credit control
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Credit Control is an important tool used by the Reserve Bank of India, a major weapon of the monetary
policy used to control the demand and supply of money (liquidity) in the economy. Central Bank
administers control over the credit that the commercial banks grant. Such a method is used by RBI to
bring “Economic Development with Stability”. It means that banks will not only control inflationary trends in
the economy but also boost economic growth which would ultimately lead to increase in real nationalincome with stability. In view of its functions such as issuing notes and custodian of cash reserves, credit
not being controlled by RBI would lead to Social and Economic instability in the country
Need for Credit Control
Controlling credit in the Economy is amongst the most important functions of the Reserve Bank of India.
The basic and important needs of Credit Control in the economy are-
To encourage the overall growth of the “priority sector” i.e. those sectors of the economy which is
recognized by the government as “prioritized” depending upon their economic condition
or government interest. These sectors broadly totals to around 15 in number.[1]
To keep a check over the channelization of credit so that credit is not delivered for undesirable
purposes.
To achieve the objective of controlling “Inflation” as well as “Deflation”.
To boost the economy by facilitating the flow of adequate volume of bank credit to different sectors.
To develop the economy.
Objectives of Credit Control
Credit control policy is just an arm of Economic Policy which comes under the purview of Reserve Bank of
India, hence, its main objective being attainment of high growth rate while maintaining reasonable stability
of the internal purchasing power of money. The broad objectives of Credit Control Policy in India have
been-
Ensure an adequate level of liquidity enough to attain high economic growth rate along with maximum
utilization of resource but without generating high inflationary pressure.
Attain stability in exchange rate and money market of the country.
Meeting the financial requirement during slump in the economy and in the normal times as well.
Control business cycle and meet business needs.
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Methods of Credit Control
There are two methods that the RBI uses to control the money supply in the economy-
Qualitative Method
Quantitative Method
During the period of inflation Reserve Bank of India tightens its policies to restrict the money supply,
whereas during deflation it allows the commercial bank to pump money in the economy.
Qualitative Method
By Quality we mean the uses to which bank credit is directed.
For example- the Bank may feel that spectators or the big capitalists are getting a disproportionately large
share in the total credit, causing various disturbances and inequality in theeconomy, while the small-scale
industries, consumer goods industries and agriculture are starved of credit.
Correcting this type of discrepancy is a matter of Qualitative Credit Control.
Qualitative Method controls the manner of channelizing of cash and credit in the economy. It is a
„selective method‟ of control as it restricts credit for certain section where as expands for the other known
as the „priority sector‟ depending on the situation.
Tools used under this method are-
Marginal Requirement
Marginal Requirement of loan = current value of security offered for loan-value of loans granted. The
marginal requirement is increased for those business activities, the flow of whose credit is to be restricted
in the economy.
e.g.- a person mortgages his property worth Rs. 1,00,000 against loan. The bank will give loan of Rs.
80,000 only. The marginal requirement here is 20%.
In case the flow of credit has to be increased, the marginal requirement will be lowered. RBI has been
using this method since 1956.
[editRationing of credit
Under this method there is a minimum limit to loans and advances that can be made, which
the commercial banks cannot exceed. RBI fixes ceiling for specific categories. Such rationing is used for
situations when credit flow is to be checked, particularly for speculative activities. Minimum
of ”Capital:Total Assets" (ratio between capital and total asset) can also be prescribed by Reserve Bank of
India.
[edit]Publicity
RBI uses media for the publicity of its views on the current market condition and its directions that will be
required to be implemented by the commercial banks to control the unrest. Though this method is not
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very successful in developing nations due to high illiteracy existing making it difficult for people to
understand such policies and its implications.
Direct Action
Under the banking regulation Act, the central bank has the authority to take strict action against any ofthe commercial banks that refuses to obey the directions given by Reserve Bank of India. There can be a
restriction on advancing of loans imposed by Reserve Bank of India on such banks. e.g. - RBI had put up
certain restrictions on the working of the MetropolitanCo-operative Banks. Also the „Bank of Karad‟ had to
come to an end in 1992.[3]
Moral Suasion
This method is also known as “Moral Persuasion” as the method that the Reserve Bank of India, being
the apex bank uses here, is that of persuading the commercial banks to follow its directions/orders on the
flow of credit. RBI puts a pressure on the commercial banks to put a ceiling on credit flow
during inflation and be liberal in lending during deflation.
quantitative Method
By Quantitative Credit Control we mean the control of the total quantity of credit.
For Example- let us consider that the Central Bank, on the basis of its calculations, considers that Rs.
50,000 is the maximum safe limit for the expansion of credit. But the actual credit at that given point of
time is Rs. 55,000(say). Thus it then becomes necessary for the Central Bank to bring it down to 50,000
by tightening its policies. Similarly if the actual credit is less, say 45,000, then the apex bank regulates its
policies in favor of pumping credit into the economy.
Different tools used under this method are-
Graph showing variations in the Bank Rate from 1935-2011(current year)][4]
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1. Bank Rate Policy:
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 of RBI. Thus the RBI, rediscounts the first
class bills in the hands of commercial banks to provide them with liquidity in case of need. This rate is
subjected to change from time to time in accordance with the economic stability and its credibility of the
nation. The bank rate signals the central bank’s long-term outlook on interest rates. If the bank rate
moves up, long-term interest rates also tend to move up, and vice-versa.
Banks make a profit by borrowing at a lower rate and lending the same funds at a higher rate of interest. If
the RBI hikes the bank rate (this is currently 6 per cent), the interest that a bank pays for borrowing
money (banks borrow money either from each other or from the RBI) increases. It, in turn, hikes its own
lending rates to ensure it continues to make a profit.
Working of the Bank Rate
This section will answer how Bank Rate policy operates to control the level of prices and business activity
in the country.
Changes in bank rate are introduced with a view to controlling the price levels and business activity, by
changing the demand for loans. Its working is based upon the principle that changes in the bank rate
results in changed interest rate in the market.
Suppose a country is facing inflationary pressure. The Central Bank, in such situations, will increase the
bank rate thereby resulting to a hiked lending rate. This increase will discourage borrowing. It will also
lead to a fall in the business activity due to following reasons.
Employment of some factors of production will have to be reduced by the businessmen.
The manufacturers and stock exchange dealers will have to liquidate their stocks, which they held
through bank loans, to pay off their loans.
The effect of Rise in Bank Rate by the Central Bank is shown in the chart (left side). Hence, we can
conclude that hike in Bank Rate leads to fall in price leveland a fall in the Bank Rate leads to an increase
in price level i.e. they share an inverse relationship .
2. Open Market Operation:
It means of implementing monetary policy by which a central bank controls the short term interest rateand the supply of base money in an economy, and thus indirectly the total money supply. In times of
inflation, RBI sells securities to mop up the excess money in the market. Similarly, to increase the supply
of money, RBI purchases securities.
3. Adjusting with CRR and SLR:
By adjusting the CRR(Cash Reserve Ratio) and SLR(Statutory Liquidity Ratio) which are short term tools
to be used to shortly regulate the cash and fund flows in the hands of the People, banks and Government,
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the RBI regularly make necessary adjustments in these rates. These variations in the rates will easily have
a greater control over the cash flow of the country.
i) CRR(Cash Reserve Ratio): All commercial banks are required to keep a certain amount of its
deposits in cash with RBI. This percentage is called the cash reserve ratio. The current CRR requirement
is 8 per cent. This serves two purposes. It ensures that a portion of bank deposits is totally risk-free and
secondly it enables that RBI control liquidity in the system, and thereby, inflation by tying their hands in
lending money
ii) SLR(Statutory Liquidity Ratio): Banks in India are required to maintain 25 per cent of their
demand and time liabilities in government securities and certain approved securities. What SLR does is
again restrict the bank’s leverage in pumping more money into the economy by investing a portion of their
deposits in government securities as a part of their statutory liquidity ratio (SLR) requirements.
4. Lending Rate:
Lending rates are the ratios fixed by RBI to lend the money to the customers on the basis of those rates.
The higher the rate means the credit to the customers is costlier. The lower the rate means the credit tothe customers is less which will encourage the customers to borrow money from the banks more that will
facilitate the more money flow in the hands of the public.
5. Repo Rate:
Repo rate is the rate at which banks borrow funds from the RBI to meet the gap between the demand they
are facing for money (loans) and how much they have on hand to lend.
If the RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate;
similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate.
6. Reverse Repo Rate:
The rate at which RBI borrows money from the banks (or banks lend money to the RBI) is termed the
reverse repo rate. The RBI uses this tool when it feels there is too much money floating in the banking
system
If the reverse repo rate is increased, it means the RBI will borrow money from the bank and offer them a
lucrative rate of interest. As a result, banks would prefer to keep their money with the RBI (which is
absolutely risk free) instead of lending it out (this option comes with a certain amount of risk)
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