Get complete information on the Methods of Credit Control

As the custodian of cash reserves of the commercial banks the RBI plays an important role in the control of credit created by the banks. For this the RBI is vested with wide powers under RBI Act and Banking Regulation Act. The important methods adopted by RBI can be classified as under.

Quantitative Methods

1. Bank Rate Policy

2. Open Market Operations

3. Variation of Cash Reserve Ratios

4. Fixation of Lending Rates of Commercial Banks

5. Credit Squeeze

Qualitative Methods

1. Fixation of Margin Requirements

2. Regulation of Consumer Credit

3. Control through Directives

4. Rationing of Credit

5. Prior Authorization Schemes

6. Moral Suasion

7. Direct Action

6. 'Repo' Transactions

Let us discuss these methods here under:

Quantitative Credit Control by RBI

These methods are called traditional methods because they have been in use for de­cades. Through these methods, the credit creation is controlled by changing the cash re­serves of commercial banks.

The methods of Bank Rate Policy, open market operations and variation of Cash Re­serve Ratios, etc., are designed to effect the lendable resources of commercial banks either directly affecting their reserve base or by making the cost of funds cheaper or dearer to them. The important methods of this nature are explained herein below:

1. Bank Rate Policy

According to the Reserve Bank of India Act, the Bank Rate is defined as "the standard rate at which the RBI is prepared to buy or rediscount bills of exchange or other commercial papers eligible for purchase under the provisions of the Act ".

Thus, the bank rate is the rate of interest at which RBI rediscounts the first-class bills in the hands of commercial banks to provide them with liquidity in case of need. However, presently RBI does not accept any bills for re-discounting. This function is being done by separate financial institutions like DHFI created for similar purposes.

Bank Rate: Whenever the RBI provides refinance or other financial assistance to Com­mercial Banks, the rate of interest on such assistance is determined with reference to Bank Rate. The RBI also charges interest with reference to Bank Rate on 'ways and means' ad­vances to governments.

For a long period up to 1990-91, the Rate remained unchanged at 10 per cent. Later, from October 1991 to April 1997 the rate remained at 12.00 per cent. During 1997-98, the rate was reactivated to serve as a reference rate for Commercial Banks' lending rates.

When Reserve Bank wants a reduction in general lending rates of Commer­cial Banks, it will signify its intention by reducing Bank Rate and vice versa. The Bank Rate was changed five times during 1997-98. The Bank Rate which was 8 per cent in November 1999 was changed to 7.00 per cent in April 2001.

It was brought down to 6.50 per cent in October 2001, 6.25 per cent in October 2002 and 6.00 per cent in April 2003. The rate fre­quently changes these days depending upon immediate monetary policy objectives.

Of late, the Reserve Bank makes changes in Bank Rate often depending upon liquidity position of banks, short-term interest level, and inflation of the situation. Ever since, Exchange Rate of rupee was allowed to be determined by market forces in March 1993. Bank Rate has been changed a little more often.

It can be seen from the table that the rate was constantly at 10 per cent for decade during 1981-91. Again the rate remained at 12 per cent for 6 years between 1991 and 1997. Thereafter, the rate is gradually reduced from 1998 to April 29, 1993. The bank rate policy as an instrument of monetary control was not successful in India for a long time. The main factors responsible for this are

(i) Inherent inflexibility involved in the use of this instrument.

(ii) The dominance of .he Public Sector whose investment requirements are cost inelastic.

(iii) The higher rate of inflation experienced in the economy.

(iv) Restricted availability of refinance facilities to banks.

(v) As the government expenditure increase, the tax burden also increases. Under heavy taxation, the businessmen feel that the interest rate is a minor factor. And the decrease in the importance of interest rate has led to the decline in the importance of bank rate.

The effectiveness of this instrument can be improved by restructured monetary system. Particularly necessary steps are to be taken to develop an active money market in the economy.

Further if bank's recourse to Reserve Bank accommodation rises, the RBI will be in a better position to influence banks' operation through Bank Rate Policy. There was a perceptible change in RBI outlook towards this instrument from 1997 for signaling short- term interest rate to the market. Hence, the rate was frequently changed thereafter.

2. Open Market Operations

Open market operations are conducted by the RBI mainly with a view to manage short- term liquidity in the market. These operations directly or indirectly affect the reserves of the commercial banks and thereby the extent of credit creation is controlled.

Section17 (8) of the Reserve Bank of India Act confers legal powers on the Reserve Bank to use this instrument of monetary policy. Under this section the Reserve Bank is authorized to purchase and sell the securities of the Central or State Government of any maturity and the security of a local authority specified by the central government on the recommendation of the banks central board.

However, at present the Reserve Bank deals only in the securities issued by the cen­tral government and not in those of State Governments and local authorities. It may be noted that in terms of Section 33 of the Reserve Bank of India Act, securities issued by the State Governments or local bodies are not eligible to be used as reserve assets against note issue. V

The Government securities market in India is narrow and is dominated by financial institutions especially by commercial banks. The Reserve Bank of India occupies a pivotal position in the market. It is continuously in the market, selling government securities of different maturities on tap; it stands ready to buy them in switch operations. The Reserve

Bank of India does not ordinarily purchase securities against cash. There are no dealers in the market who are engaged in continuous sale and purchase of securities on their own account. Incidentally, it may be noted that the Reserve Bank affects purchases and sales from time to time out of the surplus funds of IDBI, EXIM Bank, and NABARD under special arrangement.

The market, however, is served by stock brokers who act as intermediaries between prospective buyers and sellers of government securities. The Reserve Bank also enlists the services of brokers, if necessary.

The role of open market operation as an instrument of credit control will assume im­portance in the restructured monetary system. With the interest rate offered on government securities becoming truly competitive, a broad enough securities market may emerge for the Reserve Bank to use open market operations as an instrument of credit control.

It will sell the securities in open market to drain out excess liquidity from the financial system and thereby contraction of credit. When it buys securities it injects additional funds into the market and consequently credit expansion may take place. "Repos" and "Reverse Repos" transactions may be considered a supplementary operation to this system.

3. Variation of Cash Reserve Ratios

Under this requirement, certain percentage of Deposit liabilities of banks is impounded in cash form with RBI and/or to be maintained in liquid assets like government securities. The reserve requirements were originally evolved as a means for safeguarding the interests of depositors.

Later it was developed as an instrument of credit control. The variation in the reserve requirements has the effect of increasing or decreasing the funds available with commercial banks for lending. In India, the reserve requirements are of two types. They are,

(a) The Cash Reserve Ratio, and

(b) The Statutory Liquidity Ratio.

(a) Cash Reserve Ratio:

Under the provisions of the RBI Act, the Scheduled banks were required to maintain a minimum amount of cash reserve with the Reserve Bank. The reserve is made out of demand and time liabilities at certain percentage fixed by the RBI.

Section 42 (1) of the Act empowers the RBI to stipulate, by giving notification in the Gazette, the percentage of reserve, on the total net demand and time liabilities to be maintained by every banking company with RBI. In terms of Section 18 of RBI Act non-scheduled banks can maintain the cash reserve either with them or with RBI in cash.

The cash Reserve Ratio is required to be maintained in cash with RBI, in addition to the percentage to be maintained under the Statutory Liquidity Ratio. The cash Reserve Ratio cannot exceed 15% of the net demand and time Liabilities.

The Cash Reserve Ratio at the time of notification of banks was 3% which having been revised a number of times. The flat rate of 15% was introduced in the credit policy for the first half of 1989-90.

It was observed that the credit control instruments in the hands of RBI have been used to maintain the economic growth with controlled inflation and as a sharp knife to curb inflation. RBI has used these flexibilities to ensure that institutional finances for productive purposes are not lacking.

The CRR is being gradually reduced after initiating banking sector reforms from 1994- 95. The rate was 10.5 per cent as on April 1999. It stands reduced to 10.0 per cent from May 1999 and from November 1999 it stands further reduced to 9.0 per cent.

Ever since financial sector reforms and market determined exchange for Rupee the RBI uses this instrument to influence liquidity in money market and thereby exchange rate fluctuations.

In the recent past, when the exchange rate of rupee came under attack from bank speculators, it increased the CRR thereby impounding excess liquidity in the market. This policy helped RBI to main­tain stable rate in short-term. The CRR was drastically reduced during 2001, to 4.75 per cent in November 2002. It stands at 4.50 per cent from June 14, 2003.

(b) Statutory Liquidity Ratio:

Under Section 24 of the Banking Regulation Act 1949, RBI is empowered to stipulate the liquid assets every banking company is required to hold against their demand and time liabilities in addition to cash reserve requirement.

Accord­ingly the banks both scheduled and non-scheduled have to maintain liquid assets in cash, gold or unencumbered approved securities amounting to not less than 25% of their net demand and time liabilities in India.

This requirement of 25% can be increased by the RBI from time to time by a notification in the official Gazette. But the ratio so prescribed cannot exceed 40% (In the first half of 1986-87 the ratio was 37%) however; Regional Rural Banks, non-scheduled Banks and co-operative Banks are allowed to maintain statutory Liquidity Ratio at 25% only. Further, all banks are required to maintain this reserve only at 25% in respect of N.R.E accounts.

The prescribed SLR on Commercial Banks in November 1999 stands at 25 per cent of net demand and time liabilities (NDTL) of each bank. The NDTL is worked out twice in a month on reporting Fridays. The value of SLR securities for Balance Sheet purposes is determined not with reference to cost of their acquisition but, with refer­ence to their market quotations.

Banks are required to submit position in regard to SLR to the Reserve Bank as on alter­nate Fridays every month, before the 20th of succeeding month. But the Reserve Bank can call for daily position in such form as it may prescribe.

The main object of SLR is,

(a) To assure solvency of Commercial banks by compelling them to hold low risk assets up to the stipulated extent.

(b) To create or support a market for government securities in the economy which do not have a developed capital market and

(c) To allocate resources to government for augmenting the resources of the Public Sector.

Banks like Regional Rural Banks may hold entire SLR requirements in the form of cash with the sponsor banks.

Effects of Statutory Liquidity Ratio

The main purpose of prescribing SLR is to ensure the liquidity position of banks in meeting the withdrawal requirements of depositors. Since these funds are mostly invested in Government Securities they are considered to be highly liquid and also no risk of loss of value, i.e., they can be encased at quick notice or immediately.

One of the effects of SLR is to raise or lower the liquidity requirements of banks thus affecting their capacity to lend. In order to discourage the banks from contravening the liquidity provisions, the RBI may not allow the defaulting banks access to further refinance and may charge additional interest on their borrowings from it.

It is to be noted that stepping up SLR and CRR have the same effects, viz, they reduce the capacity of commercial banks to expand credit to business and industry and they are anti-inflationary.

4. Fixation of Lending Rates of Commercial Banks

The RBI controls the credit created by the commercial banks by fixing the lending rates of the banks. When the lending rates are fixed at higher level, the credit becomes costlier and it may lead to contraction of credit. Similarly when the rates are lowered, it may result into expansion of credit.

Besides controlling the rates of interest on the advances made by the banks, the RBI places certain restrictions on the grant of advances against term deposits. These relate to the quantum of advance that can be granted and the rate of interest to be charged.

As such banks usually grant only up to 75% of deposit value by way of advance. However after introduction of banking sector reforms in October, 1994, RBI has allowed the banks to fix their own lending rates. The Reserve Bank no longer decides the lending rates of Commer­cial Banks from 1996.

Each bank is however, required to fix a minimum lending rate known as Prime Lending Rate (PLR). All loans and advances of each bank is a mark-up over PLR, i.e., the bank will charge PLR plus 1 to 3 per cent depending upon the customer risk and security offered for loan.

The banks are also given freedom in October, 1997 to fix their own rates on deposits accepted by them. This, is however not applicable to savings bank ac­counts.

5. Credit Squeeze

When the bank rate policy has not been successful in controlling the expansion of credit, the method of credit squeeze is useful. Under this method, the maximum amount of bank credit is fixed at a certain limit. And, the maximum limit for commercial banks borrowing from the RBI is also fixed.

The banks are not allowed to expand the credit beyond these limits. These limits may be fixed in general for all credits or may be sector-specific like for steel industry, textile industry, etc.

But it should be noted that a general credit squeeze may make the trade and industry suffer even for legitimate purposes. Reserve Bank rarely ap­plies credit squeeze these days.

Qualitative Credit Control by RBI

The selective or qualitative credit control is intended to ensure an adequate credit flow to the desired sectors and preventing excessive credit for less essential economic activities. The RBI issues directives under Section 21 of the Banking Regulation Act 1949, to regulate the flow of banks' credit against the security of selected commodities.

It is usually applied to control the credit provided by the banks against certain essential commodities which may otherwise lead to traders using the credit facilities for hoarding and black marketing and thereby permitting spiraling prices of these commodities. The selective credit control mea­sures by RBI are resorted to commodities like, wheat, sugar, oilseeds, etc.

Methods of Selective Credit Control

The RBI adopts a number of credit control methods from time to time. The important methods are given here under.

1. Fixation of Margin Requirements on Secured Loans

Here the term "margin "refers to a portion of the loan amount which cannot be bor­rowed from bank. In other words, the margin money is required to be brought in by the borrower from his own sources. This much percentage of money will not be lent by banks. The RBI lowers the margin to expand the credit and raises margin to contract or control the credit for stock market operations.

This system was introduced in 1956. The RBI has been prescribing minimum margin for advances against commodities under selective credit control. To begin with there was a single margin for each commodity.

Subsequently, separate margins have been stipulated on the basis of level of stocks, type of borrower, variety of commodity, nature of credit instru­ment and documents, regions, stocks earmarked for free sale or otherwise and public and private sectors.

The RBI made use of the weapon of regulation of margin requirements to check bank advances against food grains, i.e., cereals and pulses, selected oil seeds indigenously grown and oil there of vanaspati and all imported oil seeds and vegetable oils, raw cotton, jute, sugar, gur and khan sari, etc.

The changes in the minimum margin requirements were ef­fected mainly to discourage speculative hoarding tendencies and to check the rising prices of agricultural commodities.

2. Regulation of Consumer Credit

The credit facilities provided by the banks to purchase durable consumer goods like cars, refrigerators, T.V. furniture, etc. is called as consumer credit. If consumer credit is ex­panded, it leads to the increase in production of consumer goods in the country.

Such in­creased sale of consumer goods will affect savings of people and capital formation in the economy. Hence, RBI may control the consumer credit extended by the commercial banks. These days RBI does not use such credit control measure as increased consumption lead to more economic activity.

3. Control through Directives

The Reserve Bank of India (Amendment) Act and the Banking Companies Act has empowered the RBI to issue directives to a particular bank or to the banks in general in regard to the following:

The purpose for which advances may or may not be made, the maximum amount of advances that can be granted to any individual, firm or company; the margins to be maintained on secured loans, and the rate of interest to be charged, etc.

For example,

(a) Banks are not allowed to provide finance for speculative purposes in stock mar­ket operations or to deal in real estate business.

(b) No banks can make advances to a single borrower company beyond 25 per cent of its paid-up capital and reserves.

(c) Reserve Bank prescribes margin on advances made by banks against the security of Commodities covered under selective credit control measures like sugar.

(d) Advances made under DRI scheme should be only at interest rate prescribed by RBI, i.e., 4 per cent per annum.

The RBI has used this weapon for many times to bring down the prices of agricultural commodities. The directives are issued by the RBI as supplement to the traditional weapons of control like the bank rate policy, open market operations, etc.

4. Rationing of Credit

This method is used to control the scheduled banks borrowings from the RBI. The RBI shows differential treatment in giving financial help to its member banks according to the purpose for which the credit is used.

This is done by framing different eligibility rules for various kinds of paper, as well as offering differential rates of rediscount on different kinds of bills offered for rediscount.

The RBI prescribed a lower rate of interest on advances to sectors like export trade, small scale industries and agriculture. Higher rate of interest was fixed for general loans.

5. Credit Authorization Scheme

Under this Scheme, the commercial banks have to obtain the RBI's prior approval for sanctioning any fresh credit of Rs. 1 crore or more to any single party in the private sector and for sanctioning any fresh credit of Rs.5 crore or more to any single concern in the public sector. The scheme has however, been discontinued from November 1988. Presently no authorization is required from RBI for commercial banks sanctioning credit limit for normal

6. Moral Suasion

Limitations of Selective Credit Controls in India Business operations. Originally this system was adopted to ensure that borrowers actual need that much credit facility and to find out the purposes for which it was required, was also ensured that most credit facility was not cornered by few borrowers.

In addition to the methods of credit control as given above, the RBI has been exercising moral suasion on banks. Moral suasion is a means of strengthening mutual confidence an understanding between the monetary authority and the banks as well as financial institute and, therefore, is an essential instrument of monetary regulation.

Either by holding meetings or by circular letters the Governor of the RBI is persuading the banks to follow a particular line of action. In certain times a mere statement or speech by a top executive of RBI does this function. Following are the few examples for such line of action given to banks:

(i) To refrain from lending for speculative purposes.

(ii) To reduce the level of advances against certain commodities without prejudice to their assistance to industry.

(iii) To increase their investment in government securities.

(iv) To invest their liquid funds in the shares of State Electricity Boards, Land Devel­opment Banks, And Industrial Finance Corporations etc.

(v) To achieve the target set in regard to lending to priority sectors. The nationalization of the leading banks has enhanced the scope of this weapon in credit control.

(vi) To maintain exchange rate stability, mostly to arrest falling rate of rupee.

7. Direct Action

When the moral suasion proves ineffective the RBI may have to use direct action on banks. The RBI is empowered to take certain penal actions against banks which do not follow the line of policy dictated by it. The banks in default will be made to suffer by way of the following:

(i) Levying penal interest rates on the defaulting banks.

(ii) Cancelling the licences of such banks ( extreme step)

(iii) Refusing to grant refinance facilities to such banks

(iv) Putting lending restrictions on the banks.

(v) Not permitting opening of new branches for the banks.

(vi) Not allowing participation in money market, etc.

This method is essentially a corrective measure which may bring about some psycho­logical pressure on the commercial banks to follow the RBI instructions.

The selective credit control suffers from the following limitations.

(i) The Banks find it difficult to ensure that the loans granted to businessmen are used for the purposes for which they are intended.

(ii) Money once spent does not vanish into thin air. It will be repent again and again, depending on the size of the multiplier and extent of leakages.

Though the banks can en­sure that the credit granted by them is made use of in the first instance for purposes ap­proved by them, they cannot have any control over the purposes for which the resulting additional purchasing power is spent.

Thus, the purchasing power that has originated from the credit granted for a particular purpose may work its way into unwanted lines when it is spent over and over again.

(iii) Selective credit control has the serious limitation that it can control only a small part of investment, on such lucrative and soon - get - rich commodities in as much as substantial volume of investments may be financed by black money i.e., sources other than bank credit.

Further investment is largely financed by capital issues, undistributed profits, borrowing from non-banking institutions. Banking policy therefore can only have a very limited effect.

(iv) Directives are issued to banks only. Other providers of funds may not follow these directives.

Thus it should be noted that the selective credit control is not competitive and alterna­tive to the quantitative measures. They are complementary to the general traditional meth­ods. The credit control can be made more effective by the comprehensive approach, i.e., including both quantitative and qualitative measures.