Essentials of credit and its qualitative
Essentials of Credit
The essentials of credit are:
(i) Availability of deposits with the Banks.
(ii) Low Bank ratios.
(iii) Banking habits of the people.
(iv) Minimun legal formalities.
(v) Easy repayment options.
(vi) Low interest rates.
Objectives of Credit Control
The main objectives of credit control are given below:
1. To maintain stability in the economy.
2. To check inflation and deflation.
3. To save the economy from the harmful effects of trade cycle.
4. To promote economic growth.
5. To ensure smooth flow of credit in the economy.
6. To safeguard the economy from the harmful effects of inflation and deflation.
Control of Credit
The chief objective of the central bank is to maintain price and economic stability. Price instability-both inflation and deflation has harmful effects. Moreover, fluctuations in overall economic activity, that is, trade cycles cause a lot of human sufferings. Now it is the responsibility of the central bank of the country to guide the money market, i.e., the commercial banks regarding supply of credit so as to maintain stability in prices as well as in overall economic activity. To overcome inflation it has to restrict the supply of credit and to prevent or get rid of the depression and deflation it has to expand the credit. The methods by which the central bank can control the supply of credit in the economy can be classified as quantitative measures and qualitative measures.
I)Quantitative Measures
These measures influence the total amount of money supply circulation. These are:
(1) Bank rate/Discount rate: It is the minimum rate at which the Central Bank of a country gives credit to the commercial banks against approved securities. To control:
(a) Inflation/Excess demand: Bank rate is increased, which further increases the rate of interest (the lending rates of commercial banks). It makes the credit costlier, demand for credit reduces, less money goes to the economy, purchasing power is curtailed, AD falls and excess demand is corrected.
(b) Deflation/Deficient demand: Bank rate is reduced, it decreases the rate of interest, makes the credit cheaper, demand for credit increases, more money flows to the system, purchasing power increases, AD rises and deficient demand is corrected.
Effectiveness of bank rate as a measure to control credit will depend on :
(a) the degree of bank’s dependence on borrowed reserves.
(b) the extent to which other rates of interest in the market change.
(c) the state of supply of and demand for funds from other sources.
(d) effect on lending rate of commercial banks.
2. Reverse Repo: A Reverse Repo or Reverse Repurchase Agreement is a money market instrument used by RBI for absorption of liquidity from financial system. Securities are acquired by RBI from commercial banks with a simultaneous commitment to resell them to the commercial banks at predetermined rate and date.
Under reverse repo, a commercial bank parks its idle excess reserves with RBI by purchasing securities. It is important to note that there is an incentive for commercial banks to enter into reverse repurchase transactions. When a reverse repurchase transaction matures, RBI returns the acquired security to the bank concerned which receives cash along with a profit. It means that the bank in question earns extra income on otherwise idle cash reserves.
To control:
(i) Inflation/excess demand: Reverse Repo rate is increased (which increases the incentive of commercial banks to park their funds with RBI). The central bank withdraws additional purchasing power. There will be contraction of credit, less money will flow in the system. Purchasing power in the economy reduces. Aggregate demand falls and excess demand stands corrected.
(ii) Deflation/deficient demand: Reverse Repo rate is decreased (which reduces the incentive of commercial banks to park their funds with RBI). The central bank injects additional purchasing power. There will be extension of credit, more money will flow in the system. Purchasing power in the economy increases. Aggregate demand rises and deficient demand is corrected.
3. Open market operations: It refers to purchase and sale of government securities in the open market (public and commercial banks) by the Central Bank. To control:
(i) Excess demand: Government securities are sold by the Central Bank in the open market. The Central Bank withdraws additional purchasing power. There will be contraction of credit, less money will flow in the system.
Purchasing power in the economy reduces. Aggregate demand falls and excess demand stands corrected.
(ii) Deficient demand: By purchasing the government securities, the Central Bank injects additional purchasing power in the system which expands credit. More money supply will flow in the system, purchasing power in the economy increases. Aggregate demand rises and deficient demand is corrected.
Effectiveness of open market operations as a successful measure to control credit:
(a) Successful conduct of OMO (Open Market Operations), as a tool of monetary policy requires that a well functioning securities market exists.
(b) Banks are not affected by the OMO if they buy. securities with excess reserves and when they sell securities, the amount realised is added to the excess reserves. In such a situation, OMO becomes an ineffective tool.
4. Varying legal reserve requirements: There are two types of reserves:
(i) CRR (cash reserve ratio or minimum reserve ratio): It is the minimum percentage of deposits of commercial banks (net demand and time liabilities) which is kept with RBI.
To control:
(a) Excess demand: CRR is increased to control excess demand. The Central Bank withdraws additional purchasing power. There will be contraction of credit, less money will flow in the system, purchasing power in the economy reduces. Aggregate demand falls and excess demand stands corrected.
(b) Deficient demand: CRR is decreased to control deficient demand. The Central Bank injects additional purchasing power in the system which expands credit. More money supply will flow in the system, purchasing power in the economy increases. Aggregate demand rises and deficient demand is corrected.
(ii) SLR (Statutory Liquidity Ratio): It is the percentage of deposits of commercial banks (net demand and time liabilities) which every bank is required to Maintain with itself in the form of designated liquid assets. Liquid assets may be :
(a) Excess cash reserves.
(b) Unencumbered government and other approved securities.
(c) Current account balances with other banks. To control
(a) Excess Demand: SLR is increased. This decreases the amount of cash that banks can disbarse as loans which in turn decreases the level of aggregate demand. (b) Deficient Demand: SLR is decreased. This increases the amount of cash that banks can disburse as loans, which in turn increases the level of aggregate demand.
(II) Qualitative Measures
These measures affect allocation of credit between alternative uses.
1. Imposing margin requirement: A margin is the difference between market value of the security offered by the borrower against the loan and the amount of the loan granted e.g., if margin requirement is 20% then the bank is allowed to give loan only upto 80% of the value of securities. To control:
(i) Excess demand: Margin requirement increased to correct excess demand. The Central Bank withdraws additional purchasing power. There will be contraction of credit, less money will flow in the system, purchasing power in the economy reduces. Aggregate demand falls and excess demand stands corrected.
(ii) Deficient demand: Margin requirement is reduced to correct deficient demand. The Central Bank injects additional purchasing power in the system which expands credit. More money supply will flow in the system. purchasing power in the economy increases. Aggregate demand rises and deficient demand is corrected.
2. Moral suasion and direct action: It is a combination of persuasion and pressure that the Central Bank applies to other banks in order to force them to follow its policy. It is done through letters, speeches and hints to the banks. Central Bank may take direct action against member banks which do not comply with its policies of credit expansion or contraction.
3. Selective credit control: This can be applied in both a positive as well as a negative manner.
(i) In a positive manner, the credit will be channelised to particular priority sectors.
(ii) In a negative manner, the flow of credit will be restricted to particular sectors.
