Functions of Central Bank

Central bank is regarded as an apex financial institution in the banking system. It is considered as an
integral part of the economic and financial system of a nation. The central bank functions as an
independent authority and is responsible for controlling, regulating, and stabilising the monetary and
banking structure of the country.
In India, the Reserve Bank of India is regarded as the central bank. It was set up in 1935. Central
banks are responsible for maintaining the financial stability and economic sovereignty of the country.

The functions of a central bank can be discussed as follows:

1. Currency regulator or bank of issue
2. Bank to the government
3. Custodian of Cash reserves
4. Custodian of International currency
5. Lender of last resort
6. Clearing house for transfer and settlement
7. Controller of credit
8. Protecting depositors’ interests

The above-mentioned functions will be discussed in detail in the following lines.

Currency regulator or bank of issue: Central banks possess the exclusive right to manufacture
notes in an economy. All the central banks across the world are involved in issuing notes to the
economy. This is one of the most important functions of the central bank in an economy and due to
this the central bank is also known as the bank of issue.
Earlier all the banks were allowed to publish their own notes which resulted in a disorganised
economy. To avoid this situation the government around the world authorised the central banks to
function as the issuer of currency, which resulted in uniformity in circulation and balanced supply of
money in the economy.

Bank to the government: One of the important functions of the central bank is to act as the bank
to the government. The central bank accepts deposits and issues funds to the government. It is also
involved in making and receiving payments for the government. Central banks also offer short term
loans to the government in order to recover from bad phases in the economy.
In addition to being the bank to the government, it acts as an advisor and agent of the government by
providing advice to the government in areas of economic policy, capital market, money market and
loans from the government.
In addition to that, the central bank is instrumental in formulation of monetary and fiscal policies that
help in regulation of money in the market and controlling inflation.
Custodian of Cash reserves: It is a practice of the commercial banks of a country to keep a part of
their cash balances in the form of deposits with the central bank. The commercial banks can draw that
balance when the requirement for cash is high and pay back the same when there is less requirement
of cash.
It is for this reason that the central bank is regarded as the banker’s bank. Central bank also plays an
important role in the credit creation policy of commercial banks.

Custodian of International currency: An important function of the central bank is to maintain a

minimum balance of foreign currency. The purpose of maintaining such a balance is to manage
sudden or emergency requirements of foreign reserves and also to overcome any adverse deficits of
balance of payments.

Lender of last resort: The central bank acts as a lender of last resort by providing money to its
member banks in times of cash crunch. It performs this function by providing loans against securities,
treasury bills and also by rediscounting bills. This is regarded as one of the most crucial functions of
the central bank wherein it helps in protecting the financial structure of the economy from collapsing.

Clearing house for transfer and settlement: Central bank acts as a clearing house of the
commercial banks and helps in settling of mutual indebtedness of the commercial banks. In a clearing
house, the representatives of different banks meet and settle the inter-bank payments.

Controller of credit: Central banks also function as the controller of credit in the economy. It
happens that commercial banks create a lot of credit in the economy that increases the inflation.
The central bank controls the way credit creation by commercial banks is done by engaging in open
market operations or bringing about a change in the CRR to control the process of credit creation by
commercial banks.

Protecting depositor’s interests: Central bank also needs to keep an eye on the functioning of the
commercial banks to protect the interests of depositors.

Some of the well-known central banks across the world are:

1. Federal Reserve (USA)
2. Reserve Bank of India (India)
3. People’s Bank of China (China)
4. Bank of England (UK)
5. European Central Bank (EU or European Union)
Credit Control in Banking
Credit Control is a role of the Reserve Bank of India's central bank, which regulates credit, or the
supply and the demand of money or liquidity in the economy. The central bank controls the credit
extended by commercial banks to their customers through this function.

Methods of Credit Control

There are basically two methods of controlling the credit. They are Qualitative and the Quantitative or
the General Methods.

Qualitative Method
Marginal Requirement Fixation- The central bank establishes the margin that financial institutions and
commercial banks must keep for amounts provided in the form of loans against commodities, stocks,
and shares using this method. To prevent speculative trading on stock exchanges, the central bank sets
margin restrictions for the underlying securities.

Credit Rationing- The central bank uses this strategy to try to limit the maximum amount of loans
and advances to a specific sector. Furthermore, the central bank may set a ceiling for different types of
loans and advances in specific instances. This restriction is also expected to be adhered to by
commercial banks. This makes it easier to reduce bank lending exposure to undesirable industries.

Regulation of the consumer credit– The apex bank establishes the down payments and the length
of time over which installments’ are to be spread in order to regulate consumer credit. Higher
limitations are imposed during inflation to control prices by reducing demand, whereas relaxations are
offered during depression to promote demand for commodities.

Control through the directives- The central bank uses this strategy to issue regular directives to
the commercial banks. Commercial banks are guided by these directives in developing their lending
policies. The central bank can use a directive to alter credit structures and limit credit supply for a
specified purpose. The Reserve Bank of India (RBI) issues guidelines to commercial banks
prohibiting them from lending money to the speculative sector, such as securities, more than a
specified amount.

Publicity- Another way of selective credits control. The Reserve Bank of India (RBI) uses it to issue
various reports on what is excellent and poor in the system. The publicly available information can
assist commercial banks in targeting credit supply to specific industries.

The Moral Suasion- It refers to the Reserve Bank of India (RBI) exerting pressure on the banking
system of India without taking any serious action to ensure compliance with the laws. It’s a
recommendation to the banks and aids in the restraint of lending during periods of high inflation.
Monetary policy keeps commercial banks informed about the central bank’s expectations. Central
banks may offer directions, recommendations, and suggestions to commercial banks to reduce loan
supply for the speculative motive under moral suasion.

Direct Actions-The RBI has the power to take actions against a bank using this way. Second, the
RBI has the authority to refuse credit to bank whose borrowings exceed their capital. By adjusting
some rates, the central banks can penalize a bank. Finally, it has the authority to impose a prohibition
on specific banks if they fail to obey its instructions and works against the monetary policy’s goals.

Quantitative Methods
Bank Rate Policy- The bank rate is the lowest rate at which a country’s central bank will lend
money to its commercial bank and RBI utilizes it to regulate the credit in the economy. Because the
central bank provides funding to the commercial banks by rediscounting bills, it is also known as the
discount rate.

Open Market operations- The RBI’s purchase and the sale of securities are referred to as OMO.
In an inflationary scenario, for example, the RBI will begin selling government securities, which will
reduce money supply in the system (because the buyer of the securities will pay in Rupee, thus
currency from the system will go out). The decline in money supply will lead to a reduction in funds
with commercial banks, which will further minimize their lending capability. As a result of the
decrease in lending, credit in the economy is reduced. However, it is limited by a number of factors,
including an underdeveloped securities market, surplus reserves held by commercial banks,
commercial bank debts, and so on.

Variation in the Reserve Ratio– The commercial banks are required by the RBI to keep a certain
percentage of their net demand and time obligations in Cash Reserves. Banks must also keep a
specified amount of their net demand and time obligations in the form of liquid assets. The Cash
Reserve Ratio (CRR) and the Statutory Liquidity Ratio (SLR) are the two reserve ratios. The reserve
position of commercial banks, which regulates the availability of money in the economy, can be
affected by even little changes in these ratios.

Repurchase Option- The central bank conducts repo transactions, also known as repurchase
transactions, to manage the cash market situation. The Central Bank grants commercial banks loans
against government-approved securities for a set length of time at a fixed rate, known as the Repo
Rate, on the premise that the borrowing bank will repurchase the securities at the established rate once
the period is up. The central bank conducts these transactions in order to drain or drain money from
the system.