What is a Central Bank? Meaning and Functions of Central Bank
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Meaning of Central Bank, Functions of Central Bank
Meaning 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.
Definition of Central Bank:- 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.
(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.
(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.
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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.There are six functions which are performed by the central bank in almost all countries.
1. Monopoly of Note Issue: The issue of money was always the prerogative of the government. Keeping the minting of coins with itself, 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 overissue 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.
(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 centralisation 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, centralised 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.
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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 modern times, bank credit has become the most important source of money in the country, relegating coins and currency notes to a minor position. Moreover, it is possible, as we have pointed out in a previous chapter, for commercial banks to expand credit and thus intensify inflationary pressure or contract credit and thus contribute to a deflationary situation. It is, thus, of great importance that there should be some authority which will control the credit creation by commercial banks. As controller of credit, the central bank attempts to influence and control the volume of bank credit and also to stabilise business conditions in the country.
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 tends 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.