Methods of Credit Control by Central Bank: 4 Methods

The following points highlight the top four methods of credit control adopted by Central bank. The methods are: 1. Bank Rate or Discount Rate Policy 2. Open Market Operations 3. Variable Reserve Ratio 4. Selective Credit Controls.

Method # 1. Bank Rate or Discount Rate Policy:

The bank rate or the discount rate is the rate fixed by the central bank at which it rediscounts first class bills of exchange and government securities held by the commercial banks. The bank rate is the interest rate charged by the central bank at which it provides rediscount to banks through the discount window.

The central bank controls credit by making variations in the bank rate. If the need of the economy is to expand credit, the central bank lowers the bank rate. Borrowing from the central bank becomes cheap and easy. So the commercial banks will borrow more.

They will, in turn, advance loans to customers at a lower rate. The market rate of interest will be reduced. This encourages business activity, and expansion of credit follows which encourages the rise in prices. The opposite happens when credit is to be contracted in the economy. The central bank raises the bank rate which makes borrowing costly from it. So the banks borrow less. They, in turn, raise their lending rates to customers.

The market rate of interest also rises because of the tight money market. This discourages fresh loans and puts pressure on borrowers to pay their past debts. This discourages business activity. There is contraction of credit which depresses the rise in price. Thus lowering the bank rate offsets deflationary tendencies and raising the bank rate controls inflation. But how do changes in the bank rate affect prices and production? There are two views which explain this process. One held by R.G. Hawtrey and the other by Keynes.

Hawtrey’s View:

According to Hawtrey, changes in the bank rate affect changes in the short-term rates of interest which, in turn, affect the behaviour of dealers and producers in holding short of finished and semi-­finished goods. Suppose the bank rate rises. It raises the stock-term interest rates. Consequently, the cost of borrowing and of holding stocks of goods increases.

The dealers will, therefore, try to reduce their stocks of goods, and place less orders to the producers of goods. The sales of producers will start declining. So they will lower prices to induce dealers to buy more of their goods. Or, they will reduce output. As they curtail output, Some of the factors of production become unemployed. Money incomes fall due to unemployment.

This further reduces the sale of goods, and the dealers reduce their orders to the producers further who, In turn, reduce their production. So ultimately there will be a fall in prices, production and employment in the economy.

The converse will be the case when the bank rate falls which will reduce the short-term interest rates, and encourage prices, production and employment through the encouraging behaviour of traders and producers.

Keynes’s View:

Keynes in his Treatise on Money gives an alternative view based upon changes in the volume of fixed capital following a change in the long-term rate of interest. According to him, when the bank rate changes, the long-term interest rates also change in the same direction and will affect investment, prices and employment in the following manner.

Suppose the bank rate is increased. It will raise the short-term interest rates in the money market, while the long-term interest rates remain unchanged. As a result, short-term securities become more attractive because they carry high rates of interest. But the value of long-term securities declines because they now carry low rates of interest than at which they were purchased in the past.

The holders of long-term securities will, therefore, sell their securities and invest in short-term securities. This will adversely affect long-term investments in the economy. Consequently, long-term rates of interest will also rise. With the rise in the long-term interest rates, businessmen and producers will reduce investment on fixed capital assets.

Employment falls in the capital goods industries. Money income declines. Expenditure on consumption goods is reduced. This leads to fall in their prices and production. Conversely, a fall in the bank rate will lower the long-term interest rates, investment, employment, income, prices and production.

It is not possible to verify empirically these two views. They presuppose that businessmen and producers are very sensitive to interest rate changes and interest charges form a considerable part of the cost of holding and production of goods. Both the assumptions are unrealistic.

First, prices and production are not so sensitive to changes in interest rates.

Second, interest rates form an insignificant part of the total cost of holding and production of goods. Interest rate is only one of the factors which determines the volume of investment in stocks of goods and in fixed capital goods. Further, the two views are neither contrary nor mutually exclusive.

Hawtrey lays emphasis on changes in the short-term interest rates and Keynes on the long-term interest rates, as a result of changes in the bank rate. But ultimately both lead to the same results, though the process of causation is a little different in each case. For instance, a change in the bank rate may affect the holdings of stocks of goods as well as the volume of fixed capital goods whether the short-term or the long-term interest rates change.

Views of Radcliffe Committee:

The Radcliffe Committee appointed by the British Government in 1959 analysed two effects of the bank rate policy upon business activity. The first is the interest-incentive effect. When the bank rate changes, it brings changes in the market rates of interest, thereby inducing a change in the incentive of investment expenditures of business firms. A rise in the bank rate raises interest rates.

The cost of holding capital goods increases which causes a disincentive for investors and business firms to borrow funds. Thus with the increase in the cost of borrowing funds, there will be a disincentive for investors and business firms to borrow from the commercial banks. The opposite will be the case when the bank rate falls.

It reduces market interest rates, thereby reducing the cost of borrowing from the banks. This provides an incentive to investors and businessmen to get more advances from the banks. But the Committee ruled out the interest- incentive effect because business decisions are primarily independent of changes in interest rates. Moreover, interest-payments form an insignificant proportion of total costs of business firms.

The Committee analysed a more important effect of the bank rate changes, known as the ‘general liquidity effect’. According to the Committee, the interest-incentive effect of a change in the bank rate being small, there may take place a ‘valuation effect’ or general liquidity effect.

Bank rate changes affect the capital values of the assets of business firms, and consequently, their balance sheets and their ability to lend. A rise in the bank rates raises the market rates, thereby reducing the value of capital assets of financial institutions. Thus they are willing to lend less. On the other hand, a fall in the bank rate lowers the market rates, and the value of capital assets increases. It encourages lenders to seek new business.

The real force of changes in the bank rate lies in its effects on the liquidity of the various groups of financial institutions through market interest rates which (i.e. liquidity), in turn, affects the liquidity of others. This is the general liquidity effect of changes in the bank rate. While analysing this effect, the Committee takes into view the interrelationship of short, medium and long-term interest rates.

Limitations of Bank Rate Policy:

The efficacy of the bank rate policy as an instrument of controlling credit is limited by the following factors:

1. Market Rates do not change with Bank Rate.

The success of the bank rate policy depends upon the extent to which other market rates of interest change along with the bank rate. The theory of bank rate policy pre­supposes that other rates of interest prevailing in the money market change in the direction of the change in the bank rate. If this condition is not satisfied, the bank rate policy will be totally ineffective as an instrument of credit control.

2. Wages, Costs and Prices not Elastic:

The success of the bank rate policy requires elasticity not only in interest rates but also in wages, costs and prices. It implies that when suppose the bank rate is raised, wages, costs and prices should automatically adjust themselves to a lower level. But this was possible only under gold standard.

Now-a-days the emergence of strong trade unions have made wages rigid during deflationary trends. And they also lag behind when there are inflationary tendencies because it takes time for unions to get a wage rise from employers. So the bank rate policy cannot be a success in a rigid society.

3. Banks do not approach Central Bank:

The effectiveness of the bank rate policy as a tool of credit control is also limited by the behaviour of the commercial banks. It is only if the commercial banks approach the central bank for rediscounting facilities that this policy can be a success. But the banks keep with them large amounts of liquid assets and do not find it necessary to approach the central bank for financial help.

4. Bills of Exchange not used:

As a corollary to the above, the effectiveness of the bank rate policy depends on the existence of eligible bills of exchange. In recent years, the bill of exchange as an instrument of financing commerce and trade has fallen into disuse. Businessmen and banks prefer cash credit and overdrafts. This makes the bank rate policy less effective for controlling credit in the country.

5. Pessimism or Optimism:

The efficacy of the bank rate policy also depends on waves of pessimism or optimism among businessmen. If the bank rate is raised, they will continue to borrow even at a higher rate of interest if there are boom conditions in the economy, and prices are expected to rise further.

On the other hand, a reduction in the bank rate will not induce them to borrow during periods of falling prices. Thus businessmen are not very sensitive to changes in interest rates and they are influenced more by business expectations.

6. Power to Control Deflation Limited:

Another limitation of the bank rate policy is that the power of a central bank to force a reduction in the market rates of interest is limited. For instance, a lowering of bank rate below 3 per cent will not lead to a decline in the market rates of interest below 3 per cent.

So the bank rate policy is ineffective in controlling deflation. It may, however, control inflationary tendencies by forcing an increase in the market rates of interest.

7. Level of Bank Rate in relation to Market Rate:

The efficacy of the discount rate policy as an instrument of credit control depends upon its level in relation to the market rate. If in a boom the bank rate is not raised to such an extent as to make borrowing costly from the central bank, and it is not lowered during a recession so as to make borrowing cheaper from it, it would have a destabilising effect on economic activity.

8. Non-Discriminatory:

The bank rate policy is non-discriminatory because it does not distinguish between productive and unproductive activities in the country.

9. Not Successful in Controlling BOP Disequilibrium:

The bank rate policy is not effective in controlling balance of payments disequilibrium in a country because it requires the removal of all restrictions on foreign exchange and movements of international capital.

Conclusion:

The above points have led the majority of economists to conclude that the power to alter the bank rate is an extremely weak weapon of monetary management. Friedman even went to the extent of proposing outright elimination of the “discount window” itself.

Method # 2. Open Market Operations:

Open market operations are another method of quantitative credit control used by a central bank. This method refers to the sale and purchase of securities, bills and bonds of government as well as private financial institutions by the central bank. But in its narrow sense, it simply means dealing only in government securities and bonds.

There are two principal motives of open market operations. One, to influence the reserves of commercial banks in order to control their power of credit creation. Two, to affect the market rates of interest so as to control the commercial bank credit.

Its method of operation is as follows. Suppose the central bank of a country wants to control expansion of credit by the commercial banks for the purpose of controlling inflationary pressures within the economy. It sells government securities in the money market amounting to, say, Rs. 10 crores. The latter give the central bank cheques for this amount drawn against the commercial banks in which the public have their accounts.

The central bank reduces this amount in their accounts with it. This applies equally if the commercial banks have also purchased securities from the central bank. The sale of securities in the open market has thus reduced their cash holdings with the central bank. This tends to reduce the actual cash ratio of the commercial banks by Rs. 10 crores. So the banks are forced to curtail their lending.

Suppose that initially the commercial banks have assets worth Rs. 1000 crores and the cash-deposit ratio is 10. This means that Rs. 1000 crores are divided between Rs. 100 crores cash and Rs. 900 crores as deposits or loans. As a result of the sale of securities by the central bank worth Rs. 10 crores, the cash is reduced by Rs. 100 crores.

So the total cash with banks remains Rs. 900 crores and loans are also reduced by the same percentage, that is, to Rs. 810crores. This reduction in the cash holding of the commercial banks causes a decrease in the supply of bank money, as shown in Figure 1. In this figure, S is the supply curve of bank money which shifts to the left as S₁ showing a decrease in the supply of bank money from B to A, given 13 the level of interest rate r.

On the other hand, when the central bank aims at an expansionary g policy during a recessionary period, it purchases government securities from the commercial banks and institution dealing with such securities. The central bank pays the sellers its cheques drawn against itself which are deposited into their accounts with the commercial banks.

The reserves of the latter increase with the central bank which are just like cash. As a result the supply curve of bank money shifts to the right from S to S₂ showing an increase in the supply of bank money from B to C. The banks will now lend more at the given rate of interest, r.

Another aspect of the open market policy is that when the supply of money changes as a result of open market operations, the market rates of interest also change. A decrease in the supply of bank money through the sale of securities will have the effect of raising the market interest rates. On the other hand, an increase in the supply of bank money through the purchase of securities will reduce the market interest rates. Thus open market operations have a direct influence on the market rates of interest also.

Limitations of Open Market Operations:

The effectiveness of open market operations as a method of credit control is dependent upon the existence of a number of conditions, the absence of which limits the full working of this policy.

1. Lack of Securities Market:

The first condition is the existence of a large and well-organised security market. This condition is very essential for open market operations because without a well-developed security market the central bank will not be able to buy and sell securities on a large scale, and thereby influence the reserves of the commercial banks. Further, the central bank must have enough saleable securities with it.

2. Cash Reserve Ratio not Stable:

The success of open market operations also requires the maintenance of a stable cash-reserve ratio by the commercial bank. It implies that when the central bank sells or buys securities, the reserves of the commercial banks decrease or increase accordingly to maintain the fixed ratio. But usually the banks do not stick to the legal minimum reserve ratio and keep a higher ratio than this. This makes open market operations less effective in controlling the volume of credit.

3. Penal Bank Rate:

According to Prof. Aschheim, one of the necessary conditions for the success of open market operations is a penal bank rate. If there is no penal discount rate fixed by the central bank, the commercial banks can increase their borrowings from it when the demand for credit is strong on the part of the latter.

In this situation, the scale of securities by the central bank to restrict monetary expansion will be unsuccessful. But if there is a penal rate of discount, which is a rate higher than the market rates of interest, the banks will be reluctant to approach the central bank for additional financial help easily.

4. Banks Act Differently:

Open market operations are successful only if the people also act the way the central bank expects them. When the central bank sells securities, it expects the business community and financial institutions to restrict the use of credit. If they simultaneously start dishoarding money, the act of selling securities by the central banks will not be a success in restricting credit. Similarly, the purchase of securities by the central bank will not be effective if people start hoarding money.

5. Pessimistic or Optimistic Attitude:

Pessimistic or optimistic attitude of the business community also limits the operation of open market policy. When the central bank purchases securities and increases the supply of bank money, businessmen may be unwilling to take loans during a depression because of the prevailing pessimism among them.

As aptly put by Crowther, banks may place plenty of water before the public horse, but the horse cannot be forced to drink, if it is afraid of loss through drinking water. On the other hand, if businessmen are optimistic during a boom, the sale of securities by the central bank to contract the supply of bank money and even the rise in market rates cannot discourage them from getting loans from the banks. On the whole, this policy is more successful in controlling booms than depressions.

6. Velocity of Credit Money not Constant:

The success of open market operations depends upon a constant velocity of circulation of bank money. But the velocity of credit money is not constant. It increases during periods of brisk business activity and decreases in periods of falling prices. Thus a policy of contracting credit by the sale of securities by the central bank may not be successful by increased velocity of circulation of bank credit.

Despite these limitations, open market operations are more effective than the other instruments of credit control available with the central bank. This method is being successfully used for controlling credit in developed countries where the securities market is highly developed.

Open Market Operations vs. Bank Rate Policy:

The question arises whether the bank rate is more effective as an instrument of credit control or open market operations. The bank rate policy influences the cost and supply of commercial bank credit, while open market operations affect the cash reserves of the commercial banks. Changes in the bank rate affect the credit creation power of the commercial bank only if they rediscount their bills with the central bank.

If the banks do not feel the necessity of availing rediscounting facilities of the central bank, a rise in the bank rate will have no effect on the commercial banks. On the other hand, the lending power of the commercial banks is directly related to their cash reserves, and open market operations influence their cash reserves directly and immediately thereby affecting their credit creation power.

Further, “from the standpoint of their strategic value to the central bank, open market operations possess a degree of superiority over rediscount policy because of the fact that initiative is in the hands of the monetary authority in the case of the former, whereas bank rate policy is passive in the sense that its effectiveness depends on the responses of commercial banks and their customers to changes in bank rates.”

Again, open market operations are flexible with respect to timing and magnitude as compared with the bank rate policy. They are carried on continuously and do not have any destabilising effects on the economy that accompany changes in the bank rate.

It is further argued that since bank rate changes have destabilising effects on the economy, this policy should be used to correct permanent maladjustments in the money market rather than temporary maladjustments. On the other hand, open market policy can be used for correcting both temporary and permanent maladjustments in the money market.

But the experience of developed countries like the USA and the UK tells us that these two policies are not competitive but complementary to each other. If they are supplemented, they can control credit more effectively than individually. For instance, if the central bank raises the discount rate for the purpose of contracting credit, it will not be effective when the commercial bank have large excess reserves with them.

They will continue to expand credit irrespective of the rise in the bank rate. But if the central bank first draws away to itself the excess reserves of the commercial banks by the sale of securities and then raises the bank rate, it will have the effect of contracting credit.

Similarly, the sale of securities alone will not be so effective in contracting credit unless the bank rate is also raised. The sale of securities by the central bank will reduce the cash reserves of commercial banks but if the discount rate is low, the latter will get funds from the “discount window” of the central bank. So for an effective policy credit control, bank rate policy and open market operations should be judiciously supplemented.

Method # 3. Variable Reserve Ratio:

Variable reserve ratio (or required reserve ratio or legal minimum requirements), as a method of credit control was first suggested by Keynes in his Treatise on Money (1930) and was adopted by the Federal Reserve System of the United States in 1935.

Every commercial bank is required by law to maintain a minimum percentage of its deposits with the central bank. The minimum amount of reserve with the central bank may be either a percentage of its time and demand deposits separately or of total deposits. Whatever the amount of money remains with the commercial bank over and above these minimum reserves is known as the excess reserves.

It is on the basis of these excess reserves that the commercial bank is able to create credit. The larger the size of the excess reserves, the greater is the power of a bank to create credit, and vice versa. It can also be said that the larger the required reserve ratio, the lower the power of a bank to create credit, and vice versa.

When the central bank raises the reserve ratio of the commercial banks, it means that the latter are required to keep more money with the former. Consequently, the excess reserves with the commercial banks are reduced and they can lend less than before.

This can be explained with the help of the deposit multiplier formula. If a commercial bank has Rs. 100 crores as deposits and 10 per cent is the required reserve ratio, then it will have to keep Rs. 10 crores with the central bank. Its excess reserves will be Rs. 90 crores.

It can thus create credit to the extent of Rs. 900 crores in this way ER/RRr where ER is the excess reserves, and RRr the required reserve ratio… 90×1/10% = 90 x 100/10 = Rs. 900 crores. When the central bank raises the required reserve ratio to 20 per cent, the bank’s power to create credit will be reduced to Rs. 400 crores = 80 x 100/20.

On the contrary, if the central bank wants to expand credit, it lowers the reserve ratio so as to increase the credit creation power of the commercial banks. Thus by varying the reserve ratio of the commercial banks the central bank influences their power of credit creation and thereby controls credit in the economy.

Limitations of Variable Reserve Ratio:

The variable reserve ratio as a method of credit control has a number of limitations.

1. Excess Reserves:

The commercial banks usually possess large excessive reserves which make the policy of variable reserve ratio ineffective. When the banks keep excessive reserves, an increase in the reserve ratio will not affect their lending operations. They will stick to the legal minimum requirements of cash to deposits and at the same time continue to create credit on the strength of the excessive reserves.

2. Clumsy Method:

It is a clumsy method of credit control as compared with open market operations. This is because it lacks definiteness in the sense that it is inexact and uncertain as regards changes not only in the amounts of reserves but also the place where these changes can be made effective.

It is not possible to tell “how much of active or potential reserve base” has been affected by changes in the reserve ratio. Moreover, the changes in reserves involve far larger sums than in the case of open market operations.

3. Discriminatory:

It is discriminatory and affects different banks differently. A rise in the required reserve ratio will not affect those banks which have large excess reserves. On the other hand, it will hit hard the banks with little or no excess reserves. This policy is also discriminatory in the sense that non-banking financial intermediaries like co-operative societies, insurance companies, building societies, development banks, etc. are not affected by variations in reserve requirements, though they compete with the commercial banks for lending purposes.

4. Inflexible:

This policy is inflexible because the minimum reserve ratio fixed by the central banks is applicable to banks located in all regions of the country. More credit may be needed in one region where there is monetary stringency, and it may be superfluous in the other region. Raising the reserve ratio for all banks is not justified in the former region though it is appropriate for the latter region.

5. Business Climate:

The success of the method of credit control also depends on the business climate in the economy. If the businessmen are pessimistic about the future, as under a depression, even a sizable lowering of the reserve ratio will not encourage them to ask for loan. Similarly, if they are optimistic about profit expectations, a considerable rise in the variable ratio will not prevent them from asking for more loans from the banks.

6. Stability of Reserve Ratio:

The effectiveness of this technique depends upon the degree of stability of the reserve ratio. If the commercial banks are authorised to keep widely fluctuating ratio, say between 10 per cent to 17 per cent, and change in the upper or lower limit will have no effect on the credit creation power of the banks.

7. Other Factors:

The reserve ratio held by the commercial banks is determined not only by legal requirements but also by how much they want to hold in relation to their deposits in addition to such requirements. This, in turn, will depend upon their expectations about future developments, their competition with other banks, and so on.

8. Depressive Effect:

The variable reserve ratio has been criticised for exercising a depressive effect on the securities market. When the central bank suddenly directs the commercial banks to increase their reserve ratios, they may be forced to sell securities to maintain that ratio. This widespread selling of securities will bring down the prices of securities and may even lead to an utter collapse of the bond market.

9. Rigid:

It is rigid in its operations because it does not distinguish between desired and undesired credit flows and can affect them equally.

10. Not for Small Changes:

This method is more like an axe than a scalpel. It cannot be used for day-to-day and week-to-week adjustments but can be used to bring about large changes in the reserve positions of the commercial banks. Thus it cannot help in ‘fine tuning’ of the money and credit systems by making small changes.

Conclusion:

The variable reserve ratios as a method of credit control are a very delicate and sensitive tool which not only produces a state of uncertainty among the banks but also adversely affects their liquidity and profitability. Therefore, according to De Kock, “it should be used with moderation and discretion and only under obvious abnormal conditions.”

Variable Reserve Ratio vs Open Market Operations:

There are divergent views about the superiority of variable reserve ratio over open market operations. To those who consider the former as a superior instrument of credit control, it is “a battery of the most improved type that a central bank can add to its armory.” They give the following arguments.

The variable reserve ratio affects the power of credit creation of the commercial banks more directly, immediately, and simultaneously than open market operations. The central bank has simply to make a declaration for changing the reserve requirements of the banks and they have to implement it immediately. But open market operations require sale or purchase of securities which is a time consuming process.

When the central bank sells securities to the banks to control inflation, they are forced to buy them. They are, therefore, prevented from giving more loans to the private credit market. On the other hand, if the reserve ratio is raised, the banks will be required to keep larger balances with the central bank.

They will also be faced with reduced earnings. They will, therefore, be induced to sell government securities and give more loans to the private credit market. Thus open market operations are more effective for controlling inflation than the change in reserve ratio.

In another sense, open market operations are more effective as an instrument of credit control than variations in the reserve ratio. In every country there are non-banking financial intermediaries which deal in securities, bonds, etc. and also advance loans and accept deposits from the public.

But they are outside the legal control of the central bank. Since they also deal in government securities, open market sale and purchase of such securities by the central bank also affect their liquidity position. But they are not required to keep any reserves with the central bank, unlike the commercial banks.

Again, variations in the reserve ratio are meant for making major and long-run adjustments in the liquidity position of the commercial banks. They are, therefore, not suited for making short-run adjustments in the volume of available bank reserves, as are done under open market operations.

The effectiveness of open market operations depends upon the existence of a broad and well-organised market for securities. Thus this instrument of credit control cannot be operative in countries which lack such a market. On the other hand, the method of variable reserve ratio does not require any such market for its operation and is applicable equally in developed and underdeveloped markets, and is thus superior to open market operations.

Further, since open market operations involve the sale and purchase of securities on a day-to-day and week-to-week basis, the commercial banks and the central bank which deal in them are likely to incur losses. But variations in the reserve ratio do not involve any losses.

Despite the superiority of variable reserve ratio over open market operations, economists like Prof. Aschheim have argued that open market operations are more effective as a tool in controlling credit than variable reserve ratio. Therefore, changes in the reserve ratio do not have any effect on their lending power. Thus open market operations are superior to variable ratio because they also influence non-banking financial institutions.

Further, as a technique, reserve ratio can only influence the volume of reserves of the commercial banks. On the other hand, open market operations can influence not only the reserves of the commercial banks but also the pattern of the interest rate structure. Thus open market operations are more effective in influencing the reserves and the credit creation power of the banks than variations in reserve ratio.

Last but not the least, the technique of variations in reserve ratio is clumsy, inflexible, and discriminatory whereas that of open market operations is simple, flexible and non-discriminatory in its effects.

It can be concluded from the above discussion of the relative merits and demerits of the two techniques that in order to have the best of the two, they should be used jointly rather than independently. If the central bank raises the reserve ratio, it should simultaneously start purchasing, and not selling, securities in those areas of the country where there is monetary stringency.

On the contrary, when the central bank lowers the reserve requirements of the banks, it should also sell securities to those banks which already have excess reserves with them, and have been engaged in excessive lending. The joint application of the two policies will not be contradictory but complementary to each other.

Method # 4. Selective Credit Controls:

Selective or qualitative methods of credit control are meant to regulate and control the supply of credit among its possible users and uses. They are different from quantitative or general methods which aim at controlling the cost and quantity of credit. Unlike the general instruments, selective instruments do not affect the total amount of credit but the amount that is put to use in a particular sector of the economy.

The aim of selective credit control is to channelize the flow of bank credit from speculative and other undesirable purposes to socially desirable and economically useful uses. They also restrict the demand for money by laying down certain conditions for borrowers.

They therefore, embody the view that the monopoly of credit should in fact become a discriminating monopoly. Prof. Chandler defines selective credit controls as those measures “that would influence the allocation of credit, at least to the point of decreasing the volume of credit used for selected purposes without the necessity of decreasing the supply and raising the cost of credit for all purposes.” We discuss below the main types of selective credit controls generally used by the central banks in different countries.

(A) Regulation of Margin Requirements:

This method is employed to prevent excessive use of credit to purchase or carry securities by speculators. The central bank fixes minimum margin requirements on loans for purchasing or carrying securities. They are, in fact, the percentage of the value of the security that cannot be borrowed or lent.

In other words, it is the maximum value of loan which a borrower can have from the banks on the basis of the security (or collateral). For example, if the central bank fixes a 10 per cent margin on the value of a security worth Rs. 1,000, then the commercial bank can lend only Rs. 900 to the holder of the security and keep Rs. 100 with it.

If the central bank raises the margin to 25 per cent, the bank can lend only Rs. 750 against a security of Rs. 1,000. If the central bank wants to curb speculative activities, it will raise the margin requirements. On the other hand, if it wants to expand credit, it reduces the margin requirements.

Its Merits. This method of selective credit control has certain merits which make it unique.

1. It is non-discriminatory because it applies equally to borrowers and lenders. Thus it limits both the supply and demand for credit simultaneously.

2. It is equally applicable to commercial banks and non-banking financial intermediaries.

3. It increases the supply of credit for more productive uses.

4. It is a very effective anti-inflationary device because it controls the expansion of credit in those sectors of the economy which breed inflation.

5. It is simple and easy to administer since this device is meant to regulate the use of credit for specific purposes.

But the success of this technique requires that there are no leakages of bank credit for non-purpose loans to speculators.

Its Weaknesses:

However, a number of leakages have appeared in this method over the years.

1. A borrower may not show any intention of purchasing stocks with his borrowed funds and pledge other assets as security for the loan. But it may purchase stocks through some other source.

2. The borrower may purchase stocks with cash which he would normally use to purchase materials and supplies and then borrow money to finance the materials and supplies already purchased, pledging the stocks he already has as security for the loan.

3. Lenders, other than commercial banks and brokers, who are not subject to margin requirements, may increase their security loans when commercial banks and brokers are being controlled by high margin requirements. Further, some of these non-regulated lenders may be getting the funds they lent to finance the purchase of securities from commercial banks themselves. Despite these weaknesses in practice, margin requirements are a useful device of credit control.

(B) Regulation of Consumer Credit:

This is another method of selective credit control which aims at the regulation of consumer instalment credit or hire-purchase finance. The main objective of this instrument is to regulate the demand for durable consumer goods in the interest of economic stability.

The central bank regulates the use of bank credit by consumers in order to buy durable consumer goods on instalments and hire-purchase. For this purpose, it employs two devices: minimum down payments, and maximum periods of repayment. Suppose a bicycle costs Rs. 500 and credit is available from the commercial bank for its purchase.

The central bank may fix the minimum down payment to 50 per cent of the price, and the maximum period of repayment to 10 months. So Rs. 250 will be the minimum which the consumer will have to pay to the bank at the time of purchase of the bicycle and the remaining amount in ten equal instalments of Rs. 25 each. This facility will create demand for bicycles.

The bicycle industry would expand along with the related industries such as tyres, tubes, spare parts, etc. and thus lead to inflationary situation in this and other sectors of the economy. To control it, the central bank raises the minimum down payment to 70 per cent and the maximum period of repayment to three installments. So the buyer of a bicycle will have to pay Rs. 350 in the beginning and remaining amount in three instalments of Rs. 50 each.

Thus if the central bank finds slump in particular industries of the economy, it reduces the amount of down payments and increases the maximum periods of repayment. Reducing the down payments tends to increase the demand for credit for particular durable consumer goods on which the central bank regulation is applied. Increasing the maximum period of repayment, which reduces monthly payments, tends to increase the demand for loans, thereby encouraging consumer credit. On the other hand, the central bank raises the amount of down payments and reduces the maximum periods of repayment in boom.

The regulation of consumer credit is more effective in controlling credit in the case of durable consumer goods during both booms and slumps, whereas general credit controls fail in this area. The reason is that the latter operate with a time lag.

Moreover, the demand for consumer credit in the case of durable consumer goods is interest inelastic. Consumers are motivated to buy such goods under the influence of the demonstration effect and the rate of interest has little consideration for them.But this instrument has its drawbacks.

It is cumbersome, technically defective and difficult to administer because it has a narrow base. In other words, it is applicable to a particular class of borrowers whose demand for credit forms an insignificant part of the total credit requirements.

It, therefore, discriminates between different types of borrowers. This method affects only persons with limited incomes and leaves out higher income groups. Finally, it tends to misallocate resources by shifting them away from industries which are covered by credit regulations and lead to the expansion of other industries which do not have any credit restrictions.

(C) Rationing of Credit:

Rationing of credit is another selective method of controlling and regulating the purpose for which credit is granted by the commercial banks. It is generally of four types. The first is the variable portfolio ceiling. According to this method, the central bank fixes a ceiling on the aggregate portfolios of the commercial banks and they cannot advance loans beyond this ceiling.

The second method is known as the variable capital assets ratio. This is the ratio which the central bank fixes in relation to the capital of a commercial bank to its total assets. In keeping with the economic exigencies, the central bank may raise or lower the portfolio ceiling and also vary the capital assets ratio.

Rationing of credit has been used very effectively in Russia and Mexico. It is, therefore, ‘a logical concomitant of the intensive and extensive planning adopted in regimented economies.’ The technique also involves discrimination against larger banks because it restricts their lending power more than the smaller banks.

Lastly, by rationing of credit for selective purposes, the central bank ceases to be the lender of the last resort. Therefore, central banks in mixed economies do not use this technique except under extreme inflationary situations and emergencies.

(D) Direct Action:

Central banks in all countries frequently resort to direction action against commercial banks. Direction action is in the form of “directives” issued from time to time to the commercial banks to follow a particular policy which the central bank wants to enforce immediately.

This policy may not be used against all banks but against erring banks. For example, the central bank refuses rediscounting facilities to certain banks which may be granting too much credit for speculative purposes, or in excess of their capital and reserves, or restrains them from granting advances against the collateral of certain commodities, etc.

It may also charge a penal rate of interest from those banks which want to borrow from it beyond the prescribed limit. The central bank may even threaten a commercial bank to be taken over by it in case it fails to follow its policies and instructions.

But this method of credit suffers from several limitations which have been enumerated by De Kock as “the difficulty for both central and commercial bank to make clear-cut distinctions at all times and in all cases between essential and non-essential industries, productive and unproductive activities, investment and speculation, or between legitimate and excessive speculation or consumption; the further difficulty of controlling the ultimate use of credit by second, third or fourth parties; the dangers involved in the division of responsibility between the central bank and commercial bank for the soundness of the lending operations of the latter; and the possibility of forfeiting the whole-hearted and active co-operations of the commercial banks as a result of undue control and intervention.”

(E) Moral Suasion:

Moral suasion in the method of persuasion, of request, of informal suggestion, and of advice to the commercial bank usually adopted by the central bank. The executive head of the central bank calls a meeting of the heads of the commercial banks wherein he explains them the need for the adoption of a particular monetary policy in the context of the current economic situation, and then appeals to them to follow it. This “jawbone control” or “slaps on the wrist” method has been found to be highly effective as a selective method of credit control in India, New Zealand, Canada and Australia, though it failed in the USA.

Its Limitations. Moral suasion is a method “without any teeth” and hence its effectiveness is limited.

1. Its success depends upon the extent to which the commercial banks accept the central bank as their leader and need accommodation from it.

2. If the banks possess excessive reserves they may not follow the advice of the central bank, as is the case with the commercial banks in the USA.

3. Further, moral suasion may not be successful during booms and depressions when the economy is passing through waves of optimism and pessimism respectively. The bank may not heed to the advice of the central bank in such a situation.

4. In fact, moral suasion is not a control device at all, as it involves cooperation by the commercial banks rather than their coercion.

It may, however, be a success where the central bank commands prestige on the strength of the wide statutory powers vested in it by the government of the country.

(F) Publicity:

The central bank also uses publicity as an instrument of credit control. It publishes weekly or monthly statements of the assets and liabilities of the commercial bank for the information of the public. It also publishes statistical data relating to money supply, prices, production and employment, and of capital and money market, etc.

This is another way of exerting moral pressure on the commercial bank. The aim is to make the public aware of the policies being adopted by the commercial bank vis-a-vis the central bank in the light of the prevailing economic conditions in the country.

It cannot be said with definiteness about the success of this method. It presupposes the existence of an educated and knowledgeable public about the monetary phenomena. But even in advanced countries, the percentage of such persons is negligible. It is, therefore, highly doubtful if they can exert any moral pressure on the banks to strictly follow the policies of the central bank. Hence, publicity as an instrument of selective credit control is only of academic interest.

Limitations of Selective Credit Controls:

Though regarded superior to quantitative credit controls, yet selective credit controls are not free from certain limitations.

1. Limited Coverage:

Like general credit controls, selective credit controls have a limited coverage. They are only applicable to the commercial banks but not to non-banking financial institutions. But in the case of the regulation of consumer credit which is applicable both to banking and non-banking institutions, it becomes cumbersome to administer this technique.

2. No Specificity:

Selective credit controls fail to fulfil the specificity function. There is no guarantee that the bank loans would be used for the specific purpose for which they are sanctioned.

3. Difficult to distinguish between Essential and Non-essential Factors:

It may be difficult for the central bank to distinguish precisely between essential and non-essential sectors and between speculative and productive investment for the purpose of enforcing selective credit controls. The same reasoning applies to the commercial banks for the purpose of advancing loans unless they are specifically laid down by the central bank.

4. Require Large Staff:

The commercial banks, for the purpose of earning large profits, may advance loans for purposes other than laid down by the central bank. This is particularly so if the central bank does not have a large staff to check minutely the accounts of the commercial banks. As a matter of fact, no central bank can afford to check their accounts. Hence selective credit controls are liable to be ineffective in the case of unscrupulous banks.

5. Discriminatory:

Selective controls unnecessarily restrict the freedom of borrowers and lenders. They also discriminate between different types of borrowers and banks. Often small borrowers and small banks are hit harder by selective control than big borrowers and large banks.

6. Malallocation of Resources:

Selective credit controls also lead to malallocation of resources when they are applied to selected sectors, areas and industries while leaving others to operate freely. They place undue restrictions on the freedom of the former and affect their production.

7. Not Successful in Unit Banking:

Unit banks being independent one-office banks in the USA operate on a small scale in small towns and meet the financial needs of the local people. Such banks are not affected by the selective credit controls of the FRS (central bank of the USA) because they are able to finance their activities by borrowing from big banks. So this policy is not effective in unit banking.

Conclusion:

From the above discussion, it should not be concluded that selective credit controls are used to the total exclusion of general credit controls. Their demerits primarily arise from this thinking. In fact, they are an adjunct to general quantitative controls. They are meant to supplement the latter and are regarded only as a “second-line instrument”.

“The vital point is not the question of general vs. selective credit control the assessment of the pros and cons as between the two methods, but that of integrating them. Indeed the coordination of selective and general controls appears to have been more effective than the use of any one of them singly and by itself.”