Control of credit is essential for the stability and orderly growth of an economy.
We may therefore study it in some detail.
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.
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: (a) Quantitative or General Credit Controls, and (b) 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.
Quantitative or General Credit Controls may take the form of:
(i) Manipulation of the Bank Rate;
(ii) Open market operations;
(iii) Varying reserve requirements; and
(iv) Credit rationing.
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.
Let us take these in turn.
Quantitative or Central Controls:
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 organised, 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.
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.
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.
There are, however, limitations to the success of this weapon of credit control:
(a) The banks may have very large excess reserves with them, which may nullify the rise in reserve requirements;
(b) A large net inflow of gold in payment of persistent export surplus may increase the banks’ power to lend; and
(c) The government policy of keeping interest rate low and stable may discourage too drastic increases in reserve requirements.
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
Direct action implies coercive measures like refusal on the part of the Central Bank to rediscount for banks whose credit policy is not in accordance with the wishes of the Central Bank, or whose borrowings from the Central Bank are excessive in relation to their capital and reserve.
The Central Bank may, on the other hand, request and persuade member-banks to refrain from increasing their loans for speculation or non-essential activities.
The method of publicity is also used. This means issuing of weekly statistics, periodical review of the money market conditions, public finances, trade and industry, the issue of weekly statement of assets and liabilities in the form of balance sheets, etc.
Selective Credit Controls: Varying Margin Requirements:
Another weapon in the hands of the Central Bank for controlling credit is to vary the margin requirements. While lending money against securities, the banks keep a certain margin. They do not advance money to the full value of the security pledged for the loan. In case it is desired to curtail bank advances, the Central Bank may issue directions that a higher margin be kept. For instance, in I960, the Reserve Bank of India raised to 50% the minimum margin requirement for bank advances against equity shares.
The raising of margin requirements is designed to check speculation in the stock markets and to prevent the typical ‘boom-bust’ pattern, in the stock markets. In this way, demand for speculative credit is controlled. The higher the margin required the less credit one would obtain for the purchase of stocks and shares.
The Reserve Bank of India made use of selective credit controls for, tie first time in 1956. It issued directives to banks to refrain from .excessive lending against food-grams, sugar, groundnuts and shares. As already mentioned, in 1960, margin requirements for advances against equity shares were raised to 50%. The selective credit controls have been operated since then by the Reserve Bank with suitable modifications from time to time in the light of demand and supply position of the commodities.
Selective Credit Control: Regulation of Consumer Credit:
Apart from credit for trade and industry, a great deal of credit, ill developed countries at any time, may be for durable consumer. Goods like houses, motor cars, refrigerators, furniture, TV and radio-sets when these are sold on hire-purchase or installment credit system. Central Banks seek to Control such credit in several ways, e.g.,
(a) By regulating the minimum down payments on specified goods,
(b) By fixing the coverage of selective consumers durable goods,
(c) By regulating the maximum maturities (payment period) on $11 installment credits, and
(d) By fixing the maximum exemption costs of installment purchases of specified goods.