UNIT 2
REGULATORY FRAMEWORK AND
LESSON 8:
THE RESERVE BANK OF INDIA
MANAGEMENT OF FINANCIAL INSTITUTION
Learning Objective
After reading this lesson, you will understand
• Organisation and management of RBI
• Function and Roles of RBI
• Treasury Bills
Today we shall discuss one of the most important aspects of
Financial Institution in India.
Introduction
A study of financial institutions in India can appropriately
begin with a brief discussion of the regulatory framework of
the country. Since the financial markets are characterised by
various degrees of imperfections, the need for regulation-
prudential or otherwise-even in a liberalised framework cannot
be denied. The financial system deals in other people’s money
and, therefore, their confidence, trust and faith in it is crucially
important for its smooth functioning. Financial regulation is
necessary to generate, maintain and promote this trust. One
reason why the public trust may be lost is that some of the
savers or investors or intermediaries may imprudently take too
much risk, which could engender defaults, bankruptcies, and
insolvencies. Thus a regulation is needed to check imprudence
in the system.
The task of efficient regulation is rendered difficult by the very
nature of financial assets, which are mobile, easily transferable or
negotiable; and also by the nature of financial markets which are
prone to a systemic risk. The modern trading technology and
the possibility of high leveraging enable market participants to
take large stakes, which are disproportionate with their own
investments. There are also frequent instances of dishonest,
unfair, fraudulent, and unethical practices or activities of the
market intermediaries or agencies such as brokers, merchant
bankers, custodians, trustees, etc. The regulation becomes
necessary to ensure that the investors are protected; that
disclosure and access to information are adequate, timely, and
equal; that the participants measure up to the rules of the
market place; and that the markets are both fair and efficient. In
this context, it is said that fairness and efficiency are two sides of
the same coin; if the market is unfair, in the end, it is also
inefficient.
The regulatory framework or apparatus for the financial sector in
India broadly consists of the Ministry of Finance of the
Government of India which administers the Companies Act,
1956, and the Securities Contracts (Regulation) Act, 1956; the
Reserve Bank of India and the Board of Financial Supervision
(BFS) under its aegis; the Securities and Exchange Board of
India (SEBI), Insurance Regulatory Authority; the Governing
Boards of various stock exchanges and the apex financial
institutions such as the IDBI, SIDBI, NHB and NCB. Among
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26
PROMOTIONAL INSTITUTIONS
these, the RBI and SEBI have special role and responsibility. We
shall first discuss the functioning of the RBI followed by the
SEBI.
What is the Organisation and Management of RBI
The Reserve Bank of India was established on April 1,1935,
under the Reserve Bank of India Act, 1934. The main functions
of the Bank are to act as the note-issuing authority. Banker’s
Bank, Banker to the government and to promote the growth
of the economy within the framework of the general economic
policy of the government, consistent with the need to maintain
price stability. The Bank also performs a wide range of
promotional functions to support the pace of economic
development. The Reserve Bank is the controller of foreign
exchange. It is the watchdog of the entire financial system. The
Bank is the sponsor bank of a wide variety of top-ranking
banks and institutions such as SBI, IDBI, NABARD and NHB.
The Bank sits on the board of all banks and it counsels the
Central and State Government and all public sector institutions
on monetary and money matters. No central bank, even in the
developed world, is saddled with such onerous responsibilities
and functions.
The RBI, as the central bank of the country, is the centre of the
Indian Financial and Monetary System. As the apex institution,
it has been guiding, monitoring, regulating, controlling, and
promoting the destiny of the IFS since its inception. It is quite
young compared with such central banks as the Bank of
England, Riksbank of Sweden, and the Federal Reserve Board
of the US. However, it is perhaps the oldest among the central
banks in the developing countries. It started functioning from
April1, 1935 on the terms of the Reserve Bank of India Act,
1934. It was a private shareholders’ institution till January 1949,
after which it became a state-owned institution under the
Reserve Bank (Transfer to Public Ownership) of India Act,
1948. This act empowers the central government, in
consultation with the Governor of the Bank, to issue such
directions to it, as they might consider necessary in the public
interest. Further, the Governor and all the Deputy Governors
of the Bank are appointed by the Central Government.
The Bank is managed by a Central Board of Directors, four
Local Boards of Directors, and a committee of the Central
Board of Directors. The functions of the Local Boards are to
advise the Central Board on matters referred to them; they are
also required to perform duties as are delegated to them. The
final control of the Bank vests in the Central Board, which
comprises the Governor, four Deputy Governors, and fifteen
Directors nominated by the central government. The committee
of the Central Board consists of the Governor, the Deputy
Governors, and such other Directors as may be present at a
given meeting. The internal organisational set-up of the Bank
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has been modified and expanded from time to time in order to
cope with the increasing volume and range of the Bank’s
activities. The underlying principle of the internal organisation
is functional specialisation with adequate coordination. In order
to perform its various functions, the Bank has been divided and
sub-divided into a large number of departments.
The pattern of central banking in India was initially based on
the Bank of England. England had a highly developed banking
system in which the functioning of the central bank as a
banker’s bank and their regulation of money supply set the
pattern. The central bank’s function as ‘a lender of last resort’
was on the condition that the banks maintain stable cash ratios
as prescribed from time to time. The effective functioning of
the British model depends on an active securities market where
open market operations can be conducted at the discount rate.
The effectiveness of open market operations however depends
on the member banks’ dependence on the central bank and the
influence it wields on interest rates. Later models, especially
those in developing countries showed that central banks play an
advisory role and render technical services in the field of foreign
exchange, foster the growth of a sound financial system and act
as a banker to government.
What are the Functions and Roles of RBI
Functions of the Bank
The RBI functions within the framework of a mixed economic
system. With regard to framing various policies, it is necessary
to maintain close and continuous collaboration between the
government and the RBI. In the event of a difference of
opinion or conflict, the government view or position can always
be expected to prevail.
The Preamble of the RBI Act, 1934 states that “Whereas it is
expedient to constitute a Reserve Bank for India to regulate the
issue of bank notes and the keeping of reserves with a view to
securing monetary stability in (India) and generally to operate
the currency and credit system of the country to its advantage”.
To elaborate, the main functions of the RBI are:
• To maintain monetary stability so that the business and
economic life can deliver welfare gains of a properly
functioning mixed economy.
• To maintain financial stability and ensure sound financial
institution so that monetary stability can be safely pursued
and economic units can conduct their business with
confidence.
• To maintain stable payments system so that financial
transactions can be safely and efficiently executed.
• To promote the development of financial infrastructure of
markets and systems, and to enable it to operate efficiently
i.e., to play a leading role in developing a sound financial
system so that it can discharge its regulatory function
efficiently.
• To ensure that credit allocation by the financial system
broadly reflects the national economic priorities and societal
concerns.
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11.621.6
• To regulate the overall volume of money and credit in the
MANAGEMENT OF FINANCIAL INSTITUTION
economy with a view to ensure a reasonable degree of price
stability.
Role of the Bank
In view of the Bank’s close contacts and intimate knowledge of
the financial markets, it is in a position to advise the Central and
State Governments on the Quantum, timing and terms of
issue of new loans. While formulating the borrowing program
for the year, the Government and the Bank take into account a
number of considerations such as the amount of Central and
State loans maturing for redemption during the year, the
estimate of available resources (based on the estimated growth
in deposits with the banks, premium income of insurance
companies and accretions to provident funds) and the
absorptive capacity of the market.
In India, banks, insurance companies and provident funds are
statutorily required to invest a portion of their liabilities,
premium income or accretions, as the case may be, in
Government and other approved securities, which ensures a
captive market for these securities, facilitating the easy
absorption of new issues. The Bank tries to ensure that over a
reasonably long period it will be neither a net purchaser of
securities from the market nor a net seller so that the loans
raised are absorbed by the market outside the Bank to the
maximum extent.
The Bank actively operates in the gilt-edged market to ensure
the success of Government loan operations. For instance, the
Bank grooms the market by acquiring securities nearing maturity
to facilitate redemption. If maturing stocks are held by
investors to the last, conditions in the money market are likely
to be disturbed as most of the cash paid out seeks avenues of
reinvestment, but, in practice, all the investors are not equally
eager to wait for cash repayment on the redemption date and
then undertake reinvestment, as they can reinvest the proceeds
at times of their own choosing if these were realized earlier, the
Bank, therefore, stands ready as the stock approaches maturity
to buy all the stocks offered for sale at these terms. Thus, in
carrying out the loan operations of the Government the Bank
endeavours on the one hand to minimize the effects of such
operations on the money market and Government securities
market, and on the other to obtain the best possible terms for
the Government concerned. The close involvement in the
market by its continuous presence and the willingness to deal in
the securities at process determined by it give the Bank a good
degree of flexibility when it is seeking occasions for
implementing a shift in policy on prices.
The timing of the issue of new loans is normally left to the
Reserve Bank. The Central Government and the state
Governments float market loans separately, but through the
Reserve Bank. For the management of the public debt of the
Government, the Bank charges a commission. In addition, the
Reserve Bank also charges for all new issues both by Central and
State Government loans, besides recovering brokerage and
expenses incurred by the Bank on account of printing of loan
notifications, telegrams, advertisements, etc.
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 Treasury Bills
MANAGEMENT OF FINANCIAL INSTITUTION

You must be well aware that Treasury Bills are the main
instrument of short-term borrowing by the Government, and
serve as a convenient gilt-edged security for the money market.
The qualities of high liquidity, absence of risk of default, and
negligible capital depreciation in case of sale before maturity
make them an ideal form of short-term investment for banks
and other financial institutions.
In certain countries, unlike in India, Treasury Bills are an
important tool for the central bank for influencing the level of
liquidity in the money market through open market operations.
Sale of Treasury Bills helps to absorb any excess liquidity in the
money market and, conversely, their purchase by the central
bank has the effect of relieving stringency. Since neither the
Government nor the money market wishes to hold surplus
cash, the central bank steps in and restores the equilibrium by
selling to or purchasing from the money market Treasury Bills
(and similar other securities) accordingly as the Government
payments are larger than its receipts or vice versa. In this way, the
Government is able to borrow cheaply to meet its immediate
needs and to use its temporary surplus to by back before
maturity some of its outstanding debt.
The Reserve Bank, as the agent of the Government, issues
Treasury Bills at a ‘discount’. These are negotiable securities and
can be rediscounted with the Bank at any time before maturity
upon terms and conditions determined by it from time to time.
Questions to Discuss:
1. Discuss the Organisation and Management of RBI.
2. What are the Functions of RBI?
3. What are the roles of RBI?
Notes:

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