Understanding Credit Control Methods in Banking
Methods of Credit Control
The central bank of a country has the responsibility of controlling the volume and direction of credit in the economy. Bank credit has become an important constituent of the money supply these days.
Broadly speaking, there are two types of methods for controlling credit:
1. Quantitative or General Methods
These methods seek to change the total quantity of credit in general. There are three in number:
- Changing the bank rate
- Open market operations
- Changing the cash reserve ratio
2. Qualitative or Selective Control Methods
These methods aim at changing the volume of a specific type of credit. In other words, the selective control method affects the use of credit for particular purposes.
We will discuss these methods in detail.
Bank Rate Policy
The bank rate is the minimum rate at which the central bank of a country provides loans to the commercial banks. The bank rate is also called the discount rate because, in earlier days, the central bank used to provide finance to the commercial banks by rediscounting bills of exchange. Through changes in the bank rate, the central bank can influence the creation of credit by the commercial banks. Bank credit is an important component of the money supply in the economy.
Changes in the money supply affect aggregate demand and thereby output and prices. For instance, when the central bank raises the bank rate, the cost of borrowings by the commercial banks from the central bank would rise. This would discourage the commercial banks from borrowing from the central bank. Further, when the bank rate is raised, the commercial banks also raise their lending rates.
When the lending rates of interest charged by the commercial banks are higher, businessmen and industrialists would feel discouraged to borrow from commercial banks. This would tend to contract the bank credit and hence result in the reduction of money supply in the economy. The reduction in the supply of money would reduce aggregate demand, which will reduce prices and check inflation in the economy. Thus, when the economy is gripped by inflation, the bank rate is generally raised to contract credit creation by the banks.
On the other hand, when there is a recession in the economy, the bank rate is lowered to overcome it. A fall in the bank rate will cause a reduction in lending interest rates of the commercial banks. With credit or loans from banks becoming cheaper, businessmen would borrow more from the commercial banks for investment and other purposes. This would lead to an increase in aggregate demand for goods and services and help in overcoming recession and bringing about recovery of the economy.
Limitations of Bank Rate Policy:
The bank rate does not always have the desired effect on investment, output, and prices. There are certain conditions that must be met for the successful working of the bank rate policy.
If the commercial banks have considerable reserves of their own at their disposal, their dependence on borrowed funds from the central bank may be very low, which will cause the bank rate policy to have less impact on lending rates. Similarly, the response of investment to the fall in the rate of interest is never vigorous. Demand by businessmen for loans for investment purposes from the banks depends on the economic situation prevailing in the economy. When the economy is gripped in recession, prospects for making profits are bleak, and businessmen would be reluctant to borrow for investment even though the lending rates have been lowered considerably to induce them to borrow.
Open Market Operations:
Open market operations are another important instrument of credit control. The term open market operations refers to the purchase and sale of securities by the central bank of the country. The theory of open market operations is as follows: the sale of securities by the central bank leads to the contraction of credit, while the purchase leads to credit expansion.
When the central bank sells securities in the open market, the cash balance of banks, which they keep with the central bank, will reduce, which will decrease the lending capacity of commercial banks, thus causing credit contraction. When the central bank buys securities, it pays through cheques drawn on itself. This increases the cash balance of commercial banks and enables them to expand credit. The open market operations method is sometimes adopted to make the bank rate policy effective. If the banks do not raise the lending rates following the rise in the bank rate due to surplus funds, the central bank can withdraw such surplus funds by the sale of securities and thus compel the member banks to raise their rates.
Limitations of Open Market Operations:
It is obvious that this method will succeed only if certain conditions are satisfied.
According to the theory of open market operations, when the central bank purchases securities, the cash reserves of the member banks will be increased, and conversely, the cash reserves will be decreased when the central bank sells securities. However, this may not always happen. The sale of securities may be offset by the return of notes from circulation and hoards. The purchase of securities, on the other hand, may be accompanied by a withdrawal of notes for increased hoarding by the public. In both these cases, cash reserves of banks may remain unaffected.
Another limitation is that when the commercial bank’s cash reserves increase, the demand for loans might increase or decrease. For example, when there is a boom in the economy and prospects of profits are favorable, businessmen would borrow even at high rates of interest. Another constraint of open market operations is the velocity of circulation of bank deposits, which is rarely constant. Thus, a policy of contracting credit may be neutralized by increased velocity of circulation or vice versa.
Changing the Cash Reserve Ratio (CRR)
Another important monetary tool to vary the quantity of credit is to change the required reserve ratio. By law, banks have to keep a certain amount of cash reserves with the State Bank of Pakistan (SBP) as reserves against the demand and time deposits. If the legal minimum cash reserve ratio, for example, is 20%, the banks will have to keep 4000 crores as reserves with SBP against their deposits of 20000 crores.
Now, the central bank of a country has the authority to vary the cash reserve ratio. If the central bank increases the reserve ratio from 20% to 25%, then the reserves of 4000 crores could support only deposits of 16000 crores. Therefore, banks having reserves of 4000 will have to reduce their deposits from 20000 crores to 16000, which will cause the contraction of credit.
On the other hand, if the central bank reduces the CRR from 20% to 10%, then the reserves of 4000 crores could support deposits of 40000 crores. Therefore, the bank having reserves of 2000 crores can increase their deposits, i.e., expand credit to 40000 crores. To sum up, an increase in the legal cash reserve ratio leads to contraction of credit, and a decrease in the legal cash reserve ratio leads to the expansion of credit. Also note that an increase in the legal cash reserve ratio will succeed in contracting credit only when banks have no excess reserves.
Selective Credit Controls:
Selective credit controls are meant to regulate the flow of credit for particular or specific purposes. Whereas general credit control seeks to regulate the total available quantity of credit and the cost of credit, selective credit controls have both positive and negative aspects. In its positive aspect, measures are taken to stimulate the greater flow of credit to some particular sectors considered important, such as agriculture, small-scale industries, and small and marginal farmers. In its negative aspect, several measures are taken to restrict the credit flowing into some specific activities or sectors that are regarded as undesirable or harmful from a social point of view, such as hoarding and speculation.