CENTRAL BANK & CREDIT CONTROL & CREDIT CREATION

Central bank (RBI in case of India) is the first source of money supply in
the form of currency in circulation. The Reserve Bank of India is the note
issuing authority of the country. The RBI ensures availability of currency
to meet the transaction needs of the economy. The Total Volume of
money in the economy should be adequate to facilitate the various types
of economic activities such as production, distribution and consumption.

The commercial banks are the second most important sources of money
supply. The money that commercial banks supply is called credit money.

FUNCTIONS OF CENTRAL BANK

Central bank takes several actions to control and regulate the demand
and supply of money with the public and the flow of credit with the view
to achieve a predetermined macroeconomic goal.
The various measures taken by central bank in this regard are:

 Open market operation

 Discount Rate or Bank Rate
 Cash Reserve Ratio

OPEN MARKET OPERATION (OMO)

Open market operation comprises of the sale and purchase of

government securities and bills (generally termed as treasury bills) by the
central bank of the country.

In India, Treasury Bills are short term promissory notes issued by the
Govt. of India through the RBI. There are two kinds of treasury bills- 91
day and 182 day bills.
The 91 day treasury bills are issued by RBI on behalf of Govt. of India at
a fixed discount rate of 4.6%.
The 181 day treasury bills are sold by the way of auction to the residents
of India for a minimum value of Rs.100000. The auction bid is invited
every fortnight and the discount rate is decided on the basis of the
auction rate.

When the central bank decides to increase the supply of money in the
economy it purchases the bonds and bills and when it decides to reduce
the circulation of money in the economy it sells the govt. bonds and
securities. The open market operation is a powerful and widely used
measure to control and regulate the flow of money and credit.
Mechanism of Open Market Operation

The central bank carries out its open market operation through
commercial banks- it does not deal directly with the public. The buyers of
govt. bonds and bills include commercial banks, financial corporations and
big business houses. These customers hold their account with bank.
When they buy bonds and bills, money is transferred from their account
to RBI account. Thus, when the central bank carries out open market
operation it affects bank deposits and its credit capacity.
When the central bank decides to decrease the supply of money, it sells
govt. bonds and securities. In this way the money flows out from the
commercial bank account to central bank account. This reduces the cash
reserve of commercial banks which further leads to reduce in their credit
creation capacity. This increases the rate of interest.
On the contrary, when the central bank decides to increase the money
supply, it buys back govt. securities and bonds. Then the money flows out
from the central bank account to the commercial bank’s account. As a
result, the deposit and cash reserve of the commercial bank increases.
This enhances their credit creation capacity and the rate of interest goes
down.
The task of open market operation becomes easier when the government
owns the commercial banks as in the case of India.

DISCOUNT RATE / BANK RATE POLICY

Bank rate is the rate at which RBI lends loans to commercial banks.
When a bank faces financial crisis then RBI charges the commercial bank
a rate of interest against the loan and advances. Such rate is Bank rate. A
more appropriate name in usage now is the discount rate. Thus bank rate
or discount rate is the rate which the central bank charges on the loans
and advances to the commercial banks.

The central bank can increase or decrease the bank rate depending upon
the situation whether it wants to expand or reduce the flow of credit from
the commercial banks. When it wants to reduce the credit creation
capacity of the commercial bank, it increases the bank rate and vice
versa. This action of central bank is called bank rate policy or discount
rate policy.

The working of bank rate policy is simple. When the central bank changes
its discount rate, commercial banks also change their bank rate. Thus
when RBI raises its bank rate, commercial banks also raise their rates.
This results in the increase of cost of credit. It pushes the interest rate
up. The rise in interest rate reduces the demand of fund.

A fluctuation in bank rates triggers a ripple-effect as it impacts every

sphere of a country’s economy. For instance, the prices in stock markets
tend to react to interest rate changes. A change in bank rates affects
customers as it influences prime interest rates for personal loans.

THE CASH RESERVE RATIO or STATUTORY RESERVE RATIO

The cash reserve ratio is the percentage of total deposit which

commercial banks are required to maintain in the form of cash reserve
with the central bank. CRR has become a handy tool for the central bank
to control money supply. When economic conditions demand contraction
of money supply the central bank increases the CRR and when economic
situation demands expansion of monetary supply the CRR is cut down.

Mechanism of CRR

Suppose commercial banks have a total deposit of Rs. 100 crore and the
CRR is 20%. It means:
1. The banks can loan Rs. 80 crore and
2. The credit or deposit multiplier is equal to 5.
3. The banks can create, through the process of credit multiplier, a
total credit of Rs. 500 crore.

Credit or Deposit multiplier refers to the factor by which a commercial

bank deposit could grow by lending it over and over again.

Credit/ Deposit Multiplier= 1/CRR = 1/ 20% =5

Thus, Total Credit Creation= Deposit Multiplier X Deposit

= 5 X 100 = 500 crore.

Now if the central bank decides to reduce the money supply in the
economy and it increases the CRR to 25%. Then the credit/deposit
multiplier will go down to 4.
i.e., Credit/ Deposit Multiplier= 1/CRR = 1/ 25% =4

With this provision the banks can provide loan only to the extent of Rs.
75 crore and total credit created by the banks goes down to 100 X 4 =
400 crore. Thus, the total credit creation capacity of the banks goes down
by Rs. 100 crore. The effect will be reversed when the central bank cuts
back the CRR to 20%.
In India, the RBI has imposed another kind of reserve requirement in
addition to CRR, called Statutory Liquidity Ratio (SLR). The SLR is the
proportion of the total deposit which commercial banks are required to
maintain with them in the form of liquid assets (gold, govt. bonds) in
addition to cash reserve ratio. This measure was taken to prevent the
commercial banks from liquidating their liquid assets when CRR is raised.
What commercial banks used to do, before SLR was imposed, was to
convert their liquid assets into cash to replenish/restock the fall in their
loanable fund due to rise in the CRR.

REPO & REVERSE REPO RATE

In addition to above measures RBI uses Repo (Repurchase Operation

Rate) and Reverse Repo Rate to control and regulate the supply of money
and credit in the economy.

Repo Rate: Repo Rate is the rate that RBI charges the banks when they
borrow from RBI. Whenever commercial banks face the problem of of
shortage of money they borrow money from RBI. Repo Rate refers to the
interest at which the banks borrow money from RBI.

Reverse Repo Rate: Reverse Repo Rate is the rate that RBI offers the
commercial banks willing to keep their money with it. Or simply say,
Reverse Repo Rate is the interest rate at which RBI borrows money from
commercial banks.

Banks are happy to lend their money to RBI since their money is in safe
hands with good interest rates. Thus, when RBI increases the Reverse
Repo Rate, commercial banks will transfer more money to RBI. On the
other hand with the decrease in Reverse Repo Rate commercial banks
would not like to transfer their money to RBI and apart from this they will
withdraw their money from RBI.

Conclusion: RBI and control the situation of inflation and deflation with
the tool of Reverse Repo Rate. In inflationary situation it will increase the
Reverse Repo Rate while in deflation it will decrease the Reverse Repo
Rate.
CREDIT CREATION BY COMMERCIAL BANKS
The process of 'Credit Creation' begins with banks lending money out of
primary deposits. Primary deposits are those deposits which are
deposited in banks. In fact banks cannot lend the entire primary deposits
as they are required to maintain a certain proportion of primary deposits
in the form of reserves with the RBI under RBI & Banking Regulation Act.
After maintaining the required reserves, the bank can lend the remaining
portion of primary deposits. Here bank's lend the money and the process
of credit creation starts.

Suppose there are a number of Commercial Banks in the Banking System

– Bank 1, Bank 2, Bank 3, & So on.

To begin with let us suppose that an individual "A" makes a deposit of Rs.
100 in bank 1. Bank "1" is required to maintain a Cash Reserve
Requirement of 5% (Prevailing Rate) which is decided by the RBI's
Monetary Policy from the deposits made by 'A'. Bank "1" is required to
maintain a cash reserve of Rs. 5 (5% of 100). The bank has now lendable
funds of Rs. 95(100 – 5). Let the Bank "1" lend Rs. 95 to a borrower; say
B. the method of lending is the same that is bank 1 opens an account in
the name of the borrower cheque for the loan amount. At the end of the
process of deposits & lending, the balance sheet of bank reads as given
below:-

Balance Sheet of Bank "1"

Liabilities Amount Assets Amount

A's deposits 100 Cash Reserve 5

Loan to "B" 95

Total 100 Total 100

Now suppose that money that borrowed from bank "1" is deposited by B
to bank 2. Bank "2" is required to maintain a cash reserve of Rs. 4.75
(5% of 95). The bank has now lendable funds of Rs. 90.5(95 – 4.5). Let
the Bank "2" lend Rs. 94.5 to a borrower; say C the method of lending is
the same as that of bank 1. At the end of the process the balance sheet
of Bank 2 will be look like:-
Balance Sheet of Bank "2"

Liabilities Amount Assets Amount

B's deposits 95 Cash Reserve 4.75

Loan to "C" 90.5

Total 95 Total 95

The amount advanced to C will return ultimately to the banking system,

as described in case of B and the process of deposits and credit creation
will continue until the reserve with the banks is reduced to zero. The final
picture that would emerge at the end of the process of deposit & credit
creation by the banking system is presented in the consolidated balance
sheet of all banks are as under:-

The combined Balance sheet of Banks

Bank Liabilities Assets Reserve Total Assets

Deposits Credits

Bank 1 100 95 5 100

Bank 2 95 90.5 4.75 95

Bank 3 90.5 85.98 4.52 90.5

- - - - -

- - - - -

Bank n 00 00 00 00

Total 2,000 1,900 100 2,000

It can be seen from the combined balance sheet that a primary deposits
of Rs. 100 in a bank 1 leads to the creation of the total deposit of Rs.
2,000. The combined balance sheet also shows that the banks have
created a total credit of Rs. 2,000. And maintained a total cash reserve of
Rs.100.Which equals the primary deposits. The total deposit created by
the commercial banks constitutes the money supply by the banks.

CONCLUSION:-

To conclude, we can say that credit creation by banks is one of the

important & only sources to generate income. And when the reserve
requirement increased by the central bank it would directly affect on the
credit creation by bank because then the lendable funds with the bank
decreases and vice versa.