Monetary Policy Tools of RBI to Regulate the Banking System in India

RBI formulated a policy in respect to the money matters of the country. It is termed as the ‘monetary policy’. It took into consideration the interest rates of borrowing and lending and distribution of credit. Since India is a developing nation, the monetary policy plays a significant role in its economic growth. Its controls the inflation, money supply and cost of credit in the economy.

Aim of Monetary Policy:

Monetary policy helps in getting loans at a lower rate for industries to encourage more of exports rather thXan import units.
It helps in promoting investments and saving if the rate of interest is high, thereby generating a healthy cash inflow in the economy.
It is the most effective tool in controlling the periods of boom and depression of a business cycle by effective supply of money and credit distribution in the country.
A monetary policy leading to lower interest can help in employment generation as small and medium business enterprise can secure loans easily.
It also allows concession in funds for infrastructural development within the economy.
With the monetary policy RBI manages and regulates the entire banking sector in the country.

Tools to regulate the monetary policy

RBI has designed various quantitative and qualitative monetary tools to control inflation or increase cost of funds etc. The main monetary tools are CRR, SLR, Bank Rate, Repo Rate, Reverse Repo Rate, Open Market Operations, Credit Rationing , etc.

Quantitative Tools of RBI

1. CRR

It is known as the Cash Reserve Ratio which means banks have to keep certain amount of deposits as current account with RBI. Banks cannot use this amount for any of their commercial and economic activities. They can’t even lend this money to any individual borrower or corporate.

For example: You deposited say Rs.1000 with the bank. Now the bank has to give certain percentage of it to RBI. If the current CRR is 6%, then the bank will have to deposit Rs.60 with RBI and the balance is left with the bank. The bank does not have access to this Rs. 60.

If RBI lowers the CRR then banks are left with more money to lend and invest which in turns spurs the economic growth.

2. SLR

Apart from CRR, banks are required to invest a certain percentage of their deposits in government securities such as bonds, gold, etc. This is known as the statutory liquid ratio. The banks earn interest on these securities.

For example: As per the current SLR i.e. 18%, if Rs. 1000 deposited in bank, Rs 180 has to be invested in the government securities.

3. Repo Rate

We take loans from the bank when we require money. The rate at which the bank gives us loan is known as cost of credit.

Similarly, when banks are in need of funds to meet their day-to-day obligations, they take loans from RBI. The rate at which banks borrows funds by selling their government securities to RBI is known as the repo rate. These are short term loans borrowed for upto 2 weeks. Banks make an agreement with the RBI to repurchase the same securities at some future date at a pre- determined rate.

For example: According to the current Repo rate being 4 %, if bank takes a loan from RBI of Rs.1000 then it will have to pay Rs. 40 as interest to RBI.

In short, higher the repo rate higher the cost of short-term credit. Lower repo rate means we will pay lower interest on the loans taken by us from the banks.

Base Rate: It is not necessary that when repo rate is cut, the banks depositing and lending rate also come down. All lending rates are connected to the base rates of every bank. Thus, base rate is the minimum rate below which the banks are not allowed to lend. Banks have to consider various factors before reducing the base rate.

4. Reverse Repo Rate

When banks have surplus money and at the same time no lending and investing options, they deposit their money with RBI for short duration. The rate of interest thus offered by RBI to the banks for this surplus fund is termed as the Reverse Repo rate. Banks earn good interest on such deposits.

5. Open Market Operations (OMO)

An Open Market Operation (OMO) is the buying and selling of government securities in the open market by RBI. When RBI wants to infuse liquidity into the monetary system, it will buy government securities in the open market. This way RBI provides commercial banks with cash. On the other hand, when RBI sells securities, it reduces liquidity. So, the RBI indirectly controls the money supply and influences short-term interest rates.

Qualitative Tools of RBI

Qualitative tools are also known as selective methods of the RBI’s monetary policy. These tools are used for distinguishing between various credit uses, such as preferring export over import or essential over non-essential supply. Both borrowers and lenders are affected by this method.

Below are some qualitative tools used by RBI for credit control:

1. Credit Rationing

A certain credit amount is fixed by the RBI for commercial banks. These banks are given credit within a limited amount available for them. For some specific purposes, an upper limit is fixed and banks have to strictly follow them. This is because banks want to limit their credit exposure to certain unimportant sectors. With the help of this method bill rediscounting can also be controlled.

2. Consumer Credit Regulation

Through this method credit supply of consumers are regulated through hire purchase and instalment of sales of consumer goods. Here, important decisions on the amount of instalment, tenure of loan, amount of down payment, etc. are determined in advance. This helps to keep a control on the credit and inflation in the country.

3. Alteration in Marginal Requirement

A definite proportion of loan amount which is not financed by any bank is termed as Margin. If there is any in the margin it will lead to change in the size of loans. This method encourages credit supply to important sectors of the society while avoiding the unnecessary ones. This is done by reducing the margins of needy sectors and increasing margins of unimportant sectors.

For example: RBI feels agriculture sectors should be allotted more credit, then it reduces the margin and so even 80 to 90% loan can be provided.

4. Moral Suasion

Proposals given to commercial banks by RBI restricting credits during inflation are referred as Moral Suasion. With the help of monetary policy, the commercial banks become aware of what is expected of them by RBI. Under this method RBI can issue guidelines, directives for commercial banks to lower the credit supply for speculative reasons.

Conclusion

The qualitative and quantitative tools of monetary policy help to increase the growth and maintains stability by controlling the credit supply in the country. Both of them have their pros and cons, but are important for price and economic stability of the economy. They also prove to be effective and efficient methods in controlling the inflation and deflation because of the fluctuations in money supply. Credit supply in the economy can be controlled with the coordination of both the methods.

Also Read: Classification of Banking System in India and how does it work with RBI