Considering the limitations of the bank rate policy and the open market operations, the need to develop a very effective method of credit control was felt. Especially the need was to directly control the power of the commercial banks to create credit, Variable cash reserve ratio was suggested as one more method of quantitative credit control by Keynes. Further this method is considered necessary for promoting the overall liquidity and solvency of the banking system, apart from improving the public confidence on the banking system.
The process of working of this method of credit control can be easily understood with an example. Suppose in an economy there is over expansion of credit which is possible with excessive cash reserves with the commercial banks. To check this, the central bank may raise the cash reserve ratio say from 20% to 25% Then this will bring down the availability of cash reserve with the commercial banks. With lesser cash reserve they can only create lesser credit. Similarly, suppose the central bank wants to expand the credit creation by the commercial banks. Then it will bring down the cash reserve ratio say from 25% to 20%. This will enable the Commercial banks to have more cash reserve with which they can create more credit. It should be noticed that the cash reserve ratio determines the credit multiplier in an economy. An increase in former will contract credit through multiplier effect and reduction in the former will expand credit through multiplier.
Though the variable cash reserve ratio is considered superior to other methods of quantitative credit control, it has the following limitations:
- Commercial banks with excess reserve are least affected by the method.
- Commercial banks with a very strong source of foreign funds can by-pass this policy.
- The central bank’s policy of liberalizing or contracting the credit may not be commensurate with the investor’s attitude.
- This policy also affects all commercial banks uniformly i.e., banks with large cash reserve as well as small reserve. As a result the policy may harm some banks in the process protecting the economy.
- The commercial banks will lose their freedom because of the policy, hence, they will always be cautious in maintaining additional reserve.
- As the cash reserves maintained by the commercial bank do not fetch any interest, in a way, this policy brings down the earnings of commercial-banks.
- As this method is very effective, it has to be very carefully applied by the central bank as otherwise it has to undo itself all that it has attempted to maintain economic stability.
- This policy directly affects the securities market as increase in cash reserve required by the central bank will force the commercial banks to dispose of securities they have, causing depression in prices of securities resulting in heavy financial loss.
In spite of all these limitations, the variable cash reserve ratio is by and large effective method of controlling the quantum of credit in an economy this policy has to be carefully adopted as otherwise, it may result in severally, unwanted consequences on the economy.