CENTRAL BANKING

What is Central Bank? The Central Bank is the supreme monetary and
banking authority. According to De Cock, " a central bank is a bank which
constitutes the apex of the monetary and banking structure." In the statutes
of Bank for International Settlement (BIS), a central bank is defined as "the
bank in any country to which has been entrusted the duty of regulating the
volume of currency and credit in that country."

Functions:

Monetary

Management,

Banking

Supervision

and

Developmental.

A. MONETARY MANAGEMENT:
Note issuance
Previously almost every bank could issue notes. It led to over issue of
notes very often and as such it created many troubles. Then
Government decided to give the power of issuing notes to a single
institution. Now the central bank enjoys the sole right to issue notes.
Notes are issued according to requirements on the basis of a certain
principle.
The notes issued by the central bank represent cash. This cash
constitutes the assets of other banks. Hence, the note-issue function is
necessary for the central bank to control the banking system by being
the ultimate source of cash.

Banker to the Government

The central bank acts as the banker to the government in the following
ways:
a) It acts as the custodian of all the funds of the government. The
bank usually pays no interest on these balances.
b) All payments of the government are made through the central
bank.
c) The central bank also acts as the lender to the government in
times of financial difficulties. The loans are allowed on short-term
basis against treasury bills and other securities.
d) It acts as the adviser to the government about financial matters.
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e) It manages the public debt on behalf the government.

Banker's Bank
The central bank acts as the banker to the commercial banks. The
commercial banks, either by law or custom, have to maintain a certain
percentage of their deposits as cash reserves with the central bank. The
reserve maintenance allows the central bank to exercise control over
the activities of those banks.

Clearing House Operation

The central bank acts as the clearing house for other banks. Its function
in this respect is to help the settlement of their mutual claims that arise
by way of collection and payment to cheques. All banks have their
reserves with the central bank. They settle their clearing differences by
drawing cheques on the central bank. The central bank will clear up
these differences by means of debit and credit entries in their accounts
with it.

Lender of the last Resort

The central bank not only maintains the reserves of the commercial
banks, it also acts as the lender of the last resort to them. Sometimes
they fail to meet the depositors demand for cash. They may not get
funds from other sources to meet their demand. Then they can
approach the central bank for help in such and other emergency needs.
The purpose of the central bank is not to compete with them but to help
them. Hence, the central bank will come forward to provide these banks
with necessary funds. The funds are allowed by rediscounting their bills
of exchange, promissory notes and other commercial papers or against
approved securities. Thus, the central bank acts as the lender of the
last resort or the ultimate source of cash to other banks.
In times of financial crisis and panic, the central banks help the
commercial banks not only by granting advances but by giving then the
benefit of advice as well.
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Foreign Exchange Operations

The value of national currency may fluctuate both at home and abroad.
The central bank is to keep certain reserves for maintaining confidence
in home currency. This reserve is the safeguard against domestic
monetary circulation. Similarly, it is to keep necessary foreign exchange
reserves for maintaining stability in the external value of national
currency. Hence, the central bank acts as the custodian of the foreign
exchange reserves and conducts foreign exchange operations in such a
way as to keep the external value of the currency stable.

Controller of Credit.
The very important function of a central bank is that it acts as the
controller of credit. Expansion and contraction of credit may be
associated with many evils. As the leader of the money market, the
central bank controls the volume of credit according to the total needs
of the economy. The supply of credit takes place through the
commercial banks. Hence, the central bank regulates their credit
creation activities through different instruments of control, such as the
bank rate, open market operation, variable reserve ratio and selective
methods.

METHODS OF CREDIT CONTROL: Quantitative and Qualitative.

Quantitative or General Methods
(i)

Bank rate policy: Bank rate is the rate at which the central bank will
rediscount bills of exchange or promissory notes and grant loans on
approved securities. Bank rate is also known as discount rate.
Sometimes, there may be more volume of credit in the economy. This will
lead to higher prices, higher wages and unusual economic activities.
Then the central bank may raise up the bank rate. With the rise in the
bank rate, the market rates will also go up. This will restrict new
investment or expansion or replacement. The ultimate result is that
prices will fall due to reduction in the volume of credit, employment and
income. The reverse will happen when bank rate is lowered.
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(ii) Open market operations: Open market operations refer to purchase

and sale of securities by the central bank in the open market on its own
initiative. When commercial banks possess more reserves for credit
expansion purpose, the central bank will sell securities in the market. The
buyers will pay the central bank with cheques drawn on their own banks.
As a result the reserves of these banks will fall, and this will reduce their
credit operations. Similarly, when it buys securities it will pay the sellers
in cash or with cheques drawn on itself. This will increase credit
expansion capacity.
(iii) Variable reserve ratio: The central bank can control volume of credit
by varying cash reserve ratio whenever necessary. If central bank raises
the reserve ratio, it will lead to a reduction in the supply of credit.
Similarly, by an opposite process the supply of credit may be expanded.

Qualitative or Selective Methods

(i)

Rationing of credit: Rationing of credit means that central bank puts

restrictions on accommodation for credit. The credit is now rationed, and
as such it will not be available as a general rule. Here central bank limits
the amount of credit for each applicant.

(ii) Direct action: Some of the commercial banks conduct their activities
against the instructions as laid down by the central bank. Direct action
means that central bank will penalize these banks by charging penalty
rates over and above the official discount rate.
(iii) Moral suasion: This refers to central bank's policy of persuading he
commercial banks to conduct their business in a particular way.
(iv) Regulation of consumer's credit: Consumer's credit is created
through the purchase and sale of consumer's durable goods like cars, TV.
etc. Their prices are repayable in installments. The central bank may
impose strict terms and conditions for restricting this credit or liberalize
terms and conditions for encouraging this credit.
(v) Fixation of Margin requirements: The central bank can also control
the flow of credit by varying the 'margin' on borrowing against certain

types of securities which are offered by a particular class of borrowers for

taking loans.
B.

BANKING SUPERVISION:

The process of bank supervision takes two forms. One is the regulatory or offsite monitoring process, while the other is on-site inspection or bank
examination process. Bank regulation usually deals with the formulation and
implementation of specific rules and regulations for the conduct of banking
business, including the monitoring of the compliance with such rules. Bank
examination, on the other hand, ensure compliance with the rules and
regulations and assesses the soundness of individual institutions. Sometimes,
the function of bank regulation and examination are centered in one
department, while in some central banks, they are separated into different
departments as a matter of policy.
C.

DEVELOPMENTAL FUNCTIONS:

In the under-developed countries, the central bank takes keen interest in the
promotion of economic development. It also takes part in the development of
commercial and other banking institutions. This development function does
not fall within the traditional functions of a central bank..

Functions of Central Bank

Traditional

Developmental

Monetary Management

Banking Supervision

On-Site

Note Issue

Govts Bank

Bankers Bank

Off-Site (CAMEL)

Clearing House

Lender of the
Last Resort

Quantitative

Bank Rate
Policy

Open Market
Operation

Foreign
Exchange
Operations

Credit Control

Qualitative

Variable Reserve
Ratio

Credit
Rationing

Direct
Action

Moral
Suasion

Regulating
Consumer Credit

Margin
Fixation