rbi has various tools to control which are listed below

8/7/2019 RBI has various tools to control which are listed below

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(i) Interest Rate Channel

The interest rate channel is described in the literature under therubric Money View. Monetary policy induced changes in money

supply

(M) influence nominal interest rate (i), i.e., the cost of credit, investment(I) and, thereby, the level of GNP (Y).

Mi IY

(ii) Credit Channel(Credit View)The credit channel is considered under two streams bank lending

channel and the balance sheet channel.

(a) Bank Lending Channel

Bank lending channel emphasises the role of changes in banks balance

sheet items, i.e., in deposits and loans as conduits for monetary policytransmission. Under this channel, credit availability aspect isemphasised.

M(Bank Deposits) (Bank Loans) IY

(b) Balance Sheet ChannelThe balance sheet channel emphasises the impact of monetary policy

induced changes on the asset prices, value of the borrowers collateral

and

actual borrowings with final impact on investment and income.(Monetary Contraction) high i (Low Asset Prices) (Fall in

Collateral Values) (Low Borrowings) Low I Low Y(iii) Asset Price Channel

Policy-induced interest rate changes affect the level of asset prices

principally those of bonds, equities and real estate in the economy.Where

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4 Obstfeld and Rogoff (1995,1996) use an intertemporal general

equilibrium framework in

expounding an analytical model in which choice of the exchange rate

regime has significant

implications for monetary policy.


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5 McCallum (1994), among others, has empirically tested the interest

parity conditions andfound plausible support for covered interest parity.

6 Examining data for 110 countries for 30 years, McCandless and Weber

(1995) conclude thatin the long run while the correlation coefficient between inflation and

money growth is nearly

one, there is no long run correlation between money growth and growthrate of output.

long-term fixed-interest bond markets are important, higher short-term

interest rates may lead to a decline in bond prices. As such markets

develop, this channel of transmission may be strengthened.

Mi Discounted Cash Flow Tobin q IY(iv) Exchange Rate ChannelFor an open economy, with flexible exchange rates, monetary policy

induced changes in money supply or rates of interest can influence the

level of income through exchange rate (e) and net exports (NX). This isthe

exchange rate channel4 . Alternatively, monetary policy intervention can

impact upon capital inflows through changes in interest parity

conditions5 .Given the fact that a managed float system of exchange rates ensures

fluctuations within a band, effects of monetary policy need not be

through

the exchange rate channel only. Inflows and outflows of capital, for

instance,

respond directly to policy-induced changes in interest rate.

Mi e NX Y

(v) Capital Flow Channel

M i (Interest Rate Differential) (Capital Flows) I

Y


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Exchange rate flexibility, coupled with the gradual removal of capital controls,

has widened the scope for monetary maneuverability, enabling transmission throughexchange rates. In the event of interest rate arbitrage triggered by monetary policy action,

foreign exchange inflows can tend to pick up until the interest rate parity is restored by

exchange rate adjustments. An appreciating exchange rate, in turn, would have adampening effect on aggregate demand, containing inflationary pressures. However, iflarge segments of economic agents lack adequate resilience to withstand volatility in

currency and money markets, the option of exchange rate adjustments may not beavailable, partially or fully. Therefore, the central bank may need to carry out foreign

exchange operations for stabilizing the market. In the process, the injection of liquidityinto the system by the central bank would go against its policy stance and weaken

monetary transmission. Thus, monetary management becomes complicated, and themonetary authority may need to undertake offsetting sterilisation transactions in defence

of monetary stability and intended transmission. In the Indian context, faced with similar- 20 - 20

circumstances, sterilization operations are being carried out from 2004 by issuances of

government securities under the Market Stabilisation Scheme (MSS).Financial Supervision

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

Board of Directors of the Reserve Bank of India.

Objective

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

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

Constitution

The Board is constituted by co-opting four Directors from the Central Board as members for a

term of two years and is chaired by the Governor. The Deputy Governors of the Reserve Bankare ex-officio members. One Deputy Governor, usually, the Deputy Governor in charge of

banking regulation and supervision, is nominated as the Vice-Chairman of the Board.

BFS meetings

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

BFS through the Audit Sub-Committee also aims at upgrading the quality of the statutory auditand internal audit functions in banks and financial institutions. The audit sub-committee includes

Deputy Governor as the chairman and two Directors of the Central Board as members.


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The BFS oversees the functioning of Department of Banking Supervision (DBS), Department ofNon-Banking Supervision (DNBS) and Financial Institutions Division (FID) and gives directions

on the regulatory and supervisory issues.

Functions

Some of the initiatives taken by BFS include:

i. restructuring of the system of bank inspectionsii. introduction of off-site surveillance,

iii. strengthening of the role of statutory auditors andiv. strengthening of the internal defences of supervised institutions.

The Audit Sub-committee of BFS has reviewed the current system of concurrent audit, norms ofempanelment and appointment of statutory auditors, the quality and coverage of statutory audit

reports, and the important issue of greater transparency and disclosure in the published accounts

of supervised institutions.

Current Focus

y supervision of financial institutionsy consolidated accounting

y legal issues in bank frauds

y divergence in assessments of non-performing assets and

y supervisory rating model for banks.

RBI has various tools to control which are listed below

(a) Bank Rate: RBI (Reserve Bank of India) lends to the commercial banks through its discount window to

help the banks meet depositors demands and reserve requirements. The interest rate the RBI charges


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the banks for this purpose is called bank rate. If the RBI wants to increase the liquidity and money supply

in the market, it will decrease the bank rate and if it wants to reduce the liquidity and money supply in the

system, it will increase the bank rate. The current rate is 6%.

(b) Cash Reserve Requirements (CRR): Every commercial bank has to keep certain minimum cash

reserves with RBI. RBI can vary this rate between 3% and 15%. RBI uses this tool to increase or

decrease the reserve requirement depending on whether it wants to affect a decrease or an increase in

the money supply. An increase in CRR will make it mandatory on the part of the banks to hold a large

proportion of their deposits in the form of deposits with the RBI. This will reduce the size of their deposits

and they will lend less. This will in turn decrease the money supply. The current rate is 6%.

(c) Statutory Liquidity Requirements (SLR): Apart from the CRR, banks are required to maintain liquid

assets in the form of gold, cash and approved securities. RBI has stepped up liquidity requirements for

two reasons: - Higher liquidity ratio forces commercial banks to maintain a larger proportion of their

resources in liquid form and thus reduces their capacity to grant loans and

advances thus it is an anti-inflationary impact. A higher liquidity ratio diverts the bank funds from loans

and advances to investment in government and approved securities.

In well developed economies, central banks use open market operations- buying and selling of eligible

securities by central bank in the money market- to influence the volume of cash reserves with commercial

banks and thus influence the volume of loans and advances they can make to the commercial and

industrial sectors. In the open money market, government securities are traded at market related rates of

interest. The RBI is resorting more to open market operations in the more recent years.

Generally RBI uses three kinds of selective credit controls:

a) Minimum margins for lending against specific securities. b) Ceiling on the amounts of credit for certain

purposes. c) Discriminatory rate of interest charged on certain types of advances.

Direct credit controls in India are of three types:

a) Part of the interest rate structure i.e. on small savings and provident funds, are administratively set. b)

Banks are mandatorily required to keep 25% of their deposits in the form of government securities. c)

Banks are required to lend to the priority sectors to the extent of 40% of their advances.

Repo (Repurchase) RateRepo rate is the rate at which banks borrow funds from the RBI to meet the gap between the demand

they are facing for money (loans) and how much they have on hand to lend.


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If the RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate;

similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate.Reverse Repo RateThis is the exact opposite of repo rate.The rate at which RBI borrows money from the banks (or banks lend money to the RBI) is termed the

reverse repo rate. The RBI uses this tool when it feels there is too much money floating in the banking

systemIf the reverse repo rate is increased, it means the RBI will borrow money from the bank and offer them a

lucrative rate of interest. As a result, banks would prefer to keep their money with the RBI (which is

absolutely risk free) instead of lending it out (this option comes with a certain amount of risk)Consequently, banks would have lesser funds to lend to their customers. This helps stem the flow of

excess money into the economyReverse repo rate signifies the rate at which the central bank absorbs liquidity from the banks, while repo

signifies the rate at which liquidity is injected.

Bank RateThis is the rate at which RBI lends money to other banks (or financial institutions.The bank rate signals the central banks long-term outlook on interest rates. If the bank rate moves up,

long-term interest rates also tend to move up, and vice-versa.Banks make a profit by borrowing at a lower rate and lending the same funds at a higher rate of interest.

If the RBI hikes the bank rate (this is currently 6 per cent), the interest that a bank pays for borrowing

money (banks borrow money either from each other or from the RBI) increases. It, in turn, hikes its own

lending rates to ensure it continues to make a profit.

Call Rate

Call rate is the interest rate paid by the banks for lending and borrowing for daily fund requirement. Si nce

banks need funds on a daily basis, they lend to and borrow from other banks according to their daily or

short-term requirements on a regular basis.

CRR


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Also called the cash reserve ratio, refers to a portion of deposits (as cash) which banks have to

keep/maintain with the RBI. This serves two purposes. It ensures that a portion of bank deposits is totally

risk-free and secondly it enables that RBI control liquidity in the system, and thereby, inflation by tying

their hands in lending moneySLRBesides the CRR, banks are required to invest a portion of their deposits in government securities as a

part of their statutory liquidity ratio (SLR) requirements. What SLR does is again restrict the banks

leverage in pumping more money into the economy.

rbi has various tools to control which are listed below

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