Chapter-2

Central Banking
2.1. Introduction

To understand what is the functions of central bank, firstly we should know about

what central bank is? Every country of the world has its own central bank for resolving all

the monetary and credit problems in the country. We can define the central bank

as “Central bank is an institution, which is charged with the responsibility of managing the

expansion and contraction of the volume in the interest of the general public welfare”.

England established her first Central Bank “Bank of England” in 1694. The Federal

Reserve System which undertakes banking in United States was organized

in 1913. France set up her Central Bank (Bank of France) in 1800. Indiaestablished the

Reserve Bank of India in 1935, Pakistan established her first central bank (State Bank of

Pakistan) on 1948. Ethiopia started the central bank (National Bank of Ethiopia)in 1906.

2.2. Functions of Central Bank

Almost the primary functions of Central Bank in almost every country are same,

but some secondary functions of central bank may different from others. De, Kock, an

economist has given the following list of the main important functions of central bank.

1. It has sole right to issue note.

2. It serves as a banker to the state.

3. It acts as banker’s bank.

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 4. It is the lender of the last resort.

5. It is the guardian of money market.

6. It performs the duties of a clearing house.

The primary functions of central bank are given below in details:-

1. Monopoly of Note-Issue

In early banking, every bank has the practice of issuing currency notes, which

lacking similarity, losing public confidence, causing inflation and ultimately failure of the

banks. Hence due to such reasons, this right of issuing currency notes was given only to

central bank of the country, everywhere in the world. Now the central bank issues currency

notes and maintains their value in the country also regulates them according to the

requirements of the country. Central banks, in modern times have been granted the sole

rights to print and distribute currency notes. So, one of the main functions of central bank

is to issue currency notes.

2. Bankers to the Government

The Central Bank acts as the banker, financial agent and advisor to the government.

The surplus money of the government is kept with the Central Bank. It lends money to

government. The Central Bank is usually required to make temporary advances to the

government in anticipation of collection of revenues. The Central Bank also undertakes to

provide the government with necessary foreign exchange for making payments abroad.

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 It is necessary that there should be close co-operation between the Central Bank

and the government. The government is the ultimate authority for laying down the broad

monetary policies of the country and Central Bank is the institution for carrying out of such

policies.

The Central Bank as a fiscal agent to the government accepts loans and manages

public debts, receives taxes and other payments from the public. The government bonds

and treasury bills are issued by the Central Bank on behalf of the government.

As the financial adviser, the Central Bank provides valuable advice to the

government on important financial matters like, foreign exchange policy, commercial

policy, rising of funds from market, etc.

3. Banker’s Banks

The Central Bank Acts as the bankers' bank. As such it performs the following function.

Custodian of cash reserves of commercial banks: The commercial banks of the country are

required to keep a certain percentage of their deposits with the Central Bank. It secures the

advantage of centralized cash reserves. Such cash reserves with the Central Bank have the

following advantages:

(a) The centralization of cash reserve is a source of great strength to the banking system of

the country as it strengthens the confidence of the public

(b) Centralized reserves can be used effectively and quickly in times of emergency.

(c) This ensures liquidity in the country.

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(d) These reserves promote liquidity of commercial banks as they enable the Central Bank

to undertake rediscounting of bills on a more extensive scale for the purpose of meeting the

requirements of the money market.

(e) The Central Bank can control credit by varying the cash reserves that commercial banks

should keep with it.

4. Lender of the Last Resort

Central bank also acts as the lender of the last resort. The central bank has been described

as "the lender of last resort", which means that it is responsible for providing its economy

with funds when commercial banks cannot cover a supply shortage. In other words, the

central bank prevents the country's banking system from failing.

In difficult time a person can get help from commercial bank. But in case of bank, his

financial requirements are fulfilled only by the central bank. Central bank provides

financial, accommodation to commercial banks; cooperative banks and other financial

institutions in case of financial crises. Central bank helps them either by advancing loans or

by discounting bill of exchange held by the commercial banks. This is also one of the

important functions of central bank.

5. Act as a Guardian

Central Bank is the custodian of nation's gold and foreign exchange reserves. Previously, to

some extent, the value of a currency depends upon the gold reserves or foreign exchange

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reserves held as the backing for the currency. As such, it is the responsibility of the Central

Bank to maintain sufficient reserves and to prevent their depletion. The Central Bank

manipulates the bank rates and takes other steps to conserve the reserves of gold and

foreign exchange.

Another function of central bank is that it is the custodian (tebaki) of all resources of

country. It controls and regulates the money market of the country. The central bank is

vested with the power to control foreign exchange and custodian of nation's gold. Hence it

exercises full control on both the visible and invisible payments from and to the country.

Similarly, credit performs the important functions of supplying money in the modern

economy. The value of money is influenced by the volume of credit. The volume of credit in

the country is regulated for the economic stability. This regulation of credit by the central

bank is known as monetary policy or credit control. Controlling credit is also from one of

the important functions of central bank.

6. Clearing House

Central bank of country also acts as a clearing house for the member banks. A clearing

house is a place where the representatives of commercial banks meet to exchange cheques

drawn on each other and then settle the difference owed to the other. It may also be

defined as an association of banks to facilitate the exchange, off-set and settlement of credit

claims among them and to serves their mutual interest. A clearing house is an institution

where interbank claims, i.e., claims of banks against one another are settled. The net

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balances or differences called the clearing balances are settled by mere transfers between

their respective accounts at the Central Bank.

As every central bank keeps a certain percentage of the cash deposits with the

central bank, the settlement of inter-bank obligations becomes easy by simple process of

book entries. With the help of clearing house, the payments and receipts of large amounts

become convenient and secure without involving any cash. The advantage of this system is

not only to secure the large amount of payments without risk, loss of time and use of

precious metal, but this facility also enables the central bank to carry on the monetary

policy of the country more effectively.

central banks also perform various other functions like

Publishes economic statistics and other information:

The Central Bank regularly collects and publishes the statistics regarding various economic

activities of the government, banking system, etc. Further it provides useful information

regarding government policies.

Development functions:

The Central Bank Acts as the catalyst of economic growth of the country. It acts as an

agency of economic growth. It renders various developmental functions such as

(i) Provision of credit facilities to agricultural industry and other priority sectors through

commercial banks and co-operative banks.

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(ii) Expansion of banking facilities in the country.

(iii) Maintaining price stability in the country.

(iv) Mitigating the effects of trade cycles by its effective monetary policies, etc.

The responsibility of the Central Bank is increasing every day and its functions are

expanding. The well-administered central banking functions are necessary for all the coun-

tries especially for the developing countries to maintain price stability and economic

growth.

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