Central Banking

Chapter Outline
21.1 Evolution of Central Banking
21.2 Definitions of Central Bank
21.3 Comparison between Central Bank and a Commercial Bank
21.4 Functions of Central Bank
21.5 Central Bank in an Underdeveloped or a Developing Economy

In every country, there is one apex institutionactingas a leaderofthe money market. It supervises,
regulates and controls the activitiesofcommercial banks as well as other financial institutions. In
other words, it plays a leading role in organising, running and developing the monetary, financial
system of the country. The design and conduct of the monetary and credit policy are its special
responsibility. Such a unique institution is known as central bank of the country. It is so called
because it occupies a central pivotal position in the monetary and banking structure ofthe country
in which it operates. Central bank offers the best means of communication and cooperation between
the banking system ofdifferent countries. It is vested with the authority to exercise special powers,
which other banking institutions do not possess. It can influence credit conditions and other
developments.

21.1 EVOLUTION OF CENTRAL BANKING

Central banking, as it exists today, is a recent development. Before the beginning of this century,
some banks in countries like England, Sweden, France, etc., were assuming increasingly important
and dominant role in the monetary shares.They acted as banker and agent to the government and
had the monopoly right ofnote issue. They were originally called as Banks of Issue or as National
Banks.The origin of the central banking can be traced back to the privately owned Risk Bank of
Sweden established in 1656. However, the successful working of the Bank of England stimulated
 Economics - I
21.2
The Bank of
the development of central banking in other parts of Europe and rest of the world.
Parliament.
England was the first central bank established as a private bank in 1694by an Act of
Charter was
The bank was conferred the monopoly right of note issue under a Royal Charter. The
indefinite
renewed from time to time. The Bank Charter Act of 1844extended the Charter for an
of trade made
period. The Industrial Revolution of England and consequent tremendous expansion
not
banks to realise the need to keep a part of their reserves with the Bank of England. The bank
only regulated the financial and monetary affairs,but also coordinated the activities of small as well
as big banks. Subsequently, even the government of Britain started it as a bank to the bankers and
a banker as well as agent to the government. Finally, it assumed the responsibility of lender of the
last resort to maintain currency and credit system of the country on a sound basis. This bank was
finally recognised as the Central Bank of Great Britain towards the end of the nineteenth century.
It was later on nationalised by the British Government in 1946.This powerful bank provided a
model to be imitated by the central banks in other countries.
International Monetary Conference at Brusselsin 1920and the establishment of the International
Monetary Fund in 1945led to an unprecedented growth of central banks all over the world,
particularly in the newly independent Afro-Asian and Latin American countries. These countries
felt that central bank could deal more effectivelywith IMF and other foreign exchange matters.
After 1945, most of the central banks were either started as State institutions or were nationalised.
At present, in most ofthe countries central banks were owned by the government. Only in a very
few countries like U.S.A.,the government does not have any interest in the ownership of central
banks. Even when the State did not participate or partici pated only to a small extent in the ownership
of the central bank, the government did claim right in its management, appointment ofdirectors
and top executives. As soon as a central bank is nationalised, the government acquires a complete
control over the ownership, management and appointments. Whatever be the nature ofownership
and management ofa central bank, the policy to be followed by it with reference to other banks is
always determined by the government.
Though the central bank may be owned and managed by the government, it should be an
independent bank and the government should not interfere with the way the central bank functions.
Presently, almost all the countries of the world have establishedtheir independent central banks to
maintain stability in the monetary, fiscal and banking system of their countries as well as for world
cooperation.

21.2 DEFINITIONS OF CENTRAL BANK

A banking institution can more easily be characterised by the functions it performs. Different
economists have identified different functions to characterise as a central bank. An American
expert Raymond P. Kent has defined a central bank "as an institution which is charged with the
responsibility of managing the expansion and contraction ofthe volume of money•in the interest
"
of the general public welfare. l
While defining a central bank, Kent emphasised only one function, i.e., the regulation of the
supply of money. Kent's definition is useful in the sense that it clearly states that unlike commercial
banks, profit maximisation is not its primary objective. Monetary policy of the modern central

I. Kent. Raymond R, Money and Banking.

 Central Bankihg
21.3
bank has become
a
India. The central powerful instrument of economic management
in a mixed economy like
the level oftrade bank not only regulatesthe internal and external values
as well as of money, but also raises
legislation which employment and hence economic
development. The preamble ofthe
regulate credit andestablished the Bank of Canada in 1934stated the objectives of the bank as "to
protect the external currency in the best interest ofthe economic life of the nation to control and
value ofthe national
in the general monetary unit and to mitigate by its influence, fluctuations
level so far as maybe
Sayers, the central possible within the scope of monetary action." According to
bank, "is the organ
of the government ofgovernment that undertakes the major financial operations
and by its conduct
behaviour of financial of these operations and by other means, influences the
institutions so as to support
R.C. Hawtrey regards the economic policy ofthe government."
the function of central
characteristic. On the bank as the 'lender of the last resort' as its essential
other hand, according to
the note issue is the VeraSmith, a complete or residuary monopoly in
most important function of
function of a central the central bank In the words ofShah, "allsufficing
bank is control ofcredit". He
central bank only for the adds that the state should issue notes and use the
distribution of the notes. Kischand Elkinfeel that "the essential
of central bank is the function
maintenance of the stabilityof the monetary standard". According
C.L.Dey, a central bank is "to to A,
help, control and stabilisethe monetary and banking system".While
Jauncey regards the "clearing
as the main operation ofcentral banking'.
The Statutes of the Bank for
International Settlements, defines a central bank as "the bank in any
country to which has been entrusted
the duty of regulating the volume ofcurrency and credit in
that country". Further, central banks
ofmany countries havebeen named as reserve banks, e.g.,the
Reserve Bank of India, the Central Reserve
Bank of Peru, the South African Reserve Bank, etc.
Thus, 'the custodian of bank reserves', may be considered as
a function of a central bank.
21.3 COMPARISON BETWEEN CENTRAL BANK AND A COMMERCIAL BANK
Tbe central bank. as an institution has evolvedfrom commercial banks. During the eighteenth and
the nineteenth centuries, this institution was in the process ofdevelopment. Several experiments
were going on in different countries of the world. The banks which operated in the medieval
Europe, particularly in the cities of Vienna, Geneva, Amsterdam and Hamberg, combined central
banking functions with commercial banking operation. In course of time, this practice was
abandoned and specialised institutions for issuing currency werecreated.Now, economists have
clear notions about the nature, structure and objectivesofa central bank It is no longer difficult to
distinguish central banks and commercial banks. Followingare the differences between a central
bank and a commercial bank.
(i) The central bank is the apex institution in the money market. A commercial bank, on the
other hand, is merely a unit in the banking structure of the country, operating under the
control ofcentral bank.
central banks are not established in a country due to
(ii) Unlike commercial banks, too many
is possibly an exception in this regard, where twelve
peculiar nature of their activities. U.S.A.
functioning, each having authority over a well defined area.
Federal Reserve Banks have been
generally owned and governed by the government. On the other hand,
(iii) Central banks are both in the public sector as well as in the private sector.
commercial banks may operate government or with the private
may lie with the entrepreneurs.
Accordingly, their ownership
 Economics• I
21.4
may earn huge profits. The central bank
(iv) A central bank does not aim at profit, though it
profitable investment to maintain stability in the
must reject many opportunities for policy
objective of the central bank is to support the economic
monetary system. Thus, the the working
effectsofits operation on
ofthe government. Central bank thinks in terms ofthe
primarily ofprofit-makink.
of the economic system, while a commercial bank thinks
deal with the general p•c.
In
(v) Unlikeacommercial bank, acentral bankdoes not normally
with
in business transactions
most of the countries, laws prevent its direct participation
direct public dealings of the
individuals and non-banking institutions. In some countries, exercise
facilitates a central bank to
central bank have been voluntarily discontinued. This
manner, thereby making its policies more effective, through
its special powers in an adequate however, a few
There are,
avoiding unhealthy competition with the commercial banks.
been mixed with the central
countries, where the commercialbanking functions have Bank of Australia, the
banking functions. The Central Bank ofFrance, the Commonwealth
Finland, the National Bank of
National Bank of Belgium, the Bank of Italy, the Bank of
Egypt, etc., are some notable examples.
while commercial banks
(vi) The central banks enjoy the monopoly power to issue currency,
are not allowed to exercisethis function.
credit.
(vii) The central banks control credit, whilethe commercial banks create
functions as a
(viii) A central bank acts as an agent and a banker to the government. It also
and gives expert
custodian of the Government's funds. Further, it manages public debts
responsibility
advice on monetary and fiscalmatters. The commercial banks have no such
towards the State.
are alike in
In spite of these differencesbetween the central bank and commercial banks, the two
in
two ways. First, both are basically monetary institutions. Secondly,both of them create credit
backing
one form or the other. When a central bank decides to issue paper money without adequate
of appropriate securities, it actually creates credit. On the other hand, when a commercial bank has
an excess cash reserve, it creates credit through primary and derivative deposits.

21.4 FUNCTIONS OF CENTRAL BANK

Almost all the central banks were originally started as privately owned and managed joint stock
banks. Over time, they have become an important part of the government machinery. They have
now, assumed a new role with expanded activities.The statutes of most of the central banks describe
their powers and functions. These functions are discussed here.

1. Bank of Issue
Central banks did not exist at the time of the origin of paper money. That is why, the State was
vested with the power to issue currency notes. When commercial banks were set up in Europe,
gradually this right was passed on to them. However,lack of uniformity in currency notes issued
by different banks became a serious obstacle to growth of trade, industry and commerce. In course
oftime, every country introduced specific legislation granting one bank either a complete monopoly
or a residual of the note issue. Today,such a bank came to be recognised as the central bank. In
practice, this function has come to be regarded as such an important feature of the central banking
Central Banking 21.5

structure that every central bank in the principle right of note

world has been given the sole or the
issue in its territory. Until the end of the an overriding
nineteenth century, this function got such
importance that central bank came to be known as a Bank of Issue.
The prerogative of note issue with the merits:
central bank of the country has the following
(a) It Brings Uniformity in Note-Issue: The chaos created by the multiplicity of currency
notes issued independently by various commercial banks is removed, when homogenous
currency units are issued by the central bank. In a modern complex economy, exchange
transactions go even beyond the geographical boundaries of the country. There is a need
for a universally acceptable international unit to facilitate such transactions. This is not
possible without uniformity in currency throughout the country by monopoly of note issue.
(b) It Facilitates Effective State Supervision: Statesupervision is necessary and desirable. It is
on the authority of the State that the currency notes issued by a central bank are declared
unlimited legaltender throughout the country. Governments exercise their supervision over
note circulation indirectly through a central bank governed by a special legislation, rather
than directly through a government department. State is responsible, if anything goes wrong
with the currency system due to mismanagement on the part of the central bank.
(c) It Avoids Instability in Currency: Exclusiveright of note issue with the State or different
banks renders the currency unstable. It may also lead to over issue of currency notes for
meeting their financial needs, resulting in depreciation in the value of currency. Out of
political considerations, the government may sacrifice the objective of sound monetary
system. Central bank's monopoly ofnote issue results in maintaining stability in the internal
and external values of home currency.
(d) It Facilitates Control of Credit: The rapid expansionoftradeis responsible fora tremendous
rise in the demand for bank credit. However, uncontrolled increase in volume of credit by
banks creates confusions and chaos through the generation of inflationary tendencies in
the economy. The monopoly of note issue gives a central bank a weapon to effectively
control the expansion ofcredit to ensure monetary stability.
(e) It Ensures Public Faith in Currency System: A paper currency, not backed by bullion
reserves carrying no guaranteeabout its convertibilityhas an inherent risk on non-
acceptability.When currency notes are-issuedby the central bank on behalf of the
government, this risk is averted. Further, it lends a distinct prestige to the paper currency,
that proves to be of crucial importance in periods of emergency and crises. As a result,
public faith in the paper currency is kept alive by the support of the State.
(f) It Brings Profit to Public Exchequer: The issue ofnotes by a central bank may bring profits
to the public exchequer.For this purpose, the Government may make it statutory obligatory
on the note issuing authority to transfer a part of their profits earned to the state treasury.
The State can also appropriate surplus through taxation, when the right to right to issue
currency notes is vested in a different bank. However, it is more cumbersome process.
(g) It introduces Elasticity in Monetary System: The central bank through its monopoly to
issue notes introduces elasticityin the monetary structure of the country. The volume of
currency can be expanded or contracted according to the legitimate requirements of the
business and general public.
 Economics - I
21.6

2. Banker, Agent and Financial Adviser to State both ofthe

the banking accounts of the government,
As banker, central bank keeps government,
ofthe states. Asa banker, the central bank offers all those services to the
centre and government
accepts deposits from
which a commercial bank offers to the general public. It basis. It also collects cheques
their accounts on regular
departments as institutions and operate available
fa•nur government. Central bank also makes
and drafts dra'.•-non other banks in ofthe brief, the
by the government. In
cash for the payment ofsalaries, wagesand other disbursements
purchases or sales Of foreign
central bank carries out all government transactions including
foreign debt or meeting a deficit
currenäes. Foreign transactions arisewhileservicingor repaying
in its external balance ofpayments.
temporary demand, till taxes are
The central bank also makes advances to the government to meet
extraordinary advances
collected or loans from the public are raised. The government can also
during a period of depression, war or emergency.
bet'.veen public finance
Central bank operates as governments banker due to intimate connection
affairs are
and monetary affairs.Public finance is the domain of the government and the monetary
as biggest
conducted by central bank The gmærnment i' the largest receiver of revenue as well
borrower in most ofthe countries. Its significantly affects the level ofeconomic activities
in the country. The manifold financial activitiesof the government influence the money market,
which are regulated by the central bank.
Aspernment's agent, the central bank makes and receives payments on behalfofthe government.
For instance, central bank receives subscriptions for government securities, such as bonds, treasury
bills, etc It also makes all arrangements in connection with the floatation, conversion or redemption
of these securities.Central bank should aim at proper timing in issuing ofgovernment bonds and
stabilisingtheir prices. It also manages the national debt on behalf of the government and makes
payment to stock holders ofinterest on national debt. The central bank should make timely changes
in the structure and composition of public debt so as to minimise the cost of servicing debt to
enable the financing ofeconomic development .For this, low interest rates should be fixed for the
government bonds. This will also raise the price of these bonds. However, the success of debt
management depends upon the existenceof well developed money and capital markets in which
wide range ofsecuritiö exist both for short and long periods. It also enforces exchange control, as
an agent of the government. As the government'sfinancial adviser, the central bank advises the
government on an financial and monetary matters. The central bank provides intelligent information
regarding the state and the trend ofmoney as wellas capital markets to enable government to take
decision for floating new loans, redeeming loans and other monetary issues. The central bank
advises the government on such economic matters as controlling inflation or deflation, devaluation
or revalution of the currency, deficit financing, balance of payments, etc. This function
assumes
particular significance during the period ofcrises, when central bank gives the
appropriate advice
to the government after judging the general financialsituation. Necessary remedial
actions can be
taken by a better coordination between the monetary and fiscal policies.

3. Banker to Banks
The central bank acts as banker to all commercial banks functioning
in the economy. In this sense,
it bears the same relationship with the banks as the latter maintain
with the general public. With
Central Banking
21.7
the establishment of
the Federal Reserve
it statutorily obligatory Banks in the USA, almost all countries of the world made
for every commercial
the central bank Earlier bank to keep certain minimum cash reserves with
this arrangement used
with the central bank to be voluntary. The centralisation ofcash reserves
has several advantages,
are the advantages. though such reserves do not earn any interest Following
(i) It gives strength to the
financial system ofthe country.
(ii) Centralised cash
reserves inject a great degreeofelasticityin the credit system than if same
were scattered among
the individual banks. The commercial banks can safely transact a
large volume of business
with small cash reserves, as they can fall upon the central bank in
case of need for additional
funds.
(iii) Such pooled bank reserves
with thecentralbankcanbesafelyand effectivelyemployed for
safe guarding and protecting the
economy during the period of emergency, war or other
crises like seasonal strain.
(iv) Centralised reservesenhance
thecapacityofthe centralbank to rediscount bills tomeet the
cash requirements of the banks.
(v) Apart of these reserves serve clearing
purposes. Payment byonebankto another is effected
by a simple book entry adjustment in the books of the central bank, where all banks keep
deposit accounts.
(vi) These reserves enable a central bankto influenceand control thecreditcreationbybanks
by changing the cash reserves requirement.
Central bank, thus, ser•.resas a custodian ofthe cash ofthe Besides receiving statutorily
minimum cash reserves, it also regularly receives surplus finds from the banks during slack season
and lends during the busy season.

4. Custodian of Nation's Gold and Foreign Exchange Reserves

The central bank is the custodian ofthe country'sstockofgold and international currencies. Tiis
function facilitates a central bank to maintain stability ofthe exchange rate fixed by the government,
besides enforcing exchange control and other regulations prescribed by the government. All the
foreign exchange transactions are routed through the central bank That is, all payments in foreign
exchange are made by this bank. Similarly, all earnings in foreign exchange transactions are to be
deposited with the central bank.
Through sale and purchase offoreign currencies in the market, central bank can bring the
value of the currencies at par with their internalvalues.This policy also helps it to pursue a
coordinated policy towards balance ofpayments situation in the country. Governments often use
gold and foreign exchange reserves for restoring equilibrium in their balance of payments.

5. Lender of Last Resort

This function of the central bank originated out of the rediscount function performed by the
central bank The rediscount facility raises the liquidity ofthe credit structure. It provides additional
funds to banks for converting some of their earning assets into cash, when the cash reserves fall
drastically.
 Economics - I
21.8

is under an obligation to provide funds to commercial

central bank
As a lender of last resort, the
need financial accommodation. after
banks, discount houses or bill brokers, as and when they sound and genuine business
of this function is that no
failingon all other fronts. The real aim They approach the central
of funds.
transaction should be restricted or abandoned due to shortage
against eligible securities, subject
bank as a last resort in distress, which advances necessary credit
exchange and other papers, which
to certain terms and conditions. The banks may offer bills of
to accommodate any eligible
have already been discounted by them. Central bank never refuses
substantial cash reserves to meet
bank In the absence of central bank, every bank will have to carry
bank from creating too much
emergencies. Central bank can use this function to desist a particular
providing temporary financial
loans against specific stocks and securities.Central bank thus, by
collapse.
accommodation saves the financial structures of the country from

6. Clearing House Function

working of any banking
The clearing house function is of great importance for the successful
facilitate transfers of
system. Clearing arrangements economise the use ofcash, as bank clearings
funds quickly, safely and at low cost.
nineteenth century to
This function for the first time was evolved by the Bank of England in the
this system,
avoid unnecessary transfer of funds between various banking institutions. Under
central bank
representatives from different banks in a city meet at the clearing house office of the
without
Payments from one bank to others are settled merelythrough simple book adjustments
considerable,
involving transfer of funds. Daily differences in the clearings between the banks maybe
the
which are adjusted by means of debit and credit entries in their respective accounts with
central bank. However, over a period of time, there is generally a small difference between the
amounts ofcheques and drafts drawn on any bank, presented by other banks on behalf of their
customers for payment with that ofcheques and drafts on these banks received by its own depositors.
For this, the cheques must be inspected to make certain that these are properly endorsed by the
payee and they appear to be regular in every way.Then, the cheques have to be sorted according to
the bank on which these are drawn. The amounts are totalled and recorded on a slip attached to
each package ofcheques. At the time ofclearing, the messengers from each bank go to the clearing
house and exchange the packages of cheques such that each messenger comes into possession of
the cheques drawn on his own bank only. A specially prepared sheet contains the total of cheques
brought to and received from the clearing house.lfthe amount received exceeds the amount brought
to the clearing house, the bank has an unfavourable balance (or is a net debtor). So, it must pay the
difference to the clearing house and vice-versa.Apart from the economy in use of money, much of
labour and inconvenience, associatedwith the individual system of clearance and settlement is
removed.
7. Controller of Credit
Credit control is perhaps the most important function of the central bank, since the bank money
has become the main circulating medium. Through this function, the central bank influences the
level as well as course of economic activity and attains price stability. Cheap credit promotes
investment, while dear money discourages it. Central bank can control inflationary and deflationary
situation in the economy by controlling and expanding the availability of credit through various
credit control measures, discussed at length in the next chapter on Credit Control.
Central Banking
21.9
21.5 CENTRAL BANK
IN AN UNDERDEVELOPED OR A DEVELOPING ECONOMY
The central banks in
the
underdevelopedor developingcountrieslike India are supposed to
undertake heavy
responsibilities in the financial this,
a growing economy sector for rapid economic development. For
must mobilise resources
industrial sector. The for investment on a large scale, particularly in the
banking the process of
industrialisation by mobilising structure plays a vital role in accelerating
these resources and making them available for productive
investment. A high rate ofinterest, unless
for investment. The the prices are rising continuously, will lead to a disincentive
central bank should control
to investment. It should the interest rates structures to give proper direction
exercise control
create confidence in the banks. over the money market to remove unfair practices and
Finally,it is the duty ofcentral bank to control the operations of the
stock exchanges. Changes in the value
Prevention of unnecessary speculation
of the
stock of shares affect the health of the economy.
will releaseinvestablefunds towards better alternative uses.
In a developing economy, the
central bank has to shoulder the additional burden of acting as an
agent of growth, by building up growth
creating impulses in the economy. Therefore, a central
bank performs not only the functions
enumerated in the previous section, but also undertakes two
additional functions of promotion and
development.
The central bank in a developing economy
intends to promote commercial banking by providing
cheap and liberalised rediscounting facilities
to commercial banks and by giving subsidies to newly
established banks. The central bank in India also performs the function of development of long-
term financial institutions known as development banks, like the Industrial Development Bank of
India (IDBI), Industrial Finance Corporation of India (IFCI), etc.These specialised institutions
provide adequate supply of funds to the industries. Further, on social consideration, the Government
of India has set up National Bank for Agriculture and Rural Development (NABARD) for providing
agriculture credit on cooperative lines.

POINTS TO REMEMBER

21.1 Evolution of Central Banking

1. Almost all the countries of the world have established their independent central banks to
maintain stability in the monetary, fiscal and banking system of their countries as well as
for world cooperation.
21.2 Definitions of Central Bank
1. The central bank, "is the organ of government that undertakes the major financial operations of
the government and by its conduct of these operations and by other means, influences the
behaviour of financial institutions so as to support the economic policy of the government

21.3 Comparison between Central Bank and a Commercial Bank

1. Following are the differences between a central bank and a commercial bank.
(i) The central bank is the apex institution in the money market. A commercial bank, on
the other hand, is merelya unit in the banking structure of the country, operating
under the control ofcentral bank.
 Economics- I
21.10
established in a country due
(ii) Unlike commercial banks, too many central banks are not
to peculiar nature of their activities.
On the other hand,
(iä) Central banks are generally owned and governed by the government.
as in the private sector,
commercial banks may operate both in the public sector as well
huge profits. The central
(iv) A central bank does not aim at profit, though it may earn maintain stability
to
bank must reject many opportunities for profitable investment
in the monetary system.
deal with the general
(v) Unlike a commercial bank, a central bank does not normally
public.
commercial
(vi) The central banks enjoy the monopoly power to issue currency, while
banks are not allowed to exercise this function.
(vii) The central banks control credit, while the commercial banks create credit.
(viii) A central bank acts as an agent and a banker to the government. It also functions as a
custodian of the Government's funds. Further, it manages public debts and gives expert
advice on monetary and fiscal matters. The commercial banks have no such
responsibility towards the State.
21.4 Functions of Central Bank
1. Bank of Issue : (i) it brings uniformity in note-issue, (ii) it facilitates effective state supervision,
(iii) it avoids instabilityin currency, (iv) it facilitatescontrol of credit, (v) it ensures public
faith in the currency system, (vi) it brings profit to public exchequer, (vi) it introduces elasticity
in monetary system.
2. Banker, Agent and Financial Adviser to State
3. Banker to the Banks
4. Custodian of Nation's Gold and Foreign Exchange Reserves
5. Lender of Last Resort
6. Clearing House Function
7. Controller of Credit.
21.5 Central Bank in an Underdeveloped or a Developing Economy
1. The central banks in the underdevelopedor developingcountries like India are supposed
to undertake heavy responsibilities in the financial sector for rapid economic development.
2. The central bank in a developingeconomy intends to promote commercial banking by
providing cheap and liberalised rediscounting facilities to commercial banks and by giving
subsidies to newly established banks. The central bank in India also performs •the function
of development of long-term financial institutions known as development banks.

CHECK YOUR PROGRESS

I. Define a central bank. Distinguish between central bank and commercial banks.
2. Explain the important functions of central bank.
3. Explain the traditional functions of a central bank.
4. Discuss the role of central bank in a developingeconomy.