Assignment – Principle of Banking & Insurance

By- Mohit Chauhan(393), FA

1. Enumerate the main supervisory powers of RBI over Commercial Banks.

Reserve Bank of India undertakes the supervisory functions relating to commercial banks through its Department of Banking Supervision (DBS) under the direction of Board for Financial Supervision (BFS). This department of banking supervision supervises 92 commercial banks of India

Board for Financial Supervision

Chairman Governor of RBI

Vice-chairperson One Deputy Governor(usually the Deputy Governor in-charge of Banking Regulation &Supervisory Function of Central Board of RBI)

Members Other Deputy Governor and Four directors of the Central Board of RBI.

The Reserve Bank undertakes supervision of banks to monitor and ensure compliance by them with its regulatory policy framework. This is achieved through on-site inspection, off-site surveillance and periodic meetings with top management of banks.

1. On-site Inspection

The Reserve Bank undertakes annual on-site inspection of banks to assess their financial health and to evaluate their performance in terms of quality of management, capital adequacy, asset quality, earnings, liquidity position as well as internal control systems. Based on the findings of the inspection, banks are assigned supervisory ratings based on the CAMELS (CALCS for foreign banks in India) supervisory model and are required to address the weaknesses identified.

2. Off-site Surveillance

The Reserve Bank requires banks to submit detailed and structured information periodically under its Off Site Surveillance and Monitoring System (OSMOS).  The primary objective of the off-site surveillance is to monitor the financial health of banks between two on-site inspections, identifying banks which show financial deterioration and would be a source for supervisory concerns. This information is thoroughly analyzed by the RBI to assess the health of individual

banks and that of the banking system, and also glean early warning signals which could serve as a trigger for necessary supervisory intervention.

3. Periodic Meetings

The Reserve Bank periodically meets the top management of banks to discuss the findings of its inspections. In addition, it also has quarterly / monthly discussions with them on important aspects based on OSMOS returns and other inputs.

4. Monitoring of Frauds

The Reserve Bank regularly sensitizes banks about common fraud-prone areas, the modus operandi and the measures necessary to prevent frauds. It also cautions banks about unscrupulous borrowers who have perpetrated frauds with other banks.

2. Explain the impact of increase in SLR and CRR on the banking system. Can RBI use both these tools simultaneously?

Cash Reserve Ratio (CRR): The share of net demand and time liabilities that banks must maintain as cash balance with the Reserve Bank. The RBI requires banks to maintain a certain amount of cash in reserve as a percentage of their deposits to ensure that banks have sufficient cash to cover customer withdrawals. The current CRR rate is 4%.

Statutory Liquidity Ratio (SLR): The share of net demand and time liabilities that banks must maintain in safe and liquid assets, such as government securities, cash and gold. The current rate of SLR is 22.50%.

Impact of increase in SLR & CRR on Banking System:

The RBI under its Monetary Policy having objective to control the flow of money in the Economy make use of these direct instruments of monetary control. At the time of Inflation when Government has to reduce the money flow in the market in order to curb inflation, the government increases the CRR and SLR rates. This restricts the bank to maintain more share of their NDTL with the RBI as per ratio requirements which leads to less quantity of money with the banks for lending purposes, resulting in increase in lending rates. This increase in lending rates by bank reduces the demand for the money by the people and also increased rates will increase interest on deposits attracting more money from people hence reducing the demand for the products by the people. Thus the creation of low supply of money in the economy leads to decrease in Inflation. Yes RBI can use both these tools together.

3. Does RBI  has the power to control or influence directly or indirectly the interest Rates of the bank If so then in what manner and to what extent.

Direct Instruments

1. Cash Reserve Ratio (CRR): The share of net demand and time liabilities that banks must maintain as cash balance with the Reserve Bank.

2. Statutory Liquidity Ratio (SLR): The share of net demand and time liabilities that banks must maintain in safe and liquid assets, such as government securities, cash and gold.

3. Refinance facilities: Sector-specific refinance facilities (e.g., against lending to export sector) provided to banks.

Indirect Instruments

1. Liquidity Adjustment Facility (LAF): Consists of daily infusion or absorption of liquidity on a repurchase basis, through repo (liquidity injection) and reverse repo (liquidity absorption) auction operations, using government securities as collateral.

2. Repo/Reverse Repo Rate: These rates under the Liquidity Adjustment Facility (LAF) determine the corridor for short-term money market interest rates. In turn, this is expected to trigger movement in other segments of the financial market and the real economy.

3. Open Market Operations (OMO): Outright sales/purchases of government securities, in addition to LAF, as a tool to determine the level of liquidity over the medium term.

4. Marginal Standing Facility (MSF): was instituted under which scheduled commercial banks can borrow over night at their discretion up to one per cent of their respective NDTL at 100 basis points above the repo rate to provide a safety valve against unanticipated liquidity shocks

5. Bank Rate: It is the rate at which the Reserve Bank is ready to buy or rediscount bills of exchange or other commercial papers. It also signals the medium-term stance of monetary policy.

6. Market Stabilisation Scheme (MSS): This instrument for monetary management was introduced in 2004. Liquidity of a more enduring nature arising from large capital flows is absorbed through sale of short-dated government securities and treasury bills. The mobilized cash is held in a separate government account with the Reserve Bank.

The Reserve Bank traditionally relied on direct instruments of monetary control such as Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR).Cash Reserve Ratio indicates the quantum of cash that banks are required to keep with the Reserve Bank as a proportion of their net demand and time liabilities and SLR prescribes the amount of money that banks must invest in securities issued by the government. The Reserve Bank increases the CRR and SLR rate in order to reduce the supply of money in the economy at the time of high inflation. When the

quantity of money with banks for lending purposes get reduced due to high ratio requirements, then the rates for lending rises as they depend on demand supply factors.

In the late 1990s, the Reserve Bank restructured its operating framework for monetary policy to rely more on indirect instruments such as Open Market Operations (OMOs). In addition, in the early 2000s, the Reserve Bank instituted Liquidity Adjustment Facility (LAF) to manage day-to-day liquidity in the banking system. These facilities enable injection or absorption of liquidity that is consistent with the prevailing monetary policy stance. The repo rate (at which liquidity is injected) and reverse repo rate (at which liquidity is absorbed) under the LAF have emerged as the main instruments for the Reserve Bank’s interest rate signaling in the Indian economy. The armor of instruments with the Reserve Bank to manage liquidity was strengthened in April 2004 with the Market Stabilisation Scheme (MSS). The MSS was specifically introduced to manage excess liquidity arising out of huge capital flows coming to India from abroad. In addition, the Reserve Bank also uses prudential tools to modulate the flow of credit to certain sectors so as to ensure financial stability. The availability of multiple instruments and their flexible use in the implementation of monetary policy has enabled the Reserve Bank to successfully influence the liquidity and interest rate conditions in the economy.