CHAPTER SEVEN

CENTRAL BANKING

INTRODUCTION
A central bank is an „apex institution‟ in the banking structure of a country. It supervises controls and
regulates the activities of commercial banks and acts as a banker to them. It also acts as a banker, agent
and adviser to the government in all financial and monetary matters. A central bank is also the custodian
of the foreign balances of the country and is responsible to maintain the rate of exchange fixed by the
government and manages exchange control. The most important function of a central bank is to regulate
the volume of currency and credit in a country. It will be no exaggeration to say that a modern central
bank is the central arch to the monetary and fiscal framework in almost all the countries developed or
developing in the world. In developing economies, the central bank has also to perform certain
promotional and developmental functions to accelerate the pace of economic growth.

Definition of Central Bank

In every country there is one bank which acts as the leader of the money market, supervising,
controlling and regulating the activities of commercial banks and other financial institutions. It acts as a
bank of issue and is in close touch with the government, as banker, agent and adviser to the latter. Such
a bank is known as the central bank of the country.

A banking institution can more easily be identified by the functions that it performs. According to Vera
Smith, “the primary definition of central banking is a banking system in which a single bank has either a
complete or residuary monopoly in the note issue.” Kisch and Elkin believe that “the essential function
of a central bank is the maintenance of the stability of the monetary standard.” In the statutes of the
Bank for International Settlements a central bank is defined as “the bank of the country to which has
been entrusted the duty of regulating the volume of currency and credit in that country.” De Kock gives
a very comprehensive definition of central bank. According to De Kock, a central bank is a bank which
constitutes the apex of the monetary and banking structure of its country and which performs, best it can
in the national economic interest, the following functions:

a) 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.

b) The performance of general banking and agency services for the state.

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 c) The custody of cash reserves of the commercial banks.

d) The custody and management of the nation‟s reserves of international currency.

e) The granting of accommodation, in the form of rediscounts, or collateral advances, to

commercial banks, bill brokers and dealers, or other financial institutions, and the general
acceptance of the responsibility of lender of last resort.

f) The settlement of clearances between the banks.

g) 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.

The nature of function of a central bank differs in a developed economy as compared to those in a
developing economy.

Functions of the Central Bank

The functions of the central bank differ from country to country in accordance with the prevailing
economic situation. But there are certain functions which are commonly performed by the central bank
in all countries. According to De Kock, there are six functions which are performed by the central bank
in almost all countries.

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1. Monopoly of Note Issue: The issue of money was always the prerogative of the government.
Keeping the minting of coins with it, the government delegated the right of printing currency notes to
the central bank. In fact the right and privilege of note issue was always associated with the origin and
development of central banks which were originally called as banks of issue. Nowadays, central banks
everywhere enjoy the exclusive monopoly of note issue and the currency notes issued by the central
banks are declared unlimited legal tender throughout the country. At one time, even commercial banks
could issue currency notes but there were certain evils in such a system such as lack of uniformity in
note issue, possibility of over-issue by individual banks and profits of note issue being enjoyed only by a
few private shareholders. But concentration of note issue in the central bank brings about uniformity in
note issue, which, in turn, facilitates trade and exchange within the country, attaches distinctive prestige
to the currency notes, enables the central bank to influence and control the credit creation of commercial
banks, avoids the over-issue of notes and, lastly, enables the government to appropriate partly or fully
the profits of note issue. The central bank keeps three considerations in view as regards issue of notes-
uniformity, elasticity (amount according to the need for money), and safety.

2. Custodian of Exchange Reserves: The central bank holds all foreign exchange reserves-key
currencies such as U.S. dollars, British pounds and other prominent currencies, gold stock, gold bullion,
and other such reserves-in its custody. This right of the central bank enables it to exercise a reasonable
control over foreign exchange, for example, to maintain the country‟s international liquidity position at a
safe margin and to maintain the external value of the country‟s currency in terms of key foreign
currencies.

3. Banker to the Government: Central banks everywhere perform the functions of banker, agent and
adviser to the government. As a banker to the government, the central bank of the country keeps the
banking accounts of the government both of the Centre and of the States performs the same functions as
a commercial bank ordinarily does for its customers. As a banker and agent to the government, the
central bank makes and receives payments on behalf of the government. It helps the government with
short-term loans and advances (known as ways and means advances) to tide over temporary difficulties
and also floats public loans for the government. It also manages the public debt (i.e., floats services and
redeems government loans). It advises the government on monetary and economic matters.

4. Banker to Commercial Banks: Broadly speaking, the central bank acts as the banker‟s bank in
three different capacities: (a) It acts as the custodian of the cash reserves of the commercial banks (b) It
acts as the lender of the last resort (c) It is the bank of central clearance, settlement and transfer. We
shall now discuss these three functions one by one.
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(a) It acts as the custodian of the cash reserves of commercial banks: Commercial banks keep part
of their cash balances as deposits with the central bank of a country known as centralization of cash
reserves. Part of these balances are meant for clearing purposes, that is, payment by one bank to another
will be simple book entry adjustment in the books of the central bank. There are many advantages when
all banks keep part of their cash reserves with the central bank of the country. In the first place, with the
same amount of cash reserves, a large amount of credit creation is possible. Secondly, centralized cash
reserves will enable commercial banks to meet crises and emergencies. Thirdly, it enables the central
bank to provide additional funds to those banking institutions which are in temporary difficulties. Lastly,
it enables the central bank to influence and control the credit creation of commercial banks by making
the cash reserves of the latter more or less.

(b) Lender of the last resort: As the banker‟s bank, the central bank can never refuse to accommodate
commercial banks. Any commercial bank wanting accommodation from the central bank can do so by
rediscounting (selling) eligible securities with the central bank or can borrow from the central bank
against eligible securities. By lender of the last resort, it is implied that the latter assumes the
responsibility of meeting directly or indirectly all reasonable demands for accommodation by
commercial banks in times of difficulties and crisis.

(c) Clearing agent: As the central bank becomes the custodian of cash reserves of commercial banks,
it is but logical for it to act as a settlement bank or a clearing house for other banks. As all banks have
their accounts with the central bank, the claims of banks against each other are settled by simple
transfers from and to their accounts. This method of settling accounts through the central bank, apart
from being convenient, is economical as regards the use of cash. Since claims are adjusted through
accounts, there is usually no need for cash. It also strengthens the banking system by reducing
withdrawals of cash in times of crisis.

Furthermore, it keeps the central bank of informed about the state of liquidity of commercial banks in
regard to their assets.

5. Controller of Credit: Probably the most important of all the functions performed by a central bank
is that of controlling the credit operations of commercial banks in order to control inflationary and
deflationary pressures within the economy. In modern times, bank credit has become the most important
source of money in the country, relegating coins and currency notes to a minor position. As controller of
credit, the central bank attempts to influence and control the volume of bank credit and also to stabilize
business conditions in the country.

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Objectives of Credit Control
• To Stabilize the Internal Price Level: - Abnormal amount of credit affects in both ways. In case of
excess; inflation grabs the economy and in case of shortage deflation plays the role. Thus, the aim of
the policy of the credit control should be to check the prices.

• Checking Booms and Depressions: - The operation of trade cycles causes instability in the country.
So the objective of the credit control should be to reduce the uncertainties caused by these cycles.
The central bank adjusts the operation of the trade cycles by increasing and decreasing the volume of
credit.

• Promotion of Economic Development: - The objective of credit control should be to promote

economic development and employment in the country. When there is lack of money, its supply
should be increased so that there are more and more economic activities and more and more people
may get employment.

• Stability of the Money Market: - The central bank should operate its weapons of credit control so
as to neutralize the seasonal variations in the demand for funds in the country. It should liberalize
credit in terms of financial stringencies to bring about stability in the money market.

• Stability in Exchange Rates: - This is also an important objective of credit control. Credit control
measures certainly influence the price level in the country. The internal price level affects the
volume of exports and imports of the country which may bring fluctuations in the foreign exchange
rates. While using any measure of credit control, it should be ensured that there will be no violent
fluctuation in the exchange rates.

Methods Used by the Central Bank for Credit Control

Some of the methods that can be used by the central bank for credit control are discussed as follows:
• Bank Rate or Discount Rate Policy: - It is the rate fixed by the central bank at which it rediscounts
first class bills of exchange and government securities held by commercial banks. It 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 and vice versa.

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 Open Market Operations: - 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. This causes the monetary
base (the quantity of notes and coins in circulation plus the quantity held by the banking system) to
be affected.

• Variable Reserve Ratio: - In some countries, banks are required to hold a certain fraction of
deposits as cash reserves, and the central bank can influence the money supply. If the reserve ratio is
raised, it means banks have to reduce their lending, so the money supply is reduced.

• Direct Action: - It 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.

6. Promoter of Economic Development: In developing economies the central bank has to play a very
important part in the economic development of the country. Its monetary policy is carried out with the
object of serving as an instrument of planned economic development with stability. The central bank
performs the function of developing long-term financial institutions, also known as development banks,
to make available adequate investible funds for the development of agriculture, industry, foreign trade,
and other sectors of the economy. The central bank has also to develop money and capital markets.

In addition, the central bank may also undertake miscellaneous functions such as providing assistance to
farmers through co-operative societies by subscribing to their share capital, promoting finance
corporations with a view to providing loans to large-scale and small-scale industries and publishing
statistical reports on trends in the money and capital markets. In short, a central bank is an institution
which always works in the best economic interests of the nation as a whole. In view of all these
functions, as discussed above, it follows that a modern central bank is much more than a Bank of Issue.