Banking Sector: Money & Banking- 1 - Free MCQ Test with solutions for UPSC

A: It is the difference between the loan amount and the actual value of the asset used as collateral.

Haircut refers to the difference (usually expressed as an absolute amount or a percentage) between the market value of collateral and the amount lent against that collateral. It is set to protect the lender from losses if the collateral's value falls or if it is costly or slow to liquidate.

The common calculation is: Haircut (%) = (1 - Loan amount / Market value of collateral) × 100. For example, if collateral is worth 100 and the lender advances 80, the haircut is 20 (or 20%).

The term is used in secured lending, including repos and margin lending, and is determined by factors such as price (market) risk, liquidity risk, credit risk, and the expected time and cost to sell the collateral. In a different context (debt restructuring), "haircut" can also mean a negotiated reduction in the amount creditors receive compared to the face value of debt.

The Reserve Bank of India will purchase government securities in the open market.

When upward pressure in money markets leads to higher interest rates, the appropriate response is to restore adequate liquidity so that credit flows smoothly. Keeping the central bank's stance unchanged would allow rates to remain elevated.

An open market purchase of government securities injects funds into the banking system by increasing bank reserves. This raises the effective money supply, eases liquidity conditions and helps bring down market interest rates, making borrowing and lending easier.

By contrast, selling government securities, raising the repo rate, or increasing the Statutory Liquidity Ratio (SLR) would all be contractionary actions that withdraw liquidity and would tend to push interest rates up further, so they are not suitable when the aim is to ease liquidity pressure.

C: 2 and 3 only

Statement 1 is incorrect. The Reserve Bank permits banks to engage in the co-lending model (CLM) with NBFCs; banks are not prohibited from co-lending to achieve PSL targets. The 2025 guidelines strengthen safeguards (for example, requiring appropriate documentation and external/audit certification) to prevent duplicate claims, but they do not ban co-lending.

Statement 2 is correct. Under the 2025 PSL Guidelines the target for Small Finance Banks (SFBs) has been specified as 60% of Adjusted Net Bank Credit (ANBC) (replacing the earlier requirement of 75% in prior frameworks).

Statement 3 is correct. The guidelines allow banks to classify export credit extended to the agriculture sector as eligible for Priority Sector Lending (PSL), subject to the sectoral definitions and documentation requirements laid out in the guidelines (similar treatment applies to specified export credit for MSMEs where applicable).

Conclusion: only statements 2 and 3 are correct; statement 1 is incorrect.

Only three

SLR (Statutory Liquidity Ratio) requires banks to maintain a prescribed portion of their net demand and time liabilities in the form of cash, gold and approved securities (for example, government dated securities and treasury bills).

Accordingly, treasury bills, cash (cash reserve) and gold are eligible to be counted toward the SLR. Commercial bonds are excluded because SLR permits only sovereign or RBI-approved instruments and excludes instruments that carry commercial credit risk.

Therefore, three of the listed assets qualify for inclusion in the SLR.

2, 3 and 4 only

Primary Agricultural Credit Societies (PACS) - Incorrect. PACS are primary-level cooperative credit societies registered under state cooperative laws that provide agricultural credit at the grassroots. They are not licensed as banks and, therefore, are not entitled to be called banks unless separately registered and regulated as a cooperative bank.

Urban Co-operative Banks, State Co-operative Banks and Central Co-operative Banks - Correct. These entities are organized and regulated as cooperative banks and fall within the regulatory framework applicable to banks (including applicability of the Banking Regulation Act, 1949 as extended to cooperative banks and supervision by the Reserve Bank of India (RBI)), so they may properly be referred to as banks.

Therefore, only the second, third and fourth statements are correct.

C: Both 1 and 2

CASA refers to Current Account and Savings Account deposits and the CASA ratio is the share of CASA in total deposits. These deposits are typically low-cost (current accounts usually pay no interest; savings accounts pay low interest), so a higher CASA ratio lowers a bank's overall cost of funds and improves Net Interest Income and net interest margin. Therefore a bank with a higher CASA ratio effectively has access to cheaper funding than a bank with a lower CASA ratio.

Provision Coverage Ratio (PCR) is defined as PCR = Provisions / Gross Non-Performing Assets (Gross NPAs). A higher PCR means a larger portion of identified bad loans is already covered by provisions, providing a buffer against credit losses. All else equal, a bank with a higher PCR is less vulnerable to credit-risk shocks because it can absorb a greater share of losses without immediate capital erosion.

Note the caveats: a high CASA ratio improves funding costs but does not by itself guarantee asset quality or profitability from other operations; and a high PCR improves resilience only if NPAs are timely and accurately recognized and provisions are adequate and forward-looking. Despite these caveats, both statements as given are correct.

1, 2 and 3

The Reserve Bank of India (RBI) has the exclusive authority to issue banknotes in India; this power is provided under Section 22 of the Reserve Bank of India Act, 1934, while the issuance of coins remains with the Government of India.

The RBI acts as banker, agent and adviser to the Central Government and also maintains accounts and provides banking services for State Governments, handling their receipts, payments and public debt operations.

The RBI is the custodian and manager of the country's foreign exchange reserves, holding and operating them to intervene in the foreign exchange market, stabilize the rupee and meet external payment obligations.

Therefore, all three functions listed are correctly attributable to the RBI.

The difference between the value of currency/money and the cost of producing it is known as Seigniorage. It is the revenue earned by the issuing authority (typically the central bank or government) when the nominal or face value of money exceeds its production cost.

Seigniorage per unit = face value - production cost. Total seigniorage over a period is the sum of per-unit seigniorage on new currency issued (or, equivalently, the nominal increase in the monetary base times the average per-unit gain).

Seigniorage provides a form of public finance because it lets the issuer obtain real resources without explicit taxation. If money creation raises the price level, the effective revenue from seigniorage acts like an inflation tax on holders of money. By contrast, negative seigniorage can occur if production and maintenance costs (or other losses) exceed the currency's face value.

In practice, seigniorage calculations incorporate costs of minting/printing, distribution, and administration, and it is an important concept linking monetary policy to government financing and inflation.

1 only

Statement 1 is correct. An accommodative monetary policy (also called expansionary policy) is used to support aggregate demand and economic activity by making borrowing cheaper and increasing money availability. The central bank does this by lowering the policy repo rate, reducing reserve requirements or providing liquidity through open market operations and targeted refinancing (e.g., LTROs, OMOs), which together increase overall liquidity and ease credit conditions.

Statement 2 is incorrect. When inflationary pressures are elevated, the appropriate response is usually the opposite-tightening monetary policy-which raises interest rates and withdraws liquidity to restrain demand and bring inflation down. Therefore, accommodative measures are not typically adopted in high-inflation episodes; they are used when inflation is moderate or falling and growth support is needed.

Hence, only Statement 1 is true.

1, 2 and 3

Willful default (as per Reserve Bank of India guidelines) covers cases where a borrower, although able to repay, deliberately avoids repayment or intentionally misuses or siphons off funds; typical indicators include capacity to pay but non-repayment, diversion of funds, and disposal/transfer of assets without lender's knowledge.

Statement 1 is correct: a borrower who defaults despite having the capacity to pay and who does not make bona fide efforts to repay fits the RBI description of a willful defaulter.

Statement 2 is correct: deliberate diversion of funds to purposes other than those for which the loan was sanctioned is a principal ground for declaring a borrower a willful defaulter.

Statement 3 is correct: selling or otherwise disposing of assets purchased with the lender's funds, or transferring charged/secured assets without informing the bank so as to frustrate recovery, constitutes disposal of assets without lender's knowledge and qualifies as willful default.

All three statements meet the RBI criteria and therefore are correctly identified under the concept of willful default.

1, 3, and 5 only

These are classified as quantitative (or general) monetary policy tools because they operate by altering the aggregate availability of bank reserves and overall money supply.

Cash Reserve Ratio (CRR): the percentage of banks' net demand and time liabilities that must be held as reserves with the central bank. Changing the CRR directly increases or decreases bank reserves and hence the credit-creating capacity of the banking system.

Statutory Liquidity Ratio (SLR): the proportion of net demand and time liabilities that banks must maintain in specified liquid assets (government securities, cash, etc.). Adjusting the SLR changes funds available for lending, affecting overall liquidity.

Open Market Operations (OMOs): purchases or sales of government securities by the central bank to inject or absorb liquidity. OMOs directly alter the money supply and short-term interest rates.

By contrast, margin requirements, moral suasion, and direct action are qualitative or selective controls: they influence credit allocation, behavior, or compliance in targeted ways rather than directly changing the total stock of money. Hence they are not counted among the quantitative instruments.

All five

Each listed activity is part of the Reserve Bank of India's Priority Sector Lending (PSL) classification: Agriculture, Education loans to individuals, Renewable energy projects, Housing loans, and Export credit.

Under RBI guidelines, scheduled commercial banks and foreign banks with 20 or more branches are required to allocate 40% of their adjusted net bank credit (ANBC) or credit equivalent of off-balance sheet exposures to the priority sector, with specific sub-targets for certain subsectors.

Hence, all five items listed fall within the PSL targets.

1, 2, 3 and 4

Statement 1 - Correct. Currency in circulation (notes and coins held by the public) is a direct component of the monetary base.

Statement 2 - Correct. Vault cash (cash held in commercial banks' tills/safes) is included in bank reserves and therefore in the monetary base.

Statement 3 - Correct. Deposits of the Government of India with the RBI are liabilities of the central bank and are part of the monetary base.

Statement 4 - Correct. Deposits of commercial banks with the RBI (bank reserves or bankers' deposits) are central-bank liabilities and form a core component of the monetary base.

All four items constitute High Powered Money (also called the monetary base or reserve money) because they are liabilities of the Reserve Bank of India that provide the base for the banking system's reserves and money creation.

Only three

The Reserve Bank of India advances funds to the central government through Ways and Means Advances (WMA) and related short-term arrangements to meet temporary mismatches in receipts and payments.

It also provides short-term credit to state governments via the same mechanism - WMA and, where applicable, sanctioned overdraft facilities under prescribed limits.

RBI lends to banks using monetary policy and standing facilities - for example, liquidity infusion via the repo rate under the Liquidity Adjustment Facility (LAF), the Marginal Standing Facility (MSF), and adjustments via the Bank Rate; in this role it functions as the lender of last resort.

RBI does not normally provide direct loans to corporate bodies; instead it channels support to industry indirectly through regulated banks and financial institutions and by providing refinance facilities to specialized agencies. Thus, direct lending to corporate entities is not part of RBI's routine functions.

Therefore, RBI lends to three of the four listed categories.

D: It is the form of money that must be compulsorily accepted in settlement of public and private within the country.

Legal tender is a legally recognised medium of payment that a creditor is obliged to accept in discharge of a debt.

It covers settlement of both public and private obligations, including debts, taxes and other dues within the country.

In India, genuine banknotes issued by the Reserve Bank of India and coins issued by the Government under the Coinage Act, 2011 are legal tender, unless their status is formally withdrawn.

Authorities can withdraw legal tender status for specific notes or coins (as in demonetisation); while parties may contractually agree to other payment methods for transactions, a creditor cannot lawfully refuse valid legal tender tendered to discharge an existing debt.

1, 3 and 5 only

Narasimham Committee (1991, 1998): Recommended comprehensive banking-sector reforms including adoption of prudential norms, stronger capital adequacy standards, recognition and provisioning for NPAs, reduction of statutory pre-emptions, and measures to promote competition and entry of private banks.

Raghuram Rajan Committee (Committee on Financial Sector Reforms, 2007-08): Proposed broad financial-sector and banking reforms to improve financial stability, regulatory architecture and competition within the banking system; its remit and recommendations are squarely within banking/financial-sector reform.

Nachiket Mor Committee (2013-14): Focused on extending banking services and financial inclusion, recommending measures such as differentiated banks, expanded use of banking correspondents, and simplified accounts-all directly related to reforms in the banking sector.

Urjit Patel Committee: Was an expert committee on the monetary policy framework (leading to adoption of inflation targeting and setting up the Monetary Policy Committee); this concerns monetary-policy framework rather than structural banking-sector reform.

N.K. Singh Committee: Tasked with reviewing the FRBM (Fiscal Responsibility and Budget Management) framework and fiscal rules; its scope is fiscal policy, not banking-sector reform.

Both Statement-I and Statement-II are correct, and Statement-II is the correct explanation for Statement-I.

cash reserve ratio (CRR) is the fraction of deposits that banks must hold as reserves with the central bank. The basic relationship for the banking system's ability to create deposits is given by the formula money multiplier = 1 / reserve ratio (where the reserve ratio is expressed as a decimal). A lower CRR reduces the denominator in this formula, therefore increasing the money multiplier.

Mechanically, a lower CRR leaves banks with larger excess reserves after meeting required reserves. Those excess reserves can be lent out; lent funds become deposits in other banks, which in turn hold the required fraction and lend out the remainder. This process of successive lending and redepositing-deposit creation-is what raises the overall money supply. Thus the second statement correctly explains how the first statement comes about.

B: 2 only

The Bank Rate is the rate at which the central bank lends to commercial banks or discounts commercial bills; it is a policy (discount) rate that influences the banking system's cost of funds.

Statement 1 - incorrect. The Bank Rate is not a legal floor beneath which commercial banks cannot lend to their customers. Commercial banks set retail lending rates based on their overall cost of funds, credit risk, competition and balance-sheet considerations. The Bank Rate affects wholesale funding costs and the general interest-rate environment, but it does not by itself prevent banks from pricing loans above or below it.

Statement 2 - correct. A reduction in the Bank Rate signals an easy-money (expansionary) stance by the central bank. Lowering the policy rate makes short-term funds cheaper, tends to push market and lending rates down, increases liquidity and encourages borrowing and investment. Raising the Bank Rate has the opposite (tightening) effect.

Hence, only Statement 2 is correct.

Only one

Statement 1 is incorrect. The Standing Deposit Facility (SDF) is a deposit facility through which the Reserve Bank absorbs surplus liquidity; it is not a borrowing window for banks in emergencies. Emergency or overnight borrowing needs are met by other facilities such as the Marginal Standing Facility (MSF) or other standing credit arrangements.

Statement 2 is incorrect. It is true that transactions under the SDF are uncollateralised - banks can place excess funds with the RBI without pledging government securities - but that describes deposits with the RBI, not borrowing from it.

Statement 3 is correct. The SDF is available to participants in the Liquidity Adjustment Facility (LAF) and serves as the floor of the LAF corridor; it replaced the fixed-rate reverse repo as the liquidity-absorption tool in 2022.

Hence, only one of the statements is correct (the third statement).