Money Supply and the Banking System
Functions of money, M0 to M3 and the money multiplier, the RBI's role, India's banking structure, NPAs, capital adequacy and banking reforms for UPSC.
SyllabusGS III · Indian economy and issues relating to mobilisation of resources; money, banking and the financial system
Prerequisites: Money and Banking: overview · National Income and Growth
The Hook: The Night Two Notes Stopped Being Money
On the evening of 8 November 2016, the Government of India announced that the ₹500 and ₹1,000 notes then in circulation (the “specified bank notes”) would cease to be legal tender from midnight. The RBI’s Annual Report for 2017-18 later reported that almost all of their value, about 99.3%, had come back into the banking system.
A piece of paper had been money one evening and was not money the next morning. The question this raises: what makes something money, who creates it, and how much of it is there?
The Core Concept
What money is and does
Money is anything generally accepted in exchange for goods and services and in settlement of debts. Modern money is fiat money: it has value because the State declares it legal tender, not because of the metal or paper in it.
| Function | Meaning |
|---|---|
| Medium of exchange | Removes the “double coincidence of wants” of barter |
| Unit of account | Common measure of value for all goods |
| Store of value | Holds purchasing power over time (eroded by inflation) |
| Standard of deferred payment | Debts are written and repaid in money |
Who issues currency in India
- Bank notes: the RBI has the sole right to issue bank notes (Section 22, RBI Act, 1934). Denominations are set by the Central Government on the RBI’s recommendation (Section 24).
- Coins and one-rupee notes: issued by the Government of India (Ministry of Finance); coins are minted at government mints and put into circulation through the RBI.
- Backing: since the late 1950s the RBI follows the Minimum Reserve System: it must hold gold coin, bullion and foreign securities worth at least ₹200 crore, of which at least ₹115 crore must be gold (Section 33).
- Digital rupee: the Finance Act, 2022 amended the RBI Act to enable the RBI to issue bank notes in digital form (a central bank digital currency). The RBI’s e-₹ pilots began on 1 November 2022 (wholesale) and 1 December 2022 (retail).
Measuring money supply
The RBI publishes monetary aggregates based on the Second Working Group on Money Supply (1977):
| Measure | Composition | Nature |
|---|---|---|
| M0 (reserve money) | Currency in circulation + bankers’ deposits with the RBI + “other” deposits with the RBI | High-powered money |
| M1 (narrow money) | Currency with the public + demand deposits with banks + “other” deposits with the RBI | Most liquid |
| M2 | M1 + savings deposits with post office savings banks | |
| M3 (broad money) | M1 + time deposits with banks | Most watched broad measure |
| M4 | M3 + all deposits with post office savings organisations (excluding National Savings Certificates) | Least liquid |
Liquidity falls from M1 to M4. “Other deposits with the RBI” are the deposits of quasi-government bodies, foreign central banks and international institutions held at the RBI; they are not bank deposits.
The money multiplier: how banks create money
When a bank receives a deposit, it keeps a fraction as reserves (cash reserve ratio, CRR) and lends the rest. The loan is spent and re-deposited, and the cycle repeats. Reserve money is the base; broad money is the building.
$$\text{Money multiplier} = \frac{M3}{M0}$$In the simple textbook case where the public holds no cash, the deposit multiplier is
$$m = \frac{1}{r}$$where $r$ is the reserve ratio. With a CRR of 10%, ₹100 of new reserves can support up to ₹1,000 of deposits. Once the public’s currency–deposit ratio $c$ is added,
$$m = \frac{1 + c}{c + r}$$So the multiplier falls when the CRR rises or when people hold more cash (as during a banking scare), and rises when people shift to digital payments and bank deposits.
The Reserve Bank of India
| Fact | Detail |
|---|---|
| Recommended by | Hilton Young Commission (Royal Commission on Indian Currency and Finance, 1926) |
| Law | Reserve Bank of India Act, 1934 |
| Started operations | 1 April 1935, as a private shareholders’ bank |
| Nationalised | 1 January 1949 |
| Headquarters | Moved from Calcutta to Bombay in 1937 |
Functions: issuer of currency; banker to the Central and State Governments (manages their accounts and public debt); banker’s bank and lender of last resort; regulator and supervisor of banks (Banking Regulation Act, 1949) and of NBFCs; custodian of foreign exchange reserves and manager under FEMA, 1999; monetary authority; regulator of payment systems (Payment and Settlement Systems Act, 2007).
The structure of Indian banking
graph TD
A["Reserve Bank of India"] --> B["Scheduled banks: in the Second Schedule of the RBI Act"]
A --> C["Non-scheduled banks"]
B --> D["Scheduled commercial banks"]
B --> E["Scheduled cooperative banks"]
D --> F["Public sector banks"]
D --> G["Private sector banks"]
D --> H["Foreign banks"]
D --> I["Regional Rural Banks"]
D --> J["Small finance banks"]
D --> K["Payments banks"]Differentiated banks (licences from 2015, following the Nachiket Mor Committee on financial services for small businesses and low-income households):
| Feature | Payments bank | Small finance bank |
|---|---|---|
| Deposits | Demand deposits only, with a per-customer cap (raised from ₹1 lakh to ₹2 lakh in 2021) | All deposits |
| Lending | Cannot lend | Can lend; 75% of adjusted net bank credit to the priority sector |
| Cards | Debit / ATM cards; no credit cards | Debit and credit cards |
| Purpose | Payments, remittances, small savings | Credit to small businesses, farmers, unorganised sector |
Milestones of banking reform
| Year | Event |
|---|---|
| 1949 | Banking Regulation Act; RBI nationalised |
| 1955 | Imperial Bank of India becomes State Bank of India (All India Rural Credit Survey Committee) |
| 1969 | 14 banks nationalised (19 July) |
| 1975-76 | Regional Rural Banks (ordinance 1975, RRB Act 1976); shareholding Centre 50%, sponsor bank 35%, State 15% |
| 1980 | 6 more banks nationalised (15 April) |
| 1982 | NABARD set up (12 July) |
| 1991, 1998 | Narasimham Committees I and II on financial sector and banking reform |
| 2002 | SARFAESI Act: banks can enforce security without courts |
| 2016 | Insolvency and Bankruptcy Code |
| 2020 | 10 public sector banks amalgamated into 4 (effective 1 April 2020); deposit insurance raised to ₹5 lakh |
Bad loans and bank safety
- Non-performing asset (NPA): a loan on which interest or principal has remained overdue for more than 90 days. NPAs are classified as sub-standard (NPA for up to 12 months), doubtful (sub-standard for 12 months) and loss assets.
- Twin balance sheet problem: the Economic Survey 2016-17 described over-leveraged companies and stressed bank balance sheets dragging each other down. The policy response is often summarised as the “4Rs”: recognition (Asset Quality Review, 2015), resolution (IBC, 2016), recapitalisation of public sector banks, and reforms.
- Capital adequacy: under Basel III, banks must hold capital against risk-weighted assets. The RBI sets the minimum capital to risk-weighted assets ratio (CRAR) at 9% (Basel’s minimum is 8%), plus a capital conservation buffer of 2.5%.
- Prompt Corrective Action (PCA): RBI restrictions on banks that breach thresholds for capital, asset quality or leverage.
- Deposit insurance: the Deposit Insurance and Credit Guarantee Corporation (DICGC), a wholly owned RBI subsidiary, insures deposits up to ₹5 lakh per depositor per bank (from 4 February 2020; earlier ₹1 lakh).
Memory Anchors
Money supply ladder: “1 is Demand, 3 is Time” → M1 adds demand deposits; M3 adds time deposits. M2 and M4 are the post office cousins of M1 and M3.
Nationalisation dates: “14 in ‘69, 6 in ‘80”: fourteen banks in 1969, six in 1980.
RRB shareholding: “50-35-15”: Centre, sponsor bank, State.
Payments bank in one line: “Takes your money, moves your money, never lends your money.”
For Prelims
- M1 = currency with public + demand deposits + other deposits with RBI; M3 = M1 + time deposits. M3 is broad money.
- Reserve money (M0) includes bankers’ deposits with the RBI.
- The money multiplier falls when CRR rises or when the public holds more cash.
- One-rupee notes and coins are issued by the Government of India, not the RBI.
- Minimum Reserve System: ₹200 crore of gold and forex, of which ₹115 crore gold.
- RBI: Act of 1934, operations from 1 April 1935, nationalised 1 January 1949.
- NPA = overdue for more than 90 days. DICGC cover = ₹5 lakh per depositor per bank.
- Payments banks cannot lend or issue credit cards.
For Mains
- Dimensions: mobilisation of savings, credit to productive sectors, financial inclusion, financial stability, governance of public sector banks, regulatory architecture.
- Keywords: financial intermediation, maturity transformation, moral hazard, evergreening, twin balance sheet, recapitalisation, resolution, consolidation, differentiated banking.
- Value-addition: the Narasimham Committee (1991) recommended reducing CRR and SLR, deregulating interest rates and allowing new private banks. The P.J. Nayak Committee (2014) examined the governance of bank boards. The Economic Survey 2016-17 coined “twin balance sheet”. The IBC (2016) shifted control from “debtor in possession” to “creditor in control” during insolvency resolution.
Common Traps
In the News
- April 2020: ten public sector banks amalgamated into four; the number of public sector banks fell to 12.
- December 2022: the RBI launched the first retail pilot of the digital rupee (e-₹), after the wholesale pilot in November 2022.
- May 2023: the RBI announced the withdrawal of ₹2,000 notes from circulation; they continue to be legal tender.
Practice
Prelims
Consider the following statements:
- M3 is a measure of broad money in India.
- M1 includes time deposits held with commercial banks.
- Reserve money includes the deposits of commercial banks with the Reserve Bank of India.
Which of the statements given above is/are correct?
Solution
Statement 1 is correct: M3 (M1 + time deposits) is broad money. Statement 2 is incorrect: M1 includes demand deposits; time deposits enter only in M3. Statement 3 is correct: reserve money (M0) = currency in circulation + bankers’ deposits with the RBI + other deposits with the RBI.
Answer: C
Which one of the following activities is a payments bank in India not permitted to undertake?
Solution
Payments banks can accept demand deposits (subject to a per-customer cap), issue ATM and debit cards, and offer payments and remittance services. They cannot lend and cannot issue credit cards; that restriction is what separates them from small finance banks.
Answer: B
If the RBI raises the cash reserve ratio while the public’s currency–deposit ratio stays the same, the money multiplier:
Solution
The multiplier is (1 + c) ÷ (c + r). Raising r (the reserve ratio) increases the denominator, so the multiplier falls. Banks must park a larger share of each deposit with the RBI and can lend less, so less money is created per rupee of reserve money.
Answer: A
Mains
What is the “twin balance sheet” problem? Examine the measures taken to resolve the stressed assets of Indian banks.
Solution
Introduction: The Economic Survey 2016-17 used “twin balance sheet” to describe two linked problems: over-leveraged companies unable to service debt, and banks weighed down by the resulting non-performing assets, each holding back investment and credit.
Body:
- Origins: infrastructure and commodity-linked lending in the boom years, project delays, falling commodity prices, and evergreening of loans.
- Recognition: the RBI’s Asset Quality Review (2015) forced banks to recognise hidden stress.
- Resolution: the Insolvency and Bankruptcy Code (2016) with time-bound resolution and “creditor in control”; SARFAESI Act (2002); asset reconstruction companies.
- Recapitalisation: capital infusion into public sector banks, including through recapitalisation bonds.
- Reforms: Prompt Corrective Action framework; amalgamation of public sector banks (2019-20); governance reforms in bank boards.
- Continuing challenges: delays in IBC timelines, low recovery in some cases, and the need for better credit appraisal.
Conclusion: The “4R” approach (recognition, resolution, recapitalisation, reforms) cleaned up bank balance sheets. Keeping them clean needs sound credit appraisal, independent bank boards and a faster insolvency process.
Quick Revision
| Point | One-liner |
|---|---|
| M1 | Currency with public + demand deposits + other deposits with RBI |
| M3 | M1 + time deposits (broad money) |
| M0 | Currency in circulation + bankers’ deposits with RBI + other deposits with RBI |
| Multiplier | M3 ÷ M0; falls when CRR or cash-holding rises |
| Note issue | RBI, Section 22; coins and ₹1 notes by the Government |
| RBI | Act 1934; operations 1935; nationalised 1949 |
| Nationalisation | 14 banks in 1969; 6 in 1980 |
| NPA | Overdue more than 90 days |
| CRAR (RBI) | 9% + 2.5% capital conservation buffer |
| Deposit insurance | ₹5 lakh per depositor per bank (DICGC, 2020) |
Key Takeaways
- M1 adds demand deposits, M3 adds time deposits; reserve money is the base on which banks build broad money.
- The RBI issues notes; the Government issues coins and one-rupee notes.
- India’s banking has layers: scheduled commercial, cooperative, RRBs and differentiated banks, each with different permissions.
- Bank health rests on recognising NPAs early, adequate capital and a credible insolvency process.
Related Topics
- Money and Banking: quick revision
- Money and Banking: practice questions
- Monetary Policy and Inflation: CRR, SLR and repo in action
- Capital Markets and Financial Inclusion
- Money Laundering and Organised Crime