Central banking methods of credit

control an overview

Dr. Prashant S. Desai,

Assistant Professor,
NLSIU

Central bank quick recap

They are different from commercial banks
It does not aim at profit although it may actually
earn good amount of profit
It aims at controlling the banking system and
supporting the economic policy of the government
It is empowered with special powers to control and
regulate the working of the commercial banking
systems of the country
It is rather popularly known for its action to control
credit in the economy

Background
Set up on the basis of the recommendations of the
Hilton Young Commission in 1926.
Report of the Chamberlain Commission of 1914
recommended that the three Presidency Banks
should be merged into one central bank.
The RBI Act, 1934 provides for the statutory basis of
the functioning of the Bank, which commenced
operations on April 1, 1935.

 RBI was started originally as a shareholders bank

and its paid up capital was Rs.5 Crores.
It took over the function of currency issue from the
Govt. of India and the power of credit control from
the then Imperial Bank of India.
It was nationalized w.e.f. 1-1-1949 on the basis of the
RBI (Transfer to Public Ownership) Act, 1948.
All shares in the capital of the bank were deemed
transferred to the Central Govt. on payment of a
suitable compensation.

Functions of RBI
Regulate the issue of banknotes
Maintain reserves with a view to securing monetary
stability
Operate the credit and currency system of the
country to its advantage
Monetary Policy, Bank Supervision and Regulation
and Overseeing the Payments System and
developing the financial markets.

Issuer of currency in India

Banker to the Government
Banker to Commercial Banks
Organizer of commercial Banking System
Regulator and supervisor of the Financial System
Financial supervision
Monetary Authority
Monetary and credit policies
Controls the volume of credit

 Authority to regulate and supervise Payment

Systems
Manager of Foreign Exchange
Maintains the value of currency
Development of Rural Banking
Money and Capital Market
Promotion of financial Institutions
Developmental role of RBI

Organization of RBI
Central Board of Directors of RBI (Sec.8)
Local Boards of RBI Mumbai, Kolkata, Chennai
and New Delhi 5 members each for a term of 4
years to represent territorial and economic interests,
the interest of cooperatives and indigenous banks.
Board for Financial Supervision (Sec.58)

RBI and Commercial Banks

Commercial Banks maintain accounts with RBI
RBI as Banker to Scheduled Commercial Banks
RBI controls the activities of Commercial Banks
RBI issues Licence to Banks
Power to inspect the Commercial Banks (Sec.35 of
BR Act)
Overall Control over management of Banks (Sec.
35B of BR Act)
Power to control the volume of credit

Two methods of credit control

1. Quantitative credit control methods
1. Bank rate or discount policy
2. Open market operation & reserve requirements

2. Qualitative or selective credit control methods

1.
2.
3.
4.
5.
6.

Regulations or margin requirements

Regulation of consumer credit
Control through directives
Moral persuasion
Rationing of credit
Direct action

Quantitative methods
Bank Rate Policy
Commercial banks when in additional need of cash
obtain from the Central Bank either
By rediscounting some of the securities; or
Borrow from the Central Bank against the securities

For this Central Bank charges interest at the rate,

which is known as Bank Rate or Discount Rate

BANKRATEGOINGUP
LENDINGRATES
OFTHE
COMMERCIAL
BANKSWILLGO
UP
PEOPLEARE
DISCOURAGED
TOTAKELOANS
MERCHANTS
LIQUIDATETHEIR
STOCKS
DEALERSIN
STOCK
EXCHANGEMAY
LIQUIDATETHEIR
STOCKSTOPAY
OFFTHEIRLOANS

BANKRATEGOINGDOWN
LENDINGRATES
GODOWN
PEOPLEARE
ENCOURAGEDTO
TAKELOANS
MERCHANTS
HOLDTHE
STOCKS
STOCKSWILLBE
HELDONTOBY
THEBROKERS
MOREPURCHASE
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ALSOTAKEPLACE

Quantitative methods
Open Market Operations
Deliberate and direct buying and selling of securities and
bills in the money market by the Central Bank on its own
initiative

Quantitative methods
Reserve Ratio Requirements
The requirement of a commercial bank to maintain
a minimum percentage of their time and demand
liabilities with the Central Bank also know as Cash
Reserve Ratio
The objective
To ensure liquidity & solvency among the banks
To provide Central Bank with supply of deposits for its local
operations
To influence ultimately restrict commercial banks extension
of credit

Selective credit control methods

Unlike the quantitative controls they are not
indiscriminately impact across all sectors
Historically these were designed and applied
during the World War II period
Advantages
They distinguish between essential and non essential uses
of the Bank credit
Only non essential uses are brought under the scope of
Central Bank controls; and
They affect not only lenders but borrowers as well

Selective credit control methods

Margin requirements
The stock-market crash of 1929 in USA
There was extensive speculation in stock markets in US
The Federal Reserve Bank of America ordered commercial
banks to restrict their loans and advances to stock brokers
by raising the margin requirements

Regulation of customer credit

The restraint under these regulations were two fold
They limited the amount of credit for the purchase of any
article listed in the regulation; and
They limit the time for repaying the debt

Moral persuasion
Implies persuasion and request made by the
Central Bank to the commercial banks to follow the
general monetary policy of the former

Rationing of credit
Method of controlling and regulating the purpose
for which credit is granted by the commercial banks

Direct action
in 1959 RBI directed the entire banking system to
refrain from excessive lending