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Banking in India - Part 3 (Credit Control in India)

Bankers Corner

Credit control in India

  • Credit control is an important function of Reserve Bank of India.
  • It is a major weapon of the monetary policy used to control the demand and supply of money (liquidity) in the economy. 
  • Central Bank administers control over the credit that the commercial banks grant. 
  • Such a method is used by RBI to bring "Economic Development with Stability". 

Need for credit control

  • Credit control policy is just an arm of economic policy which comes under the purview of Reserve Bank of India, hence, its main objective being the attainment of high growth rate while maintaining the reasonable stability of the internal purchasing power of money. 
  • The basic and important needs of credit control in the economy are-
    1. To encourage the overall growth of the "priority sector" i.e. those sectors of the economy which is recognized by the government as "prioritized" depending upon their economic condition or government interest. These sectors broadly total to around 15 in number.
    2. To keep a check on the channelization of credit so that credit is not delivered for undesirable purposes.
    3. To achieve the objective of controlling inflation as well as deflation.
    4. To boost the economy by facilitating the flow of an adequate volume of bank credit to different sectors.
    5. Stability in the exchange rate and money market of the Country.

Methods of credit control

  • There are two methods that the RBI uses to control the money supply in the economy-
    • Quantitative method
    • Qualitative method
  • During the period of inflation Reserve Bank of India tightens its policies to restrict the money supply, whereas during deflation it allows the commercial bank to pump money into the economy.

Quantitative method

  • Quantitative credit control is used to control the volume of credit and indirectly to control the inflationary and deflationary pressures caused by expansion and contraction of credit. The quantitative credit control; consist of:
    1. Bank Rate
    2. Repo Rate
    3. Reverse Repo Rate
    4. Cash Reserve Ratio
    5. Statutory Liquidity Ratio
    6. Open Market Operations

Bank Rate

  • Bank Rate refers to the official interest rate at which RBI lends loans to other bank or financial institution which includes commercial/ cooperative banks, development banks etc.
  • In other words, bank rate is the rate at which banks borrow money from the central bank, without any sale of securities. This is similar to borrowing money from someone, without security, and paying interest on that amount.
  • Such loans are given out either by direct lending or by rediscounting (buying back) the bills of commercial banks and treasury bills. Thus, bank rate is also known as discount rate. Bank rate is used as a signal by the RBI to the commercial banks on RBI’s thinking of what the interest rates should be.
  • Central banks make changes in the bank rate to control the money supply in the market.

Repo Rate

  • Repo (Repurchase) rate is the rate, at which RBI lends short-term money to the banks against securities.
  • It is the rate at which commercial banks have to sell securities to RBI with an agreement to repurchase them on a future date at a predetermined price. It is a means of short-term borrowing.
  • When the Repo rate increases, borrowing from the RBI becomes more expensive and when the repo rate decreases, borrowing becomes cheaper.
  • Repo rate injects liquidity in the market.
  • It was introduced in December, 1992, by RBI.

Difference between Bank Rate and Repo Rate

  • Both Bank rate and repo rate are the rates at which RBI makes funds available to the commercial banks. This is the similarity between the two. Though both are meant for the same purpose. There are certain basic differences between the bank rate and repo rate. These are:
    1. The first difference is in respect of collateral security for borrowing. To have funds at repo rate, commercial banks have to sell the securities to RBI with an agreement to ‘repurchase’ them on a future date at a predetermined price. The repurchase agreement (Repo) associated with the repo rate is collateralized by a security. The bank rate, on the other hand, is not collateralized. It takes place as mere lending of money to commercial banks at a fixed rate, i.e. bank.
    2. Repo rate is short-term while bank rate is long-term both in outlook and impact.
    3. Bank rate is more than the repo rate as the former has no collateral security.
    4. Bank rate is used to levy a penalty on the shortfalls in reserves required to be maintained by commercial banks with RBI, while repo rate governs the borrowings made by commercial banks from the RBI.

Reverse Repo Rate

  • Reverse Repo rate is the short-term borrowing rate at which RBI borrows money from banks. It is the opposite of Repo Rate.
  • The Reserve bank uses this tool when it feels there is too much money floating in the banking system. An increase in the reverse repo rate means that the banks will get a higher rate of interest from RBI. As a result, banks prefer to lend their money to RBI which is always safe instead of lending it others (people, companies etc) which are always risky. 
  • Reverse Repo Rate withdraws liquidity from the market.
  • Hence Repo Rate signifies the rate at which liquidity is injected into the banking system by RBI, whereas Reverse Repo rate signifies the rate at which the central bank absorbs liquidity from the banks.
  • Repo rate and Reverse Repo Rate are the parts of Liquidity Adjustment Facility (LAF) of RBI.

Cash Reserve Ratio (CRR)

  • Cash Reserve Ratio (CRR) is the average daily balance that a bank is required to maintain with the Reserve Bank as a share of such percent of its Net demand and time liabilities (NDTL) that the Reserve Bank may notify from time to time in the Gazette of India.
  • CRR is the slice of deposits banks must mandatorily park with RBI.
  • The CRR (percent of NDTL) requires banks to maintain a current account with the RBI with liquid cash.
  • While ensuring some liquid money against deposits is the primary purpose of CRR, its secondary purpose is to allow the RBI to control liquidity and rates in the economy.
  • The amount specified as the CRR is held in cash and cash equivalents are stored in bank vaults or parked with the Reserve Bank of India.
  • CRR is a crucial monetary policy tool and is used for controlling the money supply in an economy.
  • The RBI (Amendment) Bill, 2006, empowers RBI to prescribe CRR without any floor rate or ceiling rate.

Statutory Liquidity Ratio (SLR)

  • Apart from Cash Reserve Ratio (CRR), all commercial banks are also required to maintain a stipulated proportion of their net demand and time liabilities (NDTL) in the form of liquid assets like cash, gold and unencumbered securities which are called the statutory liquidity ratio (SLR).
  • In simple terms, it is the ratio of liquid assets to net demand and time liabilities (NDTL).
  • Treasury bills, dated securities issued under market borrowing programme and market stabilisation schemes (MSS), etc also form part of the SLR. Banks have to report to the RBI every alternate Friday their SLR maintenance
  • The SLR requires banks to invest in safe and quickly saleable assets such as government securities.
  • The institutions which are required to keep SLR are: All Commercial Banks (Scheduled and non scheduled), Primary (Urban) Co-operative Banks (UCBs), State and Central Cooperative Banks.

Difference between SLR and CRR

  • Cash Reserve Ratio is the percentage of the deposit (NDTL) that a bank has to keep with the RBI. CRR is kept in the form of cash and no interest is paid on such reserves. On the other hand, SLR is the percentage of deposit that the banks have to keep as liquid assets in their own vault.
  • The CRR is a more active and useful monetary policy weapon compared to the SLR.
  • SLR rate = (liquid assets / (demand + time liabilities)) × 100%
  • This percentage is fixed by the Reserve Bank Of India. The maximum limit for the SLR was 40% in India. Following the amendment of the Banking Regulation Act (1949) in January 2017, the floor rate of 20.75% for SLR was removed.
  • A higher statutory liquidity ratio compels the banks to divert funds from loans and advances to investment in the Government and approved securities.

Open market operations (OMO)

  • OMOs are the market operations conducted by the Reserve Bank of India by way of sale or purchase of government securities to adjust money supply conditions. The RBI sells government securities to suck out liquidity from the system and buys back government securities to infuse liquidity into the system.
  • The two traditional type of OMO’s used by RBI:
    1. Outright purchase (PEMO): Is outright buying or selling of government securities. (Permanent).
    2. Repurchase agreement (REPO): Is short term, and are subject to repurchase.
  • Open market operations role as a credit control instrument emerged after economic reforms of 1991, when the Indian economy was flushed with an excessive inflow of foreign funds.

Qualitative Credit Control

  • Qualitative measures are used by the RBI for selective purposes. Some of them are : 
    1. Margin requirements: This refers to the difference between the securities offered and amount borrowed by the banks.
    2. Consumer Credit Regulation: This refers to issuing rules regarding down payments and maximum maturities of installment credit for the purchase of goods.
    3. RBI Guidelines: RBI issues oral, written statements, appeals, guidelines, and warnings etc. to the banks.
    4. Rationing of credit: The RBI controls the Credit granted/allocated by commercial banks.
    5. Moral Suasion: Psychological means and informal means of selective credit control.
    6. Direct Action: This step is taken by the RBI against banks that don’t fulfill conditions and requirements. RBI may refuse to rediscount their papers or may give excess credits or charge a penal rate of interest over and above the Bank rate, for credit demanded beyond a limit.

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