Measures of Selective Credit Control for Banking

Qualitative or selective credit control policy refers to the set of policies implemented by the central bank in order to channelize the available credit in-the desired direction. For example, suppose in India the agricultural and small scale industry sectors are to be encouraged, then the RBI may direct the commercial banks to be more liberal in lending to these sectors and be strict while lending to other sectors. This will help the economy to provide ample opportunities for the priority sectors to grow. In other words, in every country the government determines in advance the priorities and to ensure that the banks conform to the priorities in their lending policies, the selective credit control policies are implemented. Hence, while the quantitative credit control policies aim at controlling the volume of credit created, and the money supply in the economy, the qualitative credit control policies help in using the available funds only for the important purposes and discourage unnecessary lending by commercial banks.

Objectives of Selective Credit Control

The objectives of the selective credit control policies are :

  1. To divert available funds only to the urgent and desirable purposes,
  2. To control and regulate a particular sector an economy without affecting the entire economy as a whole
  3. To discourage wasteful and uneconomical consumer expenditure on non-essential items.
  4. To correct the unfavorable balance of payments of a country and
  5. To control and regulate even the non-banking financial houses or intermediaries.

Methods of Selective Credit Control

The important methods of selective credit control policies are discussed in detail.

1. Margin Requirements

It is well known that commercial banks lend against valuables and securities. These securities are the collateral for the amount lent. While accepting the securities for the loan the banks first asses the market value of the securities and then considering the amount of loan required the bank would require the margin to be paid by the borrower which on most occasions is the difference between the market value of the securities and the amount of loan required. However, the central bank has the right to determine the margin amount payable by the borrowers. This margin amount is stipulated in terms of percentage of the value of the securities offered or the amount of loan required. The central bank can vary this percentage of margin requirement from time to time to regulate the flow of credit on certain securities. In other words, central bank can also fix different percentages of margin requirements on different types of securities against which the loan is given,    this method is effectively used to counter inflationary a deflationary conditions in an economy.

The major advantages of this method are:

  1. It ensures use of available funds only for productive and useful purposes,
  2. It discourages speculative activities,
  3. It helps to control inflation by diverting the funds available to produce only goods which will help to bring down the price level and
  4. It encourages sound investment projects.

However, this method has serious limitations as explained below :

  1. Fixation of very high percentage of margin may drive the borrowers to black: money market and
  2. It may encourage collusion and corruption among the bank officials to show undue favors to certain borrowers.

2. Regulation of Consumer Credit

According to this method of selective credit control the commercial banks are instructed to encourage borrowing for certain purposes and discourage certain, other types of borrowing. Usually consumers approach the commercial banks for loans to buy durable consumer good like T.V., refrigerators, washing machines, etc. The banks would direct the consumers to pay a part of the price of the item to be purchased and the, remaining amount is given as credit. The central bank may regulate the consumer credit in different ways. Most popular methods are:

  1. Central bank may extent or curtail the consumer loans to buy certain items during a particular time. For example, during inflationary period, the central bank may curtail the commercial banks from lending to enable consumers to buy T.V. fridge, etc. Then the demand for these luxury items will come down bringing down their price and indirectly helping to control general price level.
  2. The central bank may alter the initial money to be deposited by the borrower and through that encourage or discourage borrowing. For example, during inflationary situation, the central bank may instruct the commercial banks to get 40% of the value of the item to be purchased as the initial deposit payable by the consumer. Then this would discourage the consumer from borrowing. During the normal period this initial deposit requirement may be reduced to just 10%.
  3. Changing the maturity period of the loan is one more method of consumer credit regulation. Suppose the central bank wants to encourage the consumer credit, then it may allow maximum repayment period say 60 months. On the other hand, if it wants to discourage the consumer credit, it may fix the maximum repayment period as only 30 months. Accordingly the lending operations will increase or decrease.
  4. Changing the rate of interest on consumer credit is one more usual method to regulate. Increase in rate of interest will discourage borrowing while reducing the interest will encourage borrowing.

3. Control Through Directives

This method means the periodical directions, instructions, information, guidelines and warning issued by the central bank to the commercial banks to make the latter follow the credit policies of the former. The main objectives of this method are :

  1. To control the lending policies of the commercial banks.
  2. To channelize the available credit to more productive and urgent uses from less urgent and less productive purposes.
  3. To completely prohibit lending towards a particular purpose and
  4. To determine the maximum amount that could be lent for certain purposes.

Every central bank is empowered to issue such directive by virtue of the statutory powers conferred on it and usually the central bank implement this policy by offering incentives like liberal refinancing facility to banks which follow the directives and restraining the erring banks by arranging for scrutiny of their lending pattern or imposing penalties for violation. In practice the commercial banks usually follow the guidelines and directives of the central bank and conflict on the ground seldom arises.

4. Rationing of Credit

It is necessary for every commercial bank to approach the central bank to improve its liquidity in times of need. Central bank can effectively use this dependence of commercial banks to control the credit creation or make them work according to the need of the time. Rationing of credit can be interpreted in two ways:

  1. The central bank may fix the maximum amount of financial accommodation to an commercial bank on the basis of re-discounting facilities.
  2. The central bank may fix the quota for every commercial bank for financial accommodation.

The central bank may use the policy in any one of the two ways or both the ways, For instance, it may feel that a particular bank is creating excessive credit. To control this central bank may fix the maximum amount of financial accommodation that the particular commercial bank can get from central bank through re-discounting of eligible bills with central bank. This will certainly make the commercial bank to control its credit creation. But this method of credit control has certain limitations. Firstly, the central bank is suppose to be the lender of last resort for the commercial banks. But when it rations the credit to the commercial banks, it appears to be contradicting its role as a lender of the last resort. Secondly, the method is not so effective in a situation where the commercial banks have built up sufficient reserve so that they need not approach the central bank in times of need. In that case, rationing of credit has no purpose to serve. Thirdly, this method can be effective only when there is excess demand for credit over the supply of credit. However, the central bank uses this policy along with the other policies in order to improve the over all effectiveness of the selective credit control policies.

5. Moral Suasion

Moral suasion refers to the persuasive approach of the central bank towards the commercial banks in making the latter follow and implements the policies of the former. Though the central bank is empowered to take direct action on the erring or violating commercial banks, yet it exercises that option only rarely. In its place, the central bank takes efforts to explain to the commercial banks the need for following certain policies. This is done either through periodical conference with commercial banks, or by appealing to the sentiments of the commercial banks. In effect this method aims at bringing to commercial banks into line through use of moral force instead of resorting to the legal powers. It should be noted that this method has no legal back up or support. It is merely applied using the conventional relationship between the commercial banks and the central bank. It has been quite successful in countries like UK, France, Holland and others. But it has not been very effective in USA under the unit banking system. In India, the RBI has found this to be very effective as there exists a very cordial relationship between the central bank and commercial banks. Of course, the success of this policy depends on the prestige, influence and leadership of the central bank. Further since it has no legal back up in times of credit expansion it is not effective.

6. Direct Action

Direction action is one more method of selective credit control in which the central bank uses coercive measures against the erring commercial banks or banks violating the central bank ruling. It may vary from general instructions to the banks to special directives to the erring banks. Though this method has the legal sanction, central banks around the globe rarely apply this method. As a matter of direction action, central banks are vested with vast powers ranging from refusing credit and re-discounting facilities or imposing penal rate of interest on banks which have sought financial accommodation from central bank beyond the prescribed limit. In several countries, the central bank is empowered to formulate general credit policy or prescribe the rates of interest on different types of loans and advances or to divert the available bank credit to a particular industry etc. Though this method is very effective it is very rarely applied in isolation. It is normally combined with other methods.   But this method has certain limitation like:

  1. Direct action on commercial banks may make them work against the central bank at least psychologically.
  2. The commercial banks are at a loss sometimes to follow the policy of central bank regarding productive and unproductive lending, essential and non-essential borrowing, etc., in the absence of clear cut definition.
  3. The central bank through this method is able to regulate the functioning of commercial banks only.  It cannot control directly any misuse of credit by any borrower.
  4. This role of central bank contradicts its traditional function as the last resort.

7. Publicity

Use of publicity as a method of selective credit control is a debatable question. In advanced countries this is used as an effective method of credit control while developing countries it is yet to be recognized as a measure. Howeverthe central bank can public its views, opinions, policies, guidelines, directions, observations, etc., periodically about the economic situation prevailing in the country of economic variables behavior, money market, public finance, trade, industry, agriculture, etc.  Such publications help to understand the changing situations and the needs of a country.  The commercial banks are able to formulate their policies with the back ground information published, by the central bank, this method is very widely used in most of the advanced countries and in India the RBI publishes various statements, circulars, returns, etc., helping the country to follow the changing economic situations and through that guiding the commercial banks. But the effectiveness of this method of credit control is debatable and it is usually applied along with the other methods control along with the other methods of credit control.

Limitations of Selective Credit Control

On the whole all the methods discussed above are not free from limitations which are explained here under:

  1. The selective credit control policies are applicable to commercial banks. Institutions in the unorganized sector and the non-banking financial intermediaries are left out of the coverage. As a result these policies may land commercial banks in a disadvantageous position.
  2. In the absence of clear cut definition of productive and unproductive lendings, commercial banks cannot be effectively controlled through these policies.
  3. These policies are ineffective as the commercial banks are unable to ensure the use of funds for the purpose for which they are given.
  4. Commercial banks are encouraged to resort to manipulations and unhealthy practices to remain outside the effect of these policies.
  5. In practice, these policies were not found to be effective in unit banking system.
  6. These policies have no relevance if the businessmen, investors and other resort to different methods of raising funds than approaching the commercial banks.
  7. It has to be noted that credit is one of the factors affecting the price of goods and services but control of credit-alone cannot bring about the desired changes in price level. In this respect, the selective credit control policies can be treated only as the alternative available and not the only method of achieving economic stability.

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