Establishment of the Central Bank for India

After reading this article you will learn about the establishment of the central bank for India.

In order to bring some sound monetary policy, Industrial and agricultural development, provision for establishing sound principles for the upliftment of trade commerce and in manufacturing sectors a co-ordination among the banks constituted under the Company Act or otherwise including indigenous banks was immediately required.

Although after amalgamating three Presidency Banks a larger Bank The Imperial bank of India was constituted but it was functioning like a quasi- central bank where as the prevailing economic conditions particularly regulating Issue of note, money supply, money maintenance, economic policy, Monetary system, payments system and above all for regulating and controlling the banking system in India badly needed a centralized Institution which could function as a central bank of India.

Due to economic crises during 1913-17 and later in 1922 a number of banks had failed because of their unregulated activities. These circumstances created a need to seriously consider establishment of Central Bank for India. The efforts of creating a banking institution with central banking character had been considered from time to time.

In late 18^th century in 1773 a bank with character of a central bank was established in Bengal on the recommendations of Governor of Bengal but it could not live for a long time. For this central bank proceedings of the Council of Revenue were held at Fort William on 13th April 1773. But the court of Directors of East India Co. wanted certain changes in respect of the bank and they had also written to Governor-General in Council in this regard.

Such changes were opposed by Mr. Hasting and Mr. Barwell but these were over ruled by another members who succeeded in getting passed a resolution on 15,2,1775 providing for closure of the Bank.

The main view was that bank did not afford the relief which was expected. Even during the short period of its existence, the bank had considerable profits, of which the than Government took half share. After this effort’s failure, the next efforts of merging three presidency banks and establishing a larger bank, the Imperial Bank of India could also not provide the desired results and stability.

Another effort for establishment of a Central Bank was made by, a member of Bombay Government. He had in 1807-08 prepared a scheme for a General Bank

As per him:

“Having since my reappointment in India, reflected much on the financial state of the Indian Govt., the amount of public debt, the difficulties it is likely to entail and the danger of its increase, a plan has suggested itself of diminishing the weight of this heavy burden, connected with other public advantages, which I venture to submit to the favorable consideration of Government and that of the Court of Directors.”

As per his proposal the bank was to be owned jointly by the Public and the Government in proportion of 2:1.

The Governor General in Council of Bengal, to whom the scheme was submitted for consideration expressed – “The idea of Mr. Richard appeared to us to resolve themselves into mere speculation, without embracing objects capable of being realized while the machinery proposed by the gentleman for the performance of a very simple operation, was extremely cumbersome and complicated.”

The scheme was rejected by East India Company.

In 1926 the Royal Commission of Currency & Finance (Hilton Young Commission also known as young commission after carrying out wide spread survey on currency, economy and banking conditions recommended for a Central Bank to take over the entire control of banks to end the dichotomy of functions and divisions of responsibilities for control of currency and credit. The recommendations envisaged that the central bank should have its separate existence for augmenting banking functions throughout the country.

Sir Hilton Young had vast experience on financial matters and had been working as financial journalist writing for the ECONOMIST. He was London correspondent of the Financial Supplement of the New York Times. Later in 1915 he was elected to the House of Commons. Before recommending the central bank for India he had in 1925 prepared a scheme for the Government of Iraq for enabling them to issue their own currency through a Board located in London.

Before having their currency the Indian Rupee was introduced in Iraq by the British expeditionary forces. Firstly Iraq did not accept the proposal but later in 1930 Iraq agreed to the proposal as London based currency board model was already in use by Britain in numbers of its colonies. Mr. Hilton Young also played a vital role in establishing the framework in which the Iraq Currency Board was to operate.

Mr. Hilton Young had also headed a mission to Poland from 1923-25 to help establish a stable economy which introduced the Zloty. In 1925-26 he was Chairman of a Royal Commission on Indian finance, which inter-alia drew up the constitution of the Reserve Bank of India) He also served as a Director of British Bank of Middle East.

Hilton Young Commissions recommendations for creating a Central Bank for India was backed by Mr. Hilton’s rich experience in financial, economic and banking matters. But it was not so easy that the recommendations were accepted solo motto. The bill to establish a central bank for India was first introduced in January 1927 in the Legislative Assembly.

A long drawn discussion among members took place with large number of differences in views regarding ownership, constitution and composition of its Board of Directors that made the whole atmosphere so clouded that the proposal was dropped. For the purpose of brevity it may not be possible to reproduced the entire proceedings but a few excerpts of main and related matters can well be mentioned.

The Young Commission had proposed the Central Bank for India be named as Reserve Bank of India. Shri L.C.Jain, Professor, University of Punjab, Lahore had made a very analytical study of the entire legislative proceedings and the recommendations of the Young Commission.

The following points were considered during the legislative proceedings as analysed by Prof. L.C.Jain 1933:

1. What should be the Name of Central Bank:

First of all what is a Central Bank and on what principles it should be based. If the purpose is to centralizes the control of all banks it should be known as central bank and not the Reserve Bank. As regards the meaning of a Central Bank, it can be and has been defined in many ways.

But in simple words a Central Bank may be described as:

“The people’s agency to govern their supply of currency and credit, free from any undue influence of political or profits.”

The purpose of Hilton Young Commission 1926 in suggesting the name as Reserve Bank was to avoid ambiguity. In India a number of banks existed having concept or nomenclature suggesting the name of Central Bank For Example Bank of India, Central Bank of India, Indian Bank etc. but none of which was functioning like a central bank as had been suggested in the Royal Commissions Report.

The Central Bank of Africa was also founded in 1920 with the similar name i.e., Reserve Bank of South Africa. In view of this consideration the name of the Reserve Bank seemed quite suitable and people had also become familiar with it since it had been used not only in the report of the Hilton Young Commission, but also in number of reports of the provincial and Indian Banking Enquiry Committees (1929-31).

2. What should be Functions and Mechanism of Reserve Bank:

Having noted the meaning of a Central or Reserve Bank, two simple questions must now be answered viz., what does a Central Bank do and how does it do it?

According to the Indian Central Banking Enquiry Committee (1929-31), the two principal tasks of the Reserve Bank will be to maintain the inter- national value of the rupee and to control the credit situation in India, which would include the rate of interest at which credit would be available to trade and industry’.

As per the report of Indian central enquiry committee 1931.

It should have the sole right of note issue; it should be the channel, and the sole channel, for the output and intake of legal tender currency. It should be the holder of all the Government balances; the holder of all the reserves of the other banks and branches of banks in the country. It should be the agent, so to speak, through which the financial operations at home and abroad of the Government would be performed.

It would further be the duty of a central bank to effect, so far as it could, suitable contraction and suitable expansion, in addition to aiming generally at stability, and to maintain that stability within as well as without. When necessary it would be the ultimate source from which emergency credit might be obtained in the form of rediscounting of approved bills, or advances on approved short securities, or Government paper.

The conclusion off discussions on the recommendations and reports was that a central Bank must have four functions or rights:

1) The right of note issue.

2) The right to hold the reserves of the commercial banks.

3) The right to buy and sell securities, and

4) The right to discount.

The above four functions were strongly recommended by the Committee on Finance and Industry in its report of 1931. The committee was of the view that the main objective of a central Bank is to maintain stability in the value of money or, which is the same thing, steady prices.

No institution can ensure in country stability in the value of money unless it possesses requisite means to regulate the supply of currency and credit in accordance with their demand. That is what the above rights enable a Central Bank to do. How exactly they do it is the next question.

Mechanism:

It should be obvious that the twin rights of note issue and holding the reserves of the commercial banks place the Central Bank in the best position to control the existing supply of currency and credit.

As the only bank of issue it has the power, broadly speaking, to expand and contract currency, as it may deem fit; while in its capacity as the custodian of the reserves of commercial banks, it occupies the position of a sovereign bank, bankers’ bank or a Central Bank a bank which is the central supervisory body to co-ordinate the activities of all banks in the country.

Safeguards and Restrictions:

Safeguards:

It should by now be clear that a Central Bank has very wide powers in the realm of finance for it is charged with the supreme duty of maintaining stability in the value of money or a steady price-level and, therefore, equipped with the sole right of note issue coupled with the custody of the nation’s ultimate cash reserves both governmental and banking.

A Central Bank is thus both a Bankers’ Bank and a State Bank in the sense that it serves both the banks as well as the State. But it is more. It is the Nation’s Bank which exists for the larger service of the nation, sectional interests having no place in it.

This fact will explain the importance which attaches to the proper constitution of a Central Bank An ill-conceived Central Bank can be a source of much national harm, but a well- planned Central Bank is an asset of great national good.

A study of the different constitutions of Central Banks of the world shows that a Central Bank, if it is to run strictly on lines of prudential finance and in national interests, must be adequately safe­guarded from all undue influence of politics or profits, from sectional influences whether of institutions or individuals, and particularly from all extraneous and foreign influences.

Restrictions:

In view of these considerations it is usual to impose various restrictions on a Central Bank from which ordinary banks are free. In the first place, to save a Central Bank from the irruption or interruption of changing politics it is expedient to exclude from its management both government officials and members of the legislature.

In this regard, the position must be made perfectly clear. The ultimate responsibility for the stability of national currency must, of course, rest with the national government. But in the interests of such stability itself, it is best that the regulation of currency and credit is in the hands of a bank free from governmental control.

Flexibility in Constitution of Central Bank:

Once the main safeguards and restrictions are provided for, the Central Bank constitution must not be too rigid, but left as flexible as possible and permitted to develop sound traditions of its own, suited to the particular needs and prospects of the country.

In fact, while there is agreement on broad principles, the theory of central banking is of recent origin and its technique is still capable of improvement. It would be as foolish not to derive full advantage from the past experience of other countries as not to seek fresh light in new experiments and research.

In view of above analysis of commissions report the than prevailing position of Indian currency and credit was at large under active consideration to establish a Central Bank in India. A central bank broadly correlates the demand and the supply of currency and credit or is a media of purchasing power and does it in a way in which no other agency has been able to do so.

In India at that time, the agency for the control of currency was the Government itself. But the credit was under no effective control. It was influenced by the policy and practice of Imperial Bank of India which to a large extent was dominated by Government. As regards currency control, the position must be viewed both from the side of demand and of supply.

The demand for currency naturally arises from, and changes with, the requirement of trade and Industry. No Govt. however efficient can estimate it so easily and so well as a Bank. No doubt the Indian currency system at the time was one of the major evils.

According to the Royal Commission of Indian Currency and Finance the system does not secure the automatic expansion and contraction of currency. Such movements are too wholly dependent on the will of the currency authority. Nor is there effective provision for meeting seasonal variations, so prominent in an agricultural country like India, due to the requirements for financing the movements of crops.

“Again, as the Royal Commission pointed out, a well-regulated system should provide for a measure of elasticity in the expansion of currency in case of great financial crisis, when the need for additional cash for the support of credit is urgent. In such cases it is necessary to provide for an emergency issue of currency on special terms. The Indian system makes no express provision of the sort.”

After a great deal of exercise the Royal Commission was definitely of the opinion that the management of the legal tender note issue should be placed in the hands of a non-political and independent body, which shall control the conditions of issue and shall have full control and custody of the securities it holds.

3. Position of Credit:

Turning from currency to credit, the position was somewhat peculiar. India was not altogether lacking in the elements which go to make up a sound banking system. There did exist in the country indigenous bankers, co-operative societies, commercial banks, exchange banks, savings banks, investment securities, even some bills of exchange and stock exchanges, but they are all ill-developed and lack co-ordination.

Mr. L.C. Jain in his book “Monetary problems of India, 1933”, has in depth examined the Indian position. The banking reserves of the country were scattered among various agencies with no mechanism for their mobilisation, while credit, was also divorced from currency.

This was perhaps the greatest weakness of the banking system in India, and was responsible for the evils of fluctuating and high rates of interest. An annual range of three per cent, in interest rates was unheard of in other countries, but was quite ordinary in India and exercises a detrimental influence on the economic life of the country.

Some people seemed to imagine that high rates of interest naturally follow from seasonal stringency. But, as the foreign experts rightly pointed out, this was a wrong conception.

‘It is one of the principal tasks of a properly managed and well organised Reserve Bank to tide over busy periods when money is in strong demand without unduly raising the bank-rate. The absence of a mechanism, which by expanding credit can meet the seasonal demand for money, is mainly responsible for the variation in the bank rate.’