Essay, Pages 7 (1514 words)
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 with 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.
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-
- 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.
- To keep a check over the channelization of credit so that credit is not delivered for undesirable purposes.
- To achieve the objective of controlling “Inflation” as well as “Deflation”.
- To boost the economy by facilitating the flow of adequate volume of bank credit to different sectors.
- To develop the economy.
Objective of Credit Control
Credit control policy is just an arm of Economic Policy which comes under the purview of Reserve Bank of India, hence, its main objective being attainment of high growth rate while maintaining reasonable stability of the internal purchasing power of money.
The broad objectives of Credit Control Policy in India have been-
- Ensure an adequate level of liquidity enough to attain high economic growth rate along with maximum utilization of resource but without generating high inflationary pressure.
- Attain stability in exchange rate and money market of the country.
- Meeting the financial requirement during slump in the economy and in the normal times as well.
- Control business cycle and meet business needs.
Methods of Credit Control
There are two methods that the RBI uses to control the money supply in the economy-
- Qualitative Method
- Quantitative Method
During the period of inflation Reserve Bank of India tightens its policies to restrict the money supply, whereas during deflation it allows the commercial bank to pump money in the economy.
By Quality we mean the uses to which bank credit is directed. For example- the Bank may feel that spectators or the big capitalists are getting a disproportionately large share in the total credit, causing various disturbances and inequality in the economy, while the small-scale industries, consumer goods industries and agriculture are starved of credit. Correcting this type of discrepancy is a matter of Qualitative Credit Control.
Qualitative Method controls the manner of channelizing of cash and credit in the economy. It is a ‘selective method’ of control as it restricts credit for certain section where as expands for the other known as the ‘priority sector’ depending on the situation. Tools used under this method are-
Marginal Requirement of loan = current value of security offered for loan-value of loans granted. The marginal requirement is increased for those business activities, the flow of whose credit is to be restricted in the economy. e.g.- a person mortgages his property worth Rs. 1,00,000 against loan. The bank will give loan of Rs. 80,000 only. The marginal requirement here is 20%. In case the flow of credit has to be increased, the marginal requirement will be lowered. RBI has been using this method since 1956.
Rationing of credit
Under this method there is a maximum limit to loans and advances that can be made, which the commercial banks cannot exceed. RBI fixes ceiling for specific categories. Such rationing is used for situations when credit flow is to be checked, particularly for speculative activities. Minimum of “Capital/Total Assets” Ratio (ratio between capital and total asset) can also be prescribed by Reserve Bank of India.
RBI uses media for the publicity of its views on the current market condition and its directions that will be required to be implemented by the commercial banks to control the unrest. Though this method is not very successful in developing nations due to high illiteracy existing making it difficult for people to understand such policies and its implications.
Under the banking regulation Act, the central bank has the authority to take strict action against any of the commercial banks that refuses to obey the directions given by Reserve Bank of India. There can be a restriction on advancing of loans imposed by Reserve Bank of India.
This method is also known as “Moral Persuasion” as the method that the Reserve Bank of India, being the apex bank uses here, is that of persuading the commercial banks to follow its directions/orders on the flow of credit. RBI puts a pressure on the commercial banks to put a ceiling on credit flow during inflation and be liberal in lending during deflation.
By Quantitative Credit Control we mean the control of the total quantity of credit. For Example- let us 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. Different tools used under this method are-
RBI lends to the commercial banks through its discount window to help the banks meet depositor’s demands and reserve requirements for long term. The Interest rate the RBI charges the banks for this purpose is called bank rate. If the RBI wants to increase the liquidity and money supply in the market, it will decrease the bank rate and if RBI wants to reduce the liquidity and money supply in the system, it will increase the bank rate.
Working of the Bank Rate:
Changes in bank rate are introduced with a view to controlling the price levels and business activity, by changing the demand for loans. Its working is based upon the principle that changes in the bank rate results in changed interest rate in the market. Suppose a country is facing inflationary pressure. The Central Bank, in such situations, will increase the bank rate thereby resulting to a hiked lending rate. This increase will discourage borrowing. It will also lead to a fall in the business activity due to following reasons.
- Employment of some factors of production will have to be reduced by the businessmen.
- The manufacturers and stock exchange dealers will have to liquidate their stocks, which they held through bank loans, to pay off their loans.
The effect of Rise in Bank Rate by the Central Bank is shown in the chart (left side). Hence, we can conclude that hike in Bank Rate leads to fall in price level and a fall in the Bank Rate leads to an increase in price level i.e. they share an inverse relationship.
Cash Reserve Ratio (CRR)
Every commercial bank has to keep certain minimum cash reserves with RBI. Consequent upon amendment to sub-Section 42(1), the Reserve Bank, having regard to the needs of securing the monetary stability in the country, RBI can prescribe Cash Reserve Ratio (CRR) for scheduled banks without any floor rate or ceiling rate. RBI uses this tool to increase or decrease the reserve requirement depending on whether it wants to affect a decrease or an increase in the money supply. An increase in Cash Reserve Ratio (CRR) will
make it mandatory on the part of the banks to hold a large proportion of their deposits in the form of deposits with the RBI. This will reduce the size of their deposits and they will lend less. This will in turn decrease the money supply.
Statutory Liquidity ratio (SLR)
Apart from the CRR, banks are required to maintain liquid assets in the form of gold, cash and approved securities. Higher liquidity ratio forces commercial banks to maintain a larger proportion of their resources in liquid form and thus reduces their capacity to grant loans and advances, thus it is an anti-inflationary impact. A higher liquidity ratio diverts the bank funds from loans and advances to investment in government and approved securities.
Open Market Operation
In well-developed economies, central banks use open market operations—buying and selling of eligible securities by central bank in the money market—to influence the volume of cash reserves with commercial banks and thus influence the volume of loans and advances they can make to the commercial and industrial sectors. In the open money market, government securities are traded at market related rates of interest. The RBI is resorting more to open market operations in the more recent years.