The following points highlight the top seven weapons used by Reserve Bank of India to control the credit.
The weapons are: 1. Bank Rate 2. Open Market Operations 3. Varying Cash Reserve Ratio 4. Cash Rationing 5. Direct Action 6. Moral Suasion 7. Publicity.
Weapon # 1. Bank Rate:
Bank rate is the rate at which the Reserve Bank is prepared to re-discount the first class securities and to grant loans on the basis of government securities to Commercial Banks.
The bank rate is normally higher than the market rate. Further, the term rate of interest is the rate at which the Commercial Banks pay to those who keep deposits with them.
Through bate rate the Reserve Bank can control credit by raising or reducing the bank rate time to time. If the Reserve Bank wants to contract credit, it will raise the bank rate. The effect of this will be that the market rates and the other lending rates in the money market will go up. Borrowing will consequently be discouraged.
Thus, the raising of bank rate will lead to contraction of credit. Conversely, if there is fall in bank rate, it will lower the lending rates in the money market which will stimulate commercial and industrial activity for which more credit will be sought from banks. Thus, there will be expansion of the volume of bank credit.
This method of credit control can be successful only if the other rates in the money market will follow the bank rate in its movement. In under developed country like India there is no such close relationship between the bank rate and the other rates.
Weapon # 2. Open Market Operations:
The term ‘Open Market Operations’ means purchase or sale by a Central Bank of any kind of paper in which it deals. For example—Purchase and sale of government securities for any other public securities or trade bills. In practice purchase and sale of short-term as well as long-term securities at the initiative of the Central Bank. These days this method of credit control has attained great importance.
The system adopted in the kind of credit control is that the sale of securities leads to contraction of credit and purchase of securities 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 mostly drawn against the purchasing bank. In both the cases the result is practically 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 the cash, the Commercial Bank has to reduce the lending activities. This leads to credit contraction. Conversely, when the Central Bank purchases securities it pays through cheques drawn on itself. This activities increases the cash balances of the Commercial Banks and enables them to expand credit.
Weapon # 3. Varying Cash Reserve Ratio:
Under this method the Reserve Bank controls the credit by changing the statutory cash reserves of the Schedule Banks. By the Reserve Bank of India Act, 1934, it was stated in the Act that every scheduled bank will have to keep with the Reserve Bank cash reserves equivalent to 2% of its time deposits and 5% of its demand deposits. And this rule was also applicable to Non-scheduled Banks.
Weapon # 4. Cash Rationing:
Rationing of credit as an instrument of credit control was first used by the Bank of England in the closing year of the eighteenth century. The word ‘rationing of credit’ implies two things. First it means that the Reserve Bank fixes the limit upon its re-discounting facilities for any particular bank. Secondly, it means that the Reserve Bank fixes the quota of every affiliated bank for financial accommodation from the Reserve Bank. This method of credit control can be justified only as a measure to meet exceptional emergencies because it is open to serious drawbacks and difficulties.
Weapon # 5. Direct Action:
Reserve Bank of India is using this method of credit control very extensively. But there is one great difficulty that it cannot be used in isolation. It can be used as a supplement to other methods of credit control. This method is coercive measures against those Commercial Banks whose credit policies do not conform to the declared objectives of the Reserve Bank.
This method involves the issuing of general instructions by the Reserve Bank to all Commercial Banks. It may take the form of special instructions by the Reserve Bank issued to such banks which are not following the instructions of the Reserve Bank. It should always be remembered that this method can be used only as a last resort when other method fail to yield the desired result.
Weapon # 6. Moral Suasion:
Under this method the Reserve Bank encourages the scheduled banks to follow its credit policy through persuasion, suggestion and advice. To make successful this objective, the Reserve Bank calls the meetings of the representatives of the Scheduled Banks from time to time and prevails upon them to follow the policies laid down by it.
In addition, the Reserve Bank also suggests to the Schedule Banks the necessity and desirability of regulating credit by sending circular letters to them from time to time.
Making use of this method, the Reserve Bank requested the Scheduled Banks in 1979-80 to keep a vigilant check on credit expansion in the country. Before the nationalization of 20 banks in India, the method of moral suasion was not successful but now all banks follow the Reserve Bank guidelines. The position of Reserve Bank is so powerful that no bank dares to ignore its circulars and suggestions.
Weapon # 7. Publicity:
This method of credit control is an essential instrument to ensure the effectiveness of the monetary policy of the Central Bank. Under this method the Reserve Bank gives the wide publicity to what is good and what is bad in the credit system of the country.
In this connection De-Cock has said—”Publicity includes publishing regularly the weekly statement of their assets and liabilities, monthly review of credit and business conditions and comprehensive annual reports on their operations and activities. Money market and banking conditions generally public finance, trade, industry, agriculture etc.” By publicity the Reserve Bank gives wide publicity to its thinking in the field of credit.
With the publish work the Commercial Banks, are guided by the ideas of the Reserve Bank in matters relating to credit creation. Further from the other published literature of the Reserve Bank it becomes easier for the Commercial Bank and the public at large to anticipate future changes in the policies of the Reserve Bank.