By Amol Agrawal
At the start of this year, there was a buzz around the first monetary policy of the newly appointed Reserve Bank of India (RBI) Governor Sanjay Malhotra. 2025 also marks 90 years of the RBI’s first monetary policy. In 1935, the RBI was established and announced its first monetary policy by fixing bank rate and cash reserve ratio (CRR).
The idea of bank rate came from the Bank of England (BOE). BOE was established in 1694 to provide wartime loans to the British empire at an interest rate named as bank rate. The East India Company established three Presidency Banks in Bengal, Bombay, and Madras; it used the term for their interest rates. In 1921, the three Presidency Banks merged to form Imperial Bank and there was now one bank rate. Imperial Bank played a limited central banking role by acting as a banker to banks and the government. In the discussions on establishing a central bank in India, it was thought to make Imperial Bank the central bank. However, after the Hilton Young Commission Report in 1926, it was decided that a new entity — Reserve Bank of India — will serve as the central bank of India.
The RBI Act (1934) stated in its preamble its function “to regulate the issue of bank notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage”. The new central bank needed monetary instruments to act on the preamble.
Given its familiarity with the term, the RBI also adopted the bank rate as its major policy rate. The RBI Act (1934) specified the bank rate as a standard rate “at which it is prepared to buy or re-discount bills of exchange or other commercial paper eligible for purchase under this Act”. The new bank rate will determine the overall interest rate structure in the economy. Unlike the Imperial Bank’s bank rate, which was a rate on advances against government bonds, the RBI’s bank rate was a discount rate where loans would be made on good-quality trade bills not exceeding 28 days.
The history of the CRR does not originate from the British shores but from America. The first RBI History Volume (1935-51) mentions that the idea of the CRR “followed the pattern of the Federal Reserve Act of the USA, rather than that of the UK and the Continent of Europe”. The CRR enabled the central bank to control the flow of reserves in the economy and also helped in case of bank failures which were rampant in the period. The RBI also specified the penalties in case banks were not able to meet CRR provisions.
Apart from the bank rate and the CRR, the RBI also had open market operations (OMO) in its arsenal of monetary policy instruments. Under OMO, the central bank bought and sold government securities to manage liquidity in the markets. As part of its monetary policy, the central bank was also required to keep the exchange rate at
1 shilling and 6 pence, a level which was a matter of deep frictions between Indian nationalists and colonisers. The nationalists thought that the currency level should be more devalued to boost exports from India whereas the British wanted a higher rate for cheaper imports from Britain.
Given this background, let us come to the RBI’s first monetary policy. On July 3, 1935, the RBI Central Board fixed the bank rate at 3.5% tracking the Imperial Bank’s bank rate which was also 3.5%. The inter-bank call rate also hovered between 3 and 3.5% in the first half of 1935. The CRR was fixed on July 5, 1935, at 5% of demand liabilities and 2% of time liabilities. In 1973, a common CRR was imposed for both demand and time liabilities. In the 1980s, the CRR was often raised along with its ally, SLR (statutory liquidity ratio), which was introduced in 1949.
There is also a very interesting history of early disputes on monetary policy between the government and the central bank. In modern central banking, the frictions are usually with governments wishing lower interest rates while central banks are reluctant to lower them. In 1935, it was the other way round. The central bank lowered the bank rate in November 1935 to 3%, which was not liked by the government as it thought it would impact the exchange rate. The episode got heated leading to the resignation of the first governor, Osborne Smith. The next bank rate was changed 16 years later in 1951 and the CRR in 1960.
Ninety years later, the bank rate and the CRR have gave given way to the repo rate. The developments in financial markets pushed central banks to manage interest rates and infuse liquidity by using repo rates rather than discount rates and reserve ratios. The bank rate is now used as a penal rate for shortfalls in reserve requirements and changes automatically with changes in the repo rate. The conduct of monetary policy has changed in the 90 years between governor Smith and governor Malhotra. However, the monetary policy’s broad objective of managing interest rates and money supply remains unchanged.
The author teaches at Ahmedabad University.
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