Instruments of Credit Control

Instruments of credit control are the policy tools used by a central bank (in India, the Reserve Bank of India) to regulate the availability, cost, and direction of credit in the economy. Through these instruments, the central bank manages liquidity, influences interest rates, controls inflation, and ensures financial stability while supporting sustainable economic growth.
These instruments are broadly divided into two categories — Quantitative (General) and Qualitative (Selective). Quantitative measures influence the total volume of credit, while qualitative measures regulate its purpose and allocation among sectors.

Objectives of Credit Control

• To maintain price stability and control inflation or deflation.
• To ensure adequate credit for productive activities and economic growth.
• To promote financial discipline in the banking system.
• To maintain exchange rate stability and balance of payments equilibrium.
• To ensure employment and steady output through balanced monetary expansion.

I. Quantitative (General) Instruments

Quantitative credit control measures regulate the overall quantity of money and credit in the economy, affecting all sectors uniformly.

1. Bank Rate Policy

The bank rate is the rate at which the central bank lends funds to commercial banks or rediscounts their eligible bills.

• When the bank rate increases, borrowing from the central bank becomes costlier, reducing credit creation and controlling inflation.
• When the bank rate decreases, borrowing becomes cheaper, encouraging lending and stimulating growth.

This traditional tool is used to signal changes in the monetary policy stance.

2. Open Market Operations (OMO)

Open Market Operations refer to the buying and selling of government securities by the central bank in the open market.

• Sale of securities absorbs liquidity from the banking system and contracts credit.
• Purchase of securities injects liquidity, expanding credit and encouraging investment.

OMO is a flexible and widely used instrument for day-to-day liquidity management.

3. Cash Reserve Ratio (CRR)

The Cash Reserve Ratio is the proportion of a bank’s total deposits (Net Demand and Time Liabilities) that must be maintained as cash reserves with the central bank.

• Higher CRR reduces banks’ lendable resources, controlling inflation.
• Lower CRR increases liquidity, encouraging credit expansion.

By adjusting CRR, the central bank directly influences the credit creation capacity of banks.

4. Statutory Liquidity Ratio (SLR)

The Statutory Liquidity Ratio is the percentage of a bank’s deposits that must be held in the form of liquid assets such as cash, gold, or approved government securities.

• Increasing SLR reduces funds available for lending, tightening credit.
• Reducing SLR releases funds for lending, expanding credit.

This ensures the solvency of banks and supports monetary control.

5. Repo Rate and Reverse Repo Rate

These are key short-term policy rates under the Liquidity Adjustment Facility (LAF).

• Repo Rate: The rate at which the central bank lends money to commercial banks against government securities.
  • An increase in repo rate curbs inflation by making borrowing costlier.
  • A decrease in repo rate boosts liquidity and stimulates lending.
• Reverse Repo Rate: The rate at which the central bank borrows funds from commercial banks.
  • A higher reverse repo rate absorbs excess liquidity from the system.

These rates are frequently adjusted to maintain short-term liquidity and inflation control.

6. Marginal Standing Facility (MSF)

The Marginal Standing Facility allows banks to borrow overnight funds from the central bank at a rate slightly higher than the repo rate. It serves as a last-resort borrowing window for banks facing temporary liquidity shortages.

7. Credit Ceiling and Credit Rationing

The central bank may impose a credit ceiling on the total amount that banks can lend or ration credit among banks to maintain monetary stability. Such measures help restrain excessive lending during inflationary phases.

II. Qualitative (Selective) Instruments

Qualitative credit control tools guide the allocation and direction of credit to ensure that lending benefits productive sectors and discourages speculative or unproductive uses.

1. Margin Requirements

The margin requirement is the difference between the value of collateral and the loan amount.

• Increasing margin requirements restricts speculative borrowing.
• Reducing margin requirements encourages borrowing for productive purposes.

This tool is particularly effective in controlling speculative credit in commodities and securities.

2. Regulation of Consumer Credit

The central bank regulates the terms of consumer credit for durable goods by controlling down payments and repayment periods.

• Tightening credit terms reduces consumer demand during inflation.
• Relaxing credit terms stimulates demand during deflation.

3. Moral Suasion

Moral suasion refers to the central bank’s use of persuasion, advice, and appeals to influence commercial banks’ lending policies in line with national priorities. It relies on cooperation rather than compulsion and is often used to curb excessive lending or encourage credit flow to priority sectors.

4. Direct Action

When banks fail to follow the guidelines or credit policies of the central bank, direct action may be taken in the form of:

• Denial of refinancing or rediscounting facilities.
• Penalties or restrictions on operations.
• Withdrawal of certain privileges.

This ensures compliance with monetary regulations.

5. Selective Credit Control (SCC)

The central bank can impose specific restrictions on credit for particular commodities or activities that may cause price instability.

• For instance, the RBI may restrict credit for speculative trading in essential commodities like sugar or oilseeds.
• Such controls help prevent hoarding, speculation, and inflationary pressures.

III. Modern Supplementary Instruments

In addition to traditional methods, modern tools have been developed for refined control of credit and liquidity:

• Liquidity Adjustment Facility (LAF): Uses repo and reverse repo operations to adjust short-term liquidity.
• Market Stabilisation Scheme (MSS): Used to absorb excess liquidity through government securities.
• Monetary Policy Corridor: The gap between the repo and reverse repo rates sets a floor and ceiling for short-term interest rates.

IV. Comparative Overview