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eefect of monitry policy on banking sectror


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eefect of monitry policy on banking sectror

  1. 1. 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 requirement for 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) 1
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  3. 3. 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 3
  4. 4. 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 4
  5. 5. 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 5
  8. 8. 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. 8
  9. 9. 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. 9
  10. 10. 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. 10
  11. 11. 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 11
  12. 12. 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 12
  13. 13. 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 13
  14. 14. 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. 14
  15. 15. 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. 15
  17. 17. 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. 17
  18. 18. 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. 18
  19. 19. 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 19
  20. 20. 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 20
  21. 21. 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. 21
  22. 22. 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 22
  23. 23. 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. 23
  24. 24. 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. 24
  25. 25. 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
  26. 26. 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
  27. 27. 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
  28. 28. 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. 28
  30. 30. 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
  31. 31. 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. 31
  32. 32. 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. 32
  33. 33. 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
  34. 34. 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. 34
  35. 35. 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. 35
  36. 36. 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
  37. 37. 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 37
  38. 38.  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
  40. 40. 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
  41. 41. 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. 41
  42. 42. 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
  43. 43. 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
  45. 45. 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
  46. 46. 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
  48. 48. 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
  49. 49. 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
  50. 50. 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
  51. 51. 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
  52. 52. 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
  53. 53. 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
  54. 54. 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
  55. 55. (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
  56. 56. 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
  57. 57.  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
  58. 58. 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
  59. 59. 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