Professional Documents
Culture Documents
Central Banking - BM
Central Banking - BM
Assignment on
Central Banking
Date of Submission
28-08-2022
TABLE OF CONTENTS
8 LIBOR 8
13 Financial Deepening 11
References 13
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Central Bank
A central bank is a public institution that manages the currency of a country and controls the
money supply. The main objective of many central banks is price stability.
One of the main tools of any central bank is setting interest rates. A central bank is not a
commercial bank. An individual cannot open an account at a central bank or ask it for a loan and,
as a public body, it is not motivated by profit.
1. Single Organization: In a country there has only one central bank exist. In the world,
there has been no existence of two or more central bank in any country. So central bank can
be called as single organization.
2. Legal entity: Central bank is established by the special act of Government. As a result,
legal entity of central bank is much more strong than other banks. This strong legal entity
gives special privilege to other banks.
3. Nature of ownership: The ownership of central bank can be fully government or joint
venture of government and private ownership. But the reality said that government owned
central bank is maximum in the world.
4. Difference in objective: Because the operations of the central bank are such as
profoundly to affect the monetary and credit situation, they cannot be undertaken solely for
the purpose of making profit. The profit motive should only be a secondary consideration,
and not the primary motive for central banking operations.
5. Note issue: The issue of note is the most important function of a central bank. In fact, the
practical experience shown that the central bank is the most suitable and appropriate medium
for the issue of note.
6. Relation with Govt.: The central bank is closely related to the government as its banker
and the financial adviser. It is generally an organ of the government and performing the
banking operations of government. Central bank represents the government not only in
country but also the outside of the country as well.
7. Guardian of the money market: An effective monetary management requires a
centralized country over both currency and credit. Being in close and intimate contact with
the money market a central bank is in a position to know best when and to what extent to
expand or to contract currency and credit to meet the changing requirements of the money
market.
8. Banker and controller of other banks: The central bank functions as a banker’s
bank. It also controls and regulates the cameral bank and other financial institutions. For
effective control central bank prescribes different rules and regulations and it is mandatory to
maintain these rules by other banks.
9. Lender of the last Resort: As a lender or the resort central bank provides rediscounts
and advances to the commercial banks in times of credit stringency. It also gives loan to the
govt. when requires.
10.Controller of Foreign Exchange: The central bank maintains the foreign
exchange reserves of the country and attempts to stability in the exchange rates.
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1. Price Stability: Price stability is probably one of the leading objectives of central
banks. After the high levels of inflation in the 1970s and 1980s, and the disaster that was
the Great Depression of 1929, control over prices is a key element of central banking
policy.
2. Full Employment: Full employment was one of the leading objectives of the central
bank. However, most of the central bank this is done by lowering the interest rates to fuel
cheaper credit to businesses through monetary policy. In turn, businesses would use the
cheap credit to invest and expand its operations, thereby stimulating jobs in the process.
3. Financial Stability: The central bank often acts as lender of last resort in order to
maintain financial stability. For instance, most commercial banks need short-term loans
in order for them to be able to align their assets and liabilities and may have to pay a loan
to another financial institution.
1. Currency regulator or bank of issue: This is one of the most important functions
of the central bank in an economy. Earlier all the banks were allowed to publish their
own notes which resulted in a disorganised economy. To avoid this situation the
government around the world authorised the central banks to function as the issuer of
currency, which resulted in uniformity in circulation and balanced supply of money in the
economy.
2. Bank to the government: One of the important functions of the central bank is to
act as the bank to the government. The central bank accepts deposits and issues funds,
making and receiving payments for the government. Central banks also offer short term
loans to the government to recover from bad phases in the economy. It acts as an advisor
and agent of the government by providing advice to the government in areas of economic
policy, capital market, money market and loans from the government. It formulate
monetary and fiscal policies that help in regulation of money in the market and
controlling inflation.
3. Custodian of Cash reserves: It is a practice of the commercial banks of a country
to keep a part of their cash balances in the form of deposits with the central bank. The
commercial banks can draw that balance when the require to pay the same in crisis time.
For that reason the central bank is regarded as the banker’s bank. Central bank also plays
an important role in the credit creation policy of commercial banks.
4. Custodian of International currency: An important function of the central bank
is to maintain a minimum balance of foreign currency. The purpose of maintaining such a
balance is to manage sudden or emergency requirements of foreign reserves and also to
overcome any adverse deficits of balance of payments.
5. Lender of last resort: The central bank acts as a lender of last resort by providing
money to its member banks in times of cash crunch. It performs this function by
providing loans against securities, treasury bills and also by rediscounting bills. It helps
in protecting the financial structure of the economy from collapsing.
6. Clearing house for transfer and settlement: Central bank acts as a clearing
house of the commercial banks and helps in settling of mutual indebtedness of the
commercial banks. In a clearing house, the representatives of different banks meet and
settle the inter-bank payments.
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7. Controller of credit: Central banks also function as the controller of credit in the
economy. If commercial banks create a lot of credit in the economy that increases the
inflation.The central bank controls credit creation by commercial banks is done by
engaging in open market operations or change in the CRR.
8. Protecting depositor’s interests: Central bank also needs to keep an eye on the
functioning of the commercial banks in order to protect the interests of depositors.
(a)-Bank Rate Policy: The bank rate is the rate at which the Central Bank of a country is
prepared to re-discount the first class securities. It means the bank is prepared to advance loans
on approved securities to its member banks. As the Central Bank is only the lender of the last
resort the bank rate is normally higher than the market rate.
For example:- If the Central Bank wants to control credit, it will raise the bank rate. As a result,
the market rate and other lending rates in the money-market will go up. Borrowing will be
discouraged. The raising of bank rate will lead to contraction of credit.
In narrow sense—the Central Bank starts the purchase and sale of Government securities in the
money market. But in the Broad Sense—the Central Bank purchases and sale not only
Government securities but also of other proper and eligible securities like bills and securities of
private concerns. When the banks and the private individuals purchase these securities they have
to make payments for these securities to the Central Bank.
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(c)-Variable Cash Reserve Ratio: Under this system the Central Bank controls credit by
changing the Cash Reserves Ratio. For example—If the Commercial Banks have excessive cash
reserves on the basis of which they are creating too much of credit which is harmful for the
larger interest of the economy. So it will raise the cash reserve ratio which the Commercial
Banks are required to maintain with the Central Bank. This activity of the Central Bank will
force the Commercial Banks to curtail the creation of credit in the economy. In this way by
raising the cash reserve ratio of the Commercial Banks the Central Bank will be able to put an
effective check on the inflationary expansion of credit in the economy.
Similarly, when the Central Bank desires that the Commercial Banks should increase the volume
of credit in order to bring about an economic revival in the country. The Central Bank will lower
down the Cash Reserve ratio with a view to expand the cash reserves of the Commercial Banks.
With this, the Commercial Banks will now be in a position to create more credit than what they
were doing before. Thus, by varying the cash reserve ratio, the Central Bank can influence the
creation of credit.
The following are the important methods of credit control under selective method:
(a)-Rationing of Credit: Under this method the credit is rationed by limiting the amount
available to each applicant. The Central Bank puts restrictions on demands for accommodations
made upon it during times of monetary stringency.
In this the Central Bank discourages the granting of loans to stock exchanges by refusing to re-
discount the papers of the bank which have extended liberal loans to the speculators. This is an
important method of credit control and this policy has been adopted by a number of countries
like Russia and Germany.
(b)-Direct Action: Under this method if the Commercial Banks do not follow the policy of
the Central Bank, then the Central Bank has the only recourse to direct action. This method can
be used to enforce both quantitatively and qualitatively credit controls by the Central Banks. This
method is not used in isolation; it is used as a supplement to other methods of credit control.
Direct action may take the form either of a refusal on the part of the Central Bank to re-discount
for banks whose credit policy is regarded as being inconsistent with the maintenance of sound
credit conditions. Even then the Commercial Banks do not fall in line, the Central Bank has the
constitutional power to order for their closure.
This method can be successful only when the Central Bank is powerful enough and has cordial
relations with the Commercial Banks. Mostly such circumstances are rare when the Central Bank
is forced to resist to such measures.
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(c)-Moral Persuasion: This method is frequently adopted by the Central Bank to exercise
control over the Commercial Banks. Under this method Central Bank gives advice, then request
and persuasion to the Commercial Banks to co-operate with the Central Bank is implementing its
credit policies. If the Commercial Banks do not follow or do not abide by the advice or request
of the Central Bank no gross action is taken against them. The Central Bank merely was its
moral influence and pressure with the Commercial Banks to prevail upon them to accept and
follow the policies.
(d)-Method of Publicity: In modern times, Central Bank in order to make their policies
successful, take the course of the medium of publicity. A policy can be effectively successful
only when an effective public opinion is created in its favour.
Its officials through news-papers, journals, conferences and seminar’s present a correct picture of
the economic conditions of the country before the public and give a prospective economic
policies. In developed countries Commercial Banks automatically change their credit creation
policy. But in developing countries Commercial Banks being lured by regional gains. Even the
Reserve Bank of India follows this policy.
(e)-Regulation of Consumer’s Credit: Under this method consumers are given credit in
a little quantity and this period is fixed for 18 months; consequently credit creation expanded
within the limit. This method was originally adopted by the U.S.A. as a protective and defensive
measure, there after it has been used and adopted by various other countries.
Interest Rate:
Interest is what we pay for borrowing money, and what banks pay us for saving money with
them. Interest rates are shown as a percentage of the amount we borrow or save over a year. So if
we put $100 into a savings account with a 1% interest rate, we would have $101 a year later.
Prime Rate:
The prime rate is the interest rate that commercial banks charge their most creditworthy
customers, generally large corporations.
The prime interest rate, or prime lending rate, is largely determined by the federal funds rate,
which is the overnight rate that banks use to lend to one another. Prime forms the basis of or
starting point for most other interest rates—including rates for mortgages, small business loans,
or personal loans—even though prime might not be specifically cited as a component of the rate
ultimately charged.
LIBOR
LIBOR (London Interbank Offer Rate)
is the global reference rate for unsecured short-term borrowing in the interbank market. It acts as
a benchmark for short-term interest rates. It is used for pricing of interest rate swaps, currency
rate swaps as well as mortgages. It is an indicator of the health of the financial system and
provides an idea of the trajectory of impending policy rates of central banks.
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Banks also typically have secondary reserves, which are assets invested in
short-term securities and other investments that pay interest and earn revenue for the
institution. Primary reserves should not be confused with a primary reserve ratio, which
is a comparison of the expendable net assets of an organization and its total expenses.
The central bank has the sole monopoly to issue currency notes. Currency notes and coins issued
by the central bank are the legal tender money. Legal tender money is one which every
individual is bound to accept by law in exchange of goods and services.
1. Currency Principle.
2. Banking Principle.
P a g e | 10
1. Currency Principle:
According to these principles of note issue, notes are issued against gold reserve. The paper
money is a reasonable substitute for metallic money. The paper money should have backing
hundred percent of gold reserve. If there is lack of gold reserve against paper money. People will
lose confidence in such notes. Hence, notes issued should be limited to the limit and quantity of
notes issued will automatically expand or contract according to the inflow and outflow of gold
into and out of the country concerned. The advantages claimed for this principal is that there is
full care and protection to the paper currency. Moreover, excess issuance of currency in this
principle is no danger. In this case, issue of currency depends on the availability of gold.
2. Banking Principle:
In banking principle, like the commercial banks, the Central bank will keep a certain percentage
of gold and foreign currency for backing the entire note issue. We see in the day-to-day banking
business that the commercial banks do not keep the entire depositors’ money as cash in hand.
Only a small portion of the depositors’ money is used for cash in hand and the rest is given as
loan. The same way, under the banking principle of note issue, with limited amount of gold and
foreign currency reserves, the Central bank resorts to issue of more currency.
Financial deepening
Financial deepening is defined as increases in the ratio of a country's financial assets to its GDP.
It refers to the increased provision of financial services with a wider choice of services geared to
all levels of society. It also refers to the macro effects of financial deepening on the larger
economy. Financial deepening generally means an increased ratio of money supply to GDP or
some price index. It refers to liquid money. The more liquid money is available in an economy,
the more opportunities exist for continued growth.
P a g e | 12
Functions of Money
Functions of money can be broadly categorised into the following two types:
Medium of exchange:
It means that money can be used to make payments for all the transactions of goods and
services.
A buyer can buy goods through money, and a seller can sell goods for money.
It is an essential function of money.
Measure of value:
Example: When we borrow money from somebody, we have to return both the principal as well
as the interest amount in the future.
Store of value:
Transfer of value:
References
1. https://www.ecb.europa.eu/ecb/educational/explainers/tell-me/html/what-is-a-central-
bank.en.html
2. https://byjus.com/commerce/difference-between-central-bank-and-commercial-bank/
3. https://the-definition.com/a/11-features-of-a-central-bank
4. https://boycewire.com/central-bank-definition-objectives-and-functions/
5. https://www.economicsdiscussion.net/banks/methods-of-credit-control-used-by-central-
bank/13549
6. https://www.bankofengland.co.uk/monetary-policy/the-interest-rate-bank-rate
7. https://accountlearning.com/role-of-central-bank-in-issue-of-currency-principles-types-
of-issue/
8. https://www.businessstudynotes.com/others/banking-finance/methods-and-principles-of-
note-issue/
9. https://byjus.com/commerce/functions-of-money/