Monetary Policy

Monetary Policy

(With De nition, Objectives, Types – Quantitative & Qualitative, and Examples)

1. De nition:

Monetary Policy refers to the decisions and actions taken by a country’s central bank (in India, the
Reserve Bank of India - RBI) to regulate the money supply, availability of credit, and interest rates
in the economy with the aim of achieving macroeconomic objectives such as price stability,
economic growth, and nancial stability.

> Example: In 2020, during the COVID-19 pandemic, RBI reduced the repo rate to 4% to make
borrowing cheaper and boost liquidity to support economic activity.

2. Objectives of Monetary Policy:

The RBI's monetary policy is aimed at achieving the following key objectives:

1. Price Stability (In ation Control):

To control in ation and ensure that prices of goods and services remain stable.

Example: In 2022, when in ation rose above 6%, RBI increased the repo rate from 4% to 6.25%
to control in ation.

2. Economic Growth:

To encourage investment and increase production and employment.

Example: RBI may reduce interest rates to encourage borrowing and investment during periods of
slow growth.

3. Full Employment:

To ensure maximum utilization of labor force in the economy.

Example: During a recession, RBI may adopt an expansionary monetary policy to increase job
opportunities.

4. Exchange Rate Stability:

To maintain a stable value of the Indian rupee in foreign exchange markets.

Example: RBI uses foreign exchange reserves to manage volatility in USD/INR rate.

5. Balance of Payments (BoP) Equilibrium:

To ensure a healthy balance between imports and exports.

Example: RBI may in uence interest rates to attract foreign investments and improve BoP.
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 6. Neutrality of Money:

To ensure money supply changes do not negatively impact real variables like output or
employment.

7. Reduction of Economic Inequalities:

To promote inclusive growth by directing credit to priority sectors like agriculture and small
enterprises.

3. Types of Monetary Policy Instruments:

Monetary policy tools are broadly divided into two categories:

A. Quantitative Instruments

(Control overall money supply and credit ow in the economy)

1. Cash Reserve Ratio (CRR):

Banks must keep a xed percentage of their total deposits with RBI.

Example: If CRR is 4%, and a bank has ₹100 crore in deposits, it must keep ₹4 crore with RBI.

2. Statutory Liquidity Ratio (SLR):

Banks must invest a portion of their deposits in government-approved securities.

Example: If SLR is 18%, and the bank has ₹100 crore, it must invest ₹18 crore in G-secs.

3. Repo Rate:

The rate at which RBI lends short-term funds to banks against government securities.

Example: If repo rate is reduced from 6.25% to 6.00%, banks will get cheaper loans and may
lower lending rates.

4. Reverse Repo Rate:

The rate at which banks deposit surplus funds with RBI.

Example: If excess liquidity exists, RBI may increase reverse repo to attract bank deposits and
reduce in ation.

5. Marginal Standing Facility (MSF):

An emergency borrowing facility where banks can borrow overnight at a higher rate than repo.
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 Example: Used by banks during tight liquidity when they’ve exhausted repo borrowing limits.

6. Open Market Operations (OMO):

Buying and selling of government securities by RBI in the open market.

Example: RBI buys G-secs to inject liquidity and sells them to absorb excess liquidity.

7. Standing Deposit Facility (SDF):

A tool introduced in 2022 to allow banks to park surplus funds with RBI without collateral.

Example: Alternative to reverse repo, helps RBI absorb liquidity more exibly.

B. Qualitative Instruments

(Target the allocation of credit to speci c sectors or purposes)

1. Selective Credit Control (SCC):

RBI restricts or promotes credit ow to speci c sectors.

Example: During in ation, RBI may restrict loans for speculative trading in agricultural
commodities.

Methods include:

Margin Requirements: Setting a minimum margin to discourage excessive borrowing.

E.g.: A 40% margin on loans against stocks to prevent speculative bubbles.

Di erential Interest Rates: O ering cheaper loans to priority sectors like agriculture and MSMEs.

2. Moral Suasion:

RBI persuades or advises banks to follow certain practices voluntarily.

Example: RBI may request banks to restrict loans to luxury housing to reduce speculative lending.

3. Direct Action:

RBI takes action against non-compliant banks.

Example: RBI may penalize banks that do not maintain CRR or SLR or violate lending norms.

Conclusion:

Monetary policy is an essential economic tool used by the RBI to maintain economic stability,
control in ation, and support inclusive growth. Through quantitative tools, RBI controls the
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 volume of money in circulation, while qualitative tools guide credit to priority sectors. The right
balance of both types of instruments ensures that the Indian economy remains resilient and well-
regulated.

1. De nition of the Reserve Bank of India (RBI):

The Reserve Bank of India (RBI) is the central bank of India, established on April 1, 1935 under the
Reserve Bank of India Act, 1934. It became a fully government-owned institution in 1949. The RBI
is responsible for regulating and supervising the monetary and nancial system of the country to
ensure price stability, economic growth, and nancial stability.

2. Functions of the RBI:

The RBI performs the following major functions:

1. Monetary Authority:

Formulates and implements monetary policy to maintain price stability and ensure adequate
credit ow to productive sectors.

2. Regulator and Supervisor of the Financial System:

Regulates commercial banks, NBFCs, and nancial institutions to maintain nancial discipline,
asset quality, and risk management.

3. Issuer of Currency:

Has the sole authority to issue currency notes in India, except coins, which are issued by the
Government of India but distributed by RBI.

4. Manager of Foreign Exchange:

Manages the country’s foreign exchange reserves and ensures stable exchange rates under
FEMA, 1999.

5. Banker to the Government:

Manages accounts and transactions of the central and state governments, including public debt
management.

6. Bankers' Bank:

Acts as a lender of last resort and maintains liquidity in the banking system through tools like repo
rate, CRR, and SLR.

7. Developmental Role:
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 Promotes nancial inclusion, rural development, and supports sectors like agriculture and
MSMEs.

8. Financial Inclusion Promoter:

Facilitates outreach of banking services to unbanked areas through schemes like PMJDY and
promotion of digital banking.

3. Powers of the RBI:

The RBI has broad and extensive powers to regulate the economy and nancial system:

1. Monetary Control:

Manages money supply, interest rates, and liquidity through tools like repo, reverse repo, OMO,
and SDF.

2. Bank Regulation:

Licenses, inspects, and sets capital adequacy, provisioning, and risk management norms for
banks.

3. Interest Rate Management:

Controls in ation and economic activity by in uencing lending and deposit rates.

4. Currency Issuance:

Issues and manages circulation of legal tender currency in the country.

5. Foreign Exchange Regulation:

Monitors and regulates foreign exchange under FEMA, stabilizing rupee value.

6. Advisory Role:

Advises the government on matters of economic policy, public debt, and scal strategies.

4. Approaches Central Banks Use to In uence the Economy:

Central banks like RBI use two broad policy approaches depending on economic conditions:

1. Expansionary Monetary Policy:

Goal: Stimulate economic activity during recession or slowdown.

How: Decrease interest rates (e.g., repo rate), increase liquidity, lower CRR/SLR.
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Example: RBI cut repo rate to 4% during COVID-19 to promote borrowing.

2. Contractionary Monetary Policy:

Goal: Control in ation and overheating of the economy.

How: Increase interest rates, raise CRR/SLR, reduce money supply.

Example: RBI increased repo rate in 2022–23 to control rising in ation.

5. Regulatory Framework of Commercial Banks in India:

The regulatory framework ensures that banks operate safely, maintain public trust, and contribute
to economic development. It consists of a legal and institutional setup governed by the RBI
through various acts, circulars, and supervisory tools.

Main Objective: Protect depositors’ interests, maintain nancial stability, ensure fair and inclusive
bankin.

6. Key Components of the Regulatory Framework:

1. Reserve Bank of India (RBI):

Main authority responsible for regulation and supervision of all banks and NBFCs.

2. Banking Regulation Act, 1949:

Primary law governing bank licensing, capital requirements, governance, and operations.

3. Licensing and Entry Norms:

RBI grants licenses to new banks after evaluating capital, infrastructure, and compliance
standards.

4. Capital Adequacy and Prudential Norms:

Guidelines for Capital Adequacy Ratio (CAR), Basel Norms, risk classi cation, provisioning, and
exposure limits.

5. Supervision and Inspection:

RBI conducts regular on-site inspections and o -site surveillance to ensure compliance.

6. Risk Management Framework:

Regulations to manage credit, market, operational, and liquidity risks.

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7. Financial Stability Oversight:

RBI monitors macroeconomic risks, systemic threats, and conducts stress testing.

8. Consumer Protection:

Issues norms for transparency, customer service, grievance redressal through Banking
Ombudsman Scheme.

9. Digital Banking & Cybersecurity:

Sets standards for online banking, UPI, data privacy, and fraud control in ntech.

Conclusion:

The Reserve Bank of India plays a central role in managing the country’s monetary and nancial
system. Through its well-de ned functions, extensive powers, and a robust regulatory framework,
it ensures the soundness, safety, and inclusiveness of India’s banking system. The RBI’s proactive
approaches enable the economy to adapt to changing nancial challenges while maintaining
macroeconomic stability.

Basel Norms / Basel Accords

(A Global Framework for Banking Regulation and Financial Stability)

1. What are Basel Norms? (De nition)

The Basel Norms, also called Basel Accords, are a set of international banking regulations
developed by the Basel Committee on Banking Supervision (BCBS). These norms are designed to
ensure that banks maintain su cient capital to meet nancial and operational risks and avoid
failures that can disrupt the global nancial system.

They provide a global standard for capital adequacy, risk management, and supervisory practices,
and have been adopted by most countries, including India, to ensure the safety, transparency, and
stability of their banking sectors.

2. Basel Committee on Banking Supervision (BCBS):

• Formed in 1974 by central bank governors of G10 countries after the failure of
Bankhaus Herstatt (Germany).
• It functions under the Bank for International Settlements (BIS), headquartered in
Basel, Switzerland.
• Objective: Promote global nancial stability by strengthening regulation,
supervision, and risk management in the banking sector.
• Currently, it has 45 members from 28 jurisdictions, including the Reserve Bank of
India (RBI).

3. Objectives of Basel Norms:

The Basel Accords were introduced to:

• Ensure capital adequacy in banks for absorbing losses.
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 • Promote uniform international banking practices.
• Enhance the risk management framework of banks.
• Protect depositors’ interests by reducing the chances of bank failures.
• Foster con dence and stability in the nancial system.

4. Evolution of Basel Norms: Basel I, II, and III

A. Basel I – Introduced in 1988

Focus: Credit Risk and Minimum Capital Requirements

Key Concepts:
1. Credit Risk: The risk that a borrower may default on a loan.
2. Risk Weighted Assets (RWA): Assets assigned di erent risk weights (0% to 100%)
depending on the borrower’s creditworthiness.
• Example: Govt. bonds = 0%, Corporate loans = 100%.
3. Minimum Capital Requirement (CAR):
• Banks required to maintain minimum 8% capital of total RWA.
• India set this at 9%, making it stricter.

Capital Structure:
• Tier 1 Capital: Core capital (Equity capital + Reserves).
• Tier 2 Capital: Supplementary capital (Subordinated debt, hybrid instruments).

Adopted in India in 1999. Simple but did not cover market or operational risk.

B. Basel II – Introduced in 2004

Focus: Risk-Sensitive Framework and Enhanced Risk Management

Basel II was an improvement over Basel I as it included market risk and operational risk in
addition to credit risk. It was built on three pillars:

Pillar 1 – Minimum Capital Requirements:

• Banks must maintain capital for three types of risks:
1. Credit Risk
2. Market Risk
3. Operational Risk

Pillar 2 – Supervisory Review:

• Banks should develop and use their own internal risk assessment models.
• Supervisors (e.g., RBI) can ask for additional capital based on evaluation.

Pillar 3 – Market Discipline:

• Banks must disclose capital structure, risk exposure, and risk assessment methods
to improve transparency.

Capital Structure under Basel II:

• Tier 1 Capital
• Tier 2 Capital
• Tier 3 Capital: Introduced to cover market risk only (short-term subordinated debt);
later removed in Basel III.

Implemented in India from 2009 for all commercial banks.

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C. Basel III – Introduced in 2010 (Post Global Financial Crisis)

Focus: Improved Capital Quality, Leverage Control, and Liquidity Management

The 2008 nancial crisis revealed that many large banks were under-capitalized and relied too
heavily on short-term funding. Basel III addressed these weaknesses.

Key Features:

1. Capital Requirements:
• Minimum CAR raised to 10.5%, which includes:
• 8% minimum capital
• 2.5% Capital Conservation Bu er (CCB)

2. Capital Quality Improvement:

• Introduction of Common Equity Tier 1 (CET1): Equity + disclosed reserves.
• Additional Tier 1 (AT1): Instruments like perpetual bonds.

3. Leverage Ratio:
• Set to avoid excessive borrowing.
• Minimum Leverage Ratio = 3% (Tier 1 capital / Total exposure).
• In India: 3.5% for normal banks, 4% for Domestic Systemically Important Banks
(DSIBs).

4. Liquidity Standards Introduced:

• Liquidity Coverage Ratio (LCR):
• Banks must hold high-quality liquid assets (HQLAs) to survive a 30-day stress
scenario.
• Net Stable Funding Ratio (NSFR):
• Ensures banks maintain stable funding sources for 1-year duration.

5. Countercyclical Capital Bu er:

• Additional bu er (0%–2.5%) to be built during economic booms and used in
downturns.

India started Basel III implementation in 2013. As of 2025, all major Indian banks are Basel III
compliant.

5. Capital Adequacy Ratio (CAR) / CRAR

(Capital to Risk-Weighted Asset Ratio)

The Capital Adequacy Ratio (CAR) is a key risk management measure under Basel Norms. It
ensures that banks have enough capital to absorb potential losses without collapsing.

Formula:
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Explanation:
• Higher CAR indicates a safer and nancially healthier bank.
• RWA includes loans and investments weighted according to risk levels.
• Example: ₹100 crore in govt bonds (0% risk) = ₹0 RWA.
• ₹50 crore in corporate loans (100% risk) = ₹50 crore RWA.
• If CAR is 9%, the bank must have capital of at least ₹4.5 crore for ₹50 crore RWA.

Conclusion

The Basel Accords represent a globally accepted regulatory framework that has evolved to
address emerging risks and safeguard the banking sector. While Basel I introduced basic capital
requirements, Basel II expanded the risk scope, and Basel III brought stronger rules for capital
quality, liquidity, and leverage. By enforcing Capital Adequacy Ratios (CAR) and other norms, the
Basel framework ensures resilience, stability, and con dence in the global nancial system.

India, under the supervision of RBI, has proactively adopted and often exceeded Basel standards,
making its banking sector more robust and future-ready.
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