BANKING LAW PROJECT

NATIONAL LAW UNIVERSITY, ODISHA

BANKING LAW PROJECT ON:

ORIGIN AND DEVELOPMENT OF RBI
SUBMITTED BY: SNEHASHREE HOTA (13/BA/047)
SUMAN SETTY (13/BA/049)
SUBMITTED TO: MR. KAPIL SHARMA
ASSISTANT PROFESSOR OF BANKING LAW

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TABLE OF CONTENTS
INTRODUCTION2
CONTITUION OF RBI....3
FUNCTIONS OF DIRECTORS...3
DEVELOPMENT OF RBI...3
KEY POINTS IN THE JOURNEY OF RBI4
FROM PRIVATE ONERSHIP TO STATE ONERSHIP4
ROLE OF RBI IN DEVELOPMENT..5
DEVELOPMENT IN THE PAYMENT SYSTEM.5
DEVELOPMENT OF FOREX MARKET IN INDIA6
RELATIONSHIP OF RBI WITH THE GOVERNMENT.7
REFORMS IN MONETARY POLICY.8
MONETARY POLICY DURING 1972 TO 1991..8
MONETARY POLICY DURING 1991 TO 19969
FISCAL MONETARY RELATIONSHIP...10
OPEN MARKET OPERATIONS.11
COST OF CREDIT...11
REFORMS IN FOREIGN ECHANGE MARKET...11
CONCLUSION..13

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RESEARCH METHODOLOGY
OBJECTIVE: The main objective of our research is to analyze the growth and development in
the Indian banking system. To understand the impact of reforms in monetary policies in terms
of its growth and stability.
SCOPE OF STUDY: This paper deals with chapters consisting of the origin and development
of RBI. It primarily focuses on RBIs role in the development of Indian economy, Forex
Market and payment systems of the banks. It examines the changing role and importance of
monetary tools in India. Another major part focuses on the reforms in monetary policy through
decades.

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INTRODUCTION
It was the Hilton Young Commission based upon whose recommendations Reserve Bank of
India (hence referred as RBI) was set up. RBI commenced its operations from April 1,1935
onwards corresponding to the Reserve Bank of India Act 1934. Its office was in Calcutta but
in 1937 it shifted permanently to Mumbai. It was originally set up as shareholders bank but was
subsequently in 1949 it was nationalised to be fully owned by the Government of India.
The purpose for which the Bank had come about was:

Overseeing the issuing of bank notes

Ensuring monetary stability by securing reserves

Monitor credit and currency system to benefit the nation.

In the beginning of its operations RBI firstly, took over the function of controlling currency
from the Government and secondly, took over public debt and government account
management from the Imperial Bank of India.

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CONSTITUTION OF RBI
The Internal affairs of the Bank are governed by a Government of India 1 appointed or
nominated, Central Board of Directors in accordance with the Reserve Bank of India, Act, for
a period of four years. The Constitution of Directors is as; Official Directors constituted by a
Governor and a maximum of four Deputy Governors, Non Official Directors consisting of ten
Directors nominated by Indian Government2

from a variety of fields along with two

Government Official, and Four other Directors one from each local board.
The Local Boards consist of five members, appointed for a term of five years by the central
government, one from each region, New Delhi, Chennai, Calcutta , and Mumbai.

FUNCTION OF DIRECTORS
The Central Board of Directors direct affairs of the Bank and exercise control in general,
whereas, the Local boards not only represent financial and the territorial interest of the banks3
and cooperatives of the said region but also provide the Central Board with suggestion.
The Financial Supervision of RBI4 is performed in accordance with the directions issues by
Board of Financial Supervision which supervises banking and non banking companies as well
as financial institutions.

DEVELOPMENT OF RBI
In the year 1933, the circumstances in the country insisted the British to make transfer of
responsibility of the Bank from the Central Government to Indians only on the conditions of a
Reserve Bank5 which is free from political influences is founded and is operates successfully.
Accordingly a bill6 was introduced in the Indian Legislative Assembly. In the year 1934, the
bill was passed and it received assent of the Governor-General, it became the Reserve Bank of

https://www.rbi.org.in/Scripts/AboutusDisplay.aspx#EP.
Vijayaraghavan Iyengar, Introduction to Banking, Excel Books Publishers, (1st ed. 2007), Chapter 2: Reserve
Bank of India, p.26.
3
http://www.yourarticlelibrary.com/economics/7-major-functions-of-the-reserve-bank-of-india/2764/.
4
https://www.rbi.org.in/commonman/English/Scripts/Organisation.aspx.
5
Anand Chandavarkar, Central Bank and Government: An Untold Story from Rbi's Early History, Economic
and Political Weekly, Vol. 35, No. 34, (2000), 30483060.
2

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India Act, 1934. In 1935, in accordance with the Act and under its provisions7 the Reserve
Bank of India8 was constituted also commenced its operations in the same year.

FROM PRIVATE OWNERSHIP TO STATE OWNERSHIP

Initially, the Reserve Bank was constituted as a shareholders bank it was based on the model
of leading foreign central banks.9 After a period of time there was a need for a close integration
of the monetary and credit policies10 of the bank also the macro-economic policies, this raised
the notion of state ownership11 of the bank. After independence, the RBI was nationalized12
and its ownership was passed to the Government under The Reserve Bank (Transfer to Public
Ownership) Act, 1948. Since 1949, the Reserve Bank of India has started functioning as a
state-owned central banking institution.
ROLE OF RBI IN DEVELOPMENT
The central bank is seen as the major institution in the growth of the economy. 13 Initially, RBI
was segmented and thinly spread. Despite of the cooperative movement, the institutional
lending in the rural areas was not very effective and poor. India being a country, where more
than three- fourth of the population lived in the rural areas,14 contributing more than half of
GDP, there was a constant need of effective agricultural credit.
On an yearly basis a committee was constituted to evaluate and examine the mechanism of
rural credit. The objective of RBI was to raise the savings ration to higher investment which is
necessary for growth. With this objective the RBI assisted the government in setting up of
6

J. S. G., Wilson, Review of History of the Reserve Bank of India (1935-51), The Economic Journal, Vol. 81, No.
324, (1971), 994996.
7
G. Findlay, Shirras The Reserve Bank of India. The Economic Journal, Vol. 44, No. 174, (1934), 258274.
8
Aditya Mukherjee, Controversy over Formation of Reserve Bank of India, 1927-35, Economic and Political
Weekly,Vol. 27, No. 5, (1992), 229234.
9
Kusum W. Ketkar and Suhas L. Ketkar. Public ownership of commercial banks and economic development - a
case study of India / actionnariat public des banques commerciales et developpement economique: une etude de
cas en inde. Savings and Development, Vol. 17, No. 1, (1993), 522.
10
Mohan, Rakesh, Mohsin S. Khan, and M. Ashraf Janjua. Reforms, Productivity, and Efficiency in Banking:
The Indian Experience [with Comments], The Pakistan Development Review, Vol. 44, No. 4, (2005), 505538.
11
K. B. L. Mathur, Mythology of Banking Ownership. Economic and Political Weekly, Vol. 41, No. 49, (2006),
50395040.
12
Anand Chandavarkar, Resignation of the First Governor of RBI: A Response, Economic and Political
Weekly, Vol. 36, No. 23, (2001), 20882089.
13
Arun Ghosh, National Accounts and the Flow of Funds, Economic and Political Weekly, Vol. 24, No.24,
(1989), 13171319.
14
Shouvik Chakraborty and Zico Dasgupta, The Challenges Before NABARD in the Midst of Rbi's Sterilisation
Policy, Economic and Political Weekly, Vol. 45, No. 31, (2010), 7178.

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financial institutions in industrial and agricultural sectors, so that it can widen the scope of
facilities for finance and savings.
In 1956 a second Five Year Plan15 was launched to increase industrial investment. Within a
small period of time, the government with the involvement of RBI established various financial
institutions16 like, State Financial Corporations (SFCs), the Industrial Finance Corporation of
India (IFCI), Industrial Development Bank of India (IDBI) and the Industrial Credit and
Investment Corporation of India (ICICI).

DEVELOPMENT IN THE PAYMENT SYSTEM

An efficient payment and settlement system is an essential requirement for functioning of a
financial system. Hundis were the most important credit instrument used for credit, remittance
and trade transactions, has evolved since the twentieth century. In the nineteenth century the
settlement between member banks used to take place by cheques drawn on the Presidency
Banks.
Upon the establishment of RBI, the task of efficient payment and settlement system 17 was
taken given to it. With the objective of efficient payment system the Real Time Gross
Settlement (RTGS) system was operationalised in 2004 for inter-bank transactions. RBI has
delegated the commercial banks to set up MICR based cheque processing centres. The Clearing
Corporation of India Ltd. has performed operations for clearing process relating to money,
foreign exchange markets and government securities. Though the RBI does not act as a service
provider, under this arrangement it has continued to have its regulatory authority over such
functions.18 RBI also operates RTGS which provides for fund transfers in electronic mode.

Urjit R. Patel, Emerging Reforms in Indian Banking: International Perspectives, Economic and Political
Weekly, Vol. 32, No. 42, (1997), 26552660.
16
K. Kaladhar, Designing Financial Services for Rural Poor: Retooling Rural Financial Institutions?, Economic
and Political Weekly, Vol. 31, No. 39, (1996), A117A122.
17
Robert A. Kavesh, Evolving Structure of Financial Institutions, Business Economics, Vol. 5, No. 1, (1970),
3035.
18
Narendra Jadhav, Financial Sector Reforms and the Balance Sheet of the RBI, Economic and Political
Weekly, Vol. 40, No. 12, (2005), 11421150.
15

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RBIS MAJOR ROLE IN DEVELOPMENT OF FOREX MARKET IN INDIA
RBI in its Weekly Statistical Statement publishes all relevant data with respect to the Forex
Market.19 The risks involved in forex trade is in lieu of the large amounts of money dealt on a
daily basis and also by the way of transactions and payment system across time zones that has
created global interdependence.20 Accepting the suggestions of Sodhani Committee RBI, in
2001 started CCIL, with the sole purpose of easing risks in the Indian Financial Market. 21 The
function of CCIL is the forex22 trade settlement which is guaranteed through innovation
processes, on a multilateral net basis.23 CCIL settles 3500 deals on a day to day basis worth
US$3.5 bn.24 A trading platform providing for banks to deal with US dollars/rupee, was also
set up by CCIL.

RELATIONSHIP OF THE RBI WITH THE GOVERNMENT

Statutorily the RBI is a banker to the Central Government25 and to the State Governments by
virtue of agreements with them. In the early decades the RBI lost its autonomy26 as a
consequence of the overall economic policy which primarily focused on the dominant role of
the Government in the countrys economy. Over the time the relationship of RBI has evolved
with the Government,27 the functions of RBI became more diversified with operation of
economic planning in 1951.28

19

K M Parchure, RBI and Financial Reforms, Ganpati Mendali, Development of Forex Market in India,
Soumya Kanti Ghosh, RBI Intervention in the Forex Market: Results from a Tobit and Logit Model Using
Daily Data, Economic and Political Weekly, Vol. 37, No. 24, (2002), 23332348.
20

21

https://www.google.co.in/url?sa=t&rct=j&q=&esrc=s&source=web&cd=5&cad=rja&uact=8&ved=0ahUKEwiEvt
_lgY7LAhWSCo4KHeNaCPMQFgg1MAQ&url=https%3A%2F%2Fwww.scribd.com%2Fdoc%2F17262409%2F
Role-of-RBI-in-FOREX-Market&usg=AFQjCNHxT0uJTz1yn1dlFLvxmcomZdatSA
22
Soumya Kanti Ghosh, RBI Intervention in the Forex Market: Results from a Tobit and Logit Model Using
Daily Data, Economic and Political Weekly, Vol. 37, No. 24, (2002), 23332348.
23
Sumon Kumar Bhaumik and Hiranya Mukhopadhyay, Rbi's Intervention in Foreign Exchange Market: An
Econometric Analysis, Economic and Political Weekly, Vol. 35, No. 5, (2000), 373376.
24
Child, Frank C, Liberalization of the Foreign Exchange Market, The Pakistan Development Review, Vol. 8,
No. 2, (1968), 167191.
25
Anand Chandavarkar, Towards an Independent Federal Reserve Bank of India: A Political Economy Agenda
for Reconstitution, Economic and Political Weekly, Vol. 40, No. 35, (2005), 38373845.
26
M. Ramachandran, Fiscal Deficit, RBI Autonomy and Monetary Management, Economic and Political
Weekly, Vol. 35, No. 35/36, (2000), 32663272.
27
Bhattacharya, B. B. and Srabani Guha, Internal Public Debt of Government of India: Growth and
Composition, Economic and Political Weekly, Vol. 25, No. 15, (1990), 780788.
28
V. M. Dandekar, Assets and Liabilities of Government of India, Economic and Political Weekly, Vol. 29, No.
3, (1994), 111117.

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The RBI is authorized under the provisions of the Reserve Bank of India Act, 1934 to grant
advances to the Government, which are to be paid within three months.29 This tool of shortterm financing has become a permanent source of fund for the Government, RBI use to create
hoc Treasury bills at times when funds were required.30 This led to fiscal deficit31 from 19501990. The economy was in financial repression as there were huge borrowings from outside
captive market also by offering substantial fiscal incentives. 32 Since 1994, there were
Supplemental Agreement between the RBI and Government which converted the outstanding
amount into special securities phasing out the hoc Treasury bills.
Through various policy conventions between the Government and RBI the practice of
independent monetary policy33 started.34 Over the time the RBI has been able to protect balance
sheet of banks by prescribing higher risk weights on assets and its experience in managing
public debt over the years has been more efficient. The RBI has been recognising the
differences among the various segments of Indian banking system and accordingly
accommodates the flexibility required for regulatory treatment. Despite financial management,
the RBI focuses on corporate governance, financial inclusion and expansion of foreign banks.35
REFORMS IN MONETARY POLICY
The banks were nationalized to have a social control over their activities. Through
nationalization the network of banks were efficiently spreading in rural areas also there was a
success in mobilizing private savings.36 Theses mobilized savings were used for the support of
public borrowings and credit need in the rural areas. There was a need of stringent control,
regulation and supervision also significant changes in the institutional arrangements in the

P. SATISH, On Funds for NABARD, Economic and Political Weekly, Vol. 45, No. 39, (2010), 7980.
R. J. Mody, Fiscal Deficit and Stabilisation Policy, Economic and Political Weekly, Vol. 27, No. 7, (1992),
325326.
31
M. K. Datar, Impact of Fiscal Deficit, Economic and Political Weekly, Vol. 38. No. 33, (2003), 34693470.
32
Khundrakpam, Jeevan Kumar, and Sitikantha Pattanaik, Fiscal Stimulus and Potential Inflationary Risks: An
Empirical Assessment of Fiscal Deficit and Inflation Relationship in India, Journal of Economic
Integration, Vol. 25, No. 4, (2010), 703721.
33
V. M. Dandekar, Monetary Policy for Independent Monetary Authority, Economic and Political Weekly, Vol.
21, No. 4, (1986), 169174.
34
EPW Research Foundation, Budget and Monetary Policy, Economic and Political Weekly, Vol. 38, No. 12/13
(2003), 10921098.
35
R.H PATIL, Financial Sector Reforms: Realities and Myths, Economic and Political Weekly, Vol. 45, No. 19,
(2010), 4861.
36
Mark Shelley M., The American Economic Review, Vol. 48, No. 5, (1958), 10421043.
29
30

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banking system.37 Now, credit was directed to the socially preferred sectors, exchange rated
were fixed and were closely observed.
With the increase in liberalization of the economy after 1991, the monetary policy started its
operational efficiency. It was mostly related to change in economic policy framework. With
financial liberalization and monetary policy autonomy there was a development in the money
market, securities market and foreign exchange market of the economy. Since 1991 the RBI
has followed various policies to facilitate the development of markets through financial and
institutional infrastructure development.38 With the objective of integration of Indian financial
markets39 with the global markets, the RBI on a regular basis refines its operating procedures
and instruments also the risk management system, disclosure norms, accounting standards and
recognition and provisioning norms

MONETARY POLICY DURING 1972 TO 1991

In the seventies price situation of the economy had worsened, thus Reserve Bank made its
monetary policy stringent.40 But, Fiscal Policies resulted in large fiscal deficits in the economy,
a large part of this fiscal policy was monetised by borrowing from Reserve Bank. The
monetary policy in the late seventies were mostly related to neutralising inflationary impact on
the budget deficits. Various instruments were changed such as Statutory Liquidity Ratio (SLR)
and Cash Reserve Ratio (CRR) to put an effect to the budget deficits and increase the reserve
money.41 The CRR was raised to maximum limit of 25%, the SLR rate was raise to a maximum
limit of 38.5% so as to meet the borrowing requirements of the Government.
As a consequence of the raise in CRR and SLR rates, the banks funded most of the large fiscal
deficit at rates which were below the market rates. The recommendations of the S. Chakravarty
Committee report resulted in raising of interest rates on Government securities. This resulted in
HUTCHISON, MICHAEL M, RAJESWARI SENGUPTA, and NIRVIKAR SINGH, Estimating a Monetary
Policy Rule for India, Economic and Political Weekly, Vol. 45, No. 38, (2010), 6769.
38
C. Rangarajan, Role of Monetary Policy, Economic and Political Weekly, Vol. 32, No. 52, (1997), 3325
3328.
39
Bhupal Singh and Sitikantha Pattanaik, Monetary Policy and Asset Price Interactions in India: Should
Financial Stability Concerns from Asset Prices Be Addressed Through Monetary Policy?, Journal of Economic
Integration, Vol. 27, No. 1, (2012), 167194.
40
http://shodhganga.inflibnet.ac.in/bitstream/10603/1897/10/10_chapter2.pdf
41
http://www.ukessays.com/essays/economics/impact-of-monetary-policy-on-indian-industry-economicsessay.php
37

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interest on Government securities with market rates, open market operations, widened the
scope of investment in Government securities. And accordingly the statutory liquidity ratio
(SLR) was reduced below its maximum level.

MONETARY POLICY DURING 1991 TO 1996:

In the nineties there was a need in change of the institutional framework of the monetary policy
for price stability and economic growth.42 The policy of industrial liberalisation was to promote
competition and increase the economic growth.43 The economy was opened to private foreign
investment and the Indian companies were permitted to access the foreign capital markets.
Also there was an adoption of Indian rupee on current account. 44 These changes in the
institutional framework required changes in the monetary policy by the RBI, therefore there
were changes in the instruments of monetary control.
FISCAL-MONETARY RELATIONSHIP
With automatic monetization of the budget deficit, the RBI had to neutralise the impact of
inflation of Government deficit, and to ensure price stability the CRR and SLR were raised
every year. During this period CRR was gradually raised to its statutory maximum limit of
25% and SLR to the maximum ceiling of 38.5%. The fixing of CRR and SLR together raised to
an extent of 63.5%. this reduced the supply of credit in the private sector, but it also affected
the profit scope of the banking system.
OPEN MARKET OPERATIONS:
Initially in the seventies and eighties the monetary policy had no role for open market
operations because of the non-existence of the active Government securities market. In order to
activate the open market operations and profit making of banks, the recommendations of the S.
Chakravarty Committee,45 of raising rate of interest on Government securities were accepted.
The government securities were now made market determined by sale of these securities
through open auction. The interest rate structure was rationalised and the banks were given
liberty to determine their lending rates and other interest rates. These measures taken by RBI

Arvind Panagariya, India in the 1980s and 1990s: A Triumph of Reforms, (2003).
Matthew McCartney, Political Economy, Growth and Liberalisation in India, 1991-2008
44
http://shodhganga.inflibnet.ac.in/bitstream/10603/3659/10/10_chapter%204.pdf
45
https://www.bis.org/publ/plcy05e.pdf

42
43

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facilitate in the use of the use of open market operations as an instrument for controlling the
fluctuations in foreign exchange market.46
COST OF CREDIT
The rate of interest is the cost at which the credit47 is available for the borrower. The interest
rates on lending were fixed at low levels for special priority sectors like agriculture, exports,
small scale industries, whereas higher lending interest rates were fixed for other borrowers. As
a result of regulation on the lending rates there was also regulation in deposit rates so that the
cost of funds to banks is in reasonable proportion with the lending rates. The fixing of lending
and deposit rates were complex, in 1994 the lending rates were abolished for credit amount of 2
lakhs. There were two concessional rates for providing credit to the priority sectors.
REFORMS IN FOREIGN EXCHANGE MARKETS
A market that facilitates global interaction between dealers and brokers is known to be a global
market, wherein the willing parties agree on an exchange rate to trade in currencies. In India
the market comprises of RBI and customers and dealers authorised in foreign exchange. The
primary step that RBI took in 1978 was permitted the Banks in India to adopt foreign exchange
through intra-day trading. During 1975-92, it was the major trading partners whose basket of
currencies were weighted by RBI as a means to assert exchange rate of Indian rupee. To
facilitate merchant transactions RBI regularly declared buying and selling rates for the
Authorised Dealers(AD).
The crisis of 1990-91 due to industrial policies, high exchange rates and tariffs and minimizing
of fiscal deficit. This was coupled with recession, withdrawal of by financing International
Banks, 1990 Iraq war which led to the downfall in India's international image.
Thus in order to maintain BOP and put up with the international competition structural changes
such as depreciation of rupee and Liberalised Exchange Rate Management System (LERMS)
came about in 1991-93. There was also a Committee on Balance of Payments instituted which
recommended many reforms such as meeting payment obligations, supervising level of imports
and 3-month import accommodation so as to target the foreign exchange reserves and revive
46

http://cab.org.in/cab%20calling%20content/the%20sub%20prime%20crisis%20%20an%20analysis/monetory%20policy-%20simplifying%20the%20mystique.pdf
47
P. Satish, Agricultural Credit in the Post-reform Era: A Target of Systematic Policy Coarctation, Economic
and Political Weekly, Vol. 42, No. 26, (2007), 25672575.

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international confidence. Under this regime in the Foreign Exchange (Forex) market, demand
and supply play the major role in determining the rupee exchange rate.
It was the institution of Sodhani Committee which was a group of experts on foreign exchange
whose 25 out of 33 recommendations have been accepted by RBI

which included the

implementation of liberalization through a balance between internal controls and market

structuring.
As per the definition given by IMF for Foreign Exchange Reserves, 48 states," external assets
that are readily available to and controlled by monetary authorities for direct financing of
external payments imbalances, for directly regulating the magnitude of such imbalances
through intervention in exchange markets to affect the currency exchange rate and/or other
purposes."49
The RBI Act, 1934 authorises RBI as the Foreign Exchange Reserve Custodian while it also
supervises these for ascertained perspective. These reserves referred to are not only gold and
foreign securities and currency assets, but also bank reserves in the domestic sphere, SDRS.
The necessity of holding these reserves emerges from the fact the purposes of

Transaction as well as Precautionary aim so as to not affect the national interest and at
the same time ensure foreign currencies' requisite demand and supply.

Ensuring FDI as the domestic reserves are secured by external assets.50

Government buying and selling of goods.

During emergencies as insurance premium.

Resolve Government's foreign debt.

The importance of Foreign exchanges is realised as international trade transactions demand

inter-continental currency flow and it supervises exchange rate in accordance with international
capital flows.

48

http://www.igidr.ac.in/money/mfc_10/Arabi%20U_submission_19.pdf
IMF on Balance of Payments Manual and Guidelines on Foreign Exchange Reserve and Management,2001
50
Guidelines for Foreign Exchange Reserve Management, Country's Case Studies, April,2005, International
Monetary Fund.
49

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CONCLUSION
During the reform periods the Monetary Policy has achieved higher success, even though its
success it had its own limits. In the pre-reform era Monetary Policy failed to tackle budgetary
deficit, the higher level of budget deficit at that time had made the Monetary Policy ineffective.
Then the reform of automatic monetization of deficit let to high monetary expansion. This
paper undertakes an analysis of evolution of monetary policy in India. The policy regime and
institutional arrangements constrained monetary management in the pre-reform period.
Monetary policy during this period was only limited to credit rationing.
The various important segments of financial market in India were developed only in the postreform period. Money market was not organized and there is a huge amount of money market
in our country. It was not under the control of the RBI. Therefore, factors of monetary policy
did not affect the unorganized money market which made the monetary policy less affective.

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