Credit Control :- The Central Bank controls the money supply and credit in the best interests of the economy. The bank does this by taking recourse to various instruments. These are:
i) Bank Rate Policy: The bank rate is the rate at which the central bank lends funds to banks. The effect of a change in the bank rate is to change the cost of securing funds from the central bank.
A rise in the bank rate will increase the cost of borrowing from the central bank then causes the commercial banks to increase the interest rates at which they lend. This will discourage businessmen and others from taking loans. Thus reduces the volume of credit and vice versa.
ii) Open Market Operations: The act of buying and selling of government securities by the Central Bank from / to the public and banks is called open market operations.
When the Central Bank buys securities from the banks and public it adds to cash balances in the economy. If cash balances are increased in the economy there will be more deposits with the commercial banks which raise the banks’ ability to give credit and thus increase the money supply.
When the Central Bank sells securities to the banks and public it withdraws cash balances from the economy. If cash balances are decreased in the economy there will be lesser deposits with the commercial banks which reduce the banks’ ability to give credit and thus decrease the money supply.
iii) Legal Reserve Ratio (LRR) – LRR is the minimum ratio of deposits which every bank legally is required to keep as liquefied reserve. There are two components of LLR namely CRR and SLR.
Cash Reserve Ratio (CRR): The minimum percentage of their total deposits which is to be kept by commercial banks with the Central Bank is called Cash Reserve Ratio.
A change in CRR affects the power of commercial bank to create the credit. An increase in the CRR reduces the lending capacity of commercial banks to grant loan. Then the commercial banks will increase the interest rates at which they lend. This will then discourage businessmen and others from taking loans. Thus reduces the volume of credit and vice versa.
Thus the CRR should be increased when credit is to be contracted and it (CRR) should be decreased when credit is to be increased.
Statutory Liquidity Ratio ( SLR): Commercial Banks are required to maintain a specified percentage of their net total in the form of designated liquid assets or cash with themselves. This specific percentage is called Statutory Liquidity Ratio ( SLR).
An increase in the SLR reduces the lending capacity of commercial banks to grant loan. Then the commercial banks will increase the interest rates at which they lend. This will then discourage businessmen and others from taking loans. Thus reduces the volume of credit and vice versa.
Thus the SLR should be increased when credit is to be contracted and it ( SLR) should be decreased when credit is to be increased.
iv) Repo Rate: When the commercial banks are in need of funds for a short **, they can borrow from the Central Bank. The rate of interest charged by the Central Bank on such lending is called Repo Rate.
Raising Repo Rate makes such borrowings by the commercial banks costly. As such when Repo Rate is raised, banks are also forced to raise their lending rates. This has a negative effect on demand for borrowings from the commercial banks and vice versa.
v) Reverse Repo Rate: When the commercial banks have surplus funds they can *** the same with the central bank and earn interest. The rate of interest paid by the Central Bank on such deposits is called Reverse Repo Rate.
When this rate is raised, it encourages the commercial banks to keep their funds with the central bank. This has the negative effect on the lending capability of the commercial banks and vice versa.
vi) Margin Requirements: A margin is the difference between the amount of the loan and market value of the security offered by the borrower against the loan.
If the margin imposed by the Central Bank is 20%, then the bank is allowed to give a loan only up to 80% of the value of the security. By altering the margin requirements, the Central Bank can alter the amount of loans made against securities by the banks. So higher margin requirements decreases the demand for credit and vice versa.
