CHAPTER) —. .. .. Central Banking In this chapter the concept of central bank is dealt with. The following Chapter-9-deals with the Central Banking and Credit Control measures in general. The discussion on the Central Bank of India i-e., the RBI is made in Chapter-10. Today all the countries have a Central Bank, which controls their entire banking system. The first Central Bank was the Swedish Risks Bank established in 1688. The Bank of England was established in 1694 and nationalised in 1946 under Bank of England Act 1946. These banks were established not to provide direct credit to trade and commerce, but to provide money to their govern. ments and they were given special privileges over the issue of notes. In course of time the range of their operations widened and they began to render their governments a variety of services. In the 19th century many other European countries established their own Central Banks. But the current Central Banking is the idea of 20th century and it took several decades to mature into the present form. The Federal Reserve Bank of USA was established in 1914. An International Conference on Monetary System was held in 1920 at Brussels to consider the currency chaos after the First World War. It recommended that every couniry having a currency of its own should have Central Bank, Now there is no civilised country which does not possess a Central Bank. In India the Reserve Bank of India Act was passed in 1934 and the Bank began functioning from April 1, 1935 The name ‘Central Bank’ is given to that bank which is entrusted with the task of controlling the issue of money and regulating all the other banks of the country. Here the task controlling involves the managing of both expansion and contraction of the volume of money in the country. 8.1 DEFINITIONS OF CENTRAL BANK The Central Bank is defined by various authorities as follows: SI.No:|. Name of the Expert Definition 1. R.G. Hawtrey Central Bank as “the lender of last resort”. 2. Kisch and Elvin The essential function of a Central Bank is the mainten- . ance of the stability of monetary standard. 3. Shaw.W.A The central bank as “the bank whose main function is control of credit” 4.- | Vera Smith “The primary definition of central banking is a system in which a single bank has either a complete or a residuary monopoly in the note issue” 5. | Sayers RS. “The business of a Central Bank is to control the commer- cial banks in such a way as to promote the general mone- tary policy of the state” 130central Banking 131 | The above definitions are not sufficient because they do not provide the entire picture and idea ofthe Central Bank, Thus, it ean be defined as, “the strategie level, banking and monetary insti. tutions primarily engaging in controlling, and regulating the banking and monetary systems of the country for the progress of the economy”. g.2 NATURE OF CENTRAL BANKING The basic nature of Central Banking can be enumerated as follows: (a) The Central Bank does not aim at profits but aims at national welfare. (b) The Central Bank does not compete with the member banks. (c) The Central Bank has special relationship with government and with commercial banks (d) The Central Bank is generally free from political influence. (e) The Central Bank is the apex body of the banking structure of the country. () The Central Bank should have overall control over the financial system 8.3 CENTRAL BANKING AND COMMERCIAL BANKING The Central Bank and commercial banks are similar in certain aspects such as dealing in money, creation of credit, dealing in foreign exchange etc., Yet their objectives may be different. But, they are fundamentally different in various respects. Such differences can be summarised as follows Central Banking Vs Commercial Money Market Capital Market 1. Position of the Bank It is the apex bank in the banking system —_It is part of the banking system. of the country 2. Ownership It is Government owned bank. Commercial banks include public sector banks. Also foreign owned banks. 3. Basie motive It aims at economic growth and price They aim at maximisation of profit. stability and has no profit motive. 4, Dealing with the public Cental Bank does not deal directly with They deal directly with the general public. the public. 5. Competition Central Bank does not compete with co- Commercial Bank compete among them- mmercial banks. selves. 6. Relationship The relationship between the Central Commercial Banks are functioning at the Bank and commercial banks is unique. same level, They cannot exercise control The Central Bank has power to exercise over others except on their subsidiaries. control over other banks.[132 Indian Banking 7. Government Transactions Central Bank usually acts as Advisor to Public Sector banks partially undertake the Government and also conducts Gov- government transactions. However, other ernment transactions, Commercial banks are precluded from such functions, 8. Power of Note Issue The Central Bank has the sole authority to Commercial Banks cannot issue currency issue currency notes. notes 9. Dealing with Foreign Exchange Central bank has the responsibility to main- ‘They do not have any such responsibility. tain the stability of foreign exchange rates. 10. Role of Banking Central Bank functions as the banker to the They are functioning as the banker to the government. general public. 11. Basic Functions Central Bank acts as the bankers bank, and They do not have such roles and status. lender of last resort to the commercial banks. 12. Clearing House The Central bank acts as National Clearing The commercial banks do not function as House for interbank settlements. Clearing House. In India SBI conducts clearing operations. 13. Responsibility Central Bank is responsible to hold the price comercial Banks donot have responsibility. line and inflation rate. 14. Supervisory Rule Central Bank has supervisory regulatory They.can supervise and regulate only their powers over the entire financial system. own branches. ™ 8.4 FUNCTIONS OF THE CENTRAL BANK Central Banks differ from country to country in their structure and organisation, in their pol cies and techniques. But their functions are very similar. The Central Bank renders the following important functions in almost all countries. 1. Issuing of notes and regulating the volume of currency 2. Acts as banker to the government 3. Acts as banker to the banks 4, Acts as custodian of Nation’s reserves. 5. Acts as the lender of last resort 6. Functions as National clearing House i-Central Banking 133 | as controller of credit Publishes economic statistics and other information Development functions. 10. Supervises the activities of financial institutions, 1. Issue of Notes and Regulation of the Volume of Currency The Central Bank is legally empowered to issue currency notes. The Central Bank is charged with the responsibility of maintaining price stability, inflation level i.e., the domestic value of its money as well as its extemal value, The supply of money consists of the legal lender money and the bank money, The Central Bank has the monopoly power of the note issue to regulate the supply of legal tender money. This enables it to impart elasticity to the currency system and to maintain stability in the circulation of money. In Hong Kong the responsibility of issuing currency notes has been entrusted with a private sector bank viz. Hong Kong & Shanghai Banking Corporation (HSBC). By the function of note issue the central bank achieves the following merits: (a) Enhance the public confidence on the monetary system. (b) Maintaining uniformity in the monetary system throughout the country. (©) Flexibility in the monetary system. By the function of note issue the Central Bank can maintain the circulation of the economy at desired level, (d) Credit creation can be effectively controlled. The sole right of note issue enables the Cen- tral Bank to regulate the creation of credit by commercial banks and adjust the supply of money to the demand for it. (c) Maintaining the internal and external value of money. The Central Bank follows different systems of note issue according to the currency regulations. The different systems of currency are, (i) Fixed fiduciary system. (ii) Minimum fiduciary system (ii) Proportional Reserve system (iv) Foreign exchange Reserve system (v) Minimum Reserve system Whatever may be the system three basic principles are to be followed. They are (i) Uniformity (ii) Security and (iii) elasticity. The currency issued must be uniform and a single authority must be vested with the power of note issue t6 achieve uniformity. There must be security for the cur- rency without any dangers of over-issue. Public must have confidence in the currency; which to some extent, depends upon the gold and foreign exchange reserves it holds. At the same time the currency supply must be elastic, The Central Bank must be able to expand or to contract the supply of currency according to the changing needs from time to time. 2. Banker to the Government The Central Bank acts as the banker, financial agent and advisor to the government: The sur- plus money of the government is kept with the Central Bank. It lends money to both central and state governments. It helps the government to tide over the time gap between their expenditure and4 Ii34 Indian Banking collection of taxes. The Central Bank is usually required to make temporary advances to the gov. ernment in anticipation of collection of revenues. These advances are known as “ways and means advances” in India and are made for short periods. The Central Bank also undertakes to provide the government with necessary foreign exchange for making payments abroad. Iris necessary that there should be close co-operation between the Central Bank and the gov. ernment. 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 im- portant financial matters like, foreign exchange policy, commercial policy, raising of funds from market, efc., 3. Banker to the banks The central bank acts as the bankers’ bank. As such it performs the following functions: 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 centralised cash reserves. In India the Central Bank is authorised to vary these reserve requirements within certain limits. Such cash reserves with the Central Bank have the following advantages: (i) The centralisation of cash reserve is a source of great strength to the banking system of the country as it strengthens the confidence of the public. (ii) Centralised reserves can be used effectively and quickly in times of emergency. (iii) This ensures liquidity and imparts economy in the credit structure of the country. (iv) 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, (v) The Central Bank can control credit by varying the cash reserves that commercial banks should keep with it. 4. Act as custodian of National reserves 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 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. Some Central Banks have absolute powers to control the foreign exchange reserves and to license the various uses to which the foreign exchange is put to use, In modern times, the forcign exchange control has become the essential function of the Central Bank. 5. Acts as Lender of Last Resort The Central Bank acts as the lender of last resort and as the bank of rediscount. Rediscount- ing can be defined as conversion of bank credit into Central Bank credit. The commercial banksCentral Banking 135 | approach the Central Bank for its financial needs as it is the lender of the last resort or the ultimate source of finance, It lends to the commercial banks by rediscounting the eligible bills. The redis- counting facilities given by the Central Bank impart elasticity and liquidity to the entire credit structure of the country, It helps the commercial banks in a big way to prevent them from bank failures. But its limited only to the banks which suffer from techi not to those unsound and really insolvent banks. Moreover, a commercial bank is not entitled to financial accommodation simply because it has gible paper or approved securities, Unless it is conducting its business according to sound bank- ing principles, the Central Bank refuses accommodation. Thus the Central Bank is able to control credit while discharging the function of lender of last resort. The Central Bank is also regarded as performing the function of last resort when it grants accommodation to the government in times of monetary stringency. tance al insolvency and 6. Functions as National Clearing House The Central Bank acts as the national clearing house. The maintenance of accounts by all com- mercial banks with the Central Bank enables it to settle inter-bank indebtedness. Aclearing house is an institution where inter bank claims i.e., where the claims of banks against one another are settled. The net balances or differences called the clearing balances are settled by mere transfers between their respective accounts at the Central Bank. The clearing houses facilitate expeditious and economical settlement of inter-bank claims. The Central Bank acts as a bank of clearance, settlement and transfer and establishes clearing houses in the important cities and towns in the country. They are housed in the premises of the Central Bank administered by it or at their Agent banks. Clearing houses are established in the important cities and towns of a country by the respec- tive local banks. If the Central Bank has no offices of its own, the clearing houses are housed in the premises of the agents of the Central Bank. Technique of Clearance: The technique of settling the inter-bank indebtedness is simple. The clearing house operates as follows. The representatives of various member banks ofa clearing house meet at the clearing house at a particular time. Every representative delivers to others the cheque and other claims which his bank holds against them. Similarly, he receives from others the claims which they hold against his banks, Cheques dishonoured are returned to the concerned representa- tives. The amount receivable and payable are added. The net clearing balances of banks are settled by debtor banks by issuing cheques against their accounts with the central bank in favour of creditor banks, Thus the inter-bank claims are settled by mere book entries in the accounts maintained with the central bank. These days the payment system operates more efficiently through computerised operations. Advantages of Clearing House Central Banks’ function of clearing house provides the following advantages: (i) Clearing houses reduce the cost involved in the collection of cheques and claims (ii) They avoid the delay in the clearing of cheques, (iii) They ensure convenience and economy in the settlement, (iv) They minimise the risk involved in the realisation of cheques. (v) They minimise the necessity of holding large cash balances by commercial banks.[136 Indian Banking (vi) They can be used as a common platform for the discussion of the problems of member banks. (vii) They promote co-operation among member banks. (viii) Central Banks also get information about the liquidity position of commercial banks, (ix) Clearing houses offer valuable data to know the trends in the operations of commercial banks. 7. Act as the Controller of Credit The Central Bank functions as the controller of credit in the country. According to De kock, this function is considered as the most important function of the Central Bank. The credit creation by the commercial banks has a direct impact on the economy. If the banks expand the credit limits that leads to inflation and if they unduly contract credit it leads to deflation. Thus, the central bank is empowered to control the credit creation of the commercial banks. The commonly used methods of credit control are, (a) Bank Rate Policy () Open Market Operations (c) Variation of cash reserves (d) Credit rationing (e) Variation of margin requirements (f) Regulation of consumer credit (g) Moral suasion (A) Direct action (i) Selective credit control By adopting these methods, the Central Bank controls both the quantity and quality of credit created by the banks. 8, 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. 9, 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. (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 ete. The responsibility of the Central Bank is increasing every day and its functions are expanding. The well-administered central baking functions are necessary for all the countries especially for the developing countries to maintain price stability and economic growth,Central Banking 137 | However, in India the developmental role of Reserve Bank of India was gradually branched out into separate development financial institutions, such as IDBI and NABARD and investment institutions like UTI over a period of time. ‘This is primarily to allow the Central Bank to concen- trate on its core activities like regulating money supply, ensuring price stability and protecting the external value of its currency. 111 [SE REVIEW QUESTIONS See Short Answer Questions Define central banking. Write a note on the nature on Central Banking. What is meant by monopoly of note issue? What is clearance house? Write a note on lender of last resort. Write a short note on the role of central bank as custodian of national resources. Essay Type Questions a Differentiate between central banking and commercial banking, What are the functions of central bank of a country? What is the importance of clearance house? Explain the roles of central banks as Banker to the Banks and Banker to the Government.