A

PROJECT REPORT

ON

“EFFECT OF MONETARY POLICY ON BANKING SECTOR”

IN RESPECT OF PUNJAB STATE COOPERATIVE BANK BATHINDA.

Submitted In the partial fulfillment of the requirementfor the award of the degree of BACHELOR OF BUSINESS ADMINISTRATION (Finance).

Submitted to: Submitted by:

Punjabi University, Patiala Shweta Tandon

B.B.A (Part3rd)

Roll no. 10837

Under the guidance of

Ms. Vijay laxmi(Asst. Professor in Management)

S.S.D WOMEN’S INSTITUTE OF TECHNOLOGY, BATHINDA

(Affiliated to Punjabi university, Patiala)

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CERTIFICATE

This is certified that Project entitled ‘Effect of monetary policy on banking sector in Punjab state

cooperative bank’ submitted by Miss Shweta Tandon conducted a boundary bonaified piece of work

under my direct supervision and guidance. No part of this has been submitted for any other university. It

may be considered for evaluation of partial fulfillment of the requirement for award of ‘Bachelor of

Business Administration’.

Project Guide

Mrs. Vijay Laxmi

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DECLARATION

This is to certify that Project Report on “Effect of monetary policy on banking sector

Punjab state cooperative bank” submitted by me in Bachelor of Business Administration

Program from S.S.D. WOMAN’S INSTITUTE OF TECHNOLOGY, BATHINDA

(Punjabi University, Patiala) is my original work and the project report has not formed the

basis for award of any diploma, degree, associate ship, fellowship or similar other titles. It

embodies the original work done by under the able guidance supervision of Ms. Vijay

Laxmi (GUIDE & FACULTY) S.S.D WOMEN’S INSTITUTE OF TECHNILOGY.

----------------------------------

Shweta

B.B.A 6th Semester

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ACKNOWLEDGEMENT

Preparing a project is never unilateral effort I wish to acknowledge the guidance of the

professionals in bringing up the real picture of project is prepared.

I indebt to Sh. Gurdip Singh Sidhu for their insightful annotations and assistance thought the

project. Their unfailing enthusiasm and guidance kept me motivated and encourage in project.

I also express our thanking to all the staff members of the will whose names I unable to mention

here for their kind cooperation and valuable guidance to complete our project.

I also express my special thanks to Mrs. Vijay Laxmi .

Shweta Tandon

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CONTENTS

CHAPTERS

NATURE AND SCOPE OF BANKING CTIVITIES

PARAMETERS OF MP

3- MONETARY POLICY IN INDIA

4- FUNCTIONS OF COOPERATIVE BANK

5-RESEARCH METHODOLOGY

- TYPES OF RESEARCH

- DATA COLLECTIN METHOD

-OBJECTIVES OF STUDY

- IMPACT OF MONETARY

7-SUGGETIONS

8-BIBLOGRAPHY

1- INTRODUCTION TO BANK

MEANING OF BANKING

FUNCTIONS OF BANK

2- MONETARY POLICY

MEANING OF MP

OBJECTIVES OF MP

INSTRUMENTS OF MP

6- EFFECT OF MONETARY POLICY ON BANKS

- INTREST RATES

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CHAPTER-1

INTRODUCTION

TO

BANK

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Meaning of the terms Bank and Banking

Bank is an institution which deals in money and credit. It Accepts deposits from the public and grants

loans and advances to those who are in need of funds for various purposes. Banking is an activity which

involves acceptance of deposits for the purpose of lending or investing. In addition to accepting deposits

and lending funds, banking also involves providing various other services along with its main banking

activity. These are mainly agency services, but include several general services as well. A banker is one

who undertakes banking activities, accepting deposits and lending money for different purposes. The

Banking Regulation Act, 1949 defines banking as an activity of accepting funds from the public for the

purpose of lending or investment.

The essential features of banking activities are as follows:-

i) Accepting deposits from public;

ii) Lending or investment of such deposits;

iii) Incidental to the activities of accepting deposits for lending or investing, banks undertake activities

like —

a) Promoting and mobilizing savings of the public;

b) Providing funds to trade and industry by way of discounting bills, overdraft, cash credit facility, and

transfer of funds from one place to another;

c) Providing agency services to customers, such as collection Of bills, payment of insurance premium,

purchase and sale Of securities, etc., and other general services, such as issue of travelers’ cheques, credit

cards, locker facility, etc; Money deposited with the bank is assured as far as its Safety is concerned.

Further the depositor is allowed to withdraw it whenever required. Banks allow interest on deposits. Such

interest helps in the growth of funds deposited with the bank. Thus the rate of interest provided on

deposits acts as an incentive to the depositors.

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Reserve Bank of India (Central Bank)

In every country, the bank which is entrusted with the responsibility of guiding and regulating the

banking system is known as the Central Bank. In India the central banking authority is the Reserve Bank

of India. The Reserve Bank does not deal directly with the members of public. It acts as bankers’ bank

maintaining deposit accounts of all other banks and advances money to banks whenever needed. It

regulates the volume of currency and credit, and has powers of control and supervision over all banking

institutions. The Reserve Bank also acts as government banker and maintains the record of goverment

receipts, payments and borrowings under various heads. It advises the government on monetary and

credit policy, besides deciding on the rate of interest on bank deposits and bank loans. It is the custodian

of currency reserves consisting of foreign exchange, gold and other securities. Another important

function of the Reserve Bank is the issue of currency notes and regulation of the money supply.

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Co-operative Banks/Society

Co-operative Banks in India are established under the provisions of the Co-operative Societies Act 1912.

These are organized on co-operative basis. It was with a view to provide adequate credit at economical

rates of interest to the farmers, that co-operative credit societies were first organized in villages for

providing financial help to agriculturist and rural artisans.

Co-operatives banks are organized both at primary and district level. Co-operative Credit Societies

(banks) at the primary level/local level are members of central co-operative banks at the district level.

Similarly, at the state level, there are state co-operative bank, which finance, co-ordinate and control the

central co-operative banks in each state. Thus the structure of co-operative banks in India is pyramidal in

nature.

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A co-operative credit society (bank) at the primary level can be formed by the local people

having common interest and common purposes. The co-operative banks generally grant loans for

productive purposes but they can also do so for other purposes. The rate of interest charged is very

moderate. The mode of recovery of loan is not very rigid.

The Reserve Bank of India was founded on 1 April 1935 to respond to economic troubles after the First

World War, The Bank was set up based on the recommendations of the 1926 Royal Commission on

Indian Currency and Finance, also known as the Hilton–Young Commission. The original choice for the

seal of RBI was The East India Company Double Mohur, with the sketch of the Lion and Palm Tree.

However it was decided to replace the lion with the tiger, the national animal of India. The Preamble of

the RBI describes its basic functions to regulate the issue of bank notes, keep reserves to secure monetary

stability in India, and generally to operate the currency and credit system in the best interests of the

country. The Central Office of the RBI was initially established in Calcutta (now Kolkata), but was

permanently moved to Bombay (now Mumbai) in 1937. The RBI also acted as Burma's central bank,

except during the years of the Japanese occupation of Burma (1942–45), until April 1947, even though

Burma seceded from the Indian Union in 1937. After the Partition of India in 1947, the Bank served as

the central bank for Pakistan until June 1948 when the State Bank of Pakistan commenced operations.

Though originally set up as a shareholders’ bank, the RBI has been fully owned by the Government of

India since its nationalization in 1949.

1950–1960

In the 1950s, the Indian government, under its first Prime Minister Jawaharlal Nehru, developed a

centrally planned economic policy that focused on the agricultural sector. The administration

nationalized commercial banks and established, based on the Banking Companies Act of 1949 (later

called the Banking Regulation Act), a central bank regulation as part of the RBI. Furthermore, the central

bank was ordered to support the economic plan with loans.[7]

1960–1969

As a result of bank crashes, the RBI was requested to establish and monitor a deposit insurance system. It

should restore the trust in the national bank system and was initialized on 7 December 1961. The Indian

government founded funds to promote the economy and used the slogan Developing Banking. The

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Government of India restructured the national bank market and nationalized a lot of institutes. As a

result, the RBI had to play the central part of control and support of this public banking sector.

1969–1985

In 1969, the Indira Gandhi-headed government nationalized 14 major commercial banks. Upon Gandhi's

return to power in 1980, a further six banks were nationalized. The regulation of the economy and

especially the financial sector was reinforced by the Government of India in the 1970s and 1980s The

central bank became the central player and increased its policies for a lot of tasks like interests, reserve

ratio and visible deposits. These measures aimed at better economic development and had a huge effect

on the company policy of the institutes. The banks lent money in selected sectors, like agri-business and

small trade companies.

The branch was forced to establish two new offices in the country for every newly established office in a

town. The oil crises in 1973 resulted in increasing inflation, and the RBI restricted monetary policy to

reduce the effects.

1985–1991

A lot of committees analyzed the Indian economy between 1985 and 1991. Their results had an effect on

the RBI. The Board for Industrial and Financial Reconstruction, the Indira Gandhi Institute of

Development Research and the Security & Exchange Board of India investigated the national economy

as a whole, and the security and exchange board proposed better methods for more effective markets and

the protection of investor interests. The Indian financial market was a leading example for so-called

"financial repression" (Mackinnon and Shaw).[13] The Discount and Finance House of India began its

operations on the monetary market in April 1988; the National Housing Bank, founded in July 1988, was

forced to invest in the property market and a new financial law improved the versatility of direct deposit

by more security measures and liberalization.

1991–2000

The national economy came down in July 1991 and the Indian rupee was devalued The currency lost

18% relative to the US dollar, and the Narsimahmam Committee advised restructuring the financial

sector by a temporal reduced reserve ratio as well as the statutory liquidity ratio. New guidelines were

published in 1993 to establish a private banking sector. This turning point should reinforce the market

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and was often called neo-liberal. The central bank deregulated bank interests and some sectors of the

financial market like the trust and property markets. This first phase was a success and the central

government forced a diversity liberalization to diversify owner structures in 1998.

The National Stock Exchange of India took the trade on in June 1994 and the RBI allowed nationalized

banks in July to interact with the capital market to reinforce their capital base. The central bank founded

a subsidiary company—the Bharatiya Reserve Bank Note Mudran Limited—in February 1995 to

produce banknotes.

Since 2000

The Foreign Exchange Management Act from 1999 came into force in June 2000. It should improve the

foreign exchange market, international investments in India and transactions. The RBI promoted the

development of the financial market in the last years, allowed online banking in 2001 and established a

new payment system in 2004–2005 (National Electronic Fund Transfer). The Security Printing &

Minting Corporation of India Ltd., a merger of nine institutions, was founded in 2006 and produces

banknotes and coins.

The national economy's growth rate came down to 5.8% in the last quarter of 2008–2009 and the central

bank promotes the economic development

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Nature and Scope of Cooperative Banking

Banking activities are considered to be the life blood of the national economy. Without banking services,

trading and business activities cannot be carried on smoothly. Banks are the distributors and protectors of

liquid capital which is of vital significance to a developing country. Efficient administration of the

banking system helps in the economic growth of the nation. Banking is useful to trade and commerce.

Banking activities are useful to trade and industry in the following ways.

a) Money deposited in a bank remains safe. Precious articles too can be kept in the safe custody of banks

in lockers.

b) Banks provide credit facilities to their customers. Customers with bank accounts also enjoy better

credit in the business world.

c) Banks encourage the habit of saving and thrift among people. They mobilize savings and invest them

in productive activities. Thus, they help in increasing the rate of savings and investment

in the country.

d) Banks provide a convenient and safe means of transferring money from one place to another and

facilitate business dealings/ transactions.

e) Banks collect and realize bills, cheque, interest and dividend warrants etc. on behalf of their

customers.

f) Foreign trade is facilitated considerably with the help of banks which receive and make payments,

provide credit and deal in foreign exchange. They protect importers from the risk of loss on account of

exchange rate fluctuations. They issue letter of credit and provide information on the credit worthiness of

importers. They also act as referees of their customers.

g) Banks meet the financial needs of small-scale business units

Which are located in economically backward areas.

h) Farmers and artisans in rural areas can also avail of bank credit for financing their activities.

i) Commercial banks provide many other services to the general public which includes locker facility,

issue of traveler’s cheque and gift cheque, payment of insurance premium, etc.

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Effect of suspension of banking activities on Trade

Commerce and Industry

As a result of economic growth, increase in money supply, growth of banking habits, and control and

guidance by Reserve Bank of India, the Indian banking system has achieved a record progress over the

years. Banking activities in our economy have become so imperative and important for the trading

community and even for the general public, that even a temporary halt in banking activities may vitally

affect trade, commerce and industry. This position can be explained

briefly as follows.

(i) In the event of suspension of banking activities, people would neither be able to deposit their savings

in banks, nor be able to withdraw money from banks. Savings are then likely to decline with a

corresponding increase in consumption expenditure.

(ii) Non-availability of bank loans and credit facilities will adversely affect industrial production. The

volume of trade will shrink. Limited cash in hand and inadequate currency in circulation may not permit

cash transactions in buying and selling of all goods. With reduced production and rising consumption

expenditure prices would tend to rise. Traders may exploit the situation by hoarding and black-marketing

of essential goods.

(iii) Farmers and small business units will suffer badly if banking operations are suspended. They will be

forced to go to money lenders to borrow money at high rates of interest when bank finance is not

available.

(iv) Foreign trade will be badly affected in the absence of facilities regarding issue of letter of credit and

foreign exchange transactions.

(v) Business firms as well as the public will have to depend on postal services and private agencies for

remittance of money and on other agencies for collection of bills, interest and dividend warrants. Heavy

expenses will have to be incurred for the services.

(vi) People will have to go to courts of law for recovery of their jewellery and other valuable articles

from bank lockers. We cannot think of any day without the use of banking services such is the

importance of banking in our daily life.

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CHAPTER-2

MONETARY POLICY

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Monetary policy

Introduction:-

Monetary policy is the process by which the monetary authority of a country controls the supply of

money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The

official goals usually include relatively stable prices and low unemployment. Monetary theory provides

insight into how to craft optimal monetary policy. It is referred to as either being expansionary or

concretionary, where an expansionary policy increases the total supply of money in the economy more

rapidly than usual, and contraction policy expands the money supply more slowly than usual or even

shrinks it. Expansionary policy is traditionally used to try to combat unemployment in a recession by

lowering interest rates in the hope that easy credit will entice businesses into expanding. Concretionary

policy is intended to slow inflation in hopes of avoiding the resulting distortions and deterioration of

asset values. Monetary policy is the process by which the government, central bank, or monetary

authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money

or rate of interest to attain a set of objectives oriented towards the growth and stability of the economy.

Monetary theory provides insight into how to craft optimal monetary policy.

Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at

which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to

control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with

other currencies and unemployment. Where currency is under a monopoly of issuance, or where there is

a regulated system of issuing currency through banks which are tied to a central bank, the monetary

authority has the ability to alter the money supply and thus influence the interest rate (to achieve policy

goals).

The term monetary policy is also known as the 'credit policy' or called 'RBI's money

management policy' in India. How much should be the supply of money in the economy? How much

should be the ratio of interest? How much should be the viability of money? etc. Such questions are

considered in the monetary policy. From the name itself it is understood that it is related to the demand

and the supply of money.

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VARIOUS DEFINITIONS;-

Economic strategy chosen by a government in deciding expansion or contraction in the country's

money-supply. Applied usually through the central bank, a monetary policy employs three major tools:

(1) Buying or selling national debt

(2) Changing credit restrictions

(3) Changing the interest rates by changing reserve requirements.

Monetary policy plays the dominant role in control of the aggregate-demand and, by

extension, of inflation in an economy. Also called monetary regime.

According to Prof. Harry Johnson ,

"A policy employing the central banks control of the supply of money as an instrument for achieving the

objectives of general economic policy is a monetary policy."

According to A.G. Hart ,

"A policy which influences the public stock of money substitute of public demand for such assets of both

that is policy which influences public liquidity position is known as a monetary policy."

From both these definitions, it is clear that a monetary policy is related to the availability and cost of

money supply in the economy in order to attain certain broad objectives. The Central Bank of a nation

keeps control on the supply of money to attain the objectives of its monetary policy.

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Objectives of Monetary Policy

The objectives of a monetary policy in India are similar to the objectives of its five year plans. In a

nutshell planning in India aims at growth, stability and social justice. After the Keynesian revolution in

economics, many people accepted significance of monetary policy in attaining following objectives.

1. Rapid Economic Growth

2. Price Stability

3. Exchange Rate Stability

4. Balance of Payments (BOP) Equilibrium

5. Full Employment

6. Neutrality of Money

7. Equal Income Distribution

These are the general objectives which every central bank of a nation tries to attain by employing certain

tools (Instruments) of a monetary policy. In India, the RBI has always aimed at the controlled expansion

of bank credit and money supply, with special attention to the seasonal needs of a credit.Let us now see

objectives of monetary policy in detail:-

1. Rapid Economic Growth: It is the most important objective of a monetary policy. The

monetary policy can influence economic growth by controlling real interest rate and its resultant

impact on the investment. If the RBI opts for a cheap or easy credit policy by reducing interest rates,

the investment level in the economy can be encouraged. This increased investment can speed up

economic growth. Faster economic growth is possible if the monetary policy succeeds in maintaining

income and price stability.

2. Price Stability: All the economics suffer from inflation and deflation. It can also be called as

Price Instability. Both inflation are harmful to the economy. Thus, the monetary policy having an

objective of price stability tries to keep the value of money stable. It helps in reducing the income and

wealth inequalities. When the economy suffers from recession the monetary policy should be an 'easy

money policy' but when there is inflationary situation there should be a 'dear money policy'.

3. Exchange Rate Stability: Exchange rate is the price of a home currency expressed in terms

of any foreign currency. If this exchange rate is very volatile leading to frequent ups and downs in the

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exchange rate, the international community might lose confidence in our economy. The monetary

policy aims at maintaining the relative stability in the exchange rate. The RBI by altering the foreign

exchange reserves tries to influence the demand for foreign exchange and tries to maintain the

exchange rate stability.

4. Balance of Payments (BOP) Equilibrium: Many developing countries like India suffer

from the Disequilibrium in the BOP. The Reserve Bank of India through its monetary policy tries to

maintain equilibrium in the balance of payments. The BOP has two aspects i.e. the 'BOP Surplus' and

the 'BOP Deficit'. The former reflects an excess money supply in the domestic economy, while the

later stands for stringency of money. If the monetary policy succeeds in maintaining monetary

equilibrium, then the BOP equilibrium can be achieved.

5. Full Employment: The concept of full employment was much discussed after Keynes's

publication of the "General Theory" in 1936. It refers to absence of involuntary unemployment. In

simple words 'Full Employment' stands for a situation in which everybody who wants jobs get jobs.

However it does not mean that there is Zero unemployment. In that senses the full employment is

never full. Monetary policy can be used for achieving full employment. If the monetary policy is

expansionary then credit supply can be encouraged. It could help in creating more jobs in different

sector of the economy.

6. Neutrality of Money: Economist such as Wicks Ted, Robertson has always considered

money as a passive factor. According to them, money should play only a role of medium of exchange

and not more than that. Therefore, the monetary policy should regulate the supply of money. The

change in money supply creates monetary disequilibrium. Thus monetary policy has to regulate the

supply of money and neutralize the effect of money expansion. However this objective of a monetary

policy is always criticized on the ground that if money supply is kept constant then it would be

difficult to attain price stability.

7. Equal Income Distribution: Many economists used to justify the role of the fiscal policy is

maintaining economic equality. However in resent years economists have given the opinion that the

monetary policy can help and play a supplementary role in attainting an economic equality. Monetary

policy can make special provisions for the neglect supply such as agriculture, small-scale industries,

village industries, etc. and provide them with cheaper credit for longer term. This can prove fruitful for

these sectors to come up. Thus in recent period, monetary policy can help in reducing economic

inequalities among different sections of society

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Instrument of monetary policy

The instruments of monetary policy are tools or devise which are used by the monetary authority in order

to attain some predetermined objectives. There are two types of instruments of the monetary policy as

shown below.

(A) Quantitative Instruments or General Tools

The Quantitative Instruments are also known as the General Tools of monetary policy. These tools are

related to the Quantity or Volume of the money. The Quantitative Tools of credit control are also called

as General Tools for credit control. They are designed to regulate or control the total volume of bank

credit in the economy. These tools are indirect in nature and are employed for influencing the quantity of

credit in the country. The general tool of credit control comprises of following instruments.

1. Bank Rate Policy (BRP)

The Bank Rate Policy (BRP) is a very important technique used in the monetary policy for influencing

the volume or the quantity of the credit in a country. The bank rate refers to rate at which the central

bank (i.e. RBI) rediscounts bills and prepares of commercial banks or provides advance to commercial

banks against approved securities. It is "the standard rate at which the bank is prepared to buy or

rediscount bills of exchange or other commercial paper eligible for purchase under the RBI Act". The

Bank Rate affects the actual availability and the cost of the credit. Any change in the bank rate

necessarily brings out a resultant change in the cost of credit available to commercial banks. If the RBI

increases the bank rate than it reduce the volume of commercial banks borrowing from the RBI. It deters

banks from further credit expansion as it becomes a more costly affair. Even with increased bank rate the

actual interest rates for a short term lending go up checking the credit expansion. On the other hand, if

the RBI reduces the bank rate, borrowing for commercial banks will be easy and cheaper. This will boost

the credit creation. Thus any change in the bank rate is normally associated with the resulting changes in

the lending rate and in the market rate of interest. However, the efficiency of the bank rate as a tool of

monetary policy depends on existing banking network, interest elasticity of investment demand, size and

strength of the money market, international flow of funds, etc.

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2. Open Market Operation (OMO)

The open market operation refers to the purchase and/or sale of short term and long term securities by the

RBI in the open market. This is very effective and popular instrument of the monetary policy. The OMO

is used to wipe out shortage of money in the money market, to influence the term and structure of the

interest rate and to stabilize the market for government securities, etc. It is important to understand the

working of the OMO. If the RBI sells securities in an open market, commercial banks and private

individuals buy it. This reduces the existing money supply as money gets transferred from commercial

banks to the RBI. Contrary to this when the RBI buys the securities from commercial banks in the open

market, commercial banks sell it and get back the money they had invested in them. Obviously the stock

of money in the economy increases. This way when the RBI enters in the OMO transactions, the actual

stock of money gets changed. Normally during the inflation period in order to reduce the purchasing

power, the RBI sells securities and during the recession or depression phase she buys securities and

makes more money available in the economy through the banking system. Thus under OMO there is

continuous buying and selling of securities taking place leading to changes in the availability of credit in

an economy.

However there are certain limitations that affect OMO viz; underdeveloped securities market, excess

reserves with commercial banks, indebtedness of commercial banks, etc.

3. Variation in the Reserve Ratios (VRR)

The Commercial Banks have to keep a certain proportion of their total assets in the form of Cash

Reserves. Some part of these cash reserves are their total assets in the form of cash. Apart of these cash

reserves are also to be kept with the RBI for the purpose of maintaining liquidity and controlling credit in

an economy. These reserve ratios are named as Cash Reserve Ratio (CRR) and a Statutory Liquidity

Ratio (SLR). The CRR refers to some percentage of commercial bank's net demand and time liabilities

which commercial banks have to maintain with the central bank and SLR refers to some percent of

reserves to be maintained in the form of gold or foreign securities. In India the CRR by law remains in

between 3-15 percent while the SLR remains in between 25-40 percent of bank reserves. Any change in

the VRR (i.e. CRR + SLR) brings out a change in commercial banks reserves positions. Thus by varying

VRR commercial banks lending capacity can be affected. Changes in the VRR helps in bringing changes

in the cash reserves of commercial banks and thus it can affect the banks credit creation multiplier. RBI

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increases VRR during the inflation to reduce the purchasing power and credit creation. But during the

recession or depression it lowers the VRR making more cash reserves available for credit expansion.

(B) Qualitative Instruments or Selective Tools

The Qualitative Instruments are also known as the Selective Tools of monetary policy. These tools are

not directed towards the quality of credit or the use of the credit. They are used for discriminating

between different uses of credit. It can be discrimination favoring export over import or essential over

non-essential credit supply. This method can have influence over the lender and borrower of the credit.

The Selective Tools of credit control comprises of following instruments.

1. Fixed Margin Requirements

The margin refers to the "proportion of the loan amount which is not financed by the bank". Or in other

words, it is that part of a loan which a borrower has to raise in order to get finance for his purpose. A

change in a margin implies a change in the loan size. This method is used to encourage credit supply for

the needy sector and discourage it for other non-necessary sectors. This can be done by increasing

margin for the non-necessary sectors and by reducing it for other needy sectors. Example:- If the RBI

feels that more credit supply should be allocated to agriculture sector, then it will reduce the margin and

even 85-90 percent loan can be given.

2. Consumer Credit Regulation

Under this method, consumer credit supply is regulated through hire-purchase and installment sale of

consumer goods. Under this method the down payment, installment amount, loan duration, etc is fixed in

advance. This can help in checking the credit use and then inflation in a country.

3. Publicity

This is yet another method of selective credit control. Through it Central Bank (RBI) publishes various

reports stating what is good and what is bad in the system. This published information can help

commercial banks to direct credit supply in the desired sectors. Through its weekly and monthly

bulletins, the information is made public and banks can use it for attaining goals of monetary policy.

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4. Credit Rationing

Central Bank fixes credit amount to be granted. Credit is rationed by limiting the amount available for

each commercial bank. This method controls even bill rediscounting. For certain purpose, upper limit of

credit can be fixed and banks are told to stick to this limit. This can help in lowering banks credit

expoursure to unwanted sectors.

5. Moral Suasion

It implies to pressure exerted by the RBI on the Indian banking system without any strict action for

compliance of the rules. It is a suggestion to banks. It helps in restraining credit during inflationary

periods. Commercial banks are informed about the expectations of the central bank through a monetary

policy. Under moral suasion central banks can issue directives, guidelines and suggestions for

commercial banks regarding reducing credit supply for speculative purposes.

6. Control through Directives

Under this method the central bank issue frequent directives to commercial banks. These directives guide

commercial banks in framing their lending policy. Through a directive the central bank can influence

credit structures, supply of credit to certain limit for a specific purpose. The RBI issues directives to

commercial banks for not lending loans to speculative sector such as securities, etc beyond a certain

limit.

7. Direct Action

Under this method the RBI can impose an action against a bank. If certain banks are not adhering to the

RBI's directives, the RBI may refuse to rediscount their bills and securities. Secondly, RBI may refuse

credit supply to those banks whose borrowings are in excess to their capital. Central bank can penalize a

bank by changing some rates. At last it can even put a ban on a particular bank if it dose not follow its

directives and work against the objectives of the monetary policy.

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Parameters of Monetary Policy in India

Objectives

It is generally believed that central banks ideally should have a single overwhelming objective of

price stability. In practice, however, central banks are responsible for a number of objectives besides

price stability, such as currency stability, financial stability, growth in employment and income. The

primary objectives of central banks in many cases are legally and institutionally defined. However, all

objectives may not have been spelt out explicitly in the central bank legislation but may evolve through

traditions and tacit understanding between the government, the central bank and other major institutions

in an economy.

Of late, however, considerations of financial stability have assumed increasing importance in

monetary policy. The most serious economic downturns in the recent years appear to be generally

associated with financial instability. The important questions for policy in the context of financial

instability are the origin and the transmission of different types of shocks in the financial system, the

nature and the extent of feedback in policy and the effectiveness of different policy instruments.

Transmission Mechanism

Monetary policy is known to have both short and long-term effects. While it generally affects the

real sector with long and variable lags, monetary policy actions on financial markets, on the other hand,

usually have important short-run implications. Typical lags after which monetary policy decisions begin

to affect the real sector could vary across countries. It is, therefore, essential to understand the

transmission mechanism of monetary policy actions on financial markets, prices and output. Central

banks form their own views on the transmission mechanism based on empirical evidence, and their

monetary strategies and tactics are designed, based on these views. However, there could be considerable

uncertainties in the transmission channels depending on the stages of evolution of financial markets and

the nature of propagation of shocks to the system.

The four monetary transmission channels, which are of concern to policy makers are: the

quantum channel, especially relating to money supply and credit; the interest rate channel; the exchange

rate channel, and the asset prices channel. Monetary policy impulses under the quantum channel affect

the real output and price level directly through changes in either reserve money, money stock or credit

aggregates. The remaining channels are essentially indirect as the policy impulses affect real activities

through changes in either interest rates or the exchange rate or asset prices. Since none of the channels of

25

monetary transmission operate in isolation, considerable feedbacks and interactions, need to be carefully

analyses for a proper understanding of the transmission mechanism.

The exact delineation of monetary policy transmission channels becomes difficult in the wake of

uncertainties prevalent in the economic system, both in the sense of responsiveness of economic agents

to monetary policy signals on the one hand, and the proper assessment by the monetary authority of the

quantum and extent of desired policy measures on the other. The matter is particularly complex in

developing countries where the transmission mechanism of monetary policy is in a constant process of

evolution due to significant ongoing structural transformation of the economy.

Strategies and Tactics

It is important to distinguish strategic and tactical considerations in the conduct of monetary policy.

While monetary strategy aims at achieving final objectives, tactical considerations reflect the short run

operational procedures. Both strategies and tactics for monetary management are intricately linked to the

overall monetary policy framework of a central bank. Depending upon the domestic and international

macroeconomic developments, the long run strategic objective could change, leading to a change in the

nature and the extent of short run liquidity management.

The strategic aspects of monetary management crucially depend on the choice of a nominal anchor

by the central bank. In this regard, four broad classes of monetary strategies could be distinguished. Two

of these, viz., monetary targeting and exchange rate targeting strategies, use a monetary aggregate and

the exchange rate respectively as an explicit intermediate target. The third, viz., multiple indicator

approach, does not have an explicit intermediate target but is based on a wide range of monetary and

financial indicators. The fourth, viz., inflation targeting, also does not have an intermediate target, but is

characterized by an explicit final policy goal in terms of the rate of inflation.

In the 1970s when monetary policy came into prominence, many countries adopted either money

supply or exchange rate as intermediate targets. During the late 1980s, these paradigms started to change

following globalization, technological advancements and large movement of capital across national

boundaries.

In view of difficulties in conducting monetary policy with explicit intermediate targets, of late,

some countries are switching to direct inflation targeting, which works by explicitly announcing to the

public the goals for monetary policy and the underlying framework for its implementation.

26

In this framework, the monetary authorities have the freedom to deploy the instruments of

monetary policy to the best of their capacities, but are limited in their discretion of policy goals. The

framework is advocated on the ground that it clearly spells out the extent of central bank accountability

and transparency.

In reality, monetary policy strategy of a central bank depends on a number of factors that are

unique to the country and the context. Given the policy objective, any good strategy depends on the

macroeconomic and the institutional structure of the economy. An important factor in this context is the

degree of openness of the economy. The more open an economy is, the more the external sector plays a

dominant role in monetary management. The second factor that plays a major role is the stage of

development of markets and institutions: with technological development as an essential ingredient. In a

developed economy, the markets are integrated and policy actions are quickly transmitted from one

sector to another. In such a situation, perhaps it is possible for the central bank to signal its intention with

one single instrument.

Operating Procedures

Operating procedures refer to the choice of the operational target, the nature, extent and the

frequency of different money market operations, the use and width of a corridor for market interest rates

and the manner of signaling policy intentions. The choice of the operating target is crucial as this

variable is at the beginning of the monetary transmission process. The operating target of a central bank

could be bank reserves, base money or a benchmark interest rate. While actions of a central bank could

influence all these variables, it should be evident that the final outcome is determined by the combined

actions of the market forces and the central bank.The major challenge in day-to-day monetary

management is decision on an appropriate level of the operating target. The success in this direction

could be achieved only if the nature and the extent of interaction of the policy instruments with the

operating target is stable and is known to the central bank. As the operating target is also influenced by

market movements, which on occasions could be extremely volatile and unpredictable, success is not

always guaranteed. Further, success is also dependent on the stability of the relationship between the

operating target and the intermediate target. In a monetary targeting framework, this often boils down to

the stability and the predictability of the money multiplier. In an interest rate targeting framework, on the

other hand, success depends upon the strength of the relationship between the short-term and the long-

term interest rates. Finally, the stability of the relationship between the intermediate and the final target is

critical to the successful conduct of the operations.

27

Monetary Policy Transparency

Transparency in monetary policy is emphasized in the recent years on the ground that it leads to a

reduction in the market’s uncertainty about the monetary authority’s reaction function. It is further

argued that greater transparency may improve financial market’s understanding of the conduct of

monetary policy and thus reduce uncertainty. The limits to transparency are also recognized since

publishing detailed results of a central bank’s economic projections may eliminate an element of

surprise, which is useful on occasions with respect to the central bank’s operations in financial markets.

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CHAPTER-3

MONETARY POLICY IN INDIA

29

Monetary Policy in India

Policy Making Process

Traditionally, the process of monetary policy in India had been largely internal with only the end

product of actions being made public. A process of openness was initiated by Governor Rangarajan and

has been widened, deepened and intensified by Governor Jalan. The process has become relatively more

articulate, consultative and participative with external orientation, while the internal work processes have

also been re-engineered to focus on technical analysis, coordination, horizontal management, rapid

responses and being market savvy.

The stance of monetary policy and the rationale are communicated to the public in a variety of

ways, the most important being the annual monetary policy statement of Governor Jalan in April and the

mid-term review in October. The statements have become over time more analytical, at times

introspective and a lot more elaborate. Further, the statements include not only monetary policy stance or

measures but also institutional and structural aspects. The monetary measures are undertaken as and

when the circumstances warrant, but the rationale for such measures is given in the Press Release and

also statements made by Governor and Deputy Governors unless a deliberate decision is taken not to do

so on a contemporaneous basis. The sources for appreciating the policy stance encompass several

statutory and non-statutory publications, speeches and press releases. Of late, the RBI website has

become a very effective medium of communication and it is rated by experts as one of the best among

central bank websites in content, presentation and timeliness. The Reserve Bank’s communications

strategy and provision of information have facilitated conduct of policy in an increasingly market-

oriented environment.

Several new institutional arrangements and work processes have been put in place to meet the

needs of policy making in a complex and fast changing world. At the apex of policy process is Governor,

assisted closely by Deputy Governors and guided by deliberations of a Board of Directors. A Committee

of the Board meets every week to review the monetary, economic, financial conditions and advise or

decide appropriately. Much of the data used by the Committee is available to the public with about a

week’s lag. There are several other standing committees or groups of the Board and Board for Financial

Supervision plays a critical role in regard to institutional developments. Periodic consultations with

academics, market participants and financial intermediaries take place through Standing Committees and

Groups, in addition to mechanisms such as resource management discussions with banks. Within the

30

Reserve Bank, the supervisory data, market information, economic and statistical analysis are reoriented

to suit the changing needs. A Financial Markets Committee focuses on a day-to-day market operations

and tactics while a Monetary Policy Strategy Group analyses strategies on an ongoing basis.

Operating Procedures

In the pre-reform period prior to 1991, given the command and control nature of the economy, the

Reserve Bank had to resort to direct instruments like interest rate regulations, selective credit control and

the cash reserve ratio (CRR) as major monetary instruments. These instruments were used intermittently

to neutralise the monetary impact of the Government’s budgetary operations.

The administered interest rate regime during the earlier period kept the yield rate of the

government securities artificially low. The demand for them was created through intermittent hikes in the

Statutory Liquidity Ratio (SLR). The task before the Reserve Bank was, therefore, to develop the

markets to prepare the ground for indirect operations.

As a first step, yields on government securities were made market related. At the same time, the

Reserve Bank helped create an array of other market related financial products. At the next stage, the

interest rate structure was simultaneously rationalized and banks were given the freedom to determine

their major rates. As a result of these developments, the Reserve Bank could use OMO as an effective

instrument for liquidity management including to curb short-term volatilities in the foreign exchange

market.

Another important and significant change introduced during the period is the reactivation of the

Bank Rate by initially linking it to all other rates including the Reserve Bank’s refinance rates (April

1997). The subsequent introduction of fixed rate repo (December 1997) helped in creating an informal

corridor in the money market, with the repo rate as floor and the Bank Rate as the ceiling. The use of

these two instruments in conjunction with OMO enabled the Reserve Bank to keep the call rate within

this informal corridor for most of the time. Subsequently, the introduction of Liquidity Adjustment

Facility (LAF) from June 2000 enabled the modulation of liquidity conditions on a daily basis and also

short term interest rates through the LAF window, while signaling the stance of policy through changes

in the Bank Rate.

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Gains from Reform

It has been possible to reduce the statutory preemption on the banking system. The Cash Reserve

Ratio, which was the primary instrument of monetary policy, has been brought down from 15.0 per cent

in March 1991 to 5.5 per cent by December 2001. The medium-term objective is to bring down the CRR

to its statutory minimum level of 3.0 per cent within a short period of time. Similarly, Statutory Liquidity

Ratio has been brought down from 38.5 per cent to its statutory minimum of 25.0 per cent by October

1997.

It has also been possible to deregulate and rationalize the interest rate structure. Except savings

deposit, all other interest rate restrictions have been done away with and banks have been given full

operational flexibility in determining their deposit and lending rates barring some restrictions on export

credit and small borrowings.

The commercial lending rates for prime borrowers of banks have fallen from a high of about 16.5

per cent in March 1991 to around 10.0 per cent by December 2001.

In terms of monetary policy signals, while the Bank Rate was dormant and seldom used in 1991, it

has been made operationally effective from 1997 and continues to remain the principal signaling

instrument. The Bank Rate has been brought down from 12.0 per cent in April 1997 to 6.5 per cent by

December 2001. It is envisaged that the LAF rate would operate around the Bank Rate, with a flexible

corridor, as more active operative instrument for day-to-day liquidity management and steering short-

term interest rates.

A contrasting feature in the positions between 1991 and 2001 is India’s foreign exchange

reserves. The monetary and credit policy for 1991-92 was formulated against the background of a

difficult foreign exchange situation. Over the period, external debt has been contained and short-term

debt severely restricted, while reserves have been built in an atmosphere of liberalization of both current

account and to some extent capital account.

The foreign currency assets of the Reserve Bank have increased from US $ 5.8 billion in March

1991 to US $ 48.0 billion in December 2001. In view of comfortable foreign exchange reserves, periodic

oil price increases (for example in 1996-97, 1999-00 and 2000-01) did not translate into Balance of

Payment (BoP) crises as in the earlier occasions. Such enlargement of the foreign currency assets, on the

other hand, completely altered the balance sheet of the Reserve Bank.

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Large capital inflows have been accommodated by the Reserve Bank while its monetary impact

has been sterilised through OMO. This has helped in reducing the government’s reliance on credit from

the Reserve Bank. Consequently, there has been secular decline in monetized deficit, and in the process

net foreign exchange assets of the Reserve Bank have become the principal contributor to reserve money

expansion in the recent period.

Tasks before the Reserve Bank

These are impressive gains from reforms but there are emerging challenges to the conduct of

monetary policy in our country. Thus, while the twin objectives of monetary policy of maintaining price

stability and ensuring availability of adequate credit to the productive sectors of the economy have

remained unchanged, capital flows and liberalization of financial markets have increased the potential

risks of institutions, thus bringing the issue of financial stability to the fore. Credit flow to agriculture and

small- and medium-industry appears to be constrained causing concerns. There are significant structural

and procedural bottlenecks in the existing institutional set up for credit delivery. The pace of reforms in

real sector, particularly in property rights and agriculture also impinge on the flow of credit in a

deregulated environment. The persistence of fiscal deficit, with the combined deficit of the Central and

State Governments continuing to be high, draws attention to the delicate internal and external balance.

It is necessary to recognize the existence of the large informal sector, the limited reach of financial

markets relative to the growing sectors, especially services, and the overhang of institutional structure

that tend to constrain the effectiveness of monetary policy in India. The road ahead would be demanding

and the Reserve Bank would have to strive to meet the challenge of steering the structurally transforming

economy from a transitional phase to a mature and vibrant system and increasingly deal with alternative

phases of the business cycle. Some of the immediate tasks before the Reserve Bank are presented to

provoke debate and promote research.

Modeling Exercises

In addressing a gathering of elite econometricians assembled here, a mention should be made about

developments in monetary modeling. It is well recognized that monetary policy decisions must be based

on some idea of how decisions will affect the real world and this implies conduct of policy within the

framework of a model. As Dr. William White of Bank for International Settlements (BIS) mentioned in

an address recently in RBI, “the model may be as simple as one unspecified equation kept in the head of

the central bank Governor, but one must begin somewhere. Economics may not be a science, but it

33

should at least be conducted according to scientific principles recognizing cause and effect”. While

reliance on explicit modeling was rather heavy in some central banks, particularly in the 1960 and 1970s,

there has been increasing awareness among the policy makers of the limitations of such models for

several reasons. It is difficult to arrive at a proper model for any economy with the degree of certainty

that policy makers want especially in view of observed alterations in the private sector behavior in

response to official behavior.

Further, data to monitor the economy are sometimes inadequate, or delayed, and often revised. It is

said that in regard to modern economies, not only the future but even the past is uncertain, due to

significant revisions in data. The process of deregulation coupled with technological progress has led to

increasing role for market prices and consequently more complexities for establishing relationships in an

environment where everything happens very fast, and in a globally interrelated financial world. In brief,

there is need to recognize the complexities in model building for monetary policies and approach it with

great humility and a dose of skepticism but ample justification for such modeling work certainly persists.

It is felt that this is an appropriate time to explore more formally the relationship among different

segments of the markets and sectors of the economy, which will help in understanding the transmission

mechanism of the monetary policy in India. With this objective in mind, the Reserve Bank had already

announced its intention to build an operational model, which will help the policy decision process. An

Advisory Group with eminent academicians like Professors Mihir Rakshit, Dilip Nachane, Manohar Rao,

Vikas Chitre and Indira Rajaraman as external experts and a team from within the Reserve Bank were set

up for developing such a model.The model was initially conceived to focus on the short-term objective of

different sources and components of the reserve money based on the recommendations of an internal

technical group on Liquidity Analysis and Forecasting. Though multi-sector macro-econometric models

are available, such models are based on yearly data and hence these may not be very useful for guiding

the short-term monetary policy actions of the Reserve Bank.

Accordingly, it was felt that a short-term liquidity model may be developed in the Reserve Bank

focusing on the inter-linkages in the markets and then operational these linkages to other sectors of the

economy. The Advisory Group met twice and after deliberations felt that a daily/ weekly/fortnightly

model would give an idea about short- to medium-term movements but models using annual data will

also be useful to assess the implications of the monetary policy measures on the real economy. On the

basis of the advice of eminent experts in the Advisory Group, it has been decided to modify the

approach.

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The current thinking in the Reserve Bank is broadly on the following lines: the short-term liquidity

model making use of high frequency data will be explored. Accordingly, the interaction of the financial

markets with weekly data focusing mainly on policy measures and different rates in the financial

markets. An observation in the operational framework of the model is limited as the LAF has been

operationalised only a year ago. A crucial aspect in an exercise is the forecast of currency in circulation.

The intention of the Reserve Bank is to expedite the technical work in this regard and seek the

advice of individual members of Advisory Group on an ongoing basis both at formal and informal levels.

It is expected that the draft of the proposed model would be put in public domain shortly. The Reserve

Bank would seek the active participation of the interested econometricians in the debate on the draft

model and give benefit of advice to the Reserve Bank for finalizing and adoption.

Reduction in CRR

Among the unrealized medium-term objectives of reforms in monetary policy, the most important

is reduction in the prescribed CRR for banks to its statutory minimum of 3.0 per cent. The movement to

3.0 per cent can be designed in three possible ways, viz., the traditional way of pre-announcing a time-

table for reduction in the CRR; reducing CRR as and when opportunities arise as is being done in recent

years; and as a one-time reduction from the existing level to 3.0 per cent under a package of measures.

In the initial years, the first approach was effective but had to be abandoned when the time-table

had to be disrupted to meet the eruption of global financial uncertainties and pressures on foresaw

market. Hence, the second approach of lowering CRR when opportunities arise has been adopted, and

now it has been brought down to 5.5 per cent. However, if it is felt that this approach takes a longer time

and a compressed time-frame is desirable to expedite development of financial markets, it is possible to

contemplate a package of measures in this regard. The package could mean the reduction of CRR to the

statutory minimum level of 3.0 per cent accompanied by several changes such as in the present way of

maintenance of cash balances by banks with RBI. With the lagged reserve maintenance system now put

in place, banks can exactly know their reserve requirements. With the information technology available

with banks and with the operationalisation of Clearing Corporation of India Ltd. (CCIL) shortly and with

the development of repo market, it would be appropriate if CRR is maintained on a daily basis. However,

till banks adjust to such changes in the maintenance of CRR, a minimum balance of 95 per cent of the

required reserves on a daily basis may have to be maintained when CRR is reduced to 3.0 per cent. The

other elements of package have to be worked out carefully.

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Access to Call Money Market

An important related component of ongoing reform relates to restricting the call money market to

banks and Primary Dealers (PDs). Several measures have been initiated in this regard but in view of the

growing importance attached to stability in the financial system and the growing alternatives to access

liquidity management through activation of facilitated by the CCIL, there is a strong case to impose some

limits on access to non-collateralised borrowing through call money even under the dispensation of

restricted participation only to banks and PDs. The call money window should be used to iron out

temporary mismatches in liquidity and banks should not use this on a sustained basis as a source of

funding their normal requirements. A beginning has been made by prescribing for access to call money a

ceiling of 2.0 per cent of aggregate deposits in respect of urban cooperative banks (UCBs). Such a

stipulation can be extended to all commercial banks and with some modifications such as, an alternative

of 25.0 to 50.0 per cent of their net owned funds. If a bank has any temporary need to go beyond the

ceilings prescribed for access to call money, the Reserve Bank could consider such requests to alleviate

possible shocks to individual banks.

Similarly, once the repo market develops, PDs should reduce and in fact consider eliminating their

access to the call money market. There is an opinion that such restrictions of access to call money in

Indian conditions would add to stability in financial markets and help develop term money market. A

final decision would no doubt be taken after discussions in Technical Advisory Committee on financial

markets of the Reserve Bank, and further consultations with market participants.

Liquidity Adjustment Facility

The Reserve Bank influences liquidity on a day-to-day basis through LAF and is using this facility

as an effective flexible instrument for smoothening interest rates. The operations of non-bank

participants including FIs, mutual funds and insurance companies that were participating in the

call/notice money market are in the process of being gradually reduced according to pre-set norms. Such

an ultimate goal of making a pure inter-bank call money market is linked to the operationalisation of the

CCIL and attracting non-banks also into an active repo market. The effectiveness of LAF thus will be

strengthened with a pure inter-bank call/notice money market in place coupled with growth of repo

market for non-bank participants. The LAF operations combined with judicious use of OMOs are

expected to evolve into a principal operating procedure of monetary policy of the Reserve Bank. To this

end, the Reserve Bank may have to reduce substantially the liquidity through refinance to banks and

PDs. For example, if the Reserve Bank intends to tighten the money market conditions through LAF, the 36

automatic access of refinance facility from the Reserve Bank to banks and PDs may reduce the

effectiveness of such an action and thereby cause transmission losses of monetary policy. It may be

appropriate to note that in most of the developed financial markets, the standing facilities operate at the

margin.

At present the Reserve Bank provides standing facilities comprising the support available to banks

under Collateralised Lending Facility (CLF) and export credit facility to banks, and liquidity support to

PDs. One way of reducing the standing facility will be to eliminate CLF from the standing facilities and

reducing the present ratio of normal and back-stop facilities. The existing methodology of calculating

eligible export credit refinance continues till March 2002 and the Reserve Bank has expressed its

intention of moving away from sector specific refinance. As CRR gets lowered and repo market

develops, the refinance facilities should also be lowered giving more effectiveness to the conduct of

monetary policy.

Highlights of the RBI’s

Benchmark Repo Rate increased by 25 basis points (bps) from 8.25% to 8.50% with immediate effect;

Reverse Repo and Marginal Standing Facility stands revised to 7.50% and 9.50%, respectively

Bank Rate, Cash Reserve Ratio and Statutory Liquidity Ratio unchanged at 6%, 6% and 24%

Baseline projection for headline WPI inflation for March 2012 maintained at 7%; inflation expected to

remain sticky in October-November 2011 and decline from December 2011 onwards

Baseline projection for GDP growth for FY12 revised to 7.6%; in September 2011, the RBI had

indicated downside risks to its growth projection of 8% for 2011-12 made in May 2011 and July 2011,

led by moderating domestic demand and impact of weakening global growth momentum and rising

uncertainty

Monetary stance remains focused on containing inflation and anchoring inflationary expectations,

whilst aiming to balance growth concerns

Guidance provided regarding a low likelihood of a further policy rate hike in December 2010

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Interest on savings account balances deregulated - Banks allowed to offer differential rates for savings

deposits beyond Rs. 1 lakh; Deregulation could trigger increase in cost of funds for Banks

Non-food credit and broad money growth projections retained at 18% and 15.5%, respectively.

. Systemic liquidity remains within RBI

Systemic liquidity remained in deficit mode throughout Q2FY12, but largely remained within RBI’s

comfort zone of +/-1% of net demand and time liabilities, with the exception of a few days in September

2011 on account of pressures related to advance tax payments. The Marginal Standing facility (MSF)

introduced by RBI in May 2011 available to Banks at 1% higher than Repo rate has been largely

unutilized, as Banks were able to access adequate liquidity through the LAF.

Banks maintained average excess SLR investments (including Reverse Repo) of more than Rs.

2.7 lakh-crore during H1FY12, marginally lower than 2.9 lakh-crore in H1FY11. The average SLR

levels remained around 28.8% of NDTL as against the mandated 24%. GoI spending during the first half

has remained high as indicated by the negative balance with RBI since April 2011 despite achieving 61%

of FY12’s gross market borrowings in up to October 14, 2012. However, the full year GoI borrowing

target has been revised upwards by about Rs. 53,000 crore which means the GoI’s gross market

borrowing in H2FY12 would be around Rs. 2.03 lakh-crore. This could exert some pressure on systemic

liquidity particularly if credit demand remains benign.

38

CHAPTER-4

FUNCTIONS OF COOPERATIVE BANK

39

Functions of Banks

The functions of banks are of two types.

(A) Primary functions; and

(B) Secondary functions.

Let us discuss details about these functions.

(i) Primary functions

The primary functions of a bank include:

a) Accepting deposits; and

b) Granting loans and advances.

a) Accepting deposits

The most important activity of a commercial bank is to mobilize deposits from the public. People who

have surplus income and savings find it convenient to deposit the amounts with banks. Depending upon

the nature of deposits, funds deposited with bank also earn interest. Thus, deposits with the bank grow

along with the interest earned. If the rate of interest is higher, public are motivated to deposit more funds

with the bank. There is also safety of funds deposited with the bank.

b) Grant of loans and advances

The second important function of a commercial bank is to grant loans and advances. Such loans and

advances are given to members of the public and to the business community at a higher rate of interest

than allowed by banks on various deposit accounts. The rate of interest charged on loans and advances

varies according to the purpose and period of loan and also the mode of repayment.

40

i) Loans

A loan is granted for a specific time period. Generally commercial banks provide short-term loans. But

term loans, i.e., loans for more than a year may also be granted. The borrower may be given the entire

amount in lump sum or in installments. Loans are generally granted against the security of certain assets.

A loan is normally repaid in installments. However, it may also be repaid in lump sum.

ii) Advances

An advance is a credit facility provided by the bank to its customers. It differs from loan in the sense that

loans may be granted for longer period, but advances are normally granted for a short period of time.

Further the purpose of granting advances is to meet the day-to-day requirements of business. The rate of

interest charged on advances varies from bank to bank. Interest is charged only on the amount withdrawn

and not on the sanctioned amount.

Types of Advances

Banks grant short-term financial assistance by way of cash credit, overdraft and bill discounting.

Let us learn about these.

a) Cash Credit

Cash credit is an arrangement whereby the bank allows the borrower to draw amount up to a specified

limit. The amount is credited to the account of the customer. The customer can withdraw this amount as

and when he requires. Interest is charged on the amount actually withdrawn. Cash Credit is granted as

per terms and conditions agreed with the customers.

b) Overdraft

Overdraft is also a credit facility granted by bank. A customer who has a current account

with the bank is allowed to withdraw more than the amount of credit balance in his account. It is a

temporary arrangement. Overdraft facility with a specified limit may be allowed either on the security of

assets, or on personal security, or both.

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c) Discounting of Bills

Banks provide short-term finance by discounting bills that is, making payment of the amount before the

due date of the bills after deducting a certain rate of discount. The party gets the funds without waiting

for the date of maturity of the bills. In case any bill is dishonored on the due date, the bank can recover

the amount from the customer.

ii) Secondary functions

In addition to the primary functions of accepting deposits and lending money, banks perform a number of

other functions, which are called secondary functions.

These are as follows;-

a. Issuing letters of credit, traveler’s cheque, etc.

b. Undertaking safe custody of valuables, important document and securities by providing

Safe deposit vaults or lockers.

c. Providing customers with facilities of foreign exchange dealings.

d. Transferring money from one account to another; and from one branch to another

branch of the bank through cheque, pay order, demand draft.

e. Standing guarantee on behalf of its customers, for making payment for purchase of

goods, machinery, vehicles etc.

f. Collecting and supplying business information.

g. Providing reports on the credit worthiness of customers.

i. Providing consumer finance for individuals by way of loans on easy terms for purchase

of consumer durables like televisions, refrigerators, etc.

j. Educational loans to students at reasonable rate of interest for higher studies, especially

for professional courses.

E-banking (Electronic Banking)

With advancement in information and communication technology, banking services are also made

available through computer. Now, in most of the branches you see computers being used to record

banking transactions. Information about the balance in your deposit account can be known through

computers. In most banks now a day’s human or manual teller counter is being replaced by the 42

Automated Teller Machine (ATM). Banking activity carried on through computers and other electronic

means of communication is called ‘electronic banking’ or ‘e-banking’. Let us now discuss about some of

these modern trends in banking in India.

Automated Teller Machine

Banks have now installed their own Automated Teller Machine (ATM) throughout the country at

convenient locations. By using this, customers can deposit or withdraw money from their own account

any time.

Debit Card

Banks are now providing Debit Cards to their customers having saving or current account in the banks.

The customers can use this card for purchasing goods and services at different places in lieu of cash. The

amount paid through debit card is automatically debited (deducted) from the customers’ account.

Credit Card

Credit cards are issued by the bank to persons who may or may not have an account in the bank. Just like

debit cards, credit cards are used to make payments for purchase, so that the individual does not have to

carry cash. Banks allow certain credit period to the credit cardholder to make payment of the credit

amount. Interest is charged if a cardholder is not able to pay back the credit extended to him within a

stipulated period. This interest rate is generally quite high.

Net Banking

With the extensive use of computer and Internet, banks have now started transactions over

Internet. The customer having an account in the bank can log into the bank’s website and access his bank

account. He can make payments for bills; give instructions for money transfers, fixed deposits and

collection of bill, etc.

Phone Banking

In case of phone banking, a customer of the bank having an account can get information of his account;

make banking transactions like, fixed deposits, money transfers, demand draft, collection and payment of

bills, etc. by using telephone. As more and more people are now using mobile phones, phone banking is

possible through mobile phones. In mobile phone a customer can receive and send messages (SMS) from

and to the bank in addition to all the functions possible through phone banking.

43

CHAPTER-5

RESEARCH METHODOLOGY

44

RESEARCH METHODOLOGY

Introduction

Redman and Moray defines research as a “SYSTEMATIZED EFFORT TO GAIN NEW

KNOWLEDGE”. It may be noted, in the planning and development, that the significance of research lies

in its quality and quantity. Research methodology is the specification of accruing the information need to

structure or solve at hand. It is not concern to decision of the fact, but also building up to data knowledge

and to discover the new fact involve through the process of dynamic change in society.

DATA COLLECTION METHOD

Primary Data Collection

1- OBSERVATION METHOD

2-SURVEY METHOD

Secondary Data collection

To source of secondary data research requires exploring newspapers, magazines brought to the

workplace by recovery management and establishment department. It involves suffering of internet.

In my project report, I use Secondary data collection method.

45

OBJECTIVES OF STUDY

1- To study the detail of monetary policy.

2- To under stand the problems faced by bank.

3- To know how monetary policy affects banks.

4- To know the effect on policies of bank by monetary policy.

5- To show how interest rates changes due to change in monetary policy.

6- To study current monetary policy session 2011-2012.

7- To know the services provided by cooperative bank to their customers.

8- To know the terms like CRR, SLR.

46

CHAPTER-5

EFFECT OF MONETARY POLICY ON BANKS

47

Interest

rates

1- RBI's

deregulation

drive on

saving interest

rates has

created a

competitive

environment

across banks

in an effort to

retain and

capture a loyal

customer base.

The second

quarter of the

monetary

policy review

instructed

banks to

implement

deregulation

of savings

bank rates

with

immediate

effect,

allowing

banks to set

their own interest rates. The rate of interest in savings bank account was

four per annum as mandated by the government in May 2011.

However with the recent change banks are now allowed to fix their interest

rates for saving account customers. Banks now use this as a competing

factor and weave it into their merits to enhance their customer base.

2- The happy news for savings account holders is maximum benefits for

their money irrespective of the time period. Before deregulation there was

hardly any competition in this segment, and all banks offered the same rate

of interest. So, there were no second thoughts for customers about shifting

their savings account from one bank to another. However, now customers

think twice before they start a new account or wish to switch an existing

account to get the maximum benefits.

Many wonder how banks calculate their savings account interest. Let us

understand this process with an example: Earlier banks used to pay an

interest rate of four per cent per annum against the lowest available balance

in the account between the 10th and final day of a month.

3- Any deposits happening during this period were not eligible for interest

rate calculation of that month, but at the same time, withdrawals during the

period were taken into account.

For instance, Vishal had a balance of Rs 50,000 in his account as on

January 10. On January 20, he received Rs 100,000 as maturity bonus for

his LIC policy. On January 28, he had withdrawn Rs 125,000 for making a

down payment for his new flat, thereby reducing his account balance to Rs

25,000.In his case, the bank would consider Rs 25,000 for interest

calculation, as it is the lowest amount available in his account between 10

and 28 January.

48

Implications of bank ownership for the credit channel of

monetary policy transmission: Evidence from India

1. Introduction

The recent financial crisis brought to the fore the debate about the bank lending channel of monetary

policy transmission. Traditional macroeconomic models such as the IS-LM representation assume that

monetary policy affects the real economic activity by changing interest rates which, in turn, affects the

investment demand of the firms. However, this line of argument has increasingly come under scrutiny.

To begin with, evidence suggests that investment decisions of firms are affected much more by factors

such as cash flows than by the cost of borrowing (Bernanke and Gertler, 1995). Evidence also suggests

that banks are not passive intermediaries between the central bank and end users of money such as the

Firms.

For example, in an early discussion of this issue, Bernanke and Blinder (1992) demonstrate that the

composition of banks’ portfolios change systematically in response to monetary policy initiatives. They

conclude that the impact of monetary policy on the investment of firms is not entirely demand driven,

and that at least part of it can be explained by the supply side or the bank lending channel. Kashyap and

Stein (1993) demonstrate that if a central bank pursues tighter monetary policy, there is a decline in the

amount of bank loans to

firms and simultaneously a rise in the issuance of commercial paper, and include that contractionary

monetary policy reduces loan supply. Importantly, research suggests that there might be significant

heterogeneity in the reaction of banks to monetary policy initiatives. It may, for example, depend on the

extent of competition in the banking sector. Olivero, Li and Jeon (2011) argue that an increase in

competition in the banking sector weakens the transmission mechanism of monetary policy through the

bank lending channel.

Banks’ reaction to monetary policy initiatives also depends on the quality of their balance sheets. Peek

and Rosengren (1995) argue that an important determinant of a bank’s reaction would be its capital-to-

asset ratio. If banks find it difficult (or expensive) to raise capital, for example, they could be reluctant to

49

lend even if there is ample demand for credit in the aftermath of easing of monetary policy. This

hypothesis finds support in the empirical litera- ture. Kishan and Opiela (2000) find that small and

undercapitalized banks are most affected by monetary policy. Gambacorta (2005) too finds that lending

of undercapitalized Italian banks is adversely affected by contractionary monetary policy, even though

lending is not correlated with bank size. Further, there is a directional asymmetry in the impact of

monetary policy on the lending behaviour of undercapitalised banks (Kishan and Opiela, 2006). In the

event of contractionary monetary policy, there is a sharp tightening in loan disbursal by undercapitalised

banks, but in the event of an expansionary monetary policy there is no corresponding expansion of credit

disbursal.

The reaction of banks to monetary policy also depends on the composition of their assets. The

traditional or money view of monetary policy transmission assumes that all asset classes are perfect

substitutes of each other. If, therefore, contractionary monetary policy leads to a reduction in deposits, a

bank is capable of substituting for this loss of deposits dollar for dollar, using other assets like CDs, such

that loan supply is not affected. Stein (1998) argues that, contrary to this view, assets included in a

bank’s balance sheet are not perfect substitutes. For example, since deposits are guaranteed by the FDIC

(or its overseas counterpart), while CDs are not, there may be adverse selection in the market for CDs,

such that banks do not use these instruments to compensate for loss of deposits dollar for dollar. This

results in a decline in loan supply. It follows that banks that have less liquid assets such that t hey cannot

quickly and costlessly compensate for loss of deposits in the event of contractionary monetary policy or,

alternatively, those that cannot raise funds quickly to the same end, would react more to monetary policy

changes. Kashyap and Stein (2000) find that monetary policy has greater impact on loan supply of banks

with low securities-to-assets ratios. The literature does not, however, empirically examine the impact of

bank ownership on the lending channel of monetary policy transmission.

This is hardly surprising, given that much of the literature is based on the United States and Western

European experiences, where private ownership of banks overwhelmingly dominates. However, as

pointed out by La Portal et al. (2002), State-ownership of banks is ubiquitous in much of the world,

especially in emerging economies. Indeed, the 2007–09 financial crises has led to significant state-

ownership of banking assets even in developed countries such as the United Kingdom, and concerns

about the lending activities of the de facto nationalised banks have brought into focus the impact of bank

ownership on the lending channel in the developed country context as well. In this paper,

50

we address this lacuna in the literature, and examine whether the impact of monetary policy on lending

differs across banks with different ownerships.

Studying how bank ownership plays a role in the credit channel of monetary policy transmission

is important because public sector banks account for a significant portion of the banking assets and loan

portfolio emerging economies, and, at the same time, many of these country are fiscally constrained such

that monetary policy may be the only instrument available to policy makers to induce growth. This

indeed is currently the situation in a wide range of developed countries as well. Our analysis provides an

empirical basis for this policy debate concerning the relative effectiveness of monetary policy when a

significant proportion of the banking sector is under state ownership. This is one of the key contributions

of the paper.

Further, by isolating the response of foreign owned banks, it adds to the small but growing

literature on the impact of foreign banks on credit growth, especially in emerging economies context.

Our second important contribution is that we separately examine the reaction of different types of banks

(i.e., private, state and foreign) in easy and tight monetary policy regimes. As mentioned

Earlier, reaction of banks to monetary policy changes may be asymmetric:

a change in interest rates might have very different outcomes, depending on whether these rates are low

or high to begin with. If an asymmetry does exist, a greater understanding of the differences in the

impact of monetary policy in easy and tight money regimes would be imperative for successful monetary

policy interventions. The richness of our contribution is enhanced by the fact that, for each of these

monetary policy regimes, we estimate the reaction of the different types of banks based on ownership.

Finally, we examine whether impact of monetary policy differs With respect to different

maturities, and hence riskiness, of lending activities. Specifically, we examine the impact of monetary

policy on disbursal of (more risky) medium term credit and (less risky) short-term credit. We estimate

the impact for tight and easy monetary regimes, and also for the different types of banks. We use bank-

level data from India to examine these issues. We focus on India for several reasons. First, India is a fast

growing emerging market that embraced the market economy in the early nineties and has since

liberalized its economy substantially. Importantly, in the absence of a well developed market for

corporate bonds, banks are by far the largest source of credit for Indian companies, and hence bank

lending plays an important role in the transmission of monetary policy in India. Second, the Indian

banking sector is also marked by the presence of a number of state-owned and private-owned (including

foreign) banks, who compete on a level playing field. Third, the state-owned banks themselves have 51

autonomy regarding lending decisions, and many of them have sold shares to private (and even foreign)

shareholders, thereby opening themselves up to greater scrutiny. Indeed, Indian state-owned banks

resemble the de facto nationalized banks of the United Kingdom much more closely than state-owned

banks in former transition economies of Central and Eastern Europe (see, e.g., Bonin and Wachtel,

2002).

Reaction Of Cooperative

There is a fairly large literature on the bank lending channel of monetary policy. But much of this

literature is in the context of the United States, Europe and other developed economies where the banks

are heterogeneous but are almost entirely in private sector. The emerging market economies, by contrast,

have their fair share of state-owned banks, such that, in these contexts, the implications of ownership for

the bank lending channel remains an important, yet largely unexplored, policy consideration. In this

paper we address this issue, using bank-level data from India. Our results suggest that there are

considerable differences in the reactions of different types of banks to monetary policy initiatives of the

central bank. During periods of tight monetary policy, as captured by the monetary conditions index,

state-owned banks, old private banks and foreign banks curtail credit in response to an increase in

interest rate. The reaction of foreign banks is particularly sharp.

The reaction of the new private banks is not statistically significant. By contrast, during easy

money periods, an increase in interest rates by the central bank leads to an increase in the growth of

credit disbursed by old private banks, with no significant reactions from other types of banks. The

regression results

also indicate that the adverse reaction to a policy initiated increase in interest rate in a tight monetary

regime is much greater for medium term borrowing than for short-term borrowing. Our results have two

significant implications for the literature on bank lending channel. First, it suggests that the bank lending

channel of monetary policy might be much more effective in a tight money period than in an easy money

period. In other words, if interest rates are low, then a central bank that desires monetary contraction may

have to raise the rate substantially to witness an impact on money supply through the bank lending

channel. This has implications for future analyses of the bank lending channel; the condition under which

52

a central bank changes its policy rate should be explicitly taken into account. It has also implications for

the implementation of monetary policy strategies during a business cycle period or economic crisis.

For example, if the economy is going through a downturn and the authorities try to stimulate the

economy towards the recovery zone, then, depending upon the type of money regime the economy is in,

the policymakers need to consider making adjustments in policy rates to get the desired effects.

Indian Banks - The Effects of Confused Monetary Policy

Confused!  That’s  what  I  would  call  the  present  state  of  Indian  monetary  policy  today. While 

normally  the   Reserve  Bank  of  India  decides  monetary  policy  and  banks  factor  it  into  their  

lending  and  deposit  rates,  the  present  situation  in  India   is  very  different. The  Government  wants 

banks  to  follow  a  policy  which  is  at  variance  with  the policy of  the Central Bank. The 

Government  by asking  banks  not  to  pass  on  the  effects  of  the  interest  rate  hike  by   the  

Reserve  Bank   of   India  to  their  constituents  unless  they   follow  a  particular  procedure  reminds 

one  of   the  days  of   the  license  permit  raj  which  prevailed  in  India  till  the  early  1990's  when 

the  present  state  of  liberalization  started. While  it  is  too  early to  say   that   Indian  reforms  are 

being  derailed,  yet   attempts  like  this  by  the  Finance  Ministry  are  bound  to  have  adverse  effects 

on  the  Indian  Economy  and   securities  markets.

It  was  only  in  may  this  year  that   the  Indian  securities  markets  went  into  tailspin  when  the 

Government  tried  to  bring  in   taxes  through  the  administrative  route.  This  new   use   of  

administrative  authority  in  the  commercial  decisions  of  banks  is  bound  to  have  an  adverse 

effect  on  share  values ,  bank  profitability  and  allocation  of   resources  in  the  economy.  Bank 

share  prices  reportedly  fell  three  percent  in  one  day  on  account  of   the  latest  attempt  by  the 

Government  to  micromanage  the  banks.

As  a   result  of   this  latest  directive  of  the  Government,  the  public  sector  banks  are  confused 

and  are  putting  all  loan  decisions  on  hold. This  is  bound  to  have  an  effect  on  the  availability 

53

of   funds  in  the  economy  for  trade, industry  and  consumption.  The fallout of  

this could be catastrophic Analysts  should  keep  a  watch  on  the  efforts  of   the  Finance  Ministry  to 

micromanage  the  Indian  economy  as   in  my  view   this  is   today  the  latest   challenge  for   the 

Indian  economy  -  continue  to  perform in  the face of increased government intervention. 

The Reserve Bank of India's third quarter review of monetary policy was devoid of major surprises. The

only change in monetary policy instruments — a cut in the Cash Reserve Ratio (CRR) by 0.50

percentage point to 5.5 per cent — was largely expected. The move will release Rs.32, 000 crore of

funds impounded from banks, almost immediately. The key policy interest rate, the repo rate, remains

unchanged at 8.5 per cent. Consequently, the reverse repo stays at 7.5 per cent and the marginal standing

facility at 9.5 per cent. A cut in the repo rate would have more definitely indicated a downward shift in

the monetary stance but the RBI has argued that the CRR reduction is the best it could do under the

prevailing circumstances and ought to be interpreted as a signal for a softer monetary policy regime.

According to the RBI, the CRR is a policy instrument with liquidity dimension. Its reduction will bring

down the cost of money for banks and have a bearing on their ability to lend at lower rates. It may well

be so but, for most market participants, a repo rate reduction would be the more authentic signal. Soon

after the policy announcement on Tuesday, attention has immediately shifted to how soon the RBI will

act in that direction.

The reasons

The RBI has cited three well known reasons in support of its latest stance. Economic growth is

decelerating due to the combined impact of uncertain global environment, cumulative effect of past

monetary tightening and domestic policy uncertainty.

(a) While some slowdown in the growth of demand was expected as a result of earlier monetary policy

moves to control inflation, at this juncture risks to growth have increased.

(b) The fall in WPI inflation is due to a sharp decline in the prices of seasonal vegetables. However,

protein-based food items and non-manufactured food inflation remain high. Further, there are many

upside risks to inflation. Global petroleum prices remain high. The lingering effect of recent rupee

depreciation continues and there is a significant slippage in the fiscal deficit.

54

(c) Liquidity conditions have remained tight beyond the comfort zone of the RBI despite massive

infusions through open market operations.

All these have tied RBI's hands and postponed its decision to cut the repo rate. Less clear is what the half

a percentage point cut in the CRR will do to ease liquidity as a critical step towards making banks lend

more. Some analysts, notably A. Seshan (former senior RBI official), see an inherent contradiction in the

policy statement: how does a situation of liquidity shortage co-exist with low credit off take from the

banking system?

‘A crowding out' effect

Consider the following: Money supply has been on expected lines but non-food credit growth at 15.7 per

cent has been below the indicative projection of 18 per cent. The latter is due to the combined impact of a

slowing economy and risk aversion among banks concerned over non-performing assets (NPAs). There

is also ‘a crowding out' effect of increased government borrowing. Net credit to government has

increased at a significantly higher rate of 24.4 per cent as compared with 17.3 per cent last year. The last

point may be one of the reasons to explain the tightness in the money market. But the RBI has done its

bit to ease liquidity by buying back dated securities, for instance. Far more difficult it is to reconcile low

credit off take with liquidity shortage.

The only explanation is that banks have become even more shy of lending than is apparent. As pointed

out earlier, an increase in the NPAs does contribute to increased risk aversion among banks. There is also

a widespread fear psychosis: the bona fide commercial decisions of bankers are being questioned many,

many years later.

Power sector in deep trouble

A number of infrastructure sectors, especially power, are mired in deep financial troubles.

Telecom is in a mess. More recently, Kingfisher Airlines and Air India have shown how deep-seated the

financial problems are even in a sunrise sector such as civil aviation.

55

Aversion to lending

Many times in the past too, risk aversion on the part of banks has been cited to explain the fall in lending.

Given the dominance of government banks, it is of utmost importance to put in place a system of

accountability, which will not penalize risk-taking.

In short, the RBI's betting on a CRR cut as a means of assuaging the disappointment over the absence of

more overt repo rate reduction might have paid off in the short run. Stock markets are up. But for the

CRR cut draws attention to some structural blocks such as risk aversion that will limit its potential.

Rural Co-operatives

Licensing of Co-operatives

1- The Committee on Financial Sector Assessment (Chairman: Dr. Rakesh Mohan and Co-Chairman: hri

Ashok Chawla) had recommended that rural co-operative banks, which failed to obtain a licence by end-

March 2012, should not be allowed to operate. The Reserve Bank, along with the National Bank for

Agriculture and Rural Development (NABARD) implemented a roadmap for issuing licences to

unlicensed state co-operative banks (StCBs) and district central co-operative banks (DCCBs) in a non-

disruptive manner, to ensure the completion of licensing work by end-March 2012. After considering the

NABARD’s recommendations for issuance of licences based on inspection/quick scrutiny, one out of 31

StCBs and 41 out of 371 DCCBs were found to be unable to meet the licensing criteria by end-March

2012. In this regard, suitable action will be initiated in due course.

Streamlining of Short-Term Co-operative Credit Structure

2- After recapitalisation of the three-tier short-term co-operative credit structure (STCCS), 41 DCCBs

having high level of financial impairment as of end-March 2012 were unable to meet the licensing

criteria. In order to examine issues of structural constraints and explore strengthening of the rural co-

operative credit architecture with appropriate institutions and instruments of credit to fulfil credit needs,

it is proposed:

56

to constitute a Working Group to review the STCCS, which will undertake an in-depth analysis of the

STCCS and examine various alternatives with a view to reducing the cost of credit, including feasibility

of setting up of a two-tier STCCS as against the existing three-tier structure.

Urban Co-operative Banks

Exposure of UCBs to Housing, Real Estate and Commercial Real Estate

1- At present, UCBs are permitted to assume aggregate exposure on real estate, commercial real estate

and housing loans up to a maximum of 10 per cent of their total assets with an additional limit of 5 per

cent of their total assets for housing loans up to `1.5 million. In order to facilitate enhanced priority

sector lending, it is decided:

To permit UCBs to utilise the additional limit of 5 per cent of their total assets for granting housing

loans up to `2.5 million, which is covered under the priority sector.

2- 77. Detailed guidelines in this regard will be issued separately.

Licences for Setting up New Urban Co-operative Banks

1- As announced in the Monetary Policy Statement of April 2010, an Expert Committee (Chairman: Shri

Y. H. Malegam) was constituted in October 2010 for studying the advisability of granting licences for

setting up new UCBs. The Committee was also mandated to look into the feasibility of an umbrella

organization for the UCB sector. The Committee submitted its report in August 2011. The report was

placed in public domain in September 2011 for comments and suggestions from stakeholders. In the light

of the feedback received, it is proposed.

57

Highlights of the RBI’s Second Quarter Review of Monetary Policy for 2011-12 –

October 2011

Benchmark Repo Rate increased by 25 basis points (bps) from 8.25% to 8.50% with immediate effect;

Reverse Repo and Marginal Standing Facility stands revised to 7.50% and 9.50%, respectively

Bank Rate, Cash Reserve Ratio and Statutory Liquidity Ratio unchanged at 6%, 6% and 24%

Baseline projection for headline WPI inflation for March 2012 maintained at 7%; inflation expected to

remain sticky in October-November 2011 and decline from December 2011 onwards

Baseline projection for GDP growth for FY12 revised to 7.6%; in September 2011, the RBI had

indicated downside risks to its growth projection of 8% for 2011-12 made in May 2011 and July 2011,

led by moderating domestic demand and impact of weakening global growth momentum and rising

uncertainty

Monetary stance remains focused on containing inflation and anchoring inflationary expectations,

whilst aiming to balance growth concerns

Guidance provided regarding a low likelihood of a further policy rate hike in December 2010

Interest on savings account balances deregulated - Banks allowed to offer differential rates for savings

deposits beyond Rs. 1 lakh; Deregulation could trigger increase in cost of funds for Banks

Non-food credit and broad money growth projections retained at 18% and 15.5%, respectively.

58

Systemic liquidity remains within RBI comfort zone; large government borrowings in H2FY12

could exert some pressure

Systemic liquidity remained in deficit mode throughout Q2FY12, but largely remained within RBI’s

comfort zone of +/-1% of net demand and time liabilities, with the exception of a few days in September

2011 on account of pressures related to advance tax payments. The Marginal Standing facility (MSF)

introduced by RBI in May 2011 available to Banks at 1% higher than Repo rate has been largely

unutilized, as Banks were able to access adequate liquidity through the LAF.

Banks maintained average excess SLR investments (including Reverse Repo) of more than Rs.

2.7 lakh-crore during H1FY12, marginally lower than 2.9 lakh-crore in H1FY11. The average SLR

levels remained around 28.8% of NDTL as against the mandated 24%. GoI spending during the first half

has remained high as indicated by the negative balance with RBI since April 2011 despite achieving 61%

of FY12’s gross market borrowings in up to October 14, 2012. However, the full year GoI borrowing

target has been revised upwards by about Rs. 53,000 crore which means the GoI’s gross market

borrowing in H2FY12 would be around Rs. 2.03 lakh-crore. This could exert some pressure on systemic

liquidity particularly if credit demand remains benign.

59

Inflation expected to moderate in December 2011; decline to 7% by March 2012

The Central Bank indicated that the monetary policy tightening effected so far has helped in containing

inflation and anchoring inflation expectations, whilst acknowledging that both remain elevated. Headline

wholesale price index (WPI) inflation has averaged 9.6% in FY12 so far and remained in excess of 9% in

each month in the current fiscal year, substantially higher than the RBI’s comfort zone. Additionally,

inflation has been driven by all the three groups of items, namely, primary articles, fuel & power and

manufactured products, reflecting a generalization of inflationary pressures.

The RBI expects inflation to remain sticky in October-November 2011, despite the substantial policy

tightening that it has undertaken since March 2010. However, the policy review indicates a downward

momentum in the de-personalized sequential quarterly WPI data. Additionally, WPI data for September

2011 indicates that the index levels declined or remained unchanged for six of the 11 sub-groups of non

food manufactured products on a month-on-month basis, suggesting that inflationary pressures have

begun to moderate in certain sectors. The Central Bank expects WPI inflation to decline significantly in

December 2011 and continue to moderate in 2012-13.

With the potential adverse impact of the rupee depreciation, incomplete transmission of commodity price

movements, suppressed inflation related to domestic coal and electricity prices and structural rigidity of

food inflation likely to be offset by the lagged impact of cumulative monetary policy actions and

moderating demand, the RBI continues to expect inflation to decline to 7% by March 2012, in line with

ICRA’s expectations (6.8-7%). The RBI also highlighted that the impact of tight monetary policy has

been diluted by the expansionary fiscal position, and emphasized that slippages in the fiscal deficit

relative to the budget estimates would have implications for domestic inflation.

60

Baseline projection of real GDP growth for 2011-12 revised to 7.6%

The Central Bank revised the baseline projection for GDP growth for FY12 to 7.6%. In September 2011,

the RBI had indicated downside risks to its growth projection of 8% for 2011-12 made in May 2011 and

July 2011, led by moderating domestic demand and impact of weakening global growth momentum and

rising uncertainty. The pace of growth of gross domestic product (GDP) at factor cost (constant prices)

moderated to 7.7% in Q1FY12, from 8.8% in Q1FY11, led by a decline in the pace of industrial growth.

The Central Bank indicated that capacity utilization moderated in Q1FY12 as compared to the previous

quarter while business expectations declined in Q2FY12. The Index of Industrial Production (IIP)

recorded sluggish 3.9% growth in July-August 2011 relative to the same months in 2010, lower than the

6.8% growth recorded in Q1FY12. Notably, sluggish global growth is expected to dampen Indian exports

and therefore its manufacturing sector, given linkages of the Indian economy with the global economy.

Additionally, the RBI indicated that the services sector too may see some moderation in growth on

account of inter-sectoral linkages. An increase in the sown area and a favorable monsoon rainfall in 2011

are likely to boost agricultural output in FY12, although the pace of growth is likely to be moderate given

the high base effect.

The RBI indicated concerns to growth originating from the global macroeconomic environment, which

may undergo a sharp deterioration in the absence of a credible solution to sovereign debt and financial

problems in Europe, impacting Indian economic growth through trade, finance and confidence channels.

The Central Bank also highlighted the potential crowding out of private sector investment following an

increase in Government of India’s borrowing programmed for H2FY12.

Overall, ICRA expects the Indian economy to expand by 7.5-7.7% in FY12, similar to the baseline

projection of 7.6% GDP growth for FY12 made by the RBI.

61

Guidance suggests low likelihood of rate change in December 2011

Given the anticipated trajectory of inflation and risks regarding growth impulses, the Central Bank

provided a guidance of a relatively low likelihood of a rate action in the December 2011. Further, the

RBI indicated that if the evolving inflationary trajectory is similar to its forecasts, further rate hikes may

not be warranted.

The RBI indicated that the stance of monetary policy is intended to:

• Maintain an interest rate environment to contain inflation and anchor inflation expectations.

• Stimulate investment activity to support raising the trend growth.

• Manage liquidity to ensure that it remains in moderate deficit, consistent with effective monetary

transmission.

Notably, the Central Bank indicated in the Second Quarter Review of Monetary Policy that the monetary

stance is intended to stimulate investment activity, as compared to the earlier intention to manage the risk

of growth falling significantly below trend. This highlights the policy challenges facing the RBI, whose

policy stance simultaneously intends to contain inflationary pressures.

The Central Bank indicated the following expected outcomes of its monetary measures and guidance:

Continue to anchor medium-term inflation expectations on the basis of a credible commitment to low

and stable inflation.

Reinforce the emerging trajectory of inflation, which is expected to begin to decline in December

2011.

Contribute to stimulating investment activity.

62

Credit growth remains robust despite hardening interest rates; could moderate in

H2FY12

Systemic credit in the current fiscal has remained robust with incremental Bank credit of nearly Rs. 2.1

lakh-crore up to October 7, 2011, only marginally lower than Rs. 2.3 lakh-crore in the same period of

FY11. The y-o-y credit growth remained strong at around 19.3% as on October 7, 2011, as compared to

around 20% as on October 8, 2010, higher than the RBI’s projection of 18%. However, moderating

economic growth and an unyielding interest rate environment, in conjunction with a high base effect are

likely to dampen the pace of growth of credit off-take in H2FY12. ICRA expects the full-year credit

growth in FY12 to moderate from the current levels to around 18- 19%, and remain close to the RBI’s

baseline projection.

Data released by the RBI regarding deployment of credit to various sectors up to August 2011 indicates

that the 2.5% growth of Bank credit so far in FY123, was primarily driven by credit to industry and retail

housing, while credit to services remained flat and agricultural credit declined in the current year. Within

industry, a large chunk of the incremental credit extended in the current fiscal has been absorbed by the

metals sector (23%) and the infrastructure sector (36% of total incremental credit in FY12), particularly

power (31%) and roads (11%) while credit to telecom shrank (11%). The medium and large industrial

sectors which grew by 4.5% and 6.2%, respectively, continue to attract a greater share of Bank funding

as compared to services and retail loans. While housing credit expanded by Rs. 18,060 crore between

April and August 2011 (5.2% growth), data suggests incremental credit off-take for retail housing has

slowed significantly.

63

Deregulation of Savings Bank Deposit Interest Rate

In recent periods, the spread between the savings deposit and term deposit rates has widened

significantly. RBI had increased the savings bank deposit interest rate from 3.5% to 4.0% in April 2011,

pending deregulation. The savings bank deposit interest rate deregulated with immediate effect, subject

to the following two conditions:

Banks will have to offer a uniform interest rate on savings bank deposits up to Rs. 1 lakh, irrespective

of the amount in the account within this limit.

For savings bank deposits over Rs.1 lakh, a Bank may provide differential rates of Interest

The decision to deregulate of the bank savings deposits rate (operational guidelines awaited) is likely to

benefit the deposit holders as they can get higher returns on their deposits but at the same time increase

the interest rate sensitivity and the asset-liability mismatches for Banks. At the systemic level, savings

accounts are estimated to account for 22%-23% of total Bank deposits as on Sep 30, 2011, the increase in

saving rate could dilute the NIM by ~10-12 basis points, (assuming a broad based 50-75 bps increase in

the savings bank deposit interest rate; without factoring in any rise in lending rates) while the post tax

impact could be lower at 7-8 basis points, therefore return on equity could get diluted by less than 1%.

The impact could be more for banks with higher savings deposits. We believe that this step would add to

the profitability pressures on the Banks in light of tighter monetary stance followed by the Central Bank

unless they are able to pass on the burden to the borrowers.

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Conclusion

There is a fairly large literature on the bank lending channel of monetary policy. But much of this

literature is in the context of the United States, Europe and other developed economies where the banks

are heterogeneous but are almost entirely in private sector. The emerging market economies, by contrast,

have their fair share of state-owned banks, such that, in these contexts, the implications of ownership for

the bank lending channel remains an important, yet largely unexplored, policy consideration. In this

paper we address this issue, using bank-level data from India. Our results suggest that there are

considerable differences in the reactions of different types of banks to monetary policy initiatives of the

central bank. During periods of tight monetary policy, as captured by the monetary conditions index,

state-owned banks, old private banks and foreign banks curtail credit in response to an increase in

interest rate. The reaction of foreign banks is particularly sharp.

The reaction of the new private banks is not statistically significant. By contrast, during easy

money periods, an increase in interest rates by the central bank leads to an increase in the growth of

credit disbursed by old private banks, with no significant reactions from other types of banks. The

regression results

also indicate that the adverse reaction to a policy initiated increase in interest rate in a tight monetary

regime is much greater for medium term borrowing than for short-term borrowing. Our results have two

significant implications for the literature on bank lending channel. First, it suggests that the bank lending

channel of monetary policy might be much more effective in a tight money period than in an easy money

period. In other words, if interest rates are low, then a central bank that desires monetary contraction may

have to raise the rate substantially to witness an impact on money supply through the bank lending

channel. This has implications for future analyses of the bank lending channel; the condition under which

a central bank changes its policy rate should be explicitly taken into account. It has also implications for

the implementation of monetary policy strategies during a business cycle period or economic crisis.

For example, if the economy is going through a downturn and the authorities try to stimulate the

economy towards the recovery zone, then, depending upon the type of money regime the economy is in,

the policymakers need to consider making adjustments in policy rates to get the desired effects. 65

SUGGESTIONS

1. According to my experience bank should also concentrate on new policies of monetary.

2. It should increase rates of interest for customers.

3. New monetary policies should be applied seriously.

4. Without any mistake policies should be adopted.

5. Bank should focus on their various services.

6. Bank should also give knowledge to customers about time-to-time changes in monetary

policy.

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BIBLOGRAPHY

http//www.cooperative bank.com

http//www.icra.com

http//www.indian monetary.com

httpwww.monetary reform.com

http//rbi.com

http//www.cooperative services.com

BOOKS

1- Partiyogita Darpan (2009)

2- Cooperative Bank Magazine (2010)

3- Research , CR Kothari

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