functions and working.pdf

 CONTENTS Foreword ii Acknowledgements iii Chapters Description Page No. 1 E...

 CONTENTS Foreword ii Acknowledgements iii Chapters Description Page No. 1 Evolution of Central Banking Globally and in India 1 2 Legal Framework for Reserve Bank Functions 5 3 Monetary Policy Framework 14 4 Market Operations 22 5 Financial Stability 39 6 Overview of the Indian Financial System 44 7 Regulation of Commercial Banks 47 8 Supervision of Commercial Banks 58 9 Regulation and Supervision of Co-operative Banks in India 70 10 Regulation and Supervision of Non-Banking Financial 79 Companies in India 11 Enforcement in RBI 98 12 Development and Regulation of Financial Markets 103 13 Payment and Settlement Systems 122 14 Currency Management 132 15 Banker to Banks and Governments 148 16 Public Debt Management 157 17 Understanding RBI Balance Sheet 162 18 Foreign Exchange Management 175 19 Foreign Exchange (Forex) Reserves 184 20 Consumer Education and Protection 190 21 Financial Inclusion and Development 197 22 Development of Institutions 207 23 Research, Surveys and Data Dissemination 210 i  Foreword The importance of central banks has increased manifold in the last decade with such institutions taking a proactive lead in responding to situations and circumstances that have a bearing on financial stability, supporting respective economies during the global financial crisis of 2007-08 and more recently in dealing with the scenario emerging out of Covid-19 pandemic. The role of Reserve Bank of India (RBI) has also evolved with several dimensions added (recent addition as regulator for HFCs, for example), several reforms and reformations, modification and re-designing of functional domains and creation of new Departments/verticals since its establishment on April 1, 1935. It is in this context that Reserve Bank Staff College as the premier Training Institution of RBI, has constantly tried to document the functions and working of RBI in its most current form. Discerning readers and scholars may recall that the last compilation was brought out in the year 2017, which was an update on the previous publications brought out in the year 2010. What has necessitated this review and update are several factors which include some very rapid developments in central banking activities and reorganization of departments and divisions within RBI in the intervening period. A case in point are the recent additions/modifications to functional domains in the form of creation of Enforcement Department, the new Supervisory and Regulatory verticals etc. Further, the emphasis in the newer version has shifted more to the functional aspects and thus we have removed references to certain regulations which have since been over-written by new ones(manner of resolution of stressed assets, changing norms on Priority Sector Lending etc) so that the content remains sturdy and stable over longer periods of time. Other significant changes that have been covered in the revised version include introduction of new rupee liquidity management tools by RBI, reconstitution of Financial Stability and Development Council (FSDC), amendments in chapter-III of RBI Act covering changes in provisions related to NBFCs, transfer of regulation of Housing Finance Companies to RBI, introduction of new ombudsman schemes, changes in priority sector guidelines, introduction of National Strategy for Financial Education, etc. The updated version of this book earlier unveiled by Governor, RBI at RBSC, Chennai on January 3, 2020 and was subsequently modified in June 2020 through a vetting process by concerned CO Department(s). To fulfil the obligations under the bank’s Rajbhasha Policy, this book has since been translated in Hindi as well. We hope that the new updated version will make for some valuable read and we shall also look forward to suggestions to bring in more features and updates. R Kesavan Principal ii  ACKNOWLEDGEMENT Covering a wide range of fully evolved and currently evolving functions and working of Reserve Bank of India most definitely implies that an intense collaborative effort must be involved in producing Training Material of this order. Accordingly, we wish to acknowledge the sincere efforts of all Members of Faculty and all others (more specifically Rajbhasha Officers from RBSC and RO, Chennai, who worked on the Hindi translation) involved in the process, without whose help we would not have been able to bring out an updated version of the book. 2. The meticulous efforts of Members of Faculty of the Reserve Bank Staff College in updating individual chapters is heartily appreciated. The untiring efforts and hard work rendered by the editorial team, consisting of R Sathish, Satish Chandra Rath, M K Subhashree, Edwin Prabu A and Hema Chatterjee are worthy of special mention. But for their determination, hard work and discipline, this version would not have materialised. Smt R Suma, Rajbhasha Officer (RBSC), Smt Mayalakshmi, Shri Pandarinath and Shri Shyam Sunder, Rajbhasha Officers from RO, RBI, Chennai who contributed significantly to the Hindi version, also deserve our gratitude. 3. Needless to mention, there would be changes and updates in the manner we operate and function as a full service Central Bank and there would always scope to update further and improve the effort. We shall, therefore, look forward to reader’s suggestions in this regard which may be mailed to [email protected]. R Kesavan Principal iii  Chapter 1: Evolution of Central Banking Globally and in India “THERE have been three great inventions since the beginning of time: fire, the wheel and central banking” – Will Rogers The evolution of central banks can be traced back to the seventeenth century when Riksbank, the Swedish Central Bank was set up in 1668. The Bank of England was founded in 1694. The Central Bank of the United States, the Federal Reserve established in 1914, was relatively a late entrant to the Central Banking arena. The Reserve Bank of India, India’s central bank started operations in 1935. At the turn of the twentieth century there were only eighteen central banks. Today, most of the countries have a central bank. Central banks are not regular banks. They are unique both in their functions and their objectives. In the beginning, central banks were established with the primary purpose of providing finance to the government to meet their war expenses and to manage their debt. They were initially known as banks of issue with the term central banking coming into existence only in the nineteenth century. They were founded as “special” commercial banks and would evolve into public-sector institutions much later. The “special” nature of these banks was based on government charters, which made them not only the main bankers to the government but also provided them monopoly privileges to issue notes or currency. Central banks also held accounts of other banks even as they engaged in normal commercial banking activities. Given their “special” status and their size, they soon came to serve as banker to banks facilitating transactions between banks as well as providing them banking services. The eighteenth and nineteenth century witnessed several financial panics. Panics are a serious problem as failure of one bank may lead to failure of others. Banks are susceptible to panics or “runs” as more popularly known, due to the nature of their balance sheets. Their liabilities are short-term and liquid (banks’ major liabilities are demand deposits, which means depositors can ask their money back anytime they want and therefore immediately payable) and the assets are long-term and illiquid (in the sense that it is not easy to sell them and convert into cash quickly). Banks engage in this so-called maturity or liquidity transformation to allocate society’s available pool of resources effectively between savers and borrowers. The failure of banks and its potential adverse impact on the real economy was and is a serious concern for all policymakers. In 1873, Walter Bagehot, an editor of the Economist magazine, published a book titled “Lombard Street” where he clearly articulated that to avoid panics, central banks should assume the role of “lender of last resort”. The doctrine, which came to be known as Bagehot’s dictum states that a central bank, in periods of panics or crisis, should lend freely, against quality collateral and at a penal rate of interest. The idea being, a bank that is facing a “run” by its depositors or other lenders can tide over temporary liquidity problem in the stress period, by borrowing from the central bank against collateral. It can pay off the depositors and buy some time before things calm down. Given bank runs are self- fulfilling prophecies, if the banks can navigate this period without becoming insolvent, a crisis could be averted. The very fact that the bank was able to meet the withdrawal demands would 1 comfort the other depositors waiting to withdraw and wean them away. Without the ‘lender of last resort’ facility, banks must resort to fire-sale of their assets and that too at a deep discount. Thus, in addition to be a banker to the government and banks, central banks also became lenders of last resort. The main mission of a central bank is to maintain macroeconomic stability and financial stability. Macroeconomic stability refers to achieving stable and sustainable growth and keeping prices stable, i.e., low and stable inflation. Financial stability on the other hand refers to keeping the financial system resilient and avoiding financial crisis. The relative importance of these objectives has varied over time. While the pursuit of sustainable economic growth and low and stable inflation have been fundamental to central banking activities since the early nineteenth century with the advent of the gold standard, the importance of financial stability became more prominent since the Great Depression of the 1930s when the world economy faced large bank failures and deep recession. To achieve the objectives of macroeconomic stability and financial stability, central banks have certain tools at their disposal. To achieve economic stability, central banks use monetary policy. By varying short-term interest rates, i.e., either raising or lowering the interest rates, they control the supply of and demand for money in the economy and thereby economic activity and inflation. For example, if the economy is growing fast and inflation is high, central bank may raise the interest rates it charges the banks to lend money. Higher interest rates will permeate into other rates, such as housing loan, consumer loan, etc. As the cost of borrowing increases, it discourages consumption and investment and thus reduces growth and inflation. On the other hand, if the economy is growing too slow or if the inflation is too low, the central bank will lower the interest rate. This will feed into other rates and encourage spending and investment thereby pushing economic growth and inflation. The trick of the trade is to achieve sustainable growth and low and stable inflation. Thus, sometimes, central banking is said to be “neither a science nor an art, but a craft”. To deal with financial stability, central banks main tool is provision of liquidity. This tool, as explained earlier, is referred to as “lender of last resort”. Some central banks, which are also the banking regulators in their economies employ another tool, viz., regulation and supervision, also to foster financial stability. By setting prudent rules and principles and examining and monitoring banks adherence to these rules and principles, the central banks aim to create a healthy and robust banking and financial system. A resilient and safer banking system will reduce the chances of financial crisis in the first place. In many countries the regulatory and supervisory roles are performed by multiple agencies and therefore may not be a main function of the central bank. The internationalization of commercial banking activity brought several risks to the fore. The failure of two banks in 1974, the Franklin National Bank in the United States and Bank Herstatt in Germany, which had international implications necessitated international cooperation and coordination among central banks. The Basel Committee for Banking Supervision (BCBS) was thus established. The committee sets international regulatory 2 standards, known as Basel Standards that forms the bedrock for all national and international banking regulations. Since the outbreak of the financial crisis in 2007-08, the tool box of central banks has been strengthened. These tools or measures are popularly known as “unconventional policies”, reflecting their use in extraordinary circumstances. Quantitative or credit easing, negative interest rates, forward guidance, etc., are some of the tools employed by central banks to deal with the crisis and its aftermath. The central banks also became “market makers of last resort” during the crisis as the markets became dysfunctional. These concepts will be explained in subsequent chapters. Evolution of the Reserve Bank of India The origins of the Reserve Bank of India (RBI) can be traced to 1926, when the Royal Commission on Indian Currency and Finance – also known as the Hilton-Young Commission – recommended the creation of a central bank for India to separate the control of currency and credit from the Government and to augment banking facilities throughout the country. The Reserve Bank of India Act of 1934 established the Reserve Bank and set in motion a series of actions culminating in the start of operations in 1935. Since then, the Reserve Bank’s role and functions have evolved, as the nature of the Indian economy and financial sector changed. Though started as a private shareholders’ bank, the Reserve Bank was nationalised in 1949. The Preamble to the Reserve Bank of India Act, 1934, under which it was constituted, specifies its objective as “to regulate the issue of Bank notes and the keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage”. The primary role of the RBI, as the Act suggests, is monetary stability, that is, to sustain confidence in the value of the country’s money or preserve the purchasing power of the currency. Ultimately, this means low and stable expectations of inflation, whether that inflation stems from domestic sources or from changes in the value of the currency, from supply constraints or demand pressures. In addition, the RBI has two other important mandates; inclusive growth and development, as well as financial stability. In a country where a large section of the society is still poor, inclusive growth assumes great significance. Access to finance is essential for poverty alleviation and reducing income inequality. One of the core functions of the RBI, therefore, is to promote financial inclusion that leads to inclusive growth. As the central bank of a developing country, the responsibilities of the RBI also include the development of financial markets and institutions. Broadening and deepening financial markets and increasing their liquidity and resilience so that they can help allocate and absorb the risks entailed in financing India’s growth is a key objective of the RBI. India’s financial system is dominated by banks. Their regulation and supervision is therefore important both from the viewpoint of protecting the depositors’ interest and preserving financial stability. The RBI, deriving powers from the Banking Regulation Act, 1949, designs and implements the regulatory policy framework for banks operating in India. Over 3 the years, the purview of regulation and supervision has been expanded to include non- banking entities also. The global economic uncertainties during and after the Second World War warranted conservation of scarce foreign exchange by sovereign intervention and allocation. Initially, the RBI carried out the regulation of foreign exchange transactions under the Defence of India Rules, 1939 and later, under the Foreign Exchange Regulation Act of 1947. Over the years, as the economy matured, the role shifted from foreign exchange regulation to foreign exchange management. The 1991 balance of payment and foreign exchange crisis was a watershed event in India’s economic history. Being at the centre of country’s monetary and financial system, the RBI played a key supporting role in helping the Government manage the crisis and undertake necessary market and regulatory reforms. The approach under the reform era included a thrust towards liberalisation, privatisation, globalisation and concerted efforts at strengthening the existing and emerging institutions and market participants. The Reserve Bank adopted international best practices in areas, such as, prudential regulation, banking technology, variety of monetary policy instruments, external sector management and currency management to make the new policy framework effective. Central banks are at the heart of a country’s payment and settlement system. “One of the principal functions of central banks is to be the guardian of public confidence in money, and this confidence depends crucially on the ability of economic agents to transmit money and financial instruments smoothly and securely through payment and settlement systems”1. The RBI has, over the years, taken several initiatives in building a robust and state-of-the-art payment and settlement system that not only improves the “plumbing” of the financial system but also its stability. The last two and a half decades have also seen growing integration of the national economy and financial system with the world. While rising global integration has its advantages in terms of expanding the scope and scale of growth of the Indian economy, it also exposes India to global shocks. The crisis of 2007-08 gave a glimpse of financial instability in other economies posing threat to our financial stability. Hence, preserving financial stability has become an even more important mandate for the RBI. 1 Bank oversight of payment and settlement systems, BIS, May 2005 4  Chapter 2: Legal Framework for Reserve Bank Functions The structure, roles and responsibilities of central banks vary between countries, which is very much evident from their origins and also the variety of functions they perform. The statutes governing the establishment and mandate of central banks are also not uniform even as they play a crucial role in determining the functions of central banks across the world. In India, the RBI is the central banking authority constituted by the Reserve Bank of India Act, 1934 (‘RBI Act’), and its duties and responsibilities flow from that statute. However, the range of functions, which the RBI is undertaking is not only covered under the RBI Act2 but is also covered under various other statutes. Thus, the legal backing for the functions of RBI is spread over a number of statutes. In this chapter, we examine in detail the legal provisions vis-à-vis the multifarious functions that are conferred on the RBI. Reserve Bank of India – Legal Background Pursuant to the recommendation of the Royal Commission on Indian Currency and Finance, a Bill was introduced in the Legislative Assembly in 1927 to create a central bank for India, which was later withdrawn due to lack of agreement among various sections of people. Subsequently, the White Paper on Indian Constitutional Reforms (1933) recommended for the establishment of a Reserve Bank in India. Accordingly, a fresh Bill was introduced in the Legislative Assembly, which got passed and received the Governor General’s assent on March 6, 19343. Consequently, the RBI Act came into existence and the RBI commenced its operations as the central bank of the country on 1st April 1935 as a private shareholders’ bank, with a paid-up capital of Rupees five crore. Aims and Objectives – The Preamble The purposes for which the RBI has been established as India’s central bank has been spelt out in the preamble to the RBI Act, which states as follows: (i) “to regulate the issue of banknotes and the keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage; and (ii) that it is essential to have a modern monetary policy framework to meet the challenge of an increasingly complex economy and the primary objective of the monetary policy is to maintain price stability while keeping in mind the objective of growth” 4. Thus, the Preamble in the RBI Act, as amended by the Finance Act, 2016, provides that the primary objective of the monetary policy is to maintain price stability, while keeping in mind the objective of growth, and to meet the challenge of an increasingly complex economy. However, the functions which the RBI is undertaking is not restricted only within the provisions of the RBI Act, but also extends to various areas, such as, regulation and supervision 2 Section 17, RBI Act, 1934 3 Source: RBI Website, ‘History of the Reserve Bank of India’ 4 Please read Indian Finance Act, 2016 wherein amendments to RBI Act, 1934 have been brought to amend the Preamble and also new Chapter III-F 5 of banks, consumer protection, management of foreign exchange, management of government securities, regulation and supervision of payment systems, etc., for which powers are drawn from various laws, namely, the Banking Regulation Act, 1949, Foreign Exchange Management Act, 1999, Government Securities Act, 2006, Payment and Settlement Systems Act, 2007, etc. Banking Functions – Legal Background The general superintendence and direction of the affairs and business of the RBI shall be entrusted to the Central Board5 having nominees from the Central Government and Directors appointed under Section 8 of the RBI Act. The Board of the RBI is headed by the Governor and assisted by not more than four Deputy Governors6. The Board exercises all powers and do all acts and things which may be exercised by the RBI. Section 17 of the RBI Act enables RBI to do banking business, such as accepting deposits, without interest, from any person. The other business, which the RBI may transact are also mentioned in the said provision. It states that the RBI may transact various businesses such as acceptance of deposits without interest from Central Government and State Governments, purchase, sale and rediscount of Bills of Exchange, making of short term loans and advances to banks and other institutions, providing of annual Contributions to National Rural Credit Funds, dealing in Derivatives, purchase and sale of Government Securities, purchase and sale of shares of State Bank of India, National Housing Bank, Deposit Insurance and Credit Guarantee Corporation, etc., keeping of Deposits with SBI for specific purposes, making and issue of Banknotes, etc7. Section 18 facilitates the RBI to act as a ‘Lender of Last Resort’. Section 19 lists out the kinds of businesses which RBI may not transact. The provisions of the RBI Act enable the RBI to act as banker to Central Government and State Governments. Under Sections 20 and 21 of the RBI Act, RBI has an obligation and right respectively to accept monies for account of the Central Government and to make payments up to the amount standing to the credit of its account, and to carry out its exchange, remittance and other banking operations, including the management of the public debt of the Union. In the case of State Governments, the said banking functions may be undertaken by way of an agreement between the RBI and the State Government concerned, as provided in Section 21-A of the RBI Act. These agreements made between the RBI and the State Governments are statutory as they are required to be laid before the Parliament as soon as they are made. Issue Functions - Legal Background Issuance of bank notes is one of the key central banking functions the RBI is authorised and mandated to do8. Section 22 of the RBI Act confers on RBI the sole right to issue bank notes in India. The issue of bank notes shall be conducted by a department called the Issue 5 Please read Section 7 of the RBI Act, 1934 6 Please read Section 8 of the RBI Act, 1934 7 Please read Section 17 and other provisions of the RBI Act, 1934 for full details 8 See Chapter III of RBI Act, 1934 for detailed reading 6 Department, which shall be separated and kept wholly distinct from the Banking Department9. The RBI Act enables RBI to recommend to Central Government the denomination of bank notes, which can be of two rupees, five rupees, ten rupees, twenty rupees, fifty rupees, one hundred rupees, five hundred rupees, one thousand rupees, five thousand rupees and ten thousand rupees or other denominations not exceeding ten thousand rupees10. The design, form and material of bank notes shall be approved by the Central Government on the recommendations of Central Board of the RBI11. Every bank note shall be a legal tender at any place in India, however, on recommendation of the Central Board, the Central Government may declare any series of bank notes of any denomination to be not a legal tender12. Another important function is exchange of mutilated or torn notes, which under the RBI Act is not a matter of right, but of grace13. The bank notes that are being issued by the RBI are exempt from payment of stamp duty14. Monetary Policy Functions - Legal Background Chapter III-F15 of the RBI Act provides for a statutory basis for the Monetary Policy Framework and the Monetary Policy Committee. The Central Government, in consultation with the RBI shall determine the inflation target in terms of the Consumer Price Index, once in every five years, which needs to be notified in the Official Gazette16. Similarly, it is the Central Government that should constitute a Monetary Policy Committee by notification in the Official Gazette17. The Monetary Policy Committee shall consist of (a) the Governor of the RBI; (b) Deputy Governor of the RBI in charge of Monetary Policy; (c) one officer of the RBI to be nominated by the Central Board; and (d) three persons to be appointed by the Central Government18. The Monetary Policy Committee has been entrusted with the statutory duty to determine the Policy Rate required to achieve the inflation target. The decision of the Monetary Policy Committee is binding on the RBI and the RBI shall publish a document explaining the steps to be taken by it to implement the decisions of the Monetary Policy Committee19. It has been the objective of the statute that a Committee-based approach will add lot of value and transparency to monetary policy decisions. The meetings of the MPC shall be held at least 4 times a year and it shall publicize its decisions after each such meeting 20. Public Debt Functions – Legal Background The Parliament of India enacted the Government Securities Act, 2006 (‘GS Act’) with an objective “to consolidate and amend the law relating to Government securities and its management by the Reserve Bank of India” 21. The GS Act applies to Government securities 9 Please see Section 23, RBI Act, 1934 10 Please see Section 24, RBI Act, 1934 11 Please see Section 25, RBI Act, 1934 12 Section 26, RBI Act, 1934 13 Section 28, RBI Act, 1934 14 Section 29, RBI Act, 1934 15 Introduced by Finance Act, 2016 16 Section 45-ZA, RBI Act, 1934 17 Section 45-ZB, RBI Act, 1934 18 Section 45-ZB, RBI Act, 1934 19 Section 45-ZJ, RBI Act, 1934 20 Section 45-ZK, RBI Act, 1934 21 Preamble, Government Securities Act, 2006 7 created and issued by the Central Government or a State Government22. The GS Act prescribes the procedure and modalities to be followed by the RBI in the management of the public debt and also confers various powers on the RBI, including the power to determine the title to a Government security, if there exists any doubt in the opinion of the RBI23. Further, Section 18 of the GS Act provides that no order made by the RBI under that Act shall be called in question by any Court for the reasons stated therein. Prior to the enactment of the GS Act, the said public debt functions of the RBI have been governed by the provisions of the Public Debt Act, 1944. The enactment of the GS Act has not fully repealed the Public Debt Act, 1944. This is evident from Section 31 of the GS Act which states that the Public Debt Act, 1944, shall cease to apply to the Government securities to which that Act applies and to all matters for which provisions have been made under the GS Act. Foreign Exchange Management – Legal Background The powers and responsibilities with respect to external trades and payments, development and maintenance of foreign exchange market in India are conferred on the RBI under the provisions of the Foreign Exchange Management Act, 1999 (‘FEMA"). Section 10 of the FEMA empowers the RBI to authorize any person to be known as authorized person to deal in foreign exchange or in foreign securities, as an authorized dealer, money changer or off-shore banking unit or in any other manner as it deems fit. Similarly, it empowers the RBI to revoke an authorization issued to an authorized dealer in public interest, or the authorized person has failed to comply with the conditions subject to which the authorization was granted or has contravened any of the provisions of the FEMA or any rule, regulation, notification, direction or order issued by the RBI. However, the revocation of an authorization may be done by the RBI after following the prescribed procedure in the FEMA or the Regulations made there under. Section 13 of the FEMA details out the contraventions and penalties, and the RBI has been empowered to compound certain contraventions under Section 15 of the FEMA. Banking Regulation & Supervision – Legal Background India has a variety of banks viz., banking companies (banks which are companies and regulated by the Banking Regulation Act, 1949), State Bank of India (constituted by the State Bank of India Act, 1955), Nationalised Banks (constituted by the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970/ 1980), Regional Rural Banks (constituted under the Regional Rural Banks Act, 1976) and co-operative banks (constituted either under the Multi-State Co-operative Societies Act, 2002 or State Co-operative Societies Acts). Although RBI is entrusted with the task of regulating and supervising all types of banks in the country, the powers exercisable by it towards different banks are not uniform. The power to regulate and supervise banking companies has been provided by the provisions of the Banking Regulation Act, 1949 (BR Act, 1949) to the RBI. Although, the 22 Please see Section 1 of GS Act, 2006 23 Please see Section 12 of GS Act, 2006 8 preamble to the BR Act, 1949, states that it is an Act to consolidate and amend the law relating to banking. The powers of RBI to formulate banking policy24, regulate and supervise banking business etc., are scattered across the BR Act, 1949. Section 5(ca) of the BR Act, 1949, states that banking policy means any policy, which is specified from time to time by the RBI, in the interest of the banking system or in the interest of monetary stability or sound economic growth, having due regard to the interests of the depositors, the volume of deposits and other resources of the bank and the need for equitable allocation and the efficient use of these deposits and resources. The appointment of chairman and whole-time directors of a banking company shall not have effect, unless done with the previous approval of the Reserve Bank25. Similarly, as a part of control over management, Section 36-AB of BR Act, 1949, empowers RBI to appoint additional directors on the boards of banking companies. Section 36-AA of the BR Act, 1949 enables RBI to remove executives, officers and employees of a banking company under certain conditions. Moreover, the RBI has been empowered under BR Act, 1949, to supersede the boards of banking companies. Though it is not the role of the Reserve Bank to micro-manage the affairs of banks, it has powers tor to control advances by banking companies26. Section 22 of the BR Act, 1949 confers on RBI the power to issue licenses and also to cancel licenses of banking companies. Another important regulatory power that has been vested in the RBI is the power to issue directions to banking companies. Under Section 35-A of the BR Act, 1949, RBI has the power to issue directions to banking companies in public interest or in the interest of banking policy or to prevent the affairs of any banking company being conducted in a manner detrimental to the interests of the depositors or in a manner prejudicial to the interests of the banking company or to secure the proper management of any banking company. The Banking Regulation (Amendment) Act, 2017 has provided powers to RBI to issue directions to banking companies in relation to resolution of stressed assets27. As part of the supervisory powers, RBI has been empowered to inspect banking companies on its own or at the instance of Central Government under the provisions of the BR Act, 1949 28. “Thus an overall responsibility to find out the well-being of a banking company, in improving monetary stability and economic growth as well as keeping in view the interests of depositors”, has been left with the Reserve Bank of India29. Only a few provisions which are mentioned in section 51 of the BR Act will apply to State Bank of India, Nationalised Banks and Regional Rural Banks. In the case of co-operative banks, the application of the provisions of the BR Act will be subject to the modifications mentioned in section 56 of the very same Act. 24 Please see Section 5(ca) of the BR Act, 1949 25 Section 35B of the BR Act, 1949 26 See section 21 of RBR Act 27 Section 35AB of the BR Act. 28 Please see Section 35 of the BR Act, 1949 29 Janata Sahakari Bank Ltd. V/s. State of Maharashtra (AIR 1993 Bombay 252) 9 Regulation and Supervision of NBFCs – Legal Background The regulation and supervision of non-banks is one of the critical functions that the RBI has been entrusted with. Section 45-IA of the RBI Act mandates every non-banking financial company to obtain a certificate of registration from the RBI and to have a net owned fund as may be specified by the RBI in the Official Gazette, before commencing such non- banking financial business.30 Further, as a part of regulation and supervision of non-banks, the RBI has been conferred with the statutory powers to regulate or prohibit issue of prospectus or advertisements soliciting deposits of money by non-banking financial companies,31 power to determine policy and issue directions to non-banking financial companies, etc.32 Further, the RBI has been empowered under Section 45-L of the RBI Act to call for information and issue directions to non-banking financial companies for the reasons stated therein. As a part of the supervisory control over the non-banking financial companies, the RBI has the power to inspect them under Section 45-N of the RBI Act, 1934. Regulation & Supervision of Co-operative banks – Legal Background In terms of Article 246 of the Constitution of India, the legislative powers of the Union and the State are given in three Lists, viz., the Union List the State List and the Concurrent List respectively of Schedule VII to the Constitution. The entry relating to incorporation, regulation and winding-up of Cooperative Societies fall in State List33 whereas the entry relating to banking fall in the Union List34. This results in the duality of jurisdiction over cooperative banks - by the Reserve Bank of India and the Registrar of Cooperative Societies. In Janata Sahakari Bank Ltd. v. State of Maharashtra35, the Bombay High Court has held that “though the control over management of Co-operative Society where it is Co-operative Banking Society or otherwise is vested in the Registrar of Co-operative Societies, but insofar as banking is concerned, by virtue of S.56 of the Banking Regulation Act, 1949, read with S.35A of the Banking Regulation Act, 1949, it will be a subject with which the Reserve Bank of India has full power”. The Banking Regulation (Amendment) Ordinance, 2020 that was promulgated on June 27, 2020 seeks to amend the Banking Regulation Act, 1949, with regard to cooperative banks. The Ordinance states that the BR Act will not apply to primary agricultural credit societies and cooperative societies whose principal business is long term financing for agricultural development. Further, these societies shall not use the words ‘bank’, ‘banker’ or ‘banking’ in their name or in connection with their business, and act as an entity that clears cheques. The Ordinance provides that a cooperative bank may issue equity shares, preference shares, or special shares on face value or at a premium to its members or to any other person residing within its area of operation. Further, it may issue unsecured debentures or bonds or similar 30 Please read Chapter III-B of RBI Act, 1934 for detailed provisions 31 Please see Section 45-J of the RBI Act, 1934 32 Please see Section 45-JA of the RBI Act, 1934 33 Please see Entry No.32 of List II of the VII Schedule to the Constitution of India 34 Please see Entry No.45 of List I of the VII Schedule to the Constitution of India 35 AIR 1993 Bombay 252 10 securities with maturity of ten or more years to such persons subject to the prior approval of the Reserve Bank of India (RBI), and any other conditions as may be specified by RBI. The Ordinance adds that in case of a co-operative bank registered with the Registrar of Co- operative Societies of a state, the RBI will supersede the Board of Directors after consultation with the concerned state government, and within such period as specified by it. However, RBI may exempt a cooperative bank or a class of cooperative banks from certain provisions of the Act through notification for such time period and under such conditions as may be specified by the RBI36. Regulation of Derivatives and Money Market Instruments – Legal Background Chapter III-D was inserted in the RBI Act with effect from 9th January 2007 by way of an amendment to the RBI Act, 1934. In the said chapter, the Parliament of India thought it as appropriate to introduce provisions relating to regulation of transactions relating to derivatives, money market instruments, securities, etc. by the RBI. Sub-section (a) of Section 45U of the RBI Act defines derivative as an instrument to be settled at a future date, whose value is derived from change in interest rate, foreign exchange rate, credit rating or credit index, price of securities (also called ‘underlying’), or a combination of more than one of them and includes interest rate swaps, forward rate agreements, foreign currency swaps, foreign currency-rupee swaps, foreign currency options, foreign currency rupee options or such other instruments as may be specified by the RBI from time to time. Similarly, money market instruments have been defined to include call or notice money, term money, repo, reverse repo, certificate of deposit, commercial usance bill, commercial paper and such other debt instrument of original or initial maturity up to one year as the RBI may specify from time to time. The power of RBI to regulate these money market instruments have been provided under Section 45W of the RBI Act, which states that the RBI may, in public interest or to regulate the financial system of the country to its advantage, determine the policy relating to interest rates or interest rate products and give directions in that behalf to all agencies or any of them, dealing in securities, money market instruments, foreign exchange, derivatives, or other instruments of like nature as the RBI may specify from time to time. Payment and Settlement Functions – Legal Background The Parliament of India enacted the Payment and Settlement Systems Act, 2007 (‘PSS Act, 2007’) with an objective to provide for the regulation and supervision of payment systems in India and to designate the Reserve Bank of India as the authority for that purpose and for matters connected therewith or incidental thereto37. Under Section 4 of the PSS Act, 2007, no person shall commence or operate a payment system except with an authorization issued by the RBI. Similarly, under Section 8 of the PSS Act, 2007, RBI has the power to revoke the authorization granted to any person if it contravenes any of the provisions of the PSS Act or does not comply with regulations or fails to comply with the orders or directions issued by the RBI or operates the payment system contrary to the conditions subject to which the 36 www.prsindia.org 37 Preamble to the PSS Act, 2007 11 authorization was issued. The regulation and supervision of payment systems has been conferred on the RBI by virtue of provisions of Chapter IV of the PSS Act, 2007. The regulatory and supervisory controls include power to determine standards for the functioning of payment systems38, power to call for returns39, documents40 or other information41, power to enter and inspect payment systems42, power to carry out audit and inspections43, power to issue directions44, etc. Credit Information Companies Regulation Functions Reserve Bank has been entrusted with the task of regulation and supervision of Credit Information Companies under the Credit Information Companies (Regulation) Act, 2005. Three institutions form the essential pillars of the Act, viz. the Credit Information Companies, the Credit Institutions and Specified Users. The Act empowers the Reserve Bank to issue directions to Credit Information Companies and also to inspect them. The Reserve Bank is also authorised by the statute to determine policy in relation to functioning of credit information companies. Consumer Protection and promotion Functions – Legal Background Protection of the interests of the depositors is one of the vital mandates of the RBI. The various provisions in the RBI Act, 1934, BR Act, 1949, etc., are replete with the phrases like “in the interests of depositors” wherever it entrusts powers to the RBI45. Apart from depositors, the resolution of grievances of customers who deal with its regulated entities is also important for the Reserve Bank of India. Reserve Bank of India has formulated three Ombudsman Schemes for covering operations of banks, NBFCs and payment systems. Reserve Bank of India attaches high importance to its promotional and developmental roles. Clause (8AA) of section 17 of the RBI Act states that the promoting, establishing, supporting or aiding in the promotion, establishment and support of any financial institution - whether as its subsidiary or otherwise - is a business which can be transacted by the Reserve Bank. Section 54 of that Act points to the developmental role of RBI in matters of rural development. It provides that the Reserve Bank may maintain expert staff to study various aspects of rural credit and development and in particular it may (i) tender expert guidance and assistance to the National Bank; and (ii) conduct special studies in such areas as it may consider necessary to do so for promoting integrated rural development. Conclusion The powers and functions of the RBI have further widened consequent upon the amendments to the Securitisation and Reconstruction of Financial Assets and Enforcement of 38 Please read Section 10 of the PSS Act, 2007 39 Please read Section 12 of the PSS Act, 2007 40 Please read Section 12 of the PSS Act, 2007 41 Please read Section 12 of the PSS Act, 2007 42 Please read Section 14 of the PSS Act, 2007 43 Please read Section 16 of the PSS Act, 2007 44 Please read Section 17 of the PSS Act, 2007 45 Source: RBI Website 12 Security Interests Act, 200246 and the National Housing Bank Act, 198747. Although, the object and purpose of establishment of the RBI, as could be observed from the preamble to the RBI Act, 1934, is to regulate the issue of Bank notes and the keeping of reserves with a view to securing monetary stability and also to formulate monetary policy with an objective to control inflation,48 the multifarious functions which the RBI has been entrusted with through various legislations shows that the central bank of the country has much wider mandates than what have been summarized in the preamble to the RBI Act, 1934. The regulation and supervision of banks, non-banks, co-operative banks, management of currency, management of public debt of the Union and the State, management of foreign exchange, acting as banker to banks, banker to governments, protection of interests of depositors, spreading of financial literacy, etc., are all part of achieving the common goal as enshrined in the preamble to the RBI Act, 193449. 46 Enforcement of Security Interest and Recovery of Debts Laws and Miscellaneous Provisions (Amendment) Act, 2016 47 The Finance (No.2) Act, 2019 48 Preamble to the Reserve Bank of India Act, 1934 49 Report of the Commission on FSLRC in the year 2013 by Shri B.N. Srikrishna, Chairman 13  Chapter 3: Monetary Policy Framework I. Monetary Policy Making in India Definition, objectives and tools Central banks derive their objectives from their respective mandates. Monetary Policy could have either a single objective of price stability or multiple objectives. In the literature and in practice, price stability is considered as the dominant objective of monetary policy. For countries, which have adopted inflation targeting framework, price stability is the core objective. Monetary policy refers to the use of monetary instruments under the control of the central bank to influence variables, such as interest rates, money supply and availability of credit, with a view to achieving the objectives of the policy. Before the amendment of the RBI Act in May 2016, the Preamble read as “to regulate the issue of Bank notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage”. Accordingly, the objectives of monetary policy evolved as maintaining price stability and ensuring adequate flow of credit to the productive sectors of the economy. With progressive liberalization and increasing globalization of the economy, maintaining orderly conditions in financial markets emerged as an additional policy objective. Thus, over time, the role of monetary policy in India evolved to maintain a judicious balance between price stability, economic growth and financial stability. However, pursuant to the amendment to RBI Act, 1934, in May 2016, the primary objective of monetary policy is to maintain price stability while keeping in mind the objective of growth. The amended Preamble to RBI Act reads, inter alia, as follows: “to regulate the issue of Bank notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage” “AND WHEREAS it is essential to have a modern monetary policy framework to meet the challenges of an increasing complex economy; AND WHEREAS the primary objective of the monetary policy is to maintain price stability while keeping in mind the objective of growth”. There are various direct and indirect instruments used for implementing monetary policy including Repo Rate, Reverse Repo Rate, Marginal Standing Facility (MSF) under the Liquidity Adjustment Facility (LAF), Bank Rate, Cash Reserve Ratio (CRR), , Open Market Operations (OMOs) and Market Stabilization Scheme (MSS). They are briefly explained below: Repo Rate: The (fixed) interest rate at which the Reserve Bank provides overnight liquidity to banks against the collateral of government and other approved securities under the LAF. It is the policy rate decided by the Monetary Policy Committee (MPC). 14 Reverse Repo Rate: The (fixed) interest rate at which the Reserve Bank absorbs liquidity, on an overnight basis, from banks against the collateral of eligible government securities under the LAF. Liquidity Adjustment Facility (LAF): The LAF consists of overnight as well as term repo/reverse repo auctions. Progressively, the Reserve Bank has increased the proportion of liquidity injected under variable rate repo auctions across the range of tenors. The aim of term-repo is to help develop the inter-bank term-money market, which in turn can set market-based benchmarks for pricing of loans and deposits, and hence improve transmission of monetary policy. The RBI also conducts variable rate repo/reverse-repo auctions, as necessitated by market conditions. Marginal Standing Facility (MSF): A facility under which scheduled commercial banks can borrow additional amount of overnight money from the Reserve Bank against their excess SLR securities and also by dipping into their SLR portfolio up to a specified limit at a penal rate of interest. This provides a safety valve against unanticipated liquidity shocks to the banking system. Policy Corridor: The MSF rate as the ceiling and the Reverse Repo rate as the floor determines the policy corridor. The objective of liquidity management operations is to keep the WACR closely aligned to the policy repo rate. Bank Rate: It is the standard rate at which the Reserve Bank is ready to buy or rediscount bills of exchange or other commercial papers. The Bank Rate is published under Section 49 of the Reserve Bank of India Act, 1934. This rate has been aligned to the MSF rate and, therefore, changes automatically as and when the MSF rate changes alongside policy repo rate changes. Cash Reserve Ratio (CRR): The amount that a bank is required to maintain with the Reserve Bank as a specified proportion (per cent) of its Net Demand and Time Liabilities (NDTL) for a fortnight starting from a Saturday till the next reporting Friday. The proportion required to be maintained is notified by the Reserve Bank from time to time. The maintenance of CRR balances over a fortnight is on an average daily basis with a stipulated minimum daily maintenance notified by the Reserve Bank. Open Market Operations (OMOs): These include both repurchase (repo or reverse repo) operations and outright purchase and sale of government securities, for injection and absorption of liquidity, respectively. Market Stabilisation Scheme (MSS): This instrument for monetary management was introduced in 2004. Surplus liquidity of a more enduring nature arising from large capital inflows is absorbed through sale of short-dated government securities and treasury bills. Depending upon the nature of the surplus liquidity (long term/ short term) the securities 15 under MSS (long term dated securities/ short term CMBs) are issued. The cash so mobilised is held in a separate government account with the Reserve Bank50. II. Evolution of Monetary Policy Framework in India In order to attain the objectives of monetary policy, it is necessary to have a consistent policy framework. Broadly, monetary policy framework consists of objectives, operating procedure and governance arrangements. Objectives are the aims of the monetary policy, which are goal variables or nominal anchors and long-term in scope but are not directly under the control of the central bank. As a result, central banks strive to achieve these objectives only indirectly by targeting intermediate and operating targets, which bear a stable relationship with the ultimate objectives, through instruments which are under their direct control. The choice of the operating target is crucial as this variable is at the beginning of the monetary transmission mechanism. Similarly, the selection of intermediate targets is conditional upon the channels of transmission – the process through which monetary policy actions impact the ultimate objectives. Operating procedure essentially deals with how the central bank intends to influence the operating target and thereby the intermediate target through its liquidity management operations. Therefore, the operating procedure is essentially the day-to-day management of liquidity conditions consistent with the overall stance of the monetary policy. In other words, operating procedure is also called the nuts and bolts of monetary policy, the “plumbing in the architecture” (Patra et al., 2016). Governance arrangements primarily deal with the process of decision making and focus on responsibilities, powers and accountability of the monetary authority. From the perspective of global best practices, historically, bank reserves and short- term interest rates have evolved as the two dominant operating targets. However, the focus shifted to short-term interest rates in early 1990s, reflecting greater significance of interest rates in monetary transmission mechanism as markets developed in a deregulated environment. Consequently, the overnight rate emerged as the most commonly pursued operating target in the conduct of monetary policy. India's monetary policy framework has undergone several transformations reflecting underlying macroeconomic and financial conditions. During 1971-1985, the monetisation of the fiscal deficit exerted a dominant influence on the conduct of monetary policy. The pre- emption of resources by the public sector and the resultant inflationary consequences of high public expenditure necessitated frequent recourse to the CRR to neutralize the secondary 50 Key features of the scheme include, inter alia (i) under the scheme, the Government issues Treasury Bills and/or dated securities in addition to the normal borrowing requirements, for absorbing liquidity from the system; (ii) the Treasury Bills/dated securities issued under the MSS have all the attributes of regular Treasury Bills and dated securities. These securities are eligible for Statutory Liquidity Ratio (SLR), repo and Liquidity Adjustment Facility (LAF); (iii) the amounts raised under the MSS are held in a separate identifiable cash account titled the Market Stabilisation Scheme Account (MSS Account) maintained and operated by the Reserve Bank; (iv) the amounts credited into the MSS Account are be appropriated only for the purpose of redemption and / or buy back of the Treasury Bills and / or dated securities issued under the MSS. 16 effects of monetary expansion. Financial repression in the form of interest rate prescriptions, statutory pre-emptions and directed credit partly crowded out the private sector from the credit market. Against this backdrop, the Committee to Review the Working of the Monetary System (Chairman: Dr. Sukhamoy Chakravarty) recommended in 1985 a new monetary policy framework based on monetary targeting with feedback, drawing on empirical evidence of a stable demand function for money. Monetary Targeting Framework Under this framework, broad money became the intermediate target while reserve money was one of the main operating instruments for achieving control on broad money growth. Accordingly, monetary (M3) projection was made consistent with the expected real GDP growth and a tolerable level of inflation. Technically, in a simple form, if expected real GDP growth was 6 per cent, the income elasticity of demand for money was 1.5 and a tolerable inflation was 5 per cent, the M3 expansion target was set at 14 per cent [M3 growth = 1.5(6) +5 =14 percent] (Mohanty, 2010). This framework was in operation during mid-1980s to 1997-98. Analysis of the money growth outcomes during the monetary targeting regime indicates that targets were rarely met. The biggest impediment to monetary targeting was lack of control over RBI's credit to the central government, which accounted for the bulk of reserve money creation. With economic and financial sector reforms in the 1990s, there was shift in financing government and the commercial sector with increasing reliance on market-determined interest rates and exchange rate. RBI was able to move away from direct instruments to indirect market-based instruments. The SLR and CRR were gradually brought down to 25 per cent and 9.5 per cent, respectively by 1997. Further, as the pace of trade and financial liberalization gained momentum in the 1990s, the efficacy of broad money as an intermediate target was re-assessed. Financial innovations and external shocks emanating from swings in capital flows, volatility in the exchange rate and global business cycles imparted instability to the demand for money. There was also increasing evidence of changes in the underlying transmission mechanism of monetary policy with interest rate and the exchange rate gaining importance vis-à-vis quantity variables. Against this backdrop, in India, the search for an alternative monetary framework ended in switching over to Multiple Indicator Approach in 1998-99. Multiple Indicator Approach The RBI adopted a 'multiple indicator approach' in April 1998 with a greater emphasis on rate channels for monetary policy formulation relative to quantity instruments. Under this approach, a number of quantity variables such as money, credit, output, trade, capital flows and fiscal position as well as rate variables such as rates of return in different markets, inflation rate and exchange rate were analysed for drawing monetary policy perspectives. The multiple indicator approach was informed by forward looking indicators since the early 2000s drawn from the RBI's surveys of industrial outlook, credit conditions, capacity utilization, 17 professional forecasters, inflation expectations and consumer confidence. The RBI continued to give indicative projections of key monetary aggregates. The multiple indicator approach seemed to work fairly well from 1998-99 to 2008-09, as reflected in the average real gross domestic product (GDP) growth rate of 7.1 per cent associated with average inflation of about 5.5 per cent in terms of both the wholesale price index (WPI) and the Consumer Price Index (CPI). Subsequently, however, there was a mounting public censure of the efficacy and even the credibility of this framework as persistently high inflation and weakening growth co-existed, i.e., visible signs of stagflation. Use of a large panel of indicators was also not providing a clearly defined nominal anchor for monetary policy. It also left policy analysts unclear about what the RBI looks at while taking policy decisions. Since 2007 several high-level Committees in India have highlighted that the RBI must consider switching over to inflation targeting (RBI, 2014). Flexible Inflation Targeting Against this backdrop, the RBI constituted an Expert Committee to Revise and Strengthen Monetary Policy Framework (Chairman: Dr. Urjit R. Patel) on September 12, 2013 to recommend what needed to be done to revise and strengthen the current monetary policy framework with a view to, inter alia, making it transparent and predictable. The Expert Committee submitted its report in January 2014 and set the stage for a move towards the adoption of a flexible inflation targeting framework for monetary policy in India. In the flexible inflation targeting framework, the policy (repo) rate is set, based on an assessment of the current and evolving macroeconomic situation, with the aim of achieving the inflation target on an average over the business cycle, while accommodating growth concerns in the short run (RBI, 2014). Once the repo rate is announced, the operating framework designed by the RBI envisages liquidity management on a day-to-day basis through appropriate actions, which aim at anchoring the operating target – WACR – around the repo rate. The details of the operational framework of monetary policy is elaborated in the next chapter “Market Operations”. These changes in money market rates then get transmitted to the entire financial system, which, in turn, influences aggregate demand – a key determinant of inflation and growth. Prior to the amendment to the RBI Act in May 2016, the flexible inflation targeting framework, as recommended by the above-mentioned Committee, was governed by an Agreement between Government of India and Reserve Bank of India in February, 2015. The amendment of the RBI Act in May 2016 provided the statutory basis for the implementation of the flexible inflation targeting framework. As per the amended Act, the inflation target would be defined in terms of all India Consumer Price Index (CPI) and the inflation target would be set by the Government of India, in consultation with the Reserve Bank, once in every five years. The failure to achieve the inflation target was defined as when: (a) the average inflation is more than the upper tolerance level of the inflation target for any three consecutive quarters; or (b) the average inflation is less than the lower tolerance level for any three consecutive quarters. In the event of a failure to meet the inflation target, the Reserve 18 Bank has to set out in a report to the Central Government: (a) the reasons for failure to achieve the inflation target; (b) remedial actions proposed to be taken by the Bank; and (c) an estimate of the time-period within which the inflation target shall be achieved pursuant to timely implementation of proposed remedial actions. The amended Act requires the Reserve Bank to publish, once in every six months, a document called the Monetary Policy Report that explains (a) the sources of inflation; and (b) the forecast of inflation for 6-18 months ahead. The amended RBI Act came into effect in June 2016. In pursuance of the amended Act, in August 2016, the Central Government notified in the Official Gazette an inflation target of 4 per cent Consumer Price Index (CPI) inflation for the period from August 5, 2016, to March 31, 2021, with the upper tolerance limit of 6 per cent and the lower tolerance limit of 2 per cent. Section 45ZB of the amended RBI Act, 1934 also provides for a six-member Monetary Policy Committee (MPC) to be constituted by the Central Government by notification in the Official Gazette. Accordingly, a six-member Monetary Policy Committee (MPC) was constituted on September 29, 2016, with three internal and three external members, to determine the policy rate to achieve the inflation target. Under the amended RBI Act, the six- member committee is required to meet at least four times in a year. Three external MPC members are appointed for a period of 4 years. Each member of the MPC has one vote, and in the event of an equality of votes, the Governor of the RBI has a second or casting vote. The resolution adopted by the MPC is published after conclusion of every meeting of the MPC in accordance with the provisions of Chapter III F of the amended Reserve Bank of India Act, 1934. On the 14th day, the minutes of the proceedings of the MPC meeting are published which include (a) the resolution adopted by the MPC; (b) the vote of each member on the resolution, ascribed to such member; and (c) the statement of each member on the resolution adopted. Till May 2020, the MPC met 23 times since its first meeting in October 2016. The Reserve Bank's Monetary Policy Department (MPD) assists the MPC in formulating the monetary policy. Views of key stakeholders in the economy, and analytical work of the Reserve Bank contribute to the process for arriving at the decision on the policy repo rate. The Financial Markets Operations Department (FMOD) operationalises the monetary policy, mainly through day-to-day liquidity management operations. The Financial Markets Committee (FMC) meets daily to review the liquidity conditions so as to ensure close alignment of the operating target - the weighted average call money rate (WACR) – with the policy repo rate. During the global financial crisis, advanced economies suffered steep and persistent fall in the real GDP. The advanced economies’ central banks couldn’t rely solely on conventional monetary policy, i.e., reduction in policy rate due the zero-lower bound (ZLB) constraint of the policy rate leading them to introduce unconventional monetary policies to revive the economy. Unconventional monetary policy broadly consists of quantitative easing (QE) and forward guidance (FG) measures. Quantitative easing measures refer to the asset purchase programs of the advanced central banks’, which drastically increased the total assets 19 as well as altered the composition of assets in the central banks’ balance sheet unlike the conventional monetary policies, which had negligible impact on the central banks’ balance sheet. Forward guidance refers to the use of central bank communication to manage expectations about the future course of policy, thereby attempting to influence the financial decisions of the household and firms. The RBI has started implementing some of the unconventional monetary policy measures from December 2019 onwards to arrest the economic slowdown and improve the investment cycle in India. The reliance on unconventional monetary policy measures increased in February 2020 to reduce the impact of Corona virus outbreak on economic activity. Operation twist is one of the unconventional monetary policy measures adopted by the RBI since December 2019 under which the RBI simultaneously sells short-term securities and buys long-term securities through open market operations (OMO). This measure is aimed at bringing down the long-term benchmark yield rate. RBI has also introduced measures aimed at durable liquidity injections to the banking system through long-term repo operations (LTRO) with the tenor of one year and three year at reasonable cost, i.e., the repo rate. RBI has also implemented sector-specific measures such as exemptions from the cash reserve ratio (CRR) for the equivalent of incremental credit disbursed by banks as loans in certain select areas/segments and targeted LTROs (TLTROs) to provide liquidity to sectors and entities which are experiencing liquidity constraints and/or hindrances to market access 51. As explained above, monetary policy making in India has evolved over the years. In the last three decades, key changes related to the adoption of monetary targeting framework, transition to multiple indicator approach and adoption of inflation targeting. III. Monetary Policy Transmission Monetary transmission is the process through which monetary policy impulses in the form of policy rate changes by a central bank are transmitted to the entire spectrum of interest rates such as money market rates, bond yields, bank deposit and lending rates and asset prices such as stock prices and house prices. Various economic agents such as households, firms and the government respond to these interest rate changes by adjusting their spending behaviour. This alters aggregate demand of households and firms and by aligning it with aggregate supply conditions, the broader macroeconomic policy objectives such as price stability and sustainable growth of the economy are achieved. The whole process takes months, sometimes, more than a year. The empirical evidence for India suggests that monetary policy actions are felt with a lag of 2-3 quarters on output and with a lag of 3-4 quarters on inflation, and the impact persists for 8-12 quarters. Transmission takes place through various ‘channels’, namely (i) interest rate channel, (ii) credit channel, (iii) exchange rate channel, and (iv) asset price channel52. According to many studies, the interest rate channel has been found to be the 51 Detailed changes in the liquidity management of RBI is provided in the next chapter “Market Operations”. 52 See RBI (2014) 20 strongest in India. The efficacy of monetary policy depends on the magnitude and the speed with which policy rate changes are transmitted to the ultimate objectives of monetary policy, viz., growth and inflation. In a bank dominated system like India, the transmission to banks’ lending rates is the key to the successful implementation of monetary policy. Hence, it has been the endeavour of the Reserve Bank to strengthen the monetary transmission by focusing on the design of the lending interest rates of the banking system. However, the issue of transmission from the policy rate to banks’ lending rates has all along been a matter of concern. The transmission to banks’ lending rates has been impeded by a variety of factors and thus the impact of policy change on economic activity and inflation remained muted. To address this concern, the Reserve Bank has refined the interest rate setting methodology of banks from time to time. Effective October 1, 2019, in pursuance of the recommendations of the Internal Study Group (RBI, 2017), the Reserve Bank, mandated that all scheduled commercial banks (excluding regional rural banks) should link all new floating rate personal or retail loans and floating rate loans to Micro and Small Enterprises (MSEs) to the policy repo rate or 3-month T-bill rate or 6-month T-bill rate or any other benchmark market interest rate published by Financial Benchmarks India Private Ltd. (FBIL). With a view to further strengthening monetary transmission, Reserve Bank directed the banks to link their pricing of loans for the medium enterprises also to an external benchmark effective April 1, 2020. Under this benchmarking system, banks are free to choose the spread over the benchmark rate, subject to the condition that the credit risk premium may undergo change only when the borrower’s credit assessment undergoes a substantial change, as agreed upon in the loan contract. External benchmarks are transparent as they are available in the public domain and hence easily accessible to the borrowers. Subsequent to the introduction of an external benchmark system, monetary transmission has improved to the sectors where new floating rate loans have been linked to the external benchmark. References Acharya, V. V. (2017). “Monetary Transmission in India: Why is it important and why hasn’t it worked well?”, Inaugural Speech delivered at the Aveek Guha Memorial Lecture organised by Tata Institute of Fundamental Research (TIFR) at Homi Bhabha Auditorium, Mumbai, November 16. Mohanty. D (2010). “Monetary Policy framework in India: Experience with Multiple Indicators Approach” RBI Bulletin, March Patra M.D., Kapur M., Kavediya R., Lokare S.M. (2016). “Liquidity Management and Monetary Policy: From Corridor Play to Marksmanship”, in Ghate C., and Kletzer K. (eds) Monetary Policy in India, Springer, New Delhi, 257-296. RBI (1985). “Report of the Committee to Review the Working of the Monetary System” (Chairman: Dr. Sukhamoy Chakravarty). ……. (2006). Report on Currency and Finance 2004-05. ……. (2014). “Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework” (Chairman Dr. Urjit R Patel), January. ……. (2017). “Report of the Internal Study Group to Review the Working of the Marginal Cost of Funds Based Lending Rate System” (Chairman: Dr. Janak Raj), October. 21  Chapter 4: Market Operations The objective, framework and implementation of the market operations of the RBI are discussed in this Chapter, which is divided into two sections. The first section deals with Monetary Policy Operations and the second section deals with the Foreign Exchange Operations of RBI. I. Monetary Policy Operations The objective of monetary policy operations is to enable the transmission of monetary policy to the financial system. The MPC determines the policy interest rate, and the policy stance to achieve the inflation target. The operating target of monetary policy is the weighted average call rate (WACR), which is a volume weighted rate of overnight transactions undertaken in Call money market (uncollateralized segment of the money market with banks and primary dealers as participants). By conducting market operations as per the liquidity management framework designed by it, the RBI endeavours to ensure that the operating target, i.e., the WACR is aligned to policy rate on a daily basis. The liquidity management framework of RBI comprises of Liquidity Adjustment Facility (LAF) and Marginal Standing Facility (MSF) for management of transient liquidity, i.e., liquidity surplus or deficit of temporary nature. LAF includes repos and reverse repos of various tenors conducted by the RBI. MSF is an additional facility in which banks can borrow rupee funds from RBI at a higher rate against eligible collateral including by dipping below the statutory SLR up to a specified limit. For managing liquidity of enduring nature, i.e., liquidity surplus or deficit, which is persisting in the banking system for a longer period, due to various factors, instruments like Long Term Repo/Reverse Repo Operations (LTROs/LTRROs), Open Market Operations (OMOs) by outright purchase and sale of government securities, changes in required Cash Reserve Ratio (CRR), Market Stabilisation Scheme (MSS), USD/INR swaps auctions (Forex Swap Auctions) are used. The CRR is a direct instrument which immediately impacts the system liquidity. If CRR is increased, banks must maintain higher balances in their current account with RBI, thereby creating liquidity deficit in the banking system. Similarly decrease in CRR has the immediate impact of creating liquidity surplus in the banking system. Other instruments of liquidity management are detailed in the ensuing paragraphs. Liquidity Management Framework An RBI Internal Working Group has reviewed the liquidity management framework and published its report in September 2019. The Group has continued with the existing objectives of maintaining the call money rate close and consistent to the policy rate and not undermining the price discovery in the inter-bank money market. The Group recommended the continuance of a corridor system with the call money rate as the target rate but with greater flexibility in deciding about the appropriate level of liquidity deficit or surplus required in the banking system based on financial conditions. Other recommendations were regarding 22 minimizing the number of operations for greater efficiency, discontinuance of assured liquidity of up to 1% of NDTL, inclusion of longer term repo operations in addition to existing tools for durable liquidity management and dissemination of more information on liquidity management. Based on the recommendations of the above report, RBI has updated its Liquidity Management Framework vide RBI notification dated February 6, 2020, as tabulated below. Sl. No. Instrument Quantum Periodicity/Timing A. Instruments under LAF framework to manage short-term/transient liquidity 1. 14-day variable-rate repo/ Auction amount is decided On reporting Friday reverse repo auction by RBI and a single auction (2.30 p.m. to 3.00 p.m.) (either repo or reverse repo) (Main operation) is conducted based on the assessment of liquidity conditions by RBI. 2. Variable Rate Term Repo/ The auction amount is Discretionary Reverse Repo auction decided by RBI based on an (Tenor: overnight and up to assessment of the liquidity 13 days) conditions. (Fine-tuning operations) 3. Fixed Rate Reverse Repo No restriction on amount Daily between 5.30 p.m. and 11.59 p.m.* 4. Marginal Standing Facility Individual banks can draw (MSF) funds up to Excess SLR + 2 per cent below SLR. 5. FX Swaps The amount is decided by Discretionary RBI, based on the assessment of the liquidity conditions. 23  Sl. No. Instrument Quantum Periodicity/Timing Standing Deposit Facility The operational details are awaited. 6. (SDF) B. Instruments to manage durable liquidity 7. Long Term Variable Rate Repo Operation (LTRO) Tenor: beyond 14 days The auction amount is decided by RBI, based on an Discretionary 8. Long Term Variable Rate assessment of the liquidity Reverse Repo Operation conditions. (LTRRO) Tenor: beyond 14 days 9. FX Swap Auctions The auction amount is Discretionary decided by RBI, based on an assessment of the liquidity conditions. * The window was extended from 09:00 hrs to 23:59 hrs daily w.e.f. March 31, 2020 as an interim and temporary measure to provide greater flexibility in liquidity management by market participants in the wake of the disruptions caused by COVID-19. Key features of repo/reverse repo/MSF conducted under LAF are summarised below: Discretion with RBI While the main operation is a 14-day variable rate repo or reverse repo (depending upon the prevailing liquidity conditions) at the start of the reporting fortnight under the revised liquidity framework, RBI has the discretion to conduct overnight/ longer term, repo/ reverse repo auctions at variable/fixed rates depending on market conditions and other relevant factors. For using this discretion, RBI considers its assessment of the prevailing liquidity conditions based on available data and forecast of liquidity. The details of this mechanism are elaborated later in this chapter. Rate of interest The rate of interest applicable for repo is the policy rate decided by the MPC from time to time. The reverse repo rates and the MSF rates are linked to the policy rate and are decided by RBI from time to time. For variable-rate repo and reverse repo auctions, the applicable rate of interest will be the cut-off as decided by RBI, based on the bids/offers 24 received. Securities eligible for collateral SLR-eligible and unencumbered Government of India dated securities (including oil bonds)/Treasury Bills and State Development Loans (rated and unrated) are considered as eligible securities for repo/ MSF and reverse repo operations. The market value of securities on the day of operation is reckoned to calculate collateral requirement for repo/MSF/reverse repo operations. The RBI also has the option to revalue securities held as collateral at pre- determined intervals as is currently done for LTROs & TLTROs to ensure that lending remains adequately collateralised. Margin Requirement A margin is applied in respect of the eligible securities, which effectively ensures that the borrower using the repo or MSF window to borrow Rupee funds has to provide extra collateral. For example; if the margin is 5 percent and the market participant borrowing from repo window would have to provide ₹105 crore worth of eligible securities to borrow ₹100 crore Rupees. Mechanics of operations The bid/offer is submitted electronically in the Core Banking System (e- Kuber) of RBI by the members within the stipulated time. Settlement of reverse repo/MSF transactions is automatic and immediate after the placement of the bid/offer in the CBS. For variable rate operations, settlement is done after announcement of results of the auction. Results of the operations are announced through Press Release on RBI website. Decision regarding cut-off for Variable-Rate auctions Variable-rate repo: There is no restriction on the number of bids by banks. Banks can bid up to the notified amount. Once the bidding time is over, all the bids are arranged in descending order of the quoted rates and the cut-off rate is arrived corresponding to the notified amount of the auction. Successful bidders would be those who have placed their bids at or above the cut-off rate. If there is more than one successful bid at the cut-off rate, then pro-rata allotment is done. No bids are accepted at or below the prevailing repo rate. Variable-rate reverse repo: The mechanics of a variable-rate reverse-repo auction is opposite of the mechanics for repo auctions. In this case, no offers are accepted at or above the prevailing repo rate. How does the LAF corridor work? To ensure that the WACR does not deviate too much from the policy repo rate, a corridor system with the reverse repo as floor and MSF as ceiling is maintained. By accessing the MSF window, banks can borrow Rupee funds from RBI by providing acceptable securities 25 as collateral. By accessing the reverse repo window, banks can lend Rupee funds to RBI, in exchange for collateral securities. The important point to note here is that both MSF and reverse repo rates are linked to the policy repo rate set by the MPC with MSF rate being upper bound of the corridor and reverse repo rate being the lower bound of the corridor. The RBI has the discretion to decide the width of the corridor. For the current policy rates please refer to the RBI website. Banks can also borrow and lend Rupee funds from other market participants in the money market. Therefore, before availing the RBI facility, banks would consider the available options for borrowing and lending in other segments of the money market such as call money, tri-party repo53, market repo, etc. An important factor, which will influence the decision of the individual banks to borrow or lend short term funds from/to RBI or other segments of the money market would be the interest rate. While, banks also consider various aspects such as the requirement of collateral securities, ease of operations, availability, tenor, etc., interest rate level is the most important factor which enables alignment of WACR with the policy repo rate. Let us understand this with an example. XYZ bank needs to lend its surplus funds. The bank would try to lend to other participants in money market. In a situation of system level liquidity surplus (more lenders than borrowers), the rate in the money market will fall. However, given that banks have the option of deploying their excess funds in the RBI’s reverse repo facility without any limit, the reverse-repo rate sets a floor to the interbank rates as a bank will not lend it to another market participant at a rate below the reverse-repo rate. Similarly, let us suppose XYZ bank needs to borrow overnight Rupee funds. The bank would try to borrow from other participants in money market. In a situation of system level liquidity deficit (more borrowers than lenders), the rates could increase in the market. However, given that banks have the option of borrowing funds under MSF window of RBI, the MSF rate sets the ceiling as banks typically would not borrow from other market participants at a rate higher than the MSF rate. However, the amount of borrowing from MSF window is restricted by the availability of free collateral securities with the bank i.e. eligible securities held in excess of SLR requirements plus allowance given to banks to let their SLR holdings fall below the statutory requirement to the extent permitted by RBI. Therefore, in a scenario of huge system level liquidity deficit, it is possible that the money market rates can breach the ceiling and go beyond the MSF rate. However, such a scenario is only expected in extraordinary circumstances. A narrow corridor limits the possibility of huge deviations of the money market rates from the policy Repo rate and helps in anchoring the WACR to the policy repo rate, while a wider corridor allows greater room for rates to fluctuate and incentivises market development. 53 Tri-Party Repo is a money market instrument provided by CCIL in which market participants can borrow and lend short term rupee funds against eligible collateral securities. CBLO segment of the money market has been discontinued and replaced with Triparty Repo with effect from November 05, 2018 26 How is the WACR aligned to the policy repo rate? In periods of huge surplus liquidity, the call rates will trend towards lower bound of the LAF corridor, the reverse repo rate. Similarly, in periods of huge liquidity deficit, the call rates will be biased towards the upper bound, i.e., MSF rate. To ensure that the WACR is anchored to the repo rate, RBI uses fine tuning operations, i.e., the discretionary variable-rate repo and reverse repo auctions. The amount and timing is decided by RBI depending upon its assessment of the liquidity conditions. RBI also continuously monitors the money market rates during the market hours and conducts fine-tuning operations, as and when needed, to achieve the objective of keeping the WACR close to the policy rate. For example, if the WACR is close to the reverse-repo rate, it means that there is surplus in the system liquidity. Let us assume that liquidity estimation including feedback from the market participants suggests that about ₹50000 crore has come into the system due to unanticipated government spending. In such a scenario, the announcement of an additional variable rate reverse repo auction for about ₹50000 crore, will help in supporting the market rates and pushing them higher, bringing it closer to the policy repo rate. Similarly, in a situation of a large deficit in the system, when the WACR is trending towards the MSF Rate, an announcement of an additional variable-rate- repo auction for sufficient amount will pull the WACR lower and align it with the repo rate. To ascertain the amount, tenor and timing of operations, the assessment of the system-level liquidity on an ongoing basis is very important. How is the System level liquidity assessed by RBI? The important factors considered for assessment of the system level liquidity can be classified into known factors and unknown factors. On a day-to-day basis, information about the amount and impact of known factors is readily available with certainty. Some examples of known factors are reversal of outstanding RBI operations under LAF, settlement of OMOs, settlement of forex operations of RBI, government bond redemptions, coupon payments, primary auctions, etc. Information about the amount and impact of unknown factors is not readily available and it needs to be assessed or forecasted. Some examples of unknown factors are the extent of banks maintenance of reserves on any given day, changes in currency in circulation and expenses by the Central Government. Forecasting, therefore, relies on past data as well as information gathered from informal communications with government/banks. For arriving at the net impact on system liquidity, both known and unknown factors must be considered. The liquidity management framework in India stands on two broad mutually reinforcing pillars of forward looking assessment54. Pillar-I is an assessment of the likely evolution of system-level liquidity demand based on near-term (four to six weeks) projections of autonomous drivers of liquidity. The core of Pillar I is near-term forecasts of autonomous drivers of liquidity, particularly demand for 54 Dr. Urjit R. Patel. (2014). Expert Committee to Revise and Strengthen the Monetary Policy Framework. Mumbai: Reserve Bank of India 27 currency (which reflects behaviour of households), demand for excess reserves (which reflects behaviour of the banking system), and the central government's balances with the RBI (which depends on cash flows of the Government). For liquidity management, forex market intervention is also an autonomous driver of liquidity, but since there cannot be any near- term forecasts for these interventions, they are considered as and when the information is available. Using a combination of forward looking information and a backward-looking assessment of the time series evolution of the determinants of liquidity, projections are generated on a regular basis to inform the RBI's decisions on discretionary liquidity management. Pillar-II is an assessment of system-level liquidity over a relatively longer time horizon, focusing on the likely growth in broad money, bank credit and deposits, the corresponding order of base money expansion and this assessment is then juxtaposed with a breakdown into autonomous and discretionary drivers of liquidity derived under Pillar I. Thus, Pillar II becomes the broader information set within which decisions relating to discretionary liquidity management measures are taken based on Pillar I assessment. Decision regarding discretionary liquidity management operations by RBI The RBI's discretionary liquidity management operations (primarily in the form of variable- rate repos/reverse repos and OMOs) are guided by the extent of LAF deficit that is 'reasonable' at any point of time (measured by amount of net outstanding repo, reverse repo, MSF and standing liquidity facility for primary dealers), and the assessment of the nature of deficit/surplus, i.e., whether it is transient or durable. For managing liquidity of transient nature, LAF/MSF windows are used. However, for managing the liquidity condition of enduring or persistent nature, instruments like LTROs, OMOs, MSS & CRR are used. MSS is used in situations when use of OMOs may not be desirable and/or RBI's own portfolio of securities is not adequate to absorb the surplus system liquidity. The mechanics is explained in the MSS subsection in later paragraph. Calculation of System Liquidity55 We can determine whether and by how much, the system is in deficit or surplus by arriving at the net borrowing/lending from RBI from various windows i.e. LAF/ MSF/ standing liquidity facility (for Primary Dealers) or any other windows/schemes. If the net amount so derived is positive it means banks have borrowed from RBI and system is in deficit, and vice versa. However, excess reserves maintained by banks must be adjusted to the net LAF/MSF/SLF to arrive at the system liquidity. The summarised version of system liquidity is furnished below: System liquidity = Net borrowing under LAF - Excess reserves maintained by banks Net borrowing under LAF = Total of all Repo/MSF/SLF borrowings (–) Total of all Reverse repo deposits 55 Report of the Internal Working Group to Review the Liquidity Management Framework dated September 26, 2019 28 Excess reserves maintained by banks = Actual reserves maintained by banks (–) Required reserves Note: If the system liquidity derived above is positive it would indicate that system liquidity is in deficit and vice-versa. How to determine whether the liquidity condition is enduring or not? Persistent high levels of outstanding RBI Repos or Reverse Repos indicate that the deficit/surplus is of an enduring nature. Durable liquidity or permanent demand for reserves arises from permanent or long-term changes in the liabilities of the Reserve Bank viz., expansion/contraction in currency in circulation, unsterilised Fx intervention operations and decrease/increase of banking system reserves due to changes in net demand and time liabilities of the banking system (NDTL). However, reversible changes in demand/supply of reserves arising from frictional factors such as tax outflows or government expenditure generate temporary mismatches in the banking system liquidity. For example, if the government balances have come down from positive balance of ₹10,000 crore to around Nil, then this would increase the banking system surplus by that amount till such amount flows back to government account in the form of tax collections and other revenues. Similar kind of impact can be observed for the deficit also. Considering all the factors, RBI decides on the nature of the liquidity surplus or deficit and, accordingly, the appropriate instruments are used. Instruments of durable liquidity Traditionally, OMO and MSS operations are used to deal with durable liquidity. The mechanics of these operations are given in following paragraphs. However, recently, the RBI has augmented its liquidity management toolkit to meet the durable liquidity needs of the system through usage of long-term foreign exchange Buy/Sell USDINR swap auctions and introduction of Long Term Repo Operations (LTROs)/Targeted Long Term Repo Operations (TLTROs). The first Buy/Sell auction was conducted for USD 5 billion for a tenor of 3 years on March 26, 2019. LTROs were introduced in February 2020 to augment the liquidity management toolkit. The mechanism of LTROs is similar to repos but they are of longer duration from one to three years. A variant of the same, TLTROs were introduced in March 2020 to provide longer duration money to specific sectors/instruments. Liquidity availed by banks under TLTROs had to be deployed in investment grade corporate bonds, commercial paper, and non-convertible debentures in both primary and secondary markets. In April 2020, RBI announced a Targeted Long-Term Repo Operations 2.0 (TLTRO 2.0) to channel liquidity to small and mid-sized corporates, including non-banking financial companies (NBFCs) and micro finance institutions (MFIs) that had been impacted by COVID-19 disruptions. The funds availed under TLTRO 2.0 had to be deployed in investment grade bonds, commercial paper (CPs) and non-convertible debentures (NCDs) of Non-Banking Financial Companies (NBFCs). At least 50 percent of the total funds availed has to be apportioned as given below: 29  i. 10 per cent in securities/instruments issued by Micro Finance Institutions (MFIs); ii. 15 per cent in securities/instruments issued by NBFCs with asset size of ₹ 500 crore and below; and iii. 25 per cent in securities/instruments issued by NBFCs with assets size between ₹ 500 crore and ₹ 5,000 crore. Mechanics of OMO operations An OMO sale of government securities by the Reserve Bank has the impact of reducing the system liquidity. An OMO purchase of government securities, on the other hand, has the impact of increasing the system liquidity. OMO purchases will lead to increase in RBI investments in the government securities while OMO sales lead to a decrease. OMOs are conducted by RBI through auction mechanism or by directly undertaking transactions in the secondary market. Such direct secondary market transactions are undertaken on NDS-OM (Negotiated Dealing System – Order Matching) platform which is an anonymous order matching platform for Government securities. The data on total amount of OMO purchase or sale transactions by the RBI in the secondary market is published with a lag. For conducting OMO through auction mechanism, announcement is made by RBI through press releases giving details of the amount, date and time of auction and the choice of securities. On the day of auction, after the cut-off time for bidding, the bids are processed and the OMOauction committee in RBI decides on the cut-off yield. The decision is announced by way of press release. The frequency of auctions is generally not pre-determined or pre- announced, unlike the primary auctions conducted as part of Government's market borrowing programme. It