CREDIT CONTROL BY RBI

Credit control is the activity exercised by the central bank on commercial banks with a view

of increase or decrease money supply in the market. It is also known as monetary policy.

Credit creation is important for banks to overcome shortage of capital which has always been

a stumbling block on the road to industrial progress. But free hand credit creation will lead to

inflation. Therefore RBI always watch and regulate the credit creation of commercial banks.

The expansion or contraction of credit is decided according to the condition prevailing in the

economy.

OBJECTIVE OF CREDIT CONTROL

a) To stabilise the economy by removing the factors which are responsible for increase

in price or employment or fluctuation in trade

b) To achieve the objective of economic growth or price stability or correction of

adverse balance of payment

c) To exercise effective control over commercial banks

d) To help the government to achieve economic development with high per capita

income

CREDIT CONTROL MEASURES

The central bank exercises two type of credit control:

Quantitative

Qualitative

QUANTITATIVE CREDIT CONTROL

This measure aims at increasing or decreasing the quantum of money supply. The increase or

decrease in the quantum of credit influences the economic activity in the country. This is

considered as a traditional weapon and also as an indirect weapon. The effect of this type of

credit control is felt in long run.

METHODS OF QUANTITATIVE CREDIT CONTROL

The methods with which the central banks control credit are:

1> Bank rate policy

2> The open market operation

3> Variable reserve requirement

1.BANK RATE

Bank rate refers to the rate at which the central bank rediscounts the bills which are presented

by commercial banks for giving loans. It can be defined as “The varying of the terms and of

the conditions, in the broadest sense, under which the market may have temporary access to

Central bank through discounts of selected short term assets or through secured advances”.

Whenever commercial banks need funds they approach the RBI by presenting to the central

bank eligible securities. By discounting these securities the central bank grants the loans to

commercial bank. It is the same basis for commercial banks to grants the loans to its

customers. Hence if bank rate is increased the commercial banks would have to pay higher

rate of interest for borrowing from CB. The commercial banks in turn would charge higher

int. Rate when they grant loans to their customers. Thus the bank rates indirectly affect the

borrowers of the bank. Whenever the central bank deems it necessary to decrease the total

amount of money in circulation, it will increase the bank rate. This will be followed by an

increase in the market rates. Higher market rates will discourage borrowing; resulting in a

reduction of bank credit.

Under gold standard, a variation in the bank rate will readjust the internal cost-price structure

and will correct any disequilibrium in the balance of payments by curbing the movement of

gold into and out of the country. By manipulating the bank rate the RBI can regulate

commercial bank credit and the general credit situation of the country.

ASSUMPTI ONS ON WHICH THE BANK RATE OPERATES

1. The commercial banks are conducting business with minimum cash reserve.

2. The commercial banks have with them eligible securities on which the central bank grants loan by discounting them.

3. Borrowing from the central bank is the only option available for the commercial banks.

4. Taking the bank rate as the base, the interest rate on borrowings are fixed and when the bank rates arc raised, the interest on the borrowing arc also raised.

Objectives o f bank rate policy

(i) When there is inflation, the central bank increases the bank rate, and thecommercial banks are forced to raise their interest rate on its borrowers also.This discourages borrowings and thereby results in reduction of money supply. The price level is brought down. Likewise in the times of depression, when the bank rate is reduced the interest rate is also reduced on borrowings which leads to more borrowings.

(ii) For correcting the adverse balance of payment situation, an increase in thebank rate is adopted. This lowers the price level because of lesser demand inborrowings. This results in more exports.

(iii) The increase in bank rate forces the traders to liquidate their stock became they cannot afford taking loans at a higher interest rate. This makes the hoarded stocks to liquidate leading to increase in the supply of goods and prices are automatically brought down.

MECHANISM OF BANK RATE

A change in the bank rate will be followed by corresponding change in the market rates. In inflationary the central bank intervenes and raises the bank rate. This will increase the cost of borrowing for the banks. Consequently, the market rates will go up. The increased market rates will discourage businessmen from borrowing money. This will check business activity, and unemployment will ensue. The demand for goods and services decreases because of the decreased purchasing power of the people. This, in turn, will affect the producers adversely. Further reduction in productive activities and further unemployment will be the result. As demand decreases prices will ultimately come down. Thus, an increase in the bank rate will be followed by a diminution in the total amount of money in circulation, reduction in money , incomes and prices, and a general slowing down of the economic activities. Conversely, a decrease in the bank rate will be followed by a reduction in the market rates. This will be accompanied by increased borrowing, increased money incomes, increased prices

Bank Rate Policy under Gold Standard

When there is an adverse balance of payments followed by loss of gold from a country

owing to maladjustment between imports and exports or by an excessive flow of capital

owing to lower money rates prevailing in that country, the central bank can check this by

increasing the bank rate. We have already traced the internal effects of such an increase and

come to the conclusion that this will, ultimately lead to a reduction in prices.

Lower prices will induce foreigners to purchase goods from that country, while relatively

higher prices in foreign centres will discourage imports. This will help the country to develop

a favourable balance of trade. Further, higher money rates will attract foreign capital. In

short, an increase in the bank rate will help the country to correct any adverse balance of

payments through an inflow of gold.

However, a continued inflow of gold will disturb the equilibrium in the balance of payments.

When country receives too much of gold, it will accelerate the power of banks to increase the

total amount of money in circulation. Business activities will be stimulated, followed by an

increase in the internal cost-price levels and will result in an adverse balance of payments.

Therefore, whenever the central bank finds that boom conditions are developing in the

economy, it has to apply the brakes and lower the bank rate. Thus, by varying the bank rate

constantly, upwards or downwards, the central bank can maintain equilibrium in the balance

of payments.

TREND OF BANK RATE

At its very inception the bank had to maintain a cheap money policy under which the Bank

Rate was maintained constantly at 3 per cent. A change in the Bank Rate implies a

corresponding change in the market rate of interest. Only in such a case can we say that the

Bank Rate is effective. The lack of coordination between the various components of the

Indian Money Market and the lack of contact between the unorganized section of the Indian

money market and RBI make the effectiveness of the bank rate doubtful. In addition to all

this, very little use has been made of the rediscounting facilities by the commercial banks

because of the absence of a well developed and properly organized bill market.

In 1951 nov 15, RBI increased bank rate from 3 % to 3.5%.Simultaneously, a drastic change

has been effected in the Bank's policy of providing finance to the commercial banks in order

to make the bank rate policy effective. The bank announced that it would refrain from

purchasing Government Securities to meet the seasonal requirements of scheduled banks but

would, as a normal practice, advance money at the prevailing Bank Rate on Government and

other securities specified in the Reserve Bank of India Act. In 1957 the bank rate again

changed to 4%.

SLAB SYSTEM OF LENDING RATE

3 tier system

The level of bank crdit remained high due to low rate of borrowing fro RBI. This situation

indicated the need of limiting the banks access to the Reserve Bank on some basis. The RBI

decided to fix ceilings for borrowing by banks or to raise such borrowings or to adopt a

combination of both methods. It is considered best in the circumstances to introduce a system

of slab rate under which scheduled bank's access to the Reserve Bank was regulated under the

three-tier structure of rates related to the extent of borrowing.

Scheme of restriction under 3 tier system-

1> Borrowing quota in each quarter by commercial bank was fixed to half of the avg. of

statutory reserve required to be maintained by it during prev qtr. Any borrowing

above this amount charged penal rate of int by 1% on any borrowing over the quota

upto 200% of the quota. 2% int was charged if it was more then 200%.

2> All scheduled banks should adhere to a minimum lending rate of 5 per cent on all

advances, except those to other banks and employees; in addition, all banks were

required to raise their average lending rate at least by 1/2 per cent.

3> The Bank also fixed a ceiling of 2 per cent in respect of deposits accepted by

scheduled banks from the public repayable on notice or on the expiry of a period not

exceeding 21 days

The system of slab rates combined the feature of direct limitations on borrowing and

raising the cost of borrowing. It provided a technique whereby the objectives of credit

restraint could be attained without too large an adjustment in Government security prices.

4-tier system(readjustment of slab rates)

On 31st October 1962, the Reserve Bank issued a circular revising int rates. According to

the circular a bank could borrow upto 100 % of its statutory reserve at different rates as

follows :

Rate Quota for borrowing

4%- Upto 25% of the statutory reserves.

5%- Upto another 25% of the statutory reserves.

6%- Upto another 50% of its statutory reserves.

Other trends in bank rate are

1> Bank rate at 5%, differential int rate system and withdrawal of quota

system(1964)

The Reserve Bank decided to withdraw the existing scheme whereby the access of

scheduled banks to it was regulated through a system of quotas and introduced instead

a system which is intended to ensure economy in the use of central bank rediscount

facilities through a higher interest rate structure. Thus, a differential interest system

was instituted whereby banks would pay a progressively higher rate for their

borrowings from the Reserved Bank, the level of the rate depending on the real

impairment of the liquidity position of the borrowing banks. To ensure the maximum

effectiveness of the differential rate instrument, the Reserve Bank also placed a

ceiling of 9 per cent on the rate which the larger Indian banks and the foreign banks

can charge on their advances, overdrafts and discounts.

Net liquidity position was defined as the total of a bank's cash balances in current

account with other banks and investments in Government securities, less its total

borrowings from the Reserve Bank and the State Bank and time liabilities.

2> Increse in bank rate from 5 to 6%(1965)

3> In 1973 it increased to 7%

4> Discontinuation of Net Liquidity Ratio and Discretionary Accommodation

With a view to regulating the cost and availability of Reserve Bank refinance more

effectively, the system of refinance based on the Net Liquidity Ratio was

discontinued. Instead the banks were entitled to a basic refinance limit in proportion

to their total deposits as on a particular date fixed from time to time by the Reserve

Bank

5> Bank Rate at 10 per cent

In June 1981, the Bank Rate was increased to 10 per cent. The statutory liquidity ratio

was raised to 35 per cent in October 1981 and to 36 per cent in September 1984. The

increase in statutory liquidity ratio was effected for two reasons, viz., (/) higher

liquidity ratio would force commercial banks to maintain a larger proportion of their

resources in liquid form and thus would reduce their ability to grant loans to industry

and thus would be anti inflationary in its impact; and (ii) a higher liquidity ratio would

divert bank funds form loans to investments in government and other approved

securities.

Shortcomings o f bank rate The credit control weapon called the 'Bank Rate' is successful only under certain conditions listed below:

1. The commercial banks should have with them enough eligible securities which enable them to borrow from die central bank.

2. Only commercial banks should finance the economic activities of the country, no other agency could finance commercial activates.

3. Commercial banks could maintain a minimum cash reserve so that whenever there is more demand for loans, they could approach the central bank for additional funds, but if the commercial banks have large amounts of funds, then no need arises for them to approach the central bank. In this situation bank rate proves ineffective.

4. If the increase in bank rate is significant it has such an impact on the economy that borrowings would lead to unprofitable ventures. But if the increase in bank rate is marginal this encourages borrowing instead of getting discouraged. So the central bank should be very measured while increasing the bank rate.

5. If the borrower feels that die chances for earning profits in die market is much more than that of the increase in bank rate and the interest rate, the borrowers would not mind an increase in the interest rate and borrowing would continue to increase. Hence there is no substantial fall in the borrowings.

2.OPEN MARKET OPERATIONS

"Open Market Operation" implies the purchases and sales of Government securities. It is purchases and sales of equities, gold and foreign exchange, besides Government securities. But in most countries these operations are confined to the purchases and the sales of Government securities. Through selling in the money market the central bank tries to absorb the excess of money supply present with the commercial banks, insurance companies and other types of financial institutions. During the period of inflation, the sale of security by the central bank encourages the commercial banks to buy. These results in surplus cash with the commercial banks to disappear and in its place securities would appear. This results in a situation where commercial banks are left with fewer amounts of funds and they would not be able to lend more and hence borrowers would find it difficult to obtain loan. This reduces the economic activities. Thereby the prices or inflation is brought down. Likewise in the period of depression, central bank buys the securities from commercial banks and thereby infuses money supply in the economy which results in more demand and the economic activities start to revive. Price level also picks up, showing the signs of revival for the economy.

According to Reserve Bank of India Act, the Reserve Bank is authorized to engage in the purchases and sales of securities of the Central Government or a State Government or of such securities of a local authority. The Reserve Bank is authorised to make purchases and sales of

shares in, or capital of the State Bank of India or any other bank or financial institutions notified by the Central Government in this behalf.

In 1951, simultaneously with the raising of the Bank Rate, the Reserve Bank announced a change in its open market policy. According to this, it was decided to provide seasonal finance to banks not by making purchase of Government securities outright but by granting temporary accommodation against the collateral of Government securities. The RBI maintain orderly conditions in the gilt-edged market with a minimum of buying and selling and has operated on a large scale only in the event of a serious imbalance between demand and supply. It has not been the Bank's policy normally to lend support to prices of loans, either of the Central or State Governments, and by and large, Government securities have been allowed to find their own levels. Even the new flotation were generally allowed to quote below their issue prices. Broadly, the Bank follows the market trends and though it is able to influence them in the desired direction. Since November 1951, the Bank's purchases of securities have been mostly "switches", which are operations involving purchase of one security against sale of another as distinct from outright purchase or sale of security. These switch transactions are generally done with the Bank's brokers. Whatever support was given was more or less of a discriminating nature and of temporary duration. The operations were directed mainly to meet the requirements of the market of particular loans or to enable banks and other institutional investors to adjust their investment portfolio.

OPERATIVE TECHNIQUES

The Bank makes its purchases and sales of securities through approved brokers. The selection of brokers and their inclusion on the "approved list" are made on the basis of reputation, financial standing and volume of business done by the broker. The Bank hesitates to deal directly with the public because of the risk of defective title, difficulties regarding enforcement of contracts, and such other practical difficulties. It is always advantageous for the Bank to deal with the brokers as they are recognised members of an established stock exchange and are subject to the rules and regulations of the exchange.

SUCCESS OF OPEN MRKET TECHNIQUES

An important pre-requisite for the successful operation of open market operations is the stability of the cash reserves in banks. In India, scheduled banks maintain cash reserves with the Reserves Bank which are over and above the statutory minimum, the excess over the statutory minimum fluctuating with the seasonal change in monetary conditions This constitutes a limiting factor in the successful operation of open market operations because the operations would only serve to reduce the excess reserves of commercial banks. The other factors for the effective conduct of open market operations is the presence of broad and active money and capital markets

Another factor which may cause serious dislocation in the open market policies of a central bank is the lack of sufficient securities of different maturity with which it can conduct its operations. As regards the adequacy of this, it is observed that the Reserve Bank had always been equipped with sufficient securities.

The legal setting in India for the conduct of open market operations may also be considered as

favorable. At present there are no restrictions either as to the quantity or the maturity of Government securities which the Reserve Bank can buy or sell, and the Bank enjoys full discretion in this respect.

Another factor is the guidelines of primary dealers. Delivery versus Payment (DVP) system also plays a important role. It transfer securities from the seller to the buyer and the payment there for by the buyer to the seller would be simultaneous in respect of those who have an SGL Account and a Current Account with the Reserve Bank of India. Transparency of operations also plays a role in the efficacy of open market operations.

These operations have not been designed to suit the role of a full-fledged instrument of credit control. In more clear terms, open market operations have been carried out more for the purpose of assisting the Government in its borrowing operations as well as for maintaining orderly conditions in the Government securities market than for influencing the availability and cost of credit The Bank has sought, in the main, to restrict credit through other instruments of credit control, mainly cash reserve ratio (CRR). holders of Government securities sold securities to the Reserve Bank and bought an equivalent amount of securities. Such open market operations are totally neutral to overall monetary control. Again, under the pre-determined interest rate regime, the Reserve Bank would purchase a large volume of securities in the primary market and then sell the securities in the secondary market as part of its open market operations. The net effect of all these operations, which is relevant to monetary control, were generally neutral.

Limitations of open market operation

1. Without a well developed money market, open market operation eannot be attempted.

2. Statutory provisions must be adequate to enforce the commercial banks to buy securities.

3. The purchase and sale of securities should be adequate enough to decrease or increase die money supply so that the desired result is brought in (he economy.

4. Central bank needs to have adequate securities in the form of treasury bills for trading in the open market

3.VARIABLE RESERVE REQUIREMENT

This prescribes the minimum percentage of cash, the commercial banks are required to

maintain against their funds of both time and demand deposits. When the central bank

reduces the cash reserve ratio, the banks would be maintaining low cash in hand and this

enables them to grant more loans. Increased lending by commercial banks result in more

economic activities. Simultaneously in times of inflation the central bank raises the

percentage of cash reserve ratio. This leave only a lesser amount of cash is at the disposal of

commercial banks for lending.

OBJECTIVE

The main objective of variable reserve ratio is to endow the central bank with an

additional weapon in order to prevent injurious credit expansion or contraction by

varying the reserves required to be maintained by the banks with the central bank. It is

better to sterilize part of these superfluous reserves while they are still unused than to

withdraw the foundation of the structure. The principal effect of the increased reserve

requirements was not to restrict the current availability of money, but rather to limit the

potential expansion of credit which might ultimately be based upon the reserves held by

the banks.

Criticism in VCRR

Its effect on the smaller banks with fewer resources will be adverse as compared to

bigger banks with large resources.

the method lacks flexibility, in the sense, that it cannot be employed in correcting

small or localized situations of credit stringency or superfluity.

An increase in reserve ratio may cause a depressing effect on the securities market.

When the central bank increases the reserve ratio of banks, they may try to replenish

their cash reserves by selling securities included in their asset portfolio in the market.

This may cause a glut in the market prices of securities

The difference in the reserve ratios to be kept against time and demand liabilities is

not justifiable and that one flat rate is desirable. Admittedly, it is not the intention of

the central bank to ensure the liquidity of the banks while requiring them to keep cash

reserves with it. The aim is to check the multiple credit expansion of the banks. As

such, there appears to be little justification for making any distinction between the

ratios of cash reserves to be kept against time and demand liabilities of banks. On the

other hand, a uniform rate will only increase the control of the central bank in this

regard.

QUALITATIVE INSTRUMENTS OF MONETARY POLICY

The instruments discussed above are intended to control the quantity of the total amount

of bank credit by causing variations in the amount of available reserves. These methods

do not control the distribution of bank credit in particular directions. In other words, they

do not strive to control the quality of bank credit. This objective is achieved by employing

certain other instruments like credit rationing, selective credit controls, direct action

and moral suasion.

CREDIT RATIONING

Credit rationing is employed by central banks as a temporary expedient or an abnormal

measure dictated by special circumstances, or as a part of a comprehensive scheme of

national economic planning. Under this method, the central bank rations credit by limiting

the amount available to each applicant and restricting rediscounts of short-term bills.

Credit rationing is a method through which the distribution of credit is performed

according to the conditions prevailing in the national economy. If the demand for agricultural

credit is more, then the Central bank might say that certain percentage of loanable funds

should go to agriculture. The Central bank fixes a ratio in connection with the capital of a

commercial bank to its total assets. Through credit rationing, a limit is also fixed for each

portfolio of loans which are advanced by the commercial banks.

Regulation o f consumer credit

The regulation of consumer credit was first introduced in the U.S. A in 1941 as a selective

control method. When banks lend to consumers for purchasing consumer goods on instalment

basis or on hire purchase system, the bank needs to take into consideration the following Iwo

aspects:

(i) The margin money which is to be brought by the customer

(ii) The number of installments the consumer needs to pay towards the price of the

goods

The popularity of installment system and hire purchase system have necessitated this method

of selective credit control. In many countries the installment system has influenced greatly on

the general economic activity. So this method has been recognized as an important instrument

of credit control in many countries.

Regulation imposed by it on the commercial banks. Failure of which would result in

(i) Imposition of a penal interest

(ii) Refusal of rediscounting facility to the commercial bank

(iii) Stoppage of additional credit being granted to such commercial banks, which

are found to violate the regulations

However, credit rationing is not considered an instrument of monetary policy to be used

under normal circumstances. It should be used only under highly exceptional

circumstances.

Direct Action, Moral Suasion and Publicity

Direct action implies the coercive measures taken by a central bank against individual

units of the banking system. Direct action has derived its designation from the fact that it

implies direct dealings with individual banks, whereas, bank rate policy is applied

generally and objectively to all institutions which have to borrow from the central bank,

and whereas, open market operations are characterized by their impersonal application as

well as their repercussions on banks and the money market generally.

Moral suasion, as opposed to direct action, does not contemplate any coercive measures. It

implies the friendly persuasion by the central bank. Many quarters have expressed doubts

about the efficacy of this instrument of monetary policy. Persuasion as a means of credit

control has not been successful. The efficacy of warnings as an instrument of credit control

has been very slight. The success of this instrument depends on the relationship existing

between the central bank and the commercial banks. However, in spite of the limitations,

many central banks endeavour to exercise their moral influence over the links of the banking

system.

Publicity is often employed by the central banks to educate the banks about the money

market trends. As an instrument of monetary policy, much cannot be said about the efficacy

of publicity. Generally it is regarded by the central banks a matter of duty rather than an

instrument of monetary policy to publish weekly statements, monthly and other periodical

reviews and annual reports dealing with credit and business conditions.

Selective Credit Controls

Selective credit controls imply direct restraint on certain types of bank lending. They restrict

credit from flowing into particular channels which are considered as undesirable or less

essential. They are also employed to attain the positive object of diverting bank credit into

desirable channels. In developing economies, they are used to prevent the anti-social use of

strategic commodities and to push down the prices or to check any unwarranted increase in

their- price.

A distinction may be made between qualitative controls like credit rationing, direct action and

moral suasion and selective credit controls. The former affect only the supply side of the

money market, whereas the latter mainly affect the demand side and exercise are straining

influence on the demands of potential borrowers.

Limitations of Selective Credit Control Methods

1. The Central Bank could find it difficult in distinguishing between essential and non-

essential sectors for the purpose of the enforcement of selective credit control.

2. It becomes very difficult to monitor and ensure that the borrowers use the amount for

that purpose for which the fund is borrowed.

3. Although the banks have a bearing on the borrowers usage of the funds for the original

purpose, they have no control over the usage of the additional income, which are

generated by the original investment.

4. The commercial banks with a view to earn large profits could advance loans for

purposes other than that are laid down by the central bank.

5. The relationship between the central bank and the commercial banks is an important

factor determining - the success of selective controls.

6. Traders may get the necessary bank credit in the non-controlled sector and divert these

funds to the controlled sector.

The success of selective credit controls in arresting inflationary pressures in the

economy does not only depend on the selective controls on bank credit but also on

certain other factors such as aggregate and individual demand and supply. When there is

an increase in the price of a commodity owing to its scarcity, selective credit controls

cannot be expected to being about spectacular results.

CONCLUSION

A central bank, reserve bank, or monetary authority is the entity responsible for the monetary policy of a country or of a group of member states. Its primary responsibility is to maintain the stability of the national currency and money supply, but more active duties include controlling subsidiscd-loan interest rales, and acting as a "bailout" lender of last resort to the

banking sector during times of financial crisis. It could also have supervisory powers, to ensure that banks and other financial institutions do not behave recklessly or fraudulently.