The RBI Act 1934 was instituted with several key objectives at its core. Firstly, it was designed to exercise strict regulation over the issue of banknotes. This is crucial as the proper issuance of currency notes ensures an organized and stable monetary supply within the country. Secondly, the act emphasizes the importance of maintaining reserves. By keeping these reserves, the RBI is better equipped to safeguard monetary stability in India. In a nation with a large and diverse economy like India’s, monetary stability is the bedrock upon which sustainable economic growth can be built. Fluctuations in the value of the currency or instability in the money market can have far – reaching consequences for businesses, consumers, and the overall economic health of the nation.
Establishment of the RBI
Incorporation
As per Section 3 of the RBI Act 1934, the Reserve Bank of India was established on April 1, 1935. It was set up to take over the administration of the currency from the Central Government and carry on the business of banking according to the provisions of this act. Initially, the RBI was a private shareholder’s organization, but it was nationalized in 1949.
Share Capital
The authorized capital of the RBI was initially fixed at ₹5 crores (50 million), divided into shares of ₹100 each. The shares were initially held by private shareholders, but after nationalization, the entire share capital was held by the Government of India.
Functions of the RBI
Monetary Authority
Banknote Issuance (Section 22 – 29): The RBI is the sole authority responsible for the issue of banknotes in India. This function is crucial as it helps in maintaining the integrity and stability of the currency. By having a single entity in charge of note issuance, it becomes easier to control the money supply in the economy. For example, if there is a need to increase the money supply during an economic slowdown, the RBI can print and circulate more banknotes. Conversely, during inflationary periods, it can reduce the rate of note issuance. The RBI issues banknotes of various denominations, and these notes are legal tender throughout India.
Credit Control (Section 42): The RBI is responsible for controlling the credit created by commercial banks. It uses two main techniques for this purpose – quantitative and qualitative procedures. Quantitative measures include tools like the Cash Reserve Ratio (CRR) and the Statutory Liquidity Ratio (SLR). The CRR is the minimum amount of deposits that commercial banks have to hold as reserves with the RBI. Currently, the RBI can ask banks to keep up to 20% of all their demand and time liabilities as reserve. This helps in ensuring that banks do not run out of cash to meet the payment demands of their customers. The SLR requires banks to maintain a certain percentage of their deposits in the form of liquid assets such as government securities. Qualitative measures involve measures like moral suasion, where the RBI persuades banks to follow certain lending policies. For instance, during a housing boom, the RBI might use moral suasion to ask banks to be cautious in lending for real estate projects to prevent a housing bubble.
Banker to the Government
Central and State Governments (Section 20 – 21B): The RBI acts as a banker to both the central and state governments. It transacts all the financial business of the government, which includes the receipt and payment of cash for the government and the execution of its exchange, settlement, and other financial operations. The government keeps its money balance in current account deposits with the RBI. As the banker of the government, the RBI also provides short – term credit to the government to meet any deficits in its receipts over its payments. Additionally, the RBI is responsible for managing the public debt of the government. It manages all new issues of government loans, services the public debt outstanding, and looks after the market for government securities. For example, when the government wants to raise funds through the issuance of bonds, the RBI plays a key role in the process, from setting the terms of the bond issuance to ensuring its smooth sale in the market.
Custodian of Foreign Exchange Reserves
Maintaining Stability (Section 40): To keep the foreign exchange rates stable, the RBI buys and sells foreign currencies and also safeguards the country’s foreign exchange reserves. India has a significant amount of foreign exchange reserves, which as of now is around US$487 bn. When the supply of foreign currency in the domestic market is low, the RBI sells foreign currency from its reserves in the foreign exchange market. This increases the supply of foreign currency, which in turn stabilizes the exchange rate. Conversely, when there is an excess supply of foreign currency, the RBI buys it to add to its reserves. For example, if there is a sudden influx of foreign investment, leading to an appreciation of the Indian rupee, the RBI might buy the foreign currency to prevent the rupee from appreciating too rapidly, as a very strong rupee can harm the country’s export competitiveness.
Regulatory and Supervisory Powers
Scheduled Banks (Section 2(e))
A scheduled bank is defined as a bank whose name is included in the Second Schedule of the RBI Act, 1934. The RBI has regulatory and supervisory powers over scheduled banks. It can set guidelines for their operations, including capital adequacy requirements, lending norms, and disclosure requirements. For example, the RBI might require scheduled banks to maintain a certain level of capital adequacy ratio to ensure their financial stability. This helps in protecting the interests of depositors and maintaining the overall stability of the banking system.
Power of the Central Government (Section 7)
The Central Government has the power to issue directions in the public interest, from time to time, to the RBI in consultation with the RBI governor. This section also gives the power of management and direction of the affairs and business of the RBI to the Central Board of Directors. However, the RBI also has a certain degree of autonomy in its day – to – day operations to carry out its functions effectively. For example, the government might issue directions during a financial crisis to ensure that the RBI takes steps to safeguard the stability of the financial system, such as providing emergency liquidity to troubled banks.
Other Provisions
Open Market Operations (Section 17)
The RBI can engage in open market operations. It can accept money on deposit without interest from the central or state government. It can also sell, purchase, and discount bills of exchange. Under this section, the RBI has wide – ranging authority. It can buy and sell foreign exchange and can also deal with transactions abroad. In open market operations, when the RBI wants to increase the money supply in the economy, it buys government securities from the market. This injects money into the system as the sellers of these securities get cash in return. On the other hand, when it wants to reduce the money supply, it sells government securities, thereby sucking out the excess cash from the market.
Bank Rate (Section 49)
The bank rate is the standard rate at which the RBI is willing to purchase or rediscount certain instruments including bills of exchange or commercial papers. Changes in the bank rate have a significant impact on the lending rates of commercial banks. A higher bank rate will mean higher lending rates by the banks. To control liquidity in the market, the RBI can rely on raising or lowering the bank rate. For example, if there is too much liquidity in the market, leading to inflationary pressures, the RBI can raise the bank rate. This makes it more expensive for banks to borrow from the RBI, and in turn, banks increase their lending rates. As a result, borrowing by businesses and individuals becomes costlier, reducing the demand for credit and thus curbing inflation. The current bank rate is 4.65%.
Conclusion
The RBI Act 1934 is the cornerstone of India’s monetary and banking system. It has provided a comprehensive framework for the functioning of the Reserve Bank of India. Through its various provisions related to monetary management, credit control, being the banker to the government, and custodian of foreign exchange reserves, the RBI has played a crucial role in maintaining the stability of India’s currency and credit system. Over the years, with amendments to the act, the RBI has been able to adapt to the changing economic scenarios, both domestically and globally. Whether it is controlling inflation, ensuring the stability of the banking sector, or promoting economic growth, the provisions of the RBI Act 1934 have enabled the RBI to carry out its functions effectively. However, as the Indian economy continues to evolve and integrate more with the global economy, further amendments to the act may be required to ensure that the RBI can continue to meet the challenges and opportunities of the future.
Related topics
