Credit Regulation in the Context Of Modern Banking System

Credit regulation is the control of credit by the central bank for achieving some definite objectives. Modern economy is a credit economy because credit has come to play a major role in setting all kinds of monetary and business transactions in the modern economic system. Changes in the volume of credit influence the level of business activity and the price level in the economy. Credit control policy or monetary policy may be defined as "that branch of economic policy which is concerned with the regulation of the availability or supply, the costs and the directions of credit." The Reserve Bank of India is the controller of credit i.e. it has the power to influence the volume of credit created by banks in India. It can do so through changing the Bank rate or through open market operations. According to the Banking Regulation Act of 1949, the Reserve Bank of India can ask any particular bank or the whole banking system not to lend to particular groups or persons on the basis of certain types of securities.

The Reserve Bank of India is armed with many more powers to control the Indian money market. Every bank has to get a license from the Reserve Bank of India to do banking business within India, the license can be cancelled by the Reserve Bank of certain stipulated conditions are not fulfilled. Every bank will have to get the permission of the Reserve Bank before it can open a new branch. Each scheduled bank must send a weekly return to the Reserve Bank showing, in detail, its assets and liabilities. This power of the Bank to call for information is also intended to give it effective control of the credit system. As supreme banking authority in the country, the Reserve Bank of India, therefore, has the following powers : (a) It holds the cash reserves of all the scheduled banks. (b) It controls the credit operations of banks through quantitative and qualitative controls. (c) It controls the banking system through the system of licensing, inspection and calling for information. (d) It acts as the lender of the last resort by providing rediscount facilities to scheduled banks.

Credit Control of RBI Need: 1.To encourage the priority sectors for overall growth 2.Fecilitate the flow of adequate volume of bank credit to its industry, Agriculture and trade 3.To keep Inflation pressure under check 4.To ensure that Credit is not diverted to undesirable purposes 5.To facilitate the Development of Indian economic growth.

Objectives of Credit Regulation

The objectives of credit regulation of monetary policy have been different at different times in different countries according to the economic situations and problems faced by them. In the modern times economic development with monetary stability is accepted as the most important goal of credit control. The main objective of this credit-regulation function is to save economy from inflation and deflation and to stabilize the economy and prices. The important objectives of credit regulation are given below: 1. Price Stability: Violent price fluctuations cause disturbances and maladjustments in the economic system and have serious social consequences. Hence, price stability is an important objective of credit control policy. The central bank, by regulating the supply of credit in accordance with the commercial needs of the people, can bring about price stability in the country. 2. Economic Stability: Operation of the business cycle brings instability in a capitalist economy. The objective of the credit control policy of the central bank should be to eliminate cyclical fluctuations and ensure economic stability in the economy. 3. Maximization of Employment: Unemployment is economically wasteful and socially undesirable. Therefore economic stability with full employment and high per capita income has been considered as an important objective of credit control policy of a country. 4. Economic Growth: The main objective of credit control policy in the underdeveloped countries should be the promotion of economic growth within the shortest possible time. These countries generally suffer from the deficiency of financial resources. Hence, the central banks in these countries should solve the problem of financial scarcity through planned expansion of bank credit. 5. Stabilization of Money Market: Another objective of the central bank's credit control policy is the stabilization of the money market as to reduce the fluctuations in the interest rates to the minimum. Credit control should be exercised in such a way that the equilibrium in the demand and supply of money should be achieved at all times. 6. Exchange Rate Stability: Exchange rate stability can also be an objective of credit control policy. Instability in the exchange rates is harmful for the foreign trade of the country. Thus, the central bank, in the countries largely dependent upon foreign trade, should attempt to eliminate the fluctuations in the foreign exchange rates through its credit control policy.

METHODS OF CREDIT CONTROL

The various methods or instruments of credit control used by the central bank can be broadly classified into two categories: (a) quantitative or general methods, and (b) qualitative or selective methods.

General or Quantitative Method:

These measures are non-discriminatory as between banks and as between the uses to which credit may be given. They aim at regulating only the aggregate volume of money and credit available to the economy. They do not distinguish between the purposes for which borrowers use the loans, or the type of borrowers who are getting the loans. These measures are used on the assumption that there is a free market mechanism in the economy. By implication, any expansion (or contraction) of money supply is expected to spread itself quickly and evenly throughout the economy. The availability or scarcity of credit is experienced throughout the economy and does not remain confined to any segment of it. Therefore, the authorities need not worry about the part of the economy in which they inject additional credit supply, or from which they drain it. Quantitative controls are used to expand or contract the total quantity (overall size) of credit. These controls are of the following kinds: 1. Bank Rate (or Discount Rate) Policy Bank rate is the rate at which central bank rediscounts bill of exchange or provides credit to commercial banks. For controlling credit central bank may increase or decrease bank rate. When bank rate is raised, other bank's interest rates on advances also move up. When bank rate is decreased, other banks' interest rates on advances also go down. Borrowing from banks is discouraged or encouraged and, as a result, the rate of monetary expansion decreases or increases. 2. Open Market Operation Buying and selling of government securities by the central bank with a view to influencing money supply is called open market operations. When the central bank sells securities the buyers make payment for these to the central bank through commercial banks. A portion of commercial banks' cash flows to the central bank. As a result, the lending and financing power of banks decreases which leads to reduction in the rate of credit expansion. The purchase of securities by the central bank has the reverse effects.

3. Variable Reserve Ratios The amount of money which the banks are legally required to keep with the central bank is termed legal cash reserve ratio or requirement. It is a certain percentage of deposits. If the cash reserve ratio is raised, say from 5% to 7% of total deposits, the lending and financing power of banks will contract accordingly. This will cause fall in the rate of money expansion. A decrease in ratio has an opposite effect.

4.

Liquidity Ratio

In Pakistan, liquidity ratio refers to the amount of assets which banks are legally required to hold in the forms of (i) cash in hand, (ii) balances with SBP/NBP and (iii) approved securities. At present it is 35% of total deposit liabilities. The effects of varying liquidity ratio are similar to those of varying cash reserve ratio. The increase in it causes a fall and decreases in it a rise in the rate of credit expansion.

5. Credit Rationing In order to keep the total credit expansion within desirable limits, the central bank may recommend ceilings (an upper limit) on the overall credit extended by each commercial bank.

Qualitative or Selective Methods:

The methods used by the central bank to regulate the flows of credit into particular directions of the economy are called qualitative or selective methods of credit control. Unlike the quantitative methods, which affect the total volume of credit, the qualitative methods affect the types of credit extended by the commercial banks; they affect the composition rather than the size of credit in the economy. The important qualitative or selective methods of credit control are;

(i) Prescription of margins requirements: Generally, commercial banks give loan against stocks or securities. While giving loans against stocks or securities they keep margin. Margin is the difference between the market value of a security and its maximum loan value. Let us assume, a commercial bank grants a loan of Rs. 8000 against a security worth Rs. 10,000. Here, margin is Rs. 2000 or 20%.

If central bank feels that prices of some goods are rising due to the speculative activities of businessmen and traders of such goods, it wants to discourage the flow of credit to such speculative activities. Therefore, it increases the margin requirement in case of borrowing for speculative business and thereby discourages borrowing. This leads to reduction is money supply for undertaking speculative activities and thus inflationary situation is arrested. On other contrary, central bank can encourage borrowing from the commercial banks by reducing the margin requirement. When there is a grater flow of credit to different business activities, investment is increased. Income of the people rises. Demand for goods expands and deflationary situation is controlled. Thus, margin requirement is a significant tool in the hands of central bank to counter-act inflation and deflation. (ii) Consumer credit regulation: Now-a-days, most of the consumer durables like T.V., Refrigerator, Motorcar, etc. are available on installment basis financed through bank credit. Such credit made available by commercial banks for the purchase of consumer durables is known as consumer credit. If there is excess demand for certain consumer durables leading to their high prices, central bank can reduce consumer credit by (a) increasing down payment, and (b) reducing the number of installments of repayment of such credit. On the other hand, if there is deficient demand for certain specific commodities causing deflationary situation, central bank can increase consumer credit by (a) reducing down payment and (b) increasing the number of installments of repayment of such credit. (iii) Moral suasion: Moral suasion means persuasion and request. To arrest inflationary situation central bank persuades and request the commercial banks to refrain from giving loans for speculative and non-essential purposes. On the other hand, to counteract deflation central bank persuades the commercial banks to extend credit for different purposes. Central bank also appeals commercial banks to extend their wholehearted co-operation to achieve the objectives of monetary policy. Being the monetary authority directions of the central bank are usually followed by commercial banks.

(v) Direct Action: This method is adopted when a commercial bank does not co-operate the central bank in achieving its desirable objectives. Direct action may take any of the following forms: Central banks may charge a penal rate of interest over and above the bank rate upon the defaulting banks; Central bank may refuse to rediscount the bills of those banks which are not following its directives; Central bank may refuse to grant further accommodation to those banks whose borrowings are in excess of their capital and reserves.

LIMITATIONS OF CREDIT REGULATION

There are several difficulties in the way of the central bank to regulate credit. 1. Absence of developed money markets: - In underdeveloped countries, central bank control over bank credit is rendered very difficult by the absence of well-developed money markets. 2. Existence of non-monetized sector: - In less developed countries there exists a large nonmonetized and rural subsistence sector. Thus a big section of the community is quite unaffected by monetary policy. 3. Large-scale deficit financing: - A large-scale deficit financing by the government may make the central bank powerless in controlling the amount of credit and inflationary pressures. Thus, unless it is prevented, the credit control measures will have little value. 4. Cooperation of banks: - It is very difficult for a central bank to control credit if commercial banks do not extend their full cooperation. 5. Conflicting objectives: - The greatest difficulty in the way of the central bank in controlling credit is the simultaneous achievement of conflicting objectives. For example controlling inflation and increasing employment opportunities are conflicting objects.

1ST QUIZ OF MODERN BANKING SYSTEM BBM-603 Topic: - Credit Regulation in the Context of Modern Banking System

Submitted By:Abhishek Chaudhary Anchal Verma Nutan Sarna Batra Sonali Srivastava

References: www.rbi.org.in www.creditcontrol.uk.com www.isbs.com www.bis.org

BOOK: - Banking Theory and Practices: - K C Shekhar & Lekshmy Shekhar