Central bank and credit controlBy Vaghela Nayan KAsst. Prof SDJ International college

Meaning of credit control The central bank is having the authority to

regulate the amount of money supply in the economy as and when required.

Apart form the legal tender money, the credit money is also plying almost equivalent role in the economic system and almost affects in the same manner as the legal money affects.

Free and unlimited credit creation by the commercial banks may create a serious threat in the economy, and therefore, it becomes necessary to regulate the credit money along with the legal money in the economy.

Credit control means adjustment of volume credit to suit the needs of the various sectors of the economy.

Objectives of the credit control:1.To maintain stability in the internal price level.2.To maintain stability in the exchange rate.3.To maintain stability in the money market of the

economy.4.To eliminate or to reduce the vagaries of business

cycles by controlling and regulating the supply of credit.

5.To maximize income, employment and output in the economy.

6.To meet financial requirements of the economy not only during normal times but also during the emergency or war.

7.To promote economic growth.

Methods of Credit Control:A.General Methods / Quantitative methods of

Credit Control1. Bank rate policy2. Open Market Operations3. Variation in Reserve Ratio

B.Selective Methods / Qualitative methods of Credit Control

A. General or Quantitative methods:

1.Bank Rate Policy: The rate at which the central bank is willing to discount the first class bills of exchange of the commercial banks is known as the Bank Rate.

In some countries it is also known as Discounting Rate.

The rate at which general public is given loans and advances and the bills of general public is discounted is known as market rate or Interest rate.

Bank rate:…… When the commercial banks are continuously granting

loans and advances to the businessmen, then central bank may not treat this as good for Economy.

Now to control the lending activities of commercial banks, their capacity of lending must be reduced.

In the situation of Inflationary pressures, the RBI tends to increase the Bank rate.

This will increase the cost of discounting the bills to commercial banks.

The lending activity will be reduced by the commercial banks and therefore, the total supply of money in the economy will also reduce.

The reduction in the supply of money will also reduces the inflationary pressures.

On the contrary, reduction in the bank rate will have just the opposite effect.

Lowering of the bank rate will imply that co9mmercial banks can borrow at a cheaper rate from the central bank and therefore, they too will reduce their lending rates.

This will make bank credit cheaper and encourages producers and traders to borrow and invest.

The level of economic activity will increase resulting in an general price level.

This will offset the deflationary pressures.

Bank rate:……

Conditions for the success of the bank rate policy:1. close relationship between bank rate and interest rate.2. Elastic economic structure; effects of changes on the

related factors.3. Well developed and well organized money market.

Bank rate:……

Bank rate:…… Limitations of the bank rate policy:1. Commercial banks may not raise their lending rates due to

heavy surplus cash.2. In the optimistic atmosphere of inflation, the demand for

credit by businessmen will be interest inelastic.3. It makes credit costly for productive purposes and speculative

demand may increase.4. Non existence of well developed and well organized money

market in underdeveloped and developing economies.5. Insensitivity towards the rate of interest, as it is a very small

part of the cost of production.6. Non banking financial intermediaries are not affected.7. Effects of other factors.

2. Open market operations: Open market operation simply imply the purchase or sale

by the central bank of any kind of eligible paper like government securities or any other public securities or trade bills, etc.

When the central bank sells securities in the open market, other thing being equal, the cash reserve of the commercial banks decreases to the extent that they purchase these securities.

By this way the central bank can also reduce the amount of consumers deposits with commercial banks to the extent that these consumers acquire the securities sold by the central bank.

Open market operations:…..

The sell of securities by the central bank in the open market ultimately contracts the credit in the economy.

Conversely, when the central bank purchases the securities from the commercial banks and general public, the credit expands up to the extent that they have sold their securities to the central bank.

In this way the central bank can either expand or contract the quantity of money in the economy and can control the deflationary or Inflationary pressures in the economy.

Limitations of the open market operation:1. Lack of well-developed securities market.2. Contradiction between bank rate and open market

operation.3. Restricted dealings. (central bank have to be ready to

incur loses, and that’s why this measure is generally adopted for short run only to avoid the huge loses.)

4. Difficulties in execution. (sale of securities is more difficult as compared to purchase)

5. Precaution for stabilizing the governments securities market.

6. Assumption of a constant velocity is not true.

Open market operations:…..

Open market operations:…..

Usefulness of the Open Market Operation Policy:1. It enhances the efficiency of the bank rate policy as it is

complementary to it.2. It helps in maintaining the stability in the prices of

government securities by sell and purchase of it at a suitable time.

3. It also helps in contracting extreme trend in the business.4. It helps in increasing the level of exports and indirectly

helps in improving the balance of payment situation.

3. Variations in cash reserve ratio: The countries where the money market is disorganized or less

developed, they can adopt this method of quantitative credit control.

The central bank is having the power to acquire a part of reserves of commercial banks as being a bank of the bankers.

The central bank is also having a power to alter the quantum of this reserve according to the needs of the economy.

The increase in the customary reserve ration contracts the liquidity with commercial banks and lending power of the same.

On the other hand, decrease in the reserve ration increases the lending power of the commercial banks by increasing their liquidity.

The central bank changes the reserve amount according to the inflationary or deflationary situations of the economy.

Variations in cash reserve ratio……. Limitations of the Variations in the cash reserve ration:1. Large excess reserves are available with the commercial

banks.2. Determination of bank credit policy: other things are

considered at the time of deciding credit policies by the commercial banks.

3. Demand for bank credit: if demand does not changes, there may not be a desired effect on the bank credits.

4. Distortions caused by frequent use: can only be used when the large changes are to be made in the credit capacity.

5. Discriminatory effect: non banking financial institutions remains outside its purview.

B. Selective or Qualitative methods: Objectives of the Selective methods:1. To diversify the credits towards the more productive uses.2. To tackle only the sensitive spot of the economy.3. To discourage excessive consumer demand for certain

goods, induced by hire-purchase and installment schemes.4. Discrimination can be made in favour of exporting

industries, and to influence the balance of payment situation.

5. To eliminate the limitations of the quantitative methods and to control all types of credits.

Measures of selective credit control:1.Fixation of Margin Requirements:

The practice of margin requirement is generally followed by all the financial institutions dealing in the loans and advances against the securities to the borrowers.

The loan value of the security = the market value of the security – The margin.

The central bank is empowered to fix the “margin” and thereby fix the maximum amount which the purchaser of security may borrow against that security.

Effective enough without affecting actual credit capacity. To check the effect of inflation in certain spots of the economy

without affecting the Macro economic phenomenon. Diversified margins can be set for different loans. Easily administered.

2.Consumer Credit Regulation: This includes the laying down of rules regarding; Minimum down payments Minimum amount of installment Maximum period of payment, etc For certain type of consumer durable goods. This tool is extremely useful supplementary tool for

controlling inflation and maintaining economic stability. There is a problem of administration in developing countries

like India.

3.Issue of Directives: The central bank is having the authority to issue some

directions related to the credit facilities provided by the commercial banks in the economy.

The directives can be oral or written, statements, appeals or warnings, to the financial institutions.

The effectiveness of the “Directives” depends on the prestige of the central bank.

More successful in Branch banking as compared to Unit Banking System.

But it is difficult to examine the effects of these Directives.

4.Rationing of Credit: The central bank may control or regulate the purposes for

which the credit is to be granted or not and up to which limit.

It secure the diversion of financial resources in to the desired channels of public authority in furtherance of the objectives of planning.

Credit rationing can be done in two ways:a) Variable portfolio ceilingb) Variable capital asset ratio.

This method is justifiable in totalitarian economy as it expands the responsibilities of the central bank.

5. Moral Suasion and Publicity: This includes request made by the central banks to the

commercial banks to co-operate with the general monetary policies of the central bank.

Central bank can also request the commercial banks for not to involve herself in any speculative finance of non essential activities.

This can secure good results only I the case of good cooperation by the commercial banks as there is no compulsion or threat on punitive actions.

This method is more suitable in expansion of credits rather contraction of credits.

6.Direct Action: This is the most extensively used selective method for credit

control by the central bank. These direct actions may be:

a) Refusing to rediscounting of bills to commercial banks.b) Refusal of more credits to the banks who have already

borrowed in excess to their reserves.c) Charging penal interest rates on the credit demand over and

above the prescribed limit. It may affect the positive activities of the commercial banks. It is difficult to channelize the credits by the commercial

banks. Its is not easy to demarcate the essential and non essential

uses of the credits.

Limitations of the Selective methods:

1. The selective methods too excludes the non financial institutions which indirectly making the credits .

2. The qualitative credit control can not be materialized in the real sense as the commercial banks can not watch over the utilization of the loans it has granted.

3. The velocity of bank money makes the measure ineffective.4. Commercial banks are having the profit motives at the centre, and

that is why they may mischief by manipulating the accounts and sanctioning loans for forbidden uses.

Thank You