Methods of credit control employed by the central bank

Methods of credit control employed by the central bank

Credit control is an important function of the central bank. Various methods are employed by the central bank to control the creation of credit by the commercial banks. The principal methods are classified under two heads viz. Quantitative methods and Qualitative methods. Quantitative credit control methods are used to expand or contract the total volume of credit in the banking system. For example, the central bank of India believes that the safe limit for bank credit is Rs.50, 000 crore. Suppose, at a particular time the actual bank credit is Rs.75, 000 crore. Reserve Bank of India may now use bank rate as a weapon to reduce the volume of credit by Rs.25,000 crore. As such the volume of bank credit is reduced in the country. On the other hand, Qualitative credit control methods are used to control and regulate the flow of credit into particular industries or businesses depending on the economic priorities set by the government. Suppose RBI estimates that the inflationary pressure in India is due to commercial banks' loan to speculators and hoarders who have managed to control the supply of inflation-sensitive goods and thus have pushed up the price level. Now RBI may direct commercial banks not to lend to speculators and hoarders. It is concluded from the above analysis that Quantitative controls are indirect, while Qualitative controls are direct.

Quantitative or General Credit control methods

The important general methods of credit control are as follows:

1) Bank Rate (or) Discount Rate Policy

The rate of interest of every central bank is known as 'Bank Rate'. It is otherwise known as 'discount rate'. At this rate the central bank rediscounts bills of exchange and government securities held by the commercial banks. When the cash reserves of the commercial banks tend to fall below the legal minimum, the banks may obtain additional cash from the central bank either by rediscounting bills with the central bank or by borrowing from the central bank against eligible securities. The central bank charges interest rate for this service. The central bank controls credit by making variations in the bank rate. A rise in the bank rate makes borrowing costly from the central bank. So commercial banks borrow less and in turn they raise their lending rates to customers. This discourages business activity. Thereby there is contraction of demand for goods and services and ultimately fall in the price level. Therefore bank rate is raised to control inflation. In the opposite case, lowering the bank rate offsets deflationary tendencies.

2) Open Market Operations

Direct buying and selling of securities, bills, bonds of government as well as private financial institutions by the central bank, on its own initiative, is called open market operations. In periods of inflationary situation, the central bank will sell in the money market first class bills. Buyers of this bill say commercial banks make payments to the central bank. It reduces the size of the cash reserves held by the commercial bank with the central bank. Some banks are forced to curtail lending. Thus, business activity based on bank loans and which is responsible for boom conditions are curtailed. In times of depression, the central bank will buy bills and securities from the commercial banks. The central bank will pay cash to the commercial banks for such purchases. Hence, the cash reserves of the commercial banks are increased. Thereby banks expand their loans resulting in the expansion of investment, employment, production and prices. Thus central bank through its open market operations influences business activity and economic conditions of the country.

3. Variable Reserve Ratio

Every commercial bank is required by law to maintain a minimum percentage of its time and demand deposits with the central Bank. The excess money remains with the commercial bank over and above these minimum reserves is known as the excess reserves. Commercial banks create credit only based on these excess reserves. Central bank may bring changes in reserve requirements. Consequently, it will affect the amount of reserves that commercial bank must maintain as deposits with the central bank as well as the amounts available for lending or investing. For instance, when the central bank fixes the reserve requirement as 10 percent, a commercial bank will have to maintain a cash reserve of Rs.100 for every deposit of Rs.1000 and hence it can lend only upto Rs.900. To check inflation the central bank may raise the cash reserve ratio from 10 percent to 15 percent. This will force the commercial banks to deposit additional 5 percent by reducing their amount available for lending. On the other hand, to check a deflation the central bank may reduce the reserve ratio from 10 percent to 7 percent. This will raise the excess cash with the commercial banks; consequently credit will be expanded.

       4. Qualitative or selective credit control

Qualitative methods of credit control mean the regulation and control of the supply of credit among its possible users. The aim of such methods is to channelise the flow of bank credit from speculative and other undesirable purposes to socially desirable and economically useful uses. Important selective credit controls are given below.

a) Margin Requirements

The aim of this method is to prevent excessive use of credit to purchase securities by speculators. The central bank fixes minimum margin requirements on loans for purchasing securities. Suppose the central bank fixes a 30 percent as margin requirements, then for Rs.1000 worth of security, commercial bank may keep Rs.300 as margin and the remaining Rs.700 may be used for lending. If the central bank wants to curb speculative activities, it will raise the margin requirements. On the other hand, if it wants to expand credit, it reduces the margin requirements.

b) Regulation of consumer credit

Under this instrument, the central bank regulates the use of bank credit by consumers in order to buy durable consumer goods in instalments. To achieve this, it adopts two devices i) Minimum down payment ii) Maximum periods of repayment.

c) Rationing of Credit

Credit rationing is employed to control and regulate the purpose for which credit is granted by the commercial banks. Credit rationing takes two forms i) variable portfolio ceilings, wherein central bank fixes ceiling on the aggregate portfolios of the commercial bank. They cannot advance loans beyond this ceiling. ii) Variable capital assets ratio wherein the central bank fixes in relation to the capital of a commercial bank to its total assets.

d) Direct Action

Direct action refers to 'directives' of the central bank to enforce the commercial banks to follow a particular policy. The central bank gives direction to commercial banks in respect of i) lending policies ii) the purpose for which advances may be made iii) the margins to be maintained in respect of secured loans.

e) Moral suasion

Moral suasion implies persuasion and request made by the central bank to the commercial banks to follow the general monetary policy in the context of the current economic situation.

f) Publicity

The central bank publishes weekly or monthly or quarterly statements of the assets and liabilities of the commercial banks for the information of the public. It also publishes statistical data relating to money supply, prices, production, employment and of capital and money market etc.