Banking I: The Financial System, Banks, the RBI and Reforms
2. Types of banks
| Type | What it is | Regulated by | Point the paper tests |
|---|---|---|---|
| Commercial banks | Public sector, private sector and foreign banks accepting deposits and lending for profit | RBI under the Banking Regulation Act, 1949 | Scheduled banks are those in the Second Schedule of the RBI Act, 1934 |
| Regional Rural Banks | Set up under the RRB Act, 1976 to lend to small farmers, artisans and rural labour | RBI regulates; NABARD supervises | Owned 50:35:15 by the Centre, the sponsor bank and the State |
| Foreign banks | Banks incorporated abroad operating through branches or wholly owned subsidiaries in India | RBI | Subject to priority sector lending at a threshold that depends on branch count |
| Cooperative banks | Member-owned; urban cooperative banks, and a rural three-tier structure of State, district central and primary societies | Dual — RBI for banking functions, the Registrar of Cooperative Societies for incorporation and management | The dual control is the examinable weakness, tightened by the 2020 amendment |
3. The Reserve Bank of India: functions and monetary policy
The RBI was established under the Reserve Bank of India Act, 1934, began operations in 1935 and was nationalised in 1949. Its functions are asked as a list: sole issuer of currency notes other than the one-rupee note, which the Government issues; banker to the Government and to banks, and lender of last resort; custodian of foreign exchange reserves and manager of the exchange rate; regulator and supervisor of banks; controller of credit through monetary policy; and developmental functions that have since largely been spun off to NABARD, SIDBI and the NHB.
Monetary policy is decided by the six-member Monetary Policy Committee constituted under the 2016 amendment to the RBI Act — three from the RBI including the Governor, who has a casting vote, and three appointed by the Government — with a statutory inflation target of 4% consumer price inflation within a band of 2% to 6%. The instruments divide into quantitative, which act on the volume of credit, and qualitative or selective, which act on its direction.
| Instrument | What it is | To tighten money |
|---|---|---|
| Repo rate | The rate at which banks borrow overnight from the RBI against securities — the policy rate | Raise it |
| Reverse repo and SDF | The rate the RBI pays banks to park surplus with it; the standing deposit facility does so without collateral | Raise it |
| Bank rate | The rate for long-term lending to banks, now aligned with the marginal standing facility | Raise it |
| Cash reserve ratio | The share of net demand and time liabilities a bank must hold as cash with the RBI; earns no interest | Raise it |
| Statutory liquidity ratio | The share of NDTL a bank must hold in cash, gold or approved securities, with itself | Raise it |
| Open market operations | Outright purchase or sale of government securities by the RBI | Sell securities |
4. Reforms: Narasimham, Basel, risk and non-performing assets
Banking reform in India runs from the two Narasimham Committees. The first, in 1991, recommended lowering the SLR and CRR, deregulating interest rates, prudential norms for income recognition, asset classification and provisioning, capital adequacy, and entry for new private banks. The second, in 1998, recommended stronger capital norms, narrow banking for weak banks, asset reconstruction companies, and reduction of government shareholding. Most of what banking looks like today was proposed in one of the two.
| Accord | What it added |
|---|---|
| Basel I (1988) | A minimum capital to risk-weighted assets ratio of 8%, with capital in two tiers and assets weighted for credit risk only |
| Basel II (2004) | Three pillars — minimum capital now covering credit, market and operational risk; supervisory review; and market discipline through disclosure |
| Basel III (2010) | Higher and better-quality capital, a capital conservation buffer and a countercyclical buffer, a leverage ratio, and two liquidity standards — the liquidity coverage ratio and the net stable funding ratio |
A bank's risks are named and matched to the pillar that captures them: credit risk that a borrower will not repay, market risk from movements in rates and prices, operational risk from failed processes, people, systems or fraud, and liquidity risk that the bank cannot meet obligations as they fall due. Asset-liability management is the practice of matching the maturity and rate sensitivity of what the bank owes against what it owns.
5. Money, capital and government securities markets
| Market | Maturity | Instruments | Regulator |
|---|---|---|---|
| Money market | Up to one year | Call and notice money, treasury bills, commercial paper, certificates of deposit, repo, collateralised borrowing | RBI |
| Capital market | Over one year | Equity and preference shares, debentures and bonds; primary through IPO, FPO, rights and private placement; secondary on the exchanges | SEBI |
| Government securities market | Both — T-bills short, dated securities long | Treasury bills of 91, 182 and 364 days; dated securities; State development loans; sold by auction on the RBI's electronic platform | RBI, as the Government's debt manager |
Key takeaways
- A bank accepts demand deposits and creates credit; a non-banking institution may lend but cannot. Scheduled means listed in the Second Schedule of the RBI Act, a legal status and not a size.
- Cooperative banks are under dual control — the RBI for banking and the Registrar for incorporation — and RRBs are owned 50:35:15 by the Centre, the sponsor bank and the State.
- The MPC has six members and a 4% target within 2% to 6%; CRR is cash with the RBI earning nothing, SLR is held by the bank itself in cash, gold or approved securities.
- Basel II brought three pillars and Basel III brought buffers, a leverage ratio and two liquidity standards; a loan is non-performing after ninety days overdue and climbs substandard, doubtful, loss.
- Commercial paper is a company's, certificates of deposit are a bank's, treasury bills are the Government's at 91, 182 and 364 days; the money market is the RBI's and the capital market is SEBI's.
Practice questions (9)
Attempt each one before opening the answer. Every explanation names the tempting wrong option as well as the right one, because that is where marks are lost.
The cash reserve ratio differs from the statutory liquidity ratio in that the CRR:
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Answer: A — Is held as cash with the Reserve Bank and earns no interest
Both ratios are fractions of a bank's net demand and time liabilities and both are set by the RBI, so the difference lies in where the reserve sits and in what form. The CRR is a balance the bank must keep as cash with the Reserve Bank, on which nothing is earned, which is why a rise in CRR is a direct cost to banks. The SLR is maintained by the bank itself in cash, gold or approved government securities, and the securities earn interest. SEBI regulates the capital market and has no role in reserve requirements, and both ratios apply to scheduled commercial banks, not to cooperative banks alone.A loan is classified as a non-performing asset when interest or principal remains overdue for more than:
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Answer: A — 90 days
The RBI's prudential norms treat a loan as non-performing once interest or an instalment of principal has been overdue for more than ninety days, a threshold tightened from 180 days in 2004 as part of convergence with international practice. Once classified, the asset moves down a ladder — substandard for up to twelve months, doubtful thereafter, and loss when identified as uncollectible — with provisioning rising at each step. Thirty days is the point at which a special mention account is flagged, before the loan turns non-performing, and one year is the boundary between substandard and doubtful rather than the NPA threshold itself.Certificates of deposit in the Indian money market are issued by:
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Answer: A — Banks and eligible financial institutions
A certificate of deposit is a negotiable, discounted receipt for a term deposit placed with a bank or an eligible financial institution, which is what makes it a bank's instrument. Commercial paper is the parallel instrument on the corporate side — an unsecured promissory note issued by a highly rated company borrowing directly from the market — and the two are routinely set against each other for exactly this distinction. The Government's short-term instrument is the treasury bill, issued at 91, 182 and 364 days, and stock exchanges provide a secondary market for capital market securities rather than issuing money market paper.The three pillars of Basel II are:
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Answer: A — Minimum capital requirements, supervisory review and market discipline
Basel II organised bank regulation around three pillars: the first sets minimum capital against credit, market and operational risk, the second gives supervisors the power to review a bank's own assessment of its risk and require more capital, and the third uses disclosure to let the market discipline banks. The list of risks is what the first pillar measures rather than the pillars themselves, and liquidity risk was not addressed by Basel II at all. The tiers describe the quality of capital, not the pillars. The leverage ratio and the two liquidity standards are the additions of Basel III, introduced after the 2008 crisis exposed what Basel II had left out.Regional Rural Banks are owned by the Central Government, the sponsor bank and the State Government in the ratio:
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Answer: A — 50:35:15
The Regional Rural Banks Act, 1976 set the share capital of each RRB to be contributed by the Central Government, the sponsoring commercial bank and the State Government in the proportion 50:35:15, which is the figure the paper asks. The design gives the Centre a controlling stake, ties each bank to a commercial bank that provides management and support, and involves the State in whose districts it operates. RRBs are regulated by the RBI and supervised by NABARD, and successive rounds of amalgamation have reduced their number while keeping this ownership structure intact.The Monetary Policy Committee of the RBI consists of:
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Answer: A — Six members, three from the RBI and three appointed by the Government, with the Governor holding a casting vote
The 2016 amendment to the RBI Act created a six-member Monetary Policy Committee: the Governor, the Deputy Governor in charge of monetary policy and one officer nominated by the RBI's central board, together with three external members appointed by the Central Government for a fixed term. Decisions are by majority, and the Governor has a second, casting vote in the event of a tie. The committee is charged with meeting a statutory inflation target of 4% consumer price inflation within a band of 2% to 6%. Before 2016 the Governor decided policy alone with a technical advisory committee, which is the arrangement the first wrong option describes.Cooperative banks in India are subject to dual control, meaning that they are regulated by:
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Answer: A — The RBI for banking functions and the Registrar of Cooperative Societies for incorporation and management
Cooperative banks are cooperative societies first and banks second, so two laws reach them: the State Cooperative Societies Act, administered by the Registrar, governs their registration, membership, elections and management, while the Banking Regulation Act, administered by the RBI, governs their banking business. This division is the examinable weakness of the structure, because supervisory gaps opened between the two authorities, and the Banking Regulation (Amendment) Act, 2020 extended the RBI's powers over cooperative banks' management to narrow them. SEBI regulates securities markets, and NABARD supervises rural cooperatives and RRBs rather than regulating urban cooperative banks.The SARFAESI Act, 2002 enables a secured creditor to:
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Answer: A — Take possession of and sell the security for a defaulted loan without the intervention of a court
The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 gave banks and financial institutions a route around the slow civil courts: after a loan is classified non-performing and a sixty-day notice has expired, the secured creditor may take possession of the secured asset, take over its management, or sell or lease it, and the borrower's remedy is an appeal to the Debts Recovery Tribunal. The Act also provided the legal basis for asset reconstruction companies. It provides no government guarantee, no automatic conversion to equity, and the Monetary Policy Committee has nothing to do with individual loan recovery.Treasury bills in India are issued for maturities of:
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Answer: A — 91, 182 and 364 days
Treasury bills are the Government of India's short-term borrowing instrument, issued at a discount and redeemed at par, and they are auctioned by the RBI at three maturities — 91, 182 and 364 days. Being a money market instrument they never exceed one year. Government borrowing for longer periods is done through dated securities, which run from a few years to as long as forty, and those are the maturities the last option confuses with bills. Very short tenors of a week or two are the territory of the call and notice money market and of repo, not of treasury bills.