Rise of American Accounts. "Hollywood ".

INSTRUMENTS (METHODS) OF CREDIT CONTROL.

There are a number of weapons in the armoury of the central bank to control credit or money supply in the economy. These weapons or instruments can be broadly classified into two categories :

(1)Quantitative or general methods or instruments, and

(2) Qualitative or selective methods or instruments.

(1) Quantitative or general methods or instruments. The techniques used by the central bank to determine the economy's total money supply are called quantitative or general instruments of credit control. These instruments are designed to regulate the lending ability of the financial sector of the economy. The use of these methods does not discriminate among the various segments or sub-segments of the economy. These bring in general ease or 'tightness' in the economy. For example, bank rate, open market operations and cash reserve ratio.

(2) Qualitative or selective methods or instruments. In addition to the quantitative methods, the central bank also has at its disposal qualitative or selective instruments of credit control. Its purpose is to alter credit conditions in a segment or some segments of the economy in isolation from what is happening in the rest of the economy. These measures are taken either to strengthen the general credit policy or to protect a segment from the general credit policy. For example, margin requirements, regulation of consumer credit, moral suasion, etc.

1. QUANTITATIVE OR GENERAL METHODS

1.Bank Rate

The bank rate or the discount rate is the rate at which a central bank is prepared to discount bills of specified types. According to Spalding, the bank rate is "the minimum rate charged by the bank (central bank) for discounting approved bills of exchange ". It was discussed earlier that the central bank is the lender of the last resort. So, the commercial banks can borrow money from it by rediscounting the eligible papers and securities. The price, which the bank charges for rediscounting to the commercial banks or member banks, is the bank rate. In India, statutory definition of the bank rate has been given by Section 49 of the Reserve Bank of India, Act 1934. It states that the bank rate is the "standard rate at which it is prepared to buy or discount bills of exchange or other commercial papers eligible for purchase under this Act. "

The bank rate should not be confused with the market rate. The market rate is the rate of discount that prevails in the market among the other lending institutions.

Bank Rate Policy

Let us now discuss the mechanism of bank rate policy and its operation in regulating credit in the economy. The main assumption of the bank rate policy is that change in the bank rate will be followed by a corresponding change in the various types of market rates. This in turn will influence both the volume of credit and the cost of credit.

It will be desirable to understand in a simple way the various effects of bank rate on the volume of credit or money supply.

(1) Effect on demand for credit. The bank rate will affect the demand for credit. For example, if the bank rate is increased, the commercial banks will receive lesser amount than before from the rediscounting of the eligible bills and securities. Thus, the capacity of the commercial banks to create credit will decline. This will discourage the borrowers from borrowing. However, it is noteworthy that the total effect will depend upon the interest elasticity of demand for credit and the commercial banks dependence on the rediscounting facility

(2)Effect on cost of credit. The increased bank rate will make the credit costlier. The higher cost of credit will ultimately reduce the volume of credit.

(3)Psychological influence. The bank rate influences the credit psychologically. De Kock felt that its psychological value as an instrument of credit control to the central bank is very great.

Burgers said, "The importance of a change in discount rate lies principally in the fact that it is a public recognition by a group of responsible and well-informed people of a change in the credit situation ". An increase in the bank rate will generate a feeling that now the accommodation from the central bank will not be easily available and that it will be costlier. The commercial banks will become cautious in their lendings. Psychological indictions of rise and fall of bank rate were beautifully explained by Gibson. According to him, a rise in the bank rate may be regarded as "the amber coloured light of warning of a robot system of finance and economics. " while a fall may seen as "the green light indicating that the cost is clear and ship of commerce may proceed on her way with caution. " The psychological effect is sometimes called the 'announcement effect '.

(4)Blocking of funds in securities. In the case of the increase in bank rate, the new government securities will be issued at higher interest rate. The market interest rates have an inverse relationship with the market value of existing securities. Thus, due to increase in the interest rate the market value

of the existing securities will fall. It will not be profitable for the banks to liquidate these securities. The funds will get blocked up as the banks may have to wait for the maturity of the securities. The blocking of funds will naturally curtail the credit creation potentiality of the banks.

Hawtrey's and Keynees's viewpoints on bank rate policy

Hawtrey and Keynes have explained the effect of bank rate policy differently. Hawtrey is of the opinion that the bank rate changes the short term interest rates in the market, which influence the economic activity in the economy.

Keynes has expressed the opinion that the economic activity in the economy is influenced by the effect of the bank rate on the long term rates. The detailed discussion of these viewpoints is not relevent for the present purpose.

Assumptions of Bank Rate Policy

De Kock has expressed the opinion that certain conditions must exist in the economy for the proper functioning of the bank rate policy. In other words, the successful functioning of the bank rate the policy is based on the following assumptions :

(1)The interest rates of commercial banks are closely related to bank rate.

(2)Commercial banks keep cash reserves which are adequate for their day-to-day operations. For additional cash resources, they freely approach the central bank.

(3) There is no dearth of eligible securities with commercial banks.

(4) The demand for bank credit is dependent upon the prevailing interest rates.

(5) The economic structure should be elastic. Contraction or expansion in costs, prices, wages, production and employment should take place freely.

(6) There should not be any artificial and arbitrary restrictions in the international flow of capital.

Limitations of Bank Rate Policy

The bank rate policy is an important instruments of monetary management. However, the success of this delicate technique depends on the applicability of the aforementioned assumption. As these assumptions do not hold good completely, to bank rate policy suffers from the following limitations :

(1) The bank rate policy assumes that the changes in the bank rates are followed by changes in the interest rates in the money market. This presupposes a highly active and well-organised market. For example, the London Money Market and the New York Money Market. However, in developing countries money markets are not well-organised which renders the policy almost ineffective.

(2) It assumes that demand for bank credit is interest elastic. However, in reality it is not so. During the boom period the prevailing optimism makes the demand for credit interest inelastic. On the other hand, during depression the bussiness morale is so low that decline in the bank rate fails to encourage borrowings.

(3) The central banks have no direct control over the volume of discounts and advances. The most they can do is to encourage or discourage borrowings. If the borrowings intentions of commercial banks are wrongly assessed, the bank rate policy will fail to give the desired results.

(4) The assumption that commercial banks keep only just adequate cash reserves for operations may not hold true. In case the banks are keeping higher reserves with them they may not feel the necessity of borrowing from the central bank. If they do not borrow from the central bank, they may not increase the lending rates. Moreover, some banks may be reluctant to borrow because of the 'prestige ' feeling thus denying the bank rate an opportunity to influence their lending rates.

(5) The assumption of an elastic economic structure is also unrealistic. In planned economies because of the government control over wages, prices and foreign exchange, the economic structures are no longer elastic.

(6) Sometimes the bank rate may be changed to relate it more closely to other money markets. If such changes are interpreted as red or green signal for the credit conditions, it may lead to desirability.

(7) The bank rate theory believes that an increase in the bank rate will increase the interest rates, which in turn will encourage savings resulting in increase in bank deposits. This, in fact, does not hold good. Savings are more influenced by the level of income rather than the interest rates.

The limitations of the bank rate policy were fully exposed during the postwar period. It was found the discount rate changes by themselves have not been an effective instrument of monetary policy. The significance of bank rate policy as a front rank weapon in the armoury of the central bank declined. However, despite the decline, it continues to play an important role in the credit policies of the central banks.

2.Open Market Operations

This method was used in the early 19th century and was called "borrowing on consols. " However, it is mainly a post First World War American development when it superseded the bank rate policy as a leading instrument of credit control. During this period open market operations emerged as the most potent instrument of monetary policy at the disposal of central banks.

The purchases and sale of government securities by the central bank of the country is known as open market operations.

The principle behind open market operations is very simple. While discussing 'Credit Creation ' it was discussed in detail that the credit creating capacity of the banking system mainly depends upon the cash reserves with the bank. The open market operations attempt to increase or decrease the credit in the system by directly influencing the cash reserves with the banking system. This is done by selling or buying the government securities from the open market.

During boom the stability of the money market and thus of the economy is endangered by multiple credit expansion. The need in such a situation is to limit the lending capacity or credit creation capacity of the banking system. With this objective, government and other approved securities are sold in the market. Individuals or the institutions which buy these securities made payments to the central bank by drawing on their accounts maintained with the commercial banks.

This reduces the cash reserves with the banking system and credit created by it. On the other hand, during the period of depression, the central bank purchases these securities from the market. The cheques issued by the central bank to the sellers are deposited with the commercial banks. It increases the cash reserves with the banking system. The increase in the cash reserves enables the banks to lend more freely because of the increased credit creation capacity.

Obviously open market operations constitute a more direct and effective instrument of credit control. They help in stabilisation of the money market and general economic activity.

Assumptions or Conditions for Open Market Operations

The successful operation of 'market operations ' as a technique of monetary management is also dependent upon certain assumptions. If these conditions do not exist, the sharpness of this weapon will get blunted.

(1) The market for government or eligible securities should be well-organised.

(2) The sufficient quantum of eligible securities should exist or the central bank should be empowered to issue its own securities.

(3) Commercial banks should consistently keep reserves just adequate to satisfy the legal requirements. If the banks are already maintaining a reserve ratio much higher than the legal requirements, the open market operations will fail to make the desired impact. Even after the effect of open market operations, the reserves with commercial banks may be higher than the legal requirement. This will obstruct the operation of open market operations theory.

(4) There should not be excessive volume of government debt. In such security markets there may be a sharp reaction to the open market operations at times the security market may get undully depressed. This will happen if due to open market sale there is noticeable fall in the value of securities.

(5) The central bank should not be under the pressure of weightier considerations of monetary control and policy. For instance, in developing countries central banks are tremendously under pressure from the considerations of public debt management.

Objectives of Open Market Operations

The primary objective of open market operations is to influence the volume of credit in the economy. This is done by changing the cash reserves with the banking system, which are the basis of credit creation capacity of the banks. Furthermore, the open market operations can be used to achieve certain other objective as well.

Firstly, they may be used to supplement the bank rate policy. As discussed earlier, if the banks are having excess cash reserves, an increase in the bank rate will prove ineffective. Commercial banks will consider increasing the lending rate as a consequence of an increase in the bank rate only if the have to avail credit from the central bank through rediscounting of bills. However, if they have their own reserves, they will not approach the central bank for rediscounting. In such a situation, open market operations can be resorted to take away excess cash resources from the bank. This in turn will force them to depend upon the central bank and the bank rate will become an effective instrument.

Secondly, the technique may be used to stabilise the securities market. To win over the confidence of investors, it is essential that the market price of securities should remain fairly stable. This can be ensured if the central bank is ready to sell or buy any amount of securities.

Thirdly, the instrument may be used for absorbing the seasonal changes in the cash reserves with the banking system. This can be achieved by resorting to open market sales when there is excess cash and open market purchases when there is scarcity of cash with the banking system.

Fourthly, the open market operation can also be effectively used in influencing the interest rates. It is because they can easily affect changes in the supply and demand for various types of securities (i.e.,long term, short term) through open market sales and purchases.

However, it is important to understand that the central bank at a single point of time can either control the cash reserves with the banks or it can control interest rates through open market operations, but it cannot do both. For example, it could maintain a stable interest rate by offering to either buy or sell unlimited quantities of a security at a suitable rate. If the central bank did this, no one would sell it a security at a higher price : and no one would buy at a higher price since they could buy from the central bank at a lower price. Thus the price and the yield from the security gets fixed. But in doing so, the central bank will lose control over cash reserves with commercial banks. Any time the central banks buys a bill, cash reserves with commercial banks increase : any time it sells a bill. Cash reserves with commercial banks decrease. The central bank must buy or sell at the initiative of the public. It cannot determine the volume or the direction of its open market operations. If the central bank intends to control volume of cash reserves with commercial banks, it cannot control interest rates. It can control either of the two, but not both.

Limitations of Open Operations

(1) The precondition of existence of a well-organised bills market is satisfied only by a few development economies like those of the U. K., the U. S. A. etc. In underdeveloped and developing countries the situation is different. The demand or supply of the securities is inadequate. The securities market is restricted mainly to banking and non-banking financial institutions. Some of these institutions may be under legal obligation to invest a certain percentage of their total investments in the government securities. For example, in India Life Insurance Corporation (LIC) , the Unit Trust of India (UTI) etc. are under such an obligation. This, in fact, is the captive market. The free market is very limited. The absence of a well-organised market obstructs the smooth operation of the technique.

(2) In case commercial banks hold large cash reserves, i.e. more than legally required, the open market operations cannot affect the volume of credit. It has been discussed earlier. In such a situation open market operations can only complement the bank rate policy. This forced Prof. J. M. Clark to remark "...if at all, successful in the field of credit control (and) from the standpoint of credit control, open market operations were complementary to discount (bank rate) policy. "

(3) Commercial banks may follow a lending policy inconsistent with the central bank's approach. The central bank may purchase securities, so that the banks could lend more, but the banks may not be interested in increasing the lending. The central bank may increase their capacity to lend but cannot force them to lend.

(4) At times, commercial banks may use the proceeds of open market operations to reduce the volume of their indebtedness to the central bank, with the result that an open market purchase tends to ease "the pressure on the bank" and not to augment the volume of credit.

(5) An implied assumption for the open market operations theory is that the demand for the bank credit is interest elastic, which is unrealistic. The consideration of marginal efficiency of capital plays an important role. During the boom period credit continues to increase despite the increase in lending rates because of higher marginal efficiency of capital.

(6) The central bank itself may be handicapped in carrying out open market operations. Open market operations may mean losses if the central bank is forced to buy securities at high prices and sell them at low prices.

(7) The assumption of consistent velocity of circulation of credit is also unrealistic. The velocity of circulation changes with the change in economic situation.

(8) In the face of political uncertainty the hesitation among the business men may hinder the functioning of open market operations theory.

It is because of these limitations that Dr. Harris considered open market operations "a weapon of second rate effectiveness. "

BANK RATE VS OPEN MARKET OPERATIONS

There has been some controversy regarding whether the bank rate is a superior weapon for credit control or open market operations. H. P. Willis expressed the opinion that open market operations "do not constitute an independent kind of influence or type of transaction. "

Spahr expressed his doubts about the open market operations in the following words, "It is very doubtful if they can have an appreciable effect upon cyclical or secular trends in business. " On the other hand, may others believe that open market operations exercise an immediate influence upon credit and regard them as a basic device in credit control. According to Prof.Halm,"From the standpoint to their strategic value to the central bank, open market operations possess a degree of superiority over rediscount policy because of the fact that the initiative is in the hands of monetary authority in case of the former, whereas bank rate policy is passive in the sense that its effectiveness depends on the commercial banks and their customers to changes in the bank rate. "

However, it is clear that open market operations are more direct, potent and effective technique of controlling credit as compared to the bank rate. The initiative is with the central bank and not with commercial banks in case of rate policy.

Despite the superiority of open market operations the two techniques are not competitive : they are complementary : one must back up the other for the desired effect. In isolation none of these can be very effective. For example, if the open market purchases are carried out to reduce the cash reserves with commercial banks, they may not have the desired effect unless the bank rate is also increased. Banks may supplement their resources by discounting the securities. If the bank rate is also increased, rediscounting will become costlier and the open market operations will become effective.

The two techniques should be used in conjunction with each other.

3.Variable Reserve Ratio

In previous chapters it was frequently pointed out that the central bank can determine borrowing on the part of the commercial banks largely through its control of the reserves and hence of their lending power. Therefore, the simplest method of changing credit creation powers of commercial banks is to change the amount of reserves which must be kept against the liabilities of the banks. It is because only the balance cash reserves will be the basis of credit creation by the commercial banks.

An increase in commercial bank's cash reserves (i.e. after deducting the variable reserves required to be maintained) expands the lending capacity of the banking system and vice versa) . In most of the countries, central banks are legally authorised to determine the percentage of deposits to be maintained as reserves. The ratio is called variable reserve ratio.

Changes in the reserve requirements can be used to affect commercial banks' cash reserves positions and thus their credit creation capacity.

The variable reserves also ensure the liquidity and solvency of commercial banks and the banking system.

A Variant of variable reserves ratio called statutory liquidity ratio (SLR) is also used in many countries. While CRR is maintained with the central bank of the country, SLR is maintained with bank itself by making investment in liquid assets like governments securities. Both CRR and SLR has the effect of reducing loanable funds with banks.

Limitations of Variable Reserves Ratio

Variable reserve ratio as an instrument of credit control suffers from the following limitations :

(1) The weapon is effective only if commercial banks maintain only minimum legally required reserves. In case the banks of their own to ensure better liquidity are maintaining higher reserves, the instrument will be ineffective.

(2) The instrument will hit all commercial banks equally. The big commercial banks because of their scale of operation will be in a better position to adjust their position as compared with small banks. The instrument adversely affect the working of the small banks. It will be desirable to provide some relief to these banks.

(3) The weapon can be used only if a big change in the credit is aimed at. A small increase in the variable reserves ratio has the potential of bringing down the quantum of credit. For small changes in the credit, the instrument is not suitable.

(4) Like the previous techniques, the effectiveness of this techniques also depends upon the mood of the business economy. A sharp decrease in the ratio may not be able to increase credit during the depression period.

(5) The instrument affects only the commercial banking system. Non-banking financial institutions fall outside the range of the weapon.

(6) Too many changes in the variable reserves ratio are not desirable. It will create the situation of uncertainty.

(7) The method will affect the securities market as well. The higher variable reserves requirements will force the bankers to sell the securities in hand. Proper care should be taken of this aspect.

2. QUALITATIVE OR SELECTIVE METHODS

In addition to its quantitative or general techniques, the central banks also have other techniques at their disposal called qualitative or selective techniques. The quantitative techniques - the bank rate, open market operations, variable reserves ratio - are designed to open to affect the credit creation in general. They set the tone for the economy as a whole. On the other hand, qualitative or selective techniques or methods are meant to give the central bank as ability to affect particular segments of the economy on selective basis. These can be used either to reinforce the general monetary policy or to protect particular segment (s) from the general monetary policy.

The selective credit control methods try to direct the flow of credit into desired channels. The main selective techniques are discussed below :

1. Margin Requirements

Necessity is the mother of invention. The necessity to check the speculative transactions in the stock exchange market in America in 1929 : and easing the credit position arising on account of general recession stressed the need of selective techniques.

The margin requirement is the difference between the market value of the security and its maximum loan value. For example, if a security has a market value of Rs100 and if the margin requirement is 60% , then the maximum that may be advanced for the purchase of security is Rs 40. Therefore, an increase in the margin requirement will decrease the amount that may be loaned for the purchase of a security or against the security of a particular item. The higher margin requirements will bring down the amount that could be advanced against the available securities and at the same time they will discourage the speculative activity.

This method is advantageous because it controls the credit in the speculative area while the credit continues to the available for productive and essential transactions. This diversifies the credit and directs its flow into the desired channels. Moreover, the method is very simple.

A word of caution - it should be ensured that there is no leakage of credit from the productive areas to which it is granted to the non-productive or speculative areas.

The main effect of change in margin requirement is psychological and in the long run the weapon may not prove to be very effective. The technique has been used frequently by the Reserve Bank of India.

2. Regulation of Consumer Credit.

This technique is the invention of the Federal Reserve System of the United States. It is suitable for the economies where consumer credit in the form of instalment payments is popular. The system is usually popular is durable goods market. The central bank can control the consumer credit by (1) varying the cashdown required for the purchase of such goods : snd/or (2) by varying the maximum period over which the instalments could be fixed.

This technique aims at controlling current price-hikes in the consumer market by checking the excessive demand for goods. A higher cashdown requirement will place the goods beyond the reach of some consumers. If the instalment period is reduced, the monthly instalment will go up, and hence some consumers may find it difficult to afford the goods. This curtails the demand for the goods, thus bringing down the prices. The method is not useful in developing countries like India.

3. Direct Action.

Direct action implies direct dealings with individual banks which adopt policies against the policies of the central bank. This method can be used either in conjunction with the bank rate or open market operations or as an alternative to them. The central bank may take direct action in a number of ways.

However, it is notable that such a policy can be effective only when the offending banks experience the shortage of funds and cannot strengthen their cash position from other sources. Moreover, the method is coercive, and coercion is not a good technique. As a qualitative technique, it may not be able to distinguish between productive and non-productive loans. Last of all, the techniques is in conflict with the central banks's role of the lender of the last resort.

4. Credit Rationing

The Bank of England was the first one to use credit rationing as a technique of credit control towards the end of the 18th century. There is no doubt about the effectiveness of control rationing as an instrument of credit control. Under this method, the central bank fixes a limit for the credit facilities available to commercial banks. The available credit is rationed among the applicants according to the purpose of credit.

Reichbank used the technique in 1924.In regimented communist economies the instrument is naturally very popular.

However, credit rationing suffers from control and not for credit limitations. It can be used only for credit control and not for credit expansion. Like direct action, it also conflicts with the central banking function of 'lender of the last resort ' . The measure is too harsh and discriminatory and should be used only as a temporary measure to meet emergencies.

5. Moral Suasion

In recent times central banks have used moral suasion also as an instrument of credit control. Moral suasion is a general term describing a variety of informal on non-legal methods used by the central bank to persuade commercial banks to behave in a particular manner. Moral suasion generally takes the form of (1) directives or (2) publicity. In European countries where the central bank is looked upon as the leader of the banking sector, it has used the technique successfully. However, in the USA the technique has not been successful. Thus in USA a committee in 1931 expressed the opinion that " it is impracticable to use moral suasion as an effective part of a programme designed generally to restrict or control expansion in or use of Federal Reserve Credit. "

Through this technique the central bank persuades and seeks the co-operation from the commercial banks in checking and restricting non essential activities. In developing countries an additional merit of the technique is that it covers the non-banking financial sector and indigenous banking sector, which otherwise are not under the control of the central bank. The central bank may issue directives to commercial banks to refrain from certain types of lendings.

Publicity is another measure taken under this technique. The purpose is to bring the banking community under the pressure of public opinion exerting on them to follow only that credit policy which is in the interest of the economy of the country. The publicity usually takes the form of periodicals and journals. The banks are kept informed about the type of monetary policy the central bank considers conducive to the economy.

However, the success of moral suasion as a technique of credit control depends upon the moral authority which the concerned central bank enjoys and the extent to which it is able to build up public opinion. To quote Chandler, "Moral suasion can be a useful supplement to other central banking actions, but it is unlikely to be an effective substitute for them. "

SIGNIFICANCE OF SELECTIVE CREDIT CONTROLS

In recent times the selective credit control instruments have gained popularity as tools of credit management.

Firstly, selective measures are flexible. In developing countries where the quantitative measures fail to deliver the desired results because of the under developed money market, selective measures can be effective.

Secondly, selective credit controls can ensure balanced economic growth. Unbalanced regional growth can, to some extent, be corrected by them.

Thirdly, the selective measures can play an important role in the removal of sectoral imbalances which tend to emerge along with the economic growth.

Fourthly, selective credit control instruments have given more strength to the monetary policy. General measures do not distinguish between essential or non-essential sectors of the economy. This can lead to certain difficulties. However, selective measures take care of such situations.

Selective measures have been used effectively by developing countries like India. In growing economies may imbalances emerge which can be corrected by selective measures.

Limitations

The qualitative techniques have qualitative advantages in managing the uses of quantity of money supply. However, these measures suffer from certain limitations some of which are discussed below :

(1) The ultimate use of credit is not under the control of banks. Thus, there may be leakage of credit from an essential area to speculative area.

(2) The growing popularity of the company form of organisation has reduced the effectiveness of these techniques. These companies can raise finances directly from the market.

(3) Similarly, these measures prove to be ineffective in the unorganised sector of banking.

(4) Banks in quest of higher earnings may manipulate the credit lending, thus blunting the teeth of the selective credit measures.

However, despite these limitations, the selective instruments are useful tools in the kit of the central bank. Used wisely, these have the great potential of strengthening monetary policy.

scary.