UNIT: 2

CENTRAL BANKING SYSTEM

4.1EVOLUTION OF CENTRAL BANKING
Central Banking is of recent origin. Prior to the commencement of the twentieth century, there
had been no clearly defined concept of central banking. However, today there is no country in
the world, which does not have a Central Bank. It is the bank that acts as the leader of money
market. It supervises, regulates and controls the functions of commercial banks and other
financial institutions. It acts as the banker to the Government. It has become essential for the
proper functioning of the economy.

Before the commencement of the twentieth century, in many countries like England, France,
Sweden, etc., some banks were assuming more powers. They were enjoying the right of note
issue and were acting as the government’s banker and agent. They were not originally called the
Central Banks, but were generally known as the banks of issue or the national banks. The oldest
Central Bank is the Ritz Bank of Sweden, which was established in 1656. The Bank of England
came into existence in 1694. However, it was the first bank to assume the position of a Central
Bank. The successful working of the Bank of England stimulated the development of Central
banking in other parts of the world.

By the end of 19th century, almost all-European countries possessed a Central Bank. In 1914, the
Federal Reserve System was established in the USA. In the twentieth century, the development
of Central Banks took place at a faster rate. The great encouragement to the development of
central banking was provided at the International Financial Conference held in Brussels in 1920.
In this conference, a resolution was passed urging the countries without Central Bank to establish
a Central Bank as soon as possible. During this period, by following the resolution of the
conference, a number of central banks were established in different parts of the world. The
establishment of the International Monetary Fund (IMF) in 1944 facilitated the starting of
Central Banks in new Afro-Asian countries. Today almost every Independent country has a
Central Bank.
4.2 Definition of Central Bank
It is very difficult to give a brief and accurate definition for a Central Bank. The definition is
derived from the functions performed by a Central Bank. In fact, the functions of a Central Bank
have grown considerably with the passage of time. A banking institution can more easily be
identified by the functions that it performs. According to Vera Smith, “the primary definition of
central banking is a banking system in which a single bank has either a complete or residuary
monopoly in the note issue.” Kisch and Elkin believe that “the essential function of a central
bank is the maintenance of the stability of the monetary standard.” In the statutes of the Bank for
International Settlements a central bank is defined as “the bank of the country to which has been
entrusted the duty of regulating the volume of currency and credit in that country.” De Kock
gives a very comprehensive definition of central bank. According to De Kock, a central bank is a
bank which constitutes the apex of the monetary and banking structure of its country and which
performs, best it can in the national economic interest, the following functions:
(a) The regulation of currency in accordance with the requirements of business and the
general public, for which purpose it is granted either the sole right of note issue or at least
a partial monopoly thereof.
(b) The performance of general banking and agency services for the state.
(c) The custody of cash reserves of the commercial banks.
(d) The custody and management of the nation’s reserves of international currency.
(e) The granting of accommodation, in the form of rediscounts, or collateral advances, to
commercial banks, bill brokers and dealers, or other financial institutions, and the general
acceptance of the responsibility of lender of last resort.
(f) The settlement of clearances between the banks.
(g) The control of credit in accordance with the needs of business and with a view to
carrying out the broad monetary policy adopted by the state.
4.3 Functions of the Central Bank
The functions of the central bank differ from country to country in accordance with the
prevailing economic situation. But there are certain functions which are commonly performed by
the central bank in all countries. According to De Kock, there are six functions which are
performed by the central bank in almost all countries.
1. Monopoly of Note Issue: The issue of money was always the prerogative of the government.
Keeping the minting of coins with itself, the government delegated the right of printing currency
notes to the central bank. In fact the right and privilege of note issue was always associated with
the origin and development of central banks which were originally called as banks of issue.
Nowadays, central banks everywhere enjoy the exclusive monopoly of note issue and the
currency notes issued by the central banks are declared unlimited legal tender throughout the
country. At one time, even commercial banks could issue currency notes but there were certain
evils in such a system such as lack of uniformity in note issue, possibility of over-issue by
individual banks and profits of note issue being enjoyed only by a few private shareholders. But
concentration of note issue in the central bank brings about uniformity in note issue, which, in
turn, facilitates trade and exchange within the country, attaches distinctive prestige to the
currency notes, enables the central bank to influence and control the credit creation of
commercial banks, avoids the over issue of notes and, lastly, enables the government to
appropriate partly or fully the profits of note issue. The central bank keeps three considerations
in view as regards issue of notes-uniformity, elasticity (amount according to the need for
money), and safety.
2. Custodian of Exchange Reserves: The central bank holds all foreign exchange reserves-key
currencies such as U.S. dollars, British pounds and other prominent currencies, gold stock, gold
bullion, and other such reserves-in its custody. This right of the central bank enables it to
exercise a reasonable control over foreign exchange, for example, to maintain the country’s
international liquidity position at a safe margin and to maintain the external value of the
country’s currency in terms of key foreign currencies.
3. Banker to the Government: Central banks everywhere perform the functions of banker,
agent and adviser to the government. As a banker to the government, the central bank of the
country keeps the banking accounts of the government both of the
Centre and of the States performs the same functions as a commercial bank ordinarily does for its
customers. As a banker and agent to the government, the central bank makes and receives
payments on behalf of the government. It helps the government with short-term loans and
advances (known as ways and means advances) to tide over temporary difficulties and also floats
public loans for the government. It also manages the public debt (i.e., floats services and redeems
government loans). It advises the government on monetary and economic matters.
4. Banker to Commercial Banks: Broadly speaking, the central bank acts as the banker’s bank
in three different capacities: (a) It acts as the custodian of the cash reserves of the commercial
banks (b) It acts as the lender of the last resort (c) It is the bank of central clearance, settlement
and transfer. We shall now discuss these three functions one by one.
(a) It acts as the custodian of the cash reserves of commercial banks: Commercial banks keep
part of their cash balances as deposits with the central bank of a country known as centralization
of cash reserves. Part of these balances are meant for clearing purposes, that is, payment by one
bank to another will be simple book entry adjustment in the books of the central bank. There are
many advantages when all banks keep part of their cash reserves with the central bank of the
country. In the first place, with the same amount of cash reserves, a large amount of credit
creation is possible. Secondly, centralized cash reserves will enable commercial banks to meet
crises and emergencies. Thirdly, it enables the central bank to provide additional funds to those
banking institutions which are in temporary difficulties. Lastly, it enables the central bank to
influence and control the credit creation of commercial banks by making the cash reserves of the
latter more or less.
(b) Lender of the last resort: As the banker’s bank, the central bank can never refuse to
accommodate commercial banks. Any commercial bank wanting accommodation from the
central bank can do so by rediscounting (selling) eligible securities with the central bank or can
borrow from the central bank against eligible securities.
By lender of the last resort, it is implied that the latter assumes the responsibility of meeting
directly or indirectly all reasonable demands for accommodation by commercial banks in times
of difficulties and crisis.
(c) Clearing agent: As the central bank becomes the custodian of cash reserves of commercial
banks, it is but logical for it to act as a settlement bank or a clearing house for other banks. As all
banks have their accounts with the central bank, the claims of banks against each other are
settled by simple transfers from and to their accounts. This method of settling accounts through
the central bank, apart from being convenient, is economical as regards the use of cash. Since
claims are adjusted through accounts, there is usually no need for cash. It also strengthens the
banking system by reducing withdrawals of cash in times of crisis.
Furthermore, it keeps the central bank of informed about the state of liquidity of commercial
banks in regard to their assets.
5. Controller of Credit: Probably the most important of all the functions performed by a central
bank is that of controlling the credit operations of commercial banks. In modern times, bank
credit has become the most important source of money in the country, relegating coins and
currency notes to a minor position. Moreover, it is possible, as we have pointed out in a previous
chapter, for commercial banks to expand credit and thus intensify inflationary pressure or
contract credit and thus contribute to a deflationary situation. It is, thus, of great importance that
there should be some authority which will control the credit creation by commercial banks. As
controller of credit, the central bank attempts to influence and control the volume of bank credit
and also to stabilize business conditions in the country.
6. Promoter of Economic Development: In developing economies the central bank has to play
a very important part in the economic development of the country. Its monetary policy is carried
out with the object of serving as an instrument of planned economic development with stability.
The central bank performs the function of developing long-term financial institutions, also
known as development banks, to make available adequate investible funds for the development
of agriculture, industry, foreign trade, and other sectors of the economy. The central bank has
also to develop money and capital markets.
In addition, the central bank may also undertake miscellaneous functions such as providing
assistance to farmers through co-operative societies by subscribing to their share capital,
promoting finance corporations with a view to providing loans to large-scale and small-scale
industries and publishing statistical reports on tends in the money and capital markets. In short, a
central bank is an institution which always works in the best economic interests of the nation as a
whole. In view of all these functions, as discussed above, it follows that a modern central bank is
much more than a Bank of Issue.

4.4. Credit control methods

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. Before we discuss the techniques of credit control, it
is desirable to understand the objectives of credit control.
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 is guided by the following objectives:
(a) Stability of Internal Price-level: The commercial bank can create credit because their main
task is borrowing and lending. They create 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 requirements of credit in the country. This will help in keeping the
prices stable.
(b) 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.
(c) Promotion of Economic Development: The objective of credit control should be to promote
economic development and employment in the country. When there is lack of money, its supply
should be increased so that there are more and more economic activities and more and more
people may get employment. While resorting to credit squeeze, the central bank should see that
these objectives are not affected adversely.
(d) Stability of the Money Market: The central bank should operate its weapons of credit control
so as to neutralize the seasonal variations in the demand for funds in the country. It should
liberalize credit in terms of financial stringencies to bring about stability in the money market.
(e) 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 country 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.

Methods of Credit Control

The various methods employed by the central bank to control credit creation power of the
commercial banks can be classified in two group viz., quantitative controls, and qualitative
controls. Quantitative controls are designed to regulate the volume of credit created by the
banking system. These measures work through influencing the demand and supply of credit.
Qualitative measures, on the other hand, are designed to regulate the flow of credit in specific
uses.
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.
The important quantitative or 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 every central bank has been endowed
with this instrument of credit control.
Meaning
Bank rate refers to the official minimum lending rate of interest of the central bank. It is the rate
at which the central bank advances loans to the commercial banks by rediscounting the approved
first class bills of exchange of the banks. Hence, bank rate is also called as the discount rate.
Theory of Bank Rate
The theory underlying the operation of bank rate is that by manipulating the bank rate, the
central bank is in a position to exercise influence upon the supply of credit in the economy.
According to the theory of bank rate an increase or a decrease in the bank rate leads to a
reduction or an increase in the supply of credit in the economy. This is possible because changes
in the bank rate bring about changes in the other rates of interest in the economy.
Working of Bank Rate
As mentioned above, by manipulating the bank rate it is possible to effect changes in the supply
of credit in the economy. During a period of inflation, to arrest the rise in the price level, the
central bank raises the bank rate. When the bank rate is raised, all other interest rates in the
economy also go up. As a result, the commercial banks also raise their lending rates. The
consequence is an increase in the cost of credit. This discourages borrowing and hence
investment activity is curbed in the economy. This will bring about a reduction in the supply of
credit and money in the economy and therefore in the level of prices.
On the other hand, during a period of deflation, the central bank will lower the bank rate in order
to encourage business activity in the economy. When the bank rate is lowered, all other interest
rates in the economy also come down. The banks increase the supply of credit by reducing their
lending rates. A reduction in the bank rate stimulates investment and the fall in the price level is
arrested.
Conditions for the Success of the Bank Rate Policy
The efficacy of bank rate as an instrument of monetary management calls for the fulfillment of
the following conditions:
(a) Close relationship between bank rate and other interest rates: It is necessary that the
relationship between bank rate and the other interest in the economy should be close and direct.
Changes in the rate should bring about similar and appropriate changes in the other interest rates
in the economy. Otherwise the efficacy of bank rate will be limited. There is, therefore, the need
for the existence of an integrated interest rate structure.
(b) Existence of an elastic economic system: The success of bank rate requires the existence of an
elastic economic structure. That is, the entire economic system should be perfectly flexible to
accommodate itself to changes in the bank rate. Changes in the bank rate should bring about
similar and desirable changes in prices, costs, wages, output, profits, etc. The existence of a rigid
economic structure will reduce the efficacy of bank rate.
(c) Existence of short term funds market: Another condition required for the success of bank rate
policy is the existence of market for short term funds in the country. This will help to handle
foreign as well as domestic funds that come up on account of changes in the interest rates,
following changes in the bank rate.
Limitations
The Bank Rate Policy suffers from the following limitations:
(a) It has been argued that bank rate proves ineffective to combat boom and depression.
During a period of boom, investment is interest inelastic. Even if the bank rate is raised to any
extent, investment activity will not be curbed, because during a period of boom, the marginal
efficiency of capital will be very high and the entire business community will be caught in a
sweep of optimism. During depression, bank rate becomes ineffective following the general
psychology of diffidence and pessimism among the business circles.
(b) The growth of non-banking financial intermediaries has proved an effective threat to the
effectiveness of bank rate policy. It has been adequately established by the study of the Redcliffe
Report and Gurley-Shaw, that the mushroom growth of non-banking financial intermediaries has
belittled the significance of bank rate. This is because changes in the bank rate immediately
affect the rates of interest of the commercial banks only and the non-banking financial
institutions are not subject to the direct control of the central bank. Hence, it is said that “the
good boy is punished for the actions of a bad boy.”
(c) The decline in the use of bills of exchange as credit instruments also has been responsible for
the decline in the importance of bank rate.
(d) Further, of late, businessmen have found out alternative methods of business financing, self-
financing, ploughing back the profits, public deposits, etc. Indeed, the role of commercial banks
as suppliers of loanable funds has been decreasing in importance.
(e) Moreover, the economic structure has not been adequately responding itself to changes in the
bank rate. After the war, all kinds of rigidities have crept into the economic system.
(f) The invention of alternative instruments of credit control also has accounted for the decline in
the popularity of bank rate.
(g) Further, the dependence of the commercial bank on the central bank for loans also has
decreased leading to the decline in getting the bills of exchange rediscounted by the central bank.
In addition, there has been an increased liquidity in the assets of banks.
(h) Finally, the increase in the importance of fiscal policy following the Great Depression of
1930’s has also reduced the importance of bank take policy as a technique of credit control.
B. Open Market Operations
After the First World War, bank rate policy as a tool of monetary management began to lose its
significance following the invention of alternative techniques of credit control. Among the
alternative instruments of quantitative credit control invented in the post-war period, open
market operations assumed significance.
Meaning
Open market operations refer to the purchase and sale of securities by the central bank. In its
broader sense, the term includes the purchase and sale of both government and private securities.
But, in its narrow connotation, open market operations embrace the purchase and sale of
government securities only. It was in Germany that open market operations took its birth as an
instrument of quantitative credit control.
Theory of Open Market Operations
The theory underlying the operation of open market operations is that by the purchase and sale of
securities, the central bank is in a position to increase or decrease the cash reserves of the
commercial banks and therefore increase or decrease the supply of credit in the economy. During
a period of inflation, the central bank seeks to reduce the supply of credit in the economy. Hence,
it sells the securities to the banks, public and others. As a result of the sale of securities by the
central bank, there will be a transfer of cash from the buyers to the central bank. This will reduce
the cash reserves of the commercial banks. The public has to withdraw money from their
accounts in the banks to pay for the securities purchased from the central bank.
And the commercial banks themselves will have to transfer some amount to the central bank for
having purchased the securities. All this shrinks the volume of cash in the vaults of the banks. As
a result the banks will be unable to expand the supply of credit. When the supply of credit is
reduced by the banking system, the consequences on the economy will be obvious. Investment
activity is discouraged ultimately leading to a fall in the price level.
On the other hand, during a period of deflation, in order to inject more and more credit in to the
economy, the central bank purchases the securities. This will have an encouraging effect on
investment because the banks supply more credit following an increase in their cash reserves.
Thus, the central bank seeks to combat deflation in the economy.
Objectives of Open Market Operations
The main objectives of open market operations are:
(a) To eliminate the effects of exports and imports to gold under the gold standard.
(b) To impose a check on the export of capital.
(c) To remove the shortage of money in the money market.
(d) To make bank rate more effective.
(e) To prevent a ‘run on the bank’.
Conditions for the Success of Open Market Operations
The efficacy of open market operations as a tool of quantitative credit control requires the
fulfillment of certain conditions discussed below.
1. Institutional Framework: The success of open market operations requires the existence of an
institutional framework, that is, the existence of a well-knit and well developed securities market.
The absence of a matured money market constitutes a serious impediment to the development of
open market operations as an effective instrument of monetary control. In fact, in the under
developed countries, the scope for open market operations is limited because of the absence of
the institutional framework referred to above.
2. Legal Framework: The effective and meaningful functioning of open market operations calls
for a suitable legal setting. The legal setting is that there should be no legal restrictions on the
holding of securities by the central bank. It has been found that in some countries the
governments have imposed ceilings on the holdings of government securities by central banks.
Such legal restrictions obviously circumscribe the efficacy of open market operations.
3. Maintenance of a Definite Cash Reserve Ratio: Another condition that should be fulfilled
for the success of open market operations is that the cash reserves of the banks should change in
accordance with the purchase and sale of securities by the central bank. When the central bank
purchases the securities, the cash reserves of the banks should increase and when the central
bank sells the securities, the cash reserves of the banks should fall. This means that the banks
should maintain a definite cash reserve ratio. But, if the banks keep the cash reserves in excess of
the fixed ratio or have other secret reserves, the very purpose of open market operations will be
defeated.
4. Non-operation of Extraneous Factors: Due to the operation of certain extraneous factors the
cash reserves of the banks may not change in accordance with the requirement of open market
operations. For example, when the central bank purchases the securities in order to inject more
credit into the economy, this objective may be defeated by an outflow of money due to
unfavorable balance of payments or the public may hoard a part of the additional cash put into
circulation.
5. Non-existence of Direct Access of Commercial Banks to the Central Bank:
Another important condition for the smooth working of the open market operations is that the
commercial banks should not have direct access to the central bank for financial accommodation.
In case the banks have direct accommodation to the central bank, then the reduction in their cash
reserves through open market sale of securities by the central bank may be neutralized by these
banks by borrowing from the central bank.
It should be noted here that the above conditions necessary for the success of open market
operations constitute by themselves the limitations of the open market operations. In fact, in
many countries, particularly in the less developed countries, the success of open market
operations is limited because the above conditions are not fulfilled.
Popularity of Open Market Operations
Despite the limitations of open market operations, it has been argued that this technique of credit
control is superior to the bank rate policy. The superiority of open market operations stem from
the following points:
(a) The discount rate policy seeks to regulate credit in an indirect way, whereas open market
operations have a more direct and effective influence on the regulation of credit by the central
bank.
(b) The influence of bank rate is on short term interest rates only. The long term interest rates are
influenced only indirectly by changes in bank rate. But, the policy of open market operations has
a direct bearing on the prices of long term securities and hence on the long term interest rates. It
has a direct and immediate effect on the quantity of money and credit and hence on the market
interest rates. It is on this score that the policy of open market operations is now increasingly
used to influence the interest rates as well as the prices of government securities in the money
market.
But, the above two points of the superiority of the policy of open market operations should not
make us blind to the fact that the policy of open market operations will itself help to achieve the
desired results. It is necessary to combine both bank rate and open market operations judiciously
to achieve the desired results. Wherever possible, open market operations will have to be
supplemented by the bank rate policy. This will go a long way in producing effective results in
regulating the volume of credit in the economy.
C. 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, thanks to the
Federal Reserve System of the United States. It was, however, Lord Keynes who was responsible
for popularizing the use of this novel technique of monetary management. The
Federal Reserve System became the trendsetter by pressing into service variable reserve ratio for
the first time in 1933 as a weapon of quantitative credit control.
Meaning
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 have to maintain a certain
percentage of their deposits as cash reserves with the central bank. The central bank, therefore,
acts as the custodian of the cash reserve of the commercial banks. By doing so, the central bank
imparts liquidity and confidence into the system. This reserve requirement is subject to changes
by the central bank depending upon the monetary needs and conditions of the economy. In
certain countries, like United States and India, there are clear written laws stipulating the banks
to maintain the reserve requirements with the central bank. Such a reserve ratio is called the
Statutory Reserve Ratio. But, in England, the banks maintain the reserve ratio as a matter of
custom. Hence this kind of reserve ratio is called the Customary Reserve Ratio.
Anyhow, the central bank has the authority to vary the reserve requirements of the banks.
Theory of Variable Reserve Ratio
The theory underlying the mechanism of variable reserve ratio is that by varying the reserve
requirements of the banks, the central bank is in a position to influence the size of credit
multiplier of the banks and therefore the supply of credit in the economy. An increase or
decrease in the reserve requirements will have a constructionist or expansionary influence
respectively on the supply of credit by the banking system.

Working of Variable Reserve Ratio

It is interesting to examine the working of variable reserve ratio as a technique of quantitative
credit control. During a period of inflation, the central bank raises the reserve ratio in order to
reduce the supply of credit in the economy and therefore to reduce the price level. When the
reserve requirements of the banks are raised, the excess reserves of the banks shrink and hence
the size of their credit multiplier decreases. It should be noted that the size of credit multiplier is
inversely related to the reserve ratio prescribed by the central bank. An increase in the reserve
ratio, therefore, discourages the commercial banks from expanding the supply of credit.
On the contrary during a period of deflation, the central bank lowers the reserve requirements of
the banks in order to inject more purchasing power into the economy. When the reserve ratio is
lowered, the excess reserves with the banks increase and hence the size of credit multiplier
increases. This will have an encouraging effect on the ability of the banks to create credit. Thus,
the central bank seeks to combat deflation in the economy.
Limitations
The following constitute the limitations of variable reserve ratio:
(a) In the first place, variable reserve ratio has been considered to be a blunt and harsh instrument
of credit control.
(b) As compared with the open market operations, it is inexact and uncertain as regards changes
not only in the amount of reserves, but also the place where these changes can be made effective.
(c) Variable reserve ratio is accused of being discriminatory in its effect. It affects different
banks differently. Banks with a large margin of excess reserves would be hardly affected
whereas banks with small excess reserves would be hard pressed.
(d) Variable Reserve Ratio is considered to be inflexible. It lacks flexibility in that changes in
reserve requirements would not be well adjusted to meet small or localized situations of reserve
stringency or superfluity.
(e) This method of credit control is likely to create a panic among the banks and the investors.
(f) Maintaining the reserve ratio with the central bank imposes a burden on the banks because no
interest is allowed on these cash reserves by the central bank.
(g) In the event of the commercial banks having huge foreign funds, the method of variable
reserve ratio proves ineffective.

Selective or Qualitative Methods

The central bank may assume that the inflationary pressure in the country is due to artificial
scarcities created by speculators and hoarders who may hoard and black market essential goods
through the use of bank credit. Accordingly, the central bank may not regulate and control the
volume of credit but central the use of credit or the person’s security, etc. Such controls are
known as selective or direct controls. The special features of selective or qualitative controls are:
(a) They distinguish between essential and non-essential uses of bank credit.
(b) Only non-essential uses are brought under the scope of central bank controls.
(c) They affect not only the lenders but also the borrowers.
Selective controls attempt to cut down the credit extended for non-essential purposes or uses.
Loans extended to speculators to hoard goods or bank credit to consumers to raise their demand
for such durable goods as refrigerators, cars, etc., will prove to be inflationary when there is
already excessive demand as compared to the limited supply. Essentially, therefore, selective
controls are meant to control inflationary pressure in a country.
Objectives
The following are the broad objectives of selective instruments of credit control:
(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 stabilize the prices of those goods very much sensitive to inflation.
(e) To stabilize the value of securities.
(f) To correct an unfavorable 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.
Measures of Selective Credit Control
For the purpose of selective credit control, the central bank generally uses the following forms of
control, from time to time.
1. Margin Requirements: Banks are required by law to keep a safety margin against securities
on which they lend. The central bank may direct banks to raise or reduce the margin. In the
U.S.A. before World War II, the Federal Reserve Board fixed a margin of 40 per cent (i.e., a
bank could lend up to 60 per cent of the value of security). But during the war and later, the
margin requirements were raised from 40 per cent to 50 per cent, then to 75 per cent and in 1946
to 100 per cent in some cases. When the margin was raised to 75 per cent one could borrow only
25 per cent of the value of the security and when the margin requirement was fixed at 100
percent one could borrow nothing. Thus by raising the margin requirement, the central bank
could reduce the volume of bank credit which a commercial bank can grant and a party can
borrow. Margin requirement is a good tool to reduce the degree and extent of speculation in
commodity market and stock exchanges.
2. Regulation of Consumer Credit: During the Second World War an acute scarcity of goods
was felt in the U.S.A., and the position was worsened by the system of bank credit to consumers
to enable them to buy durable and semi-durable consumer goods through installment buying. The
Federal Reserve Banks of the U.S.A., were authorized to regulate the terms and conditions under
which consumer credit was extended by commercial banks. The restraints under these
regulations were two-fold: (a) They limited the amount of credit that might be granted for the
purchase of any article listed in the regulations; and
(b) they limited the time that might be agreed upon for repaying the obligation. Suppose a buyer
was required to make a down-payment of one-third of the purchase price of a car and the balance
to be paid in 15 monthly installments. Under the regulations restraining consumer credit, the
down-payment was made larger and the time allowed was made shorter. The result was a
reduction in the amount of credit extended for the purchase of cars and the time it was allowed to
run; and the ultimate result was the restriction, in the demand for consumer goods at a time when
there was a shortage in supply and when there was a necessity for restriction on consumer
spending. This measure was a success in America in controlling inflationary pressures there. In
the past-war period, it has been extensively adopted in all those countries where the system of
consumer credit is common.
3. Rationing of Credit: Rationing of credit, as a tool of selective credit control, originated in
England in the closing years of the 18th century. Rationing of credit implies two things. First, it
means that the central bank fixes a limit upon its rediscounting facilities for any particular bank.
Second, it means that the central bank fixes the quota of every affiliated bank for financial
accommodation from the central bank.
Rationing of credit occupies an important place in Russian Economic Planning.
The central bank of the Russian Federation allocates the available funds among different banks
in accordance with a definite credit plan formulated by the Planning Commission.
But the criticism of rationing of credit is that it comes into conflict with the function of the
central bank as a lender of the last resort. When the central bank acts as a lender of the last resort
it cannot deny accommodation to any bank through it has borrowed in excess of its quota.
Moreover, this method proves effective only when the demand for credit exceeds the supply of
it.
4. Control through Directives: In the post-war period, most central banks have been vested
with the direct power of controlling bank advances either by statute or by mutual consent
between the central bank and commercial banks. For instance, the
Banking Regulation Act of India in 1949 specifically empowered the Reserve Bank of India to
give directions to commercial banks in respect of their lending policies, the purposes for which
advances may or may not be made and the margins to be maintained in respect of secured loans.
In England, the commercial banks have been asked to submit to the Capital Issue Committee all
loan applications in excess of £ 50,000. There is no uniformity in the use of directives to control
bank advances. On the one extreme, the central bank may express concern over credit
developments; the concern may be combined with mild threat to avoid increase or decrease in
the existing level of bank loans. On the extreme, there can be a clear and open threat to the
commercial banks financing certain types of activities.
5. Moral Suation: This is a form of control through directive. In a period of depression, the
central bank may persuade commercial banks to expand their loans and advances, to accept
inferior types of securities which they may not normally accept, fix lower margins and in general
provide favorable conditions to stimulate bank credit and investment. In a period of inflationary
pressure, the central bank may persuade commercial banks not to apply for further
accommodation or not to use the accommodation already obtained for financing speculative or
non-essential activities lest inflationary pressure should be further worsened. The Bank of
England has used this method with a fair measure of success. But this has been mainly because
of a high degree of co-operation which it always gets from the commercial banks.
6. Direct Action: Direct action or control is one of the extensively used methods of selective
control, by almost all banks at sometime or the other. In a broad sense, it includes the other
methods of selective credit controls. But more specifically, direct action refers to controls and
directions which the central bank may enforce on all banks or any bank in particular concerning
lending and investment. The Reserve Bank of India issued a directive in 1958 to the entire
banking system to refrain from excessive lending against commodities in general and forbidding
commercial banks granting loans in excess of Rs. 50,000 to individual parties against paddy and
wheat.
There is no doubt about the effectiveness of such direct action but then the element of force
associated with direct action is resented by the commercial banks.
7. 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
bulletins, periodicals, reports etc.
Limitations of Selective Credit Controls
(a) The selective controls embrace the commercial banks only and hence the nonbanking
financial institutions are not covered by these controls.
(b) It is very difficult to control the ultimate use of credit by the borrowers.
(c) It is rather difficult to draw a line of distinction between the productive and unproductive uses
of credit.
(d) It is quite possible that the banks themselves through manipulations advance loans for
unproductive purposes.
(e) Selective controls do not have much scope under a system of unit banking.
(f) Development of alternative methods of business financing has reduced the importance of
selective controls

4.5 MONETARY POLICY:

In simple words, Monetary Policy refers to the policy formulated by the Central Bank of a
country to control and regulate the supply of money in tune with the economic conditions
prevailing in the country.
Objectives of Monetary Policy
Broadly speaking, there can be five major objectives of monetary policy. They are as follows:
1) Neutrality of Money
2) Price Stabilization
3) Exchange Rate Stabilization
4) Full Employment
5) Economic Growth