The Reserve Bank of India (RBI) is entrusted with the responsibility of formulating and implementing the monetary policy of India. This duty is explicitly laid down in the Reserve Bank of India Act, 1934. The central objective of the RBI’s monetary policy is to maintain price stability, while simultaneously fostering conditions conducive to economic growth. Price stability is considered a fundamental precondition for achieving sustainable and inclusive growth.

The monetary policy announcements are made on a bi-monthly basis, i.e., once every two months.

Reserve Bank of India (RBI)

The RBI serves as India’s central bank, established on April 1, 1935, under the Reserve Bank of India Act, 1934. It is entrusted with maintaining financial stability and overseeing the country’s currency and credit systems through its regulatory powers and instruments of monetary control.

• The general superintendence and direction of the RBI’s affairs are vested in a Central Board of Directors.
• The Governor acts as the chief executive officer, responsible for the supervision and direction of the bank’s functions.
• The RBI maintains four zonal offices located in Chennai, Delhi, Kolkata, and Mumbai.
• The bank was nationalized on January 1, 1949, following the enactment of the Reserve Bank of India (Transfer to Public Ownership) Act, 1948.
• While the RBI Act, 1934 governs the functions of the RBI, the Banking Regulation Act, 1949 governs broader financial sector regulation.

Basic Objectives of RBI

1. To regulate the issue of banknotes.
2. To maintain reserves to secure monetary stability in the country.
3. To manage and operate the currency and credit system efficiently.

Core Functions of RBI

• Formulation and execution of monetary policy.
• Foreign exchange reserves management and overseeing the external value of the rupee.
• Regulation and supervision of financial institutions.
• Acting as a banker to the government (both Central and State) and to other banks.

Composition of the Central Board

As per the RBI Act:

• A Governor and up to four Deputy Governors, appointed by the Central Government.
• Four Directors, nominated by the Central Government, representing each of the four local boards.
• Ten other Directors, also nominated by the Central Government.
• Two government officials, nominated to represent the government’s interests.

Monetary Policy Committee (MPC)

The Monetary Policy Committee (MPC) is a statutory body constituted by the Central Government to formulate the monetary policy.

Composition of MPC

• RBI Governor – Chairperson (Currently: Shaktikanta Das)
• Deputy Governor, in charge of monetary policy (Currently: Dr. Michael Debabrata Patra)
• One officer from RBI, nominated by the Central Board
• Three external members, appointed by the Central Government for a term of four years

Functions of the MPC

• The MPC is tasked with setting the policy interest rate (Repo rate) to achieve the inflation target.
• The committee is required to meet at least four times a year, and the quorum for a meeting is four members.
• Each member has one vote, and in case of a tie, the Governor holds a casting vote.
• MPC decisions are made by majority vote.
• Post-meeting disclosure:
  • A resolution adopted by the MPC is released immediately after the meeting.
  • The minutes of the meeting are published on the 14th day, including:
    • The adopted resolution
    • Each member’s vote
    • Their individual statements

Additionally, every six months, the RBI publishes a Monetary Policy Report that:

• Analyzes the sources of inflation
• Provides a forecast of inflation for the next 6–18 months

Important Concepts and Instruments

Inflation Targeting (Section 45-ZA, RBI Act)

The RBI Act mandates that the Central Government, in consultation with RBI, set an inflation target based on the Consumer Price Index (CPI) once every five years.

• As of March 31, 2021, the inflation target has been retained at 4%, with:
  • Upper tolerance limit: 6%
  • Lower tolerance limit: 2%
• A failure to meet the target occurs if:
  • The average inflation remains above 6% or below 2% for three consecutive quarters
• In such cases, the RBI must submit a report to the Central Government explaining:
  • Reasons for failure
  • Proposed corrective actions
  • Timeline for returning to the inflation target

Net Demand and Time Liabilities (NDTL)

• Demand Liabilities: Payable on demand. Include:
  • Current deposits
  • Certain savings bank deposits
  • Margins against LCs and guarantees
  • Overdue deposits
  • Demand drafts, unclaimed deposits, etc.
• Time Liabilities: Payable after a specified period. Include:
  • Fixed deposits
  • Recurring/cumulative deposits
  • Time portion of savings bank deposits
  • Gold deposits

Liquidity Adjustment Facility (LAF)

• A facility through which RBI helps commercial banks manage their short-term liquidity.
• Conducted via repurchase agreements (Repos and Reverse Repos).
• LAF plays a key role in daily liquidity management and is considered an essential tool of monetary policy.

Quantitative Instruments of Monetary Policy

Direct Instruments (Variable Reserve Ratios)

1. Cash Reserve Ratio (CRR):

• Percentage of NDTL that banks must maintain with RBI.
• E.g., if CRR = 4%, and deposits = ₹100 Cr, bank deposits ₹4 Cr with RBI.

2. Statutory Liquidity Ratio (SLR):

• Fixed percentage of bank deposits to be held in safe assets such as cash, gold, and G-secs.

Impact: Higher CRR and SLR reduce bank lending capacity, tightening liquidity.

Indirect Instruments

Repo Rate:

• The interest rate at which RBI lends to banks for short term, using G-secs as collateral.

Reverse Repo Rate:

• The rate at which RBI borrows from banks. Used to absorb liquidity from the banking system.

Bank Rate:

• Long-term interest rate for discounting/rediscounting bills (mostly dormant now).
• Penal rate for CRR and SLR defaults; aligned with MSF rate.

Open Market Operations (OMO):

• RBI buys or sells government securities to manage long-term liquidity.
• Sells during inflation, buys during deflation.

Marginal Standing Facility (MSF):

• Emergency window for banks to borrow overnight by dipping into SLR portfolio.
• Interest rate is higher than the repo rate.

Market Stabilization Scheme (MSS):

• Introduced in 2004 to absorb surplus liquidity arising from capital inflows.
• Cash collected is kept in a separate government account with RBI.

Qualitative Instruments of Monetary Policy

These instruments regulate specific uses of credit rather than total volume.

1. Variation in Margin Requirements: Controls how much banks can lend against collateral.
2. Credit Rationing: Sets ceilings on the quantity or types of loans banks can issue.
3. Moral Suasion:Persuasive techniques used by RBI to align banks with monetary policy goals.
4. Direct Action: Penal measures (e.g., refusing rediscounting, applying penalty interest) for non-compliant banks.
5. Directives: Instructions issued by RBI to banks to ensure proper credit deployment.

Marginal Cost of Funds based Lending Rate (MCLR)

• Introduced to make lending rates more responsive to RBI policy.
• Replaced the Base Rate system from April 1, 2016.
• MCLR is a tenor-linked internal benchmark based on the marginal cost of funds.
• All new loans and credit renewals are linked to MCLR to ensure transparency.

Basel III Norms and Capital Requirements

Capital Adequacy Ratio (CAR)

• Ensures banks maintain adequate capital to absorb losses.
• In India: Minimum CAR = 9% of Risk Weighted Assets (Basel III recommends 8%).

Capital Conservation Buffer (CCB)

• 2.5% buffer to be maintained over and above minimum capital requirements during good times.

Countercyclical Capital Buffer (CCCB)

• Helps banks build capital in good times to sustain lending during economic downturns.

Leverage Ratio

• A non-risk based measure to limit excessive borrowing.
• India mandates:
  • 4% for DSIBs
  • 3.5% for other banks

Government Securities (G-Secs)

• Issued by Central/State Governments to acknowledge public debt.
• Types:
  • T-Bills: Short-term (91, 182, 364 days); zero-coupon, issued at discount.
  • Dated Securities: Long-term (5 to 40 years); fixed/floating interest, paid semi-annually.
  • Cash Management Bills (CMBs): Ultra-short term (<91 days), introduced in 2010.

Sovereign Gold Bonds (SGB)

• Issued by RBI on behalf of Government of India.
• Denominated in grams of gold.
• Tenor: 8 years, with exit after 5 years.
• Return: 2.5% annual interest (taxable).
• Capital Gains on redemption: Exempt for individuals.

Other Important Terms

• Zero Coupon Bonds: Issued at discount, redeemed at face value, no periodic interest.
• Capital Indexed Bonds: Principal is inflation-indexed (e.g., CPI/WPI).
• Inflation Indexed Bonds (IIBs): Both principal and interest are inflation-protected.
• Call/Put Options on Bonds: Allows issuer or holder to redeem/sell bonds before maturity.
• Shut Period: One-day period during which bond trading is restricted to finalize redemptions.

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Subject: Economics

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