Credit Control

28/04/2020 0 By indiafreenotes

Credit control is an important tool used by Reserve Bank of India, a major weapon of the monetary policy used to control the demand and supply of money (liquidity) in the economy. Central Bank administers control over the credit that the commercial banks grant. Such a method is used by RBI to bring “Economic Development with Stability”. It means that banks will not only control inflationary trends in the economy but also boost economic growth which would ultimately lead to increase in real national income stability. In view of its functions such as issuing notes and custodian of cash reserves, credit not being controlled by RBI would lead to Social and Economic instability in the country.

Objectives of Credit Control

A central bank controls credit with the following objects in view:

(a) To safeguard its gold reserves against internal and external drains;

(b) To maintain stability of internal prices;

(c) To achieve stability of foreign exchange rate;

(d) To eliminate fluctuations in production and employment; and

(e) To assist in economic growth. This assistance is required not only in under-developed countries desirous of accelerating economic development, but also in developed countries desirous of main­taining and improving their living standards.

Need for credit control

Controlling credit in the economy is amongst the most important functions of the Reserve Bank of India. The basic and important needs of credit control in the economy are-

(a) To encourage the overall growth of the “priority sector” i.e. those sectors of the economy which is recognized by the government as “prioritized” depending upon their economic condition or government interest. These sectors broadly totals to around 15 in number.

(b) To keep a check over the channelization of credit so that credit is not delivered for undesirable purposes.

(c) To achieve the objective of controlling inflation as well as deflation.

(d) To boost the economy by facilitating the flow of adequate volume of bank credit to different sectors.

(e) To develop the economy.

Methods of Credit Control

The methods of credit control are also called the central banking techniques. There are broadly speaking two types of controls used by the Central Banks in modern times for regulating bank advances:

  1. Quantitative or General Credit Controls
  2. Qualitative Controls or the Selective Credit Controls.

The aim of the quantitative controls is to regulate the amount of bank advances, i.e., to make the banks lend more or lend less.

The object of the selective credit controls, on the other hand, is to divert bank advances into certain channels or to discourage them from lending for certain purposes. These selective credit controls have of late assumed great importance, especially in under-developed economies.

  1. Quantitative or Central Controls

(i) Changing the Bank Rate

The bank rate is the rate at which the Central bank of a country is willing to discount first class bills. It is thus the rate of discount of the Central Bank, while the market rate is the rate of discount prevailing in the money market among the other lending institutions. Since the Central Bank is only the lender of the last resort, the bank rate is normally higher than the market rate.

The term ‘rate of interest’ is the rate which the commercial banks pay to those who keep deposits with them. The banks’ call rate is the rate at which money is advanced for very short periods to bill brokers, etc. In a perfectly developed money market, all these rates bear a more or less constant relationship with one another. The relationship between the bank rate and the market rate of discount is determined by the conditions of the money market. Therefore, if the bank rate is changed, all the other rates normally move in the same direction.

In countries, where the money market is not so well organized, the relationship between the bank rate and the other rates is not so close. To that extent, therefore, the Central Bank is unable to influence these other rates by changing its own rate of discount.

Let us now see how a Central Bank can control credit by manipulating the Bank Rate. If the Central Bank wants to control credit, it will raise the Bank Rate. As a result, the market rates and the other lending rates in the money market will go up. Borrowing will consequently be discouraged. Those who hold stocks of commodities with borrowed money will also unload their stocks, since as a result of theories in interest rates; the cost of carrying stocks becomes higher.

They will repay their loans. Thus, the raising of Bank Rate will lead to contraction of credit. Conversely, a fall in Bank Rate will lower the lending rates in the money market, which in turn will stimulate commercial and industrial activity, for which larger credit will be sought from banks. There will thus be expansion of the volume of bank credit.

This method of credit control will, however, succeed only if the other rates in the money market follow the Bank Rate in its movement. In underdeveloped money markets, like that of India, there is no such close relationship between the Bank Rate and the other rates.

(ii) Open Market Operations

The term ‘Open Market Operations’ in the wider sense means purchase or sale by a Central Bank of any kind of paper in which it deals, like government securities Or any other public securities or trade bills etc. In practice, however, the term is applied to purchase or sale of government securities, short-term as well as long-term, at the initiative of the Central Bank, as a deliberate credit policy. This method of credit control has attained great importance since the thirties.

The theory of open market operations is like this: The sale of securities leads to contraction of credit and the purchase thereof to credit expansion. When the Central Bank sells securities in the open market, it receives payment in the form of a cheque on one of the commercial banks. If the purchaser is a bank, the cheque is drawn against the purchasing bank. In both cases the result is the same.

The cash balance of the bank in question, which it keeps with the Central Bank, is to that extent reduced. With the reduction of its cash, the commercial bank has to reduce its landings. Thus credit contracts. Conversely, when the central bank purchases securities, it pays through cheques drawn on it-self. This increases the cash balances of the commercial banks and enables them to expand credit. ‘Take care of the legal tender money and credit will take care of itself is the maxim.

The method is sometimes adopted to make the Ban Kate policy effective. If the member-banks do not raise their rates following the rise in the wink Rate, due to surplus funds available with them, the Central Bank can withdraw such surplus funds by the sale of securities, and thus compel the member-Dinks to raise their rates. Scarcity of funds in the market compels the banks directly or indirectly to borrow from the Central Bank through rediscounting bills. If the Bank Rate is high, the market rate cannot remain low.

(iii) Varying Reserve Requirements

When it is sought to restrict credit, the Central Bank may raise the reserve ratio. In 1960, for instance, the Reserve Bank of India required the scheduled banks to maintain with it additional reserve equivalent to 25% of the increase in their bank deposits (later raised to 50%).

The Reserve Bank has also the power to vary the cash reserve ratio (CRR) which the banks have to maintain with it from the minimum requirement of 3% up-to 15% of the aggregate liabilities (7% since June 1982) raised in stages to 8.5% effective from August 27, 1983.

Variations of reserve requirements affect the liquidity position of the banks and hence their ability to lend. The raising of reserve requirements is an anti-inflationary measure inasmuch as it reduces the excess reserves of member-banks for potential credit expansion. The lowering of the reserve ratios has the opposite effect.

(iv) Credit Rationing

Credit rationing means restrictions placed by the Central Bank on demands for accommodation made upon it during times of monetary stringency and declining gold reserves. The credit is rationed by limiting the amount available to each applicant. Further, the Central Bank restricts its discounts to bills maturing after short periods. This method of controlling credit can be justified only as a measure to meet exceptional emergencies, because it is open to serious abuses.

  1. Quantitative method

By quantitative credit control we mean the control of the total quantity of credit.

For Example- consider that the Central Bank, on the basis of its calculations, considers that Rs. 50,000 is the maximum safe limit for the expansion of credit. But the actual credit at that given point of time is Rs. 55,000(say).Thus it then becomes necessary for the central bank to bring it down to 50,000 by tightening its policies. Similarly if the actual credit is less, say 45,000, then the apex bank regulates its policies in favor of pumping credit into the economy.

Qualitative or Selective Credit Controls Consist in:

(i) Varying margin requirements for certain bank advances;

(ii) Regulation of consumer credit for regulating volume of installment credit buying; and

(iii) Issuing directives to restrict bank advances.