Capital Formation: Meaning, Process and Other Details

Meaning of Capital Formation:

Capital formation means increasing the stock of real capital in a country.

In other words, capital formation involves making of more capital goods such as machines, tools,
factories, transport equipment, materials, electricity, etc., which are all used for future production of
goods.

For making additions to the stock of Capital, saving and investment are essential.

Process of Capital Formation:

In order to accumulate capital goods some current consumption has to be sacrificed. The greater the
extent to which the people are willing to abstain from present consumption, the greater the extent
that society will devote resources to new capital formation. If society consumes all that it produces
and saves nothing, future productive capacity of the economy will fall as the present capital
equipment wears out.

In other words, if whole of the current productive activity is used to produce consumer goods and no
new capital goods are made, production of consumer goods in the future will greatly decline. To cut
down some of the present consumption and wait for more consumption in the future require far-
sightedness on the part of the people. There is an old Chinese proverb, “He who cannot see beyond
the dawn will have much good wine to drink at noon, much green wine to cure his headache at dark,
and only rain water to drink for the rest of his days.”

Three Stages in Capital Formation:

Although saving is essential for capital formation, but in a monetized economy, saving may not
directly and automatically result in the production of capital goods. Savings must be invested in
order to have capital goods. In a modern economy, where saving and investment are done mainly by
two different classes of people, there must be certain means or mechanism whereby the savings of
the people are obtained and mobilized in order to give them to the businessmen or entrepreneurs to
invest in capital.

Therefore, in a modern free enterprise economy, the process of capital formation consists of the
(a) Creation of Savings:

An increase in the volume of real savings so that resources, that would have been devoted to the
production of consumption goods, should be released for purposes of capital formation.

(b) Mobilization of Savings:

A finance and credit mechanism, so that the available resources are obtained by private investors or
government for capital formation.

following three stages:

(c) Investment of Savings:

The act of investment itself so that resources are actually used for the production of capital goods.

We shall now explain these three stages:

Creation of Savings:

Savings are done by individuals or households. They save by not spending all their incomes on
consumer goods. When individuals or households save, they release resources from the production
of consumer goods. Workers, natural resources, materials, etc., thus released are made available for
the production of capital goods.

The level of savings in a country depends upon the power to save and the will to save. The power to
save or saving capacity of an economy mainly depends upon the average level of income and the
distribution of national income. The higher the level of income, the greater will be the amount of
savings.

The countries having higher levels of income are able to save more. That is why the rate of savings in
the U.S.A. and Western European countries is much higher than that in the under-developed and
poor countries like India. Further, the greater the inequalities of income, the greater will be the
amount of savings in the economy. Apart from the power to save, the total amount of savings
depends upon the will to save. Various personal, family, and national considerations induce the
people to save.

People save in order to provide against old age and unforeseen emergencies. Some people desire to
save a large sum to start new business or to expand the existing business. Moreover, people want to
make provision for education, marriage and to give a good start in business for their children.

Further, it may be noted that savings may be either voluntary or forced. Voluntary savings are those
savings which people do of their own free will. As explained above, voluntary savings depend upon
the power to save and the will to save of the people. On the other hand, taxes by the Government
represent forced savings.

Moreover, savings may be done not only by households but also by business enterprises” and
government. Business enterprises save when they do not distribute the whole of their profits, but
retain a part of them in the form of undistributed profits. They then use these undistributed profits
for investment in real capital.

The third source of savings is government. The government savings constitute the money collected
as taxes and the profits of public undertakings. The greater the amount of taxes collected and profits
made, the greater will be the government savings. The savings so made can be used by the
government for building up new capital goods like factories, machines, roads, etc., or it can lend
them to private enterprise to invest in capital goods.

Mobilization of Savings:

The next step in the process of capital formation is that the savings of the households must be
mobilized and transferred to businessmen or entrepreneurs who require them for investment. In the
capital market, funds are supplied by the individual investors (who may buy securities or shares
issued by companies), banks, investment trusts, insurance companies, finance corporations,
governments, etc.

If the rate of capital formation is to be stepped up, the development of capital market is very
necessary. A well- developed capital market will ensure that the savings of the society-will be
mobilized and transferred to the entrepreneurs or businessmen who require them.
Investment of Savings in Real Capital:

For savings to result in capital formation, they must be invested. In order that the investment of
savings should take place, there must be a good number of honest and dynamic entrepreneurs in
the country who are able to take risks and bear uncertainty of production.

Given that a country has got a good number of venturesome entrepreneurs, investment will be
made by them only if there is sufficient inducement to invest. Inducement to invest depends on the
marginal efficiency of capital (i.e., the prospective rate of profit) on the one hand and the rate of
interest, on the other.

But of the two determinants of inducement to invest-the marginal efficiency of capital and the rate
of interest—it is the former which is of greater importance. Marginal efficiency of capital depends
upon the cost or supply prices of capital as well as the expectations of profits.

Fluctuations in investment are mainly due to changes in expectations regarding profits. But it is the
size of the market which provides scope for profitable investment. Thus, the primary factor which
determines the level of investment or capital formation, in any economy, is the size of the market
for goods.

Foreign Capital:

Capital formation in a country can also take place with the help of foreign capital, i.e., foreign
savings.

Foreign capital can take the form of:

(a) Direct private investment by foreigners,

(b) Loans or grants by foreign governments,

(c) Loans by international agencies like the World Bank.

There are very few countries which have successfully marched on the road to economic
development without making use of foreign capital in one form or the other. India is receiving a
good amount of foreign capital from abroad for investment and capital formation under the Five-
Year Plans.

Deficit Financing:

Deficit financing, i.e., newly-created money is another source of capital formation in a developing
economy. Owing to very low standard of living of the people, the extent to which voluntary savings
can be mobilised is very much limited. Also, taxation beyond limit becomes oppressive and,
therefore, politically inexpedient. Deficit financing is, therefore, the method on which the
government can fall back to obtain funds.

However, the danger inherent in this source of development financing is that it may lead to
inflationary pressures in the economy. But a certain measure of deficit financing can be had without
creating such pressures.

There is specially a good case for using deficit financing to utilise the existing under-employed labour
in schemes which yield quick returns. In this way, the inflationary potential of deficit financing can be
neutralized by an increase in the supply of output in the short-run.
 Disguised Unemployment:

Another source of capital formation is to mobilize the saving potential that exists in the form of
disguised unemployment. Surplus agricultural workers can be transferred from the agricultural
sector to the non-agricultural sector without diminishing agricultural output.

The objective is to mobilize these unproductive workers and employ them on various capital creating
projects, such as roads, canals, building of schools, health centres and bunds for floods, in which
they do not require much more capital to work with. In this way’, the hitherto unemployed, labour
can be utilised productively and turned into capital, as it were.

Capital Formation in the Public Sector:

In these days, the role of government has greatly increased. In an under-developed country like
India, government is very much concerned with the development of the economy. Government is
building dams, steel plants, roads, machine-making factories and other forms of real capital in the
country. Thus, capital formation takes place not only in the private sector by individual
entrepreneurs but also in the public sector by government.

There are various ways in which a government can get resources for investment purposes or for
capital formation. The government can increase the level of direct and indirect taxation and then can
finance its various projects. Another way of obtaining the necessary resources is the borrowing by
the Government from the public.

The government can also finance its development plans by deficit financing. Deficit financing means
the creation of new money. By issuing more notes and exchanging them with the productive
resources the government can build real capital. But the method of deficit financing, as a source of
development finance, is dangerous because it often leads to inflationary pressures in the economy.
A certain measure of deficit financing, however, can be had without creating such pressures.

Another source of capital formation in the public sector is the profits of public undertakings which
can be used by the government for further investment. As stated above, government can also get
loans from foreign countries and international agencies like World Bank. India is getting a substantial
amount of foreign assistance for investment purposes under the Five-Year Plans.

1. Industrial Finance Corporation of India (IFCI):

The Industrial Finance Corporation of India was established in 1948 under the IFC Act, 1948. The
main objective of the corporation has been to provide medium and long-term credit to industrial
concerns in India.

The objective of the corporation as laid down in the preamble of the IFC Act, 1948, are
……………………………..”making medium and long-term credits more readily available to industrial
concerns in India, particularly in circumstances where normal banking accommodation is
inappropriate or recourse to capital issue methods is impracticable.”

The financial assistance of the corporation is available to limited companies or co-operative

societies registered in India and engaged or proposing to engage in:
 (a) Manufacture, preservation or processing of good

(b) The mining industry;

(c) The shipping business;

(d) The hotel industry; and

(e) The generation or distribution of electricity or any other form of power.

Initially the authorised capital of the corporation was Rs. 10 crore which was divided in equities
of Rs. 5,000 each. Later on the authorised capital was increased to Rs. 20 crore. Since July 1, 1993
this corporation has been converted into a company and it has been given the status of a limited
company with the name Industrial Finance Corporation of India Ltd. IFCI has got its registration
under Companies Act, 1956.

Before July 1, 1993, general public was not permitted to hold shares of IFCI. Only Government of
India, RBI, Scheduled Banks, Insurance Companies and Co-operative Societies were holding the
shares of IFCI.

The financial resources of IFCI consist of paid-up capital, reserves, repayment of loans, market
borrowings in the form of bonds/debentures, loans from Government of India, advances from the
Industrial Development Bank of India and foreign currency loans.

Functions of IFCI:

The functions of the IFCI can be broadly classified into:

a. Financial Assistance, and

b. Promotional Activities.

a. Financial Assistance:

The IFCI is authorised to render financial assistance in one or more of the following forms:

(i) Granting loans or advances to or subscribing to debentures of industrial concerns repayable

within 25 years. Also it can convert part of such loans or debentures into equity share capital at its
option.

(ii) Underwriting the issue of industrial securities i.e., shares, bonds, or debentures to be disposed off
within 7 years.
(iii) Subscribing directly to the shares and debentures of public limited companies.

(iv) Guaranteeing of loans raised by industrial concerns from scheduled banks or state cooperative
banks.

(v) Guaranteeing of deferred payments for the purchase of capital goods from abroad or within
India.

(vi) Acting as an agent of the Central Government or the World Bank in respect of loans sanctioned
to the industrial concerns

Financial assistance is available from IFCI for the following purposes:

(i) For the setting up of new industrial undertakings.

(ii) For expansion or diversification of the existing concerns.

(iii) For the modernisation and renovation of the existing concerns.

(iv) For meeting existing liabilities or working capital requirement of industrial concerns in
exceptional cases.

IFCI provides financial assistance to eligible industrial concerns regardless of their size. However,
now- a-days, it entertains applications from those industrial concerns whose project cost is above Rs.
2 crores because up to project cost of Rs. 2 crores various state level institutions (such as Financial
Corporations, SIDCs and banks) are expected to meet the financial requirements of viable concerns.

While approving a loan application, IFCI gives due consideration to the feasibility of the project, its
importance to the nation, development of the backward areas, social and economic viability, etc.

b. Promotional Activities:

The IFCI has been playing very important role as a financial institution in providing financial
assistance to eligible industrial concerns. However, no less important is its promotional role whereby
it has been creating industrial opportunities also. The corporation discovers the opportunities for
promoting new enterprises.

It helps in developing small and medium scale entrepreneurs by providing them guidance through its
specialised agencies in identification of projects, preparing project profiles, implementation of the
projects, etc. It acts an instrument of accelerating the industrial growth and reducing regional
industrial and income disparities.

Working of IFCI:

The cumulative financial assistance sanctioned by IFCI up to March, 2003 aggregated Rs. 45,426.7
crores against which disbursements amounted to Rs. 44,169.2 crores. During 2003-04, IFCI
sanctioned and disbursed Rs. 1394.6 crore and Rs. 281.2 crore respectively.
However, no amount was sanctioned by IFCI during 2004-05 and disbursements also amounted to
Rs. 91 crore only. The provisional disbursement for the year 2005-06 amounted to Rs. 187 crore
only.

However, no amount was sanctioned by IFCI during 2004-05 and disbursements also amounted to
Rs. 91 crores only. The disbursements for the year 2005-06 amounted to Rs. 187 crores only. The
provisional figures of sanctions and disbursements for the year 2006-07 amounted to Rs. 1050
crores and Rs. 550 crores respectively.

The most of the assistance sanctioned by IFCI has gone to industries of national priority such as
fertilizers, cement, power generation, paper, industrial machinery etc.

The corporation is giving a special consideration to the less developed areas and assistance to them
has been stepped up. It has sanctioned nearly 49 per cent of its assistance for projects in backward
districts.

The corporation has recently been participating in soft loan schemes under which loans on
concessional rates are given to units in selected industries. Such assistance is given for
modernisation, replacement and renovation of plant and equipment.

IFCI introduced a scheme for sick units also. The scheme was for the revival of sick units in the tiny
and small scale sectors. Another scheme was framed for the self-employment of unemployed young
persons. The corporation has diversified into merchant banking also. Financing of leasing and hire
purchase companies, hospitals, equipment leasing etc. were the other new activities of the
corporation in the last few years.

Financial Institution # 2. Industrial Credit and Investment Corporation of India (ICICI):

The Industrial Credit and Investment Corporation of India (ICICI) were established in 1955 as a public
limited company under the Indian Companies Act for developing medium and small industries of
private sector.

Initially its equity capital was owned by companies, institutions and individuals but at present its
equity capital is owned by public sector institutions like banks, LIC and GIC etc. It provides term loans
in Indian and foreign currencies, underwrites issues of shares and debentures, makes direct
subscription to these issues and guarantees payment of credit made by others.

Functions of ICICI:

The corporation has been established for the purpose of assisting industries in the private sector
by undertaking the following functions:

(i) Assisting in the creation, expansion and modernisation of such enterprises.

(ii) Encouraging and promoting the participation of private capital, both internal and external.

(iii) Encouraging and promoting private ownership.

(iv) Expansion of investment market.

(v) Providing finance in the form of long or medium-term loans.

(vi) Underwriting issue of shares and debentures.

(vii) Making funds available for re-investment.

(viii) Furnishing managerial, technical and administrative services to Indian Industry.

(ix) To extend guarantee for deferred payments.

(x) To advance loans in foreign currency towards the cost of imported capital equipment.

The financial assistance sanctioned and disbursed by ICICI up to March 2002 amounted to Rs.
2,83,511 crore and Rs. 1,71,698 crore respectively. During 1998-99 alone it sanctioned Rs. 34,220
crore and disbursed Rs. 19,225 crore.

Loans sanctioned in foreign currency constitute important place in total sanctioned loans of the
corporation. The assistance sanctioned and disbursed by ICICI during 2001-02 aggregated Rs. 35,589
crores and Rs. 25,050 crores respectively registering a growth of 36.2% and 20.9% respectively over
the previous year.

Recently ICICI Ltd. (along with two its subsidiaries, ICICI Personal Finance Services Ltd., and ICICI
Capital Services Ltd.,) has been merged with ICICI Bank Ltd., effective from May 3, 2002. The
erstwhile DFI has thus ceased to exist.

Financial Institution # 3. State Financial Corporations (SFCs):

The State Financial Corporation Act was passed by the Government of India in 1951 with a view to
provide financial assistance to small and medium scale industries which were beyond the scope of
IFCI. According to this Act, a State Government is empowered to establish a financial corporation to
operate within the State. At present, there are 18 such corporations functioning in the country.

These corporations are expected to be complementary to the Industrial Finance Corporation of

India. While IFCI provides assistance only to large industrial concerns owned by public limited
companies or co-operatives, the SFCs. render assistance to all kinds of industries, may be in the form
of private limited companies, partnership firms or sole- trading concerns.

The capital structure of the State Financial Corporations has been left to be determined by State
Government within the limits of Rs. 50 lakhs to Rs. 5 crores, 25 per cent of the capital can be
subscribed by the public and the rest by the State Government, the Reserve Bank of India, insurance
companies and other institutional investors in proportion to be determined by the State
Government in consultation with the Reserve Bank of India.

Apart from share capital, the SFCs depend for financial resources on issue of bonds, borrowings from
RBI, loans from State Government, refinancing of loans by IDBI, deposits from the public, repayment
of loans and income from investments.

Functions:

The main function of the SFCs is to provide loans to small and medium scale industries engaged in
the manufacture, preservation or processing of goods, mining, hotel industry, generation or
distribution of power, transportation, fishing, assembling, repairing or packaging articles with the aid
of power, etc.

State Financial Corporations are authorised to grant financial assistance in the following forms:

(i) Granting of loans or advances to industrial concerns repayable within a period not exceeding
twenty years.
(ii) Subscribing to the debentures of industrial concerns repayable within a period not exceeding
twenty years.

(iii) Guaranteeing loans raised by industrial concerns repayable within twenty years.

(iv) Underwriting the issue of stocks, shares, bonds or debentures by the industrial concerns subject
to their being disposed off within seven years.

(v) Guaranteeing deferred payments due from any industrial concern in connection with purchase of
capital goods in India.

(vi) Acting as an agent of the Central Government or State Government or the Industrial Finance
Corporation of India in respect of any business with an industrial concern in respect of loans
sanctioned to them.

Industrial Development Bank of India (IDBI):

The Industrial Development Bank of India was established under the Industrial Development Bank of
India Act, 1964 as a wholly owned subsidiary of the Reserve Bank of India. The ownership of IDBI has
since been transferred to Central Government from February 16, 1976.

The main object of establishing IDBI was to set up an apex institution to co-ordinate the activities of
other financial institutions and to act as a reservoir on which the other financial institutions can
draw. IDBI provides direct financial assistance to industrial units also to bridge the gap between
supply and demand of medium and long term finance.

As on March 31, 1997, the paid up capital of IDBI stood at Rs. 659.4 crore and reserve funds at Rs.
6554 crore. The bank is also authorised to raise its resources through borrowings from Government
of India, Reserve Bank of India and other financial institutions.

On 31st March, 1997, the bank had borrowings of Rs. 23,802 crore by way of bonds and debentures,
deposits of Rs. 3694 crore and borrowings of Rs. 10,364 crore from RBI, Government of India and
other sources.

Functions:

The main functions of IDBI are as follows:

i. To co-ordinate the activities of other institutions providing term finance to industry and to act as
an apex institution.

ii. To provide refinance to financial institutions granting medium and long-term loans to industry.

iii. To provide refinance to scheduled banks or co-operative banks.

iv. To provide refinance for export credits granted by banks and financial institutions.

v. To provide technical and administrative assistance for promotion, management or growth of

industry.

vi. To undertake market surveys and techno-economic studies for the development of Industry.

vii. To grant direct loans and advances to industrial concerns, IDBI is empowered to finance all types
of industrial concerns engaged or proposed to be engaged in the manufacture, preservation or
processing of goods, mining, hotel industry, fishing, shipping, transport, generation or distribution of
power, etc.
The bank can also assist concerns engaged in the setting up of industrial estates or research and
development of any process or product or in providing technical knowledge for the promotion of
industries. Until recently IDBI also functioned as Export-Import Bank of the country.

viii. To render financial assistance to industrial concerns, IDBI operates various schemes of
assistance, e.g., Direct Assistance Scheme. Soft Loans Scheme, Technical Development Fund Scheme,
Refinance Industrial Loans Scheme, Bill Re-discounting Scheme, Seed Capital Assistance Scheme,
Overseas Investment Finance Scheme, Development Assistance Fund, etc.

Since its inception in 1964, IDBI has extended its operations to various areas of industrial sector. It
provides direct loans, refinances industrial loans, rediscounts bills, underwrites shares and
debentures, directly subscribes to shares and debentures of companies of industrial units etc.

Aggregate assistance sanctioned by March 2003 amounted to Rs. 2,23,932 crore and disbursements
amounted to Rs. 1,68,167 crore. Assistance sanctioned during 2004-05 amounted to Rs. 10,799 crore
and disbursements amounted to Rs. 6,183 crore in 2004-05. The provisional figures for the year
2005-06 amounted to Rs. 27,442 crore and Rs. 12,984 crore respectively.

“Credit Creation”

Introduction: - The money supply of a country consists of notes and coins. The Central bank is the
primary source of money supply in an economy through circulation of currency.

It ensures the availability of currency for meeting the transaction needs of an economy and
facilitating various economic activities, such as production, distribution and consumption.

However, for this purpose, the Central bank needs to depend upon the reserves of commercial
banks. These reserves of commercial banks are the secondary source of money supply in an
economy. The most important function of a commercial bank is the creation of credit.

Credit Creation Demand deposits are an important constituent of money supply and the expansion
of demand deposits means the expansion of money supply. The entire structure of banking is based
on credit. Credit basically means getting the purchasing power now and promising to pay at some
time in the future. Bank credit means bank loans and advances.

A bank keeps a certain part of its deposits as a minimum reserve to meet the demands of its
depositors and lends out the remaining to earn income. The loan is credited to the account of the
borrower. Every bank loan creates an equivalent deposit in the bank. Therefore, credit creation
means expansion of bank deposits.

The two most important aspects of credit creation are:

1. Liquidity – The bank must pay cash to its depositors when they exercise their right to

demand cash against their deposits.

2. Profitability – Banks are profit-driven enterprises. Therefore, a bank must grant loans in a

manner which earns higher interest than what it pays on its deposits.

The bank’s credit creation process is based on the assumption that during any time interval, only

a fraction of its customers genuinely need cash. Also, the bank assumes that all its customers

would not turn up demanding cash against their deposits at one point in time
• Cash Reserve Ratio (CRR) – Banks know that all depositors will not withdraw all deposits at the
same time. Therefore, they keep a fraction of the total deposits for meeting the cash demand of the
depositors and lend the remaining excess deposits. CRR is the percentage of total deposits which the
banks must hold in cash reserves for meeting the depositors’ demand for cash.

• Excess Reserves – The reserves over and above the cash reserves are the excess reserves. These
reserves are used for loans and credit creation.

• Credit Multiplier – Given a certain amount of cash, a bank can create multiple times credit. In the
process of multiple credit creation, the total amount of derivative deposits that a bank creates is a
multiple of the initial cash reserve

Limitations of Credit Creation: - When banks would prefer for creating credit to increase profits,
there are many limitations. These limitations make the process of creating credit non-profitable.

1) If the banks are unwilling to utilize their surplus funds for granting loans, then the economy is
headed towards recession.

2) If the public withdraws cash and holds it with themselves, then it reduces the banks’ power to
create credit

Monetary policy is the process by which the monetary authority of a country, generally the central
bank, controls the supply of money in the economy by its control over interest rates in order to
maintain price stability and achieve high economic growth.[1] In India, the central monetary authority
is the Reserve Bank of India (RBI).

It is designed to maintain the price stability in the economy. Other objectives of the monetary policy
of India, as stated by RBI, are:

Price stability

Price stability implies promoting economic development with considerable emphasis on price
stability. The centre of focus is to facilitate the environment which is favourable to the architecture
that enables the developmental projects to run swiftly while also maintaining reasonable price
stability.

Controlled expansion of bank credit

One of the important functions of RBI is the controlled expansion of bank credit and money supply
with special attention to seasonal requirement for credit without affecting the output.

Promotion of fixed investment

The aim here is to increase the productivity of investment by restraining non essential fixed
investment.

Restriction of inventories and stocks

Overfilling of stocks and products becoming outdated due to excess of stock often results in sickness
of the unit. To avoid this problem, the central monetary authority carries out this essential function
of restricting the inventories. The main objective of this policy is to avoid over-stocking and idle
money in the organisation.
Promoting efficiency

It tries to increase the efficiency in the financial system and tries to incorporate structural changes
such as deregulating interest rates, easing operational constraints in the credit delivery system,
introducing new money market instruments, etc.

Reducing rigidity

RBI tries to bring about flexibilities in operations which provide a considerable autonomy. It
encourages more competitive environment and diversification. It maintains its control over financial
system whenever and wherever necessary to maintain the discipline and prudence in operations of
the financial system

Monetary policy committee[edit]

The Reserve Bank of India Act, 1934 (RBI Act) was amended by the Finance Act, 2016, to provide a
statutory and institutionalised framework for a Monetary Policy Committee, for maintaining price
stability, while keeping in mind the objective of growth. The Monetary Policy Committee is entrusted
with the task of fixing the benchmark policy rate (repo rate) required to maintain inflation within the
specified target level. As per the provisions of the RBI Act, three of the six Members of the Monetary
Policy Committee will be from the RBI and the other three Members will be appointed by the Central
Government.

The Government of India, in consultation with RBI, notified the 'Inflation Target' in the Gazette of
India Extraordinary dated 5 August 2016 for the period beginning from the date of publication of the
notification and ending on the March 31, 2021 as 4%. At the same time, lower and upper tolerance
levels were notified to be 2% and 6% respectively. Inflation rate in 2020 is 6.2% . [2]

Monetary operations[edit]

Monetary operations involve monetary techniques which operate on monetary magnitudes such
as money supply, interest rates and availability of credit aimed to maintain price stability,
stable exchange rate, healthy balance of payment, financial stability, and economic growth. RBI, the
apex institute of India which monitors and regulates the monetary policy of the country, stabilize the
price by controlling inflation.

Instruments of monetary policy[edit]

These instruments are used to control the money flow in the economy:

Open market operations

An open market operation is an instrument of monetary policy which involves buying or selling of

government securities like government bonds from or to the public and banks. This mechanism
influences the reserve position of the banks, yield on government securities and cost of bank credit.
The RBI sells government securities to control the flow of credit and buys government securities to
increase credit flow. Open market operation makes bank rate policy effective and maintains stability
in government securities market.
CRR graph from 1992 to 2011[3]

Cash reserve ratio (CRR)

Cash reserve ratio is a certain percentage of bank deposits which banks are required to keep with
RBI in the form of reserves or balances. The higher the CRR with the RBI, the lower will be
the liquidity in the system, and vice versa. RBI is empowered to vary CRR between 15 percent and 3
percent. Per the suggestion by the Narasimham Committee report, the CRR was reduced from 15%
in 1990 to 5 percent in 2002. As of 9th October 2020, the CRR is 3.00 percent. [4]

SLR graph from 1991 to 2011[5]

Statutory liquidity ratio (SLR)

Every financial institution has to maintain a certain quantity of liquid assets with themselves at any
point of time of their total time and demand liabilities. These assets have to be kept in non cash
form such as G-secs precious metals, approved securities like bonds. The ratio of the liquid assets to
time and demand liabilities is termed as the Statutory liquidity ratio. There was a reduction of SLR
from 38.5% to 25% because of the suggestion by Narsimham Committee. As on 9th October 2020,
the SLR stands at 18%.[4]

Bank rate graph from 1991 to 2011

Bank rate policy[6]

The bank rate, also known as the discount rate, is the rate of interest charged by the RBI for
providing funds or loans to the banking system. This banking system involves commercial and co-
operative banks, Industrial Development Bank of India, IFC, EXIM Bank, and other approved financial
institutions. Funds are provided either through lending directly or discounting or buying money
market instruments like commercial bills and treasury bills. Increase in bank rate increases the cost
of borrowing by commercial banks which results in the reduction in credit volume to the banks and
hence the supply of money declines. Increase in the bank rate is the symbol of tightening of RBI
monetary policy. As of 9th October 2020, the bank rate is 4.25 percent. [4]

Credit ceiling

In this operation, RBI issues prior information or direction that loans to the commercial banks will be
given up to a certain limit. In this case, commercial bank will be tight in advancing loans to the
public. They will allocate loans to limited sectors. A few examples of credit ceiling are agriculture
sector advances and priority sector lending.

Credit authorisation scheme

Credit authorisation scheme was introduced in November, 1965 when P C Bhattacharya was the
chairman of RBI. Under this instrument of credit regulation, RBI, as per the guideline, authorise the
banks to advance loans to desired sectors. [7]

Moral suasion

Moral suasion is just as a request by the RBI to the commercial banks to take certain actions and
measures in certain trends of the economy. RBI may request commercial banks not to give loans for
unproductive purposes which do not add to economic growth but increase inflation.

Repo rate and reverse repo rate

Repo rate is the rate at which RBI lends to its clients generally against government securities.
Reduction in repo rate helps the commercial banks to get money at a cheaper rate and increase in
repo rate discourages the commercial banks to get money as the rate increases and becomes
expensive. The reverse repo rate is the rate at which RBI borrows money from the commercial
banks. The increase in the repo rate will increase the cost of borrowing and lending of the banks
which will discourage the public to borrow money and will encourage them to deposit. As the rates
are high the availability of credit and demand decreases resulting to decrease in inflation. This
increase in repo rate and reverse repo rate is a symbol of tightening of the policy. As of May 2020,
the repo rate is 4.00% and the reverse repo rate is 3.35%.

Key indicators[edit]

The key indicators as of 2021 are[9][10]

Indicator Current rate

Inflation 6.62%[11]

MSF (marginal standing facility) rate 4.25%[12]

CRR 3.5%
 SLR 18.0%

Bank rate 4.25%[12]

Reverse repo rate 3.35%[13]

Repo rate 4.0%[14]

GDP growth rate 8.4%[15]

Unit - 1 : Retail Banking - Introduction

"Retail Banking is a banking service that is geared primarily toward individual consumers.

Unlike wholesale banking, retail banking focuses strictly on consumer markets.

Although retail banking is, for the most part, mass-market driven, many retail banking products may

also extend to small and medium sized businesses.

Pure retail banking is generally conceived to be the provision of mass market banking services to

private individuals.

Attractive interest spreads since spreads are wide, since customers are too fragmented to bargain

effectively; Credit risk tends to be well diversified, as loan amounts are relatively small.

There is less volatility in demand and credit cycle than from large corporates.

Higher delinquencies especially in unsecured retail loans and credit card receivables.

In some banks retail banking was christened as consumer banking as the focus was towards
individual

consumers.

Capgemini. ING and the European Financial Management & Marketing Association (EFMA) have

studied the global Retail Banking market with the aim of providing insights to financial services

community through the World Retail Banking Report(WRBR).

The pricing indices were developed based on three usage patterns viz., less active, active and very

active users.

Introduction of the telegraph in the early 1850s which made the process of communication and

information exchange faster and reduced the price differentials between stock markets.

Banking services follow the standard industrial development pattern in which prices decline with

maturity.
The share of interest income had almost remained steady at about 84% and the share of non
interest

income also is almost stable at around 16%.This indicates that there were no serious efforts by banks

to increase the non interest income through fee based product and third party distribution models.

Retail Banking as a concept in India has been initiated by the PSBs and nurtured by the foreign banks

and new generation private sector banks.

It grew by a compounded annual growth rate of 30.5% between 1999 and 2004 and expected to
grow

at above 30% in 2010

The penetration level of retail banking in India is still very low as compared to the other Asian

countries like China, Malaysia, Thailand etc..

The retail banking objectives of any bank would mainly focus on the following:

1. Generating superior returns on assets.

2. Acquiring sufficient funding

3. Enhancing risk management

4. Understanding customers and regaining their trust.

5. Coping with increased demands regarding product transparency and overall service levels.

6. Achieving multi channel excellence with fully integrated banking channels.

7. Moving toward higher levels of industria

3. Core Banking

Definition: Core banking is a banking service provided by a group of networked bank

branches where customers may access their bank account and perform basic transactions

from any of the member branch offices.

Core banking is often associated with retail banking and many banks treat the retail

customers as their core banking customers. Businesses are usually managed via the Corporate

banking division of the institution. Core banking covers basic depositing and lending of

money. The branches of a bank are networked with each other. Customers may undertake

81

normal banking business with any branch, not necessarily at the branch where his account is

maintained (it is called HOME branch). For example, cheques up to certain amounts may be

encashed at any branch of the same bank. Pass book also may be updated at any branch.
Similarly other services may be undertaken at any of the Core Banking enabled branch of the

same bank.

Normal core banking functions will include transaction accounts, loans, mortgages and

payments. Banks make these services available across multiple channels like ATMs, Internet

banking, mobile banking and branches.

The core banking services rely heavily on computer and network technology to allow a bank

to centralise its record keeping and allow access from any location. It has been the

development of banking software has allowed core banking solutions to be developed.

Features of core banking include:

 Making and servicing loans.

 Opening new accounts.

 Processing cash deposits and withdrawals.

 Processing payments and cheques.

 Calculating interest.

 Customer relationship management (CRM) activities.

 Managing customer accounts.

 Establishing criteria for minimum balances, interest rates, number of withdrawals

allowed and so on.

 Establishing interest rates.

 Maintaining records for all the bank’s transactions.

CBS provides the following benefits:

 Improves operational efficiency and reduces cost of operations:

 Improves customer service

 Complies with Anti Money Laundering (AML) / Know Your Customer (KYC)

requirements:

 Integrates with electronic payment systems such as Anytime and Anywhere banking

(online mediums / SMS)

82

 Standardised, simple and automated processes

 Increase in quality of the service provided to the customers

 Timely and accurate information for management decision making

 Strong audit and internal controls

 Bring down the cost of transaction and thereby improving operational efficiency

 Paving way for new value added services thereby generating additional revenue for

the Bank

CBS thus provides all the features for efficiently running and managing the Bank

RETAIL BANKING Retail Banking is a banking service that is geared primarily towards individual
consumers. Retail banking is usually made available by commercial banks, as well as smaller
community banks. Retail banking is unique mass-market banking where individual customers make
use of local branches of larger commercial banks. The term Retail Banking encompasses various
financial products viz., different types of deposit accounts, housing, consumer, auto and other types
of loan accounts, demat facilities, insurance, mutual funds, credit and debit cards, ATMs and other
technology-based services, stock-broking, payment of utility bills, reservation of railway tickets, etc.,.
It caters to diverse customer groups and offers a host of financial services, mostly to individuals. It
takes care of the diverse banking needs of an individual. Retail banking is a system of providing soft
loans to the general public like family loans, house loans, personal loans, loans against property, car
loans, auto loans etc. The products are backed by world-class service standards and delivered to the
customers through the growing branch network, as well as through alternative delivery channels like
ATMs, Phone Banking, Net Banking and Mobile Banking. Customers and small businesses get
benefited from increased credit access, speedy and objective credit decisions whereas lenders get
benefited from increased consistency and compliance. Today’s retail banking sector is characterized
by three basic characteristics:  Multiple products (deposits, credit cards, insurance, investments
and securities);  Multiple channels of distribution (call centre, branch, Internet and kiosk); and 
Multiple customer groups (consumer, small business, and corporate). The objective of retail banking
is to provide customers a full range of financial products and banking services, give the customers a
one-stop window for all their banking requirements. Retail banking segment is continuously
undergoing

innovations, product re-engineering, adjustments and alignments. OBJECTIVES OF THE STUDY The
main objectives of the study are: 1. To identify various drivers of retail business in India. 2. To
highlight the competition prevailing in retail banking services in India 3. To highlight various
challenges & opportunities to retail banking in India. DRIVERS OF RETAIL BUSINESS IN INDIA: The
Indian players are bullish on the retail business and this is not totally unsubstantiated. As the face of
the Indian consumer is shifting, that is reflected in a change in the urban household income pattern,
the direct fallout of such change is on the consumption pattern and hence on the banking habits of
Indians, which is now tilted towards retail products. Following changing consumer demographics
have led to the need for growth of retail banking activities in India.  INCREASINGLY AFFLUENT AND
BULGING MIDDLE CLASS: About 320 million people will be added in the middleincome group in a
period of 15 years approximately.  YOUNGEST POPULATION IN THE WORLD: Changing consumer
demographics indicate vast potential for growth in consumption both qualitatively and
quantitatively, due to increasing affluent with bulging middle class and youngest people in the world.
70% of Indian population is below 35 years of age which means that there is tremendous
opportunity of 130 million people being added to working population. The BRIC report of the
Goldman-Sachs, which predicted a bright future for Brazil, Russia, India and China, mentioned Indian
demographic advantage as an important positive factor for India.  INCREASING LITERACY LEVELS:
Due to increase in the literacy ratio, people have developed a experience for latest technology and
variety of products and services. It will lead to larger demand for retail activities specially retail
banking activities.  HIGHER ADAPTABILITY TO TECHNOLOGY: Convenience banking in the form of
debit cards, internet and phone-banking, anywhere and anytime banking has attracted many new
customers into the banking field. Technological innovations relating to increasing use of credit /
debit card, ATMs, direct debits and phone banking have contributed to the growth of retail banking
in India.  CONTINUING TREND IN URBANIZATION: Urbanization of Indian population is also an
important feature influencing the retail banking.  INCREASING CONSUMPTION MINDSET OF
INDIANS: Economic prosperity and the consequent increase in purchasing power have given a fillip
to a consumer boom. During the 10 years after 1997, India's economy grew at an average rate of 6.8
percent and continues to grow at the almost the same rate – not many countries in the world match
this performance. It means that Indian consumers are now shifting from the tendency of buying
more and better quality to new services and products.  DECLINING TREASURY INCOME OF THE
BANKS: The Treasury income of the banks, which had strengthened the bottom lines of banks for the
past few years, has been on the decline during the last two years. In such a scenario, retail business
provides a good vehicle of profit maximization. Considering the truth that retail’ s share in impaired
assets is far lesser than the overall bank loans and advances, retail loans have put relatively less
provisioning load on banks apart from diversifying their income streams