Describe in brief the factors that led to the establishment of Reserve Bank of India (RBI) in the country.

Pre-RBI Monetary System: A Landscape of Weaknesses

Before 1935, India’s monetary and banking system was characterized by several weaknesses:

• Lack of a Central Bank: There was no single institution responsible for currency issuance, managing the government’s accounts, and regulating the banking sector.
• Currency Board System: The currency system operated under the Currency Board system established in 1898, which was primarily focused on maintaining the convertibility of the rupee to sterling. This system lacked the flexibility to respond to domestic economic needs.
• Government Control: The government directly managed currency issuance and exchange rates, leading to a lack of independence and potential for political interference.
• Limited Banking Penetration: The banking sector was underdeveloped, with limited access to credit, particularly for agriculture and small businesses.
• Frequent Banking Crises: The absence of a lender of last resort and effective regulation led to frequent banking failures and loss of public confidence.

Impact of World War I (1914-1918)

World War I significantly exacerbated the weaknesses of the Indian monetary system:

• Increased Demand for Credit: The war led to a surge in demand for credit to finance war-related expenditures.
• Inflationary Pressures: Increased government spending and disruptions to supply chains caused significant inflationary pressures.
• Strain on Exchange Rate: Maintaining the fixed exchange rate with sterling became increasingly difficult due to the war’s impact on international trade and finance.
• Metal Shortages: The war led to shortages of precious metals, impacting the currency board system.

These challenges highlighted the urgent need for a more robust and flexible monetary system capable of managing economic shocks.

Key Committees and Recommendations

The Chamberlain Commission (1926)

The Chamberlain Commission, appointed in 1926, was the first significant attempt to address the shortcomings of the Indian monetary system. It recommended:

• The establishment of a central bank to manage currency, credit, and banking regulation.
• The separation of commercial banking from central banking functions.
• The introduction of a managed paper currency system.

The Hilton Young Commission (1926)

The Hilton Young Commission, also appointed in 1926, further elaborated on the recommendations of the Chamberlain Commission. It specifically recommended:

• The establishment of the Reserve Bank of India (RBI) as a central bank with a clear mandate for monetary management and banking supervision.
• The RBI should be initially managed by a central board with a majority of Indian members.
• The RBI should have the power to issue currency, regulate credit, and act as a banker to the government and commercial banks.

The Reserve Bank of India Act, 1934

Based on the recommendations of the Chamberlain and Hilton Young Commissions, the British Parliament passed the Reserve Bank of India Act in 1934. This Act:

• Established the Reserve Bank of India as a legal entity.
• Defined the RBI’s objectives, functions, and powers.
• Provided for the establishment of a central board and a local board to oversee the RBI’s operations.
• Authorized the RBI to issue currency notes and regulate the banking sector.

Political and Economic Motivations

Beyond the economic necessities, several political factors also contributed to the establishment of the RBI:

• Growing Nationalist Sentiment: Indian nationalists increasingly demanded greater control over the country’s economic policies, including monetary policy.
• Desire for Financial Stability: The British government recognized the need for a stable financial system to promote economic growth and maintain political stability in India.
• Influence of International Best Practices: The establishment of central banks in other countries, such as the United States and Canada, served as a model for India.