Assignment: Central Banking and the Indian Banking System

Money, Banking and Financial Institutions

Q1. What is a Central Bank? Explain the Quantitative and

Qualitative Measures of Credit Control
Meaning of a Central Bank
A central bank is the apex monetary institution of a country, entrusted with the responsibility of regulating the
volume of currency and credit in the economy. It does not deal directly with the general public but works through
the banking system, acting as the banker to the government, banker's bank, and custodian of the nation's foreign
exchange reserves. In India, this role is performed by the Reserve Bank of India (RBI), established in 1935 and
nationalised in 1949.

A central bank is generally not driven by the profit motive; instead, its primary objective is to secure monetary
stability, maintain price stability, ensure adequate flow of credit to productive sectors, and safeguard the stability of
the financial system as a whole.

Main Functions of a Central Bank

• Sole authority for note issue (currency authority).

• Banker, agent and financial adviser to the government.

• Banker's bank – holds cash reserves of commercial banks and acts as lender of last resort.

• Controller of credit through monetary policy.

• Custodian of foreign exchange reserves and manager of exchange rate stability.

• Clearing house function and supervisor/regulator of the banking system.

• Developmental functions – promoting financial inclusion, priority sector lending, and institutional credit.

Meaning of Credit Control

Credit control refers to the use of monetary policy instruments by the central bank to regulate the volume, cost and
direction of credit created by commercial banks, so as to achieve objectives such as price stability, economic
growth, full employment and exchange rate stability. The methods of credit control are broadly classified into two
categories: quantitative (general) methods and qualitative (selective) methods.

A. Quantitative (General) Methods of Credit Control

Quantitative methods aim to regulate the total volume of credit in the economy without discriminating between its
uses. They affect the overall cost and availability of credit to all sectors uniformly.

• 1. Bank Rate Policy: The bank rate is the standard rate at which the central bank is prepared to rediscount
bills of exchange or lend to commercial banks against approved securities. A rise in the bank rate makes
borrowing costlier for commercial banks, which in turn raises lending rates and contracts credit; a fall has the
opposite, expansionary effect.
 • 2. Open Market Operations (OMO): This refers to the sale and purchase of government securities by the
central bank in the open market. Sale of securities withdraws liquidity from the banking system and contracts
credit, while purchase of securities injects liquidity and expands credit.

• 3. Cash Reserve Ratio (CRR): CRR is the minimum percentage of a bank's net demand and time liabilities
(deposits) that must be kept with the central bank in cash form. Raising the CRR reduces the lendable
resources of banks and contracts credit; lowering it expands credit.

• 4. Statutory Liquidity Ratio (SLR): SLR is the minimum percentage of net demand and time liabilities that
banks must maintain in the form of liquid assets such as cash, gold and approved government securities. A
higher SLR restricts the funds available for lending, while a lower SLR releases more funds for credit
expansion.

• 5. Repo and Reverse Repo Rate: The repo rate is the rate at which the central bank lends short-term funds to
commercial banks against government securities, while the reverse repo rate is the rate at which it absorbs
surplus liquidity from banks. These are key tools under the Liquidity Adjustment Facility (LAF) used for day-
to-day management of liquidity and short-term interest rates.

• 6. Marginal Standing Facility (MSF) / Standing Deposit Facility (SDF): These are additional liquidity
windows through which banks can borrow overnight funds from, or park surplus funds with, the central bank,
usually at rates slightly above or below the repo rate, thereby fine-tuning liquidity conditions.

B. Qualitative (Selective) Methods of Credit Control

Qualitative methods do not affect the total volume of credit; instead, they regulate the direction, purpose and
composition of credit, encouraging credit flow to desirable sectors while discouraging it in speculative or non-
priority sectors.

• 1. Margin Requirements: The central bank prescribes the minimum margin to be maintained by banks while
granting loans against securities or collateral (that is, the loan amount permissible is less than the value of the
security). Raising the margin reduces the loan amount available against a given collateral, thereby curbing
speculative credit, particularly for stock market and commodity transactions.

• 2. Regulation of Consumer Credit: The central bank may regulate the terms of instalment credit and hire-
purchase finance, such as the down payment required and the repayment period, to control credit used for the
purchase of consumer durables.

• 3. Rationing of Credit: The central bank fixes credit quotas for different sectors or sets ceilings on the
amount of credit available to commercial banks, restricting the flow of credit to non-essential or speculative
activities.

• 4. Moral Suasion: This involves the central bank persuading, advising and appealing to commercial banks,
through discussions, letters and meetings, to follow a particular credit policy in the wider interest of the
economy, without resorting to any statutory compulsion.

• 5. Direct Action: The central bank may take direct action against banks that fail to comply with its directives,
such as refusing to rediscount their bills, denying further credit facilities, or imposing penalties.
 • 6. Publicity: The central bank publishes data, reports and reviews on the banking and monetary situation to
shape public and banker opinion in favour of a particular credit policy stance.

• 7. Direct Credit Controls / Priority Sector Guidelines: The central bank issues directives specifying
minimum or maximum limits on credit to be advanced to particular sectors, such as priority-sector lending
targets for agriculture, micro, small and medium enterprises, and export credit.

Distinction between Quantitative and Qualitative Measures

Basis Quantitative Measures Qualitative Measures
Nature Affect total volume/supply of credit Affect direction and purpose of credit
Scope Apply uniformly to the whole economy Selectively applied to specific sectors
Control overall money supply and Channel credit to desired uses; curb
Objective
inflation speculation
Margin requirements, moral suasion,
Examples Bank rate, CRR, SLR, OMO, Repo rate
rationing of credit
In practice, the two sets of instruments are used together. Quantitative tools regulate how much credit exists in the
system, while qualitative tools ensure that this credit flows into productive and desirable channels rather than
speculative or non-essential activities.

Q2. Explain the Structure and Organisation of the Indian Banking

System
The Indian banking system has a well-defined, multi-tiered structure with the Reserve Bank of India (RBI) at the
apex, followed by various categories of banking and non-banking financial institutions that cater to different
segments of the economy. The structure can be broadly classified as follows.

1. Reserve Bank of India (RBI) – The Apex Institution

The RBI, established under the RBI Act, 1935, is the central bank of India and stands at the apex of the entire
banking structure. It formulates monetary policy, issues currency, regulates and supervises banks and non-banking
financial companies (NBFCs), acts as banker to the government and to commercial banks, manages foreign
exchange reserves under FEMA, and oversees the payment and settlement systems of the country.

2. Commercial Banks
Commercial banks form the largest segment of the banking system, accepting deposits from the public and
extending credit for various purposes, mainly governed by the Banking Regulation Act, 1949. They are further
classified as follows.

• (a) Public Sector Banks: Banks in which the government holds majority ownership (more than 50 percent),
such as the State Bank of India and other nationalised banks, which together account for a substantial share of
banking business in the country.

• (b) Private Sector Banks: Banks owned mainly by private shareholders, further divided into 'old' private
banks (existing before the 1990s reforms) and 'new' private banks (licensed after liberalisation in the 1990s
and 2000s), such as HDFC Bank, ICICI Bank and Axis Bank.
 • (c) Foreign Banks: Banks incorporated outside India but operating within the country through branches or
subsidiaries, subject to RBI regulation, such as Citibank, HSBC and Standard Chartered Bank.

• (d) Regional Rural Banks (RRBs): Established under the RRB Act, 1976, jointly owned by the central
government, a sponsoring public sector bank, and the concerned state government, with the objective of
extending credit and banking facilities to rural and semi-urban areas, particularly to small farmers, artisans
and agricultural labourers.

• (e) Small Finance Banks and Payments Banks: A newer category licensed by the RBI to extend the reach
of formal banking. Small finance banks provide basic banking services to unserved and underserved sections
such as small businesses and marginal farmers, while payments banks accept deposits (subject to a ceiling)
and provide payment/remittance services but cannot undertake lending activities.

3. Co-operative Banks
Co-operative banks are organised on co-operative principles and mainly cater to the credit needs of the rural and
agricultural sector, though urban co-operative banks also serve urban and semi-urban populations. They operate
under dual control of the RBI and the Registrar of Co-operative Societies of the respective state. They are broadly
divided into two streams.

• (a) Urban Co-operative Banks (UCBs): Operate mainly in urban and semi-urban areas, catering to small
businessmen, traders and salaried individuals.

• (b) Rural Co-operative Credit Structure: Further divided into short-term and long-term structures:

◦ Short-term structure (three-tier): State Co-operative Banks (apex level) → District Central Co-operative
Banks (district level) → Primary Agricultural Credit Societies, or PACS (village level).

◦ Long-term structure: State Co-operative Agriculture and Rural Development Banks (SCARDBs) →
Primary Co-operative Agriculture and Rural Development Banks (PCARDBs), providing long-term
credit mainly for land development and farm investment.

4. Development Financial Institutions (DFIs) / All-India Financial Institutions

These institutions provide medium- and long-term finance for industrial, agricultural and infrastructural
development, and include institutions such as NABARD (agriculture and rural development), SIDBI (small
industries), EXIM Bank (export-import finance), and the National Housing Bank (housing finance). Their role
complements that of commercial banks by financing projects with longer gestation periods.

5. Non-Banking Financial Companies (NBFCs)

NBFCs are companies registered under the Companies Act that carry on the business of loans, advances, leasing,
hire-purchase and investment, but do not hold a full banking licence — they cannot accept demand deposits or issue
cheques drawn on themselves. They are regulated by the RBI and play a significant role in extending credit to
sectors such as vehicle finance, microfinance, infrastructure and consumer durables. Housing finance companies are
a specialised category within this segment.

Overview of the Structure

 Tier Institutions
Apex/Regulatory Reserve Bank of India (RBI)
Public sector, private sector, foreign, regional rural, small finance and
Commercial Banking
payments banks
Urban co-operative banks; state, district central and primary agricultural co-
Co-operative Banking
operative societies
Development Finance NABARD, SIDBI, EXIM Bank, National Housing Bank, etc.
Non-Banking Finance NBFCs, housing finance companies, microfinance institutions
Thus, the Indian banking system is a well-organised, hierarchical structure with the RBI as the regulatory apex,
supported by a diverse mix of commercial, co-operative, development and non-banking financial institutions,
together working to mobilise savings and channel credit to different sectors of the economy, thereby supporting
overall economic growth and financial inclusion.