Chapter Two

CENTRAL BANKS AND COMMERCIAL BANKS

You might include a

quote/image related
to Quality, Education,
Studying, Motivation
… etc. (but relevant to
the subject)
Course: BANKING THEORY & PRACTICES
Course Code: BAFI3211
Specialization: Common
Department of Business Studies
Learning Outcome 2: Have a clear understanding of role of Central Bank &
Commercial Bank

Learning Objectives: After you have studied this chapter, you will:
 Understand the primary functions of Central Banks
 Understand the primary functions of commercial banks
 Learn about the services rendered by modern commercial banks

2
Learning Outcome 1: Contents
- The Establishment of Central Bank
Have a clear understanding - Functions of Central Bank of Oman
- Role of Central Bank in the Economy
of role of Central Bank & - Definition of Commercial Banks
Commercial Bank - Functions of Commercial Banks

3
 Essential Reading
1. B.Santhanam “Banking theory Law and practices” Published by Margam publication India.,5 th
edition 2007
2. K.P.M.Sundharam & Varshney, “Banking Theory Law & Practice”, Published by Sultan Chand
&Sons publication, India 17th edition 2014
3. Central Bank of Oman; https://cbo.gov.om/Pages/CBOHistory.aspx
 

4
Brief History of Oman Currency:

Before the establishment of Central Bank, the important function of a central bank, namely, the issue of
currency was carried out in different ways. Either the currency or coins of other countries were used or those
issued by the then Governments served as the medium of exchange.
Until 1970, Oman had no body whatsoever to supervise the monetary and banking system. With the
introduction of its own national currency in Oman, a need arose to establish an authority to deal with currency
management, and a monetary authority called Muscat Currency Authority was established in 1970 for purpose
of printing, issue and redemption, management and safekeeping of the new currency.
Subsequently in 1972, when the name of the country was changed from “ Sultanate of Muscat and Oman, to
Sultanate of Oman, a new currency named Rial Omani , which is in circulation till date, was introduced , and
the Muscat Currency Authority was replaced by the Currency Board.

5
The Establishment of Central Bank of Oman (CBO):

The Bank was established in the beginning of 1974, as a natural outcome of the steady evolution of monetary
system in the Sultanate, as well as of the tremendous impetus in the economic activities the country witnessed.
The Central Bank of Oman (CBO) was established under the Banking Law of 1974 and has become the main
authority responsible for the issuance of the country’s currency and the maintenance of its value. The Bank
started with an initial capital of RO 1 million. Assets and liabilities of the disbanded Oman Currency Board were
transferred to the new bank effective 1st April 1975, the date on which the Central Bank of Oman (CBO) was
opened for business.
Three years later (1978), the Central Bank of Oman (CBO) opened its first branch in Salalah. The second branch
was opened in the town of Sohar in November 1989.

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Features of Central Bank: The following are common features of every central bank:-

1. Central Banks are owned by the government.

2. Central Banks have more service-motive than profit motive.
3. Central Banks control the complete banking industry in the country.
4. Central Banks also play very important role in economic activities & policies in consultations with the
government.

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Functions of Central Bank of Oman (CBO):

The functions of the Central Bank of Oman (CBO) as defined by the Banking Law of 1974, fall under the
following main headings:
1. The Bank of the Government:
CBO functions as a banker to the government and may act for each Ministry as well. The Banking Law 1974
explain as exercising the role of bank of the government as follows:
(a) The Central Bank acts as the depository agency for the Government of the Sultanate of Oman by
accepting deposits and government revenues (e.g. taxes, oil proceeds … etc.) in the form of cash,
notes or cheques.
(b) The Central Bank manages loans on behalf of the Government. It provides borrowing funds to the
Government in respect to temporary deficiencies in revenues or to meet the Government’s
expenditures.
Generally, the revenues of the government will be irregular while its expenditures are periodical. Hence, the
CBO accommodate the deficit of expenditure by providing loans and advances to government.
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2. Act as Bankers Bank: The Central Bank is responsible for the development of banking industry in the
country. It is considered to be the bank of banks because the services it renders to banks is somewhat similar to
those rendered by banks themselves to their customers. In detail, the services rendered to banks by the CBO
comprises of the following:
(A) Maintaining Deposits of Licensed Banks: The Central Bank of Oman act as a custodian ‫ أمي ن ا لحفظ‬of the
commercial banks in the Sultanate. Commercial banks can keep two kinds of deposits with the CBO:
(i) Deposit required by the Banking Law‫ا إليداع ا لمطلوبب موجبق انونا لبنوك‬
(ii) Voluntary Deposits

(i) Deposits required by the Banking Law: According to the Banking Law, all commercial banks operating
in the Sultanate are required to deposit with the CBO of two kinds:

(a) Reserves against Deposits‫ا الحتياطيات مقاب ل ا لودائع‬: According to the Banking Law, the Central Bank may
require every licensed bank to maintain with it a deposit in Omani Rial an amount not exceeding 40% of the
total demand deposits and not more than 30% of the total time deposits held by the concerned bank within the
Sultanate. The amount of this reserve deposit is calculated at the close of business on the last Thursday of
each month.

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(b) Capital Deposits: Based on the Banking Law, the Central Bank requires that each commercial bank
operating in the Sultanate shall maintain with it a capital deposit account equivalent to one tenth of one
percent of all banking resources of the bank concerned provided that the minimum capital deposit shall
not be less than RO 50,000 and shall not exceed RO 500,000. Capital deposits are interest bearing at
rates determined by the Central Bank Board of Governors.

(ii) Voluntary Deposits. Banks by their own choice, can maintain other deposits with the Central Bank
to reap the benefits the Central Bank attaches to such deposits. Such benefits are a) facilities offered by
the Central Bank for inter banking settlements and b) the Central Bank accepts commercial banks’
deposits in foreign currency e.g. US Dollar, Pound Sterling, Yen, Mark etc., at interest rates equivalent
to current rates in international money markets.

(B) Acting as Lender of Credit:

CBO advances credit to the licensed banks and engage in investment activities through purchase and sale of
financial instruments.
Central bank also act as lender of last resort. Whenever banks are short of funds, they can take loans from
the central bank and get their trade bills discounted or selling securities for raising additional funds. This is
called as lender of last resort.

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(C) Providing Clearing House Services: CBO also act as clearing house agency
for all licensed banks. When more number of banks in operations, cheques of
different banks are received. These cheques have to be collected, realized and
credited to the account of customers.
For example, if the customer of Bank (A) deposits the cheques of Bank (B) and
similarly if the customer of the Bank (B) deposits the cheques of the Bank (A) in
their respective accounts, these cheques will be presented in the Clearing House
and the accounts between the banks will be settled. This kind of operation is called
Clearing House Operation.
This operation is also be followed in order to settled operations of inter-bank
transactions between licensed banks within or outside the Sultanate. The central
bank has its branch in all important cities and these branches undertake clearing
house operations.

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3. Act as controller of Credit and Money Supply: Central bank controls credit and money supply
through its monetary policy. The main objective of credit control function of central bank is price stability along
with full employment (level of output). It controls credit and money supply by adopting the following two
techniques:
(A) Quantitative Method of Credit Control (Traditional Weapons of Credit Control)
(B) Qualitative Method of Credit Control (Modern Weapons of Credit Control)
(A) Quantitative Method of Credit Control (Traditional Weapons of Credit Control): Quantitative credit control
measurements including:
(i) Bank Rate: Bank rate is the rate at which Central bank issues loans to the commercial banks and other
financial institutions.  
If the Central Bank wants to contract 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.
Similarly, a fall in bank rate mil lowers the lending rates in the money market which in turn will stimulate
commercial and industrial activity, for which more credit will be required from the banks. Thus, there will be
expansion of the volume of bank Credit.

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(ii) Open Market Operation: Open market operation is the all action which is done by central bank for purchase
and sale of member banks' security in open market. If CBO wants to contract the credit, then CBO will sell the
security of member bank and member bank's flow of cash will stop. If CBO wants to expand credit in recession,
then CBO will start to buy the security of member banks and member banks get cash and they can use it for
providing more loans to customers.

(iii) Cash Reserve Ratio/ Statutory Minimum Reserve: Cash reserve ratio is the minimum percentage of the
deposit to be kept as reserve by the banks with central bank. It can be used as the technique of monetary policy.
By changing cash reserve ratio, CBO can contract or expand credit in the economy. Low CRR creates more
credit to commercial banks and high CRR lower down the credit creation to commercial banks. Thus, by
varying the cash reserve ratio, the Central Bank can influence the creation of credit.

(3) ‫ ن سبة ا الحتياطيا لنقديهيا لنسبة ا لمئوية ا لدنيا ل لودائع ا لتيي جبا الحتفاظ ب ها‬:‫ ا لحد ا ألدنى ا لقانونيل الحتياط ي‬/‫ن سبة ا الحتياطيا لنقدي‬
‫ ي مكن ل لبنك‬،‫ من خال لت غيير ن سبة ا الحتياطي ا لنقدي‬.‫ي ي مكن استخدامه ك أسلوبل لسياسة ا لنقدية‬ . ‫ك احتياطي من ق بل ا لبنوك ل دىا لبنك ا لمركز‬
‫ ي خلقمع دل‬.‫ ا لمركزيا لعمانيأن ي نكمشأو ي وسع ا الئتمان ف يا القتصاد‬CRR ‫ا لمنخفضا لمزيد من ا الئتمان ل لبنوك ا لتجارية ويؤديارتفاع مع دل‬
CRR ‫ ي مكن ل لبنك ا لمركزيا لتأثير على إنشاء‬،‫ من خال لت غيير ن سبة ا الحتياطي ا لنقدي‬، ‫ وبا لتا لي‬.‫إ لى خفض ا الئتمان ا لممنوح ل لبنوك ا لتجارية‬
‫ا الئتمان‬.

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(B) Qualitative Method of Credit Control (Modern Weapons of Credit Control)

(i) Changes in Marginal Requirement of loan:-

The commercial banks generally advance loans to their customers against some security or securities offered by
the borrower and acceptable to bank.
Commercial banks do not lend up equal to the value of security. There is margin requirements against specific
securities that is determined by the Central Bank. A change in margin requirements will influence the flow of
credit by contracting it or expand it.
→ If CBO wants to contract the credit , it keeps marginal requirement high , if CBO fixes it as 40% , then
customer can get loan of RO 60 after giving security of RO 100 . So , trend of getting loan will decrease . 
→ If CBO wants to expand the credit, this rate will decrease suppose, if CBO fixes it as 10%, then customer can
get loan of RO 90 after giving security of RO 100. So, the trend of getting loan will increase.
 
 

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(ii) Credit Rationing: CBO has right to create ration (to fix) of credit under monetary policy. It can be done
by following way:-
- To fix the amount of loan for a particular bank. 
- To fix Quota for all banks. 
- To fix Quota for different traders.

(iii) Moral Persuasion: Central bank of country can control credit with moral persuasion. Under this
persuasion, central bank can call a meeting of all commercial bank and give advice in discussion that they
should not give loan for speculative purposes.

(iv) Regulation of Consumer Credit: Regulation of consumer credit is designed to check the flow of credit
for consumer durable goods. This can be done by regulating the total volume of credit that may be extended
for purchasing specific durable goods and regulating the number of installments through which such loan can
be spread. Central Bank uses this method to restrict or liberalize loan conditions accordingly to stabilize the
economy.‫ ي مكن‬.‫ي ت م ت صميم ت نظيم ا الئتمانا الستهالكيل لتحققمنت دفقا الئتمانل لسلع ا الستهالكية ا لمعمرة‬ : ‫ت نظيم ا الئتمانا الستهالك‬
‫ا لقيام ب ذلك منخال لت نظيم ا لحجم ا إلجما ليل الئتمانا لذيي مكنت مديده ل شراء س لع معمرة معينة وتنظيم عدد ا ألقساط ا لتيي مكنمنخال لها‬
‫ ي ستخدم ا لبنك ا لمركزيهذه ا لطريقة ل تقييد أو ت حرير ش روط ا لقرض وف ًقا ل ذلك ل تحقيقا الستقرار ف يا القتصاد‬.‫ت وزيع هذا ا لقرض‬.

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4. Issuing Currency Notes: One of the major responsibility the CBO has as issuing the national currency,
preserve its value and manage foreign reserves. CBO has to keep a reserve in the form of gold and foreign
securities as per statutory rules against the notes issued by it. This is to support the issue of currency and to
maintain its value.
Moreover, the Central Bank has the responsibility to maintain not only the domestic value of the currency but
also its foreign value. For this purpose, the Central Bank has to maintain adequate foreign exchange reserve. The
Central Bank receives foreign currency not only from the government but also from other commercial banks.
The foreign exchange markets in the most developed countries are deciding the value of currency by the market
forces of demand and supply. Thus, the exchange rate of the currency fluctuates according to the changes in the
demand and supply position.

16
Role of Central Bank in the Economic Development:

The Central Banks help the government in fulfilling its economic policies.
The monetary policy adopted by the Central Bank to manage the demand and supply of money must ensure
price stability, full employment and promotes the growth of agricultural, industrial and service sector.
Another major role of central bank is to improve its currency and credit system. More banks and financial
institutions are required to be set up to provide larger credit facilities and to divert voluntary savings into
productive channels.
The central bank coordinates with government functioning. It extends financial assistance to the government
whenever required to overcome any financial deficit.
Central bank also manages and controls balance of payment of the country. Central bank always attempts to
avoid fluctuations in the foreign exchange rates and to maintain stability.

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Definition of Commercial Bank:

Commercial banks are privately owned financial institutions which:

1. Accept deposits through different deposits account.

2. Make loans to individuals and organizations
3. Provide services (e.g. document collections, international banking, trade financing)

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Functions of Commercial Bank:

Banks are basically financial intermediaries between the depositors and the borrowers. Modern commercial
banks perform a vast range of functions and services on behalf of their customers. The functions performed by
the modern commercial banks vary from bank to bank and sometimes from branch to branch depending on the
location of the bank, type of customers etc. Generally, the functions of commercial banks are classified into:
A) Primary Functions (or Banking Activities):
1. Accepting Deposits: Acceptance of deposits of money from the public on various types of deposit accounts is
the most important function of almost all modern banks. The banks accept the deposits of money from the
public on the condition that the same will be repaid back to the depositors either on demand or after the expiry
of a certain period, depending upon the type of account under which the deposits are accepted.
Therefore, every deposit accepted by the bank constitutes a debt or a loan on the part of the banker towards the
depositor and repayable to them on demand or otherwise with interest earned wherever applicable.
2. Lending of Loans: Another most important function performed by the modern commercial banks is the
lending of loans and advances to individuals, traders and business enterprises at varying interest rates. The main
purpose with which banks accept deposits of money from the public is to lend loan and advances to those who
are in need of finance.
Contd.

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When a bank approves a loan, the bank agrees to place funds of its depositors at the disposal of the borrower, in
exchange for a promise of payment at a certain future date. This enables those persons and businesses, who find
their own capital insufficient for carrying on business on a large scale, to do so with the help of the funds
borrowed from a bank.
Commercial banks not only help merchants but also others who, in turn, may use funds not only to their
advantage, but also to the advantage of the community.
Commercial banks also extends credit to general public for meeting their personal needs such as personal loan,
education loans, etc.
The rate of interest on loans mainly depends upon the period for which loan is taken by the borrower and the
type of loan. Interest on loans constitutes the major source of income to be banks out of which they meet their
operating expenses, pay fair rate of interest to their depositors and declare reasonable rate of dividends to the
shareholders of the bank.

20
B) Secondary Functions of Commercial Banks: In addition to the primary functions given above,
modern commercial banks perform a vast range of other functions for the benefit and convenience of their
customers as well as the general public. These additional functions performed by the banks are generally referred
to as “Services Rendered by Banks”. The vast range of services rendered by the modern commercial banks
differs from one bank to another and also from one place to another. However, the following are some of the most
important services rendered by almost all the banks:
1. Remittances of Funds: Modern commercial banks undertake the transfer of money from one account to
another, from a place to another place or even from a country to another on behalf of their customer and as per
their instructions. This transfer of the money is done be various means including cheques, mail transfers, telex
transfers and demand drafts.

2. Issue of Various Forms of Credits: Modern commercial banks issue Letters of Credit, Travelers’ Cheques and
Credit Cards for the benefit of their customers. These means enable the customers to obtain easy and quick
finance at any time and any place especially the credit cards like ‘VISA’ and ‘MASTER’ cards, with their vast
circulation and common acceptance, have become very popular in the recent.

21
3. Safe Custody of Valuable: Modern banks also undertake the safe custody of documents, business contracts,
jewelry and other valuables on behalf of their customers and the general public. This service is offered by renting
out of the safe deposit lockers, available in the premises of the banks, to the people willing to pay the prescribed
rent.

4. Underwriting of Capital Issues: On behalf of corporate customers, modern banks perform a very important
service of underwriting of shares and debentures. As underwriters, banks take care of all the legal formalities and
make all necessary arrangements in connection of the raising of share capital or debenture loan by the companies.

5. Acting as Executors and Trustees: On behalf and for the benefit of their customers, banks act as executors and
trustees. As executors, banks administer the funds and property of deceased customers as per the instructions of
their will, wherein the banker is appointed as the legal executors. As trustees, banks take up the responsibility of
administering the funds and property or the business of their customers for some benevolent cause.

6. Acting as Guarantors
Modern banks furnish letters of guarantee on behalf of their business customers enabling them to enter into
new business relations with local businesses and also with foreign exporters. These letters of credit issued
by the banks really help the local businesses in importing raw materials and sophisticated machinery and
equipment from foreign exporters on credit.
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7. Discounting of Bills of Exchanges
Banks discount the bills of exchange drawn by the local exporters upon the foreign importers, thus enabling
the local exporters to obtain ready cash against their exports. This service is of great significance in the
growth of foreign trade.

8. Overdraft Facility: Under this service the banks allowed the customer to withdraw the money or
making payment even the account balance of the customer reaches zero.

9. Letter of References: Letter of reference issued to customer by specifying that the person or firm is a customer
of bank from a certain period of time. Bank reference also confirm that the relationship with the customer are
acceptable and there is no default from customer part.

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Banks Offer Diversified Financial Services:
Throughout the 1990s, regulations discouraged the consolidation of bank, securities, and insurance services.
Thus, banks had to either find loopholes to offer securities and insurance services, or be forced to only engage in
these services to a limited extent. In 1999, the financial Services Modernization Act was passed, which provided
more momentum for the consolidation of financial services. Banks and other financial services firms were given
more freedom to offer diversified set of financial services without being subject to stringent constraint on the
form or amount of financial services that they could offer.

1. Benefits of Diversified Services to Individuals and Firms : Since individuals commonly use financial
institutions to place deposits, obtain mortgage loans and consumer loans, purchase shares of mutual funds, order
stock transactions (brokerage services), and purchase insurance, they can obtain all their financial services from
a single financial conglomerate. Since firms commonly use financial institutions to create a business checking
account, obtain loans, issues stocks or bonds, have their pension fund managed, and purchase insurance
services, they can receive all of their financial services from a single financial conglomerate.

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 2. Benefits of Diversified Services to the Financial Institutions: By offering more diversified
services, financial institutions can reduce their reliance on the demand for any single service that they
offer. This diversification may result in less risk for the institution’s consolidated business, assuming
that the new services are not subject to a much higher degree of risk than its traditional services. The
individual units of a financial conglomerate may generate some new business simply because they are
part of the conglomerate and offer convenience to clients who already rely on its other services. Each
financial unit’s list of existing clients represents a potential source of new clients for other financial
units to pursue.
.‫لطلب‬QQ‫عتمادها علىا‬Q‫قليلا‬QQQ‫لية ت‬QQ‫لما‬QQ‫لمؤسساتا‬QQ‫مكنل‬QQ‫ ي‬، ‫نو ًعا‬QQQ‫كثر ت‬Q‫دمات‬Q
‫ خ أ‬Q‫ديم‬Q‫ق‬QQQ‫سطة ت‬Q‫وا‬QQQ‫مؤسسات ب‬: ‫ل‬QQ‫لية ا‬QQ‫لما‬QQ‫لمتنوعة ل‬QQ‫لخدماتا‬QQ‫ئد ا‬Q‫لفوا‬QQ‫ا‬
Q‫لجديدة ال‬QQ‫لخدماتا‬QQ‫نا‬Q‫ضأ‬Q‫افترا‬QQQ‫ ب‬، ‫لمؤسسة‬QQ‫لموحدة ل‬QQ‫لا‬QQ‫ألعما‬QQ‫قليلمخاطر ا‬QQQ‫لىت‬QQ‫ إ‬Q‫لتنويع‬QQ‫ؤديهذا ا‬QQ‫د ي‬QQ‫ ق‬.‫ا‬Q‫قدمه‬QQQ‫حدة ت‬Q‫دمة وا‬Q‫يخ‬Q‫علىأ‬
‫مجرد‬QQ‫لجديدة ل‬QQ‫لا‬QQ‫ألعما‬QQ‫عضا‬QQQ‫ليب‬QQ‫لما‬QQ‫لتكتلا‬QQ‫لفردية ل‬QQ‫تا‬Q‫لوحدا‬QQ‫ولد ا‬QQQ‫د ت‬QQ‫ ق‬.‫لتقليدية‬QQ‫ا ا‬Q‫دماته‬Q‫لمخاطر منخ‬QQ‫كثير منا‬QQQ‫علىب‬Q‫درجة أ‬QQ‫ ل‬Q‫خضع‬QQQ‫ت‬
‫لية‬QQ‫كلوحدة ما‬QQ‫ليينل‬QQ‫لحا‬QQ‫لعمالء ا‬QQ‫ائمة ا‬QQ‫مثلق‬QQQ‫خرى ت‬. ‫أل‬QQ‫ا ا‬Q‫دماته‬Q‫لفعلعلىخ‬QQ‫ا‬QQQ‫عتمدونب‬QQ‫لذيني‬QQ‫لعمالء ا‬QQ‫حة ل‬Q‫لرا‬QQ‫لتكتلوتوفر ا‬QQ‫زء منا‬Q‫ا ج‬Q‫نه‬Q‫أ‬
ً
‫ألخرى‬QQ‫لية ا‬QQ‫لما‬QQ‫تا‬Q‫لوحدا‬QQ‫ ا‬Q‫تتبعه‬QQ‫لجدد ل‬QQ‫لعمالء ا‬QQ‫محتمال ل‬ ‫مصدرًا‬.

25
Difference between Central Banks and Commercial Banks:
No. Factors Central Bank Commercial Banks

1. Profit Motive Non-profit Organization Profit Organization

2. by the Government by the Government,
Ownership
by Private Sector, or both
3. Issue Currency Empowered to issue currency No power to issue currency
4. Dealing with the Government the Public people
Accounts of
5. The entire Foreign Exchange Reserve of the Can have only a small portion of the Foreign
Foreign Exchange country is handled by the Central Bank Exchange that is consent with the Central Bank

6. Certain statutory controls can be exercised on Have no such controlling power and may request for
Control commercial banks assistance from the Central Banks

26
Review Questions:
1. What are the primary functions performed by the commercial banks?
2. Explain the secondary functions performed by the commercial banks?
3. Explain the credit control techniques of the central bank?
4. What are the benefits derived by the individuals, firms and financial institutions from the diversified financial
services?

27
 References:

1. B.Santhanam “Banking theory Law and practices” Published by Margam publication India.,5 th
edition 2007
2. K.P.M.Sundharam & Varshney, “Banking Theory Law & Practice”, Published by Sultan Chand
&Sons publication, India 17th edition 2014
3. Central Bank of Oman; https://cbo.gov.om/Pages/CBOHistory.aspx
 

28
CONTACT INFORMATION:

Name of the Staff: Dr. Mohammed Muslim

Office: BS045
Email: mohammed-muslim@hct.edu.om

VERSION HISTORY

Version No Date Approved Changes incorporated

02 Sem. (II) 2019/2020

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