Question

Explain the different methods of credit control by the Central bank.
(atleast 1000 words)

Answer 1

methods employed 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.

Limitations:

ADVERTISEMENTS:

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.
Limitations:

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 Ratios.

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.

Limitations:

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.

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.

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