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Origin of Reserve Bank of India

The Reserve Bank of India was set up on the basis of the recommendations of the Hilton Young Commission. The Reserve Bank of India Act, 1934 (II of 1934) provides the statutory basis of the functioning of the Bank, which commenced operations on April 1, 1935.

The Bank was constituted to:

  1. Regulate the issue of banknotes;
  2. Maintain reserves with a view to securing monetary stability, and
  3. To operate the credit and currency system of the country to its advantage.

The Bank began its operations by taking over from the Government the functions so far being performed by the Controller of Currency and from the Imperial Bank of India, the management of Government accounts and public debt. The existing currency offices at Calcutta, Bombay, Madras, Rangoon, Karachi, Lahore and Cawnpore (Kanpur) became branches of the Issue Department. Offices of the Banking Department were established in Calcutta, Bombay, Madras, Delhi and Rangoon.

Burma (Myanmar) seceded from the Indian Union in 1937 but the Reserve Bank continued to act as the Central Bank for Burma till the Japanese Occupation of Burma and later upto April, 1947. After the partition of India, the Reserve Bank served as the central bank of Pakistan upto June 1948 when the State Bank of Pakistan commenced operations. The Bank, which was originally set up as a shareholder’s bank, was nationalised in 1949.

An interesting feature of the Reserve Bank of India was that at its very inception, the Bank was seen as playing a special role in the context of development, especially Agriculture.

When India commenced its plan endeavours, the development role of the Bank came into focus, especially in the sixties when the Reserve Bank, in many ways, pioneered the concept and practise of using finance to catalyse development. The Bank was also instrumental in institutional development and helped set up insitutions like the Deposit Insurance and Credit Guarantee Corporation of India, the Unit Trust of India, the Industrial Development Bank of India, the National Bank of Agriculture and Rural Development, the Discount and Finance House of India etc. to build the financial infrastructure of the country.

Hilton Young Commission

The Reserve Bank of India was set up on the basis of the recommendations of the Royal Commission on Indian Currency and Finance, also known as the Hilton-Young Commission.

Where were the original headquarters of RBI?

The original headquarters of RBI were in Kolkata, but this was shifted to Mumbai in 1937.

In which year, Banking Regulation Act was passed?

The Banking Regulation Act, was passed in 1949, as a legislation in India that regulated all banking firms in India. Initially, the law was applicable only to banking companies. But, 1965 it was amended to make it applicable to cooperative banks and to introduce other changes.

Beginning of Banking Reforms and Nationalization of the Banks

The Indian financial system in the pre-reform period (i.e., prior to Gulf crisis of 1991), essentially catered to the needs of planned development in a mixed-economy framework where the public sector had a dominant role in economic activity. The strategy of planned economic development required huge development expenditure, which was met through Government’s dominance of ownership of banks, automatic monetization of fiscal deficit and subjecting the banking sector to large pre-emptions – both in terms of the statutory holding of Government securities (statutory liquidity ratio, or SLR) and cash reserve ratio (CRR).

Besides, there was a complex structure of administered interest rates guided by the social concerns, resulting in cross-subsidization. These not only distorted the interest rate mechanism but also adversely affected the viability and profitability of banks by the end of 1980s. There is perhaps an element of commonality of such a ‘repressed’ regime in the financial sector of many emerging market economies. It follows that the process of reform of financial sector in most emerging economies also has significant commonalities while being specific to the circumstances of each country.

Financial sector reforms were undertaken early in the reform-cycle in India. The financial sector was not driven by any crisis and the reforms have not been an outcome of multilateral aid. The design and detail of the reform were evolved by domestic expertise, though international experience is always kept in view. And the Government preferred that public sector banks manage the over-hang problems of the past rather than cleanup the balance sheets with support of the Government.

It was felt that there is enough room for growth and healthy competition for public and private sector banks as well as foreign and domestic banks. The twin governing principles were non-disruptive progress and consultative process.

The first major step was Nationalization of the Imperial Bank of India in 1955 via State Bank of India Act. In 1959, the government passed the State Bank of India (Subsidiary Banks) Act. This made SBI subsidiaries of eight that had belonged to princely states prior to their nationalization and operatonal takeover between September 1959 and October 1960, which made eight state banks associates of SBI. This une with the first Five Year Plan, which prioritised the development of rural India. The government integrated these banks into the State Bank of India system to expand its rural outreach. In 1963 SBI merged State Bank of Jaipur (est. 1943) and State Bank of Bikaner (est.1944).

In 1980, when Indira Gandhi was re-elected as the Prime Minister for her third term at the PMO, she initiated a second spate of bank nationalization. This time about six banks were nationalised and the Government of India controlled over 90 percent of the banking business in the country. Of the 20 banks that were nationalised, New Bank of India was later (in 1993) merged with Punjab National Bank.

What was the impact of Nationalization of Banks?

The nationalization of banks was a significant move undertaken by the government for the development of the country. Firstly, it instilled public confidence in the banking system encouraging the masses to save and invest.

It allowed for elimination of regional bias and promoted opening up of branches in the remote areas of the country as well, thus strengthening the banking network. By elimination of monopoly or credit competition, nationalization streamlined banking practices in the country, thereby directing funds where it was most necessary – towards industrial and sectoral development – as planned by the RBI and the Indian government.

What are financial sector reforms ? Why they are needed?

In India, financial sector reform is seen as a process rather than an event. In fact, the Indian strategy for financial sector reforms has traditionally been based on a gradualist (“no big bang”), cautious and calibrated approach. This has served India very well through the two major crises in the recent past: the Asian crisis (1997-98) and the global financial crisis (2008). In fact, not too long ago, India was called a “reluctant liberalizer”. Not any more. After the global financial crisis, with India coming out relatively unscathed and growing faster than advanced economies, the cautious stand has been vindicated.

What is the importance of year 1991 in banking of India?

Banking sector reforms were an important part of the broader agenda of structural economic reforms introduced in India in 1991. The first stage of reforms was shaped by the recommendations of the Committee on the Financial System (Narasimham Committee), which submitted its report in December 1991, suggesting reforms in banking, the government debt market, the stock markets, and in insurance, all aimed at producing a more efficient financial sector. Subsequently, the East Asian crisis in 1997 led to a heightened appreciation of the importance of a strong banking system, not just for efficient financial intermediation but also as an essential condition for macroeconomic stability.

Recognizing this, the government appointed a Committee on Banking Sector Reforms to review the progress of reforms in banking and to consider further steps to strengthen the banking system in light of changes taking place in international financial markets and the experience of other developing countries. The two reports provided a road map that has guided the broad direction of reforms in this sector.

India’s commercial banking system in 1991 had many of the problems typical of unreformed banking systems in many developing countries. There was extensive financial repression, reflected in detailed controls on interest rates, and large preemption of bank resources to finance the government deficit through the imposition of high statutory liquidity ratio (SLR), which prescribed investment in government securities at low interest rates.

The system was also dominated by public sector banks, which accounted for 90 percent of total banking sector assets, reflecting the impact of two rounds of nationalization of private sector banks above a certain size, first in 1969 and again in 1983. These banks were nationalized because of the perception that it was necessary to impose social control over banking to give it a developmental thrust, with a special emphasis on extending banking in rural areas. The system suffered from inadequate prudential regulations, and nontransparent accounting practices. Supervision by the Reserve Bank of India (RBI) was also weak.

The strategy for banking reforms was broadly similar to that followed in other countries, but with some important differences. It was similar to the extent that it focused on imposing prudential norms and improving regulatory supervision to meet Basel I standards (standards that were formulated by the committee of the Bank of International Settlement, or BIS, based in Basel, Switzerland), and it aimed at increasing competition to promote greater efficiency.

However, there were two important differences compared with reforms in other countries. First, the reforms in banking were much more gradualist than in most countries, a course of action that was in line with the general strategy of reforms in India, made possible by the fact that the reforms were not introduced in the midst of a banking sector crisis, which might have entailed greater urgency. Second, unlike the case in many other countries, there was never any intention to privatize public sector banks. It was clearly recognized that competition was desirable, and this implied that both private sector banks and foreign banks should be allowed to expand their market share if they could. However, the government also declared its intention to strengthen public sector banks and enable them to meet competition.

There was also a great deal of progress in introducing prudential norms for income recognition, asset classification, and capital adequacy in a phased manner. As a consequence of this gradualist process, income recognition norms and capital adequacy norms have been fully aligned with Basel I standards, while asset recognition norms, though still falling short of international best practice, are now close to existing international standards.

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