The most important function of the Central Bank is to control credit. The Central Bank uses various methods to control credit. This method can be classified into two broad categories. They are:
Methods of Credit Controls
1. Bank rate policy
2. Open market operations
3. Variation of cash reserve ratio
4. ‘Repo’ or Repurchase Transactions
1. Fixation of margin requirements
2. Rationing of credit
3. Regulation of consumer credit
4. Controls through directives
5. Moral suasion
7. Direct action
Let us discuss these methods one by one.
Quantitative Methods of Credit Control
The quantitative methods of credit control are the general and traditional methods. They aim at the regulation of the quantity of credit and not its application in various uses. They are expected to control and adjust the total quantity of deposits created by the commercial banks.
They relate to the volume in general. These methods are indirect in nature. The objectives of quantitative methods of credit control are as follows:
(i) Controlling the volume of credit in the economy.
(ii) Maintaining equilibrium between saving and investment in the economy.
(iii) Maintaining the stability in exchange rates.
(iv) Correcting disequilibrium in the balance of payments of the country.
(v) Removing shortage of money in the money market.
The important methods under this category are, 1. Bank Rate Policy
It is also known as discount rate policy. Bank rate is the rate at which the Central Bank is prepared to rediscount the approved bills or to lend on eligible paper.
This weapon can be used independently or along with other weapon. By changing this rate the Central Bank control the volume of credit. The bank rate is raised in times of inflation and is lowered in times of deflation.
A rise in the bank rate is usually preceded by the following events:
(i) Over supply of money and rising price level.
(ii) Great demand for money caused by active trade.
(iii) Adverse rate of exchange, and
(iv) Unfavorable balance of trade.
In times of adverse balance of payments and rising price level, the Central Bank increases the bank rate and thereby forces the market rates to go up. Because of this, credit becomes dear and borrowing from banks becomes costly. The speculators are discouraged to buy and stock goods.
They start selling their stock of goods in the market, and the prices take a downward trend. Exports begin to rise and the imports decline. Foreign investors are encouraged to keep their cash balances within the county so as to earn the increased rate of interest. The adverse balance of payments gradually disappears.
A rise in bank rate has the following consequences:
There is a corresponding rise in the market rate that is, the rate charged by financial institution.
The prices of fixed interest bearing securities tend to register a decline because the interest rate ruling in the market would be higher than the rate originally fixed on such securities.
A shift in investments from fixed interest bearing securities to equities results in a rise in the prices of the latter, especially, shares of growing companies.
There is shrinkage in investment on capital assets due to the shortage of finances.
Fall in the prices of consumer commodities due to less spending and the unloading of stocks.
Transference of foreign money into the country due to the high rates of interest ruling and the consequent improvement in the foreign exchange position.
Increase in exports.
But in times of falling prices, the Central Bank lowers the bank rate and brings about a fall in the market rates of interest. This will lead to increased volume of trade, investment, production and employment and ultimately leads to the rise in the price level.
Conditions for the Operation of Bank Rate Policy
To use the weapon of bank rate policy some basic requirements are to be fulfilled. The impact of a change in the Bank rate depends upon the following:
(i) Existence of close nexus between Bank Rate and market rates, i.e., the extent of the dependence of commercial banks on the Central Bank for funds.
(ii) The availability of funds to banks from other sources.
(iii) The extent to which other interest rates are directly influenced by changes in the bank rate. If the other rates of interest in the market do not respond to bank rate changes desired results cannot be realized.
(iv) The degree of importance attached to a change in the bank rate as an indicator of the monetary policy.
(v) There must be an organized short-term funds market in the country
(vi) There must be a great measure of elasticity in the economic structure of the country. When prices fall, the various elements in the cost of production like wages citations of Bank Rate Policy
The report of Macmillan Committee stated that the bank rate policy is an absolute essay for the sound management of a monetary system. It is an important weapon of edit control.”But, it suffers from the following limitations:
(i) The rate of interest in money market may not change according to the changes in the bank rate.
(ii) In rigid economic system, i.e., planned and regulated economies, the prices and costs may not change as a result of changes in the rate of interest.
(iii) The bank rate cannot be the sole regulator of the economic system, and the volume of savings and investments cannot be controlled through the rate of interest alone. The effectiveness of changes in interest rate depends upon the elasticity of demand for capital goods.
(iv) The effect of rise in the bank rate in controlling credit for industrial and commercial purpose is limited. If the businessmen take the view that prices will continue to rise, a slight rise in the rate of interest will not discourage them to expand their activity with borrowed money. So long as prices have a tendency to rise and so long as there is business optimism, businessmen would be willing to pay higher interest rates.
(v) In ties of depression, a fall in the rate of interest can hardly stimulate economic activity. Because the businessmen may not be prepared to increase their activity if they fear about the future. Prof. Sayers considers the bank rate as a halting, clumsy and indeed a brutal instrument.
(vi) The change in the methods of financing by the business firms reduces the importance of bank rate policy In recent years the commercial banks have ample liquid resources of their own. The business firms depend more on sloughing back of profits than borrowing from commercial banks.
(vii) The conflicting effects of bank rate also reduce the importance of this weapon. When the bank rate is increased the foreign capital may flow into the country, thus, making credit control difficult.
(viii) Indiscriminate nature of bank rate policy: The bank rate policy does not discriminate the activities into productive and unproductive activities. It affects both the activities on the same footing. This will adversely affect the genuine productive activities with increased rate of interest.
Because of these limitations, the bank rate policy has lost its importance. But during e inflationary situations it can be used with some modifications. But it may not regain its order importance.
Open Market Operations
Open market operation refers to buying and selling of eligible securities by the Central Bank in the money market and capital market. The buying and selling of securities by the Central Bank results in an increase or decrease in the cash resources of the commercial banks. This in turn affects the credit creation of the commercial banks.
Open market opera- ions tend immediately to increase or decrease the quantity of money in circulation and the ash resource of Commercial Banks.
Objectives of Open Market Operation
The weapon of open market operation helps in achieving the following objectives:
(a) To make the bank rate policy effective and successful.
(b) To avoid disturbances in the money market as a result of movement of Government funds or seasonal movements of funds generally.
(c) To eliminate the effects of inflow or outflow of gold by import and export under Gold Standard.
(d) To support Government credit in connection with the issue of new loans or the conversion of the existing loans.
(e) To counteract extreme trends in business situation by buying securities during periods of low economic activity and selling them in periods of high economic activity.
(f) To create and maintain conditions of cheap money as an aid to business recovery.
(g) To avoid undue fluctuations in the prices of Government securities and to correct undesirable or unjustifiable spreads between the yields of various types of securities.
(h) To absorb an excess of liquid funds.
(i) To insulate the credit structure from sudden and temporary changes in the balances of payments position.
The most important reason is the decline of discount rate as an instrument of credit control and the consequent need for another and more direct method.
Open market operations became necessary in order to implement the policy of cheap money. These operations have been considerably facilitated as a result of increased volume and variety of Government and other gilt-edged securities traded in markets of most countries.
Method of Operation
If the Central Bank wants to reduce the volume of credit created by the banks, it sells eligible securities in the market. When the banks and the public purchase these securities, they have to make payments to the Central Banks.
This results in the movement of cash from Commercial Banks to Central Bank. As a result of this the primary reserves of the banks fall. Hence, the capacity of the banks to expand credit will be contracted. In times of inflation the Central Bank sells eligible securities in the open market.
When the Central Bank wants to expand the volume of credit, it starts buying the approved securities from the open market. Now, the Central Bank has to make payments to the commercial banks and the public for the purchases made from them.
This result in the movement of cash from the Central Bank to commercial banks. As a result, the cash reserves in the hands of commercial banks will increase. They find themselves in a position to expand credit. This is followed during deflationary situations.
Prerequisites for the Success of Open Market Operations
(a) The market for the securities should be well organized, deep, active and broad based.
(b) The rate of interest offered on government securities should be competitive.
(c) The existence of sufficient number of securities.
(d) The willingness of commercial banks to lend.
(e) The maintenance of rigid cash reserve ratio by the commercial banks.
(f) Willingness of the general public to borrow money from the commercial banks.
(g) Commercial banks should not have direct access to accommodation “from the Central Bank.
Limitations of Open Market Operations
The following are the main limitations of the open market operations.
(i) Quantity of money circulation may not change:
It depends upon the close connection that prevails between the operations and the quantity of money in circulation. Quantity of money should at least approximately change according to operations. But in actual practice it may not change in the desired direction due to two factors, such as hoarding and dishoarding of cash and inflow and outflow of capital, etc.
(ii) Influence of economic and political reasons:
It is assumed that the commercial banks increase or decrease their loans and advances in accordance with the changes in their cash reserves. But they may not do so due to monetary, economic and political reasons. Even though there is an increase in their cash reserves, they may not expand the credit for want of credit-worthy borrowers.
(iii) Pessimistic approach of Businessmen affects the operations:
The demand for bank credit cannot be wholly controlled by commercial banks or by the Central Bank, but it depends upon the actions if the businessmen. The Central Bank may buy securities and increase the cash base of the commercial banks. The commercial banks may be willing to expand credit. But the businessmen may not borrow if they are pessimistic about the future.
(iv) Not effective in developing countries:
The effectiveness of open market operations depends upon the existence of a broad and active securities market, in short-term as well as long-term securities. But such markets are to be found only in advanced countries. However, the increased ‘ ovum of treasury bills in many countries are proving helpful for effective open market options.
(v) Dependence of resources of the Central Bank:
The Central Bank must be capable of launching operations on the necessary scale, which depends upon its resources. The resources of the Central Bank in turn depend upon its constitution and the policy of its Government.
(vi) Lacks immediate effect: The additional cash put into the money market by the Central Bank by purchasing of securities will not come to the commercial banks immediately as deposits. It takes time to reach the commercial banks. Therefore the effect of this weapon may not be immediate due to this time lag.
Variation of Cash Reserve Ratios
The weapon of variation of cash reserve ratios has been suggested as a supplement to other methods of credit control because of its efficacy under all conditions. The commercial banks have to keep a minimum cash reserve with the Central Bank.
Under this method, the Central Bank has the power to vary the percentage of deposits that must statutorily be kept with it by commercial banks, within certain limits. When the Central Bank wants to reduce credit, it will increase the cash ratio to be kept by the commercial banks.
This reduces the capacity of the commercial banks to lend and thus, the credit creation is controlled. When the Central Bank considers increasing the credit, it will lower the cash reserve ratio. Now the commercial banks will nave additional cash which will lead to credit expansion.
In India the Cash Reserve Ratio has become an important tool to control or expand liquidity position with the banking system. When excess liquidity is available with banks the CRR is hiked to impound excess cash. Similarly, this rate is also used to stabilize Exchange Rate of Rupee.
When Exchange Rate of Rupee comes under attack from speculators, CRR is raised to arrest the fall in value of Rupee. The CRR is often changed these days.
However, the rate is drastically reduced in recent times. In April 1999, it stood at 10.5 per cent for commercial banks. In May 1999, it was reduced by 0.5 per cent and stood at 10.0 per cent and in November 1999 it was further decided to 9 per cent of net demand and time liabilities of banks.
Limitations of Variations of Cash Reserve Ratios
The method of variation of reserve ratio suffers from the following limitations:
(a) This method may not be successful and effective if the commercial banks have excess cash reserves with them.
(b) The success of this method depends upon the customer’s willingness to borrow from the banks. If they are not willing to borrow the credit cannot be expanded even if the commercial banks have adequate cash reserves with them.
(c) This method imposes an increased burden on the credit system. Under this system the commercial banks follow very cautious activities and many not extend credit facilities even if they have surplus reserves due to the fear that they may be asked to maintain higher cash reserves than before.
This results in keeping idle cash reserves. Keeping such idle cash balances leads to higher rate of interest on bank advances and the burden ultimately falls on the borrowers.
(d) Discriminatory in effect that banks have to keep a certain percentage of cash reserves with the Central Bank. And the percentage may vary depending upon the policy of the Central Bank. This causes serious effects on small banks which find it difficult to maintain additional reserves.
(e) This method lacks flexibility. It cannot be well adjusted to meet sectoral requirements or localized situations of reserve stringency or surplus.
(f) This method is inexact and creates uncertainty because the commercial banks are always under certain fear of sudden changes in the cash reserves that they have to keep with the Central Bank.
(g) The weapon of variation of cash reserves gives a sweeping power to central bank over commercial banks. It is actually a very powerful weapon, but it may cause much suffering if it is not used properly.
(h) The variation of cash reserve ratio is a powerful weapon. A slight change in the cash reserve may lead to either multiple expansion or contraction of credit. Thus, it is suitable only when it is desired to effect major charges in the reserves of the commercial banks. But when marginal adjustments in the reserves are expected, this method is not suitable.
Variation of Cash Reserve Ratio vs. Open Market Operations
Variation of cash reserves is superior to open market operations in the following respects:
(a) The success of open market operations depends upon the existence of a broad and developed capital market and a large supply of Government securities with the Central Bank to conduct such operations on an extensive scale.
In countries where open market operations cannot be carried out on an extensive scale due to the absence of these conditions, the variation of cash reserves has an increasing influence on the Central Bank.
(b) The large scale sale of securities by the Central Bank as a part of open market operations policy will depress the value of securities and bring loss to the Central Bank. If the values of securities fall, commercial banks also incur loss as their portfolio consists of a large volume of government securities.
The variation of cash reserves secures the same results as open market operations but without the loss that may arise in dealing in securities. When commercial banks are asked by the Central Bank to increase the percentage of reserves, they may of course sell securities for maintaining increased case reserve.
In order that the sale of Government securities by commercial banks does not depress its price realization, the central bank may simultaneously buy such securities. It may however be stated that this method may help commercial banks to avoid incurring losses in the sale of securities, it may not serve the objective of the central bank,
(c) Another limitation of open market operations is that the cash reserves of commercial banks may be so excessive that Central Bank may not be able to reduce them by selling securities available with it but a change in reserve requirements achieve the result easily with a mere change in the reserve rate,
(d) Whenever the Central Bank conducts open market purchase of securities, the volume of earning assets held by the banks in their portfolio is reduced. Variable reserve ratios do not affect the earning assets of banks unless banks sell securities to increase their reserves.
(e) The new method of credit control can be adopted to strengthen the Central Banking control under highly liquid monetary conditions or conversely under conditions of severe credit stringency.
It has been suggested that open market operations and variation of cash ratios should be followed as complementary to each other. A judicious combination of both will remedy the defects of each technique when used individually, and produce good results.
‘Repo’ stands for repurchase. ‘Repo’ or Repurchase transactions are undertaken by the central bank to influence money market conditions. Under ‘Repo’ transaction or agreement one party lends money to another for a fixed period against the collateral of securities approved for this purpose.
At the end of the fixed period, the borrower will repurchase the securities at the predetermined price. The difference between the repurchase price and the original sale price will be the cost for the borrower.
In other words, instead of a pure or simple borrowing of funds, the borrower parts with securities to the lender with an agreement to repurchase at the end of the fixed period. This parting with the securities will make the cost of borrowing, known as ‘Repo Rate’ little cheaper than pure borrowing.
‘Repo’ transactions are conducted in Money market to manipulate short-term interest rate and to manage liquidity levels. ‘Repos’ are conducted by central banks to absorb or drain liquidity from the system. In case they desire to inject fresh funds in the cash market, they will conduct ‘Reverse Repo’ transactions.
In the reverse repo ‘the securities are received first against money paid and returned after receipt of money, at the end of the agreed period. In India, ‘Repos’ are normally conducted for a period of 3 days.
The eligible securities for the purpose are decided by RBI. These securities are usually Government promissory notes, Treasury bills and some public sector bonds.
Qualitative Methods of Credit Control
The qualitative credit control is also called as selective credit control. It is used as an adjunct to general credit control. In certain situations quantitative credit control may not be helpful. At times it may harm certain sectors of the economy.
Because, the quantitative methods control the volume of credit in total, it does not discriminate the credit flow into productive and unproductive purposes. Thus, it affects the genuine productive purposes also. But, the selective credit control provides for such discrimination.
Under these methods the credit is made available for the productive and priority sectors and restricted to others. This is very much helpful to the developing and underdeveloped economies.
Selective Credit Control
The selective credit control methods control certain types of credit and not all credit. They directly affect the demand for bank credit as also the capacity of the banks to lend. They can be used more effectively without any changes in the prevailing rates of interest.
Objectives of Selective Credit Control
a) The following are the main objectives of selective credit control measures:
b) To distinguish between essential and non-essential uses of bank credit.
c) To ensure adequate credit to the desired sectors and curtail the flow of credit to less essential economic activities.
d) To control the consumer credit used for purchase of durable consumer goods.
e) To control a particular sector of the economy without affecting the economy as a whole.
f) To correct the unfavorable balance of payments of the country.
g) To control the inflationary pressures in the particular and important sector of the economy.
h) To control the credit created by other institutions.
Methods of Selective Credit Control
The Central Bank uses the following qualitative methods to control the credit in the economy:
1. Fixation of margin requirements:
The Central Bank prescribes the margin which banks and other lenders must maintain for the loans granted by them against commodities, stocks and shares. To restrict the speculative dealing in stock exchanges, the Central Bank prescribes the margin requirements for securities dealt with.
When the Central Bank prescribes higher margin the borrowers can obtain less amount of credit on his stock. If the margin prescribed is low, the speculators can borrow from bankers buy the commodity, storage and sell only after price rise. To contract credit, the Central Bank raises margins and lowers the margins to expand the credit available.
Objectives of Margin Requirements
The Central Bank may prescribe margin requirements to achieve the following objectives:
(i) To divert investible funds from speculative to productive lines.
(ii) To reduce the volume of credit created by commercial banks.
(iii) To reduce the prospect of making speculative profits in stock exchanges.
(iv) To reduce the risks and uncertainties of joint stock companies by maintaining the stability of stock prices.
2. Rationing of credit:
The Central Bank controls the credit created by the banks through the rationing of credit. Under this method, the Central Bank fixes a maximum limit for loans that a commercial bank can provide to a particular sector or for all purposes. This can be achieved through the following two methods:
(i) Variable portfolio ceiling:
Under this method, the Central Bank fixes a ceiling on the aggregate portfolios of commercial banks above which loans and advances should not be increased. It may even fix a ceiling for specific categories of credit. It may also fix a maximum limit for the loans that the commercial banks can borrow from the Central Bank.
(ii) Variable capital assets ratio:
Under this method, the Central Bank can fix the minimum ratios which the capital and surplus of banks must bear to the volume of assets or specific categories thereof of the commercial banks. The Central Banks can change such minimum ratio from time to time. Rationing of credit can play a great role in planned economies.
It secures diversion of commercial resources into the channels fixed by the public authority in achieving the objectives of planning.
3. Regulation of consumer credit:
The Central Bank to regulate the consumer credit, fixes the down payments and the period over which the installments are spread. In developed countries, large portion of national income is spent on consumer durable goods such as cars, refrigerators, costly furniture, etc.
The installment credit for consumer durable goods plays an important part in certain economies. Expansion of such credit affects the developed economies adversely. Many countries have adopted this weapon to control credit allowed to the consumers.
It is essential to regulate consumer expenditure on such durable goods to control inflations. The method of control involves the following steps.
Steps involved in Controlling Consumer Credit
1. The scope of regulation with respect to particular consumer durable goods will have to be defined.
2. Fix the minimum down payment.
3. The length of the period over which installment payments may be spread will have to be fixed.
4. The maximum cost of installment purchases exemptions have to be prescribed.
Effect of Control
To control inflation a large number of durable goods will be listed for control, the minimum down payments will be raised, the period over which installment payment can be spread will be reduced and finally the maximum exemption costs will be lowered.
4. Control through Directives:
The Central Bank issues directives to control the credit created by commercial banks. The directives may be in the form of written orders, warnings or appeals, etc. Through such directives the Central Bank aims to achieve the following objectives:
(i) To control the lending policies of the commercial banks.
(ii) To prevent the flow of bank credit into non-essential lines.
(iii) To divert the credit to productive and essential purposes.
(iv) To fix maximum credit limits for certain purposes.
The Central Bank issues directives from time to time and the commercial banks abide
5. Moral Suasion:
Under this method, the Central Bank merely uses its moral influence on the commercial banks. It includes the advice, suggestion request and persuasion with the commercial banks to co-operate with the Central Bank.
If the commercial banks do not follow the advice extended by the Central Bank, no penal action is taken against them. The success of this method depends upon the co-operation between the Central Bank and Commercial Banks and the respect the Central Bank commands from other banks.
The Central Banks generally use the method of publicity to control the credit creation of commercial banks. Under this method, the Central Bank gives wide publicity to its credit policy through its bulletins.
By this, the Central Bank educates the general public regarding the monetary policy and its objectives. Through such publicity, the commercial banks are guided and change their lending policies accordingly.
7. Direct Action:
The method of direct action is the most effective weapon of Central Bank to control credit creation. The Central Bank uses this method to enforce both quantitative and selective credit controls. It is used as a supplement to other methods of credit control.
The Central Bank can take action against the banks which contravene its instructions. But this method may lead to conflict between the central bank and commercial banks.
However, these days no commercial bank can afford to go against the wishes of the central bank with regard to policy matters, as the central bank has wide powers even to stop banks’ operations.