RBI as Banker to the Government and Lender of Last Resort

Besides issuing currency, the Reserve Bank keeps the accounts of the Union and the States, raises and manages their debt, holds the reserves of every other bank and stands behind the banking system when liquidity fails. These are the classical functions of a central bank, and the Act sets them out with some precision: what the Bank may do, what it may not do, what it must do for the Government, and what it may do in a crisis that it may not do ordinarily.

Figure 1: The four banking roles of the Reserve Bank

1. Business the Bank May Transact

Section 17 is the charter of the Bank's banking operations. It is a long section, and it is best read as a list of the instruments through which every other function of the Bank is carried out. The principal heads are these.

• Deposits without interest (Section 17(1)): from the Central Government, State Governments, local authorities, banks and any other persons, and the collection of money for them. The words without interest are important, because Section 19 forbids the Bank to allow interest on deposits save as Section 17 itself authorises.
• Interest-bearing deposits (Section 17(1A)): inserted by the Finance Act, 2018, this clause allows the Bank to accept deposits repayable with interest from banks and other persons under the Standing Deposit Facility Scheme approved by the Central Board, for the purpose of liquidity management. It is the one express exception to the rule that the Bank's deposits are interest free.
• Purchase and rediscount of bills (Section 17(2)): bills of exchange and promissory notes arising out of bona fide commercial or trade transactions, out of the financing of agricultural operations or the marketing of crops, or out of the financing of production or marketing of cottage and small-scale industries.
• Advances to banks (Section 17(4)): loans and advances to local authorities, scheduled banks, State cooperative banks and State financial corporations, repayable on demand or on the expiry of fixed periods not exceeding ninety days, against eligible securities such as trustee securities, gold and eligible bills. This is the ordinary liquidity window and the statutory basis of the lender of last resort function.
• Advances to Governments (Section 17(5)): ways and means advances to the Central and State Governments, repayable not later than three months from the date of the advance.
• Securities, gold and foreign exchange: the purchase and sale of Government securities, of gold coin and bullion, and the making and receiving of remittances and dealings in foreign exchange.
• Management of public debt: acting as agent for the Government in the issue, management and repayment of public debt, and the custody of securities.

2. Business the Bank May Not Transact

Figure 2: What Section 17 permits and Section 19 forbids

• No trading: the Bank may not engage in trade or otherwise have a direct interest in any commercial, industrial or other undertaking, except as the Act permits.
• No interest on deposits: the Bank may not allow interest on deposits or current accounts, save as Section 17 expressly authorises, which since the Finance Act, 2018 means deposits under the standing deposit facility. Its other liabilities are therefore costless, which is what gives the Bank its distinctive income.
• No other loans: the Bank may not make loans or advances except as Sections 17, 18, 42 and 45 expressly authorise, which in practice confines it to lending against eligible security.
• No lending on immovable property: the Bank may not make advances on the mortgage of, or otherwise on the security of, immovable property, nor may it purchase immovable property except for its own use.
• No shares: the Bank may not purchase the shares of any banking company or other company, nor make advances on the security of such shares, with the exceptions the Act itself provides.
• No long bills: the Bank may not draw or accept bills payable otherwise than on demand.

3. The Lender of Last Resort

Section 18, headed power of direct discount, applies when, in the opinion of the Bank, a special occasion has arisen making it necessary or expedient to act for the purposes of regulating credit in the interests of Indian trade, commerce, industry and agriculture. The Bank may then, notwithstanding any limitation contained in Section 17, purchase, sell or discount any bill of exchange or promissory note even though it is not eligible for purchase or discount under Section 17, and may make loans or advances to a State cooperative bank, to a cooperative society on the recommendation of a State cooperative bank, or to any other person, repayable on demand or within fixed periods not exceeding ninety days, on such terms and conditions as the Bank considers sufficient.

• A power of emergency: Section 18 is engaged only when, in the opinion of the Bank, a special occasion has arisen. The Bank is the judge of that, and the courts would be slow to interfere with its assessment.
• It overrides Section 17: the words notwithstanding any limitation contained in section 17 allow the Bank to discount paper that does not satisfy the ordinary eligibility conditions and to lend to any person on such terms and conditions as it considers sufficient, within the ninety day limit.
• The classical rule: the function corresponds to the rule associated with Walter Bagehot, that in a crisis the central bank should lend freely, at a penal rate, against good collateral. Lending freely stops the panic; the penal rate and the collateral requirement limit the cost to the public and discourage reliance on the facility.
• Moral hazard: the existence of the facility encourages banks to hold fewer liquid assets than they otherwise would. The answer in law is prudential regulation, which is why the liquidity coverage ratio and the statutory liquidity ratio exist alongside the lending window.
• Solvency and liquidity: the classical function supports an illiquid but solvent bank. An insolvent bank is dealt with by the resolution machinery in the Banking Regulation Act, principally Section 45, and not by lending.

4. Banker to the Government

• The obligation (Section 20): the Bank shall undertake to accept monies for account of the Central Government and to make payments up to the amount standing to the credit of its account, and to carry out its exchange, remittance and other banking operations, including the management of the public debt of the Union.
• The right (Section 21): the Central Government shall entrust the Bank, on such conditions as may be agreed, with all its money, remittance, exchange and banking transactions in India, and shall deposit free of interest all its cash balances with the Bank. Where the Bank has no branch, the Government may use another agency.
• The States (Section 21A): the Bank transacts the business of a State Government by agreement with that State, and each State with such an agreement has its own ways and means limit.
• Agency banks: the Bank appoints agency banks to conduct Government receipts and payments at places where it has no office.
• Public debt: the Bank conducts auctions of dated securities and treasury bills, maintains the subsidiary general ledger and services the debt, under the Government Securities Act, 2006 and the agreements with the Governments.

Monetisation of the deficit

Until the 1990s, the Central Government financed itself in part by issuing ad hoc treasury bills to the Reserve Bank whenever its balance fell below a floor. The effect was automatic monetisation of the deficit, with the Bank creating money to meet Government spending and losing any real control over the money supply. An agreement of 1994 phased the practice out, and from 1997 ad hoc bills were replaced by ways and means advances under Section 17(5), which are limited in amount and repayable within three months. The Fiscal Responsibility and Budget Management Act, 2003 carried the discipline further: the Central Government may not ordinarily borrow from the Bank, and the Bank may subscribe to primary issues of Central Government securities only on the exceptional grounds the Act specifies. The Bank remains free to buy and sell those securities in the secondary market, which is how open market operations are conducted.

5. Banker to Banks

• Accounts with the Bank: scheduled banks maintain current accounts with the Reserve Bank, through which interbank settlement, clearing and remittance are effected.
• Cash reserves (Section 42(1)): every scheduled bank must maintain with the Bank an average daily balance of a percentage of its net demand and time liabilities, the cash reserve ratio. A non-scheduled bank keeps its reserve under Section 18 of the Banking Regulation Act instead.
• Scheduling (Section 42(6)): the Bank includes a bank in the Second Schedule on being satisfied as to its paid-up capital and reserves of not less than ₹5 lakh and that its affairs are not conducted in a manner detrimental to the interests of its depositors, and may remove it when those conditions cease.
• Returns and penalties: scheduled banks must submit returns of their liabilities and assets, and a shortfall in the reserve attracts penal interest under Section 42(3).
• Liquidity operations: the Bank supplies and absorbs liquidity daily through the liquidity adjustment facility, which rests on the repurchase of Government securities and on the standing facilities.

6. Questions Arising

Should debt management be separated from the Reserve Bank?

There is a recognised conflict of interest. As manager of the public debt, the Bank has an interest in low borrowing costs for the Government; as monetary authority, it may need to raise rates. Proposals for an independent Public Debt Management Agency have been made and deferred more than once. The argument for keeping the function with the Bank is that debt management, monetary operations and the regulation of the Government securities market are difficult to separate in a market that the Bank itself largely created.

Does the lender of last resort function extend to cooperative banks and non-banks?

Section 17(4) names local authorities, scheduled banks, State cooperative banks and State financial corporations, so the ordinary window is confined to those. Section 18 is wider in its terms, since on a special occasion it permits loans to a State cooperative bank, to a cooperative society on that bank's recommendation, or to any other person, on such terms and conditions as the Bank considers sufficient. In recent crises the Bank has generally supported other institutions indirectly, by providing liquidity to banks against the paper of those institutions, rather than by lending to them directly.

7. Quick Revision

8. Frequently Asked Questions

What does it mean that the Reserve Bank is the lender of last resort?

That it stands ready to lend to banks that cannot obtain liquidity elsewhere, so that a temporary shortage does not become a collapse. The statutory basis is Section 17(4), for ordinary advances against eligible security, and Section 18, which allows the Bank on a special occasion to discount ineligible paper and to lend for up to ninety days on such terms and conditions as it considers sufficient, notwithstanding the limits in Section 17.

What are ways and means advances?

Short-term advances by the Reserve Bank to the Central or a State Government under Section 17(5) to bridge a temporary mismatch between receipts and expenditure. They are repayable within three months and are subject to limits fixed in consultation with the Government. They replaced the ad hoc treasury bills that had produced automatic monetisation of the deficit.

Can the Reserve Bank pay interest on deposits?

As a rule, no. Section 19 forbids it save as Section 17 expressly authorises, and the only such authority is Section 17(1A), inserted by the Finance Act, 2018, under which the Bank pays interest on deposits placed under the standing deposit facility for liquidity management. The general rule is both practical and structural: the Bank's deposits are the reserves of the banking system and the balances of Governments, not commercial funds competing for a return, and interest-free liabilities are what enable the Bank to earn a surplus that it transfers to the Government.

Can the Reserve Bank lend directly to the Central Government?

Only within narrow limits. It may make ways and means advances under Section 17(5), repayable in three months. The FRBM Act, 2003 otherwise restricts Government borrowing from the Bank and permits the Bank to subscribe to primary issues of Union securities only on the exceptional grounds the Act specifies. The Bank buys and sells those securities freely in the secondary market.

How does Section 42 of the RBI Act differ from Section 24 of the BR Act?

Section 42(1) of the RBI Act requires a scheduled bank to keep the cash reserve ratio as a balance with the Reserve Bank. Section 24 of the Banking Regulation Act requires every banking company to maintain the statutory liquidity ratio in cash, gold or unencumbered approved securities maintained by the bank itself. The first is a monetary instrument; the second is a prudential one.

9. Related Topics and Provisions

• Establishment and management of the Reserve Bank
• Note issue and currency management
• Monetary policy and the Monetary Policy Committee
• Instruments of monetary control
• Reconstruction and amalgamation of banks (Section 45)
• Structure of the Indian banking system