Rationing of credit as a qualitative instrument of credit control is a method used by the central bank to limit the amount and purpose of credit granted by commercial banks and other financial institutions to certain sectors or industries, according to the economic priorities and objectives of the central bank.
Rationing of credit can be done by the central bank in various ways, such as:
- Fixing a ceiling or a maximum limit on the total loans and advances that commercial banks can make to different categories of borrowers, such as agriculture, industry, trade, etc. This ensures that all sectors get adequate credit and that no sector gets excessive or insufficient credit.
- Fixing a ceiling or a maximum limit on the loans and advances that commercial banks can make against certain types of securities or collateral, such as food grains, gold, stocks, bonds, etc. This prevents the diversion of credit to speculative or non-essential activities and encourages the use of credit for productive or essential activities.
- Fixing a ceiling or a maximum limit on the loans and advances that commercial banks can make to individual borrowers or firms, irrespective of the type of security or collateral offered. This prevents the concentration of credit in the hands of a few large borrowers and ensures a wider distribution of credit among small and medium borrowers.
- Fixing differential rates of interest for different types of loans and advances, depending on the purpose, duration, security, etc. This makes credit more expensive for undesirable or risky purposes and cheaper for desirable or safe purposes.
Rationing of credit can be used by the central bank to achieve various goals, such as:
- To regulate the overall credit creation in the economy, depending on the economic conditions and the inflation or deflation situation.
- To direct the credit flow to certain priority sectors or industries that are considered socially or economically desirable, such as agriculture, small-scale industries, exports, etc., and to discourage the credit flow to certain non-priority or speculative sectors or industries that are considered harmful or risky, such as luxury goods, gambling, tobacco, etc.
- To maintain the stability and soundness of the banking system and to prevent any financial crisis or contagion.
Rationing of credit is a direct and selective method of credit control that gives the central bank more flexibility and discretion in regulating the credit operations of commercial banks and other financial institutions. However, rationing of credit also has some limitations and drawbacks, such as:
- It may create distortions and inefficiencies in the allocation of resources and may interfere with the market mechanism.
- It may create difficulties in monitoring and enforcing compliance by commercial banks and other financial institutions.
- It may create resentment and resistance among commercial banks and other financial institutions who may feel that their autonomy and profitability are affected by the central bank’s intervention.