economic reforms and money market -- by syed adnan

8/6/2019 economic reforms and money market -- by Syed Adnan

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ROLE OF ECONOMIC REFORMS IN THE

GROWTH OF INDIAN MONEY MARKET

SINCE 2000

SUBMITTED IN PARTIAL REQUIRMENT FOR THE FULFILMENT OF THE

AWARD OF POST GRADUATE DIPLOMA IN BUSINESS FINANCE

(PGDBF)

SUBMITTEDBY

ADNAN KHUSRO WASTI

EE-1595

09-DBF-13

SUBMITTED

TO

PROF. ABDUL QUAYYUM KHANDEPTT. OF COMMERCE

AMU,ALIGARH

Certificate

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D e d i c a t e d T oMy P a r e n t s

&My F a m i ly

Contents

Acknowledgement

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Introduction

Chapter-1 Economic Reforms in Indian Money Market Since 2000

Chapter-2 Regulations of Money Market in India

Chapter-3 Money Market and its Instruments

Chapter-4 Future Prospects and Strategies for Indian Money

Market

Chapter-5 Conclusions and Suggestions

Bibliography

ACKNOWLEDGEMENT

I have first to bow myself in front of the Almighty ALLAH for his constant shower of

blessings which made this task accomplish bearing all phases of ups and downs.

It is my proud privilege to acknowledge my deep gratitude to my supervisor Prof. Dr

Abdul Qayyum KhanProfessor, Department of Commerce, A.M.U., Aligarh, for this

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Meaning of Money Market:

Money market refers to the market where money and highly liquid marketable

securities are bought and sold having a maturity period of one or less than one year. It is

not a place like the stock market but an activity conducted by telephone. The money

market constitutes a very important segment of the countrys financial system.

The highly liquid marketable securities are also called as money market

instruments like treasury bills, government securities, commercial paper, certificates of

deposit, call money, repurchase agreements etc.

The major player in the money market are central Bank of a country, like in

indian money market the Reserve bank of India plays an important role in regulating its

affairs and acts as an apex body beside RBI there are other institutions also like Discount

and Finance House of India (DFHI), banks, financial institutions, mutual funds,

government, big corporate houses. The basic aim of dealing in money market instruments

is to fill the gap of short-term liquidity problems or to deploy the short-term surplus to

gain income on that.

Definition of Money Market:

According to the McGraw Hill Dictionary of Modern Economics, money market is

the term designed to include the financial institutions which handle the purchase, sale,

and transfers of short term credit instruments. The money market includes the entire

machinery for the channelizing of short-term funds. Concerned primarily with small

business needs for working capital, individuals borrowings, and government short term

obligations, it differs from the long term or capital market which devotes its attention to

dealings in bonds, corporate stock and mortgage credit.

According to the Reserve Bank of India, money market is the centre for dealing,

mainly of short term character, in money assets; it meets the short term requirements of

borrowings and provides liquidity or cash to the lenders. It is the place where short term

surplus investible funds at the disposal of financial and other institutions and individuals

are bid by borrowers agents comprising institutions and individuals and also the

government itself.

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According to the Geoffrey, money market is the collective name given to the various

firms and institutions that deal in the various grades of the near money.

Objectives of Money Market:

A well developed money market serves the following objectives:

Provides an equilibrium mechanism for ironing out short-term surplus and

deficits.

Provides a focal point for central bank intervention for the influencing liquidity in

the economy.

Provides access to the users of short-term money to meet their requirements at a

reasonable price.

General Characteristics of Money Market:

The general characteristics of money market are outlined below:

Short-term funds are borrowed and lent.

No fixed place for conduct of operations, the transactions being conducted even

over the phone and therefore, there is an essential need for the presence of well

developed communications system.

Dealings may be conducted with or without the help of the brokers.

The short-term financial assets that are dealt in are close substitutes for money,

financial assets being converted into money with ease, speed, without loss and

with minimum transaction cost.

Funds are traded for a maximum period of one year.

Presence of a large number of submarkets such as inter-bank call money, billrediscounting, and treasury bills, etc.

Indian money market:

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Till 1935, when the RBI was set up the Indian money market remained highly

disintegrated, unorganized, narrow, shallow and therefore, very backward. The planned

economic development that commenced in the year 1951 market an important beginning

in the annals of the Indian money market. The nationalization of banks in 1969, setting

up of various committees such as the Sukhmoy Chakraborty Committee (1982), the

Vaghul working group (1986), the setting up of discount and finance house of India ltd.

(1988), the securities trading corporation of India (1994) and the commencement of

liberalization and globalization process in 1991 gave a further fillip for the integrated and

efficient development of India money market.

The Indian money market is not an integrated unit. It is broadly divided into two

parts the organised and unorganised sector. There is compartmentalisation between the

two sectors and as such the rate of interest different in organised sector as compared to

that of unorganised. The unorganised sector comprises of primarily indigenous bankers

and money lenders. Money lenders and indigenous bankers differs from one another in

many aspects, their organisation and operations are not same and have very little business

relations with each other that is totally different from modern banking system.

On the other hand the organised sector of Indian money market is fairly

integrated in one. Both the nationalised and commercial banks constitute the core of this

sector. The Reserve bank of India(RBI), foreign banks, co-operative banks, Discount and

Finance house of india(DFHI), other discounting and finance institutions like IDBI,

ICICI, IFCI etc. investment finance companies like LIC, GIC, UTI and mutual funds

market operates in this sector. The RBI is the apex institution in Indian money market

and hence it leads and controls the money market and keeps a keen insight on its

functioning,it has great responsibility in smooth functioning of financial system of the

country especially in terms of money market.

Since the Reserve Bank of India is the most important constituent of the

money market and the market comes within the direct preview of the Reserve Bank of

India regulations.

Therefore the aims of the Reserve Banks operations in the money market are as follows:

To ensure that liquidity and short term interest rates are maintained at consistent

levels with the monetary policy objectives of maintaining price stability.

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To ensure an adequate flow of credit to the productive sector of the economy and,

To bring about order in the foreign exchange market .

The Reserve Bank of India influence liquidity and interest rates through a number

of operating instruments - cash reserve requirement (CRR) of banks, conduct of open

market operations (OMOs), repos, change in bank rates and at times, foreign exchange

swap operations.

Composition of indian money market:

The Indian money market has been catagorised into unorganised and organised sectors .

The unorganised sector consists of indigenous bankers who pursue the banking business

on traditional lines and non banking financial corporations (NBFCs). The organised

sector comprises of RBI, the SBI and its associate banks, 20 nationalised banks and

other commercial banks (both Indian & foreign) The organised money market in india

has a number of sub-markets the treasury bill market, the commercial bill market & the

inter-bank call money market.

Un-organised sector of indian money market:

The banking facilities of un-organised sector is mainly confined and specific to small

towns and villages where modern banking facilities are still inadequate. Farmers, artisans

and other small scale producers and traders who do not have access to modern banks

borrows money from this sector.

In India, there are several types of unregulated non-banking financial intermederies

among these the most prominent are money lenders, indigenous bankers, chit funds and

nidhis. These non-banking financial intermederies mostly give loans and advances to

farmers, artisans, wholesale traders and other self-employed people and charge high rate

of interest varying from 36% to 48%.

The chit funds are saving institutions and has regular members who made periodical

subscriptions to the funds. The nidhis are somewhat like mutual funds as their dealings

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Investment in money market is done through money market Instruments. Money market

instrument meets short term requirements of the borrowers and provides liquidity to the

lenders. Common Money Market Instruments are as follows:

Treasury Bills (T-Bills):

Treasury Bills, one of the safest money market instruments, are short term borrowing

instruments of the Central Government of the Country issued through the Central Bank

(RBI in India). They are zero risk instruments, and hence the returns are not so attractive.

It is available both in primary market as well as secondary market. It is a promise to pay a

said sum after a specified period. T-bills are short-term securities that mature in one year

or less from their issue date. They are issued with three-month, six-month and one-year

maturity periods. The Central Government issues T- Bills at a price less than their face

value (par value). They are issued with a promise to pay full face value on maturity. So,

when the T-Bills mature, the government pays the holder its face value. The difference

between the purchase price and the maturity value is the interest income earned by the

purchaser of the instrument. T-Bills are issued through a bidding process at auctions. The

bid can be prepared either competitively or non-competitively. In the second type of

bidding, return required is not specified and the one determined at the auction is received

on maturity. Whereas, in case of competitive bidding, the return required on maturity is

specified in the bid. In case the return specified is too high then the T-Bill might not be

issued to the bidder. At present, the government of India issues three types of treasury

bills through auctions, namely, 91-day, 182-day and 364-day. There are no treasury bills

issued by State Governments. Treasury bills are available for a minimum amount of

Rs.25K and in its multiples. While 91-day T-bills are auctioned every week on

Wednesdays, 182-day and 364- day T-bills are auctioned every alternate week on

Wednesdays. The Reserve Bank of India issues a quarterly calendar of T-bill auctions

which is available at the Banks website. It also announces the exact dates of auction, the

amount to be auctioned and payment dates by issuing press releases prior to every

auction. Payment by allottees at the auction is required to be made by debit to their

custodians current account. T-bills auctions are held on the Negotiated Dealing System

(NDS) and the members electronically submit their bids on the system. NDS is an

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electronic platform for facilitating dealing in Government Securities and Money Market

Instruments. RBI issues these instruments to absorb liquidity from the market by

contracting the money supply. In banking terms, this is called Reverse Repurchase

(Reverse Repo). On the other hand, when RBI purchases back these instruments at a

specified date mentioned at the time of transaction, liquidity is infused in the market. This

is called Repo (Repurchase) transaction.

R epurchase Agreements:

Repurchase transactions, called Repo or Reverse Repo are transactions or short term

loans in which two parties agree to sell and repurchase the same security. They are

usually used for overnight borrowing. Repo/Reverse Repo transactions can be done only

between the parties approved by RBI and in RBI approved securities viz. central

government and State Govt Securities, T-Biliis, government bonds, Corporate bonds etc.

Under repurchase agreement the seller sells specified securities with an agreement to

repurchase the same at a mutually decided future date and price. Similarly, the buyer

purchases the securities with an agreement to resell the same to the seller on an agreed

date at a predetermined price. Such a transaction is called a Repo when viewed from the

perspective of the seller of the securities and Reverse Repo when viewed from the

perspective of the buyer of the securities. Thus, whether a given agreement is termed as a

Repo or Reverse Repo depends on which party initiated the transaction. The lender or

buyer in a Repo is entitled to receive compensation for use of funds provided to the

counterparty. Effectively the seller of the security borrows money for a period of time

(Repo period) at a particular rate of interest mutually agreed with the buyer of the

security who has lent the funds to the seller. The rate of interest agreed upon is called the

Repo rate. The Repo rate is negotiated by the counterparties independently of the coupon

rate or rates of the underlying securities and is influenced by overall money market

conditions.

Commercial Papers:

Commercial paper is a low-cost alternative to bank loans. It is a short term unsecured

promissory note issued by corporate and financial institutions at a discounted value on

face value. They are usually issued with fixed maturity between one to 270 days and for

financing of accounts receivables, inventories and meeting short term liabilities. Say, for

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example, a company has receivables of Rs 1 lacs with credit period 6 months. It will not

be able to liquidate its receivables before 6 months. The company is in need of funds. It

can issue commercial papers in form of unsecured promissory notes at discount of 10%

on face value of Rs 1 lacs to be matured after 6 months. The company has strong credit

rating and finds buyers easily. The company is able to liquidate its receivables

immediately and the buyer is able to earn interest of Rs 10K over a period of 6 months.

They yield higher returns as compared to T-Bills as they are less secure in comparison to

these bills; however chances of default are almost negligible but are not zero risk

instruments. Commercial paper being an instrument not backed by any collateral, only

firms with high quality credit ratings will find buyers easily without offering any

substantial discounts. They are issued by corporates to impart flexibility in raising

working capital resources at market determined rates. Commercial Papers are actively

traded in the secondary market since they are issued in the form of promissory notes and

are freely transferable in deemat form.

C ertificate of Deposit:

It is a short term borrowing more like a bank term deposit account. It

is a promissory note issued by a bank in form of a certificate entitling the bearer to

receive interest. The certificate bears the maturity date, the fixed rate of interest and the

value. It can be issued in any denomination. They are stamped and transferred by

endorsement. Its term generally ranges from three months to five years and restricts the

holders to withdraw funds on demand. However, on payment of certain penalty the

money can be withdrawn on demand also. The returns on certificate of deposits are

higher than T-Bills because it assumes higher level of risk. While buying Certificate of

Deposit, return method should be seen. Returns can be based on Annual Percentage Yield

(APY) or Annual Percentage Rate (APR). In APY, interest earned is based on

compounded interest calculation. However, in APR method, simple interest calculation is

done to generate the return. Accordingly, if the interest is paid annually, equal return is

generated by both APY and APR methods. However, if interest is paid more than once in

a year, it is beneficial to opt APY over APR.

Bankers Acceptance:

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It is a short term credit investment created by a non financial firm and guaranteed by a

bank to make payment. It is simply a bill of exchange drawn by a person and accepted by

a bank. It is a buyers promise to pay to the seller a certain specified amount at certain

date. The same is guaranteed by the banker of the buyer in exchange for a claim on the

goods as collateral. The person drawing the bill must have a good credit rating otherwise

the Bankers Acceptance will not be tradable. The most common term for these

instruments is 90 days. However, they can very from 30 days to180 days. For

corporations, it acts as a negotiable time draft for financing imports, exports and other

transactions in goods and is highly useful when the credit worthiness of the foreign trade

party is unknown. The seller need not hold it until maturity and can sell off the same in

secondary market at discount from the face value to liquidate its receivables.

Reference:

Indian Financial System (2004) By Bharati V. Pathak.

Financial Service and Market (2005) -By Dr.S.Guruswamy.

Money and Banking (Chartered And Financial Analyst Of India) Edition April 2009.

Financial Institution and Market (2007)- Bhole, L.M.

Money and Banking (2005)- Mithani D. M.

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CHAPTER-2

Economic reforms in Indian Money market

(With special reference from 2000)

Need for Reforms

The Indian financial system of the pre-reform period essentially catered to the

needs of planned development in a mixed-economy framework where the government

sector had a predominant role in economic activity. As part of planned development, the

macro-economic policy in India moved from fiscal neutrality to fiscal activism. Such

activism meant large developmental expenditures, much of it to finance long-gestation

projects fine rates, and understandably at below the market rates for private sector. In

order to facilitate the large borrowing requirements of the Government, interest rates on

Government securities were artificially pegged at low levels, which were unrelated to

market conditions. The government securities market, as a result, lost its depth as the

concessional rates of interest and maturity period of securities essentially reflected the

needs of the issuer (Government) rather than the perception of the market. The provision

of fiscal accommodation through ad hoc treasury bills (issued on tap at 4.6 per cent) led

to high levels of monetization of fiscal deficit during the major part of the eighties. In

order to check the monetary effects of such large-scale monetization, the cash reserve

ratio (CRR) was increased frequently to control liquidity.

The environment in the financial sector in these years was thus characterized by

segmented and underdeveloped financial markets coupled with paucity of instruments.

The existence of a complex structure of interest rates arising from economic and social

concerns of providing concessional credit to certain sectors resulted in cross

subsidization which implied that higher rates were charged from non-concessional

borrowers. The regulation of lending rates, led to regulation of deposit rates to keep cost

of funds to banks at reasonable levels, so that the spread between cost of funds and return

on funds is maintained. The system of administered interest rates was characterized by

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detailed prescription on the lending and the deposit side leading to multiplicity and

complexity of interest rates. By the end of the eighties, the financial system was

considerably stretched. The directed and concessional availability of bank credit with

respect to certain sectors resulted not only in distorting the interest rate mechanism, but

also adversely affected the viability and profitability of banks. The lack of recognition of

the importance of transparency, accountability and prudential norms in the operations of

the banking system led also to a rising burden of non-performing assets.

In sum, there was a de facto joint family balance sheet of Government, RBI and

commercial banks, with transactions between the three segments being governed by plan

priorities rather than sound principles of financing inter-institutional transactions. There

was a widespread feeling that this joint family approach, which sought to enhance

efficiency through coordinated approach, actually led to loss of transparency, of

accountability and of incentive to measure or seek efficiency.

The policies pursued did have many benefits, although the issue of the higher

costs incurred to realize the laudable objectives remains. Thus, the post-nationalization

phase witnessed significant branch expansion to mobilize savings and there was a visible

increase in the flow of bank credit to important sectors like agriculture, small-scale

industries, and exports. However, these achievements have to be viewed against the

macro-economic imbalances as well as gross inefficiencies at the micro level in the

financial sector compounded by non- transparent accounting of intra-public financial

transactions.

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Institutional Aspects of Reforms

Institutions

At present, the institutional structure of the financial system is characterized by

banks, either owned by the Government public or private (domestic or foreign) and

regulated by the RBI; development financial institutions and refinancing institutions, set

up either by a separate statute or under Companies Act, either owned by Government,

RBI, private or other development financial institutions and regulated by the RBI and

non-bank financial companies (NBFCs), owned privately and regulated by the RBI.

Since the onset of reforms, there has been a change in the ownership pattern of

banks. The legislative framework governing public sector banks (PSBs) was amended in

1994 to enable them to raise capital funds from the market by way of public issue of

shares. Many public sector banks have accessed the markets since then to meet the

increasing capital requirements, and until 2001-02, Government made capital injections

out of the Budget to public sector banks, totaling about 2 per cent of GDP. The

Government has initiated legislative process to reduce the minimum Government

ownership in nationalized banks from 51 to 33 per cent, without altering their public

sector character. The underlying rationale of the proposal appears to be that the salutary

features of public sector banking is not in the transformation process. Reforms have

altered the organizational forms, ownership pattern and domain of operations of financial

institutions (FIs) on both the asset and liability fronts. Drying up of low cost funds has

led to an intensification of the competition for resources for both banks and FIs. At the

same time, with banks entering the domain of term lending and FIs making a foray into

disbursing short-term loans, advisory services and the like. Currently, while Industrial

Credit and Investment Corporation of India Ltd. (ICICI) is in the process of finalizing its

merger with ICICI Bank, Industrial Development Bank of India (IDBI) is also expected

to be corporatized soon. At present, the RBI holds shares in a number of institutions. Thefurther reform agenda is to divest the RBI of all its ownership functions.

In the light of legal amendments in 1997, the regulatory focus of the NBFCs was

redefined, both in terms of thrust as well as the focus. While NBFCs accepting public

deposits have been subject to the entire gamut of regulations, those not accepting public

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deposits have been sought to be regulated in a limited manner. In order to consolidate the

law relating to the NBFCs, regulation is being framed to cover detailed norms with

regard to entry point and the regulatory and supervisory issues.

Competition

Steps have also been initiated to infuse competition into the financial system. The

RBI issued guidelines in 1993 is respect of establishment of new banks in the private

sector. Likewise, foreign banks have been given more liberal entry. Recently, the norms

for entry of new private banks were rationalized . Two new private sector banks have

been given in-principle approval under these revised guidelines. The Union Budget

2002-03 has also provided a fillip to the foreign banking segment, permitted these banks,

depending on their size, strategies and objectives, to choose to operate either as branches

of their overseas parent or corporatize as domestic companies. This is expected to impart

greater flexibility in their operations and provide them with a level-playing field vis--vis

their domestic counterparts. As a group, however, the performance of PSBs in terms of

profitability, spreads, non-performing assets and standard assets position seems to have

been lower than that of the new private sector and foreign banks. There have been

significant divergences in performance among the public sector banks - some have

performed on par with private and foreign banks, whereas the performance of others hasbeen relatively unsatisfactory. Hence, although PSBs have been subject to Government

intervention, these do not appear to provide a complete explanation of bank performance.

Bank specific factors such as rapid expansion, higher operating costs and differential

industry focus seem to have been important considerations as well.

Public sector banks operating in the same environment with the same constraints

have shown varied performance; ultimately this reflects the performance of management.

Regulation and Supervision

A second major element of financial sector reforms in India has been a set of

prudential measures aimed at imparting strength to the banking system as well as

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ensuring safety and soundness through greater transparency, accountability and public

credibility.

Capital adequacy norms for banks are in line with the Basel Committee standards

and from the end of March 2000, the prescribed ratio has been raised to 9 percent. While

the objective has been to meet the international standards, in certain cases, fine-tuning

has occurred keeping in view the unique country-specific circumstances. For instance,

risk weights have been prescribed for investment in Central Government securities on

considerations of interest rate risk. Also, while there is a degree of gradualism, there is

intensification beyond the 'best practices' in several instances in recent period, an

example being exposure norms stipulated for the banking sector in respect of investment

in equity. Investments are valued and classified into appropriate categories, as per

international best practices. To take into account the vagaries of interest rate risks, a

prescription for meeting a targeted Investment Fluctuation Reserve out of the realized

profits from sale of investments within a stipulated time frame has also been prescribed

recently. The supervisory strategy of the Board for Financial Supervision (BFS)

constituted as part of reform consists of a four-pronged approach, including restructuring

system of inspection, setting up of off-site surveillance, enhancing the role of external

auditors, and strengthening corporate governance, internal controls and audit procedures.

The BFS, in effect, integrates within the Reserve Bank the supervision of banks, NBFCs

and financial institutions.

Prudential regulations have had a significant impact on the banking system in

terms of ensuring system stability even in the face of both external and internal

uncertainties, almost throughout during the second half of the nineties. As at end-March

2001, 95 out of 100 scheduled commercial banks had capital adequacy ration of 9 per

cent or more. There was a distinct improvement in the profitability of public sector banks

measured in terms of operating profits as well as in terms of net profits to total assets.Reflecting the efficiency of the intermediation process, there has been a decline in the

spread between the borrowing and lending rates as reflected by the decline in the ratio of

net interest income to total assets. The most significant improvement has been in terms of

reduction in NPAs.

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Policy Environment

Changing Monetary Policy Framework

Since the onset of the reforms process, monetary management in terms of

framework and instruments has undergone significant changes, reflecting broadly the

transition of the economy from a regulated to liberalized and deregulated regime. While

the twin objectives of monetary policy of maintaining price stability and ensuring

availability of adequate credit to productive sectors of the economy to support growth

have remained unchanged; the relative emphasis on either of these objectives has varied

over the year depending on the circumstances. Reflecting the development of financial

markets and the opening up of the economy, the use of broad money as an intermediate

target has been de-emphasized, but the growth in broad money continues to be used as an

important indicator of monetary policy. The composition of reserve money has also

changed with net foreign exchange assets currently accounting for nearly one-half. A

multiple indicator approach was adopted in 1998-99 and further renewed in 2002-2003,

wherein interest rates or rates of return in different markets (money, capital and

government securities markets) along with such data as on currency, credit extended by

banks and financial institutions, fiscal position, trade, capital flows, inflation rate,

exchange rate, refinancing and transactions in foreign exchange available on high

frequency basis were juxtaposed with output data for drawing policy perspectives. Such a

shift was gradual and a logical outcome of measures taken over the reform period since

early nineties.

The thrust of monetary policy in recent years has been to develop an array of instruments

to transmit liquidity and interest rate signals in the short-term in a more flexible and bi-

directional manner. A Liquidity Adjustment Facility (LAF) has been introduced since

June 2000 to precisely modulate short-term liquidity and signal short-term interest rates.

The LAF, in essence, operates through repo and reverse repo auctions thereby setting acorridor for the short-term interest rate consistent with policy objectives. There is now

greater reliance on indirect instruments of monetary policy. The RBI is able to modulate

the large market borrowing programme by combining strategic debt management with

active open market operations. Bank Rate has emerged as a reasonable signally rate while

the LAF rate has emerged as both a tool for liquidity management and signaling of

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interest rates in the overnight market. The RBI has also been able to use open market

operations effectively to manage the impact of capital flows in view of the stock of

marketable Government securities at its disposal and development of financial markets

brought about as part of reform.

The responsibility of the RBI in undertaking reform in the financial markets has

been driven mainly by the need to improve the effectiveness of the transmission channel

of monetary policy. The developments of financial markets have therefore, encompassed

regulatory and legal changes, building up of institutional infrastructure, constant fine-

tuning in market microstructure and massive upgradation of technological infrastructure.

Since the onset of reforms, a major focus of architectural policy efforts has been on the

principal components of the organized financial market spectrum: the money market,

which is central to monetary policy, the credit market, which is essential for flow of

resources to the productive sectors of the economy, the capital market, or the market for

long-term capital funds, the Government securities market which is significant from the

point of view of developing a risk-free credible yield curve and the foreign exchange

market, which is integral to external sector management. Along with the steps taken to

improve the functioning of these markets, there has been a concomitant strengthening of

the regulatory framework.

The medium-term objective at present is to make the call and term money market purely

inter-bank market for banks, while non-bank participants, who are not subject to reserve

requirements, can have free access to other money market instruments and operate

through repos in a variety of instruments. The Clearing Corporation of India Ltd is

expected to facilitate the development of a repo market in a risk free environment for

settlement. A phased programme for moving out of the call money market has already

been announced and the final phase-out will coincide with the implementation of the Real

Time Gross Settlement (RTGS) system. Further reform is being contemplated in terms of

reduction of CRR to the statutory minimum of 3 per cent, removal of established lines of

refinance, limits on call money borrowing lending and borrowing by banks and PDs and

a move over to a full-fledged LAF. With the switchover to borrowings by Government at

market related interest rates through auction system in 1992 and then again revised in

2004 it was possible to progress towards greater market orientation in Government

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securities. Further reforms in the Government Securities market have resulted in the

rationalization of T-Bills market, increase in instruments and participants, elongated the

maturity profile, created greater fungibles in the secondary market, instituted a system of

delivery versus payment, strengthened the institutional framework through Primary

Dealers and more recently Clearing Corporation, and enhanced the transparency in the

market operations. Clarity in the regulatory framework has also been established with the

amendment to the Securities Contracts Regulation Act. A Negotiated Dealing System for

trading in Government Securities is in operation. Further developments in the

Government Securities market hinges on legislative changes consistent with modern

technology and market practices; introduction of a RTGS system, integrating the

payments and settlement systems for Government securities and standardization of

practices with regard to manner of

quotes, conclusion of deals and code of best practices for repo transactions. The

movement to a market-based exchange rate regime took place in 1993. Reforms in the

foreign exchange market have focused on market development with prudential safeguards

without destabilizing the market. Thus, authorized dealers have been given the freedom

to initiate trading position in the overseas markets; borrow or invest funds in the overseas

markets (up to 15 percent of tier I capital, unless otherwise approved); determine the

interest rates (subject to a ceiling) and maturity period of Foreign Currency Non-Resident

(FCNR) deposits (not exceeding three years); and use derivative products for asset-

liability management. These activities are subject to net overnight position limit and gap

limits, to be fixed by them. Other measures such as permitting forward cover for some

participants, and the development of the rupee-forex swap markets also have provided

additional instruments to hedge risks and help reduce exchange rate volatility. Alongside

the introduction of new instruments (cross-currency options, interest rates and currency

swaps, caps/collars and forward rate agreements), efforts were made to develop the

forward market and ensure orderly conditions. Foreign institutional investors were

allowed entry into forward markets and exporters have been permitted to retain a

progressively increasing proportion of their earnings in foreign currency accounts. The

RBI conducts purchase and sale operations in the forex market to even out excess

volatility.

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In respect of the financial markets, linkage between the money, Government Securities

and forex markets has been established and is growing. The price discovery in the

primary market is more credible than before and secondary markets have acquired greater

depth and liquidity. The number of instruments and participants in the markets has

increased in all markets, the most impressive being the Government Securities market.

The institutional and technological infrastructures that have been created by the RBI to

enable transparency in operations and secured settlement systems. The presence of

foreign institutional investors has strengthened the integration between the domestic and

international capital markets.

Credit Delivery

The reforms have accorded greater flexibility to banks to determine both the volume and

terms of lending. The RBI has moved away from micro regulation of credit to macro

management. External constraints to the banking system in terms of the statutory

preemptions have been lowered. All this has meant greater lendable resources at the

disposal of banks. The movement towards competitive and deregulated interest rate

regime on the lending side has been completed with linking of all lending rates to PLR of

the concerned bank and the PLR itself has been transformed into a benchmark rate.

As a result of reforms, borrowers are able to the get credit at lower interest rates.

The lending rate between 1991-92 and 2001-02 has declined from about 19.0 per cent to

current levels of 10.5-11.0 per cent and further in 2004-2005 to a level of 10.3 percent.

The actual lending rates for top rated borrowers could even be lower since banks are

permitted to lend at below Prime Lending Rate (PLR). Further, since banks invest in

Commercial Paper (CP), which is more directly related to money market rates, many top

rated borrowers are able to tap bank funds at rates below the prime lending rates. These

developments have been possible to banks because the overall flexibility now available in

the interest rate structure has enabled them to reduce their deposit rates and still improve

their spreads.

In terms of priority sector credit also, the element of subsidization has been removed

although some sort of directed lending to Agriculture, Small Scale Industry (SSI) and

export sector have been retained. The definition of priority sector has been gradually

increased to help banks make loans on commercially viable terms. However, the actual

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retailing of government securities. While technological, institutional and procedural

bottlenecks for retailing are being overcome by RBI, some of the constraints such as tax

treatment and relatively high administered interest rates do persist banking and insurance

sectors. RBI has so far been able to successfully reconcile the interests of Government as

its debt manager and of banks as regulator and supervisor. In this regard, recognizing the

importance of containing interest rate risks and widening the participant profile, RBI has

prescribed an Investment Fluctuation Reserve for banks and is pursuing retailing of

government securities. While technological, institutional and procedural bottlenecks for

retailing are being overcome by RBI, some of the constraints such as tax treatment and

relatively high administered interest rates do persist.

The conduct of borrowing programme of State Governments is, however, posing several

problems. While the market borrowing programme of states in aggregate is well below a

quarter of centers market borrowings, in a liberalized environment, banks cannot be

compelled to subscribe to the programme. It was necessary to provide investors a

premium for states paper over the centres paper of a comparable maturity. Of late, the

premium is widening and differing as between states, while in the case of some states,

there have been some difficulties in ensuring subscriptions. In recent years, the increases

in states budgeted borrowing programme have been large with the attendant problems of

garnering subscriptions. It has, however, been possible for RBI to conduct the

programme without serious disruption in the markets, since some states have also begun

to take initiatives to improve their fiscal profile and discharge their liabilities, especially

to banks, in a timely fashion. It is necessary to recognise that size of government

borrowings is only one element in public debt management, since there are other

liabilities also, especially ballooning of pension liabilities.

In this regard, extra budgetary transactions are also emerging, which impinge on the

balance sheets of banks and other financial institutions which take an exposure on them.

For example, oil bonds to settle governments dues to public sector oil companies and

power bonds to settle dues from State Electricity Boards to national level power

utilities fall in this category. Banks exposure to food credit, which is in the nature of

funding of buffer stock operations is also relatively large at over 2.0% of GDP. RBI had

been advocating that a law be passed imposing a ceiling on government borrowings as

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enabled by the Constitution, but more recently, a Bill is under contemplation for fiscal

responsibility at the centre and several states. Financial intermediaries, especially banks,

take exposures with a great degree of comfort when there is a sovereign guarantee. Such

guarantees are often formally extended and notified as such to the legislative bodies and

financial markets. RBI has encouraged governments to pass a legislation prescribing a

ceiling on such guarantees and also charge a fee without exception to ensure credibility to

guarantees and comfort to subscribers. Several State Governments have passed such

legislations, though some are less stringent than others. In view of the magnitudes of such

guarantees by many States, banks have been advised to exercise due diligence in

subscribing to them. Apart from explicit guarantees, recourse is occasionally made by

governments to letters of comfort which have a similar effect, and RBI has been

dissuading such relatively non-transparent practices.

There are, in addition, what may be termed as implicit-guarantees which have

maximum linkage between fiscal and financial sectors. A predominant point of financial

intermediation through banks, mutual funds, and insurance, in spite of significant reform

is undertaken by publicly owned or government backed financial institutions. Hence,

public tend to repose confidence with a corresponding implicit direct obligation on the

part of government to protect the interests of depositors or investors. Such a reasonable

expectation is not only justified on the considerations of reputational risk and the concept

of holding out or backing, but also by the obligations discharged in the past by the

Government of India, in several cases; some of them at the instance of regulator

concerned. In some cases, banks and financial institutions seek and obtain instructions

for direct debit of dues to them from government accounts to ensure the timely recovery

of dues to them and thus bring about comfort through credit enhancement. Since large

scale recourse to such mechanisms, especially when State Governments are under fiscal

strain has the potential of eroding both the integrity of budget process and the de facto

comfort to financial intermediaries, RBI has been vigorously advocating avoidance of

recourse to such direct debit mechanisms.

The governments have, in its asset portfolio, equity holding and some debts of financial

intermediaries that they own, and financial returns on these do impact the fiscal situation.

More important, whenever pockets of vulnerability arise in financial sector, the headroom

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available in the fiscal situation to provide succour to financial entities needs to be

assessed. Fortunately, on present reckoning, the magnitudes of the few pockets of

vulnerability appear to be manageable without undue fiscal strain.

In assessing fiscal financial linkage, the scope for money financing of budgets vis--vis

bond financing also needs to be considered. Since there are elements of open capital

account, the maneuverability for RBI in the short-term to monetize governments deficit

is severely circumscribed by the direction and magnitudes of such flows. Keeping these

considerations in view, RBI and Government have agreed upon freedom to RBI to

determine the extent of monetization of government budget consistent with macro-

economic stability.

Financial Sector Reform and Changes in Law

Any reform has both public and private dimensions, and ideally all participants

should recognize the emerging new realities, assess costs and benefits and make attempts

to cope. Reform outcomes should thus, be related not only to public action but also

several other factors. In public action itself, there can be legal, policy and procedural

aspects including subordinate legislations and institutional changes. There are

possibilities of significant policy and procedural changes within a given legal framework

and these need to be explored since changes in law are often difficult to get through in

any democratic process.

RBI has been articulating the need for appropriate changes in Law, assisting the

Government in the process and has also been brining about changes in the financial sector

without necessarily waiting for changes in law. Thus, several legislative measures

affecting ownership of banks, IDBI, debt recovery, regulation of non banking financial

companies, foreign exchange transactions and money market have been completed.

Those on the anvil include measures relating to fiscal and budget management, public

debt, deposit insurance, securitization and foreclosure, and prevention of money

laundering. The agenda for further legal reform, as identified by several Advisory Groups

relate to RBI, Banking Regulations, Companies, Chartered Accountant, Income-tax,

Bankruptcy, Negotiable Instruments, Contracts, Unit Trust of India, etc.

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The legislative process is complex in a democratic set up and it will be inadvisable to

rush into legislation through a big bang approach. Furthermore, many elements of

economic reform and underlying legislative framework need to be harmonized. At the

same time, it may not be necessary to wait for legislative framework to change to bring

about some of the reforms or initiate processes to demonstrate usefulness of reform-

orientation. In fact, there are several examples of managing reform within constraints of

law which need to be recalled. For example, there are some enabling but not mandated

provisions which may or may not be used. Thus, RBI had shed its direct developmental

role in the sense of money financing, by ceasing to operate on relevant provision and by

and large, confining money creation for Government of India only. Supplemental

agreement to terminate automatic monetization (WMA) of governments deficit has been

used, by way of a signed agreement between RBI and Government of India, though a

legislative compulsion in still under consideration as part of Fiscal Responsibility and

Management Bill.

In several cases, contracts with stipulated conditions have been framed in the

absence of specific law governing such transactions. Examples relate to regulation of

Clearing Houses; operating current payment systems and functioning of electronic

trading even before instructions under I.T. Act came into force. Similarly, it has been

possible to invoke prudential regulations over RBI regulated financial institutions to

effectuate best practices in financial markets, though the legal compulsion as a regulation

on all market participants may not be possible; the example of successes achieved are

dematerialisation of Commercial Paper and Demateralisation of Debt instruments,

brought about in the requirements on Banks and financial institutions. There could also

be use of incentives to conform though legal or formal regulation may be difficult.

Examples relate to valuation and accounting norms being performed by a self regulatory

organization and adopted by banks and proposals relating to information sharing with

Credit Information Bureau pending legislative initiatives. A deliberate decision may be

taken not to use regulatory powers, thus enabling development of markets. For example,

current account convertibility in external sector was implemented even before a new law

was introduced by recourse to large scale relaxations. Similarly, Credit Guarantee was

virtually given up though a new law is yet to be enacted giving up the credit-guarantee

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function of Deposit Insurance Guarantee Corporation. In all these cases, however, a

positive approach to law to enable reform was possible because of clarity about what was

to be done and finding of legal ways of doing even if it were second best.

Managing Uncertainties During Reform

Reforms in the financial sector had to be implemented keeping in view not only the

desirable directions and appropriate measures carefully sequenced, but also the emerging

uncertainties, both in domestic and global arena. By all accounts, India has managed the

uncertainties reasonably well. Recognizing that such uncertainties have a tendency to

impact the exchange rate, it is instructive to briefly review the processes of management

and drawn some tentative lessons. The Gulf crisis, which triggered the reform process

was managed without any reschedulement of any contractual obligation, but with a

recourse to stabilization measures and initiation of structural reforms. The current

account convertibility in 1994 led to liberalization of gold imports and large capital

inflows upto 1996. In 1997, the timely efforts to depreciate the currency warded off a

possible crisis due to persistence of a relatively over valued rupee in the forex markets.

This also enabled the implementation of a package of monetary and other prompt actions

in resisting contagion effects of Asian crisis in late 1997 and early 1998. The imposition

of sanctions by U.S. government and others consequent upon nuclear tests required

replacement of normal debt flows with a type of extra ordinary financing.

There was also an occasion, as in May-August 2000 where inexplicable changes in

expectations put pressure on the currency warranting yet another package to counter the

market sentiment. In contrast the events of September 11, 2001 needed measures to

reassure the markets with timely liquidity and stability in monetary measures. The

reasonable success in managing these uncertainties while adding to forex reserves with

marginal addition to total external debt but maintaining both reasonable overall macro-

economic stability and pace of reform in financial sector has some tentative lessons to

offer.

First, stable and appropriate policies governing overall management of the

external sector are important. As part of the reform process, a policy framework was

developed to gradually liberalise the external sector, move towards total convertibility on

current account, encourage non debt credit inflows while containing all external debt

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especially short term debt in capital account and make the exchange rate largely market

determined. The policy reform in the external sector, accompanied by other changes was

guided by the Report of High Level Committee on Balance of Payments, April 1993

(Chairman Dr.C.Rangarajan).

Second, the impression that a closed economy is less vulnerable to crisis is not borne out

by facts. India was a closed economy on the eve of the Gulf Crisis but the impact was

severe. Though it is now a relatively more open economy, it could without serious

disruptions withstand several uncertainties. Third, as evident from experience, if the

fundamentals are weak, the economy is more vulnerable in the face of uncertainties.

Fourth, in all instances of serious uncertainties, the existence and manifestation of

harmonious relations between the Government and the central bank become critical and

appropriate coordination is extremely useful. Fifth, while it is difficult to anticipate or

assess the uncertainties, there may be advantages in taking the risk of early action than

late action. Sixth, while in a rapidly changing world of uncertainties, commitment to

ideology can prove to be a drag on policy, especially in emerging countries, which are

attempting structural transformation, it has been demonstrated by events the world over

as well as by the Indian experience, that when the going is good, government is perceived

to be a problem but when the going gets tough, effective public policy may be the only

solution. As such, the state has a pivotal role in stabilizing the economy when there is a

spell of stormy weather.

Seventh, there may be need for several short-term actions to meet challenges but this

should not distort the medium term vision to proceed with economic reform to improve

standards of living. In other words, it is necessary for the policy makers to be conscious

and more importantly, essential for the policy maker to convince market participants that

some measures to meet the crisis are short term, while some others may get embedded

into the public policy in the medium-term. Related to this approach and to reinforce this,

there is advantage in designing measures that are easily reversible, preferably with an

explicit indication that the measures are reversible even as they are being announced,

though a specific time frame may not be prescribed Eighth, as regards the techniques and

instruments of managing uncertainties, they have to evolve keeping in view the reform

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process itself, especially developments in financial markets, monetary policy, the nature,

composition and evolution of market participants and above all public opinion.

Ninth, it is necessary to have an appropriate mix of surprise elements and anticipated

elements in policy actions for meeting any uncertainties. As an example, when the

markets are in need of comfort or assurances, when the convergence in the objectives of

policy makers and the markets are matched, and such convergence is observable in regard

to instruments, there is merit in taking the market into confidence and proceeding

accordingly. Where there is a perception that the market expectations and their possible

actions in the direction are not considered to be desirable by the policy makers, it is

always advantageous to bring an element of surprise preferably with firmness and

credibility so that all possible anticipatory actions as well as resistances are avoided.

There may be occasions when the wavelengths of markets or segments thereof and policy

maker differ significantly and in such circumstances, the conduct of policy would

presumably be more complex and difficult.

Finally, the issue of transparency is extremely important. There are many occasions

where transparency is desirable but there are also occasions where instant transparency is

not entirely essential and could even be counter-productive. An acceptable approach

seem to be one that practices transparency as a rule but the timing of transparency could

vary depending on the circumstances.

RBI and Government

During the early 1960s, Governor Iengar identified four areas of potential conflict

between the Bank and the central government. These were interest rate policy, deficit

financing, cooperative credit policies and management of sub-standard banks. It may be

of interest to note that these four areas are still some of RBIs concerns.

During the post-reform period, the relationship between the central bank and the

Government took a new turn through a welcome development in the supplemental

agreement between the Government and the RBI in September 1994 on the abolition of

the ad hoc treasury bills to be made effective from April 1997. The measure eliminated

the automatic monetisation of Government deficits and resulted in considerable

moderation of the monetised deficit in the latter half of the Nineties.

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At the same time, with gradual opening up of the economy and development of

domestic financial markets, the operational framework of the RBI

also changed considerably with clearer articulation of policy goals and more and

more public dissemination of vast amount of data relating to its operations.

In fact, during the recent period, the RBI enjoys considerable instrument

independence for attaining monetary policy objectives. Significant achievements in

financial reforms including strengthening of the banking supervision capabilities of the

RBI have enhanced its credibility and instrument independence. It has been pointed out

by some experts that the RBI, though not formally independent, has enjoyed a high

degree of operational autonomy during the post-reform period.

In terms of redefining the functions of the RBI, enabling a movement towards

meaningful autonomy, Governor Jalans statement on Monetary and Credit Policy on

April 19, 2001 is a landmark event. First, it was decided to divest RBI of all the

ownership functions in commercial banking, development finance and securities trading

entities. Secondly, a beginning was made in recommending divestiture of RBIs

supervisory functions in regard to cooperative banks, which would presumably be

extended to non-banking financial companies and later to all commercial banks. Thirdly,

the RBI signalled initiation of steps for separation of Government debt management

function from monetary policy. These measures would enable the RBI to primarily focus

on its role as monetary authority and enhance the possibility of a move towards greater

autonomy.

The emerging issues relating to autonomy of RBI can be addressed at different

levels. First, at the level of legislative framework, several suggestions have been made to

ensure appropriate autonomy and many of them are under consideration. In particular,

proposed Fiscal Responsibility and Budget Management Bill and other amendments to

Reserve Bank of India Act would cover significant ground. Several other suggestions

relating to legal framework, as recommended by the Advisory Groups are yet to be taken

up.

Second, at the policy level, there are three important constraints on the operational

autonomy even within the existing legal framework. One, the continued fiscal

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dominance, including large temporary mismatches between receipts and expenditures of

Government warranting large involuntary financing of credit needs of Government by the

RBI. Two, the predominance of publicly owned financial intermediaries and non-

financial public enterprises, which has created a blurring of the demarcation between

funding of and by Government vis--vis public sector as a whole. Three, the relatively

underdeveloped state of financial markets partly due to legal and institutional constraints,

which blunts the effectiveness of instruments of monetary policy. These issues need to be

resolved to enhance genuine autonomy.

Third, at the operational and procedural level, there is a problem of old habits die

hard. In a deregulated environment, there is considerable scope to reduce micro-

management issues in the relations between the Government and the RBI. At the level of

degree of transparency, there is a temptation to continue, what has been termed as the

joint-family approach; which ignores basic tenets of accounting principles in regard to

transactions between RBI and Government. In spite of difficulties in prioritizing the

elements relevant for reform, an attempt is made to mention some elements which present

themselves as critical in the light of experience gained so far. First, as elaborated in

Governor Jalans recent statements on Monetary and Credit Policy, several legislative

measures are needed to enable further progress. These relate in particular, to ownership,

regulatory focus, development of financial markets, and bankruptcy procedures. Some of

the serious shortcomings in the anticipated benefits of reform such as in credit delivery

do need changes in legal and incentive systems. In particular, there is need to focus on

reduction of transaction costs in economic activity, and enhancing economic incentives.

Severe penalties in law, including criminal proceedings, may not be substitutes for

increasing enforceability (i.e., probability of being caught, prosecuted, and punished

adequately and in a timely fashion). In regard to institutions, there is need to clearly

differentiate functions of owner, regulator, financial intermediary and market participant,

to replace the joint-family approach that is a legacy of the pre-reform framework.

Second, fiscal empowerment appears to be essential for obvious reasons. While the

existing level of fiscal deficit may be manageable, the headroom available for meeting

unforeseen circumstances appears rather limited. The problem is somewhat acute in

regard to finances of states, which have serious structural problems and their resolution is

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economy. In such a situation, banks which are special and backbone of payment systems,

may face problems if they are subject to disproportionate burdens. Hence, mechanisms

have to be found to reconcile these dilemmas.

Furthermore, monetary policy is increasingly focused on efficient discharge of its

objective including price stability, and this no doubt would help poverty alleviation,

albeit indirectly, while the more direct attack on poverty alleviation would rightfully be

the preserve of fiscal policy. Monetary and financial sector policies in India should

perhaps be focusing increasingly on what Dreze and Sen call growth mediated security

while support-led security, mainly consisting of direct anti-poverty interventions are

addressed mainly by fiscal and other governmental activities.

References :

Indian Economy (2006)- Ruddar Datt & K.P.M. Sundaram .

Financial Institutions & Market (2002) -Meir Kohn.

Indian Financial System and Commercial Banking (2001)-Varshney

Monetary And Financial Sector Reforms in India, A Central Bankers Perspective- ReddyY.V. (2000)Fiscal and Monetary Policy Interface: Recent Developments in India, RBI Bulletin-Reddy, Y.V. (2000)Developments in Monetary Policy and Financial Markets In India, RBI Bulletin-Reddy,

Y.V. (2001)

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CHAPTER-3

Regulation of Money Market in India

Role of Central Bank for Regulating Banking System

Need of Central Bank

The Payments System provides the arteries or highways for conducting trade, commerceand other forms of economic activities in any country. An efficient payments system

functions as a lubricant speeding up the liquidity flow in the economy and creating a

momentum for economic growth. The payments process is a vital aspect of financial

intermediation; it enables the creation and transfer of liquidity among different economic

agents. A smooth, well functioning payments system not only ensures efficient utilization

of scarce resources but also eliminates systemic risks.

The payments system assumes importance in the context of domestic financial sector

reforms and global financial integration. The time value of money flows has increased

sharply in view of the competing demands on the financial sector.

Efficient, low cost cross-border payments flow helps to promote international trade in

goods and services. Foreign investments (direct and portfolio) are encouraged by the

availability of an efficient payments system. For these reasons, an efficient and

technologically advanced payments and settlement system performs a vital infrastructural

function in the economy. Central banks have, therefore, been taking measures to set up

such an infrastructural set up.

Use of money for settlement of payment obligations has a very long history. Use of non-

cash exchange through barter preceded the introduction of money. Barter, however, co-

exists with monetized economy in some underdeveloped agricultural societies even now.

But currency or cash is the most readily accepted medium of exchange in all modern

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societies because it is the legal tender and helps to bring about irrevocable settlement.

There are, however, certain disadvantages associated with the use of cash. Holding cash

does not fetch any return-the interest foregone because of cash holding is a cost to the

holder of cash. Besides, the holder of cash bears some insurance costs in terms of the

premia that is paid to cover any loss/theft. Moreover, carrying of large quantities of cash

to make large-value payments is a security risk and also involves transportation costs.

The requirements of a modern economy in regard to settlement of transactions are diverse

and variegated and the needs of manufacturing, trade, and commerce activities involve

large value payments over vast geographic distances. External trade with the rest of the

world involves payments in different currencies. Payments can no longer be completed

by simple cash transfer in such cases. Therefore, there arises the need for additional

forms of payments, which can be facilitated with improved financial intermediation and

expansion of financial instruments. Cheques and other paper based instruments and to

some extent electronic instruments have become important modes of payment in recent

times in most countries because of growing financial intermediation. Individuals,

business entities or governments issue cheques or other forms of order on their banks in

discharge of their payment obligations. The recipients of these orders would then get the

funds embodied in these payment instruments through their own banks. As the number of

banks grew over time, the volume of instruments exchanged among them increased

substantially.

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

among banks at a location or centre, a common set of practices and mechanisms of

exchange had to be evolved. When instruments presented by customers of banks become

payable at outside locations, special collection arrangements are set in motion to collect

the funds.

If the collecting bank has a branch at the relevant outside location, there would be no

problem, but, if the collecting bank does not have a branch at the outside location, it will

have to enter into correspondent banking relationship with another bank at the said

outside location for the purpose of collecting funds. The payment instruments which are

routed through financial intermediaries involve book entries at various levels to transfer

funds from one party to the other. The range of intermediation varies to take care of

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different situations. This may, for instance, consist of instructions to intermediaries to

move goods coinciding with the movement of funds as in the case of a Letter of Credit.

Or, the instruction could be for payment of specified sums of money to the bearer of a

payment instrument, as in the case of a bearer cheque.

In some cases, the payment instruments are negotiable in the sense that they can be

transferred from person to person in lieu of cash. In yet other cases, both the ultimate

beneficiary and the destination could be pre-determined. In all these cases, banks play a

crucial part in conveying, transmitting and carrying out the instructions embodied in the

payment instruments. While doing so, these intermediaries have to settle among

themselves the monetary claims arising from the execution of payment instructions.

Thus, whenever non-cash payment instruments are involved, they are accompanied by a

chain of related fund transfers as well as a stream of book entries and messages. Banks in

turn need an intermediate agency such as the clearing house where these instruments can

be exchanged and where the financial claims on one another can be settled through a

settlement bank, which is usually the Central Bank of the country.

Clearing Houses facilitate the exchange of instruments and processing of payment

instructions at a central point among the participating banks. Clearing Houses-manual

and paper based in many advanced countries have gradually extended their range of

activities to include automated (ACH) and electronic means for settlement of payment

transactions. Such an evolution is also seen in emerging economies. Banks, as crucial

intermediaries in the payments stream, provide deposit accounts to non bank agents (i.e.

individuals, firms/corporate bodies) which are considered as liquid assets and facilitate

payments transactions. Banks provide credit facilities so that such payments can be

effected with lower working balances. Moreover, they act as conduit through which

domestic and international capital markets provide resources to the commercial sector.

The payments system has a multiplicity of layers where several levels of intermediation

occur in the transfer of funds from one person and/or institution to another. The structure

of the Payments System can be visualized as a Pyramid, with linkages among different

tiers of the payment intermediaries.

At the base of the Pyramid are the non banks (all non-depository corporations including

individuals and firms) whose assets are diverse, including bank notes and deposits. The

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types of payments at the base of the Pyramid include both cash and non-cash modes of

payments. Banks are at the intermediate level.

The assets of the banks comprise, among others, their reserves with the Central Bank,

deposits with the correspondents and claims on the correspondents, and investments in

Government and other securities, loans and advances and cash in their vaults. Typically,

their liabilities would among others, be made up of deposits from non banks and

correspondents and loans from the Central Bank.

The Clearing House and the settlement bank are the financial intermediaries who channel

the funds flow between the banks. At the apex of the pyramid is the Central Bank of the

country (i.e. Reserve Bank of India) which has the settlement accounts of the banks and

sustains the payments process.

Payments System

In the Payments System, the Central Bank has a special role to play as the settling bank

maintaining settlement accounts for banks. These are used by banks to discharge their

obligations amongst themselves. While the settlement account can be maintained with

any bank, there is always a risk of default by the settling bank. A failure of a settling bank

can have disastrous consequences leading to a possible systemic collapse. Settlement

accounts maintained with the Central Bank, on the other hand, provide the basic stability

to the settlement process as the Central Banks cannot fail. The involvement of the Central

Bank in the settlement process is therefore crucial.

This monograph is organized in the following way. After giving a brief account of the

evolution of payments system in India in Chapter II, the various paper based instruments

in vogue in India are discussed in Chapter III.

The complexities of the existing paper based payments and settlement systems,

Remittance Facilities and Currency Chests and the Uniform Regulations and Rules of

Clearing for paper based instruments form the subject matter of Chapter IV. Given the

increase in the volume of paper based instruments and the time taken for clearing these

instruments, it was inevitable to move towards item-based computerized processing and

settlement for improving systemic efficiency as well as customer service. These and other

related aspects are the main themes of interest in Chapter V. In the early and mid 90s, a

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beginning was made in introducing ACH (Automated Clearing House) services such as

Electronic Clearing Service (ECS) and Electronic Funds Transfer (EFT).

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

Network System (SPNS) of Automated Teller Machines (ATMs) are highlighted in

Chapter VI. For an efficient electronic payments system, a strong and robust

telecommunication network is necessary. The efforts made by the Reserve Bank in

particular as well as the banking industry in general in setting up a telecommunication

network to serve the needs of the industry form the contents of Chapter VII. The final

chapter provides a brief idea of the challenges ahead in modernizing the Indian payments

system.

Evolution of RBI

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

Madras and Bombay from 1862 to 1921 and thereafter by the Imperial Bank of India,

which came into existence as a result of amalgamation of the Presidency Banks. Since

April 1, 1935, the Reserve Bank has been the banker to

the Central and State Governments. According to Article 283(1) and (2) of the Indian

Constitution, it is open to the Central Government and to any State Government to make

rules for the receipt, custody and disbursement of all the amounts accruing to or held in

its consolidated or contingency funds or in its public account. Sections 20 and 21 of the

Reserve Bank of India Act, 1934 provide that the Central Government shall entrust the

Bank with all its money, remittance, exchange and banking transactions in India and the

management of its public debt, and shall also deposit all its cash balances with the Bank

free of interest.

The Bank may, by agreement with any State Government, take over similar functions on

behalf of that Government under Section 21A of the RBI Act. Accordingly, the RBI is

the common banker to the Central Government and all the State Governments in the

Indian Federation with the exception of Jammu & Kashmir and Sikkim.

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

provides several services. First, the Central Government Treasury Rules, the Central

Government Account (Receipts and Payments) Rules, in respect of the transactions of the

Central departments, and the corresponding provisions in the State Financial codes are

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deemed to be legally binding on the Bank. Second, the Bank carries on the General

Banking business of the Centre and the States in terms of the working agreement between

the Government and the Reserve Bank. The liability of the Bank to the Governments in

the conduct of the Government business is that of a banker to an ordinary customer.

Third, the Bank also undertakes to float loans and manage the loans on behalf of the

Governments on agreed terms.

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

agents of RBI and they are made responsible for transacting the entire Government

business. Fifth, the Bank does not charge to Governments, the cost of carrying on

Government business through its offices or the agency banks. Sixth, a facility for grant of

ways and means advances is provided by Reserve Bank to the Governments, to meet the

temporary mismatches in their income streams. Seventh, the RBI arranges for

investments of surplus cash balances of the Governments as a portfolio manager. Eighth,

the RBI also acts as Adviser to Government, whenever called upon to do so, on monetary

and banking related matters besides dispensing merchant banking services.

Role as a Banker to the Government

The title of the address refers to being banker to governments simply because RBI is a

banker not only to the Central Government, but also State Governments. RBI by virtue of

its charter performs several functions, the most important being to secure stability in the

internal and external value of the currency mainly through conduct of monetary policy,

while at the same time, ensuring adequate availability of credit to meet the genuine needs

of a growing economy. Currency management is yet another function of the RBI which

impacts the transactions of a large number of people. managing public debt is also

assigned to RBI, but this is sought to be separated from RBI in due course. Its regulation

of money and forex markets flows from its primary responsibility while its role in debt

markets is closely linked to it being manager of public debt. RBI is also a regulator and

supervisor of banks, development financial institutions, and non-banking financial

companies, but the process of supervision is overseen by an independent Board for

Financial Supervision, within RBI. Incidentally, RBI is also a banker to banks. Payment

System is also under the aegis of RBI, and the technological infrastructure for the

financial sector, especially in the money and Government Securities market is provided

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by RBI to sub serve its overall responsibilities. To the governments it renders advice on

financial matters, whenever called upon to do so.

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

perhaps due to the reason that it does not directly or visibly impinge on prices or output.

However, as will be explained today, though it is not a big-ticket item on RBIs balance-

sheet, its role as a banker to governments is very significant and it has been evolving in

the recent years reflecting the process of economic reform.

The Bank provides banking services to both Central and State Governments such as

acceptance of moneys on Government account, payment / withdrawal of funds and

collection and transfer of funds by various means throughout India. The Governments'

principal accounts are maintained at Central Accounts Section of the Bank at Nagpur.

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

Cells at Bhopal and Chandigarh. Further, all public sector banks and two private sectors

banks handle Governments accounts through their 20,800 branches. Currently, the

Agency banks handle Governments transactions of around Rs.12 lakh crore in a full

Financial year.

Over and above these, sizeable transactions are handled at Reserve Bank Offices. Some

transactions, though minimal, are handled in Governments own treasuries and sub

treasuries, numbering 453, equipped with Currency Chests. This data gives the

Magnitude and spread of transactions relating to Governments. The first part of todays

presentation will cover very briefly cross-country practices. The second part provides the

legal and institutional framework in India for conduct of Governments business in

banking. The third section describes the range of Banking services provided by RBI to

Governments. The fourth part describes some of the reforms already undertaken in this

area. The fifth section describes major issues while the concluding section indicates a

possible agenda for immediate actions.

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Cross-Country Practices

By custom and tradition or by express provision in the laws by which they have been

established, Central Banks are bankers to their respective Governments. In the view of

Sir Montague Norman of the Bank of England and Benjamin Strong of the Federal

Reserve System, the Central Bank should undertake all the banking business on behalf of

their own Governments. However, the actual practices do vary among countries. In the

UK, Bank of England is the main banker to Government and maintains the Principal

Central Government Account. Individual Government departments are not obliged to use

Bank of England as their banker. Typically Government Department with significant

requirements for banking service put some or all of their banking business out to tender.

In the case of South Africa, the South African Reserve Bank acts as banker to The

Central Government. Provincial Governments are, however, the clients of private

banking sector. In Japan, Bank of Japan carries out the transactions with the National

Government but not with local Governments. As regards USA, the Federal Reserve acts

as the banker to US Government. The Reserve Banks serve as depositories of the United

States and perform several payment-related services.

Legal and Institutional Framework

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

Madras and Bombay from 1862 to 1921 and thereafter by the Imperial Bank of India,

which came into existence as a result of amalgamation of the Presidency Banks. Since

April 1, 1935, the Reserve Bank has been the banker to the Central and State

Governments. According to Article 283(1) and (2) of the Indian Constitution, it is open to

the Central Government and to any State

economic reforms and money market -- by syed adnan

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