CENTRAL BANK & CREDIT CONTROL & CREDIT CREATION

Central bank (RBI in case of India) is the first source of money supply in the form of currency in circulation. The Reserve Bank of India is the note issuing authority of the country. The RBI ensures availability of currency to meet the transaction needs of the economy. The Total Volume of money in the economy should be adequate to facilitate the various types of economic activities such as production, distribution and consumption. The commercial banks are the second most important sources of money supply. The money that commercial banks supply is called credit money.

FUNCTIONS OF CENTRAL BANK

Central bank takes several actions to control and regulate the demand and supply of money with the public and the flow of credit with the view to achieve a predetermined macroeconomic goal. The various measures taken by central bank in this regard are: Open market operation Discount Rate or Bank Rate Cash Reserve Ratio

OPEN MARKET OPERATION (OMO)

Open market operation comprises of the sale and purchase of government securities and bills (generally termed as treasury bills) by the central bank of the country. In India, Treasury Bills are short term promissory notes issued by the Govt. of India through the RBI. There are two kinds of treasury bills- 91 day and 182 day bills. The 91 day treasury bills are issued by RBI on behalf of Govt. of India at a fixed discount rate of 4.6%. The 181 day treasury bills are sold by the way of auction to the residents of India for a minimum value of Rs.100000. The auction bid is invited every fortnight and the discount rate is decided on the basis of the auction rate. When the central bank decides to increase the supply of money in the economy it purchases the bonds and bills and when it decides to reduce the circulation of money in the economy it sells the govt. bonds and securities. The open market operation is a powerful and widely used measure to control and regulate the flow of money and credit.

Mechanism of Open Market Operation The central bank carries out its open market operation through commercial banks- it does not deal directly with the public. The buyers of govt. bonds and bills include commercial banks, financial corporations and big business houses. These customers hold their account with bank. When they buy bonds and bills, money is transferred from their account to RBI account. Thus, when the central bank carries out open market operation it affects bank deposits and its credit capacity. When the central bank decides to decrease the supply of money, it sells govt. bonds and securities. In this way the money flows out from the commercial bank account to central bank account. This reduces the cash reserve of commercial banks which further leads to reduce in their credit creation capacity. This increases the rate of interest. On the contrary, when the central bank decides to increase the money supply, it buys back govt. securities and bonds. Then the money flows out from the central bank account to the commercial banks account. As a result, the deposit and cash reserve of the commercial bank increases. This enhances their credit creation capacity and the rate of interest goes down. The task of open market operation becomes easier when the government owns the commercial banks as in the case of India.

DISCOUNT RATE / BANK RATE POLICY

Bank rate is the rate at which RBI lends loans to commercial banks. When a bank faces financial crisis then RBI charges the commercial bank a rate of interest against the loan and advances. Such rate is Bank rate. A more appropriate name in usage now is the discount rate. Thus bank rate or discount rate is the rate which the central bank charges on the loans and advances to the commercial banks. The central bank can increase or decrease the bank rate depending upon the situation whether it wants to expand or reduce the flow of credit from the commercial banks. When it wants to reduce the credit creation capacity of the commercial bank, it increases the bank rate and vice versa. This action of central bank is called bank rate policy or discount rate policy. The working of bank rate policy is simple. When the central bank changes its discount rate, commercial banks also change their bank rate. Thus when RBI raises its bank rate, commercial banks also raise their rates. This results in the increase of cost of credit. It pushes the interest rate up. The rise in interest rate reduces the demand of fund.

A fluctuation in bank rates triggers a ripple-effect as it impacts every sphere of a countrys economy. For instance, the prices in stock markets tend to react to interest rate changes. A change in bank rates affects customers as it influences prime interest rates for personal loans.

THE CASH RESERVE RATIO or STATUTORY RESERVE RATIO

The cash reserve ratio is the percentage of total deposit which commercial banks are required to maintain in the form of cash reserve with the central bank. CRR has become a handy tool for the central bank to control money supply. When economic conditions demand contraction of money supply the central bank increases the CRR and when economic situation demands expansion of monetary supply the CRR is cut down. Mechanism of CRR Suppose commercial banks have a total deposit of Rs. 100 crore and the CRR is 20%. It means: 1. The banks can loan Rs. 80 crore and 2. The credit or deposit multiplier is equal to 5. 3. The banks can create, through the process of credit multiplier, a total credit of Rs. 500 crore. Credit or Deposit multiplier refers to the factor by which a commercial bank deposit could grow by lending it over and over again. Credit/ Deposit Multiplier= 1/CRR = 1/ 20% =5 Thus, Total Credit Creation= Deposit Multiplier X Deposit = 5 X 100 = 500 crore. Now if the central bank decides to reduce the money supply in the economy and it increases the CRR to 25%. Then the credit/deposit multiplier will go down to 4. i.e., Credit/ Deposit Multiplier= 1/CRR = 1/ 25% =4 With this provision the banks can provide loan only to the extent of Rs. 75 crore and total credit created by the banks goes down to 100 X 4 = 400 crore. Thus, the total credit creation capacity of the banks goes down by Rs. 100 crore. The effect will be reversed when the central bank cuts back the CRR to 20%.

In India, the RBI has imposed another kind of reserve requirement in addition to CRR, called Statutory Liquidity Ratio (SLR). The SLR is the

proportion of the total deposit which commercial banks are required to maintain with them in the form of liquid assets (gold, govt. bonds) in addition to cash reserve ratio. This measure was taken to prevent the commercial banks from liquidating their liquid assets when CRR is raised. What commercial banks used to do, before SLR was imposed, was to convert their liquid assets into cash to replenish/restock the fall in their loanable fund due to rise in the CRR.

REPO & REVERSE REPO RATE

In addition to above measures RBI uses Repo (Repurchase Operation Rate) and Reverse Repo Rate to control and regulate the supply of money and credit in the economy. Repo Rate: Repo Rate is the rate that RBI charges the banks when they borrow from RBI. Whenever commercial banks face the problem of of shortage of money they borrow money from RBI. Repo Rate refers to the interest at which the banks borrow money from RBI. Reverse Repo Rate: Reverse Repo Rate is the rate that RBI offers the commercial banks willing to keep their money with it. Or simply say, Reverse Repo Rate is the interest rate at which RBI borrows money from commercial banks. Banks are happy to lend their money to RBI since their money is in safe hands with good interest rates. Thus, when RBI increases the Reverse Repo Rate, commercial banks will transfer more money to RBI. On the other hand with the decrease in Reverse Repo Rate commercial banks would not like to transfer their money to RBI and apart from this they will withdraw their money from RBI. Conclusion: RBI and control the situation of inflation and deflation with the tool of Reverse Repo Rate. In inflationary situation it will increase the Reverse Repo Rate while in deflation it will decrease the Reverse Repo Rate.

CREDIT CREATION BY COMMERCIAL BANKS

The process of 'Credit Creation' begins with banks lending money out of primary deposits. Primary deposits are those deposits which are deposited in banks. In fact banks cannot lend the entire primary deposits as they are required to maintain a certain proportion of primary deposits in the form of reserves with the RBI under RBI & Banking Regulation Act. After maintaining the required reserves, the bank can lend the remaining portion of primary deposits. Here bank's lend the money and the process of credit creation starts. Suppose there are a number of Commercial Banks in the Banking System Bank 1, Bank 2, Bank 3, & So on. To begin with let us suppose that an individual "A" makes a deposit of Rs. 100 in bank 1. Bank "1" is required to maintain a Cash Reserve Requirement of 5% (Prevailing Rate) which is decided by the RBI's Monetary Policy from the deposits made by 'A'. Bank "1" is required to maintain a cash reserve of Rs. 5 (5% of 100). The bank has now lendable funds of Rs. 95(100 5). Let the Bank "1" lend Rs. 95 to a borrower; say B. the method of lending is the same that is bank 1 opens an account in the name of the borrower cheque for the loan amount. At the end of the process of deposits & lending, the balance sheet of bank reads as given below:Balance Sheet of Bank "1" Liabilities A's deposits Total Amount 100 100 Assets Cash Reserve Loan to "B" Total Amount 5 95 100

Now suppose that money that borrowed from bank "1" is deposited by B to bank 2. Bank "2" is required to maintain a cash reserve of Rs. 4.75 (5% of 95). The bank has now lendable funds of Rs. 90.5(95 4.5). Let the Bank "2" lend Rs. 94.5 to a borrower; say C the method of lending is the same as that of bank 1. At the end of the process the balance sheet of Bank 2 will be look like:-

Balance Sheet of Bank "2" Liabilities B's deposits Total Amount 95 95 Assets Cash Reserve Loan to "C" Total Amount 4.75 90.5 95

The amount advanced to C will return ultimately to the banking system, as described in case of B and the process of deposits and credit creation will continue until the reserve with the banks is reduced to zero. The final picture that would emerge at the end of the process of deposit & credit creation by the banking system is presented in the consolidated balance sheet of all banks are as under:The combined Balance sheet of Banks Bank Bank 1 Bank 2 Bank 3 Bank n Total Liabilities Deposits 100 95 90.5 00 2,000 Assets Credits 95 90.5 85.98 00 1,900 Reserve 5 4.75 4.52 00 100 Total Assets 100 95 90.5 00 2,000

It can be seen from the combined balance sheet that a primary deposits of Rs. 100 in a bank 1 leads to the creation of the total deposit of Rs. 2,000. The combined balance sheet also shows that the banks have created a total credit of Rs. 2,000. And maintained a total cash reserve of Rs.100.Which equals the primary deposits. The total deposit created by the commercial banks constitutes the money supply by the banks. CONCLUSION:To conclude, we can say that credit creation by banks is one of the important & only sources to generate income. And when the reserve requirement increased by the central bank it would directly affect on the credit creation by bank because then the lendable funds with the bank decreases and vice versa.