banks is also regulated in terms of
threshold limits and ‘lock in’ period with a view to address conflicts of interest and for
ensuring more diversified ownership.
In the past, bank licenses for setting up universal banks were given on a ‘Stop and Go’
basis. Accordingly, 10 licenses were issued based on Guidelines on Entry of New Private
Sector banks issued in 1993 and 2 licences were issued each based on licensing guidelines
issued in 2001 and 2013. The licensing policy was reviewed and has been replaced with a
‘continuous

50
authorisation’ policy in 2016, with a view to increasing the level of competition and bringing
new ideas into the system. Accordingly, a framework for ‘on tap’ licensing was established.
With a view to furthering the cause of financial inclusion using the functional building
blocks of payments, deposits and credits, guidelines for licensing of small finance banks and
payments banks were issued in 2014. The objectives of setting up of payments banks are to
further financial inclusion by providing (i) small savings accounts and (ii)
payments/remittance services to migrant labour workforce, low income households, small
businesses, unorganised sector entities and other users. The objectives of setting up of small
finance banks are to further financial inclusion by (i) provision of savings vehicles, and (ii)
supply of credit to small business units; small and marginal farmers; micro and small
industries; and other unorganised sector entities, through high technology-low cost
operations. Accordingly, ten licences were issued to small finance banks and seven licences
were issued to payments banks. After a review of the performance of the existing small
finance banks and to encourage competition, licensing of these banks was made ‘on-tap’ in
2019.
Branch Expansion - Opening of new place of business (banking outlets)
The opening of new place of business and shifting of existing places of business of
banks is governed by the provisions of the Banking Regulation Act, 1949. In terms of these
provisions, banks cannot, without the prior approval of the Reserve Bank of India (RBI), open
a new place of business in India or abroad or change, otherwise than within the same city,
town or village, the location of the existing place of business. However, to cater to the
financial needs of a larger number of underprivileged and unbanked population, RBI
liberalised the branch licensing norms wherein all domestic commercial banks (other than
RRBs, Local Area Banks and Payments Banks) are permitted to open, unless otherwise
specifically restricted, Banking Outlets63 in Tier 1 to Tier 6 centres without having the need to
take permission from RBI in each case. Domestic commercial banks have been advised to
open at least 25% of such ‘banking outlets’ in unbanked rural centres.
Maintenance of Statutory Reserves
Commercial banks are required to maintain a certain portion of their Net Demand
and Time Liabilities (NDTL) in the form of cash with the Reserve Bank, called Cash Reserve
Ratio (CRR). In addition to the cash reserves, every bank shall also maintain assets in India,
the value of which shall not be less than the prescribed percentage of its NDTL in the form of
investment in unencumbered approved securities, Cash, Gold and any other instrument
notified by RBI. This is called Statutory Liquidity Ratio (SLR).

63
A Banking outlet is a fixed-point service delivery unit, manned by either bank’s staff or its Business Correspondent where
services of acceptance of deposits, encashment of cheques/ cash withdrawal or lending of money are provided for a minimum of
4 hours per day for at least five days a week. For more details refer to
[Link] .

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Prudential Norms
Prudential norms are the guidelines issued by the banking regulator to ensure safety
and soundness of banks. Prominent prudential norms relate to Income Recognition and
Asset Classification, Capital Adequacy, Exposures, etc.

• Income Recognition and Asset Classification and Provisioning (IRAC) Norms- Asset
Quality: In the course of their business, banks lend and invest in various classes of assets,
some of which may turn non-performing either due to the systemic factors such as economic
downturn or idiosyncratic factors specific to the borrower. Banks are required to objectively
identify such stressed assets and take corrective action. In line with the international norms
in this regard, Reserve Bank issued prudential guidelines on Income Recognition, Asset
Classification and Provisioning to ensure greater consistency and transparency in the
financial statements of banks.
 In line with the international guidelines in this regard, Indian banks are required to
classify assets as non-performing once they cease to generate income for the bank.
Illustratively, if the interest and/or instalment of principal of a term loan remains overdue for
a period of 90 days, the banks are required to classify them as non-performing loans. Banks
are required not to recognise income on such assets on accrual basis and are also required to
make provisions out of their profits as a portion of such non-performing assets. The
classification of non-performing assets is graded based on the age of the non-performing
assets and provisions are prescribed depending upon the availability of security, with higher
provisioning requirements for higher grades of NPAs.

• Basel guidelines on Capital and Liquidity: Bank’s capital (common equity and other
permitted classes of capital) acts as loss absorbing buffer protecting depositors in the event
of losses faced by the bank. Further, capital also limits leverage of the bank, ensuring its
safety. Under the Basel Capital Adequacy framework, banks’ capital requirements have been
linked to the risk profile of their asset classes, requiring riskier banks to keep larger buffers.
The Basel framework evolved over a period since the introduction of Basel I framework in
1988, which required the banks to hold capital as a percentage of their credit risk exposures.
Gradually the framework was expanded to include other risks on the banks’ balance sheet
such as market risk and operational risk. The comprehensive Basel II guidelines issued in
2006 provided banks with a flexibility to assess risks using their internal models in addition
to the standardised models.

• The global financial crisis which witnessed the failure of well capitalised banks,
triggered an overhaul of the capital framework and led to the introduction of Basel III. It
addresses shortcomings of the pre-crisis regulatory framework and provides a regulatory
foundation for a resilient banking system that supports the real economy. It seeks to increase
the quantity and quality of capital, enhance the risk coverage and introduce macro
prudential elements such as leverage ratio, countercyclical capital buffers and liquidity ratios
(Liquidity Coverage Ratio and Net Stable Funding Ratio). While LCR has already been
implemented in

52
India, the implementation of NSFR was scheduled to be adopted from April 1, 2020 but has
been differed briefly.

• Exposure Norms: A bank’s exposures to its counterparties may result in concentration

of its assets to a single counterparty or a group of connected counterparties. As a prudential
measure aimed at better risk management and avoidance of concentration of credit risks,
the Reserve Bank of India has fixed limits on bank’s exposures to an individual business
concern and to business concerns of a group. Apart from limiting the exposures to a single or
a Group of borrowers, banks have also been advised to consider fixing internal limits for
aggregate commitments to specific industry or sectors, so that the exposures are evenly
spread over various sectors. In addition, banks are also required to observe certain statutory
limits on shareholdings in companies and other regulatory exposure limits in respect of
capital market exposures and intra-group exposures.

• Investment Guidelines: Banks can invest in a variety of instruments such as

government securities, other approved securities, shares, debentures and bonds,
subsidiaries/joint ventures and other instruments like commercial paper and mutual fund
units, among others. The Reserve Bank of India issues guidelines for the investment portfolio
of the banks, keeping in view the developments in the financial markets and taking into
consideration the evolving international practices. Banks are required to follow the
prudential norms for the classification, valuation and operation of investment portfolios as
laid down by the Reserve Bank from time to time. In terms of these guidelines, the entire
investment portfolio of the banks should be classified under three categories, viz, Held to
Maturity (HTM), Available for Sale (AFS) and Held for Trading (HFT). The guidelines stipulate
the norms relating to initial recognition, valuation, transfer among categories, etc.

• Resolution of Stressed Assets: Swift, time-bound resolution of stressed assets is critical

for de-clogging bank balance sheets and for efficient reallocation of capital. The Banking
Regulation (Amendment) Act, 2017, and the subsequent authorisation given by the
Government of India therein, empowered the Reserve Bank to issue directions to the banks
for resolution of stressed assets, including referring assets to the Insolvency and Bankruptcy
Code 2016 (IBC). The action taken by the Reserve Bank under the said provisions and
issuance of the Prudential Framework for Resolution of Stressed Assets on June 7, 2019
reflect a paradigm shift in the regulatory approach towards resolution of stressed assets in
India. The Framework is aimed at ensuring early resolution of stressed assets in a
transparent and time bound manner, with collective action clauses, so that maximum value
could be realised by the lenders while also recognising the potential going concern value of
stressed assets. Unlike previous schemes for restructuring, complete discretion and
flexibility has been given to banks to formulate their own ground rules in dealing with
borrowers who have exposures with multiple banks. The lenders can implement resolution
plans that are tailored to their internal policies and risk appetites.

53
Risk Management
Banks in the process of financial intermediation are confronted with various kinds of
financial and non-financial risks, viz., credit, interest rate, foreign exchange rate, liquidity,
equity price, commodity price, legal, regulatory, reputational, operational, etc. These risks
are highly interdependent and events that affect one area of risk can have ramifications for a
range of other risk categories. Reserve Bank issues guidelines from time to time to banks to
ensure that the banks’ management gives considerable importance to improve the ability to
identify, measure, monitor and control the overall level of risks undertaken. The guidelines
relate to aspects such as banks’ risk management structure, mechanism to assess and
manage various risks, risk aggregation and capital allocation.
Further, banks are also required to operationalise formal stress testing framework to
help them in building a sound and forward-looking risk management framework. Banks are
required to assess their resilience to withstand shocks of all levels of severity indicated by
the regulator, and should be able to survive, at least the baseline shocks.
Regulation of Interest Rates
The interest rates on deposits have been progressively deregulated providing banks
greater flexibility in resource mobilisation. However, keeping the customer service under
consideration, the deposit rates are required to be uniform across all branches and for all
customers and no discrimination is permitted in the matter of interest paid on the deposits,
between one deposit and another of similar amount and tenor, accepted on the same date,
at any of its offices by the banks. Banks can allow higher interest in respect of deposits of
senior citizens, and additional interest in respect of deposits of bank’s own staff and
executives, including retired staff (subject to conditions) and associations of staff (except
associations of retired staff). Further, the interest rates offered are required to be
reasonable, consistent, transparent and available for supervisory review/scrutiny as and
when required. In respect of interest rates on advances, while banks have been provided
flexibility to offer all categories of advances on fixed or floating interest rates, the
regulations require that such rates are fair and transparent and are determined on the basis
of an internal or external benchmark rate. The banks have been mandated to link all new
floating rate personal or retail loans and floating rate loans extended to MSMEs to external
benchmarks such as Repo Rate, Treasury Bill Rate, etc. Banks can offer such external
benchmark linked loans to other types of borrowers as well. External benchmarks, being
publicly known, ensure greater transparency in determination of interest rates. To avert the
delays in transmission of monetary policy, banks have been advised to reset the interest
rates under external benchmark system at least once in three months. In order to ensure
transparency, standardisation, and ease of understanding of loan products by borrowers,
banks have been advised to adopt a uniform external benchmark within a loan category; in
other words, adoption of multiple benchmarks by the same bank is not allowed within a loan
category.

54
Know Your Customer Norms
Sound 'Know Your Customer' (KYC) policies and procedures are critical for protecting
the safety and soundness of banks and the integrity of banking system in the country. To
prevent money laundering through the banking system, the Reserve Bank has issued 'Know
Your Customer' (KYC), Anti-Money Laundering (AML) and Combating Financing of Terrorism
(CFT) guidelines. These instructions are based on the provisions of Prevention of Money
Laundering (PML) Act, 2002 and Prevention of Money Laundering (Maintenance of Records)
Rules, 2005. The Reserve Bank's regulatory stance on KYC is with the aim to safeguard banks
from being used by criminal elements for money laundering activities and to enable banks to
understand the risk posed by customers, products and services, delivery channels and
helping them assess and manage their risks prudently. Banks are required to carry out KYC
exercise for all their customers to establish their identity and report suspicious transactions
to the Financial Intelligence Unit.
Corporate Governance
Corporate Governance is the key to protecting the interests of all the stakeholders
and the need for good corporate governance has been gaining increased emphasis over the
years. Banking regulation in India shifted from prescriptive mode to prudential mode in
1990s, which implied a shift in balance away from regulation and towards corporate
governance. Banks are accorded greater freedom and flexibility to draw up their own
business plans and implementation strategies consistent with their comparative advantage.
This freedom necessitated tighter governance standards requiring bank boards to assume
the primary responsibility and the directors to be more knowledgeable and exercise
informed judgement on various strategies and policy choices. With a view to strengthening
corporate governance, over a period of time, various guidelines have been issued in matters
relating to the role to be played by the Board, fit and proper criteria for the directors of
banks in general and for elected directors of Public Sector Banks in particular, calendar of
reviews to be undertaken by the Board, broadening the fields of specialisation for directors
against the backdrop of innovations in banking and technology, qualifications and
experience for Chief Financial Officer and Chief Technology Officer, bifurcation of the post of
Chairman and Managing Director (CMD), etc. Further, with an objective to better align the
compensation policy with evolving international best practices over the past few years, and
for an objective assessment of remuneration sought by the banks for their whole-time
directors, the guidelines related to compensation have been revised.
Disclosure Norms
Public disclosure of relevant information is an important tool for enforcing market
discipline. Hence, over the years, the Reserve Bank has strengthened the disclosure norms
for banks. Banks are now required to make disclosures in their annual report, among others,
about capital adequacy, asset quality, liquidity, earnings and penalties, if any, imposed on
them by the regulator, etc.

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Deposit Insurance
Deposit Insurance protects depositors against the loss of their deposits in case a
deposit institution is not able to meet its obligation to the insured depositors. All commercial
banks, including the branches of foreign banks functioning in India, local area banks and
regional rural banks are covered under the Deposit Insurance Scheme.
Under the Scheme the insurance cover is limited to ₹5,00,000/- per depositor for
deposits held in ‘the same capacity and in the same right’ at all the branches of the bank
taken together. The premium paid by the insured banks to the DICGC is required to be borne
by the banks themselves and not passed on to the depositors.
Para banking Activities
Deregulation of the banking sector and the development of the financial sector
encouraged many banks to undertake non-traditional banking activities, also known as para
banking. The Reserve Bank has permitted banks to undertake diversified activities, such as,
mutual funds business, insurance business, merchant banking activities, factoring services,
card business, pension fund management, investment advisory services, agency business,
membership of SEBI approved stock exchanges, etc. While some of the activities are
permitted to be undertaken departmentally, some other activities are to be undertaken
through subsidiary/Joint Venture route by way of equity participation in line with Prudential
regulations for banks’ investments. Banks are also permitted to invest in equity/unit capital
of financial/non-financial companies, Alternative Investment Funds and Real Estate
Investment Trust/Infrastructure Investment Trust in line with the Prudential regulations for
banks’ investments.
Regulation of All India Financial Institutions
All India Financial institutions (AIFIs) are an important part of the Indian financial
system as they provide medium to long term finance to different sectors of the economy,
through refinance and direct lending. These institutions have been set up to meet the
growing demands of particular segments, such as, export, rural and agricultural sector,
housing and small-scale industries, and have been playing a crucial role in channelizing credit
to these sectors and addressing the challenges / issues faced by them.
The four AIFIs, viz. Export-Import (EXIM) Bank of India, National Bank for Agriculture
and Rural Development (NABARD), National Housing Bank (NHB) and Small Industries
Development Bank of India (SIDBI) are under regulation and supervision of the Reserve Bank.
These AIFIs have been constituted under their own statutes which, along with the provisions
of the Reserve Bank of India Act, 1934, provide the legal framework for their regulation. As in
the case of commercial banks, prudential norms relating to income recognition, asset
classification and provisioning, exposures, investments, capital adequacy and disclosures are
applicable to the AIFIs as well. AIFIs are also subject to on-site inspection and off-site
surveillance.

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Credit Information Companies
Credit reporting addresses a fundamental problem of credit markets: asymmetric
information between borrowers and lenders, which may lead to adverse selection, credit
rationing and moral hazard problems. Credit reporting system consists of the institutions,
individuals, statutes, procedures, standards and technology that enable information flows
relevant to making decision relating to credit and loan agreements.
Credit Reporting System in India currently consists of four credit Information
companies (CICs) viz., TransUnion CIBIL limited, Experian Credit Information Company of
India Private Ltd, Equifax Credit Information Services Private Limited and CRIF High Mark
Credit Information Services Pvt. Ltd. and credit institutions – Banks, All India Financial
Institutions, NBFCs, Housing Finance companies, State Financial Corporations, Credit Card
Companies etc., are governed by the provisions of Credit Information Companies
(Regulation) Act, 2005, Credit Information Companies Rules 2006 and Credit Information
Companies Regulation, 2006.
 The credit information reports (CIR) of borrowers can be obtained from the CICs by
specified users listed under CIC regulations which include credit institutions, telecom
companies, other regulators, insurance companies, stockbrokers, credit rating agencies,
resolution professionals, etc.
Credit Institutions have been advised to include CIR from at least one CIC as one of
the inputs for credit appraisal. CICs also offer value added products like credit scores.
Individual borrowers can also obtain credit report from CICs. RBI has directed CICs to furnish
Free Full Credit Report (FFCR) which includes credit score to individual borrowers once in a
calendar year.

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Chapter 8: Supervision of Commercial Banks
Commercial Banking Supervision – Concepts and Evolution
Supervision, in simple terms, is the enforcement of rules and regulations that are
formulated by the regulator to govern the behaviour of regulated institutions and at the
same time spot loopholes or grey areas where regulatory reinforcement may be due. RBI
undertakes supervision of the commercial banks located in India as well as branches of
Indian banks located outside India under various provisions of the Banking Regulation Act,
1949. The Department of Supervision (DoS) is responsible for supervision of all RBI regulated
entities, viz., commercial banks, non-banking finance companies, urban co-operative banks,
small finance banks and payments banks.
One of the fundamental questions that arise is how supervision is different from
regulation. In common parlance they are often used interchangeably as they serve the same
objective – protecting the interest of the depositors and preserving financial stability.
However, there is a difference between the two functions. ‘Regulation’ is synonymous with
laying down the rules and norms for doing business by all the market players and, therefore,
is uniformly applicable to all market participants. ‘Supervision’, on the other hand, is the
process through which the rules and norms are enforced at individual entity level. Thus,
while regulation is applicable to the system as a whole, supervision is entity-specific, with
the intensity of supervision being proportional to the perceived risk levels” 64.

The rationale for supervision of banks is identical to that of regulation of these

entities. The overarching objective of preserving financial stability by promoting a resilient
banking system is the foundation for effective supervision. Notably, banks occupy a pre-
eminent place in the financial system and spur economic activity by undertaking maturity
and liquidity transformation and supporting the critical payment systems. However, the
business of banking has several attributes (leverage, asset-liability mismatch, etc.), which
have the potential to generate instability. Moreover, banks also enjoy backing from
Government/Regulator in terms of liquidity support and depositor guarantee. This in turn
can potentially lead to moral hazard issues, such as excessive risk taking and consequent
impairment of balance sheet. From a systemic perspective, failure of banks can cause
immense damage to the real economy as an impaired banking system cannot perform the
essential function of financial intermediation between savers and borrowers. Therefore,
effective supervision of banks is essential to ensure that banks adhere to the rules and
regulations in letter and in spirit as well as their risk culture and risk governance does not
pose threat to its solvency.
Until the early 1990s, supervision function was serving as an adjunct to the existing
regulatory framework that primarily focused on licensing, pricing of services including
administration of interest rates on deposits as well as credit, reserves and liquid asset

64
Strengthening the Banking Supervision through Risk Based Approach: Laying the Stepping Stones, Dr. K. C. Chakrabarty,
Deputy Governor, Reserve Bank of India, May, 2013

58
requirements. The evolution of Basel accord in 1988 and the economic liberalization post the
1991 balance of payment crisis, which resulted in banking sector reforms, lead to a shift in
supervisory approach. Supervision shifted from intrusive micro-level intervention to a more
broad-based approach that reflected the prudential nature of regulation, deregulation of
interest rates, and private ownership of banks. The adoption of Basel standards realigned the
supervisory and regulatory practices to international best practices. However, this was and is
done in a phased manner taking into consideration the stage of development of Indian
financial system and overall economic condition. Over the years, many expert groups were
formed to review the processes and practices to improve the supervisory approach. The
important ones include, but not limited to, Working Group to Review the System of On-site
Supervision of Banks (Chairman: S. Padmanabhan, 1995), Working Group on Consolidated
Accounting and Other Quantitative Methods to Facilitate Consolidated Supervision
(Chairman: Vipin Malik, 2001), Working Group on Monitoring of Systemically Important
Financial Intermediaries (Financial Conglomerates) (Convener: Smt. Shyamala Gopinath,
2004), and the High Level Steering Committee for Review of Supervisory Processes for
Commercial Banks (Chairman: K C Chakrabarty, 2012).
 The Basel Committee on Banking Supervision (BCBS) has identified Core Principles for
Effective Banking Supervision originally published in September 1997. This has been used as
a benchmark by many countries, including India, for assessing the quality of their supervisory
systems and for identifying future work to be done. Since 1997, however, significant changes
have taken place in banking regulation and supervision, necessitating a review of these
principles. The latest such revision was carried out in September 2012 and there are
currently 29 core principles covering supervisory powers and responsibilities, supervisory
expectations of banks, emphasising the importance of good corporate governance and risk
management, as well as compliance with supervisory standards.
What are the attributes of good supervision? An IMF Staff Position note titled “The
Making of Good Supervision: Learning to Say ‘No’”, provides some insight. It identifies five
key attributes that are essential for a good supervisory framework. First, Good supervision is
intrusive, i.e., the supervisor should have a thorough understanding of the supervised
entity’s business model, its risk culture and governance structure. A hands-off approach is
not advisable when it comes to bank supervision. Second, Good supervision is sceptical but
proactive. Supervisors should not take things for granted and question bank’s actions even in
good times. Third, Good supervision is comprehensive. Supervision should not be restricted
to only the bank and its core activities. It should encompass subsidiaries, off-balance sheet
vehicles or structures, etc. Often the risk may emanate from the periphery rather than from
the core and the supervisor must be vigilant. Fourth, Good supervision is adaptive. Given the
high level of innovation in financial industry, the supervisors should continuously upgrade
their skills to stay in touch to identify emerging risks. Finally, Good supervision is conclusive.
Supervisors must follow-through and ensure that supervisory findings are taken to a logical
conclusion. In order to bring about good supervision, according to the IMF note, two

59
supporting pillars are necessary: the ability to act and the will to act. The ability to act is
dependent on the legal authority, the necessary resources, clear strategy, a robust internal
setup and effective working relationship with other regulators and supervisors. The will to
act is judged in terms of having a clear and unambiguous mandate, operational
independence, accountability, skilled staff, healthy relationship with the industry, and an
effective partnership with boards of directors.
Legal and Institutional Structure in RBI
RBI has been entrusted with the responsibility of supervising the Indian banking
system under various provisions of the Banking Regulation Act (BR Act), 1949 and RBI Act,
1934. In particular, the inspection of banks under section 35 of B.R. Act is undertaken as a
follow up of the bank licensing regulation and objectives as laid down in Section 22 of the
Act. The substantive objective of the statutory inspections is to verify whether the
conditions subject to which the bank has been issued license to undertake banking business
[vide sub section 3, and for foreign banks also 3A of Sec.22] continue to be fulfilled by them.
RBI set up the Board for Financial Supervision (BFS), a sub-committee of the Central
Board of RBI, in November 1994, with the objective of dedicated and integrated supervision
of all credit institutions, i.e., banks, development financial institutions and non-banking
financial companies. The BFS is the responsible for Consolidated Supervision of the financial
sector under the jurisdiction of RBI (scheduled commercial banks and urban co-operative
banks, financial institutions and non-banking finance companies). The Governor, RBI is the
Chairman of the BFS, and the Deputy Governor in charge of banking supervision, is
nominated as the Vice Chairman. The other deputy governors of the Reserve Bank are ex-
officio members and four external directors from the Central Board of the RBI are co-opted
as members for a term of two years. DoS acts as the Secretariat of the BFS, which normally
meets once every month to deliberate various supervisory issues and approve the rating of
banks.
Prior to 1993, the Department of Banking Operations & Development (DBOD) was
responsible for the supervision and regulation of commercial banks. In December 1993, the
Department of Supervision (DoS) was carved out of the DBOD, with the objective of
segregating the supervisory role from the regulatory functions of RBI. As the financial system
developed and complexity grew, it was felt that dedicated and focused supervision of
different financial entities was the need of the hour. Accordingly, DoS was split into
Department of Banking Supervision (DBS), Department of Non-Banking Supervision (DNBS)
and Department of Co-operative Bank Supervision (DCBS). The latter two were created for
supervision of non-banking finance companies and urban co-operative banks.
In November 2019, with a view to having a holistic approach to supervision and
regulation of the regulated entities so as to address growing complexities, size and inter
connectedness as also to deal more effectively with potential systemic risk that could arise
due to possible supervisory arbitrage and information asymmetry, it was decided to
integrate the supervision function into a unified Department of Supervision (DoS). This
restructuring is

60
aimed at adopting a graded supervisory approach to all the RBI supervised entities linked to
their size and complexity; to facilitate more effective consolidated supervision of financial
conglomerates among the RBI supervised entities; and to help build experienced and skilled
human resources that also results in its efficient allocation. Furthermore, to train, develop,
and improve the skills of personnel in the supervisory departments, a ‘College of Supervisors’
was set up. The ‘College of Supervisors’ will provide extensive training to the officers on a
wide array of subjects and functions related to supervision of all regulated entities.
Approach / Models used for Supervision
It is well acknowledged that there is no single optimal structure or process for
supervising banks. Accordingly, supervisory approach adopted by a country is a function of
stage of development of its financial system and size and complexity of the banking system.
Some of the other factors, which influence the supervisory approach include, but not limited
to, the business models of banks and the availability of technological and human resources
for conducting supervision. The Core Principles for Effective Banking Supervision issued by
the Basel Committee on Banking Supervision (BCBS) provides the broad framework for
supervision. Principle 8 states that “ An effective system of banking supervision requires the
supervisor to develop and maintain a forward-looking assessment of the risk profile of
individual banks and banking groups, proportionate to their systemic importance; identify,
assess and address risks emanating from banks and the banking system as a whole; have a
framework in place for early intervention; and have plans in place, in partnership with other
relevant authorities, to take action to resolve banks in an orderly manner if they become non
viable.”
Prior to the global financial crisis, in most jurisdictions, a rule-based or compliance
based supervisory approach was in place. Banks were supervised under what is known as the
CAMELS model, an abbreviation for Capital Adequacy, Asset Quality, Management, Earnings,
Liquidity and Sensitivity to Market Risk. In the Indian context, S in the CAMELS acronym
stood for Systems and Control. This approach focused on the monitoring and examination of
financial condition of banks and their compliance with the rules and regulations. Under this
model, onsite examination is carried out on an annual basis supported by offsite surveillance.
The CAMELS approach was focused on solvency and liquidity of the banks and primarily
aimed at limiting the risk of loss to depositors. This approach has the drawback of being a
‘Single Size Fit’ approach and is found to be behind the curve when it comes to keeping pace
with innovation in the financial sector.
The global financial crisis revealed that though many countries had similar financial
systems and operated under similar set of rules (Basel Standards), some of them were less
affected. One of the reasons attributed to this upshot is “better supervision”. Given the
inherent weaknesses in the CAMELS model, which may have contributed to the lax
supervision in existence before the crisis, a move towards a risk-based or risk-focused
approach to supervision gained momentum in many countries. There were primarily two
reasons for this shift towards risk-based supervision. First, there is a growing recognition
that banking in the

61
traditional sense of accepting deposits for the purpose of lending is no longer in vogue and
banks and banking are becoming complex. Second and equally important is the realisation
that supervisory resources are scarce and need to be optimally deployed to meet supervisory
goals.
Thus, there was a need for a robust supervisory framework, which proactively
identifies incipient risks and takes measures to address them. Recognizing this, the Reserve
Bank of India constituted a High-Level Steering Committee under the Chairmanship of former
Deputy Governor, Shri K C Chakrabarty, in August 2011, to review the supervisory processes
for commercial banks. The regulator, industry and academics had representation in the
Committee. The Committee, inter alia, recommended a shift to a risk-based approach to
supervision from the existing compliance-based approach. Based on the recommendations of
the committee, a risk-based approach to supervision was implemented from 2013 onwards
in a phased manner. All the scheduled commercial banks in India are now under the Risk
Based Supervisory (RBS) framework and the erstwhile CAMELS framework is no longer in
vogue.
Risk-based Supervision (RBS)
RBS may be defined as “an ongoing process wherein risks of a bank are assessed and
appropriate supervisory plans designed and implemented by the supervisor”. RBS can thus be
seen as a structured process, which identifies material and critical risks that a bank may
potentially face, and through a focused supervisory review process, assesses the bank’s
ability to manage the potential risks along with its financial vulnerability to adverse
outcomes.
The substantive objectives of supervision, risk-based or otherwise, are two-fold:

• Ensuring safety and soundness of the individual banks and thereby protecting the
interest of depositors; and

• Safeguarding the stability of the financial system

The risk-based approach to supervision aims to achieve the above overarching

objectives through a supervisory process of comprehensive and structured assessment of the
major risks faced by banks. The risk-based approach marks a considerable shift from the
earlier predominantly compliance-based CAMELS/ CALCS 65 methodology, but it continues to
involve assessing the level of compliance in banks with an objective of assessing the
compliance culture and attendant risks.
At a broad level, the risk-based and compliance-based approaches have much in
common. They both involve a combination of on-site examination and off-site data analysis.
The critical difference is that under risk-based approach a more organised structure is in
place to identify and quantify those activities of a bank that carry greater risk and also assess
the risk management practices and controls in place to mitigate the risk. Risk-based
supervisory approach is intended to result in a supervisory system that, on an ongoing and
dynamic basis,
65
CALCS (Capital Adequacy, Asset Quality, Liquidity, Compliance, Systems and Control) was the supervisory rating model
used for foreign banks

62
assesses the safety and soundness of banks. It seeks to achieve an accurate assessment of a
bank’s risks in order to ascertain the extent of capital commensurate to the level of risks a
bank is exposed to. In doing so, the risk-based supervision targets early identification and
timely response to emerging risks. This would enable the supervisor to optimally use the
scarce supervisory resources to deal with the identified risks. Moreover, unlike in a
compliance-based CAMELS model where individual risks are examined in isolation, in a risk
based framework, interaction between risks is examined. Thus, improving proportionality
and economic efficiency of supervision through the optimal use of supervisory resources and
developing specialised expertise is the cornerstone of RBS.
The RBS framework as adopted by RBI is called SPARC (Supervisory Program for
Assessment of Risk and Capital). While, the supervisory approach under CAMELS is
performance based, reactive and is a point-in-time assessment, SPARC is risk-based, forward
looking, proactive and dynamic in identifying incipient risks and prompting early response.
The three key objectives of SPARC are: (1) to apply differentiated supervision based on risk
profile of the bank. i.e., different banks will be subjected to varying degrees of supervision;
(ii) focus on areas deemed as higher risk for the bank. i.e., within a bank the focus will be
given to areas that are identified to have significant material risks; and (iii) to help banks in
improving their risk management systems, oversight and controls. The focus of SPARC is on
the unexpected losses (say, exposure as opposed to outstanding) for which more capital may
be required.
A risk-based supervisory framework has two dimensions: First, the risk of failure,
which is based on the assessment of the inherent risks, the controls in place at the entity
level, the governance & oversight at the bank and available capital; second, the impact of
failure, which takes into account the relative significance of the entity or the group in the
overall financial system. The risk of failure determines the overall supervisory rating and the
extent of supervisory capital. In arriving at supervisory stance (i.e. intensity of supervision)
the SPARC framework considers both the risk of failure and the impact of failure of a
banking entity. This is achieved through a proprietary risk scopring and aggregation model
called “Integrated Risk and Impact Scoring (IRISc)” model.
To assess the risk of failure, both onsite and offsite risk discovery is carried out. The
offsite risk discovery process involves collection of data, documents, etc., as well as
discussions with the management personnel of the banks. The offsite risk discovery process
provides information about the key risk areas (the universe of risk measures includes, credit
risk, market risk, operational risk, liquidity risk, etc.) pertaining to a bank. The offsite risk
discovery process will determine the areas, which need further clarity and necessitate an
onsite visit, the length of on-site visit and the supervisory resources required to conduct such
visit. The offsite surveillance is a key component of the supervisory framework, even more so
in RBS. The offsite surveillance enables the RBI to monitor continuously the health of the
banks, which act as input for remedial actions, if any. Since optimal utilisation of scarce
supervisory resources is one of the key objectives of the RBS, offsite monitoring assumes

63
greater importance as onsite examination is carried out in a targeted fashion with the most
critical areas receiving supervisory attention.
The onsite risk discovery process involves further investigation into identified risk
areas including obtaining additional information. In this step, a dedicated team of supervisors
conduct onsite inspection of the identified areas/ aspects at the premises of the banking
entity. The severity of risk and the volume of business determines periodicity, length and
intrusiveness of on-site examination. A major part of the on-site examination involves:(i)
discussion with the key functionaries of the bank regarding processes, products, policies,
procedures, etc., (ii) verification of the accuracy of information submitted by the bank as
part of regulatory reporting, including any additional data/ information received, (iii) review
of the effectiveness of the controls in place to deal with the material risks the bank is
exposed to, (iv) review of overall board and management oversight and the role played by
risk management and internal audit function in the bank, and (v) review of compliance with
regulatory guidelines and accounting standards including testing of transactions based on a
pre-determined sample size to ascertain if they are in compliance with the guidelines. Thus,
the RBS framework incorporates both elements of leading indicators that is aimed at risk
discovery and lagging indicators such as capital and compliance review.
 Even though the risk-based approaches applied by different supervisors are broadly similar,
they vary depending on several factors, including the mandates of the supervisory agencies.
An important dimension that many supervisory agencies have incorporated into their risk-
based system is determining the systemic importance of each firm. Systemically important
firms, all other things being equal, attract greater supervisory attention (and resources) than
non-systemically important firms.
The creation of a Senior Supervisory Manager (SSM) is one of the key features of
SPARC. The creation of SSM is primarily aimed at having a single point of supervisory contact
for banks within RBI. This is expected to improve the efficiency and effectiveness of the
supervisory processes by removing multiple points of contact for the banks within the
Department of Supervision and more broadly within RBI, which at times could undermine an
effective and continuous supervision. The SSM for a bank is supported by a dedicated team
of officers. The SSM is expected to develop a strong understanding of the bank and its
operations through off-site and on-site examination and continuous monitoring.
To summarise, the key benefits of a risk-based framework for supervision are: (i)
optimal use of scarce supervisory resources, which in turn results in better use of
organisation’s resources (ii) a dynamic and ongoing assessment of risks faced by regulated
entities; (iii) early identification and recognition of emerging risks; (iv) a structured and
consistent framework for evaluating risks based on separate assessment of both inherent
risks and risk management controls. This also enables in a system-wide assessment of
banking sector risks as all the entities are evaluated under the same model with less
subjectivity; and (v) a better understanding of a bank’s business, systems, processes, human
resource, etc.

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Typology of Supervisory Approaches
Considering the differentiated approach to supervision and the proportionality
paradigm, variant RBS models are developed in addition to the main model for regular banks
and the others for small or niche banks, based on certain benchmarks. To achieve the right
balance between onsite and off-site supervisory processes, the following classification is
adopted in the supervision of different categories of banks.
(a) Full Scope Supervision (FS): Involves the most detailed and intrusive supervisory
approach, both on-site and off-site, covering all the material risks of a bank
(b) Select Scope Supervision (SS): Off-site supervision plays the major role in this
approach with on-site examination a function of concerns emerging from off-site
analysis. Moreover, on-site examination shall be centred around operations that are
critical to the functioning of the bank, such as IT/Cyber risks in respect of private
banks, compliance in the case of small finance banks, etc.
(c) Thematic Assessment (TA): This approach is aimed at assessing topical themes, such
as asset quality, cyber risk, etc., with the assessment covering a group of banks or all
banks.
 (d) Targeted Scrutiny (TS): Under this approach, scrutiny is undertaken to examine
specific aspects of a bank based on supervisory or market intelligence inputs.
Grouping of banks for differentiated supervisory approach
The proportionality paradigm demands differentiated approach to supervision.
Accordingly, banks are classified into groups/sub groups for deciding the appropriate
supervisory approach. The principle criteria used to categorize banks is market share of their
reported assets. The supervisory intrusion is linked to the category of the bank under normal
circumstances though the same can be reviewed based on risks emanating in case of any
entity.
Various Tools of Supervision
To conduct meaningful supervision of regulated entities, both off-site surveillance and
onsite examination are equally important. RBI uses a judicious mix of off-site and on-site
tools to conduct a ‘close and continuous’ supervision of banks.
Off-site Supervision
Off-site supervision is a key supervisory tool used by authorities to analyse a bank’s
profile, culture, risk tolerance, operations and environment on a dynamic basis.
It provides the specific inputs that shape on-site examination. The objective of off-site
supervision is to make a preliminary risk assessment of the bank and discover key risk areas.
This involves assessment of their business plan/ strategies, group structure, financial
statements, compliance and internal audit/plans and reports, observations of external
auditors, etc. This along with assessment of macroeconomic factors and market intelligence

65
inputs aid in deciding the scope, focus, resources and time required for onsite examination.
In this context, an Off-site Monitoring and Surveillance (OSMOS) system was set up as a
complementary tool to on-site inspection. Under OSMOS, various returns are collected at
different periodicities, viz., fortnightly, monthly, quarterly, half yearly and annual.
Central Repository of Information on Large Credits (CRILC) has been introduced in
2014 as part of Framework for Revitalising Distressed Assets in the economy. Credit
information on large borrowers66 are collected from the banks under this system with effect
from quarter ended June 2014. Information collected under the OSMOS (along with CRILC)
system cover balance sheet, income, expenditure and profitability, capital, assets quality,
ownership, off-balance sheet exposures, liquidity and several other areas with significant
details. All users concerned access off-site data through the Database on Indian Economy
(DBIE) site67.

Borrower level credit information reported in the CRILC system and sharing relevant
information among the banks has eliminated information asymmetry and brought in much
needed transparency. It is expected to enhance the credit appraisal mechanism in banks
providing hitherto missing requisite information about the borrower. Thus, CRILC has been
found very useful for the banks, SSMs as well as for policy making. The OSMOS Division
primarily strives for (i) timely collection of data from the banks, (ii) to maintain reasonable
degree of data quality and (iii) to facilitate making sense of the data by providing useful and
meaningful readily available standard reports in DBIE apart from need-based analysis and
supply of voluminous data.
Onsite Examination
Onsite examination complements off-site surveillance by focusing on conducting
validation checks of data gathered under off-site surveillance, assessing the risk areas
identified, including capital assessment, and following-up on issues identified from previous
assessments. Onsite examination demands not just high levels of technical skills but also
interpersonal skills to both understand and assess the risk as well as draw information that
may be material to a bank’s ability to continue as a going concern.
Para-supervisory Activities
Central Fraud Registry
As Frederick William Robertson eloquently said, “There are three things in the world
that deserve no mercy - hypocrisy, fraud, and tyranny”. Fraud - there is no universal
definition of what it means - is a generic term used to describe human ingenuity that engage
in unscrupulous activities with the aim to gain an unfair advantage either through
suppression of truth or falsehood of wrong. Frauds in banking are a serious matter as banks
deal with large amounts of public money in their role as financial intermediaries. While there
can be many causes for fraud, it is important to detect them at an early stage to contain the
losses and
66
A large borrower is defined as one who has aggregate fund-based and non-fund based exposure of ₹5 crore and above
67
DBIE can be accessed from [Link]

66
prevent their recurrence. Keeping this objective in mind, a Central Fraud Registry (CFR) has
been operationalised with effect from January 20, 2016. The CFR will provide “a searchable
centralised database for use by banks”, which in turn can alert banks to take necessary steps
to develop a sound and robust fraud risk management system.
Cyber Security Framework
Information technology has become an integral part of the operational aspects of a
bank and the use of technology has grown exponentially in the recent past. While the use of
technology has many advantages, it also exposes banks to cyber-attacks.
In the wake of rising concerns on cyber security incidents in banks, the BFS directed that the
RBI should have a thorough supervisory insight into the IT systems of the banks. Accordingly,
an Expert Panel on Cyber Security and IT Examination was constituted with Executive
Director In-Charge of Department of Banking Supervision as the Chairperson. A dedicated
Cyber Security & IT Examination Cell (CSITE Cell) was also established in June 2015 within the
RBI.
Under the aegis of the Expert Panel, a comprehensive circular, “Cyber Security
Framework in Banks”, covering the best practices pertaining to various aspects of cyber
security was issued. In terms of the circular, banks are required, inter-alia, to put in place a
Cyber Security Policy distinct from Information Security Policy, report unusual cyber incidents
to RBI within stipulated time frame, carry out & submit the gap assessment with respect to
the best practices mentioned in the circular, etc.
Early Warning System and Action
Early warning indicators are critical to detect the build-up of vulnerabilities in the
banking system. At a macro level, this involves looking at aggregate indicators such as credit
to-GDP ratio, economy-wide debt service ratios (DSRs), etc., to identify systemic risk. At a
micro level, banks are subject to stress testing, capital planning, asset quality review, liquidity
monitoring, etc. These are aimed at alerting the bank management and supervisory
authorities about the potential adverse shocks that could arise from a wide range of risks as
well as provide an estimate to banks and supervisory authorities of the financial resources
that might be needed to absorb losses should risks materialise.
Prompt Corrective Action (PCA)
The "Core Principles for Effective Banking Supervision" drawn up by the Basel
Committee in 1997, which were in the nature of minimum requirements intended to guide
supervisory authorities in strengthening their current supervisory regime, stressed upon the
necessity of supervisors having at their disposal adequate supervisory measures, backed by
legal sanctions, to bring about timely corrective action when banks fail to meet prudential
requirements (such as minimum capital adequacy ratios), when there are regulatory
violations or the depositors’ interest is threatened in any other way. Accordingly, a system of
Prompt Corrective Action (PCA), based on pre-determined rule-based structured early
intervention, was put in place in December 2002 to strengthen the existing supervisory

67
framework. As per the original scheme of PCA the RBI will initiate certain structured actions,
such as, restrictions on dividend payments, entry into new lines of business, acceptance of
fresh deposits, etc., on those banks that have hit the trigger points in terms of capital
adequacy, asset quality and profitability.
As per the directions of the Sub-Committee of the Financial Stability and
Development Council (FSDC-SC) the RBI decided to review and upgrade the existing PCA
framework for banks. The revised PCA framework was notified in April 2017 and applies
without exception to all banks operating in India including small banks and foreign banks
operating through branches or subsidiaries based on breach of risk thresholds of identified
indicators. The key areas for monitoring banks under the revised framework continue to be
capital, asset quality and profitability, while leverage is monitored additionally as part of PCA
framework. The indicators tracked for capital, asset quality and profitability are
CRAR/Common equity Tier 1 ratio, Net NPA ratio and Return on Assets respectively. Certain
risk thresholds have been defined, breach of which result in invocation of PCA and result in
certain mandatory and discretionary actions. Mandatory actions include restriction on
dividend distribution, branch expansion, higher provisions, etc. There is a common menu for
selection of discretionary actions such as, Special Supervisory Interactions (for example,
special audit of the bank), Strategy related actions (instruct bank to undertake business
process reengineering), Governance related actions (actively engage with the bank’s Board
on various aspects as considered appropriate), Capital related (reduction in exposure to high
risk sectors to conserve capital), Credit risk related (strengthening of loan review
mechanism), Market risk related (restrictions on derivative activities), HR related (review of
specialized training needs of existing staff), Profitability related (restrictions on certain forms
of capital expenditure) and Operations related (restrictions on branch expansion plans). In
addition, the PCA framework does not preclude the RBI from taking any other action as it
deems fit in addition to the corrective actions prescribed in the framework.
A bank is placed under PCA framework based on the audited financial results and
supervisory assessment made by RBI. However, RBI may impose PCA on any bank during the
year, in case the circumstances so warrant.
Stress Testing
The role of stress testing has rapidly evolved and grown in importance since the
Global Financial Crisis of 2007-09. Many jurisdictions are using stress testing to decide the
appropriate level of ‘supervisory capital’. In December 2013, RBI issued guidelines on stress
testing and made it mandatory for all banks to carry out tress tests involving shocks
prescribed in the guidelines at a minimum. The guidelines stated that banks should be able
to survive at least the base line shocks and adopt stress testing programmes that is
commensurate with the degree of sophistication.

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Red Flagged Accounts (RFA)
To prevent the incidence of financial frauds, the concept of a Red Flagged Account
(RFA) was introduced in 2015 as part of the early warning system. “A RFA is one where a
suspicion of fraudulent activity is thrown up by the presence of one or more early warning
signals (EWS).”. Accordingly, banks must set up systems for identifying EWS and flagging the
accounts as RFA for exposures of ₹50 crore and above.
Presenting Supervisory Outcomes
With experience gained and in order to have a modular approach to the components
of comprehensive supervisory processes, the supervisory outcomes are broken down to (i)
Risk Assessment Reports (RAR) taking care of unexpected losses of the banks; (ii) Inspection
Report (IR) covering the expected losses of the banks through (a) Assessment of Regulatory
Operations i.e compliance review and (b) Capital Review involving assessment of available
capital; and (iii) Assessment of Conduct of Business covering issues relating to bank’s
customer and market conduct.
Supervision in cross-national context
Internationally active banks can be a source of risk both for the jurisdiction in which it
operates as well as for the home country where its major operations are carried out.
Therefore, it is important for countries to cooperate in supervising these entities. Since
regulation and supervision of banks is mostly at national level rather than supranational
level, such cooperation among the authorities is vital in preserving financial stability across
borders. RBI periodically conducts onsite examination of Indian bank branches located
abroad to ensure that they adhere to both home and host country regulations as well as to
understand the risks posed by branch balance sheets to the bank balance sheet.
Supervisory College
The Reserve Bank of India has set up, as part of supervision of cross border
operations of Indian banks abroad, Supervisory Colleges for six major banks (State Bank of
India, Bank of Baroda, Bank of India, ICICI Bank Ltd., Axis Bank Ltd. and Punjab National
Bank) which have significant international presence. The main objectives of Supervisory
College are to enhance information exchange and cooperation among supervisors to
improve understanding of the risk profile of the banking group. This, in turn would facilitate
more effective supervision of internationally active banks. Further, DoS has entered into
MoU with a large number of global institutions in the matter of supervisory cooperation and
exchanges.

References - RBI (2012). Report of the High Level Steering Committee for Review of Supervisory
Processes for Commercial Banks, RBI, June 2012.

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Chapter 9: Regulation and Supervision of Co-operative Banks
in India
“Cooperatives are a reminder to the international community that it is possible to pursue
both economic viability and social responsibility” – former UN Secretary General - Ban Ki
moon
Introduction
Mahatma Gandhi once said: “Suppose I have come by a fair amount of wealth - either
by way of legacy, or by means of trade and industry - I must know that all that wealth does
not belong to me; what belongs to me is the right to an honourable livelihood, no better than
that enjoyed by millions of others. The rest of my wealth belongs to the community and must
be used for the welfare of the community”. This forms the essence of the co-operative
movement, which is based on the same principles of community camaraderie, mutual help,
democratic decision making and open membership, etc. commonly known as “Co-operative
Principles” as detailed below:
1. Voluntary and Open Membership - Co-operatives are voluntary organisations, open to all
persons capable of using their services and willing to accept the responsibilities of
membership, without discrimination on basis of gender, social inequality, racial,
political ideologies or religious consideration.
2. Democratic Member Control - Co-operatives are democratic organisations controlled by
 their members, who actively participate in setting their policies and decision making.
Elected representative of these co-operatives are responsible and accountable to their
members.
3. Member's Economic Participation - Members contribute equally and control the capital
of their Co-operative democratically. At least a part of the surplus arising out of the
economic results would be the common property of the co-operatives. The remaining
surplus could be utilised benefiting the members in proportion to their share in the Co
operative.
4. Autonomy and Independence - Co-operatives are autonomous, self-help organisations
controlled by their members. If co-operatives enter into agreement with other
organisations including Government or raise capital from external sources, they do so
on terms that ensure their democratic control by members and maintenance of Co
operative autonomy.
5. Education, Training and Information - Co-operatives provide education and training to
their members, elected representatives and employees so that they can contribute
effectively to the development of their co-operatives. They also make the general
public, particularly young people and leaders aware of the nature and benefits of co
operation.

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6. Co-operation among Co-operatives - Co-operatives serve their members most effectively
and strengthen the co-operative movement, by working together through available
local, regional, national and international structures
7. Concern for Community - While focusing on the needs of their members, co-operatives
work for the sustainable development of communities through policies accepted by
their members.
The co-operative movement in India is more than one century old. The organisation
of co-operative institutions in India dates back to 19th century, when the first mutual aid
society ‘Anyonya Sahakari Mandali’ was formed in Gujarat at Baroda on February 05, 1889.
The first major impetus was provided to these institutions by the passage of the Co-
operative Society Act in 1904 and the Kancheepuram Co-operative Credit Society in Tamil
Nadu became the first credit society to get registered under this Act. Later in 1919, the
subject of co-operation was transferred from Central Government to Provincial States.
Co-operative credit institutions are an important segment of the banking system, as
they play a vital role in mobilising deposits and purveying credit to people of small means.
They form an important vehicle for financial inclusion and facilitate transactions.
Traditionally, the co-operative institutional structure in India is divided into two categories
viz. ‘Rural’ and ‘Urban’ with the rural cooperatives having a federal structure. The present
structure is graphically represented below.
Characteristics of Co-operative Institutions

• They have focussed area of operation

• The Board of Directors is elected by shareholders in a democratic manner

• The borrowing from these institutions is restricted only to its members

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• There is share linking to borrowing, viz., the borrowing member is required to hold
share capital in the co-operative bank, the amount of which should not be less than a
certain specified percentage of the amount borrowed from the bank

• Members can cast only one vote irrespective of the number of shares held

• The shares of these institutions cannot be listed and traded

Difference between Co-operative Credit Societies and Co-operative Banks

‘Co-operative societies’ appear at Entry 32 in the State List, whereas ‘Banking’ appear
at Entry 45 in the Union List under the Seventh Schedule to the Constitution of India. Hence,
Co-operative Societies in India are a State subject and they do not fall under the regulatory
purview of RBI. Co-operative Credit Societies primarily cater to the credit needs of its
members by mobilizing deposits from their own members.
Co-operative Credit Societies, which are licensed to carry out banking activities
function as a co-operative bank and are eligible to accept deposits from the public. Urban Co
operative Banks (UCBs) are primarily registered as Co-operative Societies under the
provisions of either the State Co-operative Societies Act of the respective State or the Multi-
State Co operative Societies Act, 2002, if the area of operation of the bank extends beyond
the boundaries of one State.
The UCBs are divided into Tier-I and Tier-II UCBs depending upon the size of deposits
and area of operation. UCBs satisfying the following criteria are defined as Tier-I UCBs:

• Deposit base below ₹100 crore and operating in a single district.

• Deposit base below ₹100 crore and operating in more than one district, provided that
the branches are in contiguous districts, and deposits and advances of branches in one
district separately constitute at least 95 per cent of the total deposits and advances,
respectively, of the bank.

• Deposit base below ₹100 crore, with branches originally in a single district, which
subsequently became multi-district due to a re-organisation of the district.
All other UCBs are defined as Tier-II UCBs.
Legal framework for regulating Co-operative banks
Though the Banking Regulation Act came into force in 1949, the banking laws were
made applicable to co-operative societies only in March 1966 through an amendment to the
Banking Regulation Act, 1949 by insertion of section 56 (Part V) of the Act, which is
colloquially known as Banking Regulation Act, 1949 (AACS)68.

With this, co-operative banks came under the dual control of respective State
Governments / Central Government and the Reserve Bank, which make these institutions
distinctly different from commercial banks. While administrative aspects like registration,

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AACS – As Applicable to Co-operative Societies

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management, recruitment, audit, write-offs, amalgamation and liquidation are regulated by
the State/Central Governments, matters related to banking are regulated by the Reserve
Bank under the Banking Regulation Act, 1949 (AACS).
With a view to bring in uniformity for protecting the interests of depositors across all
banks, the Banking Regulation (Amendment) Ordinance, 2020 69 was promulgated on June 27,
2020. The Ordinance that seeks to amend the Banking Regulation Act, 1949 (AACS) provides
for augmenting capital by Urban Co-operative Banks through issues of shares, debentures
and other similar securities with the approval and conditions that may be stipulated by RBI.
The Ordinance adds that in case of a co-operative bank registered with the Registrar of Co
operative Societies of a State, the RBI may supersede the Board of Directors after
consultation with the concerned State Government, and within such period as specified by it.
However, RBI may exempt a cooperative bank or a class of co-operative banks from certain
provisions of the Act through notification for such time period and under such conditions as
may be specified by the RBI.
While UCBs are regulated and supervised by RBI, Rural Co-operative Banks, viz., the
State Co-operative Banks (StCBs) and the District Central Co-operative Banks (DCCBs) are
regulated by RBI but supervised by NABARD70. The Long Term Rural Co-operatives, viz., State
Co-operative Agriculture and Rural Development Bank (SCARDB) and Primary Co-operative
Agriculture and Rural Development Bank (PCARDB) do not fall under the regulatory or
supervisory purview of RBI.
Definition of an Urban Co-operative Bank
Sec. 5(ccv) of Banking Regulation Act, 1949 (AACS) defines Urban Co-operative Banks
(UCBs) as a co-operative society, other than a primary agricultural credit society and
satisfying the following conditions:

• The primary object or principal business of which is the transaction of banking business;

• The paid-up share capital and reserves of which are not less than one lakh of rupees;
and
 • The bye-laws of which do not permit admission of any other co-operative society as a
member.
Growth and Consolidation of Urban Co-operative Banks (UCBs)
When the provisions of Banking Regulation Act, 1949 were made applicable to these
UCBs in 1966, making it mandatory to obtain a licence from RBI to do banking business, there
were about 1100 UCBs with deposits and advances of ₹167 crore and ₹153 crore respectively.
Thereafter, Reserve Bank pursued a liberal licensing policy, especially pursuant to the
recommendations of the Marathe Committee. Accordingly, from 1311 UCBs in the year 1993,
the number increased to 1926 UCBs by 2004. However, nearly one-third of the newly licensed

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The Ordinance has to be passed as an Act by the Parliament within 6 months
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NABARD – National Bank for Agriculture and Rural Development

73
UCBs became financially unsound within a short period. In the light of the experience and the
prevailing financial health of the UCB sector, it was decided in 2004-05 that the Reserve Bank
would consider issuance of fresh licenses only after a comprehensive policy on UCBs,
including an appropriate legal and regulatory framework for the sector, was put in place. No
fresh licences have been issued since then for setting up of new UCBs. However, due to
mergers/amalgamations, conversion to credit societies and cancellation of licences of UCBs
over the years, the number of UCBs in the country has come down to 1538 as on May 31,
2020. In terms of total assets, UCBs contributed 3.2% of total banking system assets as at
March 2019.
Initiatives taken by RBI
The Reserve Bank undertook several steps to strengthen the sector during this period.
To improve the financial soundness of the UCB sector, through better coordination between
the co-regulators, the Reserve Bank of India entered into Memoranda of Understanding
(MoU) with all State Governments and the Central Government since 2005. As part of the
arrangements under MoU, the Reserve Bank constituted, in each State, a State-level Task
Force for Co-operative Urban Banks (TAFCUB) for UCBs which operate only in one State. A
Central TAFCUB was constituted for the Multi-State UCBs. TAFCUBs identify potentially viable
and non-viable UCBs in the states and suggest revival path for the viable and non-disruptive
exit route for the non-viable ones. The exit of non-viable banks could be through merger/
amalgamation with stronger banks, conversion into societies or liquidation as the last option.
To give direction and impetus to the resolution processes for weak banks (banks with
precarious financial position), Reserve Bank has issued guidelines for financial restructuring to
aid revival of weak banks including various financial instruments that can be used for the
purpose and also on merger of UCBs with other UCBs including with and without DICGC
support, acquisition of UCBs with commercial banks.
Reserve Bank has recently also brought out guidelines for voluntary transition of UCBs
into Small Finance Banks (SFBs) subject to certain conditions and for constitution of Board of
Management (BOM), in addition to Board of directors, for bringing about improvement in the
governance and banking functions of UCBs.
 Apart from this, RBI has recently brought in norms for UCBs to adhere to stringent and
higher Priority Sector Target (in a graded approach to reach a target level of 75%) with
penalty of placement of shortfalls in RIDF at lower interest rates and tightened Exposure
norms linking the ratio to the robust Tier I capital instead of total capital and also mandating
50% of loans to be extended towards small borrowers. Nonetheless, they continue to remain
outside the Lead Bank Scheme of RBI and not represented in various fora of SLBC.
To ensure technological soundness of the UCBs basic cyber security norms have been
put in place for all banks along with additional requirements based on their digital depth.

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Regulation of UCBs
The Reserve Bank of India derives its powers to regulate UCBs mainly from the
Banking Regulation Act, 1949 (AACS) and Reserve Bank of India Act, 1934. The regulations
include issue of branch licences, authorization for extending their area of operation,
prescribing CRR and SLR requirements and prudential norms for capital adequacy, income
recognition, asset classification and provisioning norms, exposure norms, targets for priority
sector lending, inclusion of UCBs into second Schedule of RBI Act, 1934, etc.
Approach to Regulation of Co-operative Banks
With a view to enabling UCBs to offer banking services on par with commercial banks,
RBI has permitted them to open specialized branches, currency chests,
on-site/off-site/mobile ATMs, undertake intra-day short selling in government securities and
ready forward contracts in corporate debt securities, access Centralised Payment
System/RTGS/NEFT/NDS-OM, open Current Account and SGL accounts with RBI, sell
insurance products/mutual fund units, act as PAN service agents, undertake Point of
Presence services for PFRDA, engage Business Correspondents/Business Facilitators, offer
mobile banking /internet banking facility and trading facilities to Demat account holders,
issue prepaid instruments, etc. Scheduled UCBs have been permitted access to Liquidity
Adjustment Facility (LAF) and Marginal Standing Facility (MSF) of RBI. Thus, these co-
operatives provide universal banking services in a niche geographical area, whereas
commercial banks are mandated to provide niche services throughout India.
Financial Assistance for implementation of Core Banking Solution in UCBs
Keeping in view the difficulties encountered by several small UCBs in implementing
Core Banking Solution (CBS), the Reserve Bank announced a scheme of financial assistance in
April 2016, whereby the initial set up cost of up to ₹4 lakh would be borne by RBI and
technical support for implementation of CBS would be provided by the Indian Financial
Technology and Allies Services (IFTAS), a wholly owned subsidiary of RBI. This initiative has
been taken to bring the co-operative banks into a technology platform on par with
commercial banks.
Supervision of UCBs
To ensure that UCBs function on sound lines and their methods of operation are
consistent with statutory provisions and are not detrimental to the interests of depositors,
they are subject to both (i) on-site inspection and (ii) off-site surveillance.
i. On-site Inspection: The statutory inspections conducted under Section 35 of the
Banking Regulation Act, 1949 (AACS) follows the CAMELS pattern to assess the Capital
Adequacy (C), Asset Quality (A), Management (M), Earnings (E), Liquidity (L) and
Systems & Control (S) of the UCBs. These inspections basically make a core
assessment and brings out specific review of:
a. Financial condition and performance,
b. Management, systems and controls and

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c. Compliance with regulatory and other guidelines.
ii. Off-site surveillance: In order to have continuous supervision over the UCBs, the Reserve
Bank has supplemented the system of periodic on-site inspections with off-site
surveillance (OSS) through a set of periodical prudential returns that will be submitted
by UCBs to RBI. These returns are analysed at RBI for identifying incipient indicators
that may cause deterioration in the health of the banks. Sometimes, the analysis may
also act as a trigger to take up an UCB for inspection before it is scheduled.
Supervisory Action Framework (SAF)
RBI has put in place a Supervisory Action Framework (SAF) under Sec.36(1) of BR Act,
1949 (AACS) for UCBs experiencing financial stress. The framework, that was revised on
January 6, 2020 aims at bringing about the desired improvement in such UCBs as also an
expeditious resolution. Financial triggers are based on the required level of Net NPA (Asset
Quality), Profitability and Capital to Risk-Weighted Assets Ratio (CRAR). Depending on area
and extent of weakness and financial triggers71, actions may include restriction on opening
new branches, capital expenses, declaring/disbursing dividend, reducing exposure norms for
loans or freezing the limit of total advances to the level existing on a particular day, etc. Such
supervisory action will normally be initiated on the basis of assessed financial position of
UCBs by the RBI inspection. However, action may also be taken on the basis of the
reported/audited financial position which may be subsequently reviewed, if necessary, on
the basis of the statutory inspection findings. Although supervisory action taken will primarily
be based on the criteria specified under SAF, Reserve Bank will not be precluded from taking
appropriate supervisory action in case stress is noticed in other important
indicators/parameters or in case of serious governance issues or any such issues based on
merits of each case.
The banks whose financial conditions continue to severely deteriorate are brought
under All Inclusive Directions (AID) under Section 35A of the Act ibid, which entails, inter-alia
complete prohibition on accepting fresh deposits and grant of fresh loans, besides restricting
repayment of deposits to a specified ceiling. The banks under AID are monitored closely with
an advise to either have robust revival plan or explore possibilities of merger/conversion to a
Society. The Action Plan for revival consists of action in one or more of the following areas:
a) NPA recovery
 b) Capital augmentation through contribution from existing members or by making
new members
c) Capital infusion by Central/State government
d) Cost cutting measures like rationalising branch network, reducing staff expenses
and other overheads, implementing VRS, etc.

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The financial triggers are specified in the Supervisory Action Framework (SAF) issued to UCBs vide DOR (PCB).BPD. Cir No.
9/12.05.001/2019-20 dated January 6, 2020.

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