Credit Control : Regulatory Role of the Central Bank
Monetary management is the most important function of a central bank. Large fluctuations in the volume of money in the economy gives rise to wide fluctuations in the value of money and create the problems of inflation and deflation.
The central bank uses monetary policy for appropriate management.
Question : What is monetary policy ?
Answer : Monetary policy is the policy drafted and executed by the central bank to regulate and control the supply of money, the cost and the availability of credit in a country.
It is also known as Credit Policy.
Main objectives of monetary policy:
1. Economic growth
2. Price stability
3. Attainment of full employment
4. Balance of payments equilibrium
5. Stability in the rate of foreign exchange etc.
Methods of Credit Control by Central Bank:
The central bank of a country adopts various methods to control and regulate the money supply and the availability of credit in the economy. These methods are known as instruments or weapons of credit control. These methods of credit control are generally classified under two broad categories :
1.Quantitative Credit Control Methods
2. Qualitative Credit Control Methods
1. Quantitative Methods :
- These are the methods to control the overall quantity of the credit and the cost of credit.
- They have the uniform impact on all the sectors of economy.
- They are more suitable for developed economies.
- Main quantitative methods are:
1. Bank Rate
2. Open Market Operation
3. Varying Reserve Ratio
4. Repo Rate and Reverse Repo Rate
1. Bank Rate:
- Bank rate is the rate at which the central bank lends money to the commercial banks for their liquidity requirements.
- It is also called the discount rate.
- These are the rate at which the central bank re -discounts bills of exchanges, government securities, commercial papers etc. held by commercial banks.
- When the central bank charges higher bank rate from commercial banks, the commercial bank also charges higher interest on the loans to customers.
- The borrowing becomes expensive, thus decreases and this way the credit creation by the banks declines.
- During inflation period, the central bank tends to reduce the money supply in economy, hence it increases its bank rate and decline credit creation.
- During recession, the central bank injects the money supply by reducing bank rate, in turn the commercial banks also charge lower rates. Borrowing becomes cheaper, people borrow more and credit creation increases.
2. Open Market Operations:
- It refers to the buying and selling of the government securities by the central bank in the money and capital market.
- By using this method, the central bank expands or contracts the money in the banking system.
- During inflation, the central bank tends to pull out the money supply from economy.
- The central bank comes out to sell the government securities. Since these are the secure way of investment –
a. People will withdraw surplus from bank deposits to purchase these securities, hence the deposit will fall with banks.
b. Bank also use their surplus with them to purchase these securities instead of lending.
Thus, the capacity of banks to create credit falls.
- On the other hand, when the economy facing recession, the central bank tends to inject money supply in the economy.
- At this time, the central bank comes as the buyer of securities. This leaves more money in the hands of the people and the commercial banks.
- People put back the surplus money as deposits with banks.
- Credit creation capacity increases.
3. Varying Reserve Ratio :
- The commercial banks are required to maintain a certain reserves referred as Legal Reserve Ratio (LRR).
- LRR has two components: Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR).
- Cash Reserve Ratio (CRR) : It is the proportion of the net deposits which commercial banks are required to maintain with the central bank.
- Statutory Liquidity Ratio (SLR) : It is the proportion of the net deposits which the commercial banks have to, under law, hold in the liquid from (cash or gold) with themselves, is called statutory Liquidity Ratio.
- When either of the components of LRR or both – CRR and SLR are increased, the commercial banks are required to hold larger cash reserve with them and the funds to create credit through loan falls. This will decrease credit creation.
- On the other hand, when the LRR is reduced, the banks are required to hold small cash reserve with them and hence they have more funds to create credit.
4. Repo Rate and Reverse Repo Rate:
- Repo Rate or Repurchase Rate: It is the rate of interest at which RBI lends to the commercial banks for short period against government bonds.
- When RBI increases repo rate , commercial banks also increase the interest rate on credit. This will result in an expensive borrowing hence the credit creation fall.
- Reverse Repo Rate : It is the rate of interest at which the RBI borrows from commercial banks for short period. It is the interest the commercial bank get on lending to RBI.
- When Reverse repo rate is increased, it is the beneficial condition for commercial banks to lend to central bank. In this situation, commercial banks will become less interested in lending to others, this will result in decrease in credit creation.
- When Reverse repo rate is decreased, commercial banks prefer to lend out to private customers than to RBI which will finally result in increase in credit creation.
2. Qualitative Methods:
- These are the methods used to control and regulate the use and flow of credit for specific use.
- These methods are more suitable for developing economies.
- They are also known as – Selective Credit Control Methods.
- Some of the qualitative methods are as follows :
1. Regulation of Consumer Credit
2. Margin Requirement Regulation
3. Credit Rationing
4. Direct Action
5. Moral Suasion
1. Regulation of Consumer Credit:
- Regulation of consumers credit is designed to check the flow of credit for consumer expensive durable goods, like motor cars, computers etc.
- A certain percentage of the price of the goods is paid by the consumers as the cash – down payment and the remaining portion is financed by bank credit.
- The bank loan in realised from the consumers in instalments during a specific period of time.
- The central bank may regulate the use of bank credit by consumers by changing interest rates charged on such loans, by influencing the amount of down payment, number of instalments and the period of repayment.
2. Margin Requirement Regulation :
- Margin requirement is the difference between the market value and the loan value of the collateral security against which the borrowing has to be done.
- By raising the margin requirement, the loan amount against the security declines, this will leave borrowing expensive. Hence people will borrow less for consumption purpose.
- By lowering the margin requirement, the borrowings are cheaper and favourable hence credit creation increase.
3. Credit Rationing:
- Central Bank fixes the quota of credit available to different sectors of economy.
- To promote economic development, higher quota for productive purpose will be fixed, than any other loans.
4. Direct Action:
- Direct action refers to various directives issued by the central bank to commercial banks to regulate their lending and investment activities.
- The central bank can take direct actions against erring banks which do not follow the policies of the central bank.
- The action are taken in the form of refusal of re -discounting facilities or refusal of loans from the central bank charging penal rate of interest etc.
5. Moral Suasion or Moral Persuasion :
- Moral suasion is the method of persuasion advice, request, informal suggestions to commercial bank by the central bank.
- This method is frequently adopted by the central bank to exercise control over commercial banks.
- Under this method central bank gives advice, then request and persuasion to the commercial banks to co – operate with the central bank in implementing its credit policies.
- Central bank relies upon its moral fluence on the commercial banks as the head and leader of the financial institution.
6. Publicity:
- The central bank expresses its views about various monetary and banking policies, through the media of publicity.
- The central bank uses this method both for influencing credit policies of the commercial banks as well as to influence the public opinion in the country.
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