The following points outline the two primary methods of credit control used by the central bank, which are: 1. Quantitative Methods 2. Qualitative or Selective Methods of Credit Control.
1. Quantitative Methods:
The quantitative methods of credit control include:
1.1 Changes in the Bank Rate:
The bank rate represents the lowest official rate at which the central bank rediscounts accepted paper from discount houses or provides loans to them, also referring to the minimum interest rate charged by the central bank when lending to the banking system with approved securities as collateral. By adjusting the bank rate, the central bank can influence the amount of bank credit available.
The bank rate is crucial because it sets the standard for other market interest rates in both the short and long term, and changes in this rate impact the cost and availability of bank credit. For instance, if the bank rate is increased during inflation, market interest rates also rise.
As a result, there is a decrease in bank borrowing, leading to a reduced volume of credit. Conversely, lowering the bank rate during deflation results in decreased market interest rates, which encourages borrowing from banks and expands credit volume. The Reserve Bank has updated the bank rate several times throughout its history.
- Limitations:
However, the effectiveness of the bank rate policy diminishes in countries lacking a robust bill market. Additionally, in practice, there may not be a strong correlation between the bank rate and other interest rates, which is often assumed in theory.
Moreover, in underdeveloped money markets, banks may seldom seek credit from the central bank, making the bank rate policy ineffective. Due to these factors, Keynes viewed the bank rate as a weak tool for monetary (credit) control, and its relevance has decreased in recent years.
1.2 Open Market Operations:
Open market operations generally involve the buying and selling of various assets by the central bank, particularly government securities. When the central bank sells securities to commercial banks or the public, the banks pay the central bank, which reduces their cash reserves, decreases their lending capacity, and ultimately lowers the amount of bank credit.
In contrast, when the central bank buys securities from member banks or the public, it increases the cash reserves of those banks, enhancing their ability to lend and expanding the overall volume of credit.
The selling operations of the central bank lead to a decrease in credit, whereas buying operations lead to an increase in credit. It's important to recognize that during inflation, higher bank rates are used alongside sales to reduce credit, while during deflation, lower bank rates accompany purchases to increase credit.
- Limitations:
However, this approach is less effective if commercial banks have surplus cash reserves. Additionally, the success of these operations largely depends on having a strong and well-established market for government securities. This method is especially ineffective in places like India, where people generally do not buy securities regularly.
1.3 Variable Reserve Ratio:
The cash reserve ratio (CRR) is the percentage of a bank's deposits that must be held in cash reserves with the central bank, as required by law or custom. The central bank can influence the overall bank credit by adjusting this ratio. Increasing the CRR results in a reduction of bank credit since banks must maintain larger reserves, limiting their ability to offer loans.
Conversely, lowering the CRR allows for an increase in credit because banks are required to keep less cash on reserve, thus enabling them to lend more funds. Currently, in India, the Reserve Bank can set the CRR between 3% and 15% of banks' total deposits, and it was raised from 9% to 9.5% in February 1987.
Incremental CRR:
To manage excessive liquidity and tighten credit, the central bank can impose an additional CRR on excess deposits accrued since a certain date. In India, this approach is used and is referred to as impounding or addressing excess deposits via incremental CRR.
- Limitations:
J.M. Keynes strongly supported this credit control method. While it can swiftly reduce bank credit with immediate effect, it tends to be quite unfair, impacting smaller banks more severely than larger ones.
2. Qualitative or Selective Methods of Credit Control:
Here are the key qualitative or selective credit control methods:
2.1 Minimum Margin Requirements:
This method is specific and selective in its application. When it comes to a second loan, the margin refers to the cash amount a borrower must provide to qualify for a bank loan. For instance, if a loan of Rs. 9,000 is backed by a stock valued at Rs. 10,000, the margin is Rs.1,000, which is 10% of the stock's worth. Therefore, with a 10% margin requirement, a borrower can obtain 90% of the security's value.
During inflationary periods, the central bank increases the loan margin on certain essential commodities that are often subject to speculation. The Reserve Bank of India frequently directs other banks to maintain elevated margins for loans associated with vital goods such as paddy, rice, wheat, oilseeds, cotton, sugar, pulses, and edible oils. This is done to limit speculative lending and to reduce the rise in prices caused by limited supply.
This approach has proven quite effective, particularly in India's less developed money market, as it directly addresses key areas within the economy to manage the inflation of prices. However, practically identifying which commodities to regulate and determining the appropriate margin for loans poses a challenge.
2.2 Regulation of Consumer Credit:
This method first emerged in the USA during World War II, recognizing that consumer demand for long-lasting goods is highly volatile. The central bank regulates bank lending for the purchase of durable consumer items such as cars, furniture, and refrigerators. Control is achieved through oversight of down payment amounts, loan durations, and repayment conditions.
3. Additional Methods:
Beyond these strategies, various other credit control methods exist. While they may be qualitative in nature, they are still considered minor.
These include:
3.1 Credit Rationing:
Using this system, the central bank establishes quotas for bank lending or limits the total amount of advances for various purposes.
3.2 Direct Instructions:
As the top monetary authority, the central bank may occasionally issue explicit instructions (such as the Credit Authorization Scheme in India) for banks to adhere to specific monetary policies.
3.3 Moral Persuasion:
Moral suasion involves the central bank making informal recommendations through circulars to other banks for credit regulation, encouraging them to act on these suggestions.
Real-World Examples of Credit Control by Central Banks
- Fed rate hikes (2022): Made loans costly → slowed inflation.
- RBI CRR cut (2020): Gave banks more money → boosted loans in COVID.
- China margin rule (2021): Reduced risky trading.
- Bank of England (2014): Made mortgage rules stricter → avoided housing crash.
Conclusion:
It’s important to recognize that the effectiveness of these credit control methods varies across different money markets. In India’s underdeveloped money market, traditional credit control methods have limited success since a significant portion of the market operates beyond the reach of the central bank's influence.
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