Important Methods adapted

by RBI to Control Credit

Creation
Some of the methods employed by the RBI to control
credit creation are:
I. Quantitative Method
II. II. Qualitative Method.
The various methods employed by the RBI to control credit
creation power of the commercial banks can be classified
in two groups, viz., quantitative controls and qualitative
controls. Quantitative controls are designed to regulate
the volume of credit created by the banking system
qualitative measures or selective methods are designed to
regulate the flow of credit in specific uses.

Quantitative or traditional methods of credit control

include banks rate policy, open market operations and
variable reserve ratio. Qualitative or selective methods of
credit control include regulation of margin requirement,
credit rationing, regulation of consumer credit and direct
action.

I. Quantitative Method:
(i) Bank Rate:
The bank rate, also known as the discount rate, is the rate
payable by commercial banks on the loans from or
rediscounts of the Central Bank. A change in bank rate
affects other market rates of interest. An increase in bank
rate leads to an increase in other rates of interest and
conversely, a decrease in bank rate results in a fall in
other rates of interest.

A deliberate manipulation of the bank rate by the Central

Bank to influence the flow of credit created by the
commercial banks is known as bank rate policy. It does so
by affecting the demand for credit the cost of the credit
and the availability of the credit.

An increase in bank rate results in an increase in the cost

of credit; this is expected to lead to a contraction in
demand for credit. In as much as bank credit is an
important component of aggregate money supply in the
economy, a contraction in demand for credit consequent
on an increase in the cost of credit restricts the total
availability of money in the economy, and hence may prove
an anti-inflationary measure of control.

Likewise, a fall in the bank rate causes other rates of

interest to come down. The cost of credit falls, i. e., and
credit becomes cheaper. Cheap credit may induce a higher
demand both for investment and consumption purposes.
More money, through increased flow of credit, comes into
circulation.

A fall in bank rate may, thus, prove an anti-deflationary

instrument of control. The effectiveness of bank rate as an
instrument of control is, however, restricted primarily by
the fact that both in inflationary and recessionary
conditions, the cost of credit may not be a very significant
factor influencing the investment decisions of the firms.

(ii) Open Market Operations:

Open market operations refer to the sale and purchase of
securities by the Central bank to the commercial banks. A
sale of securities by the Central Bank, i.e., the purchase of
securities by the commercial banks, results in a fall in the
total cash reserves of the latter.

A fall in the total cash reserves is leads to a cut in the

credit creation power of the commercial banks. With
reduced cash reserves at their command the commercial
banks can only create lower volume of credit. Thus, a sale
of securities by the Central Bank serves as an anti-
inflationary measure of control.

Likewise, a purchase of securities by the Central Bank

results in more cash flowing to the commercials banks.
With increased cash in their hands, the commercial banks
can create more credit, and make more finance available.
Thus, purchase of securities may work as an anti-
deflationary measure of control.

The Reserve Bank of India has frequently resorted to the

sale of government securities to which the commercial
banks have been generously contributing. Thus, open
market operations in India have served, on the one hand
as an instrument to make available more budgetary
resources and on the other as an instrument to siphon off
the excess liquidity in the system.

(iii) Variable Reserve Ratios:

Variable reserve ratios refer to that proportion of bank
deposits that the commercial banks are required to keep
in the form of cash to ensure liquidity for the credit
created by them.

A rise in the cash reserve ratio results in a fall in the value

of the deposit multiplier. Conversely, a fall in the cash
reserve ratio leads to a rise in the value of the deposit
multiplier.

A fall in the value of deposit multiplier amounts to a

contraction in the availability of credit, and, thus, it may
serve as an anti-inflationary measure.

A rise in the value of deposit multiplier, on the other hand,

amounts to the fact that the commercial banks can create
more credit, and make available more finance for
consumption and investment expenditure. A fall in the
reserve ratios may, thus, work as anti-deflationary method
of monetary control.

The Reserve Bank of India is empowered to change the

reserve requirements of the commercial banks.

The Reserve Bank employs two types of reserve ratio for

this purpose, viz. the Statutory Liquidity Ratio (SLR) and
the Cash Reserve Ratio (CRR).
The statutory liquidity ratio refers to that proportion of
aggregate deposits which the commercial banks are
required to keep with themselves in a liquid form. The
commercial banks generally make use of this money to
purchase the government securities. Thus, the statutory
liquidity ratio, on the one hand is used to siphon off the
excess liquidity of the banking system, and on the other it
is used to mobilise revenue for the government.

The Reserve Bank of India is empowered to raise this ratio

up to 40 per cent of aggregate deposits of commercial
banks. Presently, this ratio stands at 25 per cent.

The cash reserve ratio refers to that proportion of the

aggregate deposits which the commercial banks are
required to keep with the Reserve Bank of India.
Presently, this ratio stands at 9 percent.

II. Qualitative Method:

The qualitative or selective methods of credit control are
adopted by the Central Bank in its pursuit of economic
stabilisation and as part of credit management.

(i) Margin Requirements:

Changes in margin requirements are designed to influence
the flow of credit against specific commodities. The
commercial banks generally advance loans to their
customers against some security or securities offered by
the borrower and acceptable to banks.
More generally, the commercial banks do not lend up to
the full amount of the security but lend an amount less
than its value. The margin requirements against specific
securities are determined by the Central Bank. A change
in margin requirements will influence the flow of credit.

A rise in the margin requirement results in a contraction

in the borrowing value of the security and similarly, a fall
in the margin requirement results in expansion in the
borrowing value of the security.

(ii) Credit Rationing:

Rationing of credit is a method by which the Central Bank
seeks to limit the maximum amount of loans and advances
and, also in certain cases, fix ceiling for specific categories
of loans and advances.

(iii) Regulation of Consumer Credit:

Regulation of consumer credit is designed to check the
flow of credit for consumer durable goods. This can be
done by regulating the total volume of credit that may be
extended for purchasing specific durable goods and
regulating the number of installments through which such
loan can be spread. Central Bank uses this method to
restrict or liberalise loan conditions accordingly to
stabilise the economy.

(iv) Moral Suasion:

Moral suasion and credit monitoring arrangement are
other methods of credit control. The policy of moral
suasion will succeed only if the Central Bank is strong
enough to influence the commercial banks.

In India, from 1949 onwards, the Reserve Bank has been

successful in using the method of moral suasion to bring
the commercial banks to fall in line with its policies
regarding credit. Publicity is another method, whereby the
Reserve Bank marks direct appeal to the public and
publishes data which will have sobering effect on other
banks and the commercial circles.

Effectiveness of Credit Control Measures:

The effectiveness of credit control measures in an
economy depends upon a number of factors. First, there
should exist a well-organised money market. Second, a
large proportion of money in circulation should form part
of the organised money market. Finally, the money and
capital markets should be extensive in coverage and
elastic in nature.

Extensiveness enlarges the scope of credit control

measures and elasticity lends it adjustability to the
changed conditions. In most of the developed economies a
favourable environment in terms of the factors discussed
before exists, in the developing economies, on the
contrary, economic conditions are such as to limit the
effectiveness of the credit control measures.