Central Bank and its Functions :
Question : Discuss the Various functions performed by the central bank in a developing economy.
Central Bank:
A central bank is the apex institution in the banking and financial structure of the country. It plays a leading role in organising, running, supervising, regulating and developing the banking and financial structure of the economy. Its activities are very essential for the proper functioning of an economy.
According to Samuelson, “Every central bank has one function. It operates to control economy, supply of money and credit.”
According to Kent, ” Central bank may be defined as an institution which is charged with the responsibility of managing the expansion and contraction of the volume of money in the interest of general public welfare.”
According to Vera Smith,” The primary definition of the central bank is the banking system in which a single bank has either a complete or residuary monopoly of note issue.”
All the countries in the world have their central banks. It is called by different names in different countries. It is known as the Bank of England in England, the Federal Reserve System in USA, the Bank of France in France, and the Reserve Bank of India in India.
The Reserve Bank of India was established on 1 April, 1935. It was nationalised on 1 January, 1949. The executive head of the RBI is called the Governor. Its headquarter is at Mumbai, which is known as the commercial capital of India. It has four zonal offices at Delhi, Kolkata, Chennai and Mumbai for four regions: northern, eastern, southern and western regions respectively.
Functions of Central Bank:
1. Bank of Issue
2. Banker, Fiscal Agent and Adviser to government
3. Banker to the Bank
4. Lender of the Last Resort
5. Clearing House Function
6. Controller of Credit
7. Custodian of Nation’s Foreign Exchange Reserve
8. Promotional and Developmental Function
1. Bank of Issue:
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The central bank is the bank of issue. The central bank enjoys the monopoly of issuing notes and currency.
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The currency issued by the central bank are legal tender, any individual can not deny to accept these as money.
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The currency issued by the central bank is high powered money as it directly or indirectly gear up the money supply of the economy.
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In India with the exception of one rupee notes which are conventionally issued the Government of India, the entire note issue is done by the Reserve Bank of India.
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In order to prevent misuse of this power the central bank is required to keep a certain minimum amount of reserve in the form of gold and foreign securities against the issue of notes.
2. Banker, Fiscal Agent and Advisor to the Government :
Central bank in all the countries act as banker, fiscal agent and adviser to the government.
A. The Central Bank as a Banker :
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Like any commercial concern, the government also needs a bank account.
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The central bank acts as a banker to the government, it performs the same functions for government as the commercial banks performs for general public.
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It accept deposits of cash, cheques, draft etc from the government.
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It provide cash to government for paying salaries and wages.
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It makes payments on behalf of the government.
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It gives short – period loans to the government.
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It buys and sells foreign currencies on behalf of the government.
B. Fiscal Agent – Function:
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The central bank manages public debt.
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It issues new loans on behalf of the government, receives subscriptions to these loans, pay interest on them and finally repay these loans.
C. Adviser Function:
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It advises the government on all financial and monetary matters and in the formulation of economic policies.
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It advises on the formulation of policy of control of inflation or deflation, devaluation or revaluation of currency etc.
3. Banker to the Banks:
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The central bank acts as the custodian of cash reserves of the commercial banks. The commercial banks are required to keep a certain percentage of their deposits as reserve with the central bank.
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The central bank provides – short – term credit to the commercial banks.
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It provides financial assistance to the banks by discounting the bills of exchange presented by the commercial banks and through loans and advances against approved securities.
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It provides them guidance and direction and regulates and control their financial activities.
4. Lender of the Last Resort:
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The central bank is regarded as the lender of the last resort. De Kocks regards this function as sine qua non means absolutely essential function.
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A lender of last resort is an institution i.e., central bank of a country, that offers loans to banks or other eligible financial institutions that are experiencing financial difficulty or are considered highly risky or near collapse.
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When commercial banks have exhausted their resources and are in need of funds, they approach the central bank to tide over their financial crises.
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The central bank acts as a lender of last resort to banks that no longer have other available means of borrowing, and whose failure to obtain credit would dramatically affect the economy.
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The central bank provides directly or indirectly all financial assistance to the commercial banks, discount houses or other financial institutions.
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In the time of financial stress the central bank assists them through discounting of approved securities and collateral loans and advances.
5. Clearing House Function:
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The central bank acts as the clearing house for transfer and settlement of mutual claims of the commercial banks on each other.
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This crucial function involves the settlement and clearance of interbank transactions and the facilitation of smooth payment operations within the economy.
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Since the commercial banks keep their cash reserve with the central bank, it is easier and convenient to clear and settle their claims on each other by making transfer entries in their accounts maintained with the central bank, without involving transfer of funds.
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The central bank provides clearing house facility in big cities and trade centres.
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It is simple, convenient, time saving and economical device for settling the claims of commercial banks on each other.
a. Clearing Interbank Transactions :
The central bank acts as a clearing house for interbank transactions. Banks engage in various financial transaction with each other, such as transferring funds, exchanging checks or settling debts. As an intermediary between banks, central bank provides a platform for these transactions to be cleared, reconciled and settled in an orderly manner.
b. Facilitating Fund Transfers:
As the clearing house, the central bank facilitates the transfer of funds between banks. When one bank needs to transfer funds to another bank, they can rely on the central bank, to ensure the transfer is completed accurately and securely. This eliminates the need for individual banks to establish direct relationships with every other bank, simplifying the process and reducing costs.
c. Providing a Secure Settlement Mechanism:
The central bank provides a secure settlement mechanism for interbank transactions. As an intermediary the central bank ensures that the funds are transferred accurately and promptly. The central bank’s oversight and monitoring of the clearing process help to maintain the integrity and stability of the financial system.
d. Managing Liquidity :
As the clearing house, the central bank manages the liquidity needs of banks. It ensures that banks have access to sufficient funds to meet their payment obligations. In case of temporary liquidity shortages, the central bank can provide short term loans to banks, ensuring the uninterrupted flow of funds within the system.
e. Maintaining Financial Stability:
By overseeing the clearing and settlement process, the central bank plays a crucial role in maintaining financial stability. It monitors the risk exposure of banks and implements necessary measures to prevent systemic risks. The central bank also sets and enforces regulations related to the clearing compliance and reducing the likelihood of fraudulent activities.
This way the clearing house function of central bank is essential for the efficient functioning of the financial system and supports the overall economic activity of a country.
6. Controller of Credit:
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The most important function of the central bank is to control the credit creation by the commercial banks.
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Bank money or credit money is the major component of supply of money. It is essential to control the supply of credit for smooth functioning of the economy.
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The central bank adopts various quantitative and qualitative methods of credit control. Which includes open market operations, varying cash reserve ratio, consumer credit regulations margin requirements, moral suasion, direct action and publicity etc.
7. Promotional and Developmental Functions:
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Central bank bears the responsibility of developing and promoting a strong banking system.
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For this purpose, it provides liberal and cheap re – discounting facilities to commercial banks and gives various types of concessions.
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