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Regulation

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Key Topics
The Principal Reasons for Bank and Nonbank
Financial-Services Regulation
The Central Banking System
Macroeconomic and Monetary Policy
Regulation vs. Growth
Size vs. Scope
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Reasons for the Regulation of Banks

Protection of the Safety of the Publics Savings
Control of the Supply of Money and Credit
Ensure Equal Opportunity and Fairness in
Access to Credit
Promote Public Confidence in the Financial
System
Avoid Concentration of Power
Support of Government Activities
Help for Special Segments of the Economy
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Macroeconomic Policies
The Governments primary objective is to achieve
economic stability and growth
Three indicators are targeted and monitored to
achieve this objective: Prices, Employment and
Balance of payments
The two pillars of macroeconomic policy are Fiscal
and Monetary policies

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Monetary Policies In India

Emphasize co-ordination between monetary and
fiscal policies
Have, as their main objectives, price stability and
ensuring availability of adequate credit to productive
sectors of the economy
They also increasingly emphasize Financial
Stability

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Money, Money Supply And Monetary

Policy
Money is something that people are universally
willing to accept in payment for goods and services
or to pay off debts
Money supply is the total quantity of money in the
economy
Monetary Policy marks the management of money
supply and its links to prices, interest rates and other
economic variables

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COMPONENTS OF THE
FINANCIAL SYSTEM
FINANCIAL MARKETS, which act as brokers, and
FINANCIAL INTERMEDIARIES, which act as asset
transformers
The objectives of both financial markets and
intermediaries are to:
Bring together savings-surplus units and savings-deficit
units
Transfer resources from surplus units to deficit units
Facilitate flow of savings into investment
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How banks create credit Banks, as financial intermediaries, cannot create currency.
The Money Multiplier
But they can create deposits, which in turn can be lent

The operation of the Money multiplier makes Money creation by banks an

iterative process
The key variables determining money supply are the monetary base and
level of leakage
The monetary base is represented by the financial liabilities of the central
bank
Central bank can control monetary base and strongly influences
leakage
Central bank sets reserve requirements [=leakage], which places a limit
on banks ability to create credit
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Liquidity Aggregates In India

Apart from monetary aggregates, in conformity with
the progressive norms, liquidity aggregates are also
computed
L1 = M3 + all deposits with Post office savings
banks, excluding NSCs
L2 = L1 + term deposits with term lending
institutions + term borrowings by institutions + CDs
issued by FIs
L3 = L2 + public deposits of non banking financial
companies
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RBIs Reserve Requirements

All banks in India are required to maintain a specified
amount of reserves as cash / bank balances with the
RBI and as investment in approved securities.
All such reserves that are to be maintained as a legal
requirement are termed Primary Reserves.
These reserve requirements are categorized as [a]
Cash Reserve Ratio [CRR] and [b] Statutory
Liquidity Ratio [SLR]
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The CRR and SLR

CRR is the FRACTIONAL RESERVE and is
maintained as cash balances with RBI
The SLR is maintained to

facilitate government borrowings through bank

investment in approved securities
Provide additional profitability/ liquidity to banking
system

Developmental financial institutions not required to

maintain reserves

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Reserve requirements vs. OMO

RBI is increasingly resorting to OMO to regulate
money supply in the economy
The reserve requirements are being used as a short
term tool
When OMOs are used as the primary policy
instrument, the use of other tools such as reserves
and bank rate become selective and restricted.

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OMO and the Repo

Use of OMO has given rise to active repo markets in
many countries
REPURCHASE AGREEMENT [REPO] IS

An agreement
Between 2 parties
Where one party SELLS securities [for raising short term funds]
At a specified price
With commitment to BUY BACK
At another date
At another predetermined price

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Why Are Repos Important?

Repos used as the policy rate to signify the central
banks monetary policy stance
They can influence interest rates by controlling
liquidity and signifying desired interest rate levels
They can be used to offset short term fluctuations in
bank reserves

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Sources of Accretion to Foreign Exchange Reserves

since 1991

Items
A

Reserves as at end-March 1991

15
1991-92 to 2010-11
(Upto September 2010)
5.8

B.I.

Current Account Balance

-144.7

B.II.

Capital Account (net) (a to e)

415.7

a. Foreign Investment

236.2

Of which

B.III.

FDI

102.7

FII

103.0

b. NRI Deposits

39.1

c. External Assistance

24.3

d. External Commercial Borrowings

76.7

e. Other items in Capital Account (including error and

omission)
Valuation Change

39.0

Reserves as at end-September 2010 (A+BI+BII+BIII)

16.5
292.9

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Data
Source: Half Yearly RBI Report on Management
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How banks invest?

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Evolution of Regulation

18th Century, Bank of Bombay

Bank of Hindustan, 1770
General Bank of Bihar and Bengal, 1773
Presidency Bank, 1806
Enactment of Companies Act, 1850
First Indian owned bank, Allahabad bank
(1865), PNB (1895),
Urban co-operative bank, Conjeevaram Urban
Co-operative Bank
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Pre 1947
Bank Failure, RBI, Regulatory system

1947-1967
Banking Companies Act, Deposit Insurance,

1967-1991-92
Tightening social controls, Priority lending, No assurance of
profitability or asset quality,

Regulated interest rates

High CRR and SLR
Limited disclosure/accounting system
Low capital, High NPA

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Nationalisation of banks in 1969, 14 banks

Paid up capital and reserves to deposit ration
dropped from 9.7 to 2.2,; increase deposits in
relation to their own capital-more leverage)

Branch Licensing Policy

Categorisation of deposits
1991-92 to date
Narashimam committee
Profitability, competitiveness, capital
Pvt banks, prudential norms
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Regulation Vs. Growth

Deleveraging (raising capital, reducing assets,
reducing lending)
Over extended deleveraging
More stringent capital requirement

Readjustment of loan maturity (shortening)

Issue on raising new capital (low p/b ratio)
Reduce overall asset size
Each percent increase in capital requirement
would reduce growth by 0.04-0.05%

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Issues with BASEL-III

Elimination of capital like subordinated debt,
mortgage backed bonds etc.
Leverage ratio (regulatory capital/total assets)
Liquidity requirement
NSFR (available stable funding/required
stable funding)
Defining capital for adequacy purpose
Defining the risk weights
How high the proportion capital to be in Tier-I
and Tier-II
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Tier-I with mortgage servicing rights, deferred tax

assets, equity in subsidiaries with bar of 10% each ,
total to be 15%
Leverage ratio-3%
Restrictions on cross-sector activity
Banks for lending vs. banks for securitisation
Performance linked incentive or incentive linked
performance
Counter cyclical capital requirement
Limit the flow of risk to institutions (Hedging-Credit
risk, Liquidity risk and Market risk)
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Basel III capital requirements

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Too Big Too Fail problem

Vickers Commission
Ring fence
Location of fence (specification of set of
activities)
Height of the fence
Higher capital for ring fenced entity

Volcker Rule
Separation of activities
Limit on trading book
proprietary trading
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rather

than

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But the questions remain??

Scope or size
Private vs. public ownership

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Quick Quiz
Briefly describe various types of banking regulations and
try to match each major law with the main
goals/functions of regulations
How have bank failures influenced recent legislation?
What regulatory issues remain to be resolved?

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