Banking Principles,

Procedures and Practices

Lecture TWO
 Banking Principles,
Procedures and Practices

The Central Bank

04.
Lecture One March.23
 Chapter Outline and Contents
 Functions of the central bank in Methods of Note Issuance in
any country different countries
Roles of the central in any country • Fixed Fiduciary System
Monetary policy • Maximum Fiduciary System
• Proportional Reserve System
Price stability
• The Minimum Reserve System
Fiscal Policy
 Nature of the Central Bank
 A central bank is a financial  It is the most powerful economic
institution that is owned by the institutions that has been developed to
government, which has a central role help society to manage its collective
of managing the currency. financial affairs.
 Some of the well-known central  The activities of the central bank
banks are the US Federal Reserve, regarded essential for the proper
Bank of England, Bank of Canada, functioning of the economy.
Reserve Bank of Australia, and the  The central banks have crystallized
European Central Bank into a distinct entity of their own.
 Core Functions of the Central Bank

• A central bank can generally be defined as a financial institution

responsible for overseeing the monetary system for a nation, or a group
of nations, with the goal of fostering economic growth without inflation.
• The main functions of a central bank in country can be listed as follows:
• To manage monetary policy with the aim of achieving price stability
• To prevent liquidity crises, situations of money market disorders and financial
crises;
• To ensure the smooth functioning of the payments system.
Roles of the Central Bank in any Country
Regulator Of Currency: Monopoly Power Of Note Issue
Controller Of Credit: Monetary Policy
Bankers Bank And Banking Supervision
Banker, Fiscal Agent And Adviser To The Government:
Lender Of The Last Resort:
Custodian Of Cash Reserves Of Commercial Banks:
Custody And Management Of Foreign Exchange Reserves:
 1. Issue and Regulator of Currency:
Monopoly Power Of Note Issue
• One of the most important functions of a central bank is the issue and regulation of
currency. Enjoy the monopoly of note issue.
• Central banks are vested with monopoly of the note issuance for the following
reasons.
• To insure uniformity in the note issue which will facilitate trade and exchange within the
country.
• To imprint the notes with a distinct prestige.
• To restrict or expand the supply of notes according to the requirements of the economy.
• To bring stability in the monetary standard and create confidence among the public.
• To influence and control credit creation by commercial banks.
 Different methods of Note Issue

Fixed Fiduciary System

Maximum Fiduciary System

Proportional Reserve System

The Minimum Reserve System

 Partial Fiduciary System
• Under this system a fixed amount laid down by law need to covered by
gold with out affecting convertibility of notes.
• The system has been criticized on the ground that it facilitates inflation
and exposes the currency to the danger of monetary instability.
 Maximum Fiduciary System
• Under this system, maximum limit up to which central bank can issue
notes without any gold backing is fixed by the government.
• The maximum limit may change depending on the circumstances.
• The central bank is given freedom with regards to the form and amount of
reserve that should be kept against note issue .
• As a result there may be excessive issue of notes leading to inflation.
 Proportional Reserve System
• Under this system, a certain percentage of note issue should be backed by gold
reserve.
• The remaining amount of note issue should be covered by government securities.
• This system was first introduced in Germany, later was adopted in USA in 1913.
• This system has the advantage of elasticity.
• The supply of money can be increased easily to meet the demands of the country.
• The system provides adequate security as a certain percentage of note issue is
covered by gold. So, it creates confidence in the public.
 Minimum Reserve System
• Under this system, the central bank is required to maintain a minimum
reserve of gold or foreign securities or both.
• No maximum limit is placed on the amount of note issue.
• The central bank can issue notes according to the needs of the country.
2. Controller Of Credit: Monetary Policy
• The most function of central bank is to control credit created by commercial bank.
• Money and credit represent a powerful force for good or evil in the economy.
• Money cannot manage itself. So, it is the duty of the central bank to ensure that
money and credit is properly managed so that inflationary and deflationary pressures
can be controlled in the economy.
• In modern times, bank credit has become the important source of money and
commercial banks have unlimited power to expand or contract credit.
• A central bank has a number of weapons to control credit created by commercial
banks.
 Methods of credit control
• Methods of credit control are broadly divided into two:-
• Quantitative credit control methods.
• Qualitative or selective credit control methods.
• Quantitative credit control methods.
• This methods aims to control the total quantity of cost of credit created by banks.
• This method is traditional and indirect.
• This includes-Bank rate policy, Open market operations and variable reserve
ratio.
 Qualitative or selective credit control
methods
• Qualitative or selective credit control methods:-
- Qualitative methods control the use and direction of credit.
• These controls are direct, which consist of:
• Regulation of consumer credit
• Margin requirements
• Rationing of credit
• Direct action
• Moral suasion
• Publicity.
 3. Bankers Bank And Banking
Supervision
• The central bank acts bankers bank in different capacities.
• Custodian of cash reserve of commercial banks.
• Lender Bank of central clearance, settlement and transfer.
 4. Banker, Fiscal Agent And Adviser To
The Government:
• The central bank acts as the banker, agent and advisor to the government.
• As a banker to the government, the central banks receives deposits and
make payments on behalf of the government.
• It buys and sells foreign currencies on behalf of the government.
• As an agent, the central bank makes short term loans to the government
for a period not exceeding 90 days.
 5. Lender Of The Last Resort:
• The main advantages of the central bank's functioning as the lender of the
last resort are:
• It increases the elasticity and liquidity of the whole credit structure of the economy.
• It enables the commercial banks to carry on their activities even with their limited
cash reserves.
• It provides financial help to the commercial banks in times of emergency.
• It enables the central bank to exercise its control over banking system of the country.
 6. 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
banks.
• 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.
 7. Custody and Management Of Foreign
Exchange Reserves:
• The central bank keeps and manages the foreign exchange reserves of the country.
• Funds coming from and going out to foreign countries are channeled through the
central bank.
• All the incomes in foreign currencies accrued to the central bank to go the foreign
exchange accounts and payments are met from these accounts.
• All the balances are kept under the custody of bank.
• Further, the central banks in most countries maintain both gold and foreign
currencies as reserves against note issue and also meet adverse balance of payments.
 9. Collection Of Data
• In addition to above functions, modern central bank collects and publishes
important monetary data pertaining to the working of the banking system
and the economy as a whole.
• It helps to understand the nature and magnitude of problems facing the
economy and seeks the solutions thereof.
 Monetary Policy
Bank of SL Monetary Policy
 Price stability
 Formulating and implementing monetary
and exchange rate policies.
 Maintaining and enhance the value of the
local currency
 Maintain financial stability
 Harmonize and coordinate Government
Fiscal policies with monetary policies.
 The Second Class-work
Group Presentation:
What is the Role of Central Banks in
Supporting Country’s Economic Growth?
 The Second Class-work
Group Presentation:
What is Monetary Policy? A Brief
Introduction.
Questions