Methods of Credit Control by RBI

Qualitative Credit Control

The Reserve Bank of India was established on April l1, 1935 in accordance with the provisions of the Reserve Bank of India Act, 193. The Central Office of the Reserve Bank was initially established in Calcutta but was permanently moved to Mumbai in 1937. The Central Office is where the Governor sits and Where Policies are formulated though originally privately owned, since nationalisation in 1949, the Reserve Bank is fully owned by the Government of India

Major functions of the RBI are as follows: 

Banker to Government

 As banker to the government the Reserve Bank manages the banking needs of the government. It has to-maintain and operate the government's deposit accounts. It collects receipts of funds and makes payments on behalf of the government. It represents the Government of India as the member of the IMF and the World Bank.

Issue of Banknotes

The Reserve Bank of India has the sole right to issue currency notes except one rupee notes which are issued by the Ministry of Finance. The RBI works as an agent of GOI (Government of India) for distributing and handling of coins. RBI also works to prevent counterfeiting of currency by regularly upgrading security features of currency. 

Manager of Country's Foreign Exchange Reserves

With increasing integration of the Indian economy with the global economy arising from greater trade and capital flows, the foreign exchange market has evolved as a key segment of the Indian financial market and RBI has an important role to play in regulating & managing this segment. RBI has the custody of the country's reserves of international currency and gold reserves of the nation, and this enables the RBI to deal with Crisis Connected with adverse balance of payments position.

On a given day, the foreign exchange rate reflects the demand for and supply of foreign exchange arising from trade and capital transactions. The RBI’s Financial Markets Department (FMD) participates in the foreign exchange market by undertaking sales / purchases of foreign currency to ease volatility in periods of excess demand for/supply of foreign currency.

Lender of Last Resort

First of all RBI works as banker to all the scheduled commercial banks. All the banks in India maintain accounts with RBI which helps them in clearing & settling interbank transactions and customer transactions smoothly & swiftly so the Commercial Banks can approach the RBI in times of emergency to tide over financial difficulties, and the RBI comes to their rescue though it might charge a higher rate of interest.

Quantitative Credit Control

In this method the central bank controls the quantity of credit given by commercial banks by using the following weapons.

Open Market Operations

It means that the bank controls the flow of credit through the sale and purchase of government securities in the open market to balance the money supply in the economy. During inflation, RBI sells the government securities to the commercial banks and other financial institution. This reduces their cash lending and credit creation capacities. Thus, Inflation can be controlled. During recessions, RBI purchases government securities from commercial banks and other financial institution. This leaves them with more cash balances for lending and increases their credit creation capacities. Thus, recession can be overcome.

Cash Reserve Ratio(CRR)

It is the amount of funds that the banks have to keep with RBI. If RBI decides to increase this rate the available amount with the banks comes down. RBI uses this method to drain out the excessive money from the banks.

Ex: - The current CRR is 4%. If RBI cuts CRR in its next monetary policy review then it will mean banks will be left with more money to lend or to invest. So, more money can be released into the economy which may spur economic growth.

CRR-5%

Individual person deposit to Bank-Rs 1000

Bank keep itself-Rs950 and remaining amount give to RBI

RBI keep-Rs 50 (CRR 5% on 1000)

Statutory Liquidity Ratio(SLR)

Besides CRR, Banks have to invest certain percentage of their deposits in specified financial securities like Central Government or State Government securities. This percentage is known as SLR.

This money is predominantly invested in government approved securities (bonds), Gold, which mean the banks can earn some amount as 'interest' on these investments as against CRR where they do not earn anything.

Ex : - An Individual deposits say Rs 1000 in bank. Then Bank receives Rs 1000 and has to keep some percentage of it with RBI as SLR. If the prevailing SLR is 20% then they will have to invest Rs 200 in Government Securities

SLR-20%

Individual person deposit to Bank-Rs 1000

Bank keep itself-Rs750 and remaining amount give to RBI

RBI keep-Rs 50 (CRR 5% on 1000)+200(SLR 20% on 1000)

Bank Rate

Bank Rate also known as the Discount Rate is the official minimum rate at which the Central Bank of the country is ready to rediscount approved bills of exchange or lend on approved securities.

When the commercial bank for instance, has lent or invested all its available funds and has little or no cash over and above the prescribed minimum, it may ask the central bank for funds. It may either re-discount some of its bills with the central bank or it may borrow from the central bank against the collateral of its own promissory notes.

In either case, the central bank accommodates the commercial bank and increases the latter’s cash reserves. This Rate is increased during the times of inflation when the money supply in the economy has to be controlled and during deflation, bank rate is decreased.

Repo Rate

When we need money, we take loans from banks. And banks charge certain interest rate on these loans. This is called as cost of credit (the rate at which we borrow the money).

Similarly, when banks need money they approach RBI. The rate at which banks borrow money from the RBI by selling their surplus government securities to RBI is known as "Repo Rate." Repo rate is short form of Repurchase Rate. Generally, these loans are for short durations up to 2 weeks.

It simply means Repo Rate is the rate at which RBI lends money to commercial banks against the pledge of government securities whenever the banks are in need of funds to meet their day-to-day obligations.

Ex : - If repo rate is 5% , and bank takes loan of Rs 1000 from RBI , they will pay interest of Rs 50 to RBI.

So, higher the repo rate higher the cost of short-term money and vice versa.

Higher repo rate may slow down the growth of the economy.

If the repo rate is low then banks can charge lower interest rates on the loans taken by us.

Reverse Repo Rate

Reverse repo rate is the rate of interest offered by RBI, when banks deposit their surplus funds with the RBI for short periods. When banks have surplus funds but have no lending (or) investment options, they deposit such funds with RBI. Banks earn interest on such funds.