XII Banking - Question 8 - Central Bank - Credit

Q.3. Show how the Central Bank of a country controls CREDIT?

The modern economy is a credit economy. Credit is the life-blood of modern business. Accordingly control of credit is essential for stability and orderly growth of an economy. There are two types of controls used by the central banks in modern time for regulating bank advances.

i.Quantitive or General Control

ii.Quantitive or Selective Credit Controls

These are discussed below


i. Quantitive or General Control.

The aim of Quantitive Controls is to regulate the amount of bank advances i.e. to make the banks lend more or lend less. Some of the controls are


a. Manipulation of Bank Rate

The bank rate is the rate at which the central bank of a country is willing discount the first class bills. It is thus the rate of discount of the central bank. If the central bank wants to control credit, it will raise the bank rate. As a result the market rate will go up. Borrowing will consequently be discouraged. Those who hold stocks of commodities with borrowed money will unload their stocks, since as a result of the rise in the interest. They will repay their loans thus the raising of bank rate will lead to a contraction of credit.


b. Open Market Operations

The term open market operations in the wider sense means purchase or sale of any kind of papers in which it deals like government securities or any other trade securities etc. In practice this term is used to identify the purchase and sale of government securities by the central bank. When the central bank sells securities in the open market it receives payments in the form of a cheque on one of the commercial banks. If the purchaser is a bank the cheque is drawn against the purchasing bank. In both cases the result is the same. The cash balance of the bank in question which it keeps with the central bank is to that extent reduced with the reduction of its cash the commercial bank has to reduce its louding. Thus credit contracts.

c. Varying Reserve Ratio

The varying reserve ratio method is comparative a new method of credit control used by central banks in recent times. The minimum balance to be maintained by the member banks with the central banks are fixed by law and the central bank is given statutory power to change these minimum reserves. Variations of reserve requirements affect the liquidity position of the banks and hence their ability to lend. It reduces the excess reserves of member banks for potential credit expansions.


d. Credit Rationing

Credit rationing means restrictions placed by the central bank on demands for accommodation made upon it during times of monetary stringency and declining gold reserves. The credit is rationed by limiting the amount available to each applicant. Further the central bank restrict its discount to bills maturing after short periods.


ii. Quantitive or Selective Controls

In this regard the following methods are used.


i. Varying Margin Requirement

The central bank controls credit by varying margin requirements. While lending money against securities the bank keeps a certain margin. They do not advance money to the full value of the security pledges for the loan. If it is desired to curtail bank advances the central bank may issue directions that a higher margin be kept. The raising of margin requirements is designed to check speculative in the stock market.


ii. Regulation of Consumer Credit

A part from credit for trade and industry a great deal of credit in development countries at any time may be for durable consumer goods like houses, motor cars, refrigerator etc on purchase or installment credit system. Central seek to control such credit in several ways. E.g.

by regulating the minimum down payments in specified goods.
by fixing the coverage of selective consumer goods
by regulating the maximum maturities on all installments credits.

iii. Direct Action

Direct action implies measures like refusal on the part of the central bank to rediscount for the banks whose credit policy is not in accordance with the wishes of the central bank or whose borrowings are excessive in relation to their capital and reserves.


iv. Moral Sausion

The central bank may request and persuade member banks to refrain from increasing their loans for speculative or non-essential activities.


v. Publicity

The method of publicity is used by issuing of weekly statistics, periodical review of the money market conditions, public finances, trade & industry the issue of weekly statements of assets & liabilities in the form of balance sheets.


BANKER'S BANK

Broadly speaking the central bank acts as a bankers bank in three capacities.


i. As the Custodian of Cash Reserves

In every country its commercial bank keep a certain percentage of their cash reserves with the central bank. Infact the establishment of central bank makes it possible for the banking system to secure the advantages of centralized cash reserves.


ii. As Lender of the Last Resort

As a lender of the last resort in times of emergencies the central bank gives financial accommodation to commercial banks by rediscounting by bills. The monopoly of note issue and centralization of cash reserves with the central bank increase its capacity of growing credit and thus to rediscount the bills as the lender of last resort.


iii. As a Bank of Central Clearance

The central bank act as a clearing house for member banks. As the central becomes the custodian of cash reserves of commerce was banks it is an easy and logical step for it to act as a settlement bank or clearing house for other banks as the claims of banks against one another are settle by simple transfers from and to other accounts.


CONTROL OF CREDIT

By far the most important of all central banks in modern times is that of controlling credit operations of commercial banks i.e. regulating the volume and direction of bank loan. On the level or volume of credit depends largely the level employment and the level of prices in a country.


Maintenance of Exchange Rates

Another important function of a central bank is to keep stable the foreign value of the home currency. A stable exchange rate is necessary to encourage foreign trade and inflow of foreign investment which is so essential for accelerating the pace of economic growth particularly underdeveloped countries.


Custodian of Cash Reserves

It is the central bank which serves as the custodian of a nation’s reserves of gold and foreign exchange. It is the duty to take appropriate measures to safeguard these reserves.