CHAPTER-TWO

CENTRAL BANKING

Introduction

According to Will Rogers, Central Bank is one of the three great inventions in the human
development, with fire and wheel. It may not be accepted by others even if the importance is known
for certainty by all.

Today, central bank is the central arch of the monetary and fiscal framework in every country of the
world and its activities are essential for the proper functioning of the economy and indispensable for
the fiscal operations for the government.
Central banking is mostly a recent development being essentially a product of the nineteenth
century.
century. The following cases can be considered here:
- Riksbank of Sweden – established in 1668
- Bank of England – established in 1694 – serve as a central bank in 1844
- Bank of France – established in 1800
- Reichs bank of Germany – established in 1876
- Bank of Netherlands – established in 1814 – on the ruins of old bank of Amsterdam
- National bank of Austria – established in 1817 – reorganized as the bank of Austria-
Hungary in 1877
- The bank of Norway – established in 1817
- The national bank of Denmark - established in 1818
- The national bank of Belgium - established in 1850
- The bank of Spain - established in 1856
- The bank of Russia - established in 1860
- The bank of Japan - established in 1882
- The bank of Italy - established in 1893
- The Swiss national bank - established in 1907
- The Federal Reserve system in America - established in 1913
- The bank of Canada - established in 1934
- National bank of Ethiopia - established in 1964 – National & Commercial Bank
proclamation, On January 1964
In the nineteenth century Central Banks of many other countries were established. They were
empowered to issue notes with special principles and powers. They became bankers and advisers of
their respective governments.

In 1920, The International Financial Conference held at Brussels resolved that “All those countries
which had not yet established a central bank should proceed to do so as soon as possible, not only
with a view to facilitating the restoration and maintenance of stability in their monetary and banking
systems but also in the interest of world cooperation.”Hence, a number of Central Banks were
added to the list of central banks in the world and there is no independent country without a central

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bank.The central banks of these countries establish an effective relationship with IMF matters
relating to foreign exchange.

Nature and Definition of Central Bank

A central bank, national bank, reserve bank or monetary authority, is an entity responsible for the
monetary policy of its country or of a group of member states and it called by different names in
different countries, such as the European Central Bank (ECB) in the European Union, the bank of
England in England,the Bank of France in France,Riks bank in Sweden, the Federal Reserve System
in the United States of America, State Bank in Pakistan, Reserve bank of India, National Bank of
Ethiopia in Ethiopia, etc. A central bank is a banking institution granted the exclusive privilege to
lend a government its currency.

Central banking is the apex of banking system. It plays an active role in implementing
government’s economic policy in the country. Its primary responsibility is to maintain the stability
of the national currency and money supply, but more active duties include controlling subsidized-
loan interest rates, and acting as a "bailout" lender of last resort to the banking sector during times
of financial crisis (private banks often being integral to the national financial system).

Economists have defined central bank differently, emphasizing its one function or the other.
 Vera Smith – The primary definition of central banking is a banking system in which a single
bank has either complete or a residuary monopoly of note issue.
 Show – The Central Bank is a bank which controls credit.
 Haultrey – Central Bank is a bank which controls credit.
 Statutes of the bank for international settlements – A Central Bank is the bank in any country to
which has been entrusted the duty of regulating the volume of currency and credit in the
country.
 Kisch and Elkin – A Central Bank is a bank whose essential duty is to maintain stability of the
monetary standard.

In general, a Central Bank may be defined as that central monetary institution which is charged with
performing the duties of bankers’ bank, fiscal agent for the government and managing the monetary
system of the country.

Functions of Central Bank

According to De Kock, and as accepted by the majority of economists the functions of a Central
Bank are:
1. Regulator of currency
2. Banker, Fiscal Agent and Advisor to the Government
3. Custodian of Cash reserve of Commercial Banks
4. Custody and Management of Foreign Exchange Reserves
5. Lender of Last resort
6. Clearing House for transfer and settlement

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7. Controller of Credit
8. Other functions

1. Bank of Issue/Regulator of Currency

The central bank is the monopoly of bank note issue. Notes issued by it circulate as legal tender
money. The reasons (benefit) for granting the exclusive monopolies of note issue to the central
bank are:
a) For credit control purpose
b) To impart the notes a distinctive prestige i.e., it brings stability in the monetary system and
creates confidence among the public.
c) To ensure uniformity in the notes issued which helps in facilitating exchange and trade
within the country.
d) To make it easy for the state to supervise and control the irregularities and malpractices
committed by the central bank in issuing notes.
e) To restrict or expand the supply of cash according to the requirements of the economy.
f) To control the banking system by being the ultimate source of cash.

2. Government Banker, Fiscal Agent and Advisor

a) As banker to the government the Central Bank keeps deposits of the Federal and regional
governments makes payments on behalf of governments, but it does not pay interest on
government deposits. It buys and sells foreign currencies on behalf of the government and
keeps the stock of gold of the government. Thus it is the custodian of government money
and wealth.
b) As a fiscal agent, the central bank makes short-term loans to the government for a period not
exceeding 90 days, floats loans, pays interest on them, and finally repays them on behalf of
the government.
c) As advisor, the central bank advises the government on such economic and money matters
as controlling inflation or deflation, devaluation or revaluation of the currency, deficit
financing and balance of payments, etc.

3. Custodian of commercial banks cash reserves requirement

Commercial banks are required by law to keep a certain percentage of the time and demand
deposits as a reserve at the Central Bank. The purpose of keeping reserves at the central bank
are:
a) For transfer of funds between commercial banks through the clearinghouse (clearance of
checks).
b) The central bank acts as the custodian of the cash reserve requirement of commercial banks
and helps in facilitating their transactions.
c) As a source of great strength to the banking system of the country.
d) As the basis of a large and more elastic credit structure than if the same amount were
scattered among the individual banks.

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 e) Centralized cash reserves can be utilized fully and most effectively during periods of
seasonal strains and in financial crises or emergencies.
f) By varying these cash reserves the central bank can control the credit creation by
commercial banks.
g) The central bank can provide additional funds on a temporary and short term basis to
commercial banks to overcome their financial difficulties.

4. Custody and Management of Foreign Exchange Reserves

This function derived from its functions as the bank of issue and the custodian of member
banks’ cash reserves. It keeps and manages the foreign exchange reserve of the country.
It is an official reservoir of gold and foreign currencies. It buys and sells foreign currencies at
international prices. It sells gold to the monetary authorities of other countries. It fixes the
exchange rates of the domestic currency in terms of foreign currencies and tries to bring stability
in foreign exchange rates. It manages exchange control operations by supplying foreign
currencies to importers and persons visiting foreign countries on business, studies, etc in
keeping with the rules laid down by the government.

5. Lender of the Last Resort

In its capacity of lender of the last resort, the central bank meets directly or indirectly all
reasonable demands for financial accommodation from the commercial banks, discount houses,
and other credit institutions subject to certain terms and conditions which constitute its discount
rate policy. As lender of last resort, the central bank grants accommodations in the form of
re-discounts and collateral advances to commercial banks, bill brokers, dealers, or other
financial institutions. These facilities help such institutions in order to help them in times of
stress so as to save financial structure of the country from collapse. Today this function is
regarded as the sine qua non of central banking

6. Bank of Central Clearance House for Settlement and Transfer

As a bankers’ bank, the central bank acts as a clearing house for transfer and settlement of
mutual claims of commercial banks. Since commercial banks keep their surplus cash reserves in
deposits with the central bank it is far easier to clear and settle claims between them by making
transfer entries in their accounts maintained with the central bank.
This function of the central bank is sometimes granted by law where as some other times by
customary functions of banks. It saves time and creates convinency plus test at any time the
degree of liquidity of banks.

7. Controller of Credit

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 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, it adopts quantitative and qualitative methods. Quantitative methods aim at
controlling the cost and quantity of credit by adopting bank rate policy, policy, open market
operations and variations in reserve ratio of commercial bank.
bank.
Qualitative methods control the use and direction of credit. It involves selective credit controls
and direct action. By adopting such methods, the central bank tries to influence and control
credit creation by commercial banks in order to stabilize economic activity in the country.
Besides to these, the central bank in a number of developing countries has been entrusted with
the responsibility of developing a strong banking system to meet the expanding requirements of
agriculture, industry, trade and commerce.

8. Central Bank Other Functions

Accordingly, the central bank possesses some additional powers listed as follows.
- supervision and control over the commercial banks
- issuing licenses to newly established financial institutions
- the regulation of branch expansion by commercial banks
- see that every bank maintains the minimum paid up capital and reserves as provided
by law
- inspecting or auditing the accounts of banks
- approve the appointment of chairmen and directors of such banks in accordance with
the rules and qualifications
- to control and recommend merger of weak banks in order to avoid their failure and protect
the interest of depositors
- to recommend nationalization of certain banks to the government in public interest
- to publish periodical reports relating to different aspects of monetary and economic policies
for the benefit of banks and the public, and
- to engage in research and train banking personnel, etc.

Objective of Credit Control

The central bank controls credit to achieve the following objectives
a) To stabilize the internal price level
Inflationary or deflationary trends need to be prevented. This can be achieved by adopting a
judicious policy of credit control. As price rise the central bank decreases money in
circulation and as price decline it increases the money supply.
b) To stabilize the rate of foreign exchange
With the change in the internal prices level, exports and imports of the country are affected.
When price decline exports increase and imports decline which leads to increase in the
demand for domestic currency in the foreign markets and exchange rate also increased.
When price rise in the domestic market export decline and imports increase. This leads to an

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 increase in the demand for foreign currency and decline in demand for domestic currency
which in turn leads to a decline in exchange rate.
c) To protect the outflow of gold
The central bank holds the gold reserves of the country in its vaults. Increase in bank credit
leads to increase in prices and decline in exports and rise in imports. This create an
unfavorable balance of payments. This necessitates the export of gold to other countries in
order to have an equilibrium balance of payments.
d) To control business cycles
Business cycles are characterized by alternating periods of prosperity and depression.
During prosperity – Large expansion in the volume of credit; production, employment and
prices rise
During depression – Credit contracts: production, employment and price fall. The central
bank can counteract such cyclical fluctuations through contraction of bank credit during
boom periods, and expansion of bank credit during depression.
e) To meet business needs
Credit is needed to meet the requirements of trade and industry. As business expands, larger
quantity of credit is needed and when a business contract, less credit is needed. Therefore, it
is the central bank which can meet the requirements of business by controlling credit.
f) To have growth with stability
The principal objective of credit control is to have growth with stability; price stability
foreign exchange rate stability, to help in achieving full employment, and accelerate growth
with stability in the economy without inflationary pressures and balance of payments
defects.

Difference between Central Bank and Commercial Bank

A central bank is basically different from a commercial bank in the following ways:
1. The Central Bank is the apex institution of the monetary and banking structure of the
country. The commercial bank is one of the organs of the money market.
2. The Central Bank is a non-profit institution which implements the economic policies of the
government. But the commercial bank is a profit-making institution.
3. The Central Bank is owned by the government, whereas the commercial bank is owned by
shareholders.
4. The Central Bank is a banker to the government and does not engage itself in ordinary
banking activities. The commercial bank is a banker to the general public.
5. The Central Bank
Bank has the monopoly of note issue, while the commercial bank can issue only
cheques. The notes are legal tender. But the cheques have the nature of near-money.
6. The Central Bank is the banker’s bank. As such, it grants accommodation to commercial
banks in the form of rediscount facilities, keeps their cash reserves, and clears their balances
7. The Central Bank controls credit in accordance with the needs of business and economy.
The Commercial Bank creates credit to meet the requirements of business.

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8. Every country has only one Central Bank with its offices at important centers of the country.
On the other hand, there are many Commercial Banks with hundreds of branches within and
outside the country.
9. The Central Bank is the custodian of the foreign currency reserves of the country while the
Commercial Bank is the dealer of foreign currencies.
10. The chief executive of the central bank is designated as “Governor” whereas the chief
executive of a Commercial Bank is called “chairman” or “president” or “managing
director”.
11. The Central Bank helps the expansion of Commercial Banks whereas Commercial Bank
facilitates the expansion of industries by underwriting shares and debentures and by meeting
financial requirements.