RBI and Monetary policy

The Reserve Bank of India

The Reserve Bank of India was set up by the RBI Act, 1935 and was nationalised on 1st Jan 1949; Its responsibilities are noted in its preamble as follows:

• “To regulate the issue of Bank notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage;
• To have a modern monetary policy framework to meet the challenge of an increasingly complex economy,
• To maintain price stability while keeping in mind the objective of growth.”

It is situated in Mumbai (since 1937) and has 19 regional offices and 9 sub-regional offices.

Appointment of the Governors and Deputy Governors

RBI has one governor and four deputy governors – Two from within the ranks, one commercial banker, and another an economist to head the monetary policy department.

The selection of Governor and Deputy governors is done as per the following procedure.

• The Financial Sector Regulatory Appointment Search Committee, headed by the Cabinet Secretary, recommends the posts to be filled due to any vacancy.
• Other members of the selection committee: Principal Secretary and Other 3 experts.

RBI’s Statutory Reports

Annual Publications: Annual Report under the RBI Act. Report on Trends and Progress of Banking in India Half-yearly: Financial Stability Report Monetary Policy Report Report on Foreign Exchange Reserves

Basic Functions of RBI:

1. Monetary Authority:

Objective: RBI is an Independent authority that formulates, implements and monitors the monetary policy in India in the best interests of the economy.

It increases or decreases the supply of high-powered money in the economy and creates incentives or disincentives for commercial banks to give loans or credits to investors.

Bank rate policy:

• Bank Rate: (To take control of the value of rdr); Rate at which Commercial banks borrow money from RBI when they run short of reserves without buying securities.
• It was originally the rate at which RBI used to buy discounted government securities.
• A high bank rate means RBI takes high interest on borrowing and thus banks limit borrowing; also, this will ensure that the commercial banks limit their credit activities and keep a greater portion as reserve => increasing rdr (R/DD). At higher rates, money multiplier is higher;

Further, RBI can:

• Vary reserve requirements, i.e. vary the CRR/SLR requirements (Explained later in this chapter);
• Vary Repo/Reverse Repo (explained later in this chapter)

2. Regulator and supervisor of the financial system:

Objective: maintain public confidence in the financial system, protect depositors’ interest and provide cost-effective banking services to the public.

• It prescribes broad parameters of banking operations within which the country’s banking and financial system functions. For example, PSL etc.

3. Manager of Foreign Exchange:

Objective: to facilitate external trade and payment and promote orderly development and maintenance of the foreign exchange market in India.

• Under the provisions of the Foreign Exchange Management Act, of 1999, the following powers have been given to the RBI.
  • Sterilisation: It is the action taken by the central bank to counter the effects on the money supply caused by the BoP surplus or deficit. In order to negate potentially harmful impacts of capital inflow, the RBI can perform sterilisation operations. It involves open market operations.
  • Open market operations: RBI purchases (or sells) government securities (bonds) to the general public in a bid to increase (or decrease) the stock of high-powered money in the economy. It will undertake an open market sale of government securities of an amount equal to the amount of foreign exchange inflow in the economy thereby keeping the stock of high-powered money

4. Issuer of currency:

Objective: to give the public an adequate quantity of supplies of currency notes and coins in good quality. It issues currency, and exchanges or destroys currency and coins not fit for circulation.

5. Banker to the Government:

It performs merchant banking functions for the central and the state governments; and also acts as their banker.

Deficit financing through Central Bank Borrowing: RBI is also a banker to GoI and state governments. It is held sometimes that governments ‘print money’ in case of a budget deficit. It borrows money by selling treasury bills or government Securities to RBI, which issues currency to the government in return.

6. Banker to banks:

Lender of the last resort: In case of crisis RBI stands by the commercial banks as a guarantor and extends loans to ensure the solvency of the latter. It maintains the banking accounts of all scheduled banks.

In India, RBI is both Central banker and Debt management agency (Treasury)

Qualitative functions of the RBI:

The RBI also performs a wide range of promotional functions to support national objectives.

1. Control of Inflation: The monetary policy framework agreement, of 2015 has made inflation targeting and achieving price stability the primary responsibility of RBI.
2. Rationing of credit: RBI controls the credit by making banks mandatory to flow credit to certain priority sectors.
3. Moral suasion: persuasion tactic used by RBI to influence and pressure banks into adhering to policy. It includes discussions, meetings, speeches, letters and hints.
4. Punitive action: Punitive action is taken against the banks that continue to defy the moral advice of RBI and function against depositor’s interests. It may charge a penalty rate in interest, refusal of refinance and even cancelling the bank’s licence.

e-Kuber: It is a core banking solution of RBI that enables each bank to connect its single current account across the country.

Monetary Policy

It is the policy of the central bank with regard to the use of monetary instruments under its control to achieve the goals specified in the Reserve Bank of India Act, 1934. RBI is vested with the responsibility of conducting monetary policy. This responsibility is explicitly mandated under the Act.

RBI uses various policy instruments in order to conduct its function.

Policy Instruments:

CRR: Cash Reserve Ratio:

CRR refers to the fraction of the total Net Demand and Time Liabilities (NDTL) of a Scheduled Commercial Bank held in India, that it has to maintain as cash deposit RBI.

• Banks do not earn interest on CRR.
• Currently 4.5%
• Incremental CRR: It is calculated with reference to the excess of the total DTL of the bank over the total of its NDTL at the close of the business on the date specified by RBI. Scheduled Commercial Banks are required to maintain an additional average daily balance as incremental CRR.
  • At present no incremental CRR is required to be maintained by the banks.
  • During demonetisation. RBI introduced an incremental CRR of 100% for new deposits.

Statutory Liquidity Ratio (SLR)

SLR is a measure taken by the RBI as per the Banking Regulations Act 1949.

Under these regulations, all Scheduled Commercial Banks in India must maintain an amount in one of the following forms as a percentage of their total DTL / Net DTL (NDTL):

1. Cash
2. Gold or
3. Investments in “un-encumbered” Instruments(meaning: non-barred instruments) that include;
   1. Treasury-Bills of the Government of India.
   2. Dated securities and those securities issued by GoI from time to time under the market borrowings programme.
   3. Bond issued by RBI’s Market Stabilization Scheme (MSS). For example, Incremental CRR and SLR are both part of MSS.
   4. State Development Loans(SDLs): issued by States under their market borrowings programme. For example, UDAY bonds are Non-SLR.
   5. Other instruments as notified by the RBI.

SLR is calculated as a percentage of all the deposits held by the bank.

Currently, the SLR rate is at 18% (2024). RBI has kept 40% as the maximum limit for SLR. In the past, there have been various recommendations for a gradual relaxation of the SLR requirements. This will be advantageous on three counts:

1. It will provide liquidity to the banks,
2. It will broaden the market for government bonds, which are now held almost exclusively by the Banks in India.
3. This will allow the banks to hold corporate bonds in greater numbers and encourage the development corporate bond market as well.

Repo Rate or Rate of Repurchase

Rate of interest RBI charges from its clients (banks) on short-term borrowing. But they have to maintain SLR in doing so. It is currently at 6.50% (2024)

• Only GoI-dated securities/T-Bills are used as collateral under LAF.
• Term Repo Rate: repo of more than one day duration. In India, the term repo has different durations. The usual durations are 7 days, 14 days and 28 days. Overall, the objective of term repo is to ensure liquidity in the banking system.
• Urjit Patel’s committee in April 2014 announced to introduction of term repo and term reverse repo.

Reverse Repo:

It is the rate of interest that RBI pays to its clients who offer Short-term loans to it. It is currently 3.35% (2024).

• When banks park their excess liquidity at the reverse repo window, they get government bonds as collateral from the central bank. This is counted in the SLR calculations.
• Little use after the introduction of the standing deposit facility

Marginal Standing Facility (MSF):

Overnight up to 1% of NDTL of the Bank from RBI @ higher than Repo rate. When banks don’t have excess government securities above SLR. Then they keep SLR securities as collateral.

Currently at 6.75%; It generally remains 25 bps higher than the Repo.

Bank Rate:

On long-term lending, RBI charges Bank rates from its clients. Currently 6.75%;

Liquidity adjustment Facility (LAF) or Liquidity Corridor:

LAF is a primary instrument of RBI for modulating liquidity and transmitting interest rate signals to the markets. It refers to :

1. Repurchase Agreement (Repo)
2. Marginal standing facility (MSF).
3. Standing deposit facility (SDF): an uncollateralized window (i.e. it doesn’t need bond as collateral), wherein banks can park their excess liquidity with RBI at their discretion.

• Higher interest:25% [June 2024] 25bps below policy rate (Repo)
• Allows RBI greater flexibility to absorb liquidity and reverse that withdrawal easily.
• What is the relevance of Reverse repo: The only utility is when banks fall short of SLR obligations, which would be rare.

VRRR vs FRRR

RBI has shifted its liquidity absorption operations from the predominant use of fixed-rate reverse repos (FRRR) into 140-day variable rate reverse repo (VRRR) auctions to guide a rise in interest rates.

• Since October, the weighted average rate on the VRRR has steadily moved up to 3.5%-3.8% following RBI acceptance of the auctions close to reverse repo levels.
• At the same time, the moving up of VRRR rates also resulted in the moving up of various short-term funding interest rates like CDs, CPs and T-Bills.

Issue of Inflation Targeting

The RBI of a country, specifically an independent monetary authority, is best suited for inflation targeting because: Monetary Policy Expertise: The RBI has the technical expertise and tools to control inflation, such as adjusting interest rates (repo and reverse repo rates) and managing money supply. Independence from Political Pressure: An independent central bank can focus on long-term price stability without being influenced by short-term political goals or election cycles. Whereas, politicians might prioritize short-term growth over inflation control. Government’s Conflict of Interest: The government ensures growth in the economy by borrowing money from the RBI. It cannot at the same time control the money supply for inflation targeting. Accountability and Transparency: The central bank, through its Monetary Policy Committee (MPC), can be held accountable for its decisions on inflation, ensuring a transparent, rule-based approach to monetary policy.

Monetary Policy Framework Agreement:

It was an agreement signed in Feb 2015, between GoI and RBI; It puts the inflation target agreed upon by RBI and the government. It aimed at achieving low and stable inflation by adopting an “independent monetary policy”

Before the amendment in the RBI Act in May 2016, the flexible inflation targeting framework was governed by an Agreement on Monetary Policy Framework (2015) between the Government and the RBI.

Objectives of Monetary Policy:

1. Primary objective: to maintain price stability while keeping in mind the objective of growth. Price stability is a necessary precondition to sustainable growth.
2. RBI’s Inflation Targeting: The amended RBI Act,2016 provides for the inflation target to be set by the Government of India, in consultation with the Reserve Bank, once every five years.

What constitutes a failure to achieve the inflation target according to GoI:

1. When average inflation is more than the upper tolerance level of the inflation target for any three consecutive quarters; or
2. The average inflation is less than the lower tolerance level for any three consecutive quarters.

Accordingly, the Central Government has notified in the Official Gazette that 4% of CPI, after the consultation is the target for the period from August 5, 2016, to March 31, 2021, with the upper tolerance limit of 6% and the lower limit of 2%.

Further, this target has been extended for 5 more years till 2026.

Consumer Price Index (CPI) is a measure that examines the inflation in the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care. Wholesale price Index (WPI) is a measure that examines the inflation in the weighted average of prices of a basket of wholesale goods such as manufactured products, primary articles, and Energy (fuel and power). CPI was mutually agreed target; but not WPI, because: WPI is largely dependent on prices of commodities that are determined by international markets. CPI measures the cost of living.

Monetary Policy Committee (MPC):

RBI Act, 1934 was amended as a part of the Finance Act of 2016 (Budget) to create MPC. It provided a statutory basis for a Monetary Policy Framework (MPF) and made Inflation targeting a law.

Function of MPC:

1. Control inflation: Current target: 4% plus/minus 2% of CPI.
2. Formulate India’s Monetary Policy: MPC decides the changes to be made to the policy rate (repo rate) to contain the inflation within the target level specified to it by the Central Government. Now, the RBI governor can’t unilaterally decide monetary policy.

If it fails to reach the specified inflation targets. It shall, in the report, give reasons for failure, remedial actions as well an estimated time within which the inflation target shall be achieved.

Constitution of MPC:

It is composed of six members:

1. RBI Governor (Chairperson),
2. RBI Deputy Governor in charge of monetary policy,
3. One official nominated by the RBI Board
4. The remaining three members would represent GoI: appointed by the Government based on the recommendations of a search cum selection committee consisting of:
5. Cabinet secretary (Chairperson),
6. RBI governor,
7. Secretary of DEA (M/o Finance),
8. 3 experts in the field of economics or banking as nominated by the government.

No act of MPC can be invalid, just because of a vacancy, any defect in the appointment of a person or irregularity in the procedure of MPC.

Decision-making and transparency in MPC:

• Each Member of the MPC has to write a statement specifying the reasons for voting in favour of, or against the proposed resolution,
• The resolution adopted by the MPC and statements of the members are published as minutes of the meeting by RBI after 14 days of the said meeting.
• After the MPC meeting, RBI has to publish a document explaining the steps to be taken by it to implement the decisions of the MPC, including any changes thereto.

Criticism of MPC:

• Monetary policy should be the exclusive domain of RBI. Only Experts and technocrats should have a say in the country’s monetary policy.
• Money is RBI’s liability, And Inflation increases its liability. Thus, RBI must be allowed to handle its liability exclusively.

Public Debt Management Agency (PDMA)

Currently, the jurisdiction of various institutions responsible for public debt management is given below:

1. Reserve Bank of India – Domestic Marketable Debt i.e., dated securities, treasury bills and cash management bills. = Internal debt
2. Ministry of Finance (MOF); Office of Aid and Accounts Division – external debt
3. Both: savings, deposits, reserve funds etc.

Till now, For monetary and fiscal coordination, there was a cash and debt management committee that met regularly. The members comprised officials from RBI and MOF.

Public Debt Management Cell (PDMC):

PDMC is an interim arrangement before a fully functional PDMA is constituted. It was set up in 2016 to streamline government Borrowing and better cash management with the overall objective of deepening bond markets.

• It is staffed with 15 “experienced” debt managers from the Budget Division, RBI, middle office and other units. It functions under the overall supervision of the Joint Secretary (Budget), Department of Economic Affairs.
• It was housed at RBI’s Delhi office as an interim arrangement and It is now upgraded to the PDMA Budget division, MoF.
• JIC (joint implementation committee) has been set up to see its implementation. It’ll work under the Monitoring Group on Cash and Debt Management with the DEA Secretary and RBI Deputy Governor as chairperson.

It (PDMA) will “bring both India’s external borrowing and domestic debt under one roof” – FM in a 2015 Budget speech.

It has been tasked to plan:

1. Government borrowing, including market borrowing and other borrowings, like Sovereign Gold bond issuance.
2. It’ll manage government Liabilities, monitor cash balances, improve cash forecasting, and foster a liquid and efficient market for government securities.
3. It’ll advise government on matters related to investments, capital market operations, administration of interest rates on small savings etc.
4. It’ll also develop an integrated Debt Database system (IDMS) as a centralised database for all government liabilities on a near real-time basis.

Government Securities Acquisition Program (G-SAP).

1. The initiative is believed to be a counterpart of Open Market Operations (OMOs) — the purchase and sale of government securities (G-Secs) by the RBI on behalf of the government — to reduce the volatility in the bond market.
2. Under this, the RBI will purchase bonds worth a specific amount, which will reduce uncertainty and allow investors to bid better in the scheduled auction with a pre-decided calendar set by the RBI.
3. When the returns on the existing securities go up, the RBI has to offer a higher rate of returns for the fresh securities it will be issuing in 2021-22, which will eventually push up the interest cost of the government.
4. G-Sec is the benchmark for any other form of borrowing in the country since it is deemed the safest form of investment. Once the G-Sec interest rates go up, all the different lending rates the RBI is not looking at will surge.
5. Hence, through G-SAP, the RBI is indirectly financing the government’s borrowing as it will print money and buy bonds. In this way, it will be able to put enough money into the financial system, which will ensure that the returns on G-Sec do not go up, and the RBI will borrow money from the government at a lower rate of interest.

Commercial lending:

After 2003, a BPLR system was introduced. In this system, the banks used to price the loans they offered you on a complicated system called the Internal benchmark prime lending rate (BPLR). Each bank has its own BPLR methodology which made it difficult for borrowers to compare rates across banks. It resulted in an opaque system.

Base rate lending (2010):

Base Rate (2010) is the minimum rate at which an individual commercial bank grants you a loan.

1. It made it easier for us to compare across banks and to get a more transparent sense of how the interest rate for the loan is being arrived at.
2. RBI had given guidelines to banks to adjust their base rates depending upon the prevailing market conditions and interest rate policies.
3. Limitation: The transmission of interest rates is not effective in the base rate system. Even if the RBI cut the repo rate, banks did not always follow suit. They did not pass on the full benefit to the customer. Or, there was a big-time delay, which defeated the goal of the rate cut.

The marginal cost of funds-based lending rate (MCLR) (2016):

MCLR is the minimum interest rate of a bank below which it cannot lend, except in some cases allowed by the RBI.

It is an internal benchmark rate for the bank. MCLR actually describes the method by which the minimum interest rate for loans is determined by a bank – based on marginal cost or the additional or incremental cost of arranging one more rupee to the prospective borrower.

It has four components—

1. Marginal cost of funds – It pertains to what the interest banks have to give to the depositors.
2. Negative carry on account of CRR – Banks do not earn anything on CRR kept with RBI. Banks need to earn enough to cover the cost of CRR too.
3. Operating costs – e. to cover operational expenses like salary and rent.
4. Tenor premium – e. the premium that banks charge over all these costs.

Significance: MCLR is linked to the actual deposit rates. Hence, when deposit rates rise, it indicates the banks are likely to hike MCLR and lending rates are set to go up. Thus, MCLR is more sensitive to policy rate signals.

Problem related to MCLR:

• Delay in Transmission of rate cut benefits: since loans based are on the median one-year MCLR rate, banks do not pass the full benefits to borrowers immediately.
• Too many variables: including the bank’s spread, their current financial overview, deposits and non-performing assets (NPAs) etc.
• RBI is yet to mandate banks to allow Millions of Customers who signed up for loans in the erstwhile ‘Base Rate’ regime and who are paying higher rates to shift to the current ‘MCLR’ structure, which is much lower than the base rate.

External benchmark:

Unlike MCLR which was an internal system for each bank, RBI has offered banks the option to choose from 4 external benchmarking mechanisms:

1. The RBI repo rate
2. The 91-day T-bill yield
3. The 182-day T-bill yield
4. Any other benchmark market interest rate as developed by theFinancial Benchmarks India Pvt. Ltd. It was recognised by the RBI as an independent Benchmark administrator on 2nd July 2015.

Repo Linked Lending Rate (RLLR):

In such a scheme, the interest rate is simply the sum of the Repo Rate and the spread of the bank. Such a system has several benefits:

1. Banks arefree to decide the spread over the external benchmark. However, the interest rate must be reset as per the external benchmark at least once every three months.
2. Anypolicy rate cut decision reaches borrowers faster.
3. It is more
4. The borrower will also know the spread or profit margin for each bank over the fixed interest rate making loan comparisons easier and more transparent.

Rate type	MCLR (Internal Benchmark)	External benchmarking – RLLR
Cost of fund	Marginal cost of fund	Repo Rate
Profit Margin	Tenor premium	Spread of the Bank
Operating expenses	Included in Calculation	Not included – Included in Spread
Cost of maintaining CRR	Included in Calculation	Not included

Problems in Inflation targeting by RBI

Monetary Policy limitations:

1. Delay in Policy Response: The economy responds after a delay. It has limited effect if production and supply of goods’ related problems: In case of floods, droughts etc.
2. Double repression: on the asset side with high PSL and SLR requirements; and on the liability side with high inflation and erosion of value and -ve real deposit rates.
3. Lack of financial institutions: People have to depend on money lenders. Even after increased flow, banks are unwilling to give loans to comparatively unproductive sectors.
4. Imported Inflation: When there is a general price rise in an economy due to inflation in the value of imported goods. In India, the import of Crude, Gold and electronic items generally leads to imported inflation. The RBI can do nothing in such type of inflation.
5. Conflict of interests: RBI manages Inflation as well as debt: It can reduce debt by raising inflation targets.
   • The government raises debt from the SLR obligations of banks, the limit for which is mandated by RBI.
   • RBI is also the debt manager. There is a conflict of interest as RBI may service government debt by forcing banks to hold higher SLRs. (Thus, reducing the profitability of the bank and RBI)
   • Selling more bonds (Open market operations) at low interest rates, can reduce Bank rates and make G-Secs more competitive. But this can increase inflation;
   • But RBI is mandated to keep inflation low.

Problems with CPI

6. A single figure cannot represent a diverse market: The single number is arrived at by assigning weights to different commodities and services. For WPI, the weights in production are used; for CPI, the consumption basket is used. But people are not homogenous. The consumption basket is vastly different for the poor, the middle classes, and the rich.
7. Changed Consumption Pattern: The consumption basket for different sections of the population has changed since 2012. But we are still using 2012 as the base year for the computation of Inflation (Consumer Price Index).
8. Under-representation of Services: In production, services are about 60% of the GDP but have no representation in WPI and about only 40% in CPI. We know that health costs shot up after the pandemic, but this has not been captured in inflation figures. Similarly, education costs soared with the requirement of mobile phones, laptops and Wi-Fi.

Capital Adequacy Norms

The central bank mandates the banks to have enough capital to cover their potential risks and losses. The weak capital position of a bank can have an impact on the financial health of the country and the world itself.

Therefore, the Bank of International Settlement (BIS) mandates the central banks around the world to enforce capital adequacy requirements for the banks in the respective countries. These are known as the Basel Banking Norms.

Bank of International Settlement (BIS)

The Bank of International Settlement is an international financial institution owned by the central banks of the member countries. It is based in Basel, Switzerland. It was initially formed to oversee the settlement of World War – I repatriation. Currently, BIS fosters cooperation among central banks with a common goal of financial stability and common standards of banking regulations (the Basel Norms). Members: Currently there are 42 member nations in the committee. India is one of its members. Recently Russia was suspended from its membership.

Basel Banking norms

Basel guidelines refer to broad supervisory standards formulated by this group of central banks- called the Basel Committee on Banking Supervision (BCBS). These norms are a result of the Basel Accords.

Basel Accord: This set of agreements mainly focuses on risks to banks and the financial system. BCBS introduced a capital measurement system called Basel Capital Accord or simply Basel 1. The purpose of the accord is to ensure that financial institutions have enough capital on account to meet obligations and absorb unexpected losses.

India has accepted the Basel Accords for the banking system.

Till Now there have been three Basel accords:

• Basel I which was agreed upon in 1988 focused almost entirely on credit risk.
• Basel II was agreed upon in 2004 and focused on developing and using better risk management techniques in monitoring. It has called for increased supervision and disclosure requirements, i.e. banks need to mandatorily disclose their risk exposure to the central bank.
• Basel III (2010) focusing banks in developed economies that were under-capitalized, over-leveraged and had a greater reliance on short-term funding risk. It introduced even tighter Capital requirements since the Basel II norms were inadequate to prevent the 2008 financial crisis.

Basel III Norms

The Basel III norms were introduced in 2010. The money lent by the banks comes from two sources – The majority of it is the depositor’s money, and the rest of it is the capital raised from the market in the form of debt (such as through bonds), or equity capital (through issue of shares).

The Basel norms call for the banks to have adequate capital (apart from depositor’s money) to ensure stability. This is because there should be enough capital in the bank to give it to the depositors in times of crisis. The bank is not liable to give back this capital raised through shares or bonds immediately, which gives them a cushion, and prevents the financial system from failure.

The capital norms that must be maintained by the banks should be as follows:

Capital requirement

Asset	Risk
Government bonds	0-2.5%
Cash	20%
Loans backed by Gold (or other high-value collateral etc.)	50%
House loan > 30L or Retail loans	75%
Loans to PSUs/Commercial real estate/unrated corporates	100%
Consumer debt/Credit cards	125%
Venture Capital investment	150%

The minimum capital requirement was fixed at 8% of risk-weighted assets (RWA).

What are risk-weighted assets (RWA)?

Different types of assets have different risk profiles.

Holding cash is less risky than holding a share of a company. An asset backed by collateral would carry lesser risks as compared to uncollateralised debt. The Basel norms assign risk value to different assets differently, as shown in the table.

Composition of the Capital

The Regulatory capital held by the bank should further be divided into two tiers.:

1. Tier 1 Capital: It is known as the Core Capital in India. The banks are required to maintain 6% of its capital in the following form:

• • Common Equity Tier 1 (CET 1) Capital: It is the capital raised through equity instruments that have discretionary dividends and no maturity. This is the most stable form of money, as the bank can choose to never return it, and is permanently available to cushion losses suffered by a bank without it being required to stop operating.
    • The Basel norms mandate that the banks must maintain a capital of at least 4.5% of RWA in the form of CET 1 Capital.
    • RBI mandates 5.5%.
  • Additional Tier 1 Capital: Securities that are subordinated to most subordinated debt, have no maturity, and their dividends can be cancelled at any time. For example, Callable bond.

2. Tier 2 Capital (CET 2) – It is known as the Supplementary Capital in India. It is an unsecured subordinated debt with an original maturity of at least five years.

• • This Cushion is lost in case the bank is winding up.
  • It also includes earnings after deducting taxes and other liabilities.

AT1 bonds

The AT1 bonds are often seen in the news. These are unsecured bonds that have perpetual tenure — or no maturity date. They have a call option, which can be used by the banks to buy these bonds back from investors. AT1 bonds are subordinate to all other debt and only senior to common equity. How RBI treats it: From April 2023, the residual maturity of these bonds will be treated as 100 years from the date of issuance of the bond, which makes it equivalent to the Tier-II Bonds.

There is also a Tier 3 capital that consists of subordinated debt to cover market risk from trading activities. It also includes undisclosed reserves. The Basel norms do not mandate any requirement for Tier 3 capital.

Capital Adequacy Ratio

Capital Adequacy ratio (CAR) or Capital-to-Risk weighted assets ratio (CRAR) is the total of Tier 1 Capital and Tier 2 Capital as a percentage of Risk Weighted Assets (RWA).

Basel norms presently call for CAR of at least 8%.

In India, the RBI mandates a bit tighter CAR norm:

• Banks are mandated to maintain 9% CAR.
• A capital conservation buffer (CCB) of an additional 2.5% must be maintained by the banks to reduce the pro-cyclical nature of lending by creating a counter-cyclical buffer.
• Within CAR, the minimum CET 1 capital ratio is prescribed at 5.5%.

Leverage ratio:

The ratio of Tier 1 Capital to the Average Consolidated Asset value is known as the Leverage Ratio. The RBI mandates that the leverage ratio should be more than 4%. (Basel Norms mandate more than 3%)

In the case of the Lehmann Brothers Crisis, this went below 2.5%, after which it was introduced under the Basel III norms.

Implementation of Basel norms:

In India, all financial institutions, including Banks and NBFCs have to adhere to the Basel norms from April 2024.

• All Scheduled commercial banks must maintain a CAR of 9%.
• All Public sector banks (PSBs) must maintain a CAR of 12%
• All Non-Banking Financial Services must maintain a CAR of 10%
• The Tier 1 Urban Cooperative Banks (UCBs) must maintain a minimum CAR of 9%, and Tier 2 to Tier 4 UCBs must maintain a CAR of 12%.

Systemically Important banks

State Bank of India (SBI), ICICI Bank, and HDFC Bank are identified by the RBI as systemically important banks (D-SIBs) or institutions that are too big to fail. Since these banks cannot be allowed to fail as that would mean the failure of India’s financial system itself, these banks must maintain the following additional capital requirements:

Bucket	Banks	Additional Common Equity Tier 1 requirement as a percentage of Risk Weighted Assets (RWAs)
5	–	1%
4	–	0.80%
3	State Bank of India	0.60%
2	–	0.40%
1	ICICI Bank, HDFC Bank	0.20%

• Under bucket 1, banks require 0.2% of additional common equity Tier 1(CET-1) capital as a percentage of risk-weighted assets (RWAs), and
• under bucket 3, banks require 0.6% of additional CET-1 capital as a percentage of RWAs.

Independence of RBI

The Independent Central Bank has 3 dimensions:

1. Autonomy as a Regulator of the financial system: Statutory independence from the state with respect to nomination, tenure and termination of Governor;
   • Unlike any other regulatory agency such as IRDA or SEBI, there is no appellate authority, which can scrutinise the RBI decisions. RBI board has only an advisory role. The Governor and Deputy governors make all the decisions.
2. Autonomy as a Monetary Authority: Monetary Policy Autonomy:
   • Monetary policy instruments, imply managing the interest rate or liquidity.
   • Monetary policy objects – inflation targeting, credit control, priority sector lending (currently 40% of advances) or any other objective that is stipulated by the government (doesn’t mean sole authority of governor in decision making)
3. Financing of government Deficit: The government has two ways to finance its deficit:
4. Taxes: Proceeds come directly to the Government but it faces many constraints when raising taxes.
5. Print money: The revenues come to the central bank; Which increases liquidity in the economy. This indirectly ensures more liquidity to the government.

Thus, the government has an incentive hidden in controlling the RBI.

This is the reason that the central Bank must be independent from the Government.

Economic Capital Framework (ECF):

RBI is an independent body, but is owned by India, and therefore gives regular dividends to the Government of India.

An Economic Capital Framework (ECF) governs the RBI’s capital requirements and terms for the transfer of its surplus to the government. It is based on an assessment of risk by RBI. It means that RBI transfers capital as dividends to the government only if it does not require that capital to maintain the financial stability of the country.

How does RBI Earn?

1. RBI provides long-term and short-term loans to the banks at the bank rate and Repo rate respectively. The RBI charges interest on this capital which becomes the source of its income.
2. RBI lends money to the government through the issue of bonds. It earns money by selling or keeping these bonds too.
3. RBI maintains various assets such as gold and foreign currency. Whenever the value of RBI’s assets enhances, it gives notional profit to RBI.

Bimal Jalan committee on the review of ECF

It was a committee headed by Former RBI Governor Bimal Jalan committee’s chairman and former Deputy Governor Rakesh Mohan deputy governor. It has reviewed the existing framework of the ECF and has come up with the following policy on RBI’s dividend.

• There should be a clear distinction between the two components of economic capital: Realized Equity and Re-evaluation Balances.
  • Realized Equity could be used for meeting all risks/losses as they were primarily built up from retained earnings.
  • Re-evaluation balances could be reckoned only as risk buffers against market risks as they represented unrealized valuation gains and hence not distributable.
• These are the country’s savings for Rainy Days which has consciously maintained with the RBI given its role as a Monetary authority and Lender of Last resort.
• Risk Provisioning: The Contingency Risk Buffer must be 6.5% to 5.5% of the RBI’s balance sheet comprising 5.5 to 4.5% for monetary and financial stability risks and 1.0% for credit and operational risks.
• The total Economic Capital must be maintained between 20.8% to 25.4% of the RBI’s balance Sheet.
• Surplus distribution policy: Only if realized equity is above its requirement. The entire amount is transferable.

The RBI Board accepted all the recommendations of the Bimal Jalan committee. It decided to transfer ₹1.76LCr to the Centre – including the interim dividend of ₹28,000 Cr paid in Feb.

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