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Credit control functions of RBI


Posted Date: 13-Mar-2010  Last Updated:   Category: Education    
Author: Member Level: Gold    Points: 25


How did RBI control the credit; How credit is controlled by RBI; Credit control functions of RBI



The RBI adopt two methods to control credit in modern times for regulating bank advances. They are as follows:-

(A) Quantitative or General Credit Control
This method aims to regulate the amount of bank advance. This method includes:
(a) Bank Rate
(b) Open Market Operation
(c) Variables Reserves Ratio

(a) Bank Rate: It is the rate at which central bank discounts the securities of commercial banks or advance loans to commercial banks. This rate is the minimum and it affects both cost and availability of credit. Bank rate is different from market rate. Market rate is the rate of discount prevailing in the money market among other lending institutions. Generally bank rate is higher than the market rate. If the bank rate is changed all the other rates normally change at the same direction. A central bank control credit by manipulating the bank rate. If the central bank raise the bank rate to control credit, the market discount rate and other lending rates in the money will go up. The cost of credit goes up and demand for credit goes down. As a result, the volume of bank loans and advances is curtailed. Thus raise in bank rate will contract credit.

(b) Open Market Operation: It refers to buying and selling of Government securities by the central bank in the open market. this method of credit control become very popular after the 1st World War. During inflation, the bank will securities and during depression, it will purchase securities from the public and financial institutions. The RBI is empowered to buy and sell government securities from the public and financial institutions. The RBI is empowered to buy and sell government securities, treasury bills and other approved securities. The central bank uses the weapon to overcome seasonal stringency in funds during the slack season.

When the central bank sells securities, they are purchased by the commercial banks and private individuals. So money supply is reduced in the economy and there is contraction in credit.
When the securities are purchased by the central bank, money goes to the commercial banks and the customers. SO money supply is increased in the economy and there is more demand for credit.

Thus open market operation is one of the superior instrument of credit control. But for achieving an ideal result both Bank Rate and Open Market Operation must be used simultaneously.

(c) Variable Reserve Ratio (VRR): This is a new method of credit control adopted by central bank. Commercial banks keep cash reserves with the central bank to maintain for the purpose of liquidity and also to provide the means for credit control. The cash reserve is also called minimum legal reserve requirement. The percentage of this ratio can be changed legally by the central bank. The credit creation of commercial banks depends on the value of cash reserves. If the value of reserve ratio increase and other things remain constant, the power of credit creation by the commercial bank is decreased and vice versa. Thus by varying the reserve ratio, the lending capacity of commercial banks can be affected.

(B) Qualitative or Selective Control Method:
It is also known as qualitative credit control. This method is used to control the flow of credit to particular sectors of the economy. The direction of credit is regulated by the central bank. This method is used as a complementary to quantitative credit control discourage the flow of credit to unproductive sectors and speculative activities and also to attain price stability. The main instruments used for this purpose are:

(1) Varying margin requirements for certain bank: While lending commercial banks accept securities, deduct a certain margin from the market value of the security. This margin is fixed by the central bank and adjust according to the requirements. This method affect the demand for credit rather than the quantity and cost of credit. This method is very effective to control supply of credit for speculative dealing in the stock exchange market. It also helps for checking inflation when the margin is raised. If the margin is fixed as 30%, the commercial banks can lend up to 70% of the market value of security. This method has been used by RBI since 1956 with suitable modifications from time to time as per the demand and supply of commodities.

(2) Regulation of consumer's credit: Apart from trade and industry a great amount of credit is given to the consumers for purchasing durable goods also. RBI seeks to control such credit in the following ways:
(a) by regulating the minimum down payments on specific goods.
(b) by fixing the coverage of selective consumers durable goods.
(c) by regulating the maximum maturities on all installment credit and
(d) by fixing exemption costs of installment purchase of specific goods.

(3) Control through Directives: Under this system, the central bank can issue directives for the credit control. There may be a written or oral voluntary agreement between the central bank and commercial banks in this regard. Sometimes the commercial banks do not follow these directives of the RBI.

(4) Rationing of credit: The amount of credit to be granted is fixed by the central bank. Credit is rationed by limiting the amount available to each commercial bank. The RBI can also restrict the discounting of bills. Credit can also be rationed by the fixation of ceiling for loans and advances.

(5) Direct Action: It is an extreme step taken by the RBI. It involves refusal by RBI to extend credit facilities, denial of permission to open new branches etc. RBI also gives wide publicity about the erring banks to create awareness amongst the public.

(6) Moral suasion: RBI uses persuasion to influence lending activities of banks. It sends letters to banks periodically, advising them to follow sound principles of banking. Discussions are held by the RBI with banks to control the flow of credit to the desired sectors.

These were the main Credit control functions of RBI.

Thank you.


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