Chapter Two: Banking System

Central Banking System

Introduction
The central bank is the apex bank in a country. It is called by different names in different
countries. It is the Reserve Bank of India in India, the Bank of England in England, the
Federal Reserve System in America, the Bank of France in France, the Riks Bank in
Sweden, National Bank of Ethiopia in Ethiopia, etc.

Definition of a Central Bank

A central bank has been defined in terms of its functions. According to Vera Smith, "The
primary definition of central banking is a banking system in which a single bank has either
complete control or a residuary monopoly of note issue,"
W.A. Shaw defines a central bank as a bank which controls credit.
To Hawtrey, a central bank is that which the lender of the last resort is. According to
A.C.L Day, a central bank is "to help control and stabilize the monetary and banking
system." According to Sayers, the central bank "is the organ of government that undertakes
the major financial operations of the government and by its conduct of these operations
and by other means, influences the behavior of financial institutions so as to support the
economic policy of the government.”
On the other hand, Samuelson's definition is wide. According to him, a central bank "is a
bank of bankers. Its duty is to control the monetary base . . . and through control of this
'high-powered money' to control the community's supply of money." But the broadest
definition has been given by De Kock. In his words, a central bank is "a bank which
constitutes the apex of the monetary and banking structure of its country and which
performs as best as it can in the national economic interest, the following functions:
(i) The regulation of currency in accordance with the requirements of business and
the general public for which purpose it is granted either the sole right of note
issue or at least a partial monopoly thereof.
(ii) The performance of general banking and agency for the state.
(iii) The custody of the cash reserves of the commercial banks.
(iv) The custody and management of the nation's reserves of international currency.
(v) The granting of accommodation in the form of re-discounts and collateral
advances to commercial banks, bill brokers and dealers, or other financial
institutions and the general acceptance of the responsibility of lender of the last
resort.
(vi) The settlement of clearance balances between the banks.

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 (vii) The control of credit in accordance with the needs of business and with a view
to carrying out the broad monetary policy adopted by the state."

Difference between Central Bank and Commercial Bank

A central bank is basically different from a commercial bank in the following ways:
1. The central bank is the apex institution of the monetary and banking structure of the
country whereas commercial bank is one of the organs of the money market.
2. The central bank is a non-profit institution which implements the economic policies of
the government. But the commercial bank is a profit-making institution.
3. The central bank is owned by the government, whereas the commercial bank is owned
by shareholders.
4. The central bank is a banker to the government and does not engage itself in ordinary
banking activities. The commercial bank is a banker to the general public.
5. The central bank has the monopoly of note issue, while the commercial bank can issue
only cheques. The notes are legal tender. But the cheques are in the nature of near-money.
6. The central bank is the banker's bank. As such, it grants accommodations to commercial
banks in the form of rediscount facilities, keeps their cash reserves, and clears their
balances. On the other hand, the commercial bank advances loans to and accepts deposits
from the public.
7. The central bank controls credit in accordance with the needs of business and economy.
The commercial bank creates credit to meet the requirements of business.
8. The central bank helps in establishing financial institutions so as to strengthen money
and capital market in a country. On the other hand, the commercial bank helps industry by
underwriting shares and debentures, and agriculture by meeting its financial requirements
through cooperatives or individually.
9. Every country has only one central bank with its offices at important centers of the
country. On the other hand, there are many commercial banks with hundreds of branches
within and outside the country.
10. The central bank is the custodian of the foreign currency reserves of the country while
the commercial bank is the dealer of foreign currencies.
11. The chief executive of the central bank is designated as "Governor" whereas the chief
executive of a commercial bank is called 'Chairman' or ‘President’.
Functions of a Central Bank
A central bank performs the following functions, as given, by De Kock and accepted by
the majority of economists.
1. Regulator of Currency
The central bank is the bank of issue—it has the monopoly of note issue. Notes issued by
it circulate as legal tender -money. It has its issue department which issues notes and, coins
to commercial banks. Coins are manufactured in the government mint but they are put into
circulation through the central bank. Central banks have been following different methods

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of note issue in different countries. The central bank is required by law to keep a certain
amount of gold and foreign securities against the issue of notes. In some countries, the
amount of gold and foreign securities bears a fixed proportion, between 25 to 40 per cent
of the total notes issued. In other countries, a minimum fixed amount of gold and foreign
currencies is required to be kept against note issue by the central bank.

The monopoly of issuing notes vested in the central bank ensures uniformity in the notes
issued which helps in facilitating exchange and trade within the country. It brings stability
in the monetary system and creates confidence among the public. The central bank can
restrict or expand the supply of cash according to the requirements of the economy. Thus,
it provides elasticity to the monetary system. By having a monopoly of note issue, the
central bank also controls the banking system by being the ultimate source of cash. Last
but not the least, by entrusting the monopoly of note issue to the central bank, the
government is able to earn profits from printing notes whose cost is very low as compared
with their face value.
2. Banker, Fiscal Agent and Adviser to the Government
Central banks everywhere act as bankers, fiscal agents and advisers to their respective
governments. As banker to the government, the central bank keeps the deposits of the
central and state governments and makes payments on behalf of governments. But it does
not pay interest on government deposits. It buys and sells foreign currencies on behalf of
the government. It keeps the stock of gold of the government. Thus it is the custodian of
government money and wealth. As a fiscal agent, the central bank makes short-term loans
to the government for a period not exceeding 90 days. It floats loans, pays interest on them,
and finally repays them on behalf of the government. Thus it manages the entire public
debt. The central bank also advises the government on such economic and money matters
as controlling inflation or deflation, devaluation or revaluation of currency, deficit
financing, balance of payments, etc.
3. Custodian of Cash Reserves of Commercial Banks
Commercial banks are required by law to keep reserves equal to a certain percentage of
both time and demand deposits liabilities with the central bank. It is on the basis of these
reserves that the central bank transfers funds from one bank to another to facilitate the
clearing of cheques. Thus the central bank acts as the custodian of the cash reserves of
commercial banks and helps in facilitating their transactions. There are many advantages
of keeping the cash reserves of the commercial banks with the central bank, according to
De Kock. In the first place, the centralization of cash in the central bank is a source of
strength to the banking system of a country. Secondly, centralized cash reserves can serve
as the basis of a large and more elastic structure than if the same amount were scattered
among the individual banks. Thirdly, centralized cash reserves can be utilized fully and
most effectively during periods of seasonal strains and in financial crises or emergencies.
Fourthly, by varying these cash reserves the central bank can control the credit creation by

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commercial banks. Lastly, the central bank can provide additional funds on a temporary
and short term basis to commercial banks to overcome their financial difficulties.
4. Custody and Management of Foreign Exchange Reserves
The central bank keeps and manages the foreign exchange reserves of the country. It is an
official reservoir of gold and foreign currencies. It sells gold at fixed prices to the monetary
authorities of other countries. It also buys foreign currencies at international prices. Further,
it fixes the exchange rates of domestic currency in terms of foreign- currencies. It holds
these rates within narrow limits in keeping with its obligations as a member of the
International Monetary Fund and tries to bring stability in foreign exchange rates. Further,
it manages exchange control operations by supplying foreign currencies to importers and
persons visiting foreign countries on business, studies, etc. in keeping with the-rules laid
down by the government.

5. Lender of the Last Resort

De Kock regards this function as a sine qua non of central banking. By granting
accommodation in the form of re-discounts and collateral advances to commercial banks,
bill brokers and dealers, or other financial institutions, the central bank acts as the lender
of the last resort. The central bank lends to such institutions in order to help them in times
of stress so as to save the financial structure of the country from collapse.
6. Clearing House for Transfer and Settlement
As bankers' bank, the central bank acts as a clearing house for transfer and settlement of
mutual claims of commercial banks. Since the central bank holds reserves of commercial
banks it transfers funds from one bank to other banks to facilitate clearing of cheques. This
is done by making transfer entries in their accounts on the principle of book-keeping. To
transfer and settle claims of one bank upon others, the central bank operates a separate
department. This department is known as the "clearing house" and it renders the service
free to commercial banks.
When the central bank acts as a clearing agency, it is time-saving and convenient for the
commercial banks to settle their claims at one place. It also economizes the use of money.
"It is not only a means of economizing cash and capital but is also a means of testing at
any time the degree of liquidity which the community is maintaining.

7. Controller of Credit
The most important function of the central bank is to control the credit creation power of
commercial bank in order to control inflationary and deflationary pressures within this
economy. For this purpose, it adopts quantitative methods and qualitative methods.
Quantitative methods aim at controlling the cost and quantity of credit by adopting bank
rate policy, open market operations, and by variations in reserve ratios of commercial
banks. Qualitative methods control the use and direction of credit. These involve selective
credit controls and direct action. By adopting such methods, the central bank tries to
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influence and control credit creation by commercial banks in order to stabilize economic
activity in the country.

Central Bank as the Controller of Credit

Meaning of Credit
The word "credit" is derived from the Latin word creditum which means to believe or trust.
In economics, the term credit refers to a promise by one party to pay another for money
borrowed or goods or services received. It is a medium of exchange to receive money or
goods on demand at some future date. R.P. Kent defines credit as the right to receive
payments or the obligation to make payment on demand at some future time on account of
the immediate transfer of goods.
Objectives of Credit Control
Credit control is the means to control the lending policy of commercial banks by the central
bank. The central bank controls credit to achieve the following objectives:
1. To Stabilize the Internal Price Level. One of the objectives of controlling credit is to
stabilize the price level in the country. Frequent changes in prices adversely affect the
economy. Inflationary or deflationary trends need to be prevented. This can be achieved
by adopting a judicious policy of credit control.
2. To Stabilize the Rate of Foreign Exchange. With the change in the internal prices level,
exports and imports of the country are affected. When prices fall, exports increase and
imports decline. Consequently, the demand for domestic currency increases in the foreign
market and its exchange rate rises. On the contrary, a rise in domestic prices leads to a
decline in exports and an increase in imports. As a result, the demand for foreign currency
increases and that of domestic currency falls, thereby lowering the exchange rate of the
domestic currency. Since it is the volume of credit money that affects prices, the central
bank can stabilize the rate of foreign exchange by controlling bank credit.
3. To Protect the Outflow of Gold. The central bank holds the gold reserves of the country
in its vaults. Expansion of bank credit leads to rise in prices which reduce exports and
increase imports, thereby creating an unfavorable balance of payments. This necessitates
the export of gold to other countries. The central bank has to control credit in order to
prevent such outflows of gold to other countries.
4. To Control Business Cycles. Business cycles are a common phenomenon of capitalist
countries which lead to periodic fluctuations in production, employment and prices. They
are characterized by alternating periods of prosperity and depression. During prosperity,
there is large expansion in the volume of credit, and production, employment and prices
rise. During depression, credit contracts, and production, employment and prices fall. The
central bank can counteract such cyclical fluctuations through contraction of bank credit
during boom periods, and expansion of bank credit during depression.

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5. To Meet Business Needs. According to Burgess, one of the important objectives of credit
control is the "adjustment of the volume of credit to the volume of business." Credit is
needed to meet the requirements of trade and industry. As business expands, larger quantity
of credit is needed, and when business contracts less credit are needed. Therefore, it is the
central bank which can meet the requirements of business by controlling credit.
6. To Have Growth with Stability. In recent years, the principal objective of credit control
is to have growth with stability. The other objectives, such as price stability, foreign
exchange rates stability, etc., are regarded as secondary. The aim of credit control is to help
in achieving full employment and accelerated growth with stability in the economy without
inflationary pressures and balance of payments deficits.

Methods of Credit Control

The central bank adopts two types of methods of credit control. They are the quantitative
and qualitative methods. Quantitative methods aim at controlling the cost and quantity of
credit by adopting such techniques as variations in the bank rate, open market operations,
and variations in the reserve ratios of commercial banks. On the other hand, qualitative
methods controls the use and direction of credit. These involve selective credit controls and
direct action.

1. Bank Rate or Discount Rate Policy

The bank rate or the discount rate is the rate fixed by the central bank at which it rediscounts
first class bills of exchange and government securities held by the commercial banks. The
bank rate is the interest rate charged by the central bank at which it provides rediscount to
banks through the discount window. The central bank controls credit by making variations
in the bank rate. If the need of the economy is to expand credit, the central bank lowers the
bank rate. Borrowing from the central bank becomes cheap and easy. So the commercial
banks will borrow more. They will, in turn, advance loans to customers at a lower rate. The
market rate of interest will be reduced. This encourages business activity, and expansion
of credit follows which encourages the rise in prices.
The opposite happens when credit is to be contracted in the economy. The central bank
raises the bank rate which makes borrowing costly from it. So the banks borrow less. They,
in turn, raise their lending rates to customers. The market rate of interest also rises because
of the tight money market. This discourages fresh loans and puts pressure on borrowers to
pay their past debts. This discourages business activity. There is contraction of credit which
depresses the rise in price. Thus lowering the bank rate offsets deflationary tendencies and
raising the bank rate controls inflation.
2. Open Market Operations
Open market operations are another method of quantitative credit control used by a central
bank. This method refers to the sale and purchase of securities, bills and bonds of
government as well as private financial institutions by the central bank. But in its narrow
sense, it simply means dealing only in government securities and bonds.

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There are two principal motives of open market operations. First, it serves to influence the
reserves of commercial banks in order to control their power of credit creation. Secondly,
it serves to affect the market rates of interest so as to control the commercial bank credit.
3. Variable Reserve Ratio
Variable reserve ratio (or required reserve ratio or legal minimum requirements), as a
method of credit control was first suggested by Keynes in his Treatise on Money (1930)
and was adopted by the Federal Reserve System of the United States in 1935.
Every commercial bank is required by law to maintain a minimum percentage of its
deposits with the central bank. The minimum amount of reserve with the central bank may
be either a percentage of its time and demand deposits separately or of total deposits.
Whatever the amount of money remains with the commercial bank over and above these
minimum reserves is known as the excess reserves. It is on the basis of these excess
reserves that the commercial bank is able to create credit. The larger the size of the excess
reserves, the greater is the power of a bank to create credit, and vice versa. It can also be
said that the larger the required reserve ratio, the lower the power of a bank to create credit,
and vice versa.
When the central bank raises the reserve ratio of the commercial banks, it means that the
latter are required to keep more money with the former. Consequently, the excess reserves
with the commercial banks are reduced and they can lend less than before.
On the contrary, if the central bank wants to expand credit, it lowers the reserve ratio so as
to increase the credit creation power of the commercial banks. Thus by varying the reserve
ratio of the commercial banks the central bank influences their power of credit creation and
thereby controls credit in the economy.

Qualitative (Selective) Credit Controls

Selective or qualitative methods of credit control are meant to regulate and control the
supply of credit among its possible users and uses. They are different from quantitative or
general methods which aim at controlling the cost and quantity of credit. Unlike the general
instruments, selective instruments do not affect the total amount of credit but the amount
that is put to use in a particular sector of the economy. The aim of selective credit controls
is to channelize the flow of bank credit from speculative and other undesirable purposes to
socially desirable and economically useful uses. They also restrict the demand for money
by laying down certain conditions for borrowers. They therefore, embody the view that the
monopoly of credit should in fact become a discriminating monopoly.
It measures that would influence the allocation of credit, at least to the point of decreasing
the volume of credit used for selected purposes without the necessity of decreasing the
supply and raising the cost of credit for all purposes.
(A) Regulation of Margin Requirements

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This method is employed to prevent excessive use of credit to purchase or carry securities
by speculators. The central bank fixes minimum margin requirements on loans for
purchasing or carrying securities. They are, in fact, the percentage of the value of the
security that cannot be borrowed or lent. In other words, it is the maximum value of loan
which a borrower can have from the banks on the basis of the security (or collateral). For
example, if the central bank fixes a 10% margin on the value of a security worth Br 1,000,
then the commercial bank can lend only Br 900 to the holder of the security and keep Br
100 with it. If the central bank raises the margin to 25%, the bank can lend only Br 750
against a security of Br 1,000. If the central bank wants to curb speculative activities, it
will raise the margin requirements. On the other hand, if it wants to expand credit, it reduces
the margin requirements.
(B) Regulation of Consumer Credit
This is another method of selective credit control which aims at the regulation of consumer
installment credit or hire-purchase finance. The main objective of this instrument is to
regulate the demand for durable consumer goods in the interest of economic stability. The
central bank regulates the use of bank credit by consumers in order to buy durable
consumer goods on installments and hire purchase.
(C) Rationing of Credit
Rationing of credit is another selective method of controlling and regulating the purpose
for which credit is granted by the commercial banks. It is generally of four types. The first
is the variable portfolio ceiling. According to this method, the central bank fixes a ceiling
on the aggregate portfolios of the commercial banks and they cannot advance loans beyond
this ceiling.
The second method is known as the variable capital assets ratio. This is the ratio which the
central bank fixes in relation to the capital of a commercial bank to its total assets. In
keeping with the economic exigencies, the central bank may raise or lower the portfolio
ceiling, and also vary the capital assets ratio. Thirdly, the technique also involves
discrimination against larger banks because it restricts their lending power more than the
smaller banks. Finally, by rationing of credit for selective purposes, the central bank ceases
to be the lender of the last resort. Therefore, central banks in mixed economies do not use
this technique except under extreme inflationary situations and emergencies.
(D) Direct Action
Central banks in all countries frequently resort to direct action against commercial banks.
Direction action is in the form of "directives" issued from time to time to the commercial
banks to follow a particular policy which the central bank wants to enforce immediately.
This policy may not be used against all banks but against erring banks. For example, the
central bank refuses rediscounting facilities to certain banks which may be granting too
much credit for speculative purposes, or in excess of their capital and reserves, or restrains
them from granting advances against the collateral of certain commodities, etc. It may also

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charge a penal rate of interest from those banks which want to borrow from it beyond the
prescribed limit. The central bank may even threaten a commercial bank to be taken over
by it in case it fails to follow its policies and instructions.

(E) Moral Suasion

Moral suasion is the method of persuasion, of request, of informal suggestion, and of advice
to the commercial bank usually adopted by the central bank. The executive head of the
central bank calls a meeting of the heads of the commercial banks wherein he explains
them the need for the adoption of a particular monetary policy in the context of the current
economic situation, and then appeals to them to follow it.
(F) Publicity
The central bank also uses publicity as an instrument of credit control. It publishes weekly
or monthly statements of the assets and liabilities of the commercial bank for the
information of the public. It also publishes statistical data relating to money supply, prices,
production and employment, and of capital and money market, etc. This is another way of
exerting moral pressure on the commercial bank. The aim is to make the public aware of
the policies being adopted by the commercial bank vis-a-vis the central bank in the light of
the prevailing economic conditions in the country.

Commercial Banking
Definition of Commercial Banking
Chamber's Twentieth Century Dictionary defines a bank as an "institution for the keeping,
lending and exchanging, etc. of money." Economists have also defined a bank highlighting
its various functions. According to Crowther, "The banker's business is to take the debts of
other people to offer his own in exchange, and thereby create money." A similar definition
has been given by Kent who defines a bank as "an organization whose principal operations
are concerned with the accumulation of the temporarily idle money of the general public
for the purpose of advancing to others for expenditure.' Sayers, on the other hand, gives a
still more detailed definition of a bank thus: "Ordinary banking business consists of
changing cash for bank deposits and bank deposits for cash; transferring bank deposits
from one person or corporation (one 'depositor') to another; giving bank deposits in
exchange for bills of exchange, government bonds, the secured or unsecured promises of
businessmen to repay, etc.'" Thus a bank is an institution which accepts deposits from the
public and in turn advances loans by creating credit, It is different from other financial
institutions in that they cannot create credit though they may be accepting deposits and
making advances.

Commercial Banking Services

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Commercial banks perform a variety of functions which can be divided as: 1) accepting
deposits; (2) advancing loans; (3) credit creation; (4) financing foreign trade; (5) agency
services; and (6) miscellaneous services to customers. These functions are discussed as
follows:
(1) Accepting Deposits
This is the oldest function of a bank and the banker used to charge a commission for
keeping the money in its custody when banking was developing as an institution,
Nowadays a bank accepts three kinds of deposits from its customers. The first is the savings
deposits on which the bank pays small interest to the depositors who are usually small
savers. The depositors are allowed to draw their money by cheques up to a limited amount
during a week or year. Businessmen keep their deposits in current accounts. They can
withdraw any amount standing to their credit in current deposits by cheques without notice.
The bank does not pay interest on such accounts but instead charges a nominal sum for
services rendered to its customers. Current accounts are known as demand deposits.
Deposits are also accepted by a bank in fixed or time deposits. Savers who do not need
money for a stipulated period from months to longer periods ranging up to 10 years or more
are encouraged to keep it in fixed deposit accounts. The bank pays a higher rate of interest
on such deposits. The rate of interest increases with the length of the time period of the
fixed deposit. But there is always the maximum limit of the interest rate which can be paid.
(2) Advancing Loans
One of the primary functions of a commercial bank is to advance loans to its customers. A
bank lends a certain percentage of the cash lying in deposits on a higher interest rate than
it pays on such deposits. This is how it earns profits and carries on its business. The bank
advances loans in the following ways:
(a} Cash Credit. The bank advances loans to businessmen against certain specified
securities. The amount of the loan is credited to the current account of the borrower. In
case of a new customer a loan account for the sum is opened. The borrower can withdraw
money through cheques according to his requirements but pays interest on the full amount.
(b) Call Loans. These are very short-term loans advanced to the bill brokers for not more
than fifteen days. They are advanced against first class bill of securities. Such loans can be
recalled at a very short notice. In normal times they can also be renewed.
(c) Overdraft. A bank often permits a businessman to draw cheques for a sum greater than
the balance lying in his current account. This is done by providing the overdraft facility up
to a specific amount to the businessman. But he is charged interest only on the amount by
which his current account is actually overdrawn and not by the full amount of the overdraft
sanctioned to him by the bank.
(d) Discounting bills of Exchange. If a creditor holding a bill of exchange wants money
immediately, the bank provides him the money by discounting the bill of exchange. It
deposits the amount of the bill in the current account of the bill-holder after deducting its
rate of interest for the period of the loan which is not more than 90 days. When the bill of

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exchange matures, the bank gets its payment from the banker of the debtor who accepted
the bill.
(3) Credit Creation
Credit creation is one of the most important functions of the commercial banks. Like other
financial institutions, they aim at earning profits. For this purpose, they accept deposits and
advance loans by keeping small cash in reserve for day-to-day transactions. When a bank
advances a loan, it opens an account in the name of the customer and does not pay him in
cash but allows him to draw the money by cheque according to his needs. By granting a
loan, the bank creates credit or deposit.
(4) Financing Foreign Trade
A commercial bank finances foreign trade of its customers by accepting foreign bills of
exchange and collecting them from foreign banks. It also transacts other foreign exchange
business and buys and sells foreign currency.
(5) Agency Services
A bank acts as an agent of its customers in collecting and paying cheques, bills of exchange,
drafts, dividends, etc. It also buys and sells shares, securities, debentures, etc. for its
customers. Further, it pays subscriptions, insurance premia, rent, electric and water bills,
and other similar charges on behalf of its clients. It also acts as a trustee and executor of
the property and will of its customers. Moreover, the bank acts as an income tax consultant
to its clients. For some of these services, the bank charges a nominal fee while it renders
others free of charge.
(6) Miscellaneous Services
Besides the above noted services, the commercial bank performs a number of other
services. It acts as the custodian of the valuables of its customers by providing them lockers
where they can keep their jewelry and valuable documents. It issues various forms of credit
instruments, such as cheques, drafts, travellers' cheques, etc. which facilitate transactions.
The bank also issues letters of credit and acts as a referee to its clients. It underwrites shares
and debentures companies and helps in the collection of funds from the public. Some
commercial banks also publish journals which provide statistical information about the
money market and business trends of the economy.

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