ROLE OF RESERVE BANK OF INDIA IN

INDIAN ECONOMY

A Minor Project

Submitted in partial fulfillment of the requirements for BBA (Banking &

Insurance) Semester III Programme of G.G.S. Indraprastha University, Delhi

Submitted By
Rahul mehra
BBA (B&I) III SEM
0091221808

Delhi College of Advanced Studies

(B-7 Shanker Garden Najafgarh Road New Delhi)
 Declaration

I hereby declare that the dissertation entitled “Role of Reserve Bank of India in

Economy” submitted for the BBA (B&I). Degree is my original work and the

dissertation has not formed the basis for the award of any degree, associate ship,

fellowship or any other similar titles.

Place:

Date:

SIGNATURE OF THE STUDENT

COUNTER SIGNED

(Internal supervisor)
 Acknowledgement

The money market and banking system are the key component of the financial
system as it is the fulcrum of monetary operations conducted by the central
bank in its pursuit of monetary policy objectives. It is a market for short-term
funds with maturity ranging from overnight to one year and includes financial
instruments that are deemed to be close substitutes of money. The money
market performs three broad functions. One, it provides an equilibrating
mechanism for demand and supply of short-term funds. Two, it enables
borrowers and lenders of short-term funds to fulfill their borrowing and
investment requirements at an efficient market clearing price. Three, it provides
an avenue for central bank intervention in influencing both quantum and cost of
liquidity in the financial system, thereby transmitting monetary policy impulses
to the real economy. The key objectives of the monetary policy are (1)
Regulation of monetary growth consistent with expected growth in output and a
desirable rate of inflation and (2) Ensuring adequate expansion of credit for the
purpose of meeting genuine credit requirements of productive sector of the
economy. As excessive money market volatility could deliver confusing signals
about the stance of monetary policy, it is critical to ensure orderly market
behavior from the point of view of both monetary and financial stability.

First and foremost I thank the director of our institution DR. NARINDER
MOHAN and my supervisor cum guide Ms. Mansi NagPal It was entirely their
vision and support that facilitated the project. The flow given to this project is
credited to their insightful ideas and guidance
 Literature Review
India's Growth Experience: An Overview

We are now passing through a period of remarkable change and very interesting
times. For half a century before independence in 1947, there was hardly any
discernible economic growth in the whole Indian sub-continent. We have come
a long way from the growth of 3-3.5 per cent growth in 1950s, to around 5.5 per
cent in 1980s, 5.8 per cent in 1990s, and most recently to a sustainable growth
path of around 8.5 per cent plus (Table 1). But, what is even more striking is the
fact that if we take into account the decline in the rate of population growth
from 2.2 per cent for 40 years during 1960-90 to 1.8 per cent in the 1990s and
further down to 1.6 per cent currently, the growth in per capita GDP has seen a
tremendous push from around 1.6 per cent a year in the 1950s to around 7 per
cent per year now.

Table 1: Growth and Inflation in India - A Historical Record

(Per cent)
Period (Averages) GDP Growth RateWPI Inflation RateGDP Growth Per Capita
1 2 3
1951-52 to 1959-60 3.6 1.2 1.6
1960-61 to 1969-70 4.0 6.4 1.7
1970-71 to 1979-80 2.9 9.0 0.6
1980-81 to 1990-91 5.6 8.2 3.3
1992-93 to 1999-006.3 7.2 4.2
2000-01 to 2006-076.9 5.1 5.3
2003-04 to 2006-078.6 4.9 7.1
Source: Reddy (2007).
With such a high rate of economic growth that we have now experienced in
recent years, progress in the country is now very palpable. The growth is
manifesting itself in many ways all across the country. Innovation and
entrepreneurship are in the air. Exciting changes are taking place in all spheres.
Even in agriculture, which otherwise has exhibited low growth over the past
decade, a great deal of innovation is taking place.

Low and stable inflation is essential: high and uneven inflation enhances risk
and is hence inimical to innovation and risk taking. Investment cannot take
place without the availability of risk capital, buttressed by the availability of an
adequate flow of credit to nurture the investment climate. Furthermore, the cost
of money available must reflect appropriately the risk and opportunity cost of
lending. Under pricing of risk can lead to excessive risk taking, and overpricing
would lead to the converse. For people to take risk, to innovate and grow, to
have confidence in the future, the environment of low and stable inflation has to
be supported by the maintenance of overall financial stability. Finally, it is the
existence of sound financial institutions that is necessary for the appropriate
supply of financial resources to take place. It is the job of the central bank and
other regulatory institutions to ensure the existence of such an overall financial
environment.The whole process of economic reforms, capital market forms,
financial market reforms, banking reforms, and monetary policy reforms have
all combined to provide such an environment.
 Objectives of the Study

The objective of the research is

• To find the different roles and policies that RBI makes to control the money

market instruments

• To know whether RBI is able to control it properly or not?

• To determine whether RBI has been successful to achieve its objectives with

which it was constituted

 Research Methodology
Research design is the plan/blueprint that specifies the sources and types of

information relevant to the research problem. It is the strategy specifying the

approach for gathering and analyzing data. It considers the cost and time

constraints.

In my study, I started with the exploratory research design and later went on to

secondary data based research design.

Research Methodology

The study would contain both exploratory research and secondary data study.

The following steps will be a part of most formal research, both basic and

applied:

Exploratory - Secondary Data Study

• Provides understanding/insights.

• Quick and economical method.

• Review of earlier stated hypothesis in secondary data base.

Secondary data base can be internal/external

• Internal data sources are found within the company.

External data sources are books, newspapers, journals, periodicals, government

published data sources, Internet etc. In my study I have used the secondary data

as it is quick accessible, it has lots of varieties and of its low-cost.

 Limitation

The problems of this method are deluge of information / search results, lack of

authentication and lack of updating. Study of secondary data research has no

formal design but is not done aimlessly. It can be expedited and effectively used

if done in an organized manner.

The secondary data is collected from various sources:

• Newspapers
• Internet
• Magazines
• Journals
• Websites
• RBI published data which has enabled to understand the problem definition
of the research and find the answers to the question raised as well.
 Data Analysis

The April 17-2008, 50bp CRR hike announcement came as a surprise to many
market participants. While there were many who were expecting RBI to respond
with such an action, its timing was definitely not anticipated, especially with the
Credit Policy announcement just around the corner.

In general, the market has interpreted this as an emergency measure to address

the aggravating inflationary scenario. The surge in inflation rate in the recent
months has put renewed focus on monetary policy administration. The headline
inflation rate has picked up dramatically in the recent months to little below 7.5
per cent and has come as a surprise also for the RBI. Not so far back, RBI was
expecting inflation to be anchored at 4.5 per cent and about six months back the
actual inflation was hovering around 3.5 per cent. The haste with which the
CRR action was initiated leads to some obvious questions. Will the RBI follow
up with rate hikes tomorrow? Are we headed for another round of more intense
tightening? And the more fundamental question of whether the Monetary
Policy measures have become ineffective in attaining price stability.

Looking at the recent history one notes that the ongoing monetary tightening
cycle started in October 2004; with initial focus on rate measures (till mid 2006)
and later shifting to quantitative measures like increase in CRR rate and
tightening of adequacy rates for banks.

Over the entire tightening phase the reverse repo (i.e. the absorption rate) and
the repo rate (i.e. the liquidity injection rate) have been increased by 150 bps
and 175 bps respectively to 6 per cent and 7.75 per cent respectively. In
comparison, the CRR has increased by 350bps. Including the latest move the
CRR has been increased by 200 bps over Mach 2007 while the policy rates have
remained unchanged. It is evident that concerns on inflation has been there for a
while and has figured in several forms in RBI's past statements. These included
concerns on overheating, concerns on financial stability and quality of credit
accumulation.

But despite the concerted efforts, inflationary threats have failed to recede. On
the contrary, things have got aggravated and now the RBI is getting increasingly
concerned about worsening inflationary expectation.

While it was hoped that the measured monetary steps towards slowing down
demand and supply creation emanating from huge capital formation will help
bring down inflation, the obtaining situation so far indicate that the objective of
price stability has remained elusive. RBI's manufacturing sector survey tends to
suggest that despite the mild slowdown that we have seen in the recent quarters,
the capacity prevailing and expected utilization level for the manufacturing
sector have remained high around, which indicates continued supply
constraints. Possibly, the capacity creation in general has yet to materialize or
the demand pressures have continued to overweigh.

A significant reason for the ineffectiveness of both fiscal and monetary

measures has been the fact that the demand and supply pressures we have is not
just local but also global. This is evident from similarity of inflationary
concerns faced by most emerging market economies. Even in advanced
economies, despite the slowdown threat, inflation continues to remain above
comfort levels.

It's a common believe today that the current inflation is supply shock driven and
hence, monetary measures may not be effective. Hence, RBI should refrain
from tightening. Some have argued that a more aggressive strategy towards
easing supply bottlenecks will possibly address the problem better. There are
also views around banning futures trading in commodities market to prevent
speculative demand.
In my view, the scenario may be somewhere in between. Supply constraints
have build up only because of continued demand pressure. Price escalations
have happened over a period of several years and hence, cannot be termed as a
shock. A large part of agro product price rise can be attributed to increasing
trend towards conversion of agro commodities into bio-fuel, which has been
catalyzed by high fuel prices.

Since there is a significant contribution from the demand side, it will be

incorrect to hypothesize irrelevance of monetary measures. In fact most other
emerging central banks have deployed monetary tightening measures to control
inflation. The common course of action is to moderate demand and credit flows.
These are coupled with measures to ease supply bottleneck.

Whether, this will translate into any immediate moderation in inflationary

pressures is questionable. Even while there has been containment of credit
growth in India, slowing of demand pressures has been moderate. Supply side
mismatch is unlikely to ease in the near term given the structural nature some of
the factors have attained.

So while the options available to attain price stability is limited and the RBI is
likely to hold on to a tight monetary stance. But the possibility of policy rate
(repo and reverse repo rate) hikes is low given that it impacts most sectors
uniformly, which RBI is getting increasingly sensitive about.

The recent CRR rate hike move suggests that RBI will continue to rely more of
quantitative measures with a focus on managing liquidity, also through other
instruments such as LAF and open market operation.

While past measures have successfully slowed credit growth, money supply
growth has continued to remain above target. Hence, there will likely be
renewed focus on slowing money supply.
Use of exchange rate appreciation as a policy tool to contain inflation may not
be a plausible option at the moment as the balance of risk does not seem to
support any significant rupee appreciation. Raising rates to enable such a
scenario is froth with the risk of further aggravating the liquidity management
problems.

I believe that while it might be inappropriate to conjecture that monetary

measures are ineffective, it will not be incorrect to say that in the current
scenario, the transmission of monetary signals towards impacting inflation has
weakened due to underlying factors attaining global dimensions.

The current situation requires coordinated and concerted efforts by major global
central banks and governments, specially in the emerging markets to attain price
stability, much akin to the efforts made by the Fed, the ECB and Bank of
England to attain financial stability through liquidity infusion measures.

Attainment of growth and price stability through isolated measures by RBI may
not be the most effective way.
 Conclusion

A central bank can operate a truly independent monetary policy when the
exchange rate is floating. If the exchange rate is pegged or managed in any way,
the central bank will have to purchase or sell foreign exchange. These
transactions in foreign exchange will have an effect on the monetary base
analogous to open market purchases and sales of government debt; if the central
bank buys foreign exchange, the monetary base expands, and vice versa.

Accordingly, the management of the exchange rate will influence domestic

monetary conditions. In order to maintain its monetary policy target, the central
bank will have to sterilize or offset its foreign exchange operations. For
example, if a central bank buys foreign exchange (to counteract appreciation of
the exchange rate), base money will increase. Therefore, to sterilize that
increase, the central bank must also sell government debt to contract the
monetary base by an equal amount. It follows that turbulent activity in foreign
exchange markets can cause a central bank to lose control of domestic monetary
policy when it is also managing the exchange rate.

Many economists began to believe that making a nation's central bank

independent of the rest of executive government is the best way to ensure an
optimal monetary policy, and those central banks which did not have
independence began to gain it. This is to avoid overt manipulation of the tools
of monetary policies to effect political goals, such as re-electing the current
government. Independence typically means that the members of the committee
which conducts monetary policy have long, fixed terms. Obviously, this is a
somewhat limited independence. Independence has not stunted a thriving crop
of conspiracy theories about the true motives of a given activities
 Bibliography

• www.rbi.org.in

• www.bidocs.rbi.org.in

• www.cpolicy.rbi.org.in

• Reserve Bank of India Bulletin (March, 2008)

• Reserve Bank of India, Functions and Workings (Published by RBI)

• https://cdbmsi.reservebank.org.in

• Economic Survey, At a Glance -2007-08

• www.cir.rbi.org.in

• www.wss.rbi.org.in

• The Economics Times

 Introduction

Reserve Bank of India

The Reserve Bank of India was established on April 1, 1935 in accordance with
the provisions of the Reserve Bank of India Act, 1934. The Central Office of the
Reserve Bank was initially established in Calcutta but was permanently moved
to Mumbai in 1937. The Central Office is where the Governor sits and where
policies are formulated.

Though originally privately owned, since nationalisation in 1949, the Reserve

Bank is fully owned by the Government of India.

Preamble

The Preamble of the Reserve Bank of India describes the basic functions of the
Reserve Bank 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."

Central Board

The Reserve Bank's affairs are governed by a central board of directors. The
board is appointed by the Government of India in keeping with the Reserve
Bank of India Act.

Appointed/nominated for a period of four years

• Constitution:
• Official Directors
Full-time: Governor and not more than four Deputy Governors
Non-Official Directors

Nominated by Government: ten Directors from various fields and one

Government Official

Others: four Directors - one each from four local boards

Functions: General superintendence and direction of the Bank's affairs

Local Boards

One each for the four regions of the country in Mumbai, Calcutta, Chennai and
New Delhi

Functions: To advise the Central Board on local matters and to represent

territorial and economic interests of local cooperative and indigenous banks; to
perform such other functions as delegated by Central Board from time to time.

Financial Supervision

The Reserve Bank of India performs this function under the guidance of the Board
for Financial Supervision (BFS). The Board was constituted in November 1994 as
a committee of the Central Board of Directors of the Reserve Bank of India.

Objective

Primary objective of BFS is to undertake consolidated supervision of the financial

sector comprising commercial banks, financial institutions and non-banking
finance companies.

Constitution

The Board is constituted by co-opting four Directors from the Central Board as
members for a term of two years and is chaired by the Governor. The Deputy
Governors of the Reserve Bank are ex-officio members. One Deputy Governor,
usually, the Deputy Governor in charge of banking regulation and supervision, is
nominated as the Vice-Chairman of the Board.
BFS meetings

The Board is required to meet normally once every month. It considers inspection
reports and other supervisory issues placed before it by the supervisory
departments.

BFS through the Audit Sub-Committee also aims at upgrading the quality of the
statutory audit and internal audit functions in banks and financial institutions. The
audit sub-committee includes Deputy Governor as the chairman and two Directors
of the Central Board as members.

The BFS oversees the functioning of Department of Banking Supervision (DBS),

Department of Non-Banking Supervision (DNBS) and Financial Institutions
Division (FID) and gives directions on the regulatory and supervisory issues.

Functions

I. Some of the initiatives taken by BFS include:

II. Restructuring of the system of bank inspections
III. Introduction of off-site surveillance,
IV. Strengthening of the role of statutory auditors and
V. Strengthening of the internal defences of supervised institutions.

The Audit Sub-committee of BFS has reviewed the current system of concurrent
audit, norms of empanelment and appointment of statutory auditors, the quality and
coverage of statutory audit reports, and the important issue of greater transparency
and disclosure in the published accounts of supervised institutions.
Current Focus

• Supervision of financial institutions

• Consolidated accounting
• Legal issues in bank frauds
• Divergence in assessments of non-performing assets and
• Supervisory rating model for banks.

Legal Framework

• Umbrella Acts
• Reserve Bank of India Act, 1934: governs the Reserve Bank functions
• Banking Regulation Act, 1949: governs the financial sector Acts governing
specific functions.
• Public Debt Act, 1944/Government Securities Act (Proposed): Governs
government debt market.
• Securities Contract (Regulation) Act, 1956: Regulates government securities
market
• Indian Coinage Act, 1906:Governs currency and coins
• Foreign Exchange Regulation Act, 1973/Foreign Exchange Management
Act,
• 1999: Governs trade and foreign exchange market
• Acts governing Banking Operations
• Companies Act, 1956:Governs banks as companies
• Banking Companies (Acquisition and Transfer of Undertakings) Act,
1970/1980: Relates to nationalisation of banks
• Bankers' Books Evidence Act
• Banking Secrecy Act
• Negotiable Instruments Act, 1881
Acts governing Individual Institutions

• State Bank of India Act, 1954

• The Industrial Development Bank (Transfer of Undertaking and Repeal)
Act, 2003
• The Industrial Finance Corporation (Transfer of Undertaking and Repeal)
Act, 1993
• National Bank for Agriculture and Rural Development Act
• National Housing Bank Act
• Deposit Insurance and Credit Guarantee Corporation Act

Main Functions

Monetary Authority: formulate implement and monitors the monetary policy.

Objective: maintaining price stability and ensuring adequate flow of credit to
productive sectors.

Regulator and supervisor of the financial system:

• Prescribes broad parameters of banking operations within which the

country's banking and financial system functions.
• Objective: maintain public confidence in the system, protect depositors'
interest and provide cost-effective banking services to the public.
• Manager of Foreign Exchange
• Manages the Foreign Exchange Management Act, 1999.
• Objective: to facilitate external trade and payment and promote orderly
development and maintenance of foreign exchange market in India.
• Issuer of currency:
• Issues and exchanges or destroys currency and coins not fit for circulation.
• Objective: to give the public adequate quantity of supplies of currency notes
and coins and in good quality.
Developmental role

• Performs a wide range of promotional functions to support national

objectives.

• Related Functions

• Banker to the Government: performs merchant banking function for the

central and the state governments; also acts as their banker.

• Banker to banks: maintains banking accounts of all scheduled banks.

Brief history of RBI

The Reserve Bank of India is the central bank of the country. Central banks are a
relatively recent innovation and most central banks, as we know them today, were
established around the early twentieth century.

The Reserve Bank of India was set up on the basis of the recommendations of the
Hilton Young Commission. The Reserve Bank of India Act, 1934 (II of 1934)
provides the statutory basis of the functioning of the Bank, which commenced
operations on April 1, 1935.

The Reserve Bank of India was set up as a Share Holders' Bank. The Share Issue of
the Bank offered in March, 1935 was the largest share issue in India at the time.
The matter was further compounded by the conditions and restrictions imposed
under the Act. These conditions related to qualifications of the shareholders, the
geographical distribution and allotment of shares (to avoid concentration of shares
and to ensure that those holding the shares were fit and proper. To simplify
matters, Share Certificate Forms of the different registers were printed in different
colours. Despite the intricate and gigantic nature of the task, it was carried out with
great 'accuracy and dispatch'.
A message sent by the Viceroy to the Governor, Osborne Smith when the Reserve
Bank of India commenced its operations on 1st April, 1935
Message

Osborne smith governor reserve bank Calcutta. Following has been received from
secretary for you. Begins, as reserve bank commences operations today i take
opportunity to convey you and your colleagues on the board my most good wishes
and to express my confidence that this great undertaking will contribute largely to
the economic well being of India and of its people. Private secretary viceroy

Reserve Bank Begins Business

Bombay Office

Functions Taken Over From Imperial Bank

In Bank Street Bombay under an ironwork verandah, recalling more than one
Shaftesbury Avenue Theatre, is a new very large brassplate. Across the plate are
written the words "Reserve Bank of India". To right and left of the plate are open
doors, for the Bank is now open to the public and business is in full swing to the
tune of much hammering. The overpowering smell of fresh paint and the rushing to
and fro of new peons in new drab brown suits.

The building is a famous one having housed for many years the Bombay Head
Office of the Imperial Bank of India. It will become more famous now as the head
office in the west of India for the Reserve Bank. It is old fashioned as banking
buildings go, but has three roomy floors and ample space.

Managing this new concern is Mr. W.T. Mc Callum from the Imperial Bank of
India. He has a staff of 180. The Bank will have no branches but will work in
mofusil through the branches of the Imperial Bank. The Reserve Bank Head Office
is situated in Calcutta.
Bankers' Clearing House

The Reserve Bank opened by taking over the Public Debt Office, the Public
Accounts Office and the Currency Department. It will not resume its full
responsibilities until July 1 when the accounts of the Scheduled Banks will be
taken over under Section 42 of the Act. Within a few weeks it will take the
Bankers' Clearing House. To counter balance the removal of these important
functions from the Imperial Bank of India that Bank will extend more along the
lines of the regular commercial banking firm. It is now free to deal in exchange
business whereas hitherto it hqad to work through other banks. A start has not,
however, actually been made.

It is also understood that the Imperial Bank will open a new department, which will
enable it to undertake the work of trustees and executors.

The Reserve Bank of India was nationalised with effect from 1st January, 1949 on
the basis of the Reserve Bank of India (Transfer to Public Ownership) Act, 1948.
All shares in the capital of the Bank were deemed transferred to the Central
Government on payment of a suitable compensation. The image is a newspaper
clipping giving the views of Governor CD Deshmukh, prior to nationalisation.
The Bank was constituted to

 Regulate the issue of banknotes

 Maintain reserves with a view to securing monetary stability and
 To operate the credit and currency system of the country to its advantage.

The Bank began its operations by taking over from the Government the functions
so far being performed by the Controller of Currency and from the Imperial Bank
of India, the management of Government accounts and public debt. The existing
currency offices at Calcutta, Bombay, Madras, Rangoon, Karachi, Lahore and
Cawnpore (Kanpur) became branches of the Issue Department. Offices of the
Banking Department were established in Calcutta, Bombay, Madras, Delhi and
Rangoon.

Burma (Myanmar) seceded from the Indian Union in 1937 but the Reserve Bank
continued to act as the Central Bank for Burma till Japanese Occupation of Burma
and later upto April, 1947. After the partition of India, the Reserve Bank served as
the central bank of Pakistan upto June 1948 when the State Bank of Pakistan
commenced operations. The Bank, which was originally set up as a shareholder's
bank, was nationalised in 1949.

An interesting feature of the Reserve Bank of India was that at its very inception,
the Bank was seen as playing a special role in the context of development,
especially Agriculture. When India commenced its plan endeavours, the
development role of the Bank came into focus, especially in the sixties when the
Reserve Bank, in many ways, pioneered the concept and practise of using finance
to catalyse development. The Bank was also instrumental in institutional
development and helped set up insitutions like the Deposit Insurance and Credit
Guarantee Corporation of India, the Unit Trust of India, the Industrial
Development Bank of India, the National Bank of Agriculture and Rural
Development, the Discount and Finance House of India etc. to build the financial
infrastructure of the country.

With liberalisation, the Bank's focus has shifted back to core central banking
functions like Monetary Policy, Bank Supervision and Regulation, and Overseeing
the Payments System and onto developing the financial markets.

Economic Development

The economic development of a nation is reflected by the progress of the various

economic units, broadly classified into corporate sector, government and
household sector. While performing their activities these units will be placed in a
surplus/deficit/balanced budgetary situations.

There are areas or people with surplus funds and there are those with a deficit. A
financial system or financial sector functions as an intermediary and facilitates the
flow of funds from the areas of surplus to the areas of deficit. A Financial System
is a composition of various institutions, markets, regulations and laws, practices,
money manager, analysts, transactions and claims and liabilities.
Financial System
The word "system", in the term "financial system", implies a set of complex and
closely connected or interlined institutions, agents, practices, markets, transactions,
claims, and liabilities in the economy. The financial system is concerned about
money, credit and finance-the three terms are intimately related yet are somewhat
different from each other. Indian financial system consists of financial market and
financial intermediation. These are briefly discussed below;

Financial Markets

A Financial Market can be defined as the market in which financial assets are
created or transferred. As against a real transaction that involves exchange of
money for real goods or services, a financial transaction involves creation or
transfer of a financial asset. Financial Assets or Financial Instruments represents a
claim to the payment of a sum of money sometime in the future and /or periodic
payment in the form of interest or dividend.

Money Market- The money market is a wholesale debt market for low-risk,
highly-liquid, short-term instrument. Funds are available in this market for periods
ranging from a single day up to a year. This market is dominated mostly by
government, banks and financial institutions.

Capital Market - The capital market is designed to finance the long-term

investments. The transactions taking place in this market will be for periods over a
year.

Forex Market - The Forex market deals with the multicurrency requirements,
which are met by the exchange of currencies. Depending on the exchange rate that
is applicable, the transfer of funds takes place in this market. This is one of the
most developed and integrated market across the globe.
Credit Market- Credit market is a place where banks, FIs and NBFCs purvey
short, medium and long-term loans to corporate and individuals.

Constituents of a Financial System

Financial Intermediation

Having designed the instrument, the issuer should then ensure that these financial
assets reach the ultimate investor in order to garner the requisite amount. When
the borrower of funds approaches the financial market to raise funds, mere issue of
securities will not suffice. Adequate information of the issue, issuer and the
security should be passed on to take place. There should be a proper channel
within the financial system to ensure such transfer. To serve this purpose, Financial
intermediaries came into existence. Financial intermediation in the organized
sector is conducted by a wide range of institutions functioning under the overall
surveillance of the Reserve Bank of India. In the initial stages, the role of the
intermediary was mostly related to ensure transfer of funds from the lender to the
borrower. This service was offered by banks, FIs, brokers, and dealers. However,
as the financial system widened along with the developments taking place in the
financial markets, the scope of its operations also widened. Some of the important
intermediaries operating ink the financial markets include; investment bankers,
underwriters, stock exchanges, registrars, depositories, custodians, portfolio
managers, mutual funds, financial advertisers financial consultants, primary
dealers, satellite dealers, self regulatory organizations, etc. Though the markets are
different, there may be a few intermediaries offering their services in move than
one market e.g. underwriter. However, the services offered by them vary from one
market to another.

Intermediary Market Role

Secondary Market to
Stock Exchange Capital Market
securities
Capital Market, Credit Corporate advisory
Investment Bankers
Market services, Issue of securities
Capital Market, Money Subscribe to unsubscribed
Underwriters
Market portion of securities
Issue securities to the
Registrars, Depositories, investors on behalf of the
Capital Market
Custodians company and handle share
transfer activity
Primary Dealers Satellite Market making in
Money Market
Dealers government securities
Ensure exchange ink
Forex Dealers Forex Market
currencies

India's Growth Experience: An Overview

 We are now passing through a period of remarkable change and very interesting
times. For half a century before independence in 1947, there was hardly any
discernible economic growth in the whole Indian sub-continent. We have come a
long way from the growth of 3-3.5 per cent growth in 1950s, to around 5.5 per cent
in 1980s, 5.8 per cent in 1990s, and most recently to a sustainable growth path of around 8.5
per cent plus (Table 1). But, what is even more striking is the fact that if we take into account the
decline in the rate of population growth from 2.2 per cent for 40 years during 1960-90 to 1.8 per
cent in the 1990s and further down to 1.6 per cent currently, the growth in per capita GDP has
seen a tremendous push from around 1.6 per cent a year in the 1950s to around 7 per cent per
year now.

Table 1: Growth and Inflation in India - A Historical Record

(Per cent)

Period (Averages) GDP Growth Rate WPI Inflation Rate GDP Growth Per Capita

1 2 3

1951-52 to 1959-60 3.6 1.2 1.6

1960-61 to 1969-70 4.0 6.4 1.7

1970-71 to 1979-80 2.9 9.0 0.6

1980-81 to 1990-91 5.6 8.2 3.3

1992-93 to 1999-00 6.3 7.2 4.2

2000-01 to 2006-07 6.9 5.1 5.3

2003-04 to 2006-07 8.6 4.9 7.1

Source: Reddy (2007).

With such a high rate of economic growth that we have now experienced in
recent years, progress in the country is now very palpable. The growth is
manifesting itself in many ways all across the country. Innovation and
entrepreneurship are in the air. Exciting changes are taking place in all spheres.
Even in agriculture, which otherwise has exhibited low growth over the past
decade, a great deal of innovation is taking place.
Low and stable inflation is essential: high and uneven inflation enhances risk
and is hence inimical to innovation and risk taking. Investment cannot take
place without the availability of risk capital, buttressed by the availability of an
adequate flow of credit to nurture the investment climate. Furthermore, the cost
of money available must reflect appropriately the risk and opportunity cost of
lending. Under pricing of risk can lead to excessive risk taking, and overpricing
would lead to the converse. For people to take risk, to innovate and grow, to
have confidence in the future, the environment of low and stable inflation has to
be supported by the maintenance of overall financial stability. Finally, it is the
existence of sound financial institutions that is necessary for the appropriate
supply of financial resources to take place. It is the job of the central bank and
other regulatory institutions to ensure the existence of such an overall financial
environment.

The whole process of economic reforms, capital market forms, financial market
reforms, banking reforms, and monetary policy reforms have all combined to
provide such an environment. We need to ensure that this kind of growth
environment – low and stable inflation and financial stability – is indeed
maintained and sustained in the medium to long-term, so that in India,
entrepreneurship can flower and flourish further.

Conditions for Innovation and Growth

The foremost economic thinker who talked about innovation was Joseph
Schumpeter. He defined it to encompass any of a number of different features.
The introduction of a new method of production would naturally embody some
innovation. Indian industry has clearly embraced a host of new methods of
production in recent years. Second, the opening of new markets also needs
innovation in marketing approaches and techniques. The data collected in the
Market Information Surveys of Households (MISH) by the National Council of
Applied Economic Research (NCAER) amply demonstrate how new markets
have been developed in the country, right since late 1980s. Third, the use of
new sources of supply of raw materials also involves innovation. With trade
liberalization, industry now has access to all raw materials and goods available
in the world, so a great deal of innovation has been taking place in their
procurement and use. A fourth possibility is innovation in new forms of
industrial organization. With overall change taking place in the economic
environment, we are also witnessing new forms of industrial organization on a
regular basis. Thus, from all these four points of view, the pace of innovation
has been very healthy in India since the early 1990s.

Besides Schumpeter, there are others who have talked about different types of
innovation such as business model innovation, marketing innovation,
improvement in product design and in product pricing. Here again, we can
observe a bucket-full of innovation in the country. In terms of organizational
innovation, Indian business organizations have ventured into all kinds of new
kinds of business models -- be it the introduction of flat organizations, lean
organizations, or pyramidal organizations – and things keep on changing
according to the changing business environment. New business practices are
also being introduced: for example, the practice of 360 degree evaluation within
companies is a new concept and perhaps alien to a hierarchical society. Another
type of innovation is process innovation. The Indian pharmaceutical industry is
known for its great degree of process innovation in drugs. Yet another area is
product and service innovation in terms of new goods and services for which
Indian examples can be many. As regards supply chain innovation, the best
example comes from the rural sector particularly the agriculture sector, but
which is still in its infancy in India.

All these innovations take place when there is some need. The old saying that
"necessity is the mother of all invention" is clearly true. What has spurred the
acceleration of invention in India is the overall economic reform process. For
example, delicensing of industry in 1991 ushered in a new era of competition;
which was then reinforced by continuing trade liberalization and tariff reform
throughout the decade. Furthermore the freeing of foreign direct investment
(FDI) not only provided new competition, but also brought new techniques and
technology into the country. Thus, Indian industry was forced to innovate in all
the different ways mentioned to cope with the new competition.

All the innovations in the real sector needed corresponding innovations in the
financial sector as well. Innovations in products and services in the real sector
therefore, move ideally in parallel with innovations in the financial sector.
Furthermore, strong public policies and good governance structures nurture
these two developments and direct them in a non-disruptive and constructive
manner so that the positive growth process can be sustained. Financial
innovation involves development of new financial services and products. And
these new products and services need to be more easily accessible. So, financial
firms have to innovate to broaden access to their services. Greater financial
inclusion is a must. The spread of micro finance is one method by which
financial inclusion is being sought to be achieved.
Innovation involves risk. If risk is to be financed effectively, it is essential for
financial institutions to improve their risk management systems in their entirety.
First is the need to develop appropriate risk assessment systems. Here the
proposed introduction of credit information bureaus should help greatly in the
future. Second is the development of risk mitigation systems. Third, appropriate
risk allocation mechanisms have to be developed, so that risk is adequately
distributed from the point of view of the financial institutions. As financial
systems become more market oriented and as price discovery of interest rates
becomes more efficient, financial institutions find better and better ways of
managing and allocating risk. Effective development of financial systems to
finance innovation takes a good deal of time.

Innovations can either be supply induced or demand led. Supply led innovations
arise from new research and development activities that give rise to new
technologies, new products, and new processes. Demand led innovation
essentially arises from the pressures of new competition. And, of course, R & D
itself can be demand induced.

For innovation to take place on a continuous and efficient basis in response to

the pressures felt there is a need for an effective national innovation system.
Apart from the structuring of in house mechanisms within firms, there is need
for the existence of mutually supporting networks of organizations that nurture
the culture of research development and innovation. R & D institutions have to
be supported by standard setting organizations, technical consultancies and the
like so that firms have adequate technical support systems. Clusters and
incubators are also needed for creating such supportive environments for small
and medium firms.

While it is interesting to note that productivity appears to have picked up

worldwide over the last decade or so and new investments could have been the
source of its acceleration, the implications of such positive shocks for sustained
growth need to be understood. The rapid replacement of new technology means
that the technological progress gets embedded in the accumulation of fresh
capital stock at a faster rate than would otherwise be the case. Second, recent
research shows that new technology is quite sensitive to movements in the cost
of capital. A combination of high price elasticity and the declining price of
high-tech equipment also contributes to an investment boom. Third, these
investments have considerable externalities or spill over effects. The application
of new technology has helped to reduce operating expenses and as a result of
higher productivity there has been considerable stability in labour costs.
Globalisation in terms of outsourcing combined with the availability of new
skilled labour in China and India has also contributed to low inflation
worldwide. Combined with the impact of competition in exercising pricing
leverage, these developments have helped significantly in containing
inflationary pressures during the expansion phase of global GDP over the past
decade.

In this process, the law of supply creating its own demand also operates. First,
productivity increases result in a higher potential for growth and this in turn
generates further demand for goods and services. The real rate of return on new
investments increases and capital spending accelerates to take advantage of the
profit opportunities. Employment and income generated help to augment
consumer demand as well. The spurt in capital market valuations could be a
reflection of such higher profitability. The wealth effect of such a capital market
spurt could further accelerate both consumer and investment demand.

Higher the growth in productivity, higher is the overall growth at given levels of
investment and that also means that much higher growth can be sustained by
higher investments without arousing inflationary pressures. The best thing thus
one can do is to encourage innovation, productivity and growth which can then
bring about better control over inflation. This is exactly what has happened in
the world in the last 10 years. Central banks around the world congratulate
themselves for having been very successful especially in the last 10 to 15 years
for having tamed inflation internationally. But, what lies behind that
achievement through monetary policy is also the gains that have come through
increases in productivity. The productivity boom in the US has contributed
immensely to non-inflationary growth in the US and also globally in the last
decade. What is important from the central bankers’ point of view is that this
inflation moderation has taken place in the presence of considerable monetary
accommodation over the same period. In the US, most of the 1995-2000
productivity growth acceleration can be attributed to investments in technology
and management know-how needed to exploit it. Thus, encouraging innovative
activity through investments in R & D activity is something that is central to the
concern of central banks. Innovation and productivity growth contribute to the
attainment of low and stable inflation, and low and stable inflation, in turn,
provides an appropriate environment for innovation. Whereas innovation is
characteristically done within firms or in R&D organization, for such activity to
flourish, it is essential that there is both macroeconomic and financial stability.
In sum, we need a conducive macroeconomic environment for innovation and
growth, a supportive financial system and an innovation nurturing environment
through national innovation systems.

There are now some signs that inflation could be again increasing worldwide.
Commodity prices, particularly of food and oil, have been increasing in
particular. Similarly there are indications that global growth could be slowing
down at the same time, particularly in the United States. Is this happening
because innovation and productivity growth is slowing down in the US? Similar
tendencies are evident in the UK. So, the outlook for productivity growth is
crucial in the global context and of great concern to central bankers.

Role of Financial Sector Reforms in Promoting Innovation and Growth

The key issue for innovation and growth in financial sector development is how
well the financial system is able to finance new ideas, new products and new
entrepreneurs. In a repressed financial system, sans adequate risk management
systems and limited depth of financial markets, banks are typically happy to
fund incumbents, and exhibit little interest in funding new businesses and new
ideas. As financial systems develop, larger corporates can go to the market
directly and disintermediation takes place. So, banks have fewer incumbents to
finance and so it can be expected that they would be pushed increasingly into
financing more and more new projects, new entrepreneurs and new ideas.

Has this happened in India? Financial sector reforms have covered almost all
aspects of banking and the capital market. The decontrol and expansion of
capital markets should have made the access to market intermediated financial
resources easier for well established, credit rated large incumbents. Reforms in
the banking system have been aimed to bring in greater efficiency by
introducing new competition through the new private sector banks and
increased operational autonomy to public sector banks. In the government
securities market, the reform measures have been aimed at better price
discovery of interest rates by auctioning government securities, and developing
the infrastructure for efficient trading. In the forex market likewise, there has
been a gradual movement towards a market-based exchange rate regime
coupled with the introduction of newer products and players. Side-by side,
conscious steps have been undertaken towards building up of the institutional
architecture in terms of markets, technological and legal infrastructure.

Consequent upon the wide array of such measures, the cost of funds for the
corporate sector has become market-related. Coupled with greater access to
foreign investment alongside improvements through trade liberalization, there is
a significant growth in manufacturing exports as also the import intensity of
exports. The corporate sector has thus become increasingly exposed to
international product and factor prices. Such market-driven pricing of products
and factors combined with gradual reduction in rates of interest in an overall
benign interest rate environment and moderate debt equity ratios have resulted
in lower interest outgo. This, in turn, has promoted better resource allocation
and efficient use of new technology, which has become reflected in their profit
and efficiency parameters.

What has been the result in terms of corporate performance? All the important
parameters: sales, gross profit, profit after tax, all have recorded robust growth
rates since 2002-03, implying that economic activity in the corporate sector has
improved tremendously over this period . The dependence on banks for
financing has indeed gone down. There has been a very significant reduction of
interest expenses in total expenditure. To that extent, the corporate sector could
have become more insensitive to small movements in interest rates. The high
growth in profits of the corporate sector suggests that competition is inadequate
and that entry of new firms or even the threat of entry of new firms is low.
Growth in output is being driven more by expansion of existing firms rather
than through the creation of new firms. This pattern would suggest that new
firms are not finding it easy to access funds from the banking system at
reasonable risk adjusted rates. It is essential that banks should be careful in their
risk assessment, and that the interest rates charged and volumes of funds lent
should reflect the risk assessed. In the presence of the kind of high growth rates
being observed in the economy, are banks being adequately supportive? What is
the evidence?

First, the pattern of funding from banks is predominantly to the urban and
metropolitan sectors which account for the overwhelming share of credit. The
share of metropolitan areas, in fact, has risen further in the current decade, with
that of rural and urban areas declining (Table 2).

Table 2: Population group-wise outstanding credit of commercial banks

(Per cent to total)
Population March
March 2001 March 2005 March 2006
Group 2007
Rural 10.1 9.2 8.4 7.9
Semi urban 11.5 11.3 10.0 9.7
Urban 16.8 16.4 16.4 16.2
Metropolitan 61.6 63.1 65.3 66.1
Memo:
Amount (Rupees billion)
All India 5564 11578 15175 19496
Source: Reserve Bank of India
Second, the pattern of funding by the banks remains skewed towards larger
firms. The problem for the banks, however, is that profit growth in the corporate
sector has been so high in recent years, that they do not need much bank
borrowing, and the share of debt service in corporate balance sheets has been
getting lower and lower. In fact, in view of the reduced need of large firms for
bank funding there is great competition among banks to fund the incumbents, to
fund the larger firms, leading to lending rates levied on them becoming much
lower than the declared benchmark prime lending rates (BPLR). This is in some
sense an encouraging sign, so that if the banks do not have enough income
generation from the larger firms, they may be willing to lend more to the newer
entrepreneurs. The existing preference for lending to larger firms is presumably
due to the old banking habit of greater comfort with incumbents to whom it is
safer and easier to lend. Finding new entrepreneurs, new ideas, new products,
and new services to finance need greater effort and more sophisticated risk
management systems. Indian banks have also been handicapped by the absence
of credit information bureaus and any availability of centralized credit records
of small and medium entrepreneurs. This problem should now get rectified
since the Credit Information Companies Act has been passed by parliament.
Guidelines for these companies have also been issued by the Reserve Bank, so
we can expect such new companies to get established in the near future.

There is some corroborating evidence suggesting the difficulty of entry for new
business entrepreneurs. When we look at the World Bank surveys on doing
business across countries, India typically ranks quite low in the range of 120-
130. At the same time, we find that both the level of profits of the corporate
sector in India and growth of profits is among the highest in the world. How can
both be true: that doing business in India is more difficult than in other
countries, while at the same time the Indian corporate sector has exhibited
higher profit growth than probably any other country in the world over the past
4-5 years? A possible explanation for this apparent contradiction seems to be
the high entry costs: once you get in, it is easy to grow, but getting in, in the
first place, is difficult. This suggests that the Indian financial system is, perhaps,
still not adequately geared to finance new ideas and new firms.

Further, one of the distinguishing features of the high credit growth in recent
years has been the continuing low share of credit going to small and medium
enterprises (SMEs), although there has been some change in the trend this past
year. Again, it is puzzling how the credit growth to SMEs among all the
segments has actually been the lowest. What has really happened is that banks
have essentially moved from lending to the corporate sector to individuals and
retail, still leaving out the middle, namely SMEs. And again, banks appear to
have moved to individuals and retail because of the high quality of collateral
available for such loans. For the financial system to nurture innovation and
growth, its risk assessment practices need to improve while transaction costs are
reduce. Greater availability of credit histories and credit information should
help in this regard. All these will lead to better capacity in the financial system
to take informed credit decisions. As we go ahead with further development of
the financial system, it should enable slicing of risk in such a way that investors
with different risk appetites from higher to lower, are able to find appropriate
vehicles for investment. The issue is basically one of informed risk management
in terms of segregating more risky from less risky credits and finding
appropriate ways of financing them. As we go along with reforms, we need to
work harder to develop such institutions and systems.
Strengthening of the domestic financial system is a prerequisite for external
sector opening up particularly in the capital account. Periodic assessment of
financial sector gains importance in this respect. Such assessment includes
appraisals of the relative importance of the various financial institutions in the
system; the sensitivity of the system to shocks under alternative scenarios and
financial soundness indicators. They also encompass assessments of liquidity
developments and policies, the crisis-management framework, the regulation
and supervisory practices. Secondly, assessments of the extent to which
financial sector standards and codes are observed make it possible to identify
gaps in regulation and transparency, evaluate the overall stability of the
financial system, and measure a country’s practices against international
benchmarks. India undertook a comprehensive self-assessment of financial
standards and codes some five years ago and this is being reviewed on an
ongoing basis. India was one of the earliest to participate in the financial sector
assessment by the IMF and World Bank and recently a Committee has been
constituted by Government of India in consultation with the Reserve Bank to
take up a comprehensive self assessment of financial sector.

The Role of RBI’s Monetary Policy

Coming to the role of monetary policy: what we have achieved over the last
decade? And how is it relevant for fostering innovation, entrepreneurship and
growth? A great deal of market development has taken place in the financial
sector. We now have market related flexible interest rates, more open forex
markets, and flexible market related exchange rates, although the Reserve Bank
continues to intervene in the forex market. We also have a active capital market
for equities, though the corporate bond market has some way to go. We also
have more competition in banking. So there has been pro-active monetary and
financial sector policy during last decade or so, which has promoted economic
growth, maintained low inflation along with financial stability.
In India, monetary policy has the twin objectives of price stability and growth.
While the Reserve Bank does not target an explicit inflation rate as some
countries do, the objective currently is to contain the inflation rate within an
upper bound of 5 percent and attempt to reduce it further in the medium term.
The relative emphasis of monetary policy stance varies with the prevailing
macroeconomic and monetary conditions: for example, inflation was an issue
during much of 2007, and continues to be of concern now. The upshot of these
concerns has been reflected in a gradual tightening of policy rates and additional
measures such as increase in cash reserve ratio since the latter part of 2004.

The best contribution that monetary policy can make for fostering innovation
and growth is to provide an environment of low inflation, low inflation
expectations, along with confidence in the maintenance of financial stability.
Entrepreneurs take considerable risk as it is: on top of that if we add macro-
economic risks in terms of higher inflation, high inflation volatility and higher
interest rates, then the risk perception can be such that entrepreneurship,
innovation and investment gets effectively constrained. That will inevitably
result in lower investment rates and hence lower economic growth. Therefore,
to keep the momentum of high growth, it is extremely important to recognise
that the best contribution that monetary policy can make is indeed to ensure that
inflation and inflation expectations are well anchored.

There is evidence that pro-cyclical behaviour of financial markets and pro-

cyclical macroeconomic policies have not encouraged growth; they have in fact
increased growth and consumption volatility in developing countries that have
integrated to a larger extent in international financial markets. The menu of
macroeconomic policies for financial and real economic stability has thus
expanded in recent years to multiple objectives and significant trade-offs.
Preventive or prudential macroeconomic and financial policies, which aim to
avoid the excess accumulation of public and private sector debts during periods
of upward cycle, have become a part of the standard policy prescription.

Policy choices presently involve a mix of counter-cyclical fiscal and monetary

policies, which also include the practice of an appropriate exchange-rate regime,
buttressed by active capital account management that reduces the risks that can
arise from turbulence in international financial markets. Such measures would
also include adequate prudential regulation of the financial sector, and
particularly of the banking system. Thus, for instance, the increase in risk
weights on lending to certain sectors such as real estate has been aimed at
curbing excessive credit growth to sectors that seem in danger of over-
extension.

While India has been maintaining one of the highest growth rates among
countries for quite some time now, the growth dynamics has dramatically
shifted in the last three to four years and the economy is poised to break from an
intermediate growth rate of around 6 percent to a high growth rate regime of
well above 8 percent. Despite high levels of internal resource generation and
access to external borrowings, credit demand across sectors also had picked up
quite substantially pushing the rate of investment to new heights. The increasing
consumer and business confidence have been attracting foreign investment
flows resulting in easy liquidity conditions in the financial system. The central
bank had to address these complex set of pressures of increased liquidity,
substantial expansion in credit particularly to certain sensitive sectors such as
real estate and retail and the growing capital inflows and consequent need for
sterilization.
A cross-country comparison of major EMEs that have adopted inflation
targeting (IT) indicates that growth in India has been amongst the highest while
inflation remains relatively low (Mohan, 2007). Thus, the recent record of
macroeconomic management in India is exemplary, even amongst the EMEs
that target inflation. The challenge for monetary policy now is to reduce
inflation further in the medium term towards international levels, while
maintaining the momentum of high growth and preserving financial stability.
Real GDP growth has averaged 8.7 per cent per annum during the 5-year period
ending 2007-08. The present domestic investment rate of around 36-37 per cent
is expected to help sustain the current growth momentum. In Indian economic
history, there has never been this order of growth for five consecutive years; this
has been achieved while keeping inflation low and stable and anchoring
inflationary expectations. Apart from increase in productivity, benefits through
trade liberalization, fiscal consolidation and more effective monetary policy
have also helped in sustaining relatively a low inflation rate since the mid-
1990s. Spikes and seasonal falls in headline inflation rates will continue to
occur due to relative price adjustments and supply shocks emanating from
agricultural and other commodity prices. Such shocks have evidently amplified
over the past 2-3 years on account of large increases in a range of global
commodity prices such as oil, food and metals. In view of the success in
reducing inflation from the long-run average of 7-8 per cent to 4-5 per cent
now, the society's tolerance rate of inflation has also come down. In this crucial
stage of transition, it is important to recognize that price and financial stability
are very crucial to sustain the growth at current levels without any disruptive
forces coming into play.
 MONEY MARKET DEVELOPMENTS –

MID-1980s ONWARDS

The Vaghul Working Group (1987) recommended several measures for

widening and deepening the money market. Some of the major
recommendations, inter alia, included (i) activating existing instruments and
introducing new instruments to suit the changing requirements of borrowers and
lenders; (ii) freeing interest rates on money market instruments; and (iii)
creating an active secondary market through establishing, wherever necessary, a
new set of institutions to impart sufficient liquidity to the system. The
Committee on the Financial System, 1991 further recommended phased
rationalisation of the CRR for the development of the money market. Second
generation reforms in the money market commenced when the Committee on
Banking Sector Reforms, 1998 recommended measures to facilitate the
emergence of a proper interest rate structure reflecting the differences in
liquidity, maturity and risk.

In pursuance of the recommendations of the two committees, a comprehensive

set of measures was undertaken by the Reserve Bank to develop the money
market. These included (i) withdrawal of interest rate ceilings in the money
market; (ii) introduction of auctions in Treasury Bills; (iii) abolition of ad hoc
Treasury Bills; (iv) gradual move away from the cash credit system to a loan-
based system; (v) relaxation in the issuance restrictions and subscription norms
in the case of many money market instruments; (vi) introduction of new
financial instruments; (vii) widening of participation in the money market; and
(viii) development of a secondary market. All these policy measures have
helped in developing the money market significantly over the years as reflected
in the volumes and turnover in various market segments.
Prior to the mid-1980s, as discussed earlier, the market participants heavily
depended on the call money market for meeting their funding requirements.
However, inherent volatility in the market impeded efficient price discovery,
thereby hampering the conduct of monetary policy. Against this backdrop, the
Chakravarty Committee (1985) recommended activation of the Treasury Bills
market (with the discount rate being market related) to reduce dependence on
the call money market and abolish ceilings on the call rate along with permitting
more institutional participation to widen the market base. The Vaghul
Committee, in view of the continued existence of an unaligned overall interest
rate structure, recommended abolition of the ceiling interest rate on the call
money market. However, it held the view that the call money market should
continue to remain a strictly inter-bank market (barring LIC and the erstwhile
UTI which could continue as lenders only) and recommended the setting up of a
Finance House of India to impart liquidity to short-term money market
instruments.

The reforms commenced with the setting up of an institution, viz., the Discount
and Finance House of India (DFHI) in 1988 as a money market institution to
impart liquidity to money market instruments. Interest rate in the call money
market was deregulated with the withdrawal of the ceiling rate with respect to
DFHI from October 1988 and with respect to the call money market in May
1989. Although the Vaghul Committee had recommended that call/notice
money should be restricted to banks only, the Reserve Bank favoured the
widening of the call/notice money market. In the absence of adequate avenues
for deployment of short-term surpluses by non-bank institutions, a large number
of non-bank participants such as FIs, mutual funds, insurance companies and
corporates were allowed to lend in the call/notice money market, although their
operations were required to be routed through the PDs from March 1995. In this
context, PDs and banks were permitted to both lend and borrow in the market.
The Reserve Bank exempted inter-bank liabilities from the maintenance of
CRR/ SLR (except for the statutory minimum) effective April 1997 with a view
to imparting stability to the call money market.

The Narsimham Committee (1998), however, noted that the money market
continued to remain lopsided, thin and extremely volatile. While the non-bank
participation was a source of comfort, it had not led to the development of a
stable market with depth and liquidity. The non-bank participants, unlike banks,
were not subjected to reserve requirements and the call/notice money market
was characterised by predominant lenders and chronic borrowers causing heavy
gyrations in the market. There was also over-reliance of banks in the call/notice
money segment, thereby impeding the development of other segments of the
money market. The Reserve Bank also did not have any effective presence in
the market and operated with pre-determined lines of refinance. As interest rates
in other money market segments move in tandem with the inter-bank call
money rate, the volatility in the call segment inhibited proper risk management
and pricing of instruments. Thus, freeing of interest rates did not result in a
well-defined yield curve. Furthermore, banks’ role in the money market was
further impaired by the health of their own balance sheets, lack of integrated
treasury management and sound asset-liability management.

The Narasimham Committee (1998) made several recommendations to further

develop the money market. First, it reiterated the need to make the call/notice
money market a strictly inter-bank market, with PDs being the sole exception,
as they perform the key function of equilibrating the call money market and are
formally treated as banks for the purpose of inter-bank transactions. Second, it
recommended prudential limits beyond which banks should not be allowed to
rely on the call money market. The access to the call money market should only
be for meeting unforeseen fund mismatches rather than for regular financing
needs. Third, the Reserve Bank’s operations in the money market need to be
market-based through LAF repos and reverse repo auctions, which would
determine the corridor for the market. Fourth, non-bank participants could be
provided free access to rediscounting of bills, CP, CDs, Treasury Bills and
money market mutual funds.

Following the recommendations of the Reserve Bank’s Internal Working Group

(1997) and the Narasimham Committee (1998), steps were taken to reform the
call money market by transforming it into a pure inter-bank market in a phased
manner. The corporates, which were allowed to route their transactions through
PDs, were phased out by end-June 2001. The non-banks’ exit was implemented
in four stages beginning May 2001 whereby limits on lending by non-banks
were progressively reduced along with the operationalisation of negotiated
dealing system (NDS) and CCIL until their complete withdrawal in August
2005. In order to create avenues for deployment of funds by non-banks
following their phased exit from the call money market, several new
instruments were created such as market repos and CBLO. Maturities of other
existing instruments such as CPs and CDs were also gradually shortened in
order to align the maturity structure to facilitate the emergence of a rupee yield
curve. The Reserve Bank has been modulating liquidity conditions through
OMOs (including LAF), MSS and refinance operations which, along with
stipulations of minimum average daily reserve maintenance requirements, have
imparted stability to the call money market.

Despite these reforms, however, the behaviour of banks in the market has not
been uniform. There are still some banks, such as foreign and new private sector
banks, which are chronic borrowers and public sector banks, which are the
lenders. Notwithstanding excessive dependence of some banks on the call
money market, the short-term money markets are characterised by high degree
of stability. The Reserve Bank has instituted a series of prudential measures and
placed limits on borrowings and lendings of banks and PDs in the call/notice
market to minimize the default risk and bring about a balanced development of
various market segments. In order to improve transparency and strengthen
efficiency in the money market, it was made mandatory for all NDS members to
report all their call/notice money market transactions through NDS within 15
minutes of conclusion of the transaction. The Reserve Bank and the market
participants have access to this information on a faster frequency and in a more
classified manner, which has improved the transparency and the price discovery
process. Furthermore, a screen-based negotiated quote-driven system for all
dealings in the call/notice and the term money markets (NDS-CALL),
developed by CCIL, was operationalised on September 18, 2006 to bring about
increased transparency and better price discovery in these segments.

Various reform measures over the years have imparted stability to the call
money market. It has witnessed orderly conditions (barring a few episodes of
volatility) and provided the necessary platform for the Reserve Bank to conduct
its monetary policy. The behaviour of call rates has, historically, been
influenced by liquidity conditions in the market. Call rates touched a peak of
about 35 per cent in May 1992, reflecting tight liquidity on account of high
levels of statutory pre-emptions and withdrawal of all refinance facilities,
barring export credit refinance. After some softness, call rates again came under
pressure to touch 35 per cent in November 1995, partly reflecting turbulence in
the foreign exchange market. The Reserve Bank supplied liquidity through
repos and enhanced refinance facilities while reducing the CRR to stabilise the
market. After softening to a single digit level, the rate hardened again to touch
29 per cent in January 1998, reflecting mopping up of liquidity by the Reserve
Bank to ease foreign exchange market pressure. Barring these episodes of
volatility, call rates remained generally stable in the 1990s. After the adoption
of the LAF in June 2000, the call rate eased significantly to a low of 4.5 per cent
in September 2004, reflecting improved liquidity in the system following
increased capital inflows. However, it came under some pressure in December
2005 on account of IMD redemptions and increased to about 7 per cent in
February 2007, partly due to monetary tightening. With the institution of LAF
and consequent improvement in liquidity management by the Reserve Bank, the
volatility in call rates has come down significantly compared to the earlier
periods. The mean rate has almost halved from around 11 per cent during April
1993-March 1996 to about 6 per cent during April 2000-March 2007.

Volatility, measured by coefficient of variation (CV) of call rates, also halved

from 0.6 to 0.3 over the same period. Thus, while statutory pre-emptions like
CRR and SLR, and reserve maintenance period were the main factors that
influenced call rates in the pre-reform period, it is the developments in other
market segments, mainly the foreign exchange and the government securities
market along with the Reserve Bank’s liquidity management operations that
have been the main driver of call rates in the post-reform period. This signifies
increased market integration and improved liquidity management by the
Reserve Bank. With the transformation of the call money market into a pure
inter-bank market, the turnover in the call/notice money market has declined
significantly. The activity has migrated to other overnight collateralized market
segments such as market repo and CBLO. The daily average turnover in the call
money market, which was Rs.35,144 crore in 2001-02, declined to Rs.14,170
crore in 2004-05 before increasing again to Rs.21,725 crore during 2006-07.
The recent rise in call money market turnover reflects the general tendency of
heightened market activity following the imbalance between growth in bank
credit and bank deposits in recent years against the backdrop of sustained pick-
up in non-food credit.
Since forward trading in securities was generally prohibited in India, repos were
permitted under regulated conditions in terms of participants and instruments.
Reforms in this market have encompassed both institutions and instruments.
Both banks and non-banks were allowed in the market. All government
securities and PSU bonds were eligible for repos till April 1988. Between April
1988 and mid-June 1992, only inter-bank repos were allowed in all government
securities. Double ready forward transactions were part of the repos market
throughout this period. Subsequent to the irregularities in securities transactions
that surfaced in April 1992, repos were banned in all securities, except Treasury
Bills, while double ready forward transactions were prohibited altogether.
Repos were permitted only among banks and PDs. In order to reactivate the
repos market, the Reserve Bank gradually extended repos facility to all Central
Government dated securities, Treasury Bills and State Government securities. It
is mandatory to actually hold the securities in the portfolio before undertaking
repo operations. In order to activate the repo market and promote transparency,
the Reserve Bank introduced regulatory safeguards such as delivery versus
payments (DvP) system during 1995-96. The Reserve Bank allowed all non-
bank entities maintaining subsidiary general ledger (SGL) account to
participate in this money market segment. Furthermore, non-bank financial
companies, mutual funds, housing finance companies and insurance companies
not holding SGL accounts were also allowed by the Reserve Bank to undertake
repo transactions from March 2003, through their “gilt accounts” maintained
with custodians. With the increasing use of repos in the wake of phased exit of
non-banks from the call money market, the Reserve Bank issued comprehensive
uniform accounting guidelines as well as documentation policy in March 2003.
Moreover, the DvP III mode of settlement in government securities (which
involves settlement of securities and funds on a net basis) in April 2004
facilitated the introduction of rollover of repo transactions in government
securities and provided flexibility to market participants in managing their
collaterals.
The transactions that are put through at various agency bank branches in the
State concerned are consolidated at the link cell in the respective State capitals
and settled with the Reserve Bank Office in the State. Currently, Reserve Bank
also handles directly, banking business of four State Governments viz.,
Karnataka, Maharashtra, Thailand and West Bengal. The consolidated position
including the State Government transactions put through at RBI Offices is
ultimately booked in the Principal Account of the respective State maintained at
CAS, Nagpur. Central Accounts the Central Accounts Section (CAS) at the RBI
maintains the principal accounts of both Central and State Governments. The
principal accounts in Nagpur are based on the daily position / aggregate receipts
and payments in respect of each Government, Ministry / department, received
from RBI offices and agency banks. Each of the accredited a

Role Of Central Bank for Regulating Banking System

Need of Central Bank

The Payments System provides the arteries or highways for conducting trade,
commerce and other forms of economic activities in any country. An efficient
payments system functions as a lubricant speeding up the liquidity flow in the
economy and creating a momentum for economic growth. The payments
process is a vital aspect of financial intermediation; it enables the creation and
transfer of liquidity among different economic agents. A smooth, well
functioning payments system not only ensures efficient utilization of scarce
resources but also eliminates systemic risks.

The payments system assumes importance in the context of domestic financial

sector reforms and global financial integration. The time value of money flows
has increased sharply in view of the competing demands on the financial sector.
Efficient, low cost cross-border payments flow helps to promote international
trade in goods and services. Foreign investments (direct and portfolio) are
encouraged by the availability of an efficient payments system. For these
reasons, an efficient and technologically advanced payments and settlement
system performs a vital infrastructural function in the economy. Central banks
have, therefore, been taking measures to set up such an infrastructural set up.

Use of money for settlement of payment obligations has a very long history.
Use of non-cash exchange through barter preceded the introduction of money.
Barter, however, co-exists with monetized economy in some underdeveloped
agricultural societies even now. But currency or cash is the most readily
accepted medium of exchange in all modern societies because it is the legal
tender and helps to bring about irrevocable settlement. There are, however,
certain disadvantages associated with the use of cash. Holding cash does not
fetch any return-the interest foregone because of cash holding is a cost to the
holder of cash. Besides, the holder of cash bears some insurance costs in terms
of the premia that is paid to cover any loss/theft. Moreover, carrying of large
quantities of cash to make large-value payments is a security risk and also
involves transportation costs. The requirements of a modern economy in regard
to settlement of transactions are diverse and variegated and the needs of
manufacturing, trade, and commerce activities involve large value payments
over vast geographic distances. External trade with the rest of the world
involves payments in different currencies. Payments can no longer be
completed by simple cash transfer in such cases. Therefore, there arises the need
for additional forms of payments, which can be facilitated with improved
financial intermediation and expansion of financial instruments. Cheques and
other paper based instruments and to some extent electronic instruments have
become important modes of payment in recent times in most countries because
of growing financial intermediation. Individuals, business entities or
governments issue cheques or other forms of order on their banks in discharge
of their payment obligations. The recipients of these orders would then get the
funds embodied in these payment instruments through their own banks. As the
number of banks grew over time, the volume of instruments exchanged among
them increased substantially.

Consequently, as also to have an orderly means of transfer of payment

instructions among banks at a location or centre, a common set of practices and
mechanisms of exchange had to be evolved. When instruments presented by
customers of banks become payable at outside locations, special collection
arrangements are set in motion to collect the funds.

If the collecting bank has a branch at the relevant outside location, there would
be no problem, but, if the collecting bank does not have a branch at the outside
location, it will have to enter into correspondent banking relationship with
another bank at the said outside location for the purpose of collecting funds. The
payment instruments which are routed through financial intermediaries involve
book entries at various levels to transfer funds from one party to the other. The
range of intermediation varies to take care of different situations. This may, for
instance, consist of instructions to intermediaries to move goods coinciding with
the movement of funds as in the case of a Letter of Credit. Or, the instruction
could be for payment of specified sums of money to the bearer of a payment
instrument, as in the case of a bearer cheque.

In some cases, the payment instruments are negotiable in the sense that they can
be transferred from person to person in lieu of cash. In yet other cases, both the
ultimate beneficiary and the destination could be pre-determined. In all these
cases, banks play a crucial part in conveying, transmitting and carrying out the
instructions embodied in the payment instruments. While doing so, these
intermediaries have to settle among themselves the monetary claims arising
from the execution of payment instructions.

Thus, whenever non-cash payment instruments are involved, they are

accompanied by a chain of related fund transfers as well as a stream of book
entries and messages. Banks in turn need an intermediate agency such as the
clearing house where these instruments can be exchanged and where the
financial claims on one another can be settled through a settlement bank, which
is usually the Central Bank of the country.

Clearing Houses facilitate the exchange of instruments and processing of

payment instructions at a central point among the participating banks. Clearing
Houses-manual and paper based in many advanced countries have gradually
extended their range of activities to include automated (ACH) and electronic
means for settlement of payment transactions. Such an evolution is also seen in
emerging economies. Banks, as crucial intermediaries in the payments stream,
provide deposit accounts to non bank agents (i.e. individuals, firms/corporate
bodies) which are considered as liquid assets and facilitate payments
transactions. Banks provide credit facilities so that such payments can be
effected with lower working balances. Moreover, they act as conduit through
which domestic and international capital markets provide resources to the
commercial sector. The payments system has a multiplicity of layers where
several levels of intermediation occur in the transfer of funds from one person
and/or institution to another. The structure of the Payments System can be
visualized as a Pyramid, with linkages among different tiers of the payment
intermediaries.
At the base of the Pyramid are the non banks (all non-depository corporations
including individuals and firms) whose assets are diverse, including bank notes
and deposits. The types of payments at the base of the Pyramid include both
cash and non-cash modes of payments. Banks are at the intermediate level.

The assets of the banks comprise, among others, their reserves with the Central
Bank, deposits with the correspondents and claims on the correspondents, and
investments in Government and other securities, loans and advances and cash in
their vaults. Typically, their liabilities would among others, be made up of
deposits from non banks and correspondents and loans from the Central Bank.

The Clearing House and the settlement bank are the financial intermediaries
who channel the funds flow between the banks. At the apex of the pyramid is
the Central Bank of the country (i.e. Reserve Bank of India) which has the
settlement accounts of the banks and sustains the payments process.
 Figure Payments System Pyramid

In the Payments System Pyramid, the Central Bank has a special role to play as
the settling bank maintaining settlement accounts for banks. These are used by
banks to discharge their obligations amongst themselves. While the settlement
account can be maintained with any bank, there is always a risk of default by
the settling bank. A failure of a settling bank can have disastrous consequences
leading to a possible systemic collapse. Settlement accounts maintained with the
Central Bank, on the other hand, provide the basic stability to the settlement
process as the Central Banks cannot fail. The involvement of the Central Bank
in the settlement process is therefore crucial.

This monograph is organized in the following way. After giving a brief account
of the evolution of payments system in India in Chapter II, the various paper
based instruments in vogue in India are discussed in Chapter III.

The complexities of the existing paper based payments and settlement systems,
Remittance Facilities and Currency Chests and the Uniform Regulations and
Rules of Clearing for paper based instruments form the subject matter of
Chapter IV. Given the increase in the volume of paper based instruments and
the time taken for clearing these instruments, it was inevitable to move towards
item-based computerized processing and settlement for improving systemic
efficiency as well as customer service. These and other related aspects are the
main themes of interest in Chapter V. In the early and mid 90s, a beginning was
made in introducing ACH (Automated Clearing House) services such as
Electronic Clearing Service (ECS) and Electronic Funds Transfer (EFT).

The developments in this regard, including the establishment of a Shared

Payment Network System (SPNS) of Automated Teller Machines (ATMs) are
highlighted in Chapter VI. For an efficient electronic payments system, a strong
and robust telecommunication network is necessary. The efforts made by the
Reserve Bank in particular as well as the banking industry in general in setting
up a telecommunication network to serve the needs of the industry form the
contents of Chapter VII. The final chapter provides a brief idea of the
challenges ahead in modernizing the Indian payments system.

Role as a Banker to the Government

The title of the address refers to being banker to governments simply because
RBI is a banker not only to the Central Government, but also State
Governments. RBI by virtue of its charter performs several functions, the most
important being to secure stability in the internal and external value of the
currency mainly through conduct of monetary policy, while at the same time,
ensuring adequate availability of credit to meet the genuine needs of a growing
economy. Currency management is yet another function of the RBI which
impacts the transactions of a large number of people. managing public debt is
also assigned to RBI, but this is sought to be separated from RBI in due course.
Its regulation of money and forex markets flows from its primary responsibility
while its role in debt markets is closely linked to it being manager of public
debt. RBI is also a regulator and supervisor of banks, development financial
institutions, and non-banking financial companies, but the process of
supervision is overseen by an independent Board for Financial Supervision,
within RBI. Incidentally, RBI is also a banker to banks. Payment System is also
under the aegis of RBI, and the technological infrastructure for the financial
sector, especially in the money and Government Securities market is provided
by RBI to sub serve its overall responsibilities. To the governments it renders
advice on financial matters, whenever called upon to do so.

Being banker to governments is also an important function, but is seldom in

high profile, perhaps due to the reason that it does not directly or visibly
impinge on prices or output. However, as will be explained today, though it is
not a big-ticket item on RBI’s balance-sheet, its role as a banker to governments
is very significant and it has been evolving in the recent years reflecting the
process of economic reform.

The Bank provides banking services to both Central and State Governments
such as acceptance of moneys on Government account, payment / withdrawal of
funds and collection and transfer of funds by various means throughout India.
The Governments' principal accounts are maintained at Central Accounts
Section of the Bank at Nagpur.

Government accounts are handled by RBI at 15 Offices, besides two State

Government Cells at Bhopal and Chandigarh. Further, all public sector banks
and two private sectors banks handle Governments accounts through their
20,800 branches. Currently, the Agency banks handle Governments transactions
of around Rs.12 lakh crore in a full Financial year.
Over and above these, sizeable transactions are handled at Reserve Bank
Offices. Some transactions, though minimal, are handled in Governments’ own
treasuries and sub treasuries, numbering 453, equipped with Currency Chests.
This data gives the Magnitude and spread of transactions relating to
Governments. The first part of today’s presentation will cover very briefly
cross-country practices. The second part provides the legal and institutional
framework in India for conduct of Government’s business in banking. The third
section describes the range of Banking services provided by RBI to
Governments. The fourth part describes some of the reforms already undertaken
in this area. The fifth section describes major issues while the concluding
section indicates a possible agenda for immediate actions.

Cross-Country Practices

By custom and tradition or by express provision in the laws by which they have
been established, Central Banks are bankers to their respective Governments. In
the view of Sir Montague Norman of the Bank of England and Benjamin Strong
of the Federal Reserve System, the Central Bank should undertake all the
banking business on behalf of their own Governments. However, the actual
practices do vary among countries. In the UK, Bank of England is the main
banker to Government and maintains the Principal Central Government
Account. Individual Government departments are not obliged to use Bank of
England as their banker. Typically Government Department with significant
requirements for banking service put some or all of their banking business out
to tender.

In the case of South Africa, the South African Reserve Bank acts as banker to
The Central Government. Provincial Governments are, however, the clients of
private banking sector. In Japan, Bank of Japan carries out the transactions with
the National Government but not with local Governments. As regards USA, the
Federal Reserve acts as the banker to US Government. The Reserve Banks
serve as depositories of the United States and perform several payment-related
services.

Legal and Institutional Framework

Government business in India was initially handled by the Presidency Banks of

Bengal, Madras and Bombay from 1862 to 1921 and thereafter by the Imperial
Bank of India, which came into existence as a result of amalgamation of the
Presidency Banks. Since April 1, 1935, the Reserve Bank has been the banker to
the Central and State Governments. According to Article 283(1) and (2) of the
Indian Constitution, it is open to the Central Government and to any State
Government to make rules for the receipt, custody and disbursement of all the
amounts accruing to or held in its consolidated or contingency funds or in its
public account. Sections 20 and 21 of the Reserve Bank of India Act, 1934
provide that the Central Government shall entrust the Bank with all its money,
remittance, exchange and banking transactions in India and the management of
its public debt, and shall also deposit all its cash balances with the Bank free of
interest. The Bank may, by agreement with any State Government, take over
similar functions on behalf of that Government under Section 21A of the RBI
Act. Accordingly, the RBI is the common banker to the Central Government
and all the State Governments in the Indian Federation with the exception of
Jammu & Kashmir and Sikkim. The Reserve Bank, as banker to various
Governments, has well defined obligations and provides several services. First,
the Central Government Treasury Rules, the Central Government Account
(Receipts and Payments) Rules, in respect of the transactions of the Central
departments, and the corresponding provisions in the State Financial codes are
deemed to be legally binding on the Bank.
Second, the Bank carries on the General Banking business of the Centre and the
States in terms of the working agreement between the Government and the
Reserve Bank. The liability of the Bank to the Governments in the conduct of
the Government business is that of a banker to an ordinary customer. Third, the
Bank also undertakes to float loans and manage the loans on behalf of the
Governments on agreed terms.

Fourth, where there is no full-fledged office of RBI, it appoints commercial

banks as agents of RBI and they are made responsible for transacting the entire
Government business. Fifth, the Bank does not charge to Governments, the cost
of carrying on Government business through its offices or the agency banks.
Sixth, a facility for grant of ways and means advances is provided by Reserve
Bank to the Governments, to meet the temporary mismatches in their income
streams. Seventh, the RBI arranges for investments of surplus cash balances of
the Governments as a portfolio manager. Eighth, the RBI also acts as Adviser to
Government, whenever called upon to do so, on monetary and banking related
matters besides dispensing merchant banking services.

Range of Banking Services

Banker to Central Government the work relating to Government business is

attended by the Public Accounts Department of the RBI. The discharge of the
Bank's functions as banker to Government involves the receipt and payment of
money on behalf of the various Governments departments.

For this purpose, under Section 45 of the RBI Act 1934, initially the RBI
appointed State Bank of India as its sole agent at all places where the Bank had
no office or branch of its Banking Department. In turn, SBI entered into agency
agreements with all its associate banks and delegated the agency functions to
some of the branches of the associate banks at certain centers. Considering the
increasing volume of Government business and nationalization of some
commercial banks, the Government and the RBI associated nationalized banks,
which had a vast network of branches, to conduct Government business. In
1970, the Government empowered the RBI to appoint them as agents at any
centre. By 1976, the SBI, Associate Banks and nationalized banks were acting
as agents of the RBI for this business. In order to facilitate the handling of
Government receipts and payments, currency chests were established with a
number of branches of nationalized banks in addition to SBI and Associate
Banks.

Prior to 1976, the responsibility for arranging payments and compiling accounts
of receipts and disbursals and auditing of transactions of all Central
Government Ministries devolved on a single authority, viz., Comptroller and
Auditor General of India. The Government introduced from April 1976, a
scheme in stages for decentralization and departmentalization of accounts of
individual Ministries at the Centre, thereby transferring the responsibility for
maintenance of accounts at all stages to the Ministries / Departments
themselves. Under this scheme each ministry/ department has been allotted. A
specific public sector bank for handling its transactions based on the principle of
'one bank - one ministry/department'. Hence, the Reserve Bank does not handle
government’s day-to-day transactions as before, except where the Bank itself
has been nominated as banker to a particular ministry/department.

Banker to State Governments the financial transactions of the State

Governments are carried out at a number of offices, including those of the RBI
SBI, nationalized banks, Treasuries, etc. The Government transactions
conducted at all such places are allowed without any reference to the actual
position of the cash balance of the State Government, the accounts of which are
maintained at the Central Accounts Section of the RBI at Nagpur.

gency banks has set up a link office at Nagpur to liaise with CAS for funds
settlement. Thus, the Bank's offices and agency banks' branches function like
tributaries,

Which flow in the direction and merge into the Central Accounts Section. CAS,
Nagpur, thus plays a pivotal role in consolidating the transactions and working
out the overall daily position of each government. The actual day-to-day
transactions are handled by the Bank's offices and agency bank branches. They
render accounts to respective Government accounting authorities while
effecting monetary settlement with RBI. Since frequent adjustments between
the various Governments are unavoidable, settlement of these transactions
through Central Accounts Section is convenient, accurate and expeditious.
Reserve Bank through its Remittance Facilities Scheme operates a funds
transfer system. It carries out the adjustments as between the various
Governments providing in effect, facilities for the transfer of funds on a very
large scale within the Government Sector. In order to facilitate the actual
conduct of Government transactions, the Reserve Bank has built up over the
years, a network of currency chests, repositories and small coins depots, all of
which are intended to service all the Governments in the country.

As banker to the Government, Reserve Bank works out the overall funds
position and sends daily advices showing the balances in its books, ways and
means granted and investments made. The daily advices are followed up with
monthly statements, and are Useful from the point of view of enabling the
Government to prepare their ways and means budgets. The arrangement
between the Government of India and the Reserve Bank on the one hand and the
public sector banks and the Reserve Bank on the other, are based largely on
trust as well as being merely contractual. Treasury System all payments on
account of Central and State Governments are made either by cheques or by
bills. The Government of India, Reserve Bank and the banks, which serve the
treasuries and sub-treasuries normally, prefer cheques to bills.

Certain States like Maharashtra, Gujarat, Karnataka, West Bengal etc. have
adopted the system of payments by cheques at their Treasuries. However, a
large number of States are yet to introduce the cheque System. In view of the
advantages of cheques as compared with bills, Official policy continues to be in
favour of changing over to cheque system. Since 1976, Treasuries and non-
departmental Pay and Accounts Offices have ceased to be responsible for
handling transactions on behalf of the Central (Civil) Departments as integrated
financial advisers and principal accounts officers of these departments have
taken over the responsibility for receiving and paying money,

Compiling and maintaining the accounts, in respect of all the transactions

relating to these departments. The pay and accounts officer or a drawing and
disbursing officer of each Ministry or Department are linked to a designated
public sector bank or RBI and are not allowed to draw on a treasury. Other
Services In addition to being a pure banker to Government, RBI provides a full
range of related services to Government.

These include exchange, remittance transactions, and management of public

debt and issue of new loans, handling the forex transactions of the Government
of India, investment of surplus funds of Governments, providing safe custody
facility, providing of ways and means advances, management of special funds
Like Consolidated Sinking Fund, Guarantee Redemption Fund, Calamity Relief
Funds, National Defence Scheme, etc., issue and management of tap bonds like
Relief Bonds, Administration of the Scheme for disbursal of pensions of Central
and State Governments’ employees through public sector banks and as Advisor
to Government on all matters involving monetary and economic perspective.
The fee recovered by the Bank for some of the above services, which are
rendered as an adjunct to its role as Banker to Government, are nominal and do
not even cover the costs, while for most other services no charge is levied.

Recent Reforms Undertaken

Focal Point and Beyond. The experience of the working of the

"Departmentalized Scheme" has shown a few shortcomings. With the large
number of bank branches handling the work, delays often occurred in the
transmission of the relevant documents (paid cheques, challans scrolls etc) to
Pay and Accounts Officers (PAOs) for accounting. Besides, there were certain
difficulties in reconciliation of figures between government departments and
Banks. In order to obviate these difficulties as well as making reconciliation
easier, a

Working Group was set up in 1986 to review the working of the scheme, and on
the basis of its recommendation existing procedures were revised. This marked
the beginning of focal point approach for reporting and settlement of
government transactions and set the pace for further refinement of the
accounting system. The focal point approach envisages "one focal point branch
- one (Pay and Accounts Office) PAO". This concept was incorporated into the
system to bring about an interactive method of resolving the day-today
problems while achieving expeditious reconciliation. This system ensures
updating of accounts at PAO level and speedy settlement of funds at Central
Accounts Section at Nagpur. It has, sought to bridge the gap between RBI
accounts and Government accounts. Based on its success, it has been
subsequently adopted in phases, in Central Board of Direct Taxes (CBDT) and
extended to Departmentalized Ministries Accounts (DMA) (both civil and non-
civil ministries). There has been a close alignment between accounting
jurisdiction of the government and the dealing branches of the bank.

However, in the envisaged computerized environment, with electronic

connectivity, the settlement of funds on real time basis, directly between the
dealing branches and CAS at Nagpur for credit of Government Account without
the intervention If Focal Point and Link Cell may be a distinct possibility in the
near future. Standing Committee on Computerization Given the large magnitude
of the transactions in Government account, the manual system results in delays
in handling transactions.

Complete electronic data processing in the preparation and settlement of the

accounts of Government business by the agency banks as also for compilation
of accounts at Treasury/Pay and Accounts Office/Accountant General will
eliminate the time lag in the flow of information and improve standards of
accuracy. During the last few years, RBI offices and agency banks have
initiated steps for computerization of Government transactions at their dealing
Branches.
The Committee on Technology Up gradation in Banking Sector laid down the
Road map for computerization of bank branches handling Government business,
to be achieved in phases. The first phase envisaged computerization of all Focal
Point branches of agencies by March 31, 2000 and State government Link
Cells / dealing branches in the second phase thereafter. The Committee desired
that efforts should be made to interconnect the computerized branches dealing
in Government Accounts with Link Offices/ branches, and the Public Accounts
Departments of the Bank and also Central Accounts Section, Nagpur where it is
ultimately accounted for in the books of accounts. On Government side, the
Committee suggested that all PAOs/Circle Offices of Government should be
computerized by March 31, 2001 and the Drawing Offices / Treasury Offices
well before March 31, 2002 in alignment with computerization of Focal Point
and Dealing branches.

A Standing Committee comprising members from RBI, Government and

agency banks is monitoring the computerization of government transactions.
There have been some delays in adhering to the time schedule mentioned. RBI
has been urging the agency banks to capture 80 per cent of Government
business by June 2002. Payment Systems Reforms Payment and Settlement
Systems constitute the backbone of any economy and the existence of
competent payment and settlement systems have a positive impact on the
efficient functioning of the various sectors of the economy.

Central Banks in the world are according great importance to well established
payment and settlement systems. The Reserve Bank, too, has taken up as its
mission, the establishment of a robust, safe, and secure and efficient payment
and settlement system for the country as part of its initiatives aimed at financial
sector reforms in this area. Constituted in 1999, the National Payments Council
is the Apex level body, which provides general policy directions and guidelines
for reforms in the Payment and Settlement Systems of the country.
Initiatives aimed at improvements in the payments and settlement systems are
centered on the three-pronged strategies of consolidation, development and
integration of the various components of the payment and settlement systems.
Consolidation takes its base from existing activities such as computerized
clearing, etc.

Development envisages opening of new clearing houses, introduction of

systems such as the Centralized Funds management System and Real Time
Gross Settlement (RTGS) and Integration of all these initiatives both within the
Reserve Bank and for the banking Sector as a whole would result in the
culmination of the reform process. Non-paper based payment systems, such as
Electronic Funds Transfers (EFT) and Electronic Clearing Services (debit and
Credit Clearing), have been accepted widely for use within the country. The
proposed introduction of the Real Time Gross Settlement (RTGS) System
would ensure settlement of funds in real time and in an electronic manner. All
these would have positive impact for the government sector too, which could
exploit the benefits of ECS and EFT for even their conventional payments -
such as tax collections, various payments, tax refunds, drawback payments, etc.
Since movement of funds is scheduled to take place using electronic means, the
need for providing for a more elaborate and clear legal infrastructure has also
been recognized. Accordingly, work has commenced on draft legislation to
regulate the payment systems, which may not only be restricted to banks and
financial institutions, but could also go beyond that. The proposed legislation
will also have powers to regulate EFT, except that the proposed EFT regulation
will deal only with credit transfer.

The debit transfer transactions will continue to be governed by the Negotiable

Instruments Act, 1881. Further, in order to deal with electronic instruments like
e-cheques, which are in the nature of debit transfer, amendments to the
Negotiable Instruments Act 1881 and IT Act 2000 have been suggested for
consideration of Government.

Since July 1, 2001, a state-of-the-art technological Architecture for management

of Government Accounts at Central Accounts Section, Nagpur was set up. The
system provides online data processing capability in front office mode and on
line connectivity to all the RBI offices, agency banks and State Governments.
The system is designed to provide information on a real-time on-line basis to
Central and State Governments for ascertaining their cash balance position and
other transactions.

As a further improvement, a Virtual Private Network (VPN) is being established

between CGA and Principal Accounts Officers of various ministries. The
network is also proposed to be extended to the Pay & Accounts Office level.
The network would act as a hub for electronic interchange of information
between CAS Nagpur and various civil and non-civil ministries. While Inter
Government Transactions would be handled on an Online basis, the Agency
Bank transactions will be available as and when reported to CAS.

The above arrangements when fully put in place will enable the various
Principal Accounts Offices to send Inter-Government Transactions, along with
details of the relative sanction orders to CAS electronically, get confirmation
advices (clearance memos) instantly and eliminate most of the reconciliation
problems not only at the level of Central Government but also facilitate proper
accounting in the States.
In fact State Governments have been complaining regarding delays in receipt of
action orders as a result of which they are unable to know the purpose of the
funds being given from Central Government at the time of such amount being
credited by RBI to their accounts. RBI has also taken initiative in redesigning
the format of the IGA (Inter Government Adjustment) advice and Clearance
Memo to ensure that the advice being sent to CAS is comprehensive and meets
requirements of the State Governments as well. I would request the Office of
CGA to examine the suggestions made by us in this regard and implement the
revised IGA format at the earliest. Another benefit of the connectivity would be
strong MIS support. From the Bank's view point, on-line access will eliminate
the need for periodical statements being sent to the accounting authorities as the
authorities will be able to choose the period (a week, fortnight, month or more)
for which they want the data and then can use it for any number of MIS
purposes. Maintenance of parallel records can also be eliminated.

The RBI is also examining the feasibility of using the Internet to connect all
State Governments, Central Government Departments and various agency
banks to implement total workflow automation in respect Government
transaction. Under the current procedure, the fund settlement at CAS Nagpur
takes place after the rendering of accounts by the focal point branches to the
local PAO. The focal point branches receive the scrolls and the documents from
the dealing branches by post (normally by Registered post). This means that
settlement of funds is inevitably delayed for the period of postal transit plus the
time for consolidation at focal point branch creating a lag in final accounting in
government account with CAS Nagpur. During this lag, the funds remain in
pipeline as a float at the cost of government departments. Often, the banks also
suffer opportunity loss due to delay in monetary settlement.
With the computerization of transactions both at the bank branches and
government departments, it would be possible to re-engineer the process.
Forwarding of paper scroll/receipted challans and paid cheques to government
offices could take place at a later stage than the electronic transmission of
transactions. This means that the focal point branch would transmit the
transactions to CAS Nagpur without waiting for the scrolls received from the
Branches to be consolidated and verified.

The Committee on Technology Upgradation in Banking Sector examined this

aspect and felt that this would help in quicker finalization of government
account and fund settlement at CAS Nagpur. The issue remains open.
Interaction with States A forum has been provided by the Reserve Bank
bringing all the Finance secretaries of State Governments and the Union for
exchange of ideas and sorting out the problems. These conferences are held in
Reserve Bank for the last few years and the deliberations have proved useful in
identifying the common problems and developing best practices in regard to
Government finances. Between November 1997 and November 2001, nine such
conferences have been held. A number of important initiatives relating to ways
and means advances, approach to market borrowing programme, investment of
surpluses, ceilings on State guarantees, apart from changes in the content and
format for reporting have emanated and taken shape as a result of interactions in
these meetings.
Major Issues

Minimum Balances Requirements in Government The RBI is authorized to

provide Ways and Means Advances to Central and State Governments in terms
of Section 17(5) of the RBI Act. Until 1994-95, the needs of Government were
accommodated through automatic monetization by issuing ad hoc Treasury
Bills at 4.6 per cent. Considering the ill effects of automatic monetization of
Government deficit, the Reserve Bank and the Government agreed mutually in
September 1994 to restrict the issue of ad hocks for the year-end and also within
the year and for scrapping the issue of ad hoc treasury bills from 1 April 1997.
Accordingly the issue of ad hoc treasury bills was discontinued with effect from
1 April 1997.

Simultaneously, a scheme of granting Ways and Means Advances by the

Reserve Bank to 10Government of India has been introduced to accommodate
temporary mismatches in Government receipts and payments, interest on which
was initially confessional, is presently at Bank Rate. Currently, Central
Government is required to maintain a minimum balance of Rs.10 crore on a
daily basis and Rs.100 crore on Fridays. The limit For Ways & Means
Advances for 2001-2002 to Central Government has been fixed at Rs. 10,000
crore for the first half year and at Rs. 6,000 crore for the second half year.

When the Government utilizes 75 per cent of the WMA limit, the Reserve Bank
considers fresh floatation of market loan depending on market conditions. State
Governments were expected to match the outflows with inflows very carefully
so as to avoid recourse to ways and means advances from RBI. If a State
Government allowed its account to emerge in overdraft, this would have been
regarded with extreme disfavor and also as reflecting on the competence and
ability of the State Government to manage its own finances. Over the years, the
State Governments resorted increasingly to WMA and overdraft. The WMA
limits were fixed as a multiple of minimum balance of States. However, while
the multiples increased, the minimum balances required to be maintained by the
State Governments were not revised between 1976 and 1999. Since 1999, the
WMA Scheme is being worked out on the basis of the Recommendations of the
B.P.R.Vittal Committee (1998).

The Committee recommended that the minimum balance should be revised and
linked to the same base as normal WMA which itself is worked out taking into
account the sum of revenue receipts and capital expenditure. The first revision
after the implementation of the Vittal Committee formula was effected from
April 1, 1999, followed by the next revision from February 1, 2001. The latest
revision took effect from April 1, 2002. However, the minimum balances have
not been revised since April 1, 1999. A review of the WMA scheme will be
made in April 2003. Automatic Debit Mechanism The Technical Committee of
State Finance Secretaries on the State Government Guarantees has observed that
such a mechanism runs the risk of resulting in insufficient funds for financing
minimum obligatory payments and other grounds as well. Using an automatic
recovery mechanism for inviting subscription to bonds issued by autonomous
bodies with State Government Guarantees not only erodes the credibility of the
State Government, but also would prompt other States to request for such
assurance to offer additional comfort for investors. The matter is under the
consideration of the Reserve Bank and the Central Government.

Expansion in Agency Banks At present, the RBI, SBI and nationalized banks
conduct business relating to Governments. More recently, private banks
promoted by the all India Financial Institutions (AFI), which meet the defined
criteria, are also being considered for induction for conduct of Government
business. The objective is to help the State Governments to get better, quick
service with safety of funds. The question is to strike a balance between the two
and this may have to be decided by the States with the help of RBI.

Thus, there can be competition for Government business in the future. The
Reserve Bank, being a Central Bank, for achieving the functional focus, may
have to consider in due course, shedding of the retail banking business in
relation to Governments in favour of the agency banks with a view to ensuring
that in the long run, the Bank will maintain only the Principal Accounts of the
Governments, leaving the dayto- day banking business to the commercial banks
functioning as its agents.
Treasury

The treasury system has evolved very gradually over a number of years and has
worked with reasonable satisfaction. Nevertheless, there is scope for
improvement with a view to providing more facilities to the general public in a
number of ways. First, the non-banking treasuries / sub-treasuries, which handle
the cash business itself, could be gradually converted into banking treasuries by
transferring their cash business to banks. Second, States may weigh the option
of introducing separation of audit and accounts and departmentalization of
accounts on the lines of Centre gradually. Third, as cheques for various reasons
are preferable to bills, it is desirable to encourage wider use of cheques.

The treasury is the primary accounting unit and its cash accounts are prepared
and rendered to Accountant General. Fourth, in order to cut short delays, many
treasuries, sub-treasuries and pay and accounts offices have made arrangements
for disbursing small amounts in cash without the intervention of the bank, even
when they are served by the public sector banks as agents. It may be
advantageous to raise the monetary limit for payments across the counters,
without requiring the payees to visit the banks.

Rationalizing Agency Charges

The agreements entered into by Bank with the State Governments provide that
the Bank shall not be entitled to any remuneration for the conduct of ordinary
banking business of the Government other than such advantage that may accrue
to it from holding of cash balances free of obligation to pay interest thereof. The
minimum balances by no means compensate the Bank for the cost of conducting
Government business. On the contrary, the Bank has been remunerating the
Agency banks for conducting the Government business on its behalf at a rate
related to the costs incurred by them for conducting Government business. The
rate is revised from time to time quinquennially after ascertaining the actual cost
of conducting the government business and the present rate is 11.80 paise per
Rs.100 of Government turnover. Agency banks requested for a revision of the
methodology of determining the rates and an Expert Committee was constituted
to study their request. Recently in its report, the Expert Group on revising the
methodology for determining the cost of conducting Government business has
observed that in most of the countries, the cost is borne by the respective
Governments and not the Central Bank. The cost of conducting government
business has been rising in the recent years. A possible way of rationalizing the
agency charges from the present cost plus system could be to move over to a
system of bidding for Government business by agency.

Banks

Reducing Lags in Credit At present, banks have been allowed a transit time of 5
days in respect of local receipts and 9 days in respect of outstation receipts for
settlement of funds. In order to ensure expeditious credit to Government
account by the dealing branches, a deterrent measure has been put in place.
Accordingly, any delay in crediting the receipts to Government account beyond
the stipulated period (of 15 days in case of delayed remittances over Rs.1 lakh
and one month in other cases) attracts penal interest. As compared to public
sector banks, the newly inducted private banks are allowed merely 5 days for
settlement. This is based on the distinction in regard to the degree of
computerization of public sector banks vis-à-vis private banks. With the up
gradation of payment systems in the country and electronic connectivity, the cut
off limits needs to be made more stringent with the ultimate goal of achieving
real time settlement in Government Account, with CAS, Nagpur.
Possible Improvements by Government

Submission of Scrolls in Electronic Form

At present, the scrolls are submitted in paper form separately for receipts and
payments. With the computerization of bank branches and government
departments, the scrolls in magnetic media (floppy form) should be acceptable
to Government Departments. A switch over to submission of scrolls on
magnetic media, will necessitate Delinking of paid instruments and the payment
scrolls. The Reserve Bank has introduced 'Electronic Clearing Service' (ECS)
for bulk receipts / payments which involve multiple credits with a single debit
or vice-versa. ECS is customer friendly and remains untapped by Government.
Government should use ECS for bulk and repetitive transactions like salary,
pension, income tax refund orders etc. As recommended by the Committee on
Technology Upgradation in the Banking Sector, the Government may examine
the feasibility of introducing a variant of an electronic funds transfer system to
facilitate collection of taxes, beginning with direct taxes.

Elimination of Paper-based Reporting System Under the present system, it is a

government requirement that all deposits in the government account should be
accompanied by appropriate channels. The channels are in multiple copies,
different shapes and sizes. This requirement of the government has constrained
the process of electronic banking in government business. Over the years,
despite the deliberations in various fora, it has not been possible to reduce the
number of copies of channels.

With the swift progress in banking, and the electronic connectivity as

envisaged, it would become possible for the assesses to deposit the government
dues in any designated bank by using a simple pay-in slip as in the case of bank
deposit, and at a later stage, electronically by quoting the PAN. The elimination
of the channels would pave the way for electronic settlement. Discontinuance of
Advice System for Income Tax Refund Orders At present, Income-tax refund
orders advices for value upto Rs.999 are sent directly to assess while advices for
Rs.1, 000 and above are forwarded to payee banks.

The advices are not received promptly resulting in the return of refund orders
causing inconvenience to assess. Significantly, even after switchover to MICR
form with all its in-built security features on par with a cheque, the advice
system has been continued regardless of the difficulties caused to the assesses.
At the Government level, issues related to ECS and forwarding of advices in
electronic formats viz., magnetic media, etc., are being considered. Customer
Service Government of India has constituted a standing committee at Apex
level to monitor the working of the schemes pertaining to Departmentalized
Ministries. Similar monitoring committees at local level are also functioning for
Central Board of Excise and Customs (CBEC) and CBDT. Reserve Bank has
been proactive in extending prompt and courteous customer service. The bank
has an institutionalized set up for redressal of complaints from customers on
regular basis. The Bank has also taken Citizen Charter initiatives and displayed
the Charter for frontline Departments with public interface. Specific to this,
customer satisfaction surveys are organized at frequent intervals and appropriate
responses are formulated for improving service and avoiding recurrence of
complaints, to the extent feasible.

In order to assess the level of customer satisfaction rendered by the Reserve

Bank and its agencies in acting as banker to Governments in the light of all
round technological developments taking place at RBI/agency banks/
Government Departments and to suggest improvements in the day-to-day
operations of the Government business, Reserve Bank had constituted five sub-
Groups in October 2001, one each at Bangalore, Chennai, Hyderabad, Mumbai
and Nagpur offices comprising officials from Reserve Bank, preventatives from
Finance Department of the State Governments. The sub-Groups had deliberated
on the day-to-day operational procedures in vogue in Reserve Bank and
evaluated their efficiency in relation to the users and accounting authorities.

The Groups came up with very valuable suggestions in January 2002. This
includes laying down a roadmap for enhancing the level of computerization,
both at agency banks and Government Departments, provision of tele-banking
facility at all Link Offices, simplification of challan forms, making the challans
easily available through internet, transmission of scrolls / DMS through
electronic media in addition to regular Mode, phasing out of non-MICR
instruments, acceptance of only local cheques for Government payments instead
of outstation instruments, cheque system to replace bill 14

System at Government Departments, use of ECS for effecting Government

payments, introduction of note sorting machines at Government Departments,
easing pensioners' problems, acceptance of cash by RBI beyond working hours,
curtailing the cut-off period for levy of penal interest on delayed remittance of
Government collections / funds to RBI by agency banks progressively,
extension of time available at CAS for settlement of funds by link cells of
agency banks at Nagpur. The RBI is earnest in its intent to implement all these
recommendations in consultation with the Governments/agency banks. The RBI
is also formalizing the review mechanism by setting up Standing Advisory
Committees under the Regional Directors of RBI offices at all centers, so as to
ensure optimum customer satisfaction at all times. The day-to-day procedures
are being recast in the light of the suggestions, which have emerged.

The Endeavour of the RBI is to create conditions for the common person to pay
Government dues at his/her bank branch of choice, while ensuring
instantaneous credit to the Government account with Reserve Bank. This can be
achieved with a high degree of computerization with appropriate connectivity /
net-working, encompassing agency banks, Government Departments and
Central Bank for expeditious, cost effective and seamless financial flows, in a
paperless environment.

In view of the enormous work of Government and complexities and inter

linkages between the Central and State Governments and the banking system, it
maybe possible to explore the setting up of an Advisory Board, which could
meet quarterly, for evolving

Best practices in the overall interest of discharging the Reserve Bank's duties as
Banker to Governments. This arrangement will be analogous to the Cash and
Debt Management Group in which Government of India and the RBI are
involved. I commend the acceptance of this proposal as a fitting tribute to this
Silver Jubilee Celebrations.
 RBI As An Economy Controller

Economic Reforms and Evolving Role of RBI

Founding of Accounts Organization and I recognize it as a reflection of the

close cooperation and understanding that have evolved between Reserve Bank
of India (RBI) as a banker to Government of India and its Accounts
organization. The title of the address refers to being banker to governments
simply because RBI is a banker not only to the Central Government, but also
State Governments. RBI by virtue of its charter performs several functions, the
most important being to secure stability in the internal and external value of the
currency mainly through conduct of monetary policy, while at the same time,
ensuring adequate availability of credit to meet the genuine needs of a growing
economy. Currency Management is yet another function of the RBI which
Impacts the transactions of a large number of people. Managing public debt is
also assigned to RBI, but this is sought to be separated from RBI in due course.

Its regulation of money and forex markets flows from its primary responsibility
while its role in debt markets is closely linked to it being manager of public
debt. RBI is also a regulator and supervisor of banks, development financial
institutions, and non-banking financial companies, but the process of
supervision is overseen by an independent Board for Financial Supervision,
within RBI. Incidentally, RBI is also a banker to banks. Payment System is also
under the aegis of RBI, and the technological infrastructure for the financial
sector, especially in the money and Government Securities market is provided
by RBI to sub serve its overall responsibilities. To the governments it renders
advice on financial matters, whenever called upon to do so.
Being banker to governments is also an important function, but is seldom in
high profile, perhaps due to the reason that it does not directly or visibly
impinge on prices or output. However, as will be explained today, though it is
not a big-ticket item on RBI’s balance-sheet, its role as a banker to governments
is very significant and it has been evolving in the recent years reflecting the
process of economic reform.

The Bank provides banking services to both Central and State Governments
such as acceptance of moneys on Government account, payment / withdrawal of
funds and collection and transfer of funds by various means throughout India.
The Governments' principal accounts are maintained at Central Accounts
Section of the Bank at Nagpur.

Government accounts are handled by RBI at 15 Offices, besides two State

Government Cells at Bhopal and Chandigarh. Further, all public sector banks
and two private sectors banks handle Governments accounts through their
20,800 branches. Currently, the Agency banks handle Governments transactions
of around Rs.12 lakh crore in a full Financial year. Over and above these,
sizeable transactions are handled at Reserve Bank Offices. Some transactions,
though minimal, are handled in Governments’ own treasuries and sub treasuries,
numbering 453, equipped with Currency Chests. This data gives the Magnitude
and spread of transactions relating to Governments.

The first part of today’s presentation will cover very briefly cross-country
practices. The second part provides the legal and institutional framework in
India for conduct of Government’s business in banking. The third section
describes the range of Banking services provided by RBI to Governments. The
fourth part describes some of the reforms already undertaken in this area. The
fifth section describes major issues while the concluding section indicates a
possible agenda for immediate actions.

Cross-Country Practices

By custom and tradition or by express provision in the laws by which they have
been established, Central Banks are bankers to their respective Governments. In
the view of Sir Montague Norman of the Bank of England and Benjamin Strong
of the Federal Reserve System, the Central Bank should undertake all the
banking business on behalf of their own Governments. However, the actual
practices do vary among countries. In the UK, Bank of England is the main
banker to Government and maintains the Principal Central Government
Account. Individual Government departments are not obliged to use Bank of
England as their banker. Typically Government Department with significant
requirements for banking service put some or all of their banking business out
to tender. In the case of South Africa, the South African Reserve Bank acts as
banker to The Central Government. Provincial Governments are, however, the
clients of private banking sector. In Japan, Bank of Japan carries out the
transactions with the National Government but not with local Governments. As
regards USA, the Federal Reserve acts as the banker to US Government. The
Reserve Banks serve as depositories of the United States and perform several
payment-related services.

Legal and Institutional Framework

Government business in India was initially handled by the Presidency Banks of

Bengal, Madras and Bombay from 1862 to 1921 and thereafter by the Imperial
Bank of India, which came into existence as a result of amalgamation of the
Presidency Banks. Since April 1, 1935, the Reserve Bank has been the banker to
the Central and State Governments. According to Article 283(1) and (2) of the
Indian Constitution, it is open to the Central Government and to any State
Government to make rules for the receipt, custody and disbursement of all the
amounts accruing to or held in its consolidated or contingency funds or in its
public account. Sections 20 and 21 of the Reserve Bank of India Act, 1934
provide that the Central Government shall entrust the Bank with all its money,
remittance, exchange and banking transactions in India and the management of
its public debt, and shall also deposit all its cash balances with the Bank free of
interest.

The Bank may, by agreement with any State Government, take over similar
functions on behalf of that Government under Section 21A of the RBI Act.
Accordingly, the RBI is the common banker to the Central Government and all
the State Governments in the Indian Federation with the exception of Jammu &
Kashmir and Sikkim.

The Reserve Bank, as banker to various Governments, has well defined

obligations and provides several services. First, the Central Government
Treasury Rules, the Central Government Account (Receipts and Payments)
Rules, in respect of the transactions of the Central departments, and the
corresponding provisions in the State Financial codes are deemed to be legally
binding on the Bank. Second, the Bank carries on the General Banking business
of the Centre and the States in terms of the working agreement between the
Government and the Reserve Bank. The liability of the Bank to the
Governments in the conduct of the Government business is that of a banker to
an ordinary customer. Third, the Bank also undertakes to float loans and
manage the loans on behalf of the Governments on agreed terms.
Fourth, where there is no full-fledged office of RBI, it appoints commercial
banks as agents of RBI and they are made responsible for transacting the entire
Government business. Fifth, the Bank does not charge to Governments, the cost
of carrying on Government business through its offices or the agency banks.
Sixth, a facility for grant of ways and means advances is provided by Reserve
Bank to the Governments, to meet the temporary mismatches in their income
streams. Seventh, the RBI arranges for investments of surplus cash balances of
the Governments as a portfolio manager. Eighth, the RBI also acts as Adviser to
Government, whenever called upon to do so, on monetary and banking related
matters besides dispensing merchant banking services.

Range of Banking Services

Banker to Central Government the work relating to Government business is

attended by the Public Accounts Department of the RBI. The discharge of the
Bank's functions as banker to Government involves the receipt and payment of
money on behalf of the various Governments departments. For this purpose,
under Section 45 of the RBI Act 1934, initially the RBI appointed State Bank of
India as its sole agent at all places where the Bank had no office or branch of its
Banking Department. In turn, SBI entered into agency agreements with all its
associate banks and delegated the agency functions to some of the branches of
the associate banks at certain centers.

Considering the increasing volume of Government business and nationalization

of some commercial banks, the Government and the RBI associated
nationalized banks, which had a vast network of branches, to conduct
Government business. In 1970, the Government empowered the RBI to appoint
them as agents at any centre. By 1976, the SBI, Associate Banks and
nationalized banks were acting as agents of the RBI for this business. In order to
facilitate the handling of Government receipts and payments, currency chests
were established with a number of branches of nationalized banks in addition to
SBI and Associate Banks. Prior to 1976, the responsibility for arranging
payments and compiling accounts of receipts and disbursals and auditing of
transactions of all Central Government Ministries devolved on a single
authority, viz., Comptroller and Auditor General of India.

The Government introduced from April 1976, a scheme in stages for

decentralization and departmentalization of accounts of individual Ministries at
the Centre, thereby transferring the responsibility for maintenance of accounts
at all stages to the Ministries / Departments themselves. Under this scheme each
ministry/ department has been allotted. A civic public sector bank for handling
its transactions based on the principle of 'one bank - one ministry/department'.
Hence, the Reserve Bank does not handle government’s day-to-day transactions
as before, except where the Bank itself has been nominated as banker to a
particular ministry/department.

Banker to State Governments the financial transactions of the State

Governments are carried out at a number of offices, including those of the RBI
SBI, nationalized banks, Treasuries, etc. The Government transactions
conducted at all such places are allowed without any reference to the actual
position of the cash balance of the State Government, the accounts of which are
maintained at the Central Accounts Section of the RBI at Nagpur. The
transactions that are put through at various agency bank branches in the State
concerned are consolidated at the link cell in the respective State capitals and
settled with the Reserve Bank Office in the State. Currently, Reserve Bank also
handles directly, banking business of four State Governments viz., Karnataka,
Maharashtra, Thailand and West Bengal.
The consolidated position including the State Government transactions put
through at RBI Offices is ultimately booked in the Principal Account of the
respective State maintained at CAS, Nagpur. Central Accounts the Central
Accounts Section (CAS) at the RBI maintains the principal accounts of both
Central and State Governments. The principal accounts in Nagpur are based on
the daily position / aggregate receipts and payments in respect of each
Government, Ministry / department, received from RBI offices and agency
banks. Each of the accredited agency banks has set up a link office at Nagpur to
liaise with CAS for funds settlement. Thus, the Bank's offices and agency
banks' branches function like tributaries, Which flow in the direction and merge
into the Central Accounts Section. CAS, Nagpur, thus plays a pivotal role in
consolidating the transactions and working out the overall daily position of each
government.

The actual day-to-day transactions are handled by the Bank's offices and agency
bank branches. They render accounts to respective Government accounting
authorities while effecting monetary settlement with RBI. Since frequent
adjustments between the various Governments are unavoidable, settlement of
these transactions through Central Accounts Section is convenient, accurate and
expeditious. Reserve Bank through its Remittance Facilities Scheme operates a
funds transfer system. It carries out the adjustments as between the various
Governments providing in effect, facilities for the transfer of funds on a very
large scale within the Government Sector. In order to facilitate the actual
conduct of Government transactions, the Reserve Bank has built up over the
years, a network of currency chests, repositories and small coins depots, all of
which are intended to service all the Governments in the country. As banker to
the Government, Reserve Bank works out the overall funds position and sends
daily advices showing the balances in its books, ways and means granted and
investments made.
The daily advices are followed up with monthly statements, and are Useful from
the point of view of enabling the Government to prepare their ways and means
budgets. The arrangement between the Government of India and the Reserve
Bank on the one hand and the public sector banks and the Reserve Bank on the
other, are based largely on trust as well as being merely contractual.

Treasury System all payments on account of Central and State Governments are
made either by cheques or by bills. The Government of India, Reserve Bank and
the banks, which serve the treasuries and sub-treasuries normally, prefer
cheques to bills. Certain States like Maharashtra, Gujarat, Karnataka, West
Bengal etc. have adopted the system of payments by cheques at their Treasuries.
However, a large number of States are yet to introduce the cheque System. In
view of the advantages of cheques as compared with bills, Official policy
continues to be in favour of changing over to cheque system. Since 1976,
Treasuries and non-departmental Pay and Accounts Offices have ceased to be
responsible for handling transactions on behalf of the Central (Civil)
Departments as integrated financial advisers and principal accounts officers of
these departments have taken over the responsibility for receiving and paying
money,

Compiling and maintaining the accounts, in respect of all the transactions

relating to these departments. The pay and accounts officer or a drawing and
disbursing officer of each Ministry or Department are linked to a designated
public sector bank or RBI and are not allowed to draw on a treasury. Other
Services In addition to being a pure banker to Government, RBI provides a full
range of related services to Government.

These include exchange, remittance transactions, and management of public

debt and issue of new loans, handling the forex transactions of the Government
of India, investment of surplus funds of Governments, providing safe custody
facility, providing of ways and means advances, management of special funds
Like Consolidated Sinking Fund, Guarantee Redemption Fund, Calamity Relief
Funds, National Defence Scheme, etc., issue and management of tap bonds like
Relief Bonds,

Administration of the Scheme for disbursal of pensions of Central and State

Governments’ employees through public sector banks and as Advisor to
Government on all matters involving monetary and economic perspective. The
fee recovered by the Bank for some of the above services, which are rendered as
an adjunct to its role as Banker to Government, are nominal and do not even
cover the costs, while for most other services no charge is levied.

Recent Reforms Undertaken

Focal Point and Beyond. The experience of the working of the

"Departmentalized Scheme" has shown a few shortcomings. With the large
number of bank branches handling the work, delays often occurred in the
transmission of the relevant documents (paid cheques, challans scrolls etc) to
Pay and Accounts Officers (PAOs) for accounting. Besides, there were certain
difficulties in reconciliation of figures between government departments and
Banks. In order to obviate these difficulties as well as making reconciliation
easier, a

Working Group was set up in 1986 to review the working of the scheme, and on
the basis of its recommendation existing procedures were revised. This marked
the beginning of focal point approach for reporting and settlement of
government transactions and set the pace for further refinement of the
accounting system.
The focal point approach envisages "one focal point branch - one (Pay and
Accounts Office) PAO". This concept was incorporated into the system to bring
about an interactive method of resolving the day-today problems while
achieving expeditious reconciliation. This system ensures updating of accounts
at PAO level and speedy settlement of funds at Central Accounts Section at
Nagpur. It has, sought to bridge the gap between RBI accounts and Government
accounts. Based on its success, it has been subsequently adopted in phases, in
Central Board of Direct Taxes (CBDT) and extended to Departmentalized
Ministries Accounts (DMA) (both civil and non-civil ministries). There has
been a close alignment between accounting jurisdiction of the government and
the dealing branches of the bank. However, in the envisaged computerized
environment, with electronic connectivity, the settlement of funds on real time
basis, directly between the dealing branches and CAS at Nagpur for credit of
Government Account without the intervention If Focal Point and Link Cell may
be a distinct possibility in the near future. Standing Committee on
Computerization Given the large magnitude of the transactions in Government
account, the manual system results in delays in handling transactions.

Complete electronic data processing in the preparation and settlement of the

accounts of Government business by the agency banks as also for compilation
of accounts at Treasury/Pay and Accounts Office/Accountant General will
eliminate the time lag in the flow of information and improve standards of
accuracy. During the last few years, RBI offices and agency banks have
initiated steps for computerization of Government transactions at their dealing
Branches.
The Committee on Technology Up gradation in Banking Sector laid down the
Road map for computerization of bank branches handling Government business,
to be achieved in phases. The first phase envisaged computerization of all Focal
Point branches of agencies by March 31, 2000 and State government Link
Cells / dealing branches in the second phase thereafter. The Committee desired
that efforts should be made to interconnect the computerized branches dealing
in Government Accounts with Link Offices/ branches, and the Public Accounts
Departments of the Bank and also Central Accounts Section, Nagpur where it is
ultimately accounted for in the books of accounts.

On Government side, the Committee suggested that all PAOs/Circle Offices of

Government should be computerized by March 31, 2001 and the Drawing
Offices / Treasury Offices well before March 31, 2002 in alignment with
computerization of Focal Point and Dealing branches. A Standing Committee
comprising members from RBI, Government and agency banks is monitoring
the computerization of government transactions. There have been some delays
in adhering to the time schedule mentioned. RBI has been urging the agency
banks to capture 80 per cent of Government business by June 2002.

Payment Systems Reforms Payment and Settlement Systems constitute the

backbone of any economy and the existence of competent payment and
settlement systems have a positive impact on the efficient functioning of the
various sectors of the economy. Central Banks in the world are according great
importance to well established payment and settlement systems. The Reserve
Bank, too, has taken up as its mission, the establishment of a robust, safe, and
secure and efficient payment and settlement system for the country as part of its
initiatives aimed at financial sector reforms in this area. Constituted in 1999, the
National Payments Council is the Apex level body, which provides general
policy directions and guidelines for reforms in the Payment and Settlement
Systems of the country.
Initiatives aimed at improvements in the payments and settlement systems are
centered on the three-pronged strategies of consolidation, development and
integration of the various components of the payment and settlement systems.
Consolidation takes its base from existing activities such as computerized
clearing, etc. Development envisages opening of new clearing houses,
introduction of systems such as the Centralized Funds management System and
Real Time Gross Settlement (RTGS) and Integration of all these initiatives both
within the Reserve Bank and for the banking Sector as a whole would result in
the culmination of the reform process.

Non-paper based payment systems, such as Electronic Funds Transfers (EFT)

and Electronic Clearing Services (debit and Credit Clearing), have been
accepted widely for use within the country. The proposed introduction of the
Real Time Gross Settlement (RTGS) System would ensure settlement of funds
in real time and in an electronic manner.