The following points highlight the two main methods of credit control by central bank. The methods are: 1. Quantitative Methods 2. Qualitative or Selective Methods of Credit Control.
1. Quantitative Methods:
The following are the quantitative methods of credit control:
1. Variation in the Bank Rate:
The bank rate is the minimum official rate at which the central bank rediscounts ‘eligible paper’ presented by the discount hours or make loan to them. It may also mean the minimum rate of interest at which the central bank lends to the banking system 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 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 is a fall in borrowing from the banks and the volume of credit will automatically fall. The lowering of the bank rate, as done during deflation, on the other hand, causes a fall in market interest rates. As a result borrowing from the banks increases and the volume of credit expands. The bank rate has been revised by the Reserve Bank several times in the past.
But the bank rate policy is not very effective in the absence of a well-developed bill market in the country. Besides, in reality there may not exist a close relation between the bank rate and the other rates of interest as is postulated in theory.
Furthermore, the bank rate policy becomes ineffective in the underdeveloped money markets as the banks do not approach the central bank very frequently for obtaining credit facilities. For all these reasons, Keynes regarded the bank rate as an ineffective instrument of monetary (credit) control. And, in fact, its importance has diminished in recent years.
2. Open Market Operations:
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 banks 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 member banks (or from the public at large) causes the central bank to make payments to the banks. As a result the cash balances of member 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 contraction, and the low bank rate with the purchase operations during deflation for credit expansion.
But this method becomes ineffective in reducing credit where the commercial banks have excess cash balances. Furthermore, these operations cannot be carried out effectively in the absence of a broad and well- developed market for government securities. Finally, it is not much effective in countries like India where people are not in the habit of buying securities as a matter of routine.
3. Variable Reserve Ratio:
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 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 9½% of total deposits in February 1987.
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 or excess deposits through incremental CRR.
J.M. Keynes strongly advocated this weapon of credit control. Although this method can bring about a quick reduction in the bank credit by a mere stroke of pen, it is considered to be highly discriminatory as it affects the different banks differently – affecting smaller banks more adversely than their larger counterparts.
2. Qualitative or Selective Methods of Credit Control:
The following are the major qualitative methods of credit control or selective credit controls:
a. Minimum margin requirements:
This weapon is selective in respect of the field of its application. In a second advance, the margin refers to the amount of cash one must put up in, to be eligible to borrow from a bank. Thus, if a loan of Rs. 9,000 is secured by a stock worth of 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 valu6 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. in order to restrict speculative credit and to curb speculative rise in their prices on account of 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, in practice, to select the commodities to be brought under such control or to determine the proper margin for advances.
b. Consumer Credit Regulation:
Originated in the U.S.A. during the World War II, this technique is based on the observation that the monetary demand for durable consumer goods is extremely unstable. Under this method, the central bank controls the bank advances intended for the instalment buying of consumers’ durable such as automobiles, household furniture, refrigerators, etc. Such control is exercised by regulating the terms and amount of down payments and the period of repayment.
3. Other Methods:
Besides, there are some other methods of credit. Although qualitative in character, they are 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.
2. Direct Orders:
The central bank, being the supreme monetary authority sometimes gives direct orders or instructions (e.g., Credit Authorisation Scheme 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.
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 m6ney markets as found in India the methods of credit control, specially the traditional ones, have limited efficacies as a significant segment of the country’s money market remains outside the influence and control of the central bank.