CHAPTER TWO - CENTRAL BANKING

INTRODUCTION
A central bank is an ‘apex institution’ in the banking
structure of a country. It supervises controls and regulates the
activities of commercial banks and acts as a banker to them. It
also acts as a banker, agent and adviser to the government in
all financial and monetary matters.

A central bank is also the custodian of the foreign balances

of the country and is responsible to maintain the rate of
exchange fixed by the government and manages exchange
control.
 Cont,d
 The most important function of a central bank is to regulate
the volume of currency and credit in a country. It will be no
exaggeration to say that a modern central bank is the central
arch to the monetary and fiscal framework in almost all
the countries developed or developing in the world.
 In developing economies, the central bank has also to
perform certain promotional and developmental functions to
accelerate the pace of economic growth.
 Definition of Central Bank
• A banking institution can more easily be identified by the
functions that it performs.

• According to Vera Smith, “the primary definition of central

banking is a banking system in which a single bank has
either a complete or residuary monopoly in the note issue.”
 Cont,d
 Kisch and Elkin believe that “the essential function of a
central bank is the maintenance of the stability of the
monetary standard.”
 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.”
 Cont,d
• De Kock gives a very comprehensive definition of central
bank. According to De Kock, a central bank is a bank which
constitutes the apex of the monetary and banking structure
of its country.
 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.
According to De Kock, there are six functions
which are performed by the central bank in almost
all countries.
Cont,d
 Cont,d
Monopoly of Note Issue: The issue of money was
always the prerogative of the government. Keeping
the minting of coins with it, 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.
 Cont,d
• 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.
• The central bank keeps three considerations in view
as regards issue of notes-uniformity, elasticity
(amount according to the need for money), and
safety.
 Cont,d
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 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.
 Cont,d
• 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.
• As adviser to the government It advises the government on monetary
and economic matters.
 Cont,d
. 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.
 (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. This are:
1. with the same amount of cash reserves, a large
amount of credit creation is possible.
2. centralised cash reserves will enable commercial
banks to meet crises and emergencies.
3. it enables the central bank to provide additional funds
to those banking institutions which are in temporary
difficulties.
4. 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.
 cont
• 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
claim 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.
 Cont,d
. 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
 Cont,d
. 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.
 Quize 1
What it mean that the central bank is the last
resort of the commercial bank? explain it