Credit Control

Introduction to Credit Control

The Reserve Bank of India is the controller of credit i.e. it has the power to influence the volume of credit created by banks in India. It can do so through changing the Bank rate or through open market operations.

According to the Banking Regulation Act of 1949, the Reserve Bank of India can ask any particular bank or the whole banking system not to lend to particular groups or persons on the basis of certain types of securities. Since 1956, selective controls of credit are increasingly being used by the Reserve Bank.

What is Credit Control?

Credit control is a very important function of RBI as the Central Bank of India. For smooth functioning of the economy RBI control credit through quantitative and qualitative methods. Thus, the RBI exercise control over the credit granted by the commercial bank. Detail of this has been discussed as a separate heading.

The reserve Bank is the most appropriate body to control the creation of credit in view if its functions as the bank of note issue and the custodian of cash reserves of the member banks. Unwarranted fluctuations in the volume of credit by causing wide fluctuations in the value of money cause great social & economic unrest in the country.

Thus, RBI controls credit in such a manner, so as to bring ‘Economic Development with stability’. It means, bank will accelerate economic growth on one side and on other side it will control inflationary trends in the economy. It leads to increase in real national income of the country and desirable stability in the economy.

Objectives

The RBI regulates the availability, cost and terms and conditions of credit in the market. It aims at regulating and controlling the money supply as per the requirements of the economy and the monetary policy.

The various objectives of credit control are as follows:

  • To obtain stability in the internal price level.
  • To attain stability in exchange rate.
  • To stabilize money market of a country.
  • To eliminate business cycles-inflation and depression-by controlling supply of credit.
  • To maximize income, employment and output in a country.
  • To meet the financial requirements of an economy not only during normal times but also during emergency or war.
  • To help the economic growth of a country within specified period of time. This objective has become particularly necessary for the less developed countries of present day world.

Methods of Credit Control

The methods of credit control are usually categorized into:

  • General (or quantitative) methods
  • Selective (or qualitative) methods

The Bank Rate Policy, variable reserve requirements, statutory liquidity requirement, and open market operations policy fall in the category of general credit control methods. The various directives issued by the Reserve Bank restricting the quantum and other terms of granting credit against certain specified commodities constitute the selective control method.

The main difference between the general and selective credit control methods is that the former influence the cost and overall volume of credit granted by banks.

They affect credit related to the whole economy whereas the selective controls affect the flow of credit to only specified sector of the economy, wherein speculative tendency and rising trend of prices, due to excessive bank credit, is noticed.

Methods and Instruments of Credit Control

There are many methods of credit control. These methods can be broadly divided into two categories:

  • Quantitative or General Methods
  • Qualitative or Selective Methods

The quantitative methods of credit control aim at influencing the quantity or total volume of credit in an economy during a particular period of time. The qualitative methods of credit control aim at influencing the quality of use of credit with respect to a particular area or field of activity.

Quantitative system of credit control includes following instruments

  • Bank Rate
  • Open Market Operation (OMO)
  • Cash Reserve Ratio (CRR)
  • Statutory Liquidity Ratio (SLR)
  • Repo and Reverse Repo Rate

Qualitative system consist of the following instruments:

  • Selective Credit control
  • Rationing of Credit
  • Moral Persuasion
  • Publicity
  • Direct Action

Quantitative Methods of Credit Control

Bank Rate

Bank rate is the rate at which central bank grant loans to the commercial banks against the security of government and other approved first class securities. According to section 49 of RBI Act, “Bank rate is the standard rate on which RBI purchase or discount such exchange bills or commercial papers which can be purchased under this act.” Reserve Bank of India controls credit by affecting quantity and cost of credit money through its bank rate policy. But this method of credit control would be effective only when there is organized money market and commercial banks depend on reserve bank for their credit.

Open Market Operations

The term ‘Open market operation’ implies the purchase and sale by the Central Bank not only the Govt. securities but also of other eligible papers. Like bills and securities of private concerns section 17(8) of RBI Act. Empowers Reserve Bank to purchase the securities of central Govt. state Govt. and other autonomous institutions. Apart from this section 17(2)(A) empower Reserve Bank to purchase or sell of short term bills. Open market operations are used as supporting instrument of bank rate. This method is used to influence the flow of credit.

The open market operations in India are limited by Reserve Bank. The bank has used this policy only to make successful government debt policy and to maintain price stability of Govt. securities. It is used to fulfill seasonal credit requirements of commercial banks.

Cash Reserve Ratio (CRR)

“Cash reserve ratio refers to the cash which banks have to maintain with the RBI as a certain percentage of their demand and time liabilities.” Originally the objective was to ensure safety and liquidity of bank deposits. But over years it has emerged as an effective tool of directly regulating the lending capacity of the banks i.e., as an instrument of the monetary policy. RBI has the power to impose penal interest rates on the banks in case of a shortfall in the prescribed CRR. The penal rate is generally higher than the bank rate and it increases if the default is prolonged. RBI can also disallow any fresh access to refinance in such cases.

Statutory Liquidity Ratio (SLR)

Under the Banking Regulation Act (sec 24(2A)) as amended in 1962, banks have to maintain a minimum liquid assets of 25 percent of their demand and time liabilities in India. The assets classified as liquid for fulfilling the SLR requirements are: cash in hand, balance in the current account with SBI and its subsidiaries, gold.

The Reserve Bank of India is empowered to change this ratio. As on 21, 1997, it was fixed to 25% of the total deposits of Banks. It also influences the credit creation capacity of the banks. The effect of bi\both cash reserve ratio and statutory liquidity ratio on credit expansion is similar. Penalties are levied by RBI for not maintaining these ratios from scheduled banks.

Repo Rate and Reverse Repo Rate

Repo Rate and Reverse Repo RateThere is two kind of repo and are as under:

Inter Bank Repo : Such repos are now permitted only under regulated conditions. Repos are misused by banks/brokers during the 1992 securities scam, they were banned subsequently. With the lifting of the ban in 1995, repos were permitted for restricted, eligible participants and instruments. Initially, repo deals were allowed in T-bills and five dated securities on the NSE. With gradual liberalization over the years, all central govt. dated securities, state Govt. security and T-bills of all maturities have been made eligible for repo. Banks and PDs can undertake repo deals if they are routed through the SGL, accounts maintained by the RBI. Repos are allowed to develop a secondary market in PSU bonds, FIs bonds, corporate bonds and private debt securities if they are held in demat form and the deals are done through recognized stock exchange(s).

RBI Repos : The RBI undertakes repo/reverse repo operations with banks and PDs as part of its OMOs, to absorb/inject liquidity. With the introduction of the LAF, the RBI has been injecting liquidity into the system through repo on a daily basis. The repo auctions are conducted on all working days except Saturdays and are restricted to banks and PDs. This is in addition to the liquidity support given by the RBI to the PDs through refinance/reverse repo facility at a fixed price. Auctions under LAF were earlier conducted on a uniform price basis, that is, there was a single repo rate for all successful bidders. Multiple price auction was introduces subsequently. The weighted average cut-off yield in case of a multiple price auction is released top the public. This, along with the cut-off price, provides a band for call money to operate.

Qualitative Methods of Credit Control

Under section 21 of RBI Act, Reserve Bank is empowered to regulate control and direct the commercial banks regarding their loans and advances. Qualitative methods are used to affect the use, distribution and direction of credit. It is used to encourage such economic authorities as desirable and to discourage those which are injurious for the economy. It also helps to prevent speculative holding with the help of bank credit of certain essential commodities like food grain, sugar, cotton and basic raw materials and thereby checking an undue rise in their price. Reserve bank of India from time to time adopted the following qualitative methods of credit control.

Selective Credit Control

Section 36(1) (a) of the Banking Regulation Act, empowers the RBI to contain or prohibit banking companies generally or any banking company. The objective of these controls is to discourage some forms of activities while encouraging others. Such controls are used in respect of agriculture commodities, which are subject to speculative hoarding and wide price fluctuation.

Under section 21 of the banking regulation Act, 1949, the Reserve Bank is empowered to issue directives to banking companies regarding making of advances.

These directions may be as follows :

  • The purpose for which advances may or may not be made.
  • Fixing the margin requirements for advances against each commodity.
  • Fixing of maximum limit to be advanced by banks to a particular borrower.
  • Fixing of rate of interest and other terms for making advances.
  • Fixing of maximum guarantees may be given by the banks on behalf of any firm or company.
  • Prohibition on grant of credit against book debts and clean credits.
Differential Discount Rates

The reserve Bank fixes different discounting rates for the bills of different sectors. The sector for which more credit is to be made available the exchange bills re discounted at a lower rate. On the other hand, if RBI wants to discourage credit for a particular sector, it increases the discount rate for bills or the facility for rediscounting is postponed.

Credit Authorization Scheme

This scheme was introduced in November 1965 with the objectives of enforce financial discipline on the larger borrowers and ensure that they did not pre-empt scare bank resources. Through this scheme, the RBI regulates not only the quantum but also the term of credit flows.

Fixation of Margin

The commercial banks generally advance loans to their customers against some security or securities offered by the borrowers and acceptable to the banks. The commercial banks do not lend up to the full amount of the value of a security but lend an amount less than its value. The margin requirements against specific securities are determined by the Reserve Bank. RBI changed the margin frequently according to the credit policy. Changes in margin requirements are designed to influence the flow of credit against specific commodities. A rise in the margin requirements results in 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. If RBI desires that more loans should be advanced against particular securities, it can lower the margin requirement.

Rationing of Credit : In this method the RBI seeks to limit the maximum or ceiling of loans and advances and also in certain cases, fixes ceiling for specific categories of loans and advances. The various methods adopted under this arrangement are:

  • Requiring the banks to restrict the drawing power of their borrower under cash credit limit.
  • Stipulating certain targets for credit distribution for the priority sector.
  • Stipulating a prescribed credit deposit ratio for rural semi urban branches of banks.

Moral Persuasion

Moral persuasion refers to those cases where the Reserve Bank endeavours to achieve its object by making suitable representations to the banking institutions concerned and relying on its moral influence and power of persuasion.

Being an apex institution and lender of the last resort, the RBI can use its more pressure and persuade the commercial bank to follow its policy. During inflationary conditions it may request the commercial banks not to press for frequent loans, to refuse loans to the customers and to refrain from investing funds in the unproductive or less productive occupations.

Publicity

The RBI may also follow the policy of publicity in order to make known to the public its views about the credit expansion or contraction. It may issue warning to the people and commercial banks, substantiating its views by facts, figures and statements, through the media of publicity.

This method, however, is ineffective in the developing economies where mass illiteracy exists and people do not understand the implications of the policy.

Direct Action

Under Banking Regulations Act, the RBI is empowered to initiate direction action against those commercial banks which ignore its advice. In such cases RBI can impose restriction on sanctioning of loans and advances of concerned banks.

Winding up of Bank of Karad in 1992 because of financial irregularities and putting up of certain restrictions on the working of Metropolitan Co-operative Bank are the examples of direct action initiated by RBI. The RBI may refuse re-discounting facilities to the banks who do not cooperative with the policies of the Bank.


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