The methods of credit control are usually categorized into (1) General (or quantitative) methods, and (2) Selective (or qualitative) methods. The Bank Rate Policy, variable reserve requirements, statutory liquidity requirement, and open market operations policy fall in the category of general credit control methods. The various directives issued by the Reserve Bank restricting the quantum and other terms of granting credit against certain specified commodities constitute the selective control method.
The main difference between the general and selective credit control methods is that the former influence the cost and overall volume of credit granted by banks. They affect credit related to the whole economy whereas the selective controls affect the flow of credit to only specified sector of the economy, wherein speculative tendency and rising trend of prices, due to excessive bank credit, is noticed.
The general credit control measures affect the (1) cost, and (2) availability (or quantum) of bank credit. The cost of credit is influenced by the Bank Rate at which the central bank provides refinance to the banks. In the past years, the Reserve bank had relied upon its powers to regulate the interest rates of bank advances and directly regulated the interest rates of banks rather than through the instruments of Bank Rate. Now the interest rates are largely deregulated.
The overall quantum of credit created by banks depends on their cash reserves, comprising cash in hand and balances with the Reserve Bank. The cash reserves increase through (1) a rise in deposit sources of banks, (2) borrowings from the Reserve Bank, or (3) by sale of their investments. Regulation of credit by the Reserve Bank means regulations of the quantum of cash reserves of commercial banks. These control measures exert their influence on the assets pattern of commercial banks. When the reserve Bank desires to control, it adopts various methods whereby the quantum of refinance is restricted and the flow of bank resources to investments and statutory reserves with the Reserve Bank is enhanced, thereby curtailing the availability of loan-able resources with the bank.
Refining Policy of Reserve Bank:
As the central bank of the country, the Reserve bank is the lender of last resort to the banking system. Its refinancing policy, therefore, has great significance to the commercial banks. Changes in this policy are carried out in two ways:
1. by varying the cost of borrowings through a variation in its Bank Rate, and
2. by varying the availability (i.e. quantum) of credit to the banks.
The bank rate policy:
Section 49 of the Reserve Bank of India Act, 1934, defines Bank Rate as the standard rate at which it (the Reserve bank) is prepared to buy or rediscount bills of exchange or other commercial papers eligible for purchase under this Act. As the provision regarding rediscounting of bills by the Reserve Bank had remained inoperative for a long time in the past, the rate charged by Reserve Bank on its advances to banks has been treated as the Bank Rate.
A change in the Bank Rate – upward or downward — usually has an immediate effect on the costs of credit available to the commercial banks from the central bank. A high Bank rate is intended to raise the cost of Reserve Bank accommodation to banks, which in turn raises their own lending rates to the borrowers. Discouraged by high rate of interests, the borrowers consequently reduce the level of their borrowings from the banks which in turn bring down the level or re-finance secured by them from the central bank. Thus a high Bank rate is intended to result in contraction of bank credit.
Theoretically, the Bank rate happens to be prime rate – it is a pace setter to all other rates of interests in money market, i.e all other rates of interest generally move in the same direction in which then Bank rate moves. When the central bank intends to follow the policy of high cost of money, it raises the Bank rate first, which is followed by rise in all other rates of interest. Such a policy is called the policy of dear money. The objective of such a policy happens to make money scarce and costly so as to restrict its use to the deserving purposes only.