2. Credit Control
Credit control is defined as the lending strategy that banks and
financial institutions employ to lend money to customers. The
strategy emphasizes on lending money to customers who have a
good credit score or credit record.
Quantitative or General Methods:
The methods used by the central bank to influence the total
volume of credit in the banking system, without any regard for the
use to which it is put, are called quantitative or general methods
of credit control.
3. Instruments of credit control
The important quantitative methods of credit control are-
(a) bank rate,
(b) open market operations,
(c) cash-reserve ratio.
These methods regulate the lending ability of the financial sector of the whole economy and do not
discriminate among the various sectors of the economy.
4. Manipulation of bank rate
Bank Rate policy
The bank rate policy is the traditional method of credit control used by a central bank. The bank rate
or the discount rate is the rate at which a central bank is prepared to discount the first-class bills of
exchange.
In its capacity as ‘lender of last resort’, the central bank helps the commercial banks by
rediscounting the first-class bills (i.e., by advancing loans against approved securities). The rate of
interest which the central bank charges from the commercial banks for rediscounting the bills is
called bank rate.
The bank rate is distinct from the market interest rate. The bank rate is the rate of discount of the
central bank, while the market interest rate is the lending rate charged in the money market by the
ordinary financial institutions.
There is a direct relationship between the bank rate and the market interest rates. A change in the
bank rate leads to change in other interest rates prevailing in the market. In this sense, bank rate is
the effective rate for lending or borrowing which prevails in the market.
5. Effects of Bank Rate Policy:
Various effects of bank rate policy are discussed below:
• Effect on Cost and Availability of Credit:
Bank rate policy influences both the cost and the availability of credit
lo the commercial banks. By changing the bank rate, the central bank
affects the cost of credit; by raising the bank rate, it raises the cost of
credit and by lowering the bank rate, it lowers the cost of credit
• Determination of Interest Rates and Money Supply:
The central bank, through its bank rate policy, is able to influence the
interest rates and the money supply in the economy. Changes in the
bank rate influence the interest rates in the money market. Changes
in the amount that the central bank is willing to lend influence the
money supply. But, the central bank cannot simultaneously set both
interest rates as well as the money supply.
6. • Effect on the Level of Economic Activity:
• The bank rate policy affects the level and structure of interest rates and thereby the level of economic activity in
an economy. A change in the bank rate leads to a corresponding change in the other interest rates of the market.
This makes credit either dearer or cheaper. The changes in the market interest rates affect the willingness of the
businessmen to borrow and invest. This will, in turn, affect the level of economic activity and the price level.
• Bank Rate Policy during Inflation and Depression:
Bank rate policy is used to control the inflationary as well as deflationary situations in the
economy. During inflation, the central bank increases the bank rate. As a result, other interest rates
in the money market will rise, thereby rising the cost of bank credit.
This will discourage the businessmen from borrowing from banks. The Volume of credit will
decrease, the level of economic activity will decline and the price level will fall.
During depression, the bank rate is reduced. It will reduce the market rates of interest, make the
bank credit cheaper, encourage the businessmen to borrow, and invest, push up the level of
economic activity and the price level.
7. Limitations of Bank Rate Policy:
Ineffective in Controlling Deflation:
Bank rate policy is more ineffective in off-setting depression than in controlling inflation. When bank
rate is lowered during a period of deflation, the resulting lower rates of interest may not be able to
induce the entrepreneurs to borrow and invest more because of falling prices and falling profits.
Indiscriminatory:
The bank rate policy is indiscriminatory in nature. In other words, it makes no distinction
between the productive and unproductive activities in the country. For example, if the
bank rate is raised to control speculative activities, it will also adversely affect the genuine
productive activities.
8. Varying reserve Requirements
Variations of reserve requirements affect the liquidity position of the banks and
hence their ability to lend. The raising of reserve requirements is an anti-
inflationary measure inasmuch as it reduces the excess reserves of member-banks
for potential credit expansion.
Reserve requirements are the amount of funds that a bank holds in reserve to
ensure that it can meet liabilities in case of sudden withdrawals.
Reserve requirements are a tool used by the central bank to increase or decrease
the money supply in the economy and influence interest rates.
Reserve requirements are currently set at zero as a response to the COVID-19
pandemic
9. The method of variable cash reserve ratio or changing minimum cash
reserves to be kept with the central bank by the commercial banks is
comparatively new method of credit control used by the central banks.
the method of cash reserve ratio is a more direct and more effective method
in dealing with the abnormal situations when, for example, there are
excessive reserves with the commercial banks based on which they are
creating too much credit, leading to inflationary situation.
Thus, a change in reserve requirements affect the money supply in two ways-
(a) it changes the level of excess reserves;
(b) it changes the credit multiplier.
10. Excess reserves are capital reserves held by a bank or financial institution in excess of what is
required by regulators, creditors or internal controls. For commercial banks, excess reserves are
measured against standard reserve requirement amounts set by central banking authorities. These
required reserve ratios set the minimum liquid deposits (such as cash) that must be in reserve at a
bank; more is considered excess.
Credit Multiplier Economists and bankers often look at a multiplier effect from the
perspective of banking and money supply. This multiplier is called the money supply
multiplier or just the money multiplier. The money multiplier involves the reserve
requirement set by the Board of Governors of the Federal Reserve System and it varies
based on the total amount of liabilities held by a particular depository institution. The most
recent Federal Reserve reserve requirements prior to the Covid-19 pandemic mandated
that institutions with more than $127.5 million have reserves of 10%. This changed as the
Fed responded to the Covid-19 pandemic by eliminating these requirements to free up
liquidity.
11. Limitations of Variable Cash Reserve Ratio:
This method is not effective when the commercial banks keep
very large excessive cash reserves. In such a case ever if cash
reserve ratio is raised, ample reserves remain after satisfying the
minimum requirements.
This method is not effective when the commercial banks happen
to possess large foreign funds. Thus, even if the central bank
reduces the reserves by raising the cash reserve ratio, these banks
will continue to create credit based on the foreign funds.
Despite the limitations, the variable cash reserve ratio is a useful
method of credit control. It assumes special significance in the
underdeveloped countries
12. Differences:
• Bank Rate Policy:
It is an indirect method of influencing the volume of credit in the economy. It
first influences the cost and availability of credit to the commercial banks
and thereby, influences the willingness of the businessmen to borrow and
invest.
• Varying Reserve Requirement
It is the most direct method because it controls the volume of credit by
directly influencing the cash reserves of the commercial banks. (ii) It
produces immediate effect on the cash reserves of the commercial
banks. It is suitable when large changes in the cash reserves of the
commercial banks are required.
13. Conclusion:
• The comparative study of the two methods of credit control
shows that each method has its own merits and demerits. No
method, taken alone, can produce effective results. The correct
approach is that, instead of selecting this method or that
method, all the three methods should be judiciously combined
in right proportions to achieve the objectives of credit control
effectively.