Money and Banking

A cashless society is an economic state where financial transactions are conducted without physical bank notes or coins. Instead, transactions occur through the transfer of digital information, typically an electronic representation of money, between the transacting parties. Some countries have begun moving towards economies that rely less on cash and more on digital transactions. In India, the government has made consistent investments in reforms to promote greater financial inclusion and a cashless economy. Initiatives launched include Jan Dhan accounts, Aadhar enabled payment systems, e-Wallets, and the National Financial Switch (NFS). The widespread penetration of mobile and smart phones across the country is seen as making financial inclusion a realistic goal. Demonetisation, an initiative by the Government of India in November 2016, also contributed to this shift. While primarily aimed at tackling corruption, black money, terrorism, and fake currency, it had the additional effect of encouraging a transition from the cash economy to the formal payment system. Households and firms began to shift towards electronic payment technologies as a result of demonetisation.

**History of Indian Banking:** - **Bank of Bengal (1806)**, Bank of Bombay (1840), Bank of Madras (1843): Three Presidency Banks - **1921**: Three Presidency Banks merged → **Imperial Bank of India** (also performed central bank functions in absence of RBI) - **1935**: RBI established - **1955**: Imperial Bank nationalized → **State Bank of India (SBI)** (under State Bank of India Act 1955) - **July 1969**: 14 banks nationalized — deposits > Rs. 50 crore — objective: "Control the commanding heights of the economy" - **April 1980**: 6 more banks nationalized — deposits > Rs. 200 crore — PSB share of deposits = **92%** - Priority sector lending target raised to **40%** post-nationalization - Pre-1991: CRR = **15%**, SLR = **38.5%** (compared to 2% and 25% in 1960) **Narasimham Committee I (1991) — Committee on Financial System:** - Constituted to review financial sector in context of 1991 crisis - Key recommendations: - Reduce SLR to **25%** - Deregulate interest rates; use OMOs more than CRR changes - Phase out directed credit programme - Establish **Asset Reconstruction Company (ARC)** for bad loans - Create 3-4 large international banks + 8-10 national banks - RBI should be primary regulator of banking; end duality with Ministry of Finance **Narasimham Committee II (1997) — Committee on Banking Sector Reforms:** - Key recommendations: - Reduce GoI equity in nationalized banks to **33%** for greater autonomy - Merge large banks to support international trade (stronger banks) - Raise capital adequacy norms - RBI (as regulator) should NOT own banks — conflict of interest; RBI transferred SBI, NHB, NABARD shareholdings to GoI **P.J. Nayak Committee (January 2014):** - Purpose: Review governance of boards of banks in India (report submitted May 2014) - Recommended: **Bank Investment Company (BIC)** under Companies Act 2013 - Government transfers PSB ownership to BIC; BIC holds banks as subsidiaries - Government reduces stake to below 50% - PSBs become limited companies (e.g., "State Bank of India Limited") - Interim recommendation: **Banks Board Bureau (BBB)** via executive order; BIC to replace BBB eventually - Nachiket Mor Committee (September 2013): For financial inclusion — each resident within 15-min walking distance of a payment access point; Aadhaar as prime driver for bank account expansion **Banks Board Bureau → FSIB:** - BBB set up per P.J. Nayak recommendation - **FSIB (Financial Services Institutions Bureau)**: Replaced BBB from **1 July 2022** - Functions: Recommends WTDs (whole-time directors) and NECs (non-executive chairpersons) for PSBs, FIs (NABARD, SIDBI, NHB, EXIM, MUDRA), and PSIs (public sector insurers) **FSDC (Financial Stability and Development Council):** - Established: **December 2010** (non-statutory; gazette notification) - Chairman: **Finance Minister** - Members: Heads of RBI, SEBI, PFRDA, IRDA, IBBI, Chief Economic Advisor + secretaries of Finance, IT, Corporate Affairs Ministries - Functions: Financial stability, inter-regulatory coordination, financial literacy, financial inclusion, macro-prudential supervision, coordination with FATF/FSB **NPA Classification:** - **NPA (Non-Performing Asset)**: Interest/principal overdue for more than **90 days** - **Stressed assets = NPAs + Restructured loans + Written-off assets** - **Restructured asset**: Loan modified via extended repayment, reduced interest rate, or conversion to equity - **Write-off**: Bank removes loan from balance sheet (accounting); borrower still owes **SARFAESI Act 2002:** Full name: Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act 2002 - Purpose: Allow banks to recover NPAs WITHOUT court intervention - Process: Issue 60-day notice to defaulter; if unremedied, enforce security interest (seize and sell collateral) - Three processes: (1) Security Enforcement without court, (2) Asset Reconstruction (ARC buys rights in debt), (3) Securitization (convert illiquid assets to marketable securities) **Bad Bank — NARCL and IDRCL (2021):** - **NARCL (National Asset Reconstruction Company Ltd.)**: "Bad Bank"; 51% PSBs + 49% private lenders; purchases NPAs from commercial banks - Payment structure: 15% cash + 85% government-guaranteed securities (paid once bad bank recovers) - **IDRCL (India Debt Resolution Company)**: Non-govt company; manages and resolves bad assets acquired by NARCL - Together form India's bad bank structure **Insolvency and Bankruptcy Code 2016 (IBC):** - Enacted: May 2016; replaces overlapping laws (DRT, SARFAESI, SICA, Companies Act winding-up) - Default threshold: Rs. **1 crore** - Process: Creditor/debtor files with **NCLT (National Company Law Tribunal)**; 10-day demand notice; NCLT admits - Timeline: **180 days** (+ 90-day extension in complex cases; max 330 days with legal proceedings) - **Committee of Creditors (CoC)**: Financial creditors only; 66% majority required for decisions - Appeal: NCLAT (appellate); DRAT for individual insolvencies - 4 Institutional Pillars: Insolvency Professionals (IPs) → Information Utilities → NCLT/DRT → Insolvency and Bankruptcy Board (IBB) - Workers' protection: Salary for up to 24 months gets first priority in liquidation **IBC Pre-Pack Scheme (2021 Amendment):** - For MSMEs with default < Rs. 1 crore - Original management retains control (unlike normal CIRP where management passes to Resolution Professionals) - Timeline: **120 days** (vs 180 days for CIRP) - **Swiss Challenge**: If operational creditors not fully compensated, open bidding process activated **Transfer Pricing and BEPS:** - **APA (Advance Pricing Agreement)**: Pre-agreed pricing for intra-company (related party) transactions; binding on taxpayer and government for ~5 years - Prevents **BEPS (Base Erosion and Profit Shifting)** — strategy of MNCs to shift profits to low-tax jurisdictions - India ratified **MLI (Multilateral Convention to Implement BEPS Measures)**: Signed Paris June 2017; effective in India from **1 October 2019**

Banks hold part of the money people keep in their bank deposits as reserve money and lend out the rest to various investment projects. Reserve money consists of two things: vault cash in banks, and deposits of commercial banks with the Reserve Bank of India (RBI). This reserve money is also called **high-powered money** or **monetary base** as it forms the basis for credit creation. The **Reserve Deposit Ratio (rdr)** is the proportion of the total deposits commercial banks keep as reserves. Keeping reserves is costly for banks since they could otherwise lend this balance to interest-earning investment projects. However, RBI requires commercial banks to keep reserves in order to ensure that banks have a safe cushion of assets to draw on when account holders want to be paid. RBI uses various policy instruments to bring about a healthy commercial banking system. These tools can be broadly classified into **quantitative** (e.g., CRR, Bank Rate, Open Market Operations) and **qualitative** (e.g., moral suasion, margin requirement). The first instrument is the **Cash Reserve Ratio (CRR)**, which specifies the fraction of their deposits that banks must keep with RBI. This is a legal requirement, binding on banks, to ensure no bank is 'over lending'. There is another tool called the **Statutory Liquidity Ratio (SLR)**, which requires banks to maintain a certain proportion of their demands and time deposits in the form of specified liquid assets for short-term liquidity. The RBI also acts as the **lender of last resort**, ready to lend to banks at all times. **Money Multiplier:** If the total initial deposit is Rs 1 and the reserve ratio is r, banks will lend out (1 − r), then lend (1 − r)² again, and so on. The total money supply generated from an initial deposit of Rs 1 is: Money Multiplier = 1 / (1 − (1 − r)) = 1 / r For example, if r = 0.2 and initial deposits = Rs 1, total deposits in the banking system = Rs 5. The money supply (M1, narrow money) consists of: currency held by the public + demand deposits in commercial banks. Currency notes and coins are **fiat money** and **legal tenders**, deriving their value from the issuing authority and being universally accepted. However, demand deposits are **not legal tenders**. M1 = CU + DD, where CU = currency (notes and coins) held by the public, DD = demand deposits in commercial banks. The RBI publishes four measures of money supply: M1, M2, M3, and M4. M2 = M1 + Savings deposits with Post Office savings banks. Broad money (M3) = M1 + time deposits in commercial banks. M4 = M3 + Total deposits with Post Office savings organisations (excluding National Savings Certificates). The difference in values between M1 and M3 is attributable to the time deposits held by commercial banks. M1 and M2 are known as narrow money, while M3 and M4 are broad money. These measures are in decreasing order of liquidity, with M1 being the most liquid and M4 the least. M3 is the most commonly used measure of money supply, also known as aggregate monetary resources.

The Reserve Bank of India (RBI) is the central bank of India. It acts as the banker to the government, the banker to commercial banks, the lender of last resort, and the issuer of currency. **Functions of Money:** Money serves as (1) a medium of exchange eliminating the need for barter, (2) a unit of account that measures the value of goods, (3) a store of value that transfers purchasing power from the present to the future, and (4) a standard of deferred payment. Economic exchanges without money are barter exchanges, which require a "double coincidence of wants." For money to function well as a store of value, its purchasing power must remain sufficiently stable, as a rising price level can erode it. **Demand for Money:** There are two motives for holding money: - The **Transaction Motive**: People hold money to meet everyday transactions (buying goods and services). This demand depends on income; a rise in income leads to a rise in demand for money. It is generally positively related to real GDP and the average price level. - The **Speculative Motive**: People hold money as an asset when they expect other assets (like bonds) to lose value. If interest rates are expected to rise (bond prices fall), people prefer to hold money. When interest rates are very high, speculative demand for money is low as capital gains from bond-holding are anticipated. Conversely, when interest rates are very low and expected to rise, speculative demand for money is high due to anticipated capital losses. This relationship can lead to a 'liquidity trap' where the speculative demand for money is infinitely elastic at a very low interest rate. **Instruments of Monetary Policy:** 1. **Open Market Operations (OMO):** RBI buys or sells government securities in the open market. When RBI buys securities from commercial banks, it increases their reserves (expansionary). When RBI sells securities, it reduces bank reserves (contractionary). OMOs can be 'outright' (permanent) or 'repo' (repurchase agreement - temporary). 2. **Cash Reserve Ratio (CRR):** Raising CRR reduces lendable funds; lowering it expands credit. The RBI decides a certain percentage of deposits which every bank must keep as reserves to ensure banks are not 'over lending'. 3. **Statutory Liquidity Ratio (SLR):** Minimum liquid assets (mainly government securities) banks must hold. A higher SLR reduces credit availability. Banks are required to keep some reserves in liquid form in the short term. 4. **Bank Rate (Repo Rate):** The rate at which RBI lends to commercial banks. A higher bank rate makes borrowing costly for banks, reducing credit in the economy. This refers to the rate for loans given by RBI to commercial banks. 5. **Moral Suasion:** RBI persuades (not compels) banks to follow certain policies. This is a qualitative tool. Commercial banks can borrow from RBI at the **Bank Rate**. RBI uses the Bank Rate to control the cost of credit in the economy. Commercial banks borrow short-term funds from RBI at the **Repo Rate** and park excess funds at the **Reverse Repo Rate**. The tools used by the Central bank to control money supply can be quantitative (e.g., CRR, bank rate, OMO) or qualitative (e.g., moral suasion, margin requirement).

Seigniorage represents the profit derived from the creation of money. It provides a mechanism for governments to generate revenue without resorting to conventional taxes. This profit primarily accrues to central banks. The process of seigniorage involves several key ways in which central banks, such as the Reserve Bank of India (RBI), generate this revenue. Firstly, when a central bank issues currency, it maintains certain reserves or backups. The interest income earned on these reserves, after accounting for the cost of printing currency, contributes to seigniorage. Secondly, central banks earn interest from the balances that commercial banks are required to hold with them to fulfill their reserve requirements, such as the Cash Reserve Ratio (CRR). These balances may either be interest-free or accrue interest at rates below prevailing market rates. Thirdly, seigniorage encompasses the concept of an "inflation tax." This is measured as the product of the inflation rate and the monetary base. The inflation tax effectively reduces the central bank's liability because the currency notes held by the public lose value due to inflation, thereby decreasing the real value of the central bank's outstanding obligations.

Open Market Operations (OMO) are a significant quantitative tool employed by the Central Bank, such as the Reserve Bank of India (RBI), to manage and control the money supply within an economy. These operations primarily involve the buying and selling of government bonds in the open market. The authority for these transactions is typically entrusted to the Central Bank, acting on behalf of the Government. When the RBI purchases government bonds in the open market, it issues a cheque as payment. This action leads to an increase in the total amount of reserves held within the economy, consequently expanding the overall money supply. Conversely, if the RBI opts to sell government bonds to private individuals or institutions, it results in a reduction in the quantity of reserves, which in turn diminishes the money supply. OMO are categorized into two main types: outright operations and repurchase agreements (repo). Outright open market operations are characterized by their permanent nature; when the central bank buys securities, there is no subsequent promise to sell them, and when it sells securities, there is no promise to buy them back later. This ensures a permanent injection or absorption of money. In contrast, a repurchase agreement (repo) involves the central bank buying a security with a pre-specified date and price for its resale. The interest rate applicable to such lending is known as the repo rate. Similarly, a reverse repurchase agreement (reverse repo) occurs when the central bank sells securities with an agreement detailing the date and price at which they will be repurchased, with the associated interest rate being the reverse repo rate. The Reserve Bank of India actively conducts repo and reverse repo operations across various maturities, including overnight, 7-day, and 14-day agreements, making them a primary instrument of its monetary policy.

Demonetisation in India (2016) was a significant policy initiative undertaken by the Government of India in November 2016. Its primary objectives were to address issues such as corruption, black money, terrorism financing, and the circulation of fake currency within the economy. As part of this measure, existing currency notes of Rs 500 and Rs 1000 denominations were declared no longer legal tender. Simultaneously, new currency notes of Rs 500 and Rs 2000 denominations were introduced. The public was provided with a deadline of December 31, 2016, to deposit their old currency notes into bank accounts without requiring any declaration. A further provision allowed deposits with the Reserve Bank of India (RBI) until March 31, 2017, with a necessary declaration. To mitigate an immediate cash crunch and avoid a complete breakdown of transactions, the government initially permitted the exchange of Rs 4000 old currency for new per person per day. Additionally, until December 12, 2016, old currency notes remained acceptable for specific transactions, including payments at petrol pumps, government hospitals, and for government dues like taxes and power bills. The policy initially led to challenges, including long queues outside banks and ATM booths, and a shortage of currency in circulation, which adversely affected economic activities. However, the situation gradually improved, and normalcy eventually returned. The demonetisation move is noted to have several positive impacts: it enhanced tax compliance by bringing more individuals into the tax ambit, channelized individual savings into the formal financial system, and consequently, increased bank resources for providing more loans at potentially lower interest rates. It also served as a clear signal from the state against tax evasion and corruption, encouraging a shift from a cash-based economy to a formal payment system utilizing electronic payment technologies.

High-powered money, also known as reserve money or monetary base, refers to the currency issued by the central bank of an economy. In a modern economy, the supply of money is created by a system that includes both the central bank and the commercial banking system. From the perspective of money supply, the central bank's primary function of issuing currency is crucial. This issued currency can be held either by the public or by commercial banks. A fundamental characteristic of high-powered money is its role as the basis for credit creation within the economy.

In a modern economy, currency notes and coins are classified as **fiat money**. This classification stems from the fact that their intrinsic value, such as the value of the paper in a hundred-rupee note or the metal in a five-rupee coin, is negligible and certainly less than their printed or face value. The actual value of these currency notes and coins is derived solely from the guarantee provided by the issuing authority. For instance, every currency note in India features a promise from the Governor of the Reserve Bank of India (RBI) that the note's holder will receive purchasing power equivalent to its printed value when presented to the RBI or any commercial bank. Coins also operate on this principle, though they are issued by the Government of India. Furthermore, these currency notes and coins are also considered **legal tender**. This means that they cannot be lawfully refused by any citizen of the country when offered for the settlement of any kind of transaction. This legal backing ensures their universal acceptability within the economy as a medium of exchange. In contrast, other forms of money, such as demand deposits (balances in savings or current accounts) on which cheques can be drawn, are not considered legal tender because individuals retain the right to refuse them as a mode of payment. Historic events like demonetisation illustrate the concept of legal tender, where certain currency notes lose their status as legal tender, thereby ceasing to be acceptable for transactions.

**Financial Inclusion History in India:** - **1956**: Nationalization of Life Insurance companies - **1969**: Nationalization of 14 banks (>Rs. 50 crore deposits) - **1972**: Nationalization of general insurance companies - **1975**: Regional Rural Banks (RRBs) established by Indira Gandhi government - **August 2014**: **PMJDY (Pradhan Mantri Jan Dhan Yojana)** — financial inclusion for all; ~41.75 crore accounts opened by January 2021 **National Strategy for Financial Inclusion (NSFI) 2019-2024:** - Announced by RBI; 6 strategic pillars: 1. Universal Access to Financial Services 2. Providing basic bouquet of financial services 3. Effective co-ordination 4. Financial literacy and education 5. Customer protection and grievance redressal 6. Access to livelihood and skill development **MUDRA (Micro Units Development and Refinance Agency Ltd.):** - Purpose: Provide funding to non-corporate (informal sector) small businesses - Eligible borrowers: Small manufacturing units, shopkeepers, fruit/veg sellers, hair salons, truck operators, hawkers, artisans - Maximum loan: Rs. **10 lakhs** - Structure: MUDRA Ltd. is a **Non-Banking Finance Company (NBFC)** and subsidiary of **SIDBI**; NOT a bank (no direct lending — refinancing only through banks/NBFCs/MFIs) - **Three loan categories (PM Mudra Yojana):** - **Shishu**: Up to Rs. **50,000** - **Kishor**: Rs. 50,001 to Rs. **5 lakhs** - **Tarun**: Rs. 5 lakhs to Rs. **10 lakhs** **National Bank for Financing Infrastructure and Development (NaBFID):** - Set up as DFI with Rs. **20,000 crore** corpus - Government initially holds 100% equity; to reduce stake to **26%** later **SIDBI (Small Industries Development Bank of India):** - Established: **1990** (under Small Industries Development of India Act 1989) - Role: Principal financial institution for promotion, financing, and development of MSMEs - Method: **Indirect financial assistance** (refinance) to financial institutions for onward lending to MSMEs **Priority Sector Lending (PSL):** - Banks must lend minimum **40%** of Adjusted Net Bank Credit (ANBC) to priority sectors - Priority sectors include: Agriculture, MSME, Education, Housing (affordable), Social Infrastructure, Renewable Energy, Export Credit, Others - Startups now included under PSL (since recent notification) - Food processing and agro-based units: Classified under **Agriculture** for PSL purposes - If PSL target not met: Banks must contribute to **RIDF (Rural Infrastructure Development Fund)** under NABARD - Priority sector raised to 40% after 1980 bank nationalization (was 33.3%) **NBFCs (Non-Banking Financial Companies):** - Registered under Companies Act; registered with and regulated by RBI (under RBI Act 1934) - NBFC functions: Loans, acquisition of securities, leasing, hire-purchase, insurance (except agriculture activity, industrial activity, goods trading, or real estate) - NBFCs EXEMPT from RBI registration (regulated by other bodies): VCFs/Merchant Banking/Stock Broking (SEBI); Insurance Companies (IRDA); Nidhi Companies (MCA); Chit Funds (State govts) - **NBFC-MFI**: Micro Finance Institutions — a class of NBFCs with limits on credit provided to households - **NBFC-P2P**: Peer-to-Peer lending platforms; fund transfers through **escrow accounts**; cash prohibited; lender aggregate limit = Rs. **50 lakhs** **Microfinance:** - Definition: Collateral-free loan to household with annual income up to Rs. **3,00,000** - Services: Small loans/credit, savings, insurance, remittances - Household = husband + wife + unmarried children **Base Rate and MCLR:** - **Base Rate** (introduced **July 2010**, replacing BPLR): Minimum rate below which Scheduled Commercial Banks cannot lend; calculated based on average cost of deposits, CRR/SLR cost, operational costs, return on net worth - **MCLR (Marginal Cost of Funds Based Lending Rate)** (from **1 April 2016**): Replaced Base Rate; based on MARGINAL (new) cost of deposits (not average); ensures faster transmission of repo rate changes to lending rates - MCLR components: Marginal cost of deposits, CRR/SLR cost, operational costs, **tenor premium** (time-period based) - **External Benchmark Rate** (from **1 October 2019**): RBI mandated all new floating rate personal/retail loans and MSME loans to be linked to external benchmark; banks can choose: repo rate, 3-month T-bill yield, 6-month T-bill yield, or FBIL published rate - Spread components: Credit risk premium + operational costs; credit risk premium can change only with substantial change in borrower's credit assessment; other spread components alterable once in 3 years - Reset frequency: External benchmark rate resets **at least once in 3 months** **Basel Norms:** **Basel I (1988):** BCBS introduced; minimum capital = **8% of risk-weighted assets**; focused on credit risk only; India adopted 1999 **Basel II (2004):** Three pillars: 1. **Capital Adequacy**: Minimum 8% of risk assets 2. **Supervisory Review**: Better risk management for credit, market, and operational risks 3. **Market Discipline**: Increased disclosure requirements (CAR, risk exposure) **Basel III (2010):** Response to 2008 Global Financial Crisis; addresses under-capitalization and over-leverage: - Focus on 4 parameters: **Capital, Leverage/Debt, Funding, Liquidity** - International minimum CRAR: **10.5%** (including 2.5% capital conservation buffer) - **India (RBI requirement): 11.5%** - Tier 1 Capital (equity and equity-like): 7% - Tier 2 Capital (bonds): 2% - Capital Conservation Buffer (equity): 2.5% - CRAR = Capital / Risk-Weighted Assets; higher CRAR = safer deposits **BIS (Bank for International Settlements):** - Headquarters: **Basel, Switzerland** - Fosters cooperation among central banks with goal of financial stability - Hosts meeting of central bank governors every 2 months - **BCBS (Basel Committee on Banking Supervision)**: Currently 28 member nations; formulates Basel accords

The Reserve Bank of India (RBI) publishes figures for four alternative measures of money supply, which are M1, M2, M3, and M4. Money supply is defined as the total stock of money circulating among the public at a particular point in time, and it is considered a stock variable. These measures are classified based on the liquidity of the components they include. **M1** is the most liquid measure and is known as **narrow money**. It comprises currency (notes plus coins) held by the public (CU) and net demand deposits (DD) held by commercial banks. The term 'net' signifies that only public deposits are included, while interbank deposits are excluded. **M2** expands on M1 by adding savings deposits held with Post Office savings banks to the M1 components. **M3** is a broader measure, classified as **broad money**. It consists of M1 plus the net time deposits of commercial banks. M3 is the most commonly used measure of money supply and is also referred to as aggregate monetary resources. **M4** is the broadest measure of money supply. It includes M3 along with total deposits held with Post Office savings organisations, explicitly excluding National Savings Certificates. These four measures, M1, M2, M3, and M4, are presented in decreasing order of liquidity. This implies that M1 is the easiest to use for transactions, whereas M4 is the least liquid of all the measures.