Unit II: RBI Act, 1934

Credit Control by Reserve Bank of India

Synopsis

Meaning of Credit Control

Objectives of Credit Control

Stability of Internal Price-Level

Checking Booms and Depressions

Promotion of Economic Growth

Regulation and Expansion of Banking

Stabilisation of the Money Market

Stability in Exchange Rates

Preparation for war and other Emergencies

Methods of Credit Control :

1. Quantitative Methods: Bank Rate or Discount Rate Policy

Refinance Policy
Open Market Operations
Variable Cash Reserve Ratio
Statutory Liquidity Requirement (SLR)

2. Qualitative/Selective Methods Moral Suasion

Rationing of Credit
Credit Authorisation Scheme (CAS)
Credit Monetary Arrangements
Direct Action
Publicity
Post sanction supervision, control and
monitoring of credit
Credit Control: Meaning

Credit Control means the regulation of the creation and contraction of credit in the economy.
It is an important function of central bank of any country. The importance of credit control
has increased because of the growth of bank credit and other forms of credit. Commercial
banks increase the total amount of money in circulation in the country through the
mechanism of credit creation. In addition businessmen buy and sell goods and services on
credit basis. Because of these developments, most countries of the world are based on credit
economy rather than money economy. Fluctuations in the volume of credit cause fluctuations
in the purchasing power of money. This fact has far reaching economic and social
consequences. That is why, credit control has become an important function of any central
bank

Credit control is the principal method by which the Reserve Bank fulfils three principal
objectives of monetary policy - (a) stabilisation of exchange rates, (b) stabilisation of general
price level, and (c) stabilisation of business activity and employment..

Objectives of Credit Control

The central bank is usually given many weapons to control the volume of credit in the
country. The use of these weapons are guided by the following objectives.

(i) Stability of Internal Price-Level

The commercial bank can create credit because their main task is borrowing and lending.
They creates credit without any increase in cash with them. This leads to increase in the
purchasing power of many people which may lead to an increase in the prices. The central
bank applies its credit control to bring about a proper adjustment between the supply of credit
and measures required to that effect in the country concerned. This helps in keeping the
prices stable under control.

(ii) Checking Booms and Depressions The operation of trade cycles causes instability in the
country, so the objective of the credit control should be to reduce the uncertainties caused by
these cycles. The central bank adjusts the operation of the trade cycles by increasing and
decreasing the volume of credit.

(iii) Promotion of Economic Growth

The objective of credit Control policy in backward and underdeveloped countries should be
to promote economic growth within the shortest possible time. Generally speaking, the
economic development in these countries is retarded on account of lack of financial
resources. Hence, the Central Banks in these countries often try to solve the problems of
financial stringency through planned expansion of bank credit

(iv) To Regulate and Expand Banking RBI regulates the banking system of the economy.
RBI has expanded banking to all parts of country. Through monetary policy, RBI issues
directives to different banks for setting up rural branches for promoting agricultural credit.
Besides it, government has also set up cooperative banks and regional rural banks. All this
has expanded banking in all parts of country

(v) Stabilisation of the Money Market

According to some economists the credit control policy of the Central Bank should aim at the
stabilisation of the money market in the country. To achieve this objective, the Central Bank
should neutralize seasonal variations in the demand for funds. It should for example, provide
extra credit in times of emergencies. In fact, the control on credit should be exercised by the
Central Bank in such a manner as to bring about an equilibrium in the demand and supply of
money at all times.

(vi) Stability in Exchange Rates

This is also an important objective of credit control. Credit control measures certainly
influence the price level in the country. The internal price level affects the volume of exports
and imports of the county which may bring fluctuations in the foreign exchange rates. While
using any measure of credit control, it should be ensured that there will be no violent
fluctuation in the exchange rates.

(vii) Preparation for war and other Emergencies

Sometimes the objective of the Central bank is to prepare the country for war through
expansion of credit to enable the Government to meet its financial requirement. Modem wars
are so expensive that it is not possible to meet their costs without adequate expansion of bank
credit. During the second world war almost every country resorted to expansion of credit on a
large scale to meet the rising war expenditure

The Measures of Credit Control can be classified into two categories:

 1. Quantitative Methods
2. Qualitative Methods

1.Quantitative Methods

Quantitative methods aim at controlling the total volume of credit in the country. They relate
to the volume and cost of bank credit in general, without regard to the particular field of
enterprise or economic activity in which the credit is used or utilised. The important
quantitative or the general methods of credit control are as follows:

a. Bank Rate or Discount Rate Policy

Bank rate Policy or the Discount Rate Policy has been the earliest instrument of quantitative
credit control. It was the bank of England which experimented with the bank rate policy for
the first time as a technique of monetary management. Now almost every central bank has
been endowed with this instrument of credit control.

(i) Meaning
The bank rate is the ‘minimum rate of interest’ at which the central bank is ready to
grant loans to commercial banks or to rediscount the bills of exchange. Hence, the
‘bank rate’ is also called as the ‘discount rate’. Section 49 of the Reserve Bank of
India Act, 1934 has defined the bank rate as the standard rate at which the Reserve
Bank is prepared to buy or rediscount bills of exchange or other commercial papers
eligible for purchase under the Act. Thus bank rate is the rate at which the Reserve
Bank purchases or rediscounts the specified bills and commercial papers. But it is
significant to note that for a long time there was no bill market in India. So the rate of
interest charged by the Reserve Bank on the advances made by it to the commercial
banks was treated as the bank rate

The Reserve Bank regulates credit of commercial banks and the general credit situation of the
country by manipulating the bank rate. The change in the bank rate generally has the effect
on the cost of credit available to the commercial banks from the Reserve Bank. If the bank
rate is increased, the cost of the lending rates to the borrowers increases, due to which the
level of the borrowings of the banks is reduced. In effect the increased bank rates results in
contraction of bank credit. Therefore, where the Central Bank of the country increases the
bank rates, all other rates of interests also increase. The policy of raising the bank rate is
called the policy of dear money and the objective of such a policy is to make money scarce
and costly, so as to restrict its use and flow to the deserving purposes only

b.Refinance Policy

Section 17 of the Reserve Bank of India Act, 1934, permits the Reserve Bank to provide
accommodation to commercial banks by way of re-discounting of eligible bills or as
advances against approved securities. But such lending is subject to the policy formulated by
the Bank in this regard; banks cannot claim such facility as a matter of right. The Reserve
Bank of India has restricted the availability of its refinance to banks through the various
methods followed by it from time-to-time since 1960.

c.Open Market Operations

Open market operations of a central bank consist of purchase and sale of government and
other securities in the open market with a view to regulate the supply of money. But in India,
open market operations are used by the Reserve Bank more to give support to the government
securities than to regulate the volume of money. It was in Germany perhaps for the first-time
‘Open Market Operations’ were conceived as an instrument of quantitative credit control and
later adopted in other countries. The Central Bank purchase and sales the Govt. Securities,
Gold, Foreign Exchange etc., for enlarging or contracting the cash basis of the commercial
banks under section 17(8). The reserve Bank of India is authorized to purchase and sale of
securities of the central Govt, or State Govt, for the any maturity period or of such securities
of a local authority, as may be specified in this behalf by Central Govt, on the
recommendation of the Central Board to that effect. The securities fully guaranteed as to
principal and interest thereon by any such Govt, authority shall be deemed to be securities of
such Govt, or authority. The Reserve Bank of India can influence the reserves of commercial
banks i.e. the cash basis of commercial banks buying or selling Govt, securities in Open
market. If the reserve Bank of India buys Govt. Securities in the market from commercial
Banks, there is a transfer of cash from the Reserve Bank of India to the commercial banks
and this increase the cash base of the commercial banks enabling them to expand credit and,
conversely, if the reserve Bank of India sales Govt, securities to the commercial banks, the
commercial banks transfer cash to the reserve Bank of India, therefore, their cash base is
reduced. Thus adversely affecting the capacity of commercial banks to expend their credit.

d.Variable Cash Reserve Ratio

The traditional instruments of quantitative credit control, bank rate policy and open market
operations, suffer from certain inherent defects and have been found unsuitable to serve the
interests of underdeveloped countries. Hence, an entirely new and unorthodox instrument of
quantitative credit control, in the form of variable reserve ratio came into vogue.

Variable Reserve Ratio refers to the percentage of the deposits of the commercial banks to be
maintained with the central bank, being subject to variations by the central bank. In other
words, altering the reserve requirements of the commercial banks is called variable reserve
ratio. It is a well-known fact that all the commercial banks are required to keep a certain
percentage of their deposits as cash reserves with the Reserve Bank of India. The Reserve
Bank of India is legally authorized to raise or lower the minimum reserve that the bank must
maintain against the total deposits. This reserve requirement is subject to changes by the
central bank depending upon the monetary needs and conditions of the economy.

Section 42 of the RBI Act provides that every scheduled bank shall maintained with the
reserve bank an average daily balance the amount of which shall not be less than 3% of the
total demand and time liabilities in India of such bank. The reserve bank may by notification
in the Gazette of India increase the said rate to such higher rate as may be specified in the
notification; so, however, that the rate shall not be more than 20% of the total of the demand
and time liabilities

e. Statutory Liquidity Requirement (SLR)

Section 24 of the Banking Regulation Act, 1949 contains a statutory requirement regarding
he maintenance of liquid assets by banks in India. This Section was amended by the Banking
Laws (Amendment) Act, 1983. Before such amendment every banking company was
required to maintain in India in cash, gold or unencumbered approved securities an amount
which shall not at the close of business on any day be less than 25 per cent of the total of its
demand and time liabilities in India. After the amendment, the Reserve Bank has been
empowered to step up this ratio to 40% of the net demand and time liabilities, so as to compel
the banks to keep a large proportion of their deposit liabilities in liquid assets.

2.Qualitative or Selective Credit Controls

The selective credit control is used to prevent speculative hoarding of commodities like food
grains so as to prevent or control inflationary pressures in these areas. Sections 21, 35 and 36
of particular the Banking Regulation Act, 1949 empower the Reserve Bank to determine the
policy in relation to advances to be followed by banking companies generally or by any
banking company in particular, if it is satisfied that it is necessary or expedient in the public
interest or in the interest of depositors. When the policy has been so determined, all banking
companies or the banking company concerned as the case may be, shall be bound to follow
the policy as so determined.

Objectives

The following are the broad objectives of selective instruments of credit:

(a) To divert the flow of credit from undesirable and speculative uses to more desirable and
economically more productive and urgent uses.

(b) To regulate a particular sector of the economy without affecting the economy as a whole.

(c) To regulate the supply of consumer credit.

(d) To stabilise the prices of those goods very much sensitive to inflation.

(e) To stabilise the value of securities.

(f) To correct an unfavourable balance of payments of the country.

(g) To bring under the control of the central bank credit created by non-banking financial
intermediaries.

(h) To exercise control upon the lending operations of the commercial banks.

Every banking company shall be bound to comply with any directions given to it under
Section 21 The power conferred on the reserve bank under this section had been greatly
enlarged with the amendment of the Banking regulation Act with effect from Feb,1964. Prior
to the amendment, the reserve bank could issue directions to banks only as to the purposes of
their advances and the margins and rate of interest there on. In Reserve Bank of India case,
held that In exercise of powers conferred by sections 21 and 35A of the Act, the Reserve
Bank can issue directions having statutory force of law, prohibiting inter alia, payment of
interest on current accounts.

In Johny Kuruvilla v. Reserve Bank of India, 2004 (2) KLT 693 Kerala interpreting ss.
20,21,&35 and dealing with power of the RBI to issue circulars, it was held to be a measure
to curb the possible misuse of position of persons at the helms of affairs of urban bank and
there was no Jurisdiction of the court to prove into the deliberation. It was also held, that
classification of a group of persons as relatives of Directors could not be considered as
objectionable arbitrary.

In Gulabchand Laxmichand Bhutada v. Central Bank of India,1992 (1) Mh.L.J. 68,

Bombay where it was proved that bank had charged interest at a higher rate than prescribed
by RBI directives or had charged compound interest on a loan to agriculturist contrary to RBI
directives, it was held that banking company would be bound to comply with the RBI
directions regarding interest, and court could give appropriate relief as per such directives.

a.Moral Suasion

Moral Suasion means persuasion of commercial banks to follow certain policies, impressing
upon them the necessity to do. There is no legal compulsion in this regard by the Reserve
Bank or Government of India and therefore the success of these measures depends upon the
cooperation of the commercial banks. Through the instrument of Moral Suasion, the approach
is informal rather than formal. In advance countries like USA, this method is used by the
Central bank controlling the credit. In this direction, after the devaluation of rupee 1949, the
Reserve Bank advised all banks to restrict advances to genuine trade requirements and not to
grant accommodation for any speculative purposes. The Reserve Bank further advised the
commercial banks in June 1957, to reduce their advances particularly against agricultural
commodities without effecting their magnitude to industries. Similarly by a letter dated 8th
January, 1971 to Chairmen and Chief Executive Officers of the commercial banks, the
Governor of the Reserve Bank emphasized the need for credit restraint and asked the banks to
minimize the resort to borrowings from the Reserve Bank and to step up their efforts at
deposit mobilization. The Governor has been meeting with the Chairmen and Chief
Executive Officers of the banks and writing personal letters to them advising them to resort to
credit control. These persuasions have given satisfactory results.

b.Rationing of Credit

Under this method, the central bank controls credit by rationing it among its various uses. It
also seeks to control the allocation of bank credit among the various categories of borrowers.
The Reserve Bank has been authorised to secure distribution of credit in conformity with the
national priorities. As required by the Central Government, the Reserve Bank has issued
directives to the commercial banks that at least 40% of their credit must be disbursed among
the priority sectors of the economy such as agriculture, small industries, artisans, education,
housing, etc. Rationing of credit can play a significant role in a planned economy by
diverting financial resources into the priority sectors. But it cannot be denied that it curtails
the freedom of the commercial banks. The commercial banks cannot follow an independent
policy because the channels of investment are determined in advance by the Reserve Bank.

(d) Credit Authorisation Scheme (CAS)

This scheme was introduced by RBI in 1965. Under this scheme, the banks were to take
authorisation of RBI before sanctioning any fresh loan of Rs 1 crore or more to any single
party. The amount of this limit has been changed from time to time. It was raised in 1986 to
Rs 6 crore. This scheme has been abolished by RBI in 1988.

(e) Credit Monetary Arrangements

Under these arrangements RBI monitors and scrutinises all sanctions of bank loan exceeding
Rs 5 crores to any single party for working capital requirements. RBI will scrutinize all such
loans after these are sanctioned by commercial banks.

(f) Direct Action

The Central Bank may take action against banks which are pursuing unsound credit policies.
This may take the form of charging a penal rate of interest or refusing to grant further
rediscounting facilities to the banks who are violating the rules and directives of the Central
Bank. The element of force associated with it is not conducive to the attainment of positive
results. Direct action would result in a division of responsibility between the Central Bank
and the Commercial Bank. The banks constantly feel that the ultimate responsibility rests
with the Central Bank and until some action is taken they extend credit. This confusion
resulting from the evasion of regulations by some banks and their observance by other are
fraught with grave dangers to the financial welfare of the community

(g) Publicity Under this method, the central bank gives wide publicity regarding the probable
credit control policy it may resort to by publishing facts and figures about the various
economic and monetary condition of the economy. The central bank brings out this publicity
in its bulletin, periodicals, report etc.

(h) Post sanction supervision, control and monitoring of credit

The objective of bank of providing credit being, purpose oriented, the post sanction
supervision, control and monitoring of credit becomes very important. The banks should
ensure that the utilisation of credit is in accordance with the purpose for which the same was
granted and the funds are not diverted for any other purpose. The banks have also to see that
the security obtained by the bank against the loan granted by it is safe and adequate. It has
also to be seen by the banks that the terms and conditions for the grant of loans are being
complied with by the borrowers. The supervision, control and monitoring of credit may be
divided into following categories :

(i) Legal Control

Legal control on the credit may be undertaken by executing proper documents, complying
with the legal requirement full for creation of security and keeping the document in force,
complying with the directive of Reserve Bank and instructions issued by the bank’s Central
Office.

(ii) Physical Control Inspection of the securities to the bank, verification of books of account,
inspection of the go down to verify the stock and name plate near the hypothecated stocks,
inspection of factory, is done to ensure that the borrower is carrying its business in a rightful
manner.

(iii) Financial Control Evaluation of performance of borrower is done from the financial
statements submitted by it, monitoring the utilisation of limits, through statements,
comprehensive review of credit account etc.

(iv) Off-site and on-site inspection and supervision. The inspection and supervision of
accounts of the borrower may be undertaken off-site or onsite. Off-site supervision means the
supervision undertaken at bank's desk level by calling periodical statements and returns,
whereas the on-site inspection is undertaken by the bank's staff at the borrower's place of
business. Some of the tools of off-site supervision and control have been prescribed by the
Reserve bank, whereas some of the methods are evolved by the bunks themselves.

For PPT reference :

1. https://www.slideshare.net/RITAKAKADE/credit-control-by-rbi-79368457

2. https://www.slideshare.net/waqassyed/rbi-credit-control

3. https://www.slideshare.net/ronak22/credit-control-bycentralbank