The following points highlight the three important methods to control the credits.
Method # 1. Quantitative Methods of Credit Control:
The following are the quantitative methods of credit control:
a. Variation in the Bank Rate:
The bank rate is the minimum official rate at which the central bank rediscounts first class bills brought by the commercial banks to it. It may also mean the minimum rate of interest on the central bank’s advances to other banks against some approved securities. The central bank controls the volume of bank credit by raising or lowering its bank rate.
The importance of the bank rate lies in the fact that it acts as a pace-setter to the other market rates of interest, both short-run and long-run, and that its variation affects both cost and availability of bank credit. The raising of the bank rate as done during inflation leads to an increase in market interest rates, as a result there will be a fall in borrowings from the banks and the volume of credit will be contracted.
ADVERTISEMENTS:
The lowering of the bank rate as done during inflation, on the other hand, causes a fall in market interest rates, as a result the borrowings from the banks will increase and the volume of credit will be expanded. The bank rate is raised during rising price for credit contraction but lowered during falling prices for credit expansion. In India the bank rate was raised last time in July 1981 from 9% to 10% and from 10% to 11% and from 11% to 12% by the for credit restraint to check the inflationary rise in prices.
Limitations:
But the bank rate policy becomes ineffective in the absence of a well- developed bill market in the country. Besides, there may not exist a close relation between the bank rate and the other rates as postulated in the theory of bank rate.
Further, the bank rate policy becomes ineffective in the underdeveloped money markets as the banks do not approach very much the central bank for credit facilities. For this reason, Keynes regarded the bank rate as the ineffective instrument of control. Its importance has, however, decreased at present times. In fact it was abolished in England in 1972.
b. Open Market Operations:
ADVERTISEMENTS:
The technique of open market operations refers broadly to the purchase and sale by the central bank of a variety of assets, particularly government securities. The sale of securities by the central bank to commercial bank or to the public causes the banks to make payments to the central bank; as a result the cash balances of the banks fall, their power to lend decreases and, ultimately, the volume of bank credit declines.
The purchase of securities, on the other hand, by the Central Bank from banks or from the public causes the Central Bank to make payments to their banks, as a result the cash balances of other banks increase, their power to lend increases and the volume of credit expands. So the sale operations of the Central Bank causes a contraction of credit and the purchase operations an expansion of credit. It is to be noted that, in actual practice, the high bank rate is combined with the sale operations during inflation for credit expansion.
Limitations:
But this method becomes ineffective in reducing credit where the commercial banks have excess cash balances. Further, these operations cannot be carried out effectively in the absence of a broad market for securities.
c. Variable Reserve Ratio:
ADVERTISEMENTS:
The Cash Reserve Ratio (CRR) refers to a certain percentage of a bank’s deposits which the bank keeps in cash, by law or convention, with the central bank as a reserve. The central bank can control the total volume of bank credit by raising or lowering this cash reserve ratio.
The raising of the CRR causes a contraction of bank credit, because, when the CRR is high, the banks are to keep larger reserves at the central bank and their power to give credit is reduced. The lowering of the CRR, on the other hand, causes an expansion of credit as the banks are to keep a smaller reserve at the central bank and so get a larger fund for lending. In India, the Reserve Bank of India at present can vary the CRR from 3% to 15% of the total deposits of the banks. The reserve ratio was raised from 9% to 9.5% of total deposits in February 1987.
Incremental CRR:
For tightening credit restraint and for managing excess liquidity in the banking system, a central bank can ask for an additional CRR for excess deposits accumulated from a specified date. This technique is followed in India and is known as impounding of excess deposits through incremental CRR.
Limitations:
Lord Keynes lent his warm support to this weapon of credit control. Although this method can bring about a quick reduction in the bank credit by “a mere stroke of a pen,” it is considered to be highly discriminating as it affects the different banks differently— affecting smaller banks more adversely than the larger ones.
Method # 2. Qualitative Methods of Credit Control:
Objectives:
While general credit controls operate on the cost and total volume of credit, selective credit controls relate to tools available with the monetary authority for regulating the distribution or direction of bank resources to particular sectors of the economy in accordance with broad national priorities considered necessary for achieving the set developmental goals.
Selective controls have special relevance in the developing countries where, on the one hand, the scarce supply of credit has to be channelised into productive areas and, on the other, credit flows to less essential activities have to be curbed so that the physical storages of essential goods are not exploited for speculative profits with the aid of bank finance.
Operationally, therefore, they seek to influence the demand for bank credit by making the borrowing — for certain purposes which are regarded as relatively inessential or less desirable — costly or by imposing stringent conditions for lending for these purposes or to certain sectors, or, conversely, by giving concession to certain desired types of activity.
ADVERTISEMENTS:
Broadly stated, the objective of selective credit control in India is one of preventing speculative hoarding, with the help of bank credit, of certain essential commodities like food-grains and basic raw materials and, thereby, checking an undue rise in their prices.
Selective credit control is considered a useful supplement to general credit regulation and its effectiveness may be greatly enhanced when used together with general credit controls. Thus, selective control measures are formulated by the central bank in harmony with the general credit and monetary policies and are operated in consonance with the policies, priorities and control of the government.
Tools:
The following are the major qualitative methods of credit control or selective credit controls:
1. Minimum Margin Requirements:
ADVERTISEMENTS:
This weapon is selective in respect to the field of its application. The margin refers to the amount of cash one must put up in addition to what one may borrow on his stock from a bank. Thus, if a loan of Rs. 9,000 is secured by a stock worth Rs. 10,000, the margin is said to be Rs. 1,000 or 10% of the value of the stock.
Therefore, with a 10% margin requirement, one can borrow 90% of the value of the security. During inflation the central bank raises the margin in respect of loans taken against some speculative, essential commodities.
The Reserve Bank of India gives frequent instructions to other banks to keep higher margins for giving loans against essential commodities like paddy or rice, wheat, oilseeds, cotton textile, sugar, pulses, edible oils, etc. to restrict speculative credit and to curb speculative rise in their prices on account of their short supply.
This method is highly effective (as found in the underdeveloped money market of India) because it can strike at the strategic spot of the economy for controlling the inflationary rise in prices, but it is difficult to select the commodities to be brought under this control or to determine the proper margin for advances.
ADVERTISEMENTS:
2. Consumer Credit Regulation:
Originated in the U.S. A. during the World War II (1939-45) as the ‘Regulation W’, this technique is based on the observation that the monetary demand for durable consumers’ goods is extremely unstable. Under this method, the central bank controls the bank advances intended for the installment buying of durable consumers’ goods like automobiles, household furniture, refrigerators, etc. by regulating the terms and amount of down payments and the period of payment.
Method # 3. Other Methods:
Besides, there are some other methods, which, although qualitative, yet treated as minor ones.
These are as follows:
1. Rationing of Credit:
The Central Bank, by this method, introduces the quota system regulating bank loans or fixes the maximum limit of bank advances for different purposes.
ADVERTISEMENTS:
2. Direct Orders:
The Central Bank, being the supreme monetary authority, sometimes gives direct orders or instructions (e.g., Credit Authorisation Scheme as in India) to other banks to follow a particular policy of monetary control.
3. Moral Suasion:
Moral suasion implies informal suggestions or recommendations through circulars which the central bank may make to other banks for credit regulation. The banks are persuaded to implement these suggestions.
Conclusion:
It is to be noted that these methods of credit control do not have the same amount of effectiveness in all types of money markets. In the underdeveloped money markets as found in India the methods of credit control, specially the traditional methods, have limited efficacies as a significant segment of the country’s money market remains outside the influence and control of the central bank.