Money and Banking

Imagine trying to buy groceries by swapping a chicken for vegetables. That is a world without money. Money makes exchange easy, and the banking system built on it stores our savings, lends for investment, and even creates new money. Understanding money, banks and the central bank is at the core of how a modern economy works.

Money is anything generally accepted as payment for goods and services. Before money, people relied on barter (directly swapping goods), which was clumsy because it needed a "double coincidence of wants". Money solves this by performing four key functions:

• a medium of exchange: accepted by all in trade,
• a measure (unit) of value: prices everything in common terms,
• a store of value: wealth can be saved for later, and
• a standard of deferred payment: debts can be settled over time.

Modern money, such as paper currency, has no value in itself. It is accepted because the government authorises it. The rupee is issued by the Reserve Bank of India on behalf of the government.

The total stock of money in the economy is measured through standard aggregates. M1 (narrow money) is the most liquid measure. It consists of currency with the public, demand deposits with banks, and other deposits with the RBI. M3 (broad money) adds time deposits with banks to M1. M3 is therefore the sum of currency with the public, demand deposits, time deposits and other deposits with the RBI, and it is the most watched measure of money supply in India.

Liquidity falls in a clear order. Currency is the most liquid asset. Demand deposits come next because they can be withdrawn instantly. Savings deposits carry some restrictions, and time deposits are the least liquid because of their lock-in period. Note one classic trap: withdrawing cash from a demand deposit leaves the total money supply unchanged. The withdrawal merely converts one component of money (a deposit) into another (currency in hand).

Commercial banks are the institutions where most people keep their money. They do two basic things: accept deposits from savers and lend money to borrowers. They charge more interest on loans than they pay on deposits. This interest difference is a bank's main source of income. Banks thus connect savers with borrowers and put idle money to productive use.

Crucially, banks do not keep all deposits idle. They keep only a fraction as reserve and lend out the rest. When that loan is spent and re-deposited, it can be lent again, and so on. In this way the banking system creates credit, expanding the total money supply far beyond the original deposits.

Credit means a loan: an agreement in which the lender gives money, goods or services in return for repayment later, usually with interest. Credit can cut two very different ways:

• Helpful credit: a farmer or trader who borrows to invest can earn more and repay easily. The borrower ends up better off.
• Debt trap: if the investment fails, for example when a crop is ruined, the borrower may have to sell land or other assets to repay. The borrower ends up worse off.

To protect themselves, lenders usually demand collateral: an asset such as land, a house or jewellery that the borrower pledges and the lender can seize if the loan is not repaid.

Loans come from two broad kinds of sources:

• Formal sources: banks and cooperatives. They charge lower interest, follow fair terms, and are supervised by the Reserve Bank of India.
• Informal sources: moneylenders, traders and friends. They charge very high interest, follow no rules, and often exploit poor borrowers, deepening their debt.

A major goal of development is to expand cheap formal credit to everyone, especially the rural poor, who still depend heavily on moneylenders.

At the top of the system sits the central bank, which in India is the Reserve Bank of India (RBI). It is the banker's bank and the guardian of the nation's money. Its main roles are:

• to issue currency (banknotes),
• to act as banker to the government and to other banks,
• to regulate and supervise commercial banks, and
• to control the money supply and credit through monetary policy, for example by changing interest rates or reserve requirements.

By tightening or loosening money, the RBI keeps inflation in check while supporting growth. This makes it one of the most powerful economic institutions in the country.

The RBI controls credit with two families of instruments. Quantitative tools act on the overall volume of money in the economy:

• Repo rate: the rate at which commercial banks borrow short-term from the RBI against government securities. It is the benchmark policy rate.
• Bank rate: the rate at which the RBI discounts (rediscounts) bills of exchange and commercial paper for banks. It is not the rate banks charge their customers, and it is not the rate banks pay on deposits.
• Cash Reserve Ratio (CRR): the fraction of deposits that banks must park with the RBI as cash.
• Statutory Liquidity Ratio (SLR): the fraction of deposits that banks must hold in liquid assets such as cash, gold and approved government securities. Because banks meet the SLR largely by holding government securities, the SLR is also the mechanism through which bank credit flows to the government.
• Open market operations: the RBI's buying and selling of government securities to inject or absorb liquidity.

Selective credit controls, by contrast, steer credit toward or away from particular uses. They include margin requirements, regulation of consumer credit, and rationing of credit. Variable reserve ratios such as the CRR and SLR are quantitative tools, not selective ones.

Since 2016 the benchmark repo rate has been set by the Monetary Policy Committee (MPC), a six-member statutory body chaired by the RBI Governor, not by the Finance Minister. The Narasimham Committee on financial sector reforms recommended reducing the SLR, the CRR and priority sector financing, so that banks could lend more freely on commercial judgement.

The RBI Governor is appointed by the Central Government and draws his powers from the RBI Act, 1934. No provision of the Constitution empowers the government to issue directions to the RBI. The RBI earns its income from buying and selling government bonds, from dealing in foreign currency, and from issuing currency. It does not manage pension funds, and it does not lend to private companies. One administrative quirk recurs in exams: the RBI's accounting year ran from July to June, unlike the Government of India's April–March financial year.

Modern Indian banking began under colonial rule. The Oudh Commercial Bank, founded in 1881, was the first bank of limited liability managed by Indians. Today the commercial banking system contains public sector banks, private sector banks, foreign banks, regional rural banks and cooperative banks.

• Public sector (nationalised) banks: banks in which the government holds a majority stake. Corporation Bank, Dena Bank and Vijaya Bank were nationalised banks. Federal Bank, by contrast, is a private sector bank.
• Private sector banks: foreign direct investment in them is permitted up to 74 per cent, with up to 49 per cent under the automatic route. There is no rule capping the shareholding of Indian promoters at 49 per cent.
• Foreign banks: they may operate in India as branches or as wholly owned subsidiaries. A wholly owned banking subsidiary needs a minimum capital of Rs 500 crore, and at least half of its board members must be Indian nationals.
• Urban cooperative banks: regulated jointly by the RBI and the state registrars of cooperative societies, not by local boards of state governments. They can issue equity shares and preference shares. They were brought under the Banking Regulation Act, 1949 (the principal law governing banks) through an amendment in 1966.

The Narasimham Committee (expert panels of 1991 and 1998) examined and suggested India's financial sector reforms. Internationally, the Basel Committee on Banking Supervision sets banking standards. Basel II laid down international standards for measuring the adequacy of a bank's capital. Basel III seeks to improve the banking sector's ability to deal with financial and economic stress and to improve risk management. The Capital Adequacy Ratio (CAR) is the amount of a bank's own funds held against risk-weighted assets to absorb losses when borrowers fail to repay. The RBI fixes the CAR following Basel norms. Individual banks cannot decide it for themselves.

Several RBI rules shape day-to-day banking:

• Priority Sector Lending: mandatory lending targets covering agriculture, micro and small enterprises, weaker sections, education and housing. All bank loans to MSMEs qualify as priority sector lending. The MSMED Act, 2006 (the law that classifies micro, small and medium enterprises) now uses investment plus turnover criteria, and the old plant-and-machinery slabs stand revised.
• MCLR (Marginal Cost of Funds based Lending Rate): the loan-pricing framework that improves transparency in how banks set interest rates on advances and keeps credit available at rates fair to both borrowers and banks.
• Banking Ombudsman: a grievance redressal authority appointed by the RBI. Its service is free of any fee, and even non-resident Indians with accounts in India can complain. Its awards are not final and binding, because an appeal lies to the RBI's appellate authority.

Public sector bank governance has its own machinery. The Banks Board Bureau recommends candidates for the posts of chairmen and whole-time directors of public sector banks and helps them develop strategies and capital-raising plans. It is headed by a chairman appointed by the government, not by the RBI Governor. The merger of the State Bank of India's associate banks with SBI was completed in 2017, while government capital infusion into public sector banks has varied from year to year rather than rising steadily. For bad loans, the Inter-Creditor Agreement signed by banks aims at faster resolution of stressed assets of Rs 50 crore or more under consortium lending. The RBI's Scheme for Sustainable Structuring of Stressed Assets (S4A) allowed lenders to rework the financial structure of big corporate borrowers facing genuine difficulties.

Financial inclusion means bringing every household into the formal financial system. Bank nationalisation (1969), the formation of Regional Rural Banks (RRBs) in 1975, and the adoption of villages by bank branches were all steps toward this goal. Under the Lead Bank Scheme, an individual bank adopts a particular district for intensive banking development. The Service Area Approach, which assigned each rural branch a defined service area for credit delivery, was implemented under this scheme.

Rural credit flows through several channels. Scheduled commercial banks now disburse the largest share of credit to agriculture and allied activities. Within the cooperative structure, District Central Cooperative Banks (DCCBs) form the middle tier, and one of their main functions is to provide funds to the village-level Primary Agricultural Credit Societies. RRBs and Land Development Banks grant direct credit to rural households. NABARD (the apex bank for agriculture and rural development, 1982) refinances these lenders but does not lend directly to households. NABARD also initiated the Self-Help Group (SHG) Bank Linkage Programme, in which all members of a group take responsibility for a loan that an individual member takes. RRBs and scheduled commercial banks support SHGs. A typical SHG has fifteen to twenty members, often women. They pool their small savings regularly into a common fund and give small low-interest loans to members from it. After saving steadily, the group can also borrow from a bank as a unit. SHGs bring affordable credit to people whom banks would not otherwise reach. They empower women by giving them a say over money, and they have become an important tool against rural poverty. Microfinance, the provision of financial services to low-income groups, covers credit, savings, insurance and fund transfer facilities.

Recent policy added new institutions and schemes:

• Pradhan Mantri Jan Dhan Yojana (2014): universal bank accounts to promote financial inclusion in the country.
• Pradhan Mantri MUDRA Yojana: loans that bring small entrepreneurs into the formal financial system.
• Payment banks: can be promoted by mobile telephone companies and supermarket chains. They accept small deposits and issue debit cards, but they cannot lend and cannot issue credit cards.
• Small finance banks: set up to supply credit to small business units, small and marginal farmers, and micro and small industries.
• Business Correspondents (Bank Saathi): bank agents in branchless areas through whom villagers can make deposits and withdrawals and draw their subsidies and social security benefits.

The National Payments Corporation of India (NPCI), the umbrella body for retail payments set up by the RBI and banks, promotes financial inclusion through low-cost payment systems. It operates the National Financial Switch, the network that links all the ATMs in India, and it launched RuPay, the domestic card payment scheme. Its flagship is the Unified Payments Interface (UPI), which transfers money directly between bank accounts through mobile phones, making separate mobile wallets unnecessary for online payments. The BHIM app lets a user transfer money to anyone with a UPI-enabled bank account. UPI merchant payments are now accepted abroad, including in the United Arab Emirates, France and Singapore.

Older transfer systems remain important. RTGS (Real Time Gross Settlement) settles each payment instantaneously and individually, while NEFT settles in batches and so takes some time. Both systems now operate round the clock, and customers are not charged for inward transactions in either. Core Banking Solutions is the networking of a bank's branches that enables customers to operate their accounts from any branch, regardless of where the account was opened. The Merchant Discount Rate (MDR) is the charge a bank levies on a merchant for accepting payments from customers through cards. Under the RBI's data localisation directive on storage of payment system data, providers must store the entire data relating to their payment systems only in India.

The RBI also issues the digital rupee, India's central bank digital currency (CBDC). It is a sovereign currency issued in alignment with monetary policy, it appears as a liability on the RBI's balance sheet, and it is freely convertible against commercial bank money and cash. It carries no built-in insurance against inflation. CBDCs make it possible to pay without using the US dollar or the SWIFT messaging system, and they are programmable: a digital currency can be distributed with conditions coded into it, such as a time-frame for spending.

Non-Banking Financial Companies (NBFCs) lend and invest much like banks but are not banks. The key difference is that they cannot accept demand deposits such as savings or current accounts. They can, however, acquire securities issued by the government. NBFCs are regulated by the RBI.

Credit rating agencies, which grade the creditworthiness of borrowers and debt instruments, are regulated by SEBI, not by the RBI. ICRA is a public limited company, and Brickwork Ratings is an Indian credit rating agency. Two specialised institutions recur in exams. The National Housing Bank (1988), the apex institution of housing finance, was set up as a wholly owned subsidiary of the RBI. SIDBI (Small Industries Development Bank of India) was established as a wholly owned subsidiary of the Industrial Development Bank of India.

After Independence, India created development finance institutions to supply long-term capital that ordinary banks could not provide. Their founding order is a favourite exam fact:

• IFCI (1948): Industrial Finance Corporation of India, the first development bank for industrial finance.
• ICICI (1955): Industrial Credit and Investment Corporation of India, set up to finance private industry.
• UTI (1964): Unit Trust of India, the first mutual fund organisation.
• IDBI (1964): Industrial Development Bank of India, established later in the same year as the apex institution for industrial finance.
• NABARD (1982): the apex bank for agriculture and rural development.

The chronological sequence therefore runs IFCI, ICICI, UTI, IDBI and then NABARD.

The Life Insurance Corporation of India (LIC), created in 1956 by nationalising life insurers, is the oldest insurance company in India. General insurance was nationalised in 1972, when National Insurance Company Limited and others were made subsidiaries of the General Insurance Corporation of India. United India Insurance Company has its headquarters at Chennai.

Pension cover runs on three tracks:

• National Pension System (NPS): a contributory pension scheme. It is mandatory for central government employees, excluding the armed forces, who joined service on or after 1 January 2004. State government employees join from the date their state government notifies the scheme. Other citizens can join voluntarily.
• Atal Pension Yojana: a minimum guaranteed pension scheme mainly targeted at unorganised sector workers. The same pension is guaranteed for the spouse for life after the subscriber's death, and more than one member of a family may join.
• Indira Gandhi National Old Age Pension Scheme (IGNOAPS): a non-contributory social assistance pension for elderly persons below the poverty line. As originally launched, the scheme covered only persons aged 65 and above. The entry age was lowered to 60 only in 2011. Central assistance has been Rs 200 per month, never Rs 300, rising to Rs 500 above age 80, and states are urged to add matching amounts. A description of the original scheme that gives an entry age of 60, or a central pension of Rs 300, is therefore wrong on both counts.

The money market deals in short-term funds, generally for periods up to one year. Its main instruments are:

• Call money: short-term finance used for interbank transactions, often overnight.
• Treasury bills: short-term paper issued only by the Government of India, never by state governments. They are issued at a discount from the par value and redeemed at face value.
• Commercial paper: a short-term unsecured promissory note issued by corporates.
• Certificate of deposit: a short-term instrument issued by banks, not by the RBI.
• CBLO (Collateralised Borrowing and Lending Obligation): a money market instrument under which participants borrow and lend against government securities as collateral.

The RBI manages and services the securities of both the Government of India and the state governments. A related instrument, the zero-coupon bond, pays no periodic interest at all. It is sold at a discount, and the investor's return comes at redemption.

The capital market raises long-term funds. It includes the stock market and the government bond market, while the call money market and the treasury bill market belong to the money market. Companies raise capital by issuing shares, which make investors part-owners, or bonds and debentures, which make investors creditors. Debenture holders are creditors of a company, not shareholders. Bondholders carry lower risk than stockholders precisely because they are lenders and are prioritised for repayment. The gilt-edged market is the market for government securities, the safest instruments. Yields on Indian government bonds are influenced by RBI actions, domestic inflation and short-term interest rates, and even by the United States Federal Reserve, whose moves swing global capital flows. Retail investors can invest in treasury bills and Government of India bonds in the primary market through demat-based platforms, and NDS-OM (Negotiated Dealing System-Order Matching) is the RBI's trading platform for government securities. CDSL, a securities depository, was promoted by the Bombay Stock Exchange, not by the RBI. Insurance companies, pension funds and retail investors can all trade in corporate bonds and government securities. Stock exchanges can offer separate trading platforms for debt, and some NBFCs can access the RBI's Liquidity Adjustment Facility.

SEBI (Securities and Exchange Board of India) was given statutory regulatory powers to prevent the recurrence of scams in the capital market and to protect investors. SEBI, not the RBI, mandates top listed companies to submit the Business Responsibility and Sustainability Report (BRSR), whose disclosures are largely non-financial. The Sensex is the benchmark index of the Bombay Stock Exchange, based on 30 important stocks weighted by free-float market capitalisation. A rise in the Sensex means an overall rise in the prices of that group of shares, not of every listed company. A related point of world history trips many candidates: the Amsterdam stock exchange is regarded as the oldest in the world. The New York Stock Exchange is the largest, but it is not the oldest. India's stock market has grown rapidly, at one point overtaking Hong Kong's in value, and India accounts for a very large portion of all equity option contracts traded globally. Among Indian exchanges, the BSE recorded the highest turnover in 2000–01. IndoNext, launched in January 2005, was an alternative trading platform promoted by the BSE and the regional stock exchanges for smaller companies. The Unit Trust of India long remained the largest mutual fund organisation in India.

Market vocabulary and instruments recur in exams:

• Bull and bear: a bull expects share prices to rise, while a bear expects the price of a security to fall.
• Beta: a numeric value that measures how much a stock fluctuates relative to the overall market.
• Venture capital: long-term start-up capital provided to new entrepreneurs.
• Alternative Investment Funds: a SEBI category that covers hedge funds and venture capital, but not ordinary stocks and bonds.
• Financial instruments: include exchange-traded funds and currency swaps. Physical assets such as motor vehicles are not financial instruments.
• Inflation-Indexed Bonds: protect investors from inflation uncertainty and let the government borrow at lower coupon rates, but their returns remain taxable.
• Convertible bonds: pay a lower rate of interest because they carry an option to convert into equity, and that option gives the holder some indexation to rising prices.
• Sovereign Gold Bond Scheme and Gold Monetisation Scheme: aim to bring idle household gold into the economy and reduce India's dependence on gold imports.

Each segment of the financial system has its own regulator. The RBI regulates banks, NBFCs and the money market. SEBI regulates the securities market and credit rating agencies. The IRDAI oversees insurance, and the PFRDA oversees pensions.

Commodity derivatives followed a separate path. The Forward Markets Commission, set up under the Forward Contracts (Regulation) Act, 1952, regulated commodity futures trading only. It did not regulate currency futures or equity futures. In 2015 it was merged into SEBI, which now regulates commodity derivatives as well.

Foreign Direct Investment (FDI) is investment that brings a lasting interest and a degree of control: subsidiaries of foreign companies in India, majority foreign equity holdings in Indian companies, and companies financed exclusively by foreign firms. Its major characteristic is that it is a largely non-debt creating capital flow. Foreign currency convertible bonds, global depository receipts, and foreign institutional investment beyond prescribed limits are counted within FDI, while ordinary portfolio investment is a separate category. Investment by foreign institutional investors (FIIs), now called foreign portfolio investors, increases capital availability in general, whereas FDI targets specific sectors. FII money is also more volatile than FDI. Registered foreign portfolio investors issue Participatory Notes to overseas investors who want exposure to the Indian stock market without registering themselves with SEBI.

A few recurring facts complete the picture. A large share of FDI reaches India through Mauritius rather than mature economies because India signed a Double Taxation Avoidance Agreement with Mauritius. Masala bonds are rupee-denominated bonds issued abroad as a source of debt financing for the public and private sector. The International Finance Corporation, an arm of the World Bank, pioneered them. An indirect transfer is a transaction in which a foreign company transfers shares that derive their substantial value from assets located in India, which India seeks to tax. Sector patterns shift over time: the engineering sector drew the largest FDI share during 1997–2000, while telecommunications attracted the highest inflows over the following decade. Resurgent India Bonds (1998) were issued in US dollars, pound sterling and Deutsche Mark to attract NRI funds after sanctions. The 2001–02 FDI policy allowed 100 per cent FDI in tea subject to disinvestment of 33 per cent equity to an Indian partner within four years, and required the single largest Indian shareholder in print media to hold more than 26 per cent.

The exchange rate is the price of the rupee in terms of foreign currency. A market-driven fall in its value is depreciation, while a deliberate official reduction under a fixed-rate system is devaluation. Devaluation necessarily improves the competitiveness of domestic exports in foreign markets because it lowers their prices abroad. It does not necessarily improve the trade balance, and it reduces, rather than increases, the foreign value of the currency. The Nominal Effective Exchange Rate (NEER) is an index of the rupee against a basket of currencies, and a rise in NEER indicates appreciation. The Real Effective Exchange Rate (REER) adjusts NEER for inflation differences. A rising REER signals a loss of trade competitiveness, and domestic inflation persistently higher than that of trading partners widens the divergence between NEER and REER.

Convertibility of the rupee means freely permitting its conversion into other currencies and back. India has had full current account convertibility, covering trade in goods and services, since 1994. The freedom is managed, not absolute: in 2000 the ceilings on foreign exchange released for a host of current account transaction heads were lowered. The step was taken because of a fall in the country's foreign currency assets. Capital account convertibility, the freedom to exchange the rupee for major currencies in order to trade financial assets, remains partial. The Tarapore Committee (RBI panels of 1997 and 2006) prepared the roadmap for fuller capital account convertibility. Full convertibility would mean a free float, direct exchange with any international currency anywhere, and the rupee acting like any other international currency. It is advocated mainly because market-determined convertibility is expected to stabilise the rupee's exchange value against major currencies. The Foreign Exchange Management Act (FEMA), 1999 replaced the older FERA, and under FEMA the violation of foreign exchange rules ceased to be a criminal offence. Hawala refers to payments exchanged between rupees and overseas currencies without going through official channels.

The RBI manages the rupee with its foreign exchange reserves, which comprise foreign currency assets, the gold holdings of the RBI, Special Drawing Rights (SDRs) and the reserve tranche position at the IMF. Import cover is the number of months of imports that these reserves could pay for. To stop a depreciating rupee the RBI sells dollars in the market, and to prevent excess appreciation it buys dollars. An increase in foreign exchange reserves causes monetary expansion, so the RBI offsets the effect through sterilisation: conducting open market operations, chiefly selling government securities, to absorb the extra liquidity. For the same reason, when inflation is too high the RBI sells, not buys, government securities. Tight monetary policy by the US Federal Reserve can trigger capital flight to dollar assets and raise the interest cost of firms with external commercial borrowings (ECBs), foreign currency loans whose currency risk increases when the rupee falls. Stable foreign exchange earners, such as the IT sector's export income and remittances from Indians abroad, reduce the risk of a currency crisis, as does avoiding short-term foreign borrowing. Measures to arrest a rupee slide include curbing non-essential imports, promoting exports, encouraging rupee-denominated masala bond issues and easing ECB conditions. An expansionary monetary policy would do the opposite and worsen the slide.

The balance of payments (BoP) is a systematic record of all economic transactions between a country and the rest of the world during a given period, normally a year. It gives a better picture than the balance of trade, which covers only visible goods, because the BoP also records invisible items.

The BoP has two main accounts:

• Current account: the balance of trade in goods plus the balance of invisibles, which covers services, income and transfers such as private remittances.
• Capital account: foreign loans, foreign direct investment and portfolio investment.

Spending by foreign nationals inside India, for example visitors who came to watch the Commonwealth Games, counts as an export of services. A current account deficit can be reduced by devaluing the currency, which makes exports cheaper and imports dearer, and by adopting policies that attract greater FDI and portfolio inflows. Cutting export subsidies would hurt exports and would not reduce the deficit.

International liquidity is the stock of internationally accepted means of payment available to settle transactions between countries. The problem of international liquidity is therefore the non-availability of dollars and other hard currencies, not a shortage of goods, gold or exportable surplus.

To supplement such reserves, the IMF created the Special Drawing Right (SDR) in 1969. The SDR is treated as an artificial currency: an accounting unit valued against a basket of major currencies, allocated to member countries and exchangeable among them. By contrast, ADRs and GDRs (depository receipts that allow a company's shares to trade on foreign exchanges) are equity instruments, not artificial currencies.