Chapter 12- CREDIT CONTROL

by • 17/06/2011 • 2nd year BankingComments (0)1678

Definition:       Credit control is one the principal functions of the central bank. Credit money expands through commercial banks by means of cheques. It is the responsibility of the central bank to keep the credit money at the optimum level.

METHODS OF CREDIT CONTROL

The central bank adopts the following method to control credit:

I.          General or Quantitative Controls

1.         Bank rate policy

2.         Open market operations

3.         Change in reserve ratios

4.         Rationing of credit

II           Selective Controls

1.         Bank rate policy

2.         Moral persuasion

3.         Legislation

4.         Publicity

I.          General Methods / Controls

1.         Bank Rate Policy:     Bank rate is the interest rate at which the central bank rediscounts the first class bills of exchange of the commercial bank. If the central bank wants to expand the credit money it lowers the bank rate making the availability of loan less expensive. Consequently, commercial banks will borrow more from the central bank and lend more to the businessmen at a lower rate of interest, hence, increasing the credit money on the market. Inversely, if the central bank wants to contract the credit money supply it would raise the bank rate making the load more costly. The step will bring down the credit money to a lower level. Bank rate policy also affects inflow, outflow, and the rate of foreign exchange.

This method is effective in the following situations.

  1. When the financial market is well-oganized.
  2. The economic structure of the country is flexible to the extent that the procedure should beneficially affect wages, rents, commerce, production. However, Lord Keyness suggests that the method of controlling credit has become obsolete.

2.         Open Market Operations (OMO):    This method is also adopted by the central bank to expand or contract credit money in the market. Under this method the bank either sells or purchases government securities to control credit. When it wants to expand credit it starts purchasing government securities with the result that more money is pumped into the market. This money in return, is deposited with the commercial banks which become more competent to grant a greater amount of loans thereby expanding credit in the market.

On the other hand when the central bank wants to contract credit it starts selling the government securities owing to which market money goes to the central bank with the result that money in the market is reduced. The deposits of commercial banks go down, weakening their power to lend.

This method will work when the following conditions are fulfilled.

1.         The method should affect the reserves of commercial banks. They should contract or expand as a result of OMO. The method would fail if the bank reserves remain unaffected.

2.         Demand for bank loans should increase or decrease in line with the increase or decrease in the bank cash reserves and rate of interest.

3.         Circulation of bank credit should remain unchanged.

3.         Change in the Reserve Ratios: Every commercial bank is required to deposit with the central bank a certain part of its total deposits. When the central bank wants to expand credit it decreases the reserve ratio as required for the commercial banks. And when the central bank wants to contract credit the reserve ratio requirement is increased. By adopting this mechanism the central bank is able to either expand or contract credit supply in the market according to the need of the economy of the country.

4.         Rationing of Credit:   Rationing of credit refers to fixation of the upper limit of the loans (credits) to the commercial banks. By increasing or decreasing the upper limit of the loan available to commercial banks directly affects expansion or contraction of credit money. This method should be adopted only in special cases or emergencies. It should not be adopted frequently.

Selective Controls:    The central bank under certain conditions adopts the following measures.

1.         Direct Action: The central bank may take direct action against commercial banks that violate the rules, order or advice of the central bank. The direct action may include the refusal of accepting the bills of exchange presented by the commercial banks. This punishment is very severe for a commercial bank.

2.         Moral Persuasion:    It is another method by which central bank may get credit supply expanded or contracted. By moral pressure it may prohibit or dissuade commercial banks to deal in speculative business.

3.         Legislation:    The central bank may also adopt necessary legislation for expanding or contracting credit money in the market.

For example new laws may be made to introduce changes in the reserve ratio requirement.

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