Few weeks back a friend of mine posed a question on RBI and asked what do they do? I told him they regulate banking and financial markets. I am not sure that answered his query but then he was not interested in knowing beyond that. Today I read an article in Knowledge @ Wharton about RBI and their role in compensation of top management of banks, including private and foreign banks in India. They are intervening in order to ensure compensation packages of top executives in banks are not encouraging risky investments / lending. This is something that derailed many banks in the west in the past year. Some words of praise in that article kindled my interest to post here on RBI and their role in ensuring relatively peaceful economic life of India.
RBI is responsible for the monetary policy of Indian economy. It has a mandate to contain inflation. They set base interest rate, influence money supply in the economy, set various reserve ratios for banks, intervene and support Rupee in the foreign exchange market, regulate and guide functioning of banks, financial institutions and non-banking finance companies, set lending norms, set risk weightages for various bank assets, etc. The list is too big to remember, for me, and fill here. Let me, in a nutshell, share here, the major role of RBI and its contribution to our economy.
Banks borrow money (through deposits and other modes) and lend money. Money borrowed is their liability and money lent is their asset. Their return from lending should be higher than the cost of borrowing so that they meet their expenses and then make profits. Naturally banks would want to acquire assets that promise more returns. Remember, higher the return, higher will be the risk associated with it. With more exposure to risk, a bank's financial stability is threatened and their ability to repay their lenders is cast a shadow. RBI steps in here and curbs certain types of asset acquisition by banks. Besides it also assigns a risk weightage to each type and class of banking assets. An asset carrying higher risk weight would require a bank to maintain higher capital while a low risk weighted asset wouldn't put much stress on the capital of a bank. This is to ensure that a bank provides for more capital when it goes for more risky assets. Though this is a global practice, risk weightages for various asset types are fixed by individual central banks (like RBI). RBI is one of the earliest central banks to increase the risk weightage of real estate assets (lending to and investment in real estate) and that promptly preempted over exposure of Indian banks to real estate. It is real estate investment bubble that swallowed many banking monsters in the west. Hope I come out clear in my explanation here.
Bank also invest besides lending. Some times it is easier and safer for banks to invest say in government securities and bonds than lend. This, if excessively done, will stifle economic growth as business won't get enough money. RBI, according to situation, dabble with interest rates to discourage or encourage banks' lending and investment activities. Also it ensures country's primary sector, agricultural, gets enough funding support by fixing a minimum limit (a % out of total lending) for primary sector lending. It also plays a vital role in financial inclusion of rural areas.
Banks cannot deploy all the money it borrows as it would affect its liquidity and financial stability. But then not all will retain enough resources to support its customers and lenders. To ensure banks maintain enough cash balance and also sufficient amount of liquid assets (assets that can be converted into cash on quick notice) it sets, adjusts and mandates banks to maintain Cash reserve ratio (CRRs) and Statutory Liquid Ratio (SLRs). These are set in accordance with prevailing economic condition.
RBI plays a major role in Rupee exchange rate. It intervenes in the foreign exchange market to curb speculation effects on Rupee. But there is a general feeling in the import lobby that RBI mostly acts in the interest of export lobby than in general interest.
RBI annually audit banks and financial companies for compliance with their rules and guidelines on functioning and various norms. Through this they ensure banks and financial institutions comply with rules and guidelines set in the interest of monetary stability of the nation.
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