CREDIT POLICY
It is good to have this opportunity of discuss some important issues at a Credit Conference of the American Bankers Association. I am especially glad to have the opportunity to discuss the distinctions and interactions between federal Reserve monetary policy and commercial bank credit policy, as the title of my talk suggests. A common fallacy is to refer to money and credit interchangeably. A central point throughout my remarks will be that money and credit are not the same. there is no doubt that central bank monetary policies affect commercial banks credit policies, and I would venture that the credit polices engaged in by commercial banks have influenced monetary policies. Nevertheless, one should not think of them as being the same.1
I will begin by highlighting the distinction between money and credit, and with this distinction in mind, I will review recent monetary and credit developments as I see them.
As you are probably all aware, every Thursday evening the Federal Reserve releases for publication recent data on Federal Reserve credit, bank deposits, reserves, and related items. The Friday morning editions of major newspapers usually carry a column in which these data are reported and interpreted. One Friday last year the heading of one such column in a major newspaper stated that “A Limited Easing of Credit is Seen”. The first sentence of that column told us, and I quote, “Federal Reserve credit policy appears to be moving gradually toward a less restrictive stance, banking data published yesterday showed.”
That same morning a comparable column in another leading newspaper was headed by the words “Fed Reports Tight Money Back Again.” The first sentence in this column told us, and again I quote, “Federal Reserve weekly statistics showed that the basic money situation has shifted back to the fight side after some temporary factors. Presumably the authors of each of these columns had before them the same data, so apparently they chose different items as being important.
I would like to discuss the issues involved in the distinction between money and credit, and to make clear my view of the relevant measures to look at when assessing the influence of monetary actions. I shall content that there is one appropriate measure when assessing the impact of such actions on over-all economic activity and one should take quite different approach when analyzing the effects on various segments of our economy of the credit policies of commercial banks and other financial institutions.
Monetary Policy:
The Influence of monetary policy, which in recent times in the United States had been almost the exclusive province of the United States has been almost the exclusive province of the Federal Reserve, operate on aggregate spending in the economy. I believe the fundamental objective on monetary policies is to provide conditions conducive to an appropriate rate of growth in demand for services, consumption goods, and investment goods. This rate of growth should be equal to the ability of the economy to produce such goods and services. I admit that it is far easier to state this objective than to achieve it. The distributional effects to monetary actions on various sectors are not usually the primary goals of the policymakers. Although such distributional effects are much less predictable than are the effects on aggregate demand.
The channel through which monetary actions affect aggregate demand is by varying the quantity of money made available to the private sector of the economy. If money is provided at a rate greater than the at which businesses and individuals desire to acquire currency and demand deposit balances, then the effort to exchange these excess money balances for other assets will increase aggregate demand for goods and services. Conversely, if businesses and individuals desire to acquire currency and demand deposit balances faster than the rate at which the total amount of money is increasing, their efforts to build up such balances will result in a decrease in the demand for goods and services.
The primary tool of the Federal Reserve in the conduct of monetary policy is buying and selling securities in the open market. It is useful to summarize shout-term monetary actions within the framework of a concept called the monetary base. When the Federal Reserve increases its holdings of Government securities, which is the dominant source component of the monetary base, the primary uses of the base, currency held by the public and bank reserves, are increased. The growth trend of the money stock, even though shot-term movements in the money stock may also be influenced by changes in time deposits and U.S Government deposits at commercial banks.
Studies of the money creation process conducted at the Federal Reserve Bank of St. Louis as well as elsewhere indicate that the stock of money supplied to the economy could be adequately controlled on a monthly average basis. As techniques for establishing the appropriate amount of money to supply under varying conditions are improved and gain wider acceptance, the fundamental objectives of monetary policy, as I view them, can be met with greater reliability than in the past.
I think it is important to note that during the process of monetary expansion, the credit policies of commercial banks, interacting with forces emanating from the nonbank public, determine the sectors that are first affected. I will return shortly of further discussion of this process.
Federal Reserve “Credit Policy”:
I do not intend for my remarks concerning monetary policy to imply that the federal Reserve cannot or does not take actions which have a direct bearing on commercial banks credit policies. Since monetary and the price of credit extended by banks are affected. This is one important channel through which monetary actions influence the real sectors of the economy.
However, a side from the monetary actions of the Federal Reserve which have a direct bearing on the growth of aggregate demand for goods and services, the Federal Reserve can and does take actions which have a significant impact on the quantity, and price of bank credit. Furthermore, these actions may have no more than marginal effect on the total amount of credit outstanding. This brings me back to my central point regarding the distinction between money and credit.
An increase in the stock of money increases the total purchasing power of the economy, whereas changes in the composition of total private sector credit may represent only a re-channeling of the flow of purchasing power that is transferred from some economic units to other economic unit chooses to save some of its current income by increasing its holdings of time or savings deposits at a bank, it is choosing to forego some present spending in order to preserve some purchasing power for future use. When a commercial bank, in its intermediary role, uses the proceeds of the increased deposits to purchase securities of increase its business or consumer loans, the present purchasing power preserved by one economic unit is transferred to another economic unit. This transfer permits some economic units to obtain more current command over services, consumption goods or investment goods than their own income would otherwise allow.
One example of an action that could be taken by the Federal Reserve, which would affect the credit policies of banks would be to lower or hold the maximum interest rates banks are permitted to pay on time and savings deposits below the yields available to servers from competing institutions or financial instruments. Under such circumstances, these deposits will flow out of commercial banks, and the amount of bank credit extended to the public will contract. In addition to a decrease in the volume of bank credit, there will be an increase in the price of such credit since banks will allocate the available supply of funds of those most willing and best able to pay, given quality and other considerations.
A decrease in the volume of bank credit resulting from such an action by the central bank will not necessarily reduce the total credit flow in the economy; only the flows through the most efficient channels are altered. The experience with regard to CDs U.S. Treasury bills, commercial paper, and direct loans in recent years confirms this pint. Once short-term market rates of interest had risen to the pont that the yields banks were permitted to pay on time deposits were on longer competitive, the volume of these deposits at banks declined. Banks were forced to sell securities and contract loans. However, corporate depositors merely shifted to directed ownership of short-term Government securities and to placement of short-tem loanable funds on the commercial paper market.
Credit Policies of Commercial Banks:
I will now turn to a discussion on the credit policies of commercial banks during the past two years, with references to the monetary actions taken during the same period. For background. I will digress for a moment to a summery of the developments during 1967 and 1968. Throughout those two years every aggregate monetary measure, including Federal Reserve credit, member bank reserves, the monetary base, and both the broad and narrow definitions of the money supply, were expanding at excessively rapid rate. I assume that in retrospect there is little disagreement that monetary policies were highly simulative during that period, although at the time some observers chose to point to the rising interest rates as being an indication that restrictive monetary policies were being pursued.
At the same time, total loans and investments at commercial banks were rising at historically rapid rates. Taking volume as the appropriate measure. one would say that bank credit policies were very easy. However, the borrowers were pointing to the price they were paying and arguing that credit was tight. I suspect that the nation’s biggest borrower, the U.S Treasury, felt that the price they paid for funds at the time was an indication of tight credit.
The developments in the first half of 1969 highlight the distinction between monetary and credit policies. From January to July 1969 the narrowly defined money stock (demand deposits plus currency held by the public) grew at a little more than a 5 per cent annual rate, which was somewhat less simulative than the 7.5 per cent rate of growth of the previous two years, but certainly not sufficiently to bring an early end to the considerable inflation that had been generated.
By early 1969 most market interest rates had reached a point where Regulation Q ceilings on the rates banks were permitted to pay on time deposits began to sharply impinge. Since banks were less able to compete for funds, total time deposits at commercial banks contracted throughout 1969. The contraction was much sharper in the second half of the year than in the first. As a result of the considerably reduced growth of total deposits, banks were forced to correspondingly reduced their rate of total credit expansion. The growth of total loans and investments in early 1969 was less than half the rate of the previous two years.
Judging from the substantially slower growth a bank credit, and the continued high and sharply rising interest rates in early 1969, it would appear that policies were much more restrictive than indicated by the somewhat reduced growth rate of the money stock. The reduced growth of bank credit, however, was manifested almost entirely in a rather sharp contraction in the security holdings of banks. There was little slowing in the growth of loans outstanding. Thus, from a loan volume standooint, one would conclude that bank credit available to loan customers that bank credit available to loan customers had tightened.
Turning to the second half of 1969, there is no question that both federal reserve monetary policy and commercial bank credit policies were tight. The money stock was essentially unchanged from July to December 1969, which was very restrictive in view of the inflation we were experiencing. Furthermore, time deposits at banks continued to decrease as market interest rates remained high compared to the ceiling rates banks could offer. Large banks turned to non deposit sources of funds to offset the contraction in total deposits. As a result, banks managed a small increase in the volume of credit outstanding in the second half of the year, with loans outstanding continuing to grow at moderately rapid rates while bank investments contracted almost as rapidly.
From the outset of 1970 the Federal reserve moved in the direction of easier monetary policy and also took a series of actions which had the effect of bringing about easier credit conditions. Growth of the money stock was resumed and maintained, and by the end of 1970 the amount of money in the hands of the public was 5.4 percent greater than a year earlier. Considering the inflationary forces continuing in 1970. Monetary policy during the year should b viewed as sufficiently expansionary to prevent substantial declines in real production and provide for the gradual abatement of the rate of the rate of price advances. At the same time the monetary policy of the past year has been adequately easy to facilitate the adjustment process of changing national priorities inherent in the partial demobilization of military forces and shifts in production from defense to non-defense related industries.
The first step taken by the federal reserve in early 1970 to help ease the credit flow through banks was to raise the ceilings on the rates banks were permitted to pay on small time and savings deposits. This improved somewhat the banks’ competitive position in attracting funds, but probably of considerably greater significance was the decline in market interest rates.
Early in 1970 the demand for credit was contracting and short-term interest rates began declining, as a result of the sharply restrictive monetary actions of late 1969. In February 1970 market interest rates had moved down sufficiently that rates on bank deposits again became competitive, and all types and sizes of time deposits, banks were again able to acquire earning assets and to reduce their use of relatively expensive non-deposit it sources of funds. The composition of bank credit extended in 1970 was opposite that of the previous year. Whereas banks had sold securities in 1969 in order to accommodate a continued strong loan demand, the growth of bank credit in early 1970 was all investments, as total bank loans reminded about unchanged from December 1969 to June last year.
The very rapid growth of bank credit and the sharply declining interest rates last year indicate very easy credit conditions. However, this type of ease should not be construed as having any implications regarding subsequent strength of aggregate demand or indicating resurgence of forces contributing to increased inflationary pressures. The re-intermediation of time deposits at commercial banks reflected mainly changes in the ownership of securities and a return of the flow of credit through channels that had been closed or considerably narrowed during the previous year.
At the end of 1970 banks had increased their outstanding loans by only 4 per cent from December 1969, while bank investments rose over 14 per cent during the same period. I think it is clear that the very rapid growth in the volume of total credit extended by banks, and the significantly lower prices of that credit as the year progressed, should not be construed to indicate that the Federal Reserve was engaged in highly simulative policies.
Suppose economic conditions had not been such in early 1970 that the Federal Reserve took actions which caused resumption in the growth of the money stock. Market interest rates on short-term instruments would have still declined in the face of reduced demand for funds, although probably not so rapidly. Generally falling short-term interest rates, together with the actions that raised or abolished the maximum rates banks could pay on some time and savings deposits would have been sufficient to cause rapid re-intermediation of time deposits at commercial banks, even if monetary policy hard remained as restrictive as in late 1969. This return of funds to banks through time deposits would have provided for a substantial increase in bank credit, although somewhat less than actually occurred.
Meaning of Credit Policy:
Guidelines that spell out how to decide which customers are sold on open account, the exact payment terms, the limits set on outstanding balances and how to deal with delinquent accounts.
Though most consumers expect to pay cash or use of credit card when making a purchase, commercial customers typically want to be billed for any products and services they buy. You need to decide how much credit you’re willing to extend them and under what circumstances. There’s no one-size-fits-all credit policy your policy will be based on your particular business and cash-flow circumstances, industry standards, current economic conditions, and the degree of risk involved.
As you create your policy, consider the link between credit and sales. Easy credit terms can be an excellent way to boost sales, but they can also increase losses if customers default. A typical credit policy will address the following points.
Credit limits: You’ll establish dollar figures for the amount of credit you’re willing to extend and define the parameters or circumstances.
Credit terms: If you agree to bill a customer, you need to decide when the payment will be due. Your terms may also include early-payment discounts and late-payment penalties.
Deposits: You may require customers to pay a portion of the amount due in advance.
Credit Cards and Personal Checks: Your bank is a good resource for credit card merchant status and for setting policies regarding the acceptance of personal checks.
Customer Information: This section should outline what you want to know about a customer before making a credit decision. Typical points include years in business, length of time at present location, financial data, credit rating with other vendors and credit reporting agencies, information about the individual principals of the company, and how much they expect to purchase from you.
Documentation: This includes credit applications, sales agreements, contracts, purchase orders, bills of lading, delivery receipts, invoices, correspondence and so on.
Principles of Credit Policy:2
Lending is most profitable business of a commercial bank, but at the some time it is highly risky. Loans always accompany credit risk arising out of borrowers default in repaying the money a banks should, therefore, manage loan business in a profitable and safe manner. He should take all precautions to minimise the risk associated with loan. In considering loan proposal the banker must keep in mind certain general principles of lending. The principles are discussed below.
Safety: Safety of funds is the most important guiding principles of a banker. While lending out funds a banker should ensure that funds being lent out would remain. Safe otherwise the bank will not be in a position to repay his deposits and consequently it will lose public confidence which may subsequently, spell death knell of the bank itself. Safety of funds implies that the borrower would repay the principal sum and interest as per the terms and conditions provided in the loan agreement. A banker should always take a calculated risk. This is why a banker always insists upon collateral margins and guarantees in addition to personal promise of the borrower.
Liquidity: Since majority of commercial bank liabilities are payable either on demand or after short notice the banker should ensure that loan would be liquid. Liquidity as already defined signifies the readiness with which the bank can convert its assets into cash with number or insignificant of loan will be liquid. If it has been given for a short period to finance same purchase of stock, raw materials etc.,
Diversification of Risks: A banker should aware to the principle of diversification while lending out funds. Diversification implies dispersal of funds over a large number of borrowing firms situated in different regions of the country. Diversification is a means of minimising risk inherent in loans.
The most important form of diversification which a banker should attempt to achieve in the banker loan portfolio is maturity diversification. Under maturity diversification loan portfolio is staggered over different maturity periods. So that, a certain amount of loans mature at regular intervals which could be utilised to meet the depositors demands. If such funds are not needed the same can be lent but invested in securities that best fit into the bank’s loan and investment portfolio.
Profitability: Equally important is the principles of profitability in bank advances. Like other commercial institutions banks must make sufficient income to pay interest to the depositors, establishment expenses to retain a portion of income for future and to pay dividends to owners. The difference between lending and borrowing rates constitutes gross profit of the bank and no banker ordinarily think of an advance without satisfying margin or profit.
Purpose: Bankers should inquire into the purpose of the loan for which, it is taken. As a matter of fact safety and liquidity of loan depend on the purpose. If an advance is given for productive purpose say for financing purchase of inventories in all profitability – it will be rapid because grant of loan will a generate additional income sufficient to repay the loan. In the advance made for non-productive and speculative purpose is subject to greater credit risk because the purpose for which loan was sought would in no way improve repaying capacity of the borrower.
Characteristics of Commercial Bank Loan in India:
Bulk of the bank loans in India is provided to trade and industries bank are lackadaisical to agriculture sector, because of relatively high greater credit risks inherent in it and in ability of agriculturists to furnish good amount of security.
Another striking feature of a bank loan in our country Is that nearly three fourths of it is given for a period for a period of less than one year. This is essentially because of high liquidity of such loans. The short term loans are given for financing seasonal needs of businessmen and also for working capital purpose to facilitate the process of production and distribution. Seasonal loans are primarily for the purpose of increasing the inventory of a business firm.
Commercial banks in India demand sound security for loans. A very high percentage of advances 80-90% by Indian Banks are secured by goods, financial asset and hypothecation. A major portion of the bank credit is given against the security of commodities which represent short term security unsecured credit facilities are given to firm with sound financial position and stable earnings records.
Bank borrowers mostly lie in average profitability group a highly profitable firm would rely less on bank loans for financing expansion or current needs because it has sufficient earnings to do so. Contrary to this less profitable concerns or less sustaining concern need bank support to hide over their grim financial position caused by shortage of liquid funds.
Another characteristics of bank borrowers is that most of the business concerns borrowing bank money are relatively small, young and growing one’s. It is obvious to find smaller firms to depend more on bank loans for financial their needs because of their limited assess to other sources of financing.
Need of the Credit Policy:
The credit policy documents that carefully specifies the do’s and don’t’s while sanctioning the loan proposals. Instead guideline can be given within the credit policy for the decision makers to enable them to screen out loans proposals which can be out rightly rejected loan than can be sanctioned without any reference to the top management.
Factors influencing loan policy in a Bank:
The important factors which go into the determination of loan policies of a bank are following.
Capital Position: Capital position is probably the most important factor influencing loan policies of a bank. As observed earlier capital provides cushion to absorb losses that may occur. It serves as a protective factor against losses for depositors and guarantee fund to creditors. A bank with strong capital position can assure more credit risk than one with weak capital position. Accordingly the former can follows liberal lending policy and provide different types of loan including long-term loans promising higher interest rates which the latter cannot do so because of the greater risk involved.
Earning Requirements: Profit making is one of the principal objectives of a commercial bank. However, some banks may be in a position to emphasis income, but others may stress on liquidity. These banks who have set income as the principal goal of their lending would follow aggressive policy of lending and might make large amount of term loans or consumer loans which normally are made at higher interest rates because of relatively greater amount of risks, which they accompany. This should not suggest that banker would take under risks for a accomplishing the objective of profitability, where earning receive greater emphasis in loan policy of a bank it may mean that the would keep a larger amount of secondary reserves or it would include in its investment account securities carrying shorter maturity periods and possess relatively less risks.
Deposit Variability: Banks that have experienced credit movement in their deposits will have to follow conservative lending policy. They cannot afford to incur undue risks by extending term lending facilities. Similar policy should also be followed where banks are faced with declining deposits. In a refreshing contrast with this liberal lending policy can be pursued by banks whose deposits show little or no fluctuations and who can easily predict fluctuations in deposits and loan demands and make provision for them through secondary reserves. Banker whose deposits have shown rising tendency in the past and expect the rising trend to persist in future can also be liberal in their loan policy.
State of Local and National Economy: In formulating lending policy for his banks the banker should also keep in mind economic conditions that are prevailing in the region served by the bank. A bank operating in an area which is subject to seasonal and cyclical fluctuations can ill afford to adopt liberal policy because that would entail the bank in hazards of illiquidity. But in stable economy where possibility of fluctuation in levels of deposits and loan demands is limited the banker can follow liberal loan policy. If economic conditions of the country are expected to improve and level of business activity is likely to increase banker can liberalise lending policy by relating credit standards and security requirements to accommodate those borrowers who were either refused banking faculties due to stiff credit policy.
Monetary Policy: Monetary policy of central banking authorities goes a long way in determining the lending policy of a commercial bank. Through variation in minimum reserve requirement and net liquidity ratio central bank influence, the lending ability of banks. Thus, by reducing the proportion of minimum cash reserve which a commercial bank is required to carry with the central bank and reducing net liquidity ratio and bank would get additional funds which can be utilised in lending form. In the event the cash reserve ratio and net liquidity ratio is increased lending ability of bank is limited.
Ability and Experience of loan Officers: Loan officers in a bank play a significant role in execution of loan policies of the bank. The board should therefore, consider the skill and competence of the bank loan officers while laying down loan policy. Where a bank is staffed with a larger number of credit officers having expertise knowledge and rich experience in diverse forms of loans the banker can afford to provide different types of lending faculties and formulate the policy accordingly. But this cannot be done by banks whose credit officers are competent to deal with certain types of loans. This is why smaller banks have been found limiting their lending business to short-term loans. Most of those banks have obtained from consumer lending and also term-lending to business enterprises because they were equipped with skilled personnel.
Competitive Position: In formulating loan policy the management should give consideration to the competitive position of the bank. Where a bank finds that strong competing institutions exist, say in the field of term lending and the management feels that it cannot afford to provide the loans on terms being offered by the other existing institution, it might follow a policy of refraining the bank from entering in the sphere of term-loans.
Credit needs to the Area Served: Credit needs of the area served by the bank would also influence the loan policy. A bank is supposed to meet Loan demands of all local borrowers who present logical and economically sound loan requests and granting of such requests would not violate the prudent banking. If this cannot be done there will be little justification for an institution to exist in that region. Thus in an economy predominantly dependent on agriculture, the bank must tailor its loan policy to meet the seasonal loan demands of the farmers.
Components of Credit Policy:
The credit policy of bank consist the five major components, which are as follows.
Objectives:
The first step in framing a credit policy in the formulation of objectives of the proposed policy with diverse objectives like profitability, liquidity, volume of business risk factor etc.
Volume of mix loan:
The policy should specify the targeted composition of the loan portfolio such composition being in terms of industry / location / size / interest rate / security.
Geographical Spread:
There will be various locations from where a bank conduct its operation of there locations some my be weak credit demand areas with a considerable high deposits potential and vice-versa.
Loan Evaluation Procedures:
The evaluation involves a careful selection of the borrowers by understanding their credit worthiness. This can be done by assessing the ability of the client to pay back the loan and also willingness to repay the loan.
It is good to have this opportunity of discuss some important issues at a Credit Conference of the American Bankers Association. I am especially glad to have the opportunity to discuss the distinctions and interactions between federal Reserve monetary policy and commercial bank credit policy, as the title of my talk suggests. A common fallacy is to refer to money and credit interchangeably. A central point throughout my remarks will be that money and credit are not the same. there is no doubt that central bank monetary policies affect commercial banks credit policies, and I would venture that the credit polices engaged in by commercial banks have influenced monetary policies. Nevertheless, one should not think of them as being the same.1
I will begin by highlighting the distinction between money and credit, and with this distinction in mind, I will review recent monetary and credit developments as I see them.
As you are probably all aware, every Thursday evening the Federal Reserve releases for publication recent data on Federal Reserve credit, bank deposits, reserves, and related items. The Friday morning editions of major newspapers usually carry a column in which these data are reported and interpreted. One Friday last year the heading of one such column in a major newspaper stated that “A Limited Easing of Credit is Seen”. The first sentence of that column told us, and I quote, “Federal Reserve credit policy appears to be moving gradually toward a less restrictive stance, banking data published yesterday showed.”
That same morning a comparable column in another leading newspaper was headed by the words “Fed Reports Tight Money Back Again.” The first sentence in this column told us, and again I quote, “Federal Reserve weekly statistics showed that the basic money situation has shifted back to the fight side after some temporary factors. Presumably the authors of each of these columns had before them the same data, so apparently they chose different items as being important.
I would like to discuss the issues involved in the distinction between money and credit, and to make clear my view of the relevant measures to look at when assessing the influence of monetary actions. I shall content that there is one appropriate measure when assessing the impact of such actions on over-all economic activity and one should take quite different approach when analyzing the effects on various segments of our economy of the credit policies of commercial banks and other financial institutions.
Monetary Policy:
The Influence of monetary policy, which in recent times in the United States had been almost the exclusive province of the United States has been almost the exclusive province of the Federal Reserve, operate on aggregate spending in the economy. I believe the fundamental objective on monetary policies is to provide conditions conducive to an appropriate rate of growth in demand for services, consumption goods, and investment goods. This rate of growth should be equal to the ability of the economy to produce such goods and services. I admit that it is far easier to state this objective than to achieve it. The distributional effects to monetary actions on various sectors are not usually the primary goals of the policymakers. Although such distributional effects are much less predictable than are the effects on aggregate demand.
The channel through which monetary actions affect aggregate demand is by varying the quantity of money made available to the private sector of the economy. If money is provided at a rate greater than the at which businesses and individuals desire to acquire currency and demand deposit balances, then the effort to exchange these excess money balances for other assets will increase aggregate demand for goods and services. Conversely, if businesses and individuals desire to acquire currency and demand deposit balances faster than the rate at which the total amount of money is increasing, their efforts to build up such balances will result in a decrease in the demand for goods and services.
The primary tool of the Federal Reserve in the conduct of monetary policy is buying and selling securities in the open market. It is useful to summarize shout-term monetary actions within the framework of a concept called the monetary base. When the Federal Reserve increases its holdings of Government securities, which is the dominant source component of the monetary base, the primary uses of the base, currency held by the public and bank reserves, are increased. The growth trend of the money stock, even though shot-term movements in the money stock may also be influenced by changes in time deposits and U.S Government deposits at commercial banks.
Studies of the money creation process conducted at the Federal Reserve Bank of St. Louis as well as elsewhere indicate that the stock of money supplied to the economy could be adequately controlled on a monthly average basis. As techniques for establishing the appropriate amount of money to supply under varying conditions are improved and gain wider acceptance, the fundamental objectives of monetary policy, as I view them, can be met with greater reliability than in the past.
I think it is important to note that during the process of monetary expansion, the credit policies of commercial banks, interacting with forces emanating from the nonbank public, determine the sectors that are first affected. I will return shortly of further discussion of this process.
Federal Reserve “Credit Policy”:
I do not intend for my remarks concerning monetary policy to imply that the federal Reserve cannot or does not take actions which have a direct bearing on commercial banks credit policies. Since monetary and the price of credit extended by banks are affected. This is one important channel through which monetary actions influence the real sectors of the economy.
However, a side from the monetary actions of the Federal Reserve which have a direct bearing on the growth of aggregate demand for goods and services, the Federal Reserve can and does take actions which have a significant impact on the quantity, and price of bank credit. Furthermore, these actions may have no more than marginal effect on the total amount of credit outstanding. This brings me back to my central point regarding the distinction between money and credit.
An increase in the stock of money increases the total purchasing power of the economy, whereas changes in the composition of total private sector credit may represent only a re-channeling of the flow of purchasing power that is transferred from some economic units to other economic unit chooses to save some of its current income by increasing its holdings of time or savings deposits at a bank, it is choosing to forego some present spending in order to preserve some purchasing power for future use. When a commercial bank, in its intermediary role, uses the proceeds of the increased deposits to purchase securities of increase its business or consumer loans, the present purchasing power preserved by one economic unit is transferred to another economic unit. This transfer permits some economic units to obtain more current command over services, consumption goods or investment goods than their own income would otherwise allow.
One example of an action that could be taken by the Federal Reserve, which would affect the credit policies of banks would be to lower or hold the maximum interest rates banks are permitted to pay on time and savings deposits below the yields available to servers from competing institutions or financial instruments. Under such circumstances, these deposits will flow out of commercial banks, and the amount of bank credit extended to the public will contract. In addition to a decrease in the volume of bank credit, there will be an increase in the price of such credit since banks will allocate the available supply of funds of those most willing and best able to pay, given quality and other considerations.
A decrease in the volume of bank credit resulting from such an action by the central bank will not necessarily reduce the total credit flow in the economy; only the flows through the most efficient channels are altered. The experience with regard to CDs U.S. Treasury bills, commercial paper, and direct loans in recent years confirms this pint. Once short-term market rates of interest had risen to the pont that the yields banks were permitted to pay on time deposits were on longer competitive, the volume of these deposits at banks declined. Banks were forced to sell securities and contract loans. However, corporate depositors merely shifted to directed ownership of short-term Government securities and to placement of short-tem loanable funds on the commercial paper market.
Credit Policies of Commercial Banks:
I will now turn to a discussion on the credit policies of commercial banks during the past two years, with references to the monetary actions taken during the same period. For background. I will digress for a moment to a summery of the developments during 1967 and 1968. Throughout those two years every aggregate monetary measure, including Federal Reserve credit, member bank reserves, the monetary base, and both the broad and narrow definitions of the money supply, were expanding at excessively rapid rate. I assume that in retrospect there is little disagreement that monetary policies were highly simulative during that period, although at the time some observers chose to point to the rising interest rates as being an indication that restrictive monetary policies were being pursued.
At the same time, total loans and investments at commercial banks were rising at historically rapid rates. Taking volume as the appropriate measure. one would say that bank credit policies were very easy. However, the borrowers were pointing to the price they were paying and arguing that credit was tight. I suspect that the nation’s biggest borrower, the U.S Treasury, felt that the price they paid for funds at the time was an indication of tight credit.
The developments in the first half of 1969 highlight the distinction between monetary and credit policies. From January to July 1969 the narrowly defined money stock (demand deposits plus currency held by the public) grew at a little more than a 5 per cent annual rate, which was somewhat less simulative than the 7.5 per cent rate of growth of the previous two years, but certainly not sufficiently to bring an early end to the considerable inflation that had been generated.
By early 1969 most market interest rates had reached a point where Regulation Q ceilings on the rates banks were permitted to pay on time deposits began to sharply impinge. Since banks were less able to compete for funds, total time deposits at commercial banks contracted throughout 1969. The contraction was much sharper in the second half of the year than in the first. As a result of the considerably reduced growth of total deposits, banks were forced to correspondingly reduced their rate of total credit expansion. The growth of total loans and investments in early 1969 was less than half the rate of the previous two years.
Judging from the substantially slower growth a bank credit, and the continued high and sharply rising interest rates in early 1969, it would appear that policies were much more restrictive than indicated by the somewhat reduced growth rate of the money stock. The reduced growth of bank credit, however, was manifested almost entirely in a rather sharp contraction in the security holdings of banks. There was little slowing in the growth of loans outstanding. Thus, from a loan volume standooint, one would conclude that bank credit available to loan customers that bank credit available to loan customers had tightened.
Turning to the second half of 1969, there is no question that both federal reserve monetary policy and commercial bank credit policies were tight. The money stock was essentially unchanged from July to December 1969, which was very restrictive in view of the inflation we were experiencing. Furthermore, time deposits at banks continued to decrease as market interest rates remained high compared to the ceiling rates banks could offer. Large banks turned to non deposit sources of funds to offset the contraction in total deposits. As a result, banks managed a small increase in the volume of credit outstanding in the second half of the year, with loans outstanding continuing to grow at moderately rapid rates while bank investments contracted almost as rapidly.
From the outset of 1970 the Federal reserve moved in the direction of easier monetary policy and also took a series of actions which had the effect of bringing about easier credit conditions. Growth of the money stock was resumed and maintained, and by the end of 1970 the amount of money in the hands of the public was 5.4 percent greater than a year earlier. Considering the inflationary forces continuing in 1970. Monetary policy during the year should b viewed as sufficiently expansionary to prevent substantial declines in real production and provide for the gradual abatement of the rate of the rate of price advances. At the same time the monetary policy of the past year has been adequately easy to facilitate the adjustment process of changing national priorities inherent in the partial demobilization of military forces and shifts in production from defense to non-defense related industries.
The first step taken by the federal reserve in early 1970 to help ease the credit flow through banks was to raise the ceilings on the rates banks were permitted to pay on small time and savings deposits. This improved somewhat the banks’ competitive position in attracting funds, but probably of considerably greater significance was the decline in market interest rates.
Early in 1970 the demand for credit was contracting and short-term interest rates began declining, as a result of the sharply restrictive monetary actions of late 1969. In February 1970 market interest rates had moved down sufficiently that rates on bank deposits again became competitive, and all types and sizes of time deposits, banks were again able to acquire earning assets and to reduce their use of relatively expensive non-deposit it sources of funds. The composition of bank credit extended in 1970 was opposite that of the previous year. Whereas banks had sold securities in 1969 in order to accommodate a continued strong loan demand, the growth of bank credit in early 1970 was all investments, as total bank loans reminded about unchanged from December 1969 to June last year.
The very rapid growth of bank credit and the sharply declining interest rates last year indicate very easy credit conditions. However, this type of ease should not be construed as having any implications regarding subsequent strength of aggregate demand or indicating resurgence of forces contributing to increased inflationary pressures. The re-intermediation of time deposits at commercial banks reflected mainly changes in the ownership of securities and a return of the flow of credit through channels that had been closed or considerably narrowed during the previous year.
At the end of 1970 banks had increased their outstanding loans by only 4 per cent from December 1969, while bank investments rose over 14 per cent during the same period. I think it is clear that the very rapid growth in the volume of total credit extended by banks, and the significantly lower prices of that credit as the year progressed, should not be construed to indicate that the Federal Reserve was engaged in highly simulative policies.
Suppose economic conditions had not been such in early 1970 that the Federal Reserve took actions which caused resumption in the growth of the money stock. Market interest rates on short-term instruments would have still declined in the face of reduced demand for funds, although probably not so rapidly. Generally falling short-term interest rates, together with the actions that raised or abolished the maximum rates banks could pay on some time and savings deposits would have been sufficient to cause rapid re-intermediation of time deposits at commercial banks, even if monetary policy hard remained as restrictive as in late 1969. This return of funds to banks through time deposits would have provided for a substantial increase in bank credit, although somewhat less than actually occurred.
Meaning of Credit Policy:
Guidelines that spell out how to decide which customers are sold on open account, the exact payment terms, the limits set on outstanding balances and how to deal with delinquent accounts.
Though most consumers expect to pay cash or use of credit card when making a purchase, commercial customers typically want to be billed for any products and services they buy. You need to decide how much credit you’re willing to extend them and under what circumstances. There’s no one-size-fits-all credit policy your policy will be based on your particular business and cash-flow circumstances, industry standards, current economic conditions, and the degree of risk involved.
As you create your policy, consider the link between credit and sales. Easy credit terms can be an excellent way to boost sales, but they can also increase losses if customers default. A typical credit policy will address the following points.
Credit limits: You’ll establish dollar figures for the amount of credit you’re willing to extend and define the parameters or circumstances.
Credit terms: If you agree to bill a customer, you need to decide when the payment will be due. Your terms may also include early-payment discounts and late-payment penalties.
Deposits: You may require customers to pay a portion of the amount due in advance.
Credit Cards and Personal Checks: Your bank is a good resource for credit card merchant status and for setting policies regarding the acceptance of personal checks.
Customer Information: This section should outline what you want to know about a customer before making a credit decision. Typical points include years in business, length of time at present location, financial data, credit rating with other vendors and credit reporting agencies, information about the individual principals of the company, and how much they expect to purchase from you.
Documentation: This includes credit applications, sales agreements, contracts, purchase orders, bills of lading, delivery receipts, invoices, correspondence and so on.
Principles of Credit Policy:2
Lending is most profitable business of a commercial bank, but at the some time it is highly risky. Loans always accompany credit risk arising out of borrowers default in repaying the money a banks should, therefore, manage loan business in a profitable and safe manner. He should take all precautions to minimise the risk associated with loan. In considering loan proposal the banker must keep in mind certain general principles of lending. The principles are discussed below.
Safety: Safety of funds is the most important guiding principles of a banker. While lending out funds a banker should ensure that funds being lent out would remain. Safe otherwise the bank will not be in a position to repay his deposits and consequently it will lose public confidence which may subsequently, spell death knell of the bank itself. Safety of funds implies that the borrower would repay the principal sum and interest as per the terms and conditions provided in the loan agreement. A banker should always take a calculated risk. This is why a banker always insists upon collateral margins and guarantees in addition to personal promise of the borrower.
Liquidity: Since majority of commercial bank liabilities are payable either on demand or after short notice the banker should ensure that loan would be liquid. Liquidity as already defined signifies the readiness with which the bank can convert its assets into cash with number or insignificant of loan will be liquid. If it has been given for a short period to finance same purchase of stock, raw materials etc.,
Diversification of Risks: A banker should aware to the principle of diversification while lending out funds. Diversification implies dispersal of funds over a large number of borrowing firms situated in different regions of the country. Diversification is a means of minimising risk inherent in loans.
The most important form of diversification which a banker should attempt to achieve in the banker loan portfolio is maturity diversification. Under maturity diversification loan portfolio is staggered over different maturity periods. So that, a certain amount of loans mature at regular intervals which could be utilised to meet the depositors demands. If such funds are not needed the same can be lent but invested in securities that best fit into the bank’s loan and investment portfolio.
Profitability: Equally important is the principles of profitability in bank advances. Like other commercial institutions banks must make sufficient income to pay interest to the depositors, establishment expenses to retain a portion of income for future and to pay dividends to owners. The difference between lending and borrowing rates constitutes gross profit of the bank and no banker ordinarily think of an advance without satisfying margin or profit.
Purpose: Bankers should inquire into the purpose of the loan for which, it is taken. As a matter of fact safety and liquidity of loan depend on the purpose. If an advance is given for productive purpose say for financing purchase of inventories in all profitability – it will be rapid because grant of loan will a generate additional income sufficient to repay the loan. In the advance made for non-productive and speculative purpose is subject to greater credit risk because the purpose for which loan was sought would in no way improve repaying capacity of the borrower.
Characteristics of Commercial Bank Loan in India:
Bulk of the bank loans in India is provided to trade and industries bank are lackadaisical to agriculture sector, because of relatively high greater credit risks inherent in it and in ability of agriculturists to furnish good amount of security.
Another striking feature of a bank loan in our country Is that nearly three fourths of it is given for a period for a period of less than one year. This is essentially because of high liquidity of such loans. The short term loans are given for financing seasonal needs of businessmen and also for working capital purpose to facilitate the process of production and distribution. Seasonal loans are primarily for the purpose of increasing the inventory of a business firm.
Commercial banks in India demand sound security for loans. A very high percentage of advances 80-90% by Indian Banks are secured by goods, financial asset and hypothecation. A major portion of the bank credit is given against the security of commodities which represent short term security unsecured credit facilities are given to firm with sound financial position and stable earnings records.
Bank borrowers mostly lie in average profitability group a highly profitable firm would rely less on bank loans for financing expansion or current needs because it has sufficient earnings to do so. Contrary to this less profitable concerns or less sustaining concern need bank support to hide over their grim financial position caused by shortage of liquid funds.
Another characteristics of bank borrowers is that most of the business concerns borrowing bank money are relatively small, young and growing one’s. It is obvious to find smaller firms to depend more on bank loans for financial their needs because of their limited assess to other sources of financing.
Need of the Credit Policy:
The credit policy documents that carefully specifies the do’s and don’t’s while sanctioning the loan proposals. Instead guideline can be given within the credit policy for the decision makers to enable them to screen out loans proposals which can be out rightly rejected loan than can be sanctioned without any reference to the top management.
Factors influencing loan policy in a Bank:
The important factors which go into the determination of loan policies of a bank are following.
Capital Position: Capital position is probably the most important factor influencing loan policies of a bank. As observed earlier capital provides cushion to absorb losses that may occur. It serves as a protective factor against losses for depositors and guarantee fund to creditors. A bank with strong capital position can assure more credit risk than one with weak capital position. Accordingly the former can follows liberal lending policy and provide different types of loan including long-term loans promising higher interest rates which the latter cannot do so because of the greater risk involved.
Earning Requirements: Profit making is one of the principal objectives of a commercial bank. However, some banks may be in a position to emphasis income, but others may stress on liquidity. These banks who have set income as the principal goal of their lending would follow aggressive policy of lending and might make large amount of term loans or consumer loans which normally are made at higher interest rates because of relatively greater amount of risks, which they accompany. This should not suggest that banker would take under risks for a accomplishing the objective of profitability, where earning receive greater emphasis in loan policy of a bank it may mean that the would keep a larger amount of secondary reserves or it would include in its investment account securities carrying shorter maturity periods and possess relatively less risks.
Deposit Variability: Banks that have experienced credit movement in their deposits will have to follow conservative lending policy. They cannot afford to incur undue risks by extending term lending facilities. Similar policy should also be followed where banks are faced with declining deposits. In a refreshing contrast with this liberal lending policy can be pursued by banks whose deposits show little or no fluctuations and who can easily predict fluctuations in deposits and loan demands and make provision for them through secondary reserves. Banker whose deposits have shown rising tendency in the past and expect the rising trend to persist in future can also be liberal in their loan policy.
State of Local and National Economy: In formulating lending policy for his banks the banker should also keep in mind economic conditions that are prevailing in the region served by the bank. A bank operating in an area which is subject to seasonal and cyclical fluctuations can ill afford to adopt liberal policy because that would entail the bank in hazards of illiquidity. But in stable economy where possibility of fluctuation in levels of deposits and loan demands is limited the banker can follow liberal loan policy. If economic conditions of the country are expected to improve and level of business activity is likely to increase banker can liberalise lending policy by relating credit standards and security requirements to accommodate those borrowers who were either refused banking faculties due to stiff credit policy.
Monetary Policy: Monetary policy of central banking authorities goes a long way in determining the lending policy of a commercial bank. Through variation in minimum reserve requirement and net liquidity ratio central bank influence, the lending ability of banks. Thus, by reducing the proportion of minimum cash reserve which a commercial bank is required to carry with the central bank and reducing net liquidity ratio and bank would get additional funds which can be utilised in lending form. In the event the cash reserve ratio and net liquidity ratio is increased lending ability of bank is limited.
Ability and Experience of loan Officers: Loan officers in a bank play a significant role in execution of loan policies of the bank. The board should therefore, consider the skill and competence of the bank loan officers while laying down loan policy. Where a bank is staffed with a larger number of credit officers having expertise knowledge and rich experience in diverse forms of loans the banker can afford to provide different types of lending faculties and formulate the policy accordingly. But this cannot be done by banks whose credit officers are competent to deal with certain types of loans. This is why smaller banks have been found limiting their lending business to short-term loans. Most of those banks have obtained from consumer lending and also term-lending to business enterprises because they were equipped with skilled personnel.
Competitive Position: In formulating loan policy the management should give consideration to the competitive position of the bank. Where a bank finds that strong competing institutions exist, say in the field of term lending and the management feels that it cannot afford to provide the loans on terms being offered by the other existing institution, it might follow a policy of refraining the bank from entering in the sphere of term-loans.
Credit needs to the Area Served: Credit needs of the area served by the bank would also influence the loan policy. A bank is supposed to meet Loan demands of all local borrowers who present logical and economically sound loan requests and granting of such requests would not violate the prudent banking. If this cannot be done there will be little justification for an institution to exist in that region. Thus in an economy predominantly dependent on agriculture, the bank must tailor its loan policy to meet the seasonal loan demands of the farmers.
Components of Credit Policy:
The credit policy of bank consist the five major components, which are as follows.
Objectives:
The first step in framing a credit policy in the formulation of objectives of the proposed policy with diverse objectives like profitability, liquidity, volume of business risk factor etc.
Volume of mix loan:
The policy should specify the targeted composition of the loan portfolio such composition being in terms of industry / location / size / interest rate / security.
Geographical Spread:
There will be various locations from where a bank conduct its operation of there locations some my be weak credit demand areas with a considerable high deposits potential and vice-versa.
Loan Evaluation Procedures:
The evaluation involves a careful selection of the borrowers by understanding their credit worthiness. This can be done by assessing the ability of the client to pay back the loan and also willingness to repay the loan.
