central bank - Definition, Functions

Central Banks

The banking system of a country can work systematically in coordinated manner, only if there is an apex institution to direct the activities of the banks. Such apex institution is popularly known as 'central bank'. The central bank of the country is an autonomous institution, entrusted with powers of control and supervision. It controls the monetary and banking system of the country. After World War II, the International Monetary conference held at Brussels in 1929 recommended the setting up of a central bank in every country. The central bank of our country, known as Reserve Bank of India was set up in 1935. The central bank of England called Bank of England was established in 1694. It is known as the 'mother of central banks', since it provides the fundamentals of the art of central banking.

The central bank of France called 'Bank of France' was founded in 1800. The USA established a central banking system in the form of Federal Reserve Banks in 1914.

Definition of a central bank

A central bank has been defined in terms of its functions. The following are some of the definitions given by economists.

According to 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'.

H.A. Shaw defines a central bank, 'as a bank which controls credit'.

In the words of Hawtrey 'a central bank is that which is the lender of the last resort'.

According to Samuelson, 'a central bank is a bank of bankers. Its duty is to control the monetary base and through control of high-powered money to control the community's supply of money.

Distinction between central banks and commercial banks

The central bank is basically different from commercial banks in the following respects.

The central bank is the apex institution of the monetary and banking system of the country. A commercial bank is only a constituent unit of the banking system and a subordinate to the central bank.

While the central bank possesses the monopoly of note-issue, commercial banks do not have this right.

The central bank is not a profit making institution. Its aim is to promote the general economic policy of the government. But, the primary objective of commercial banks is to earn profit for their shareholders.

The central bank maintains the foreign exchange reserves of the country. The commercial banks only deal in foreign exchange under the directions of the central bank.

The central bank is an organ of the government and acts as its banker and the financial advisor, whereas commercial banks act as advisors and bankers to the general public only.

Functions of Central bank

The main functions of a central bank are common all over the world. But the scope and content of policy objectives may vary from country to country and from period to period depending on the economic situations of the respective country. Generally all the central banks aim at achieving economic stability along with a high growth rate and a favourable external payment position through proper monetary management. The common functions of central banks are discussed below.

Regulator of currency

The issue of paper money is the most important function of a central bank. The central bank is the authority to issue currency for circulation, which is a legal tender money. The issue department of the central bank has the responsibility to issue notes and coins to the commercial banks. The central bank regulates the credit and currency according to the economic situation of the country. In the methods of note issue, the central bank is required to keep a certain amount or a fixed proportion of gold and foreign securities against the total notes issued. The Reserve Bank of India is required to keep Rs.115 crore in gold and Rs.85 crore in foreign securities, but there is no limit to the issue of notes.

Having the monopoly of note issue, central bank gains advantages as

Ensuring uniformity of the notes issued and a proper control over the supply of money can be exercised.

Bring stability in the monetary system and creates confidence among the public.

Government is able to earn profits from printing currencies.

Banker, Agent and Adviser to the Government

The central bank of the country acts as the banker, fiscal agent and advisor to the government. As a banker, it keeps the deposits of the central and state governments and makes payments on behalf of governments. It buys and sells foreign currencies on behalf of the government. It keeps the stock of gold of the country. As a fiscal agent, the bank makes short-term loans to the government for a period not exceeding 90 days. It floats loans and advances to the State governments and local bodies. It manages the entire public debt on behalf of the government. As an adviser, the bank gives useful advice to the governments on important monetary and economic problems like devaluation, foreign exchange policy and budgetary policy.

Custodian of cash Reserves of commercial banks

Commercial banks are required to keep a certain percentage of cash reserves with the central bank. On the basis of these reserves, the central bank transfers funds from one bank to another to facilitate the clearing of cheques.

Custodian and Management of Foreign Exchange reserves

The central bank keeps and manages the foreign exchange reserves of the country. It fixes the exchange rate of the domestic currency in terms of foreign currencies. If there are any fluctuations in the foreign exchange rates, it may have to buy and sell foreign currencies in order to minimize the instability of exchange rates.

Lender of the last resort

By giving accommodation in the form of re-discounts and collateral advances to commercial banks, bill brokers and their 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 when they are faced with difficult situations so as to save the financial structure of the country from collapse.

Clearing Function

The central bank acts as a 'clearing house' for other banks and mutual obligations are settled through the clearing system. Since it holds cash reserves of commercial banks, it is easier for the central bank to act as a 'clearing house'.

Controller of credit

The most important function of the central bank is to control the credit creation power of commercial banks in order to control inflationary and deflationary pressures within the economy. For this purpose, the central bank adopts Quantitative methods and Qualitative (selective) methods. Quantitative methods aim at controlling the cost and quantity of credit by adopting i) bank rate policy ii) open market operations iii) variations in reserve ratios of commercial banks. Qualitative methods control the use and direction of credit. It involves i) regulation of margin requirements ii) regulation of consumer credit, iii) rationing of credit, iv) direct action by the central bank, and v) moral suasion

Besides the above functions, the central bank performs many additional functions. It has to study all problems relating to i) credit, ii) fluctuations in price level iii) fluctuations in foreign exchange value. It has to collect monetary and financial statistics, conduct research and provide information. It has to look after the matters relating to IMF and the World Bank. All together, the central bank is the financial and monetary guardian of the nation.