Methods of Credit Control used by Central Bank

The following points highlight the two categories of methods of credit control by central
bank.

The two categories are: I. Quantitative or General Methods II. Qualitative or Selective
Methods.

Category # I. Quantitative or General Methods:

1. Bank Rate Policy:
The bank rate is the rate at which the Central Bank of a country is prepared to re-discount the
first class securities.

It means the bank is prepared to advance loans on approved securities to its member banks.

As the Central Bank is only the lender of the last resort the bank rate is normally higher than the
market rate.

For example:
If the Central Bank wants to control credit, it will raise the bank rate. As a result, the market rate
and other lending rates in the money-market will go up. Borrowing will be discouraged. The
raising of bank rate will lead to contraction of credit.

Similarly, a fall in bank rate mil lowers the lending rates in the money market which in turn will
stimulate commercial and industrial activity, for which more credit will be required from the
banks. Thus, there will be expansion of the volume of bank Credit.

2. Open Market Operations:

This method of credit control is used in two senses:
(i) In the narrow sense, and

(ii) In broad sense.

In narrow sense—the Central Bank starts the purchase and sale of Government securities in the
money market. But in the Broad Sense—the Central Bank purchases and sale not only
Government securities but also of other proper and eligible securities like bills and securities of
private concerns. When the banks and the private individuals purchase these securities they have
to make payments for these securities to the Central Bank.

This gives result in the fall in the cash reserves of the Commercial Banks, which in turn reduces
the ability of create credit. Through this way of working the Central Bank is able to exercise a
check on the expansion of credit.

Further, if there is deflationary situation and the Commercial Banks are not creating as much
credit as is desirable in the interest of the economy. Then in such situation the Central Bank will
start purchasing securities in the open market from Commercial Banks and private individuals.

With this activity the cash will now move from the Central Bank to the Commercial Banks. With
this increased cash reserves the Commercial Banks will be in a position to create more credit
with the result that the volume of bank credit will expand in the economy.

3. Variable Cash Reserve Ratio:

Under this system the Central Bank controls credit by changing the Cash Reserves Ratio. For
example—If the Commercial Banks have excessive cash reserves on the basis of which they are
creating too much of credit which is harmful for the larger interest of the economy. So it will
raise the cash reserve ratio which the Commercial Banks are required to maintain with the
Central Bank.

This activity of the Central Bank will force the Commercial Banks to curtail the creation of
credit in the economy. In this way by raising the cash reserve ratio of the Commercial Banks the
Central Bank will be able to put an effective check on the inflationary expansion of credit in the
economy.

Similarly, when the Central Bank desires that the Commercial Banks should increase the volume
of credit in order to bring about an economic revival in the country. The Central Bank will lower
down the Cash Reserve ratio with a view to expand the cash reserves of the Commercial Banks.
With this, the Commercial Banks will now be in a position to create more credit than what they
were doing before. Thus, by varying the cash reserve ratio, the Central Bank can influence the
creation of credit.

Which is Superior?
Either variable cash reserve ratio or open market operations:
From the analysis and discussions made above of these two methods of credit, it can be said that
the variable cash reserve ratio method is superior to open market operations on the following
grounds:

(1) Open market operations is time consuming procedure while cash reserves ratio produces
immediate effect in the economy.

(2) Open market operations can work successfully only where securities market in a country are
well organised and well developed.

While Cash Reserve Ratio does not require such type of securities market for the successful
implementation.

(3) Open market operations will be successful where marginal adjustments in cash reserve are
required.

But the variable cash reserve ratio method is more effective when the commercial banks happen
to have excessive cash reserves with them.

These two methods are not rival, but they are complementary to each other.

Category # II. Qualitative or Selective Method of Credit Control:

The qualitative or the selective methods are directed towards the diversion of credit into
particular uses or channels in the economy. Their objective is mainly to control and regulate the
flow of credit into particular industries or businesses.

The following are the important methods of credit control under selective method:
1. Rationing of Credit.

2. Direct Action.

3. Moral Persuasion.
4. Method of Publicity.

5. Regulation of Consumer’s Credit.

6. Regulating the Marginal Requirements on Security Loans.

1. Rationing of Credit:
Under this method the credit is rationed by limiting the amount available to each applicant. The
Central Bank puts restrictions on demands for accommodations made upon it during times of
monetary stringency.

In this the Central Bank discourages the granting of loans to stock exchanges by refusing to re-
discount the papers of the bank which have extended liberal loans to the speculators. This is an
important method of credit control and this policy has been adopted by a number of countries
like Russia and Germany.

2. Direct Action:
Under this method if the Commercial Banks do not follow the policy of the Central Bank, then
the Central Bank has the only recourse to direct action. This method can be used to enforce both
quantitatively and qualitatively credit controls by the Central Banks. This method is not used in
isolation; it is used as a supplement to other methods of credit control.

Direct action may take the form either of a refusal on the part of the Central Bank to re-discount
for banks whose credit policy is regarded as being inconsistent with the maintenance of sound
credit conditions. Even then the Commercial Banks do not fall in line, the Central Bank has the
constitutional power to order for their closure.

This method can be successful only when the Central Bank is powerful enough and has cordial
relations with the Commercial Banks. Mostly such circumstances are rare when the Central Bank
is forced to resist to such measures.

3. Moral Persuasion:
This method is frequently adopted by the Central Bank to exercise control over the Commercial
Banks. Under this method Central Bank gives advice, then request and persuasion to the
Commercial Banks to co-operate with the Central Bank is implementing its credit policies.
If the Commercial Banks do not follow or do not abide by the advice or request of the Central
Bank no gross action is taken against them. The Central Bank merely was its moral influence and
pressure with the Commercial Banks to prevail upon them to accept and follow the policies.

4. Method of Publicity:
In modern times, Central Bank in order to make their policies successful, take the course of the
medium of publicity. A policy can be effectively successful only when an effective public
opinion is created in its favour.

Its officials through news-papers, journals, conferences and seminar’s present a correct picture of
the economic conditions of the country before the public and give a prospective economic
policies. In developed countries Commercial Banks automatically change their credit creation
policy. But in developing countries Commercial Banks being lured by regional gains. Even the
Reserve Bank of India follows this policy.

5. Regulation of Consumer’s Credit:

Under this method consumers are given credit in a little quantity and this period is fixed for 18
months; consequently credit creation expanded within the limit. This method was originally
adopted by the U.S.A. as a protective and defensive measure, there after it has been used and
adopted by various other countries.

6. Changes in the Marginal Requirements on Security Loans:

This system is mostly followed in U.S.A. Under this system, the Board of Governors of the
Federal Reserve System has been given the power to prescribe margin requirements for the
purpose of preventing an excessive use of credit for stock exchange speculation.

This system is specially intended to help the Central Bank in controlling the volume of credit
used for speculation in securities under the Securities Exchange Act, 1934.