8 functions of a central bank
central bank
The central bank is the apex bank and has several functions relating to the banking sector and other financial institution. These functions are taken generally to improve the whole macroeconomic goals which include; high employment rate, balance of payment, increases the standard of living, reduce inflation etc.
A central bank has been defined in terms of its functions. According to smith, “the primary definition of central banking is a banking system in which a single bank has either complete control or a residuary monopoly of note issue.” Shaw on the other hand defines a central bank as a bank which control credit. For haw trey, a central bank is that which the lender of the last resort is. According to A.C.L. Day, a central bank is: to help control and stabilize the monetary and banking system. “According to Sayers, 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 behavior of financial institutions so as to support the economic policies of the government, “Sayers refers only to the central bank as the governments bank. All these definitions are narrow because they refer only to one particular functions of a central bank.
On the other hand, Samuelsson definition is wide. According to him, a central bank “is a bank of bankers. Its duty is to control the monetary base and through control of this high powered money to control the communities supply of money. But the broadest definition has been given by De kock in his book central banking. In his words, a central bank is “a bank which constitutes the apex of the monetary and banking structure of its country and which performs as best as it can in the national economic interest, the following are the major functions of the central bank in a country:
1. Regulator of currency
2. Banker, fiscal agent and adviser to the government
3. Custodian of cash reserve of commercial banks
4. Custody and management of foreign exchange reserve
5. Lender of the last resort
6. Clearing house for transfer and settlement
7. Controller of credit
8. Other functions
Regulator of currency:
The central bank is the bank issue. It has the monopoly of note issue. Notes issued by it circulate as legal tender money. It has its issue department which issue notes and coins to commercial banks. Coins are manufactured in the government mint but they are put into circulation through the central bank.
Central banks have been following different methods of note issue in different countries. The central bank is required by law to keep a certain amount of gold and foreign securities against the issue notes. In some countries, the amount of gold and foreign securities bears a fixed proportion, between 25 to 40 percent of the total notes issued. In other countries, a minimum fixed amount of gold and foreign currencies is required to be kept against note issue by the central bank.
The monopoly of issuing note vested in the central bank ensures uniformity in the notes issued which helps in facilitating exchange and trade within the country. It brings stability in the monetary system and creates confidence among the public. The central bank can restrict or expand the supply of cash according to the requirement of the economy. Thus it provides elasticity to the monetary system. By having a monopoly of note issue, the central bank also controls the banking system by being the ultimate source of cash. Last but not the least, by entrusting the monopoly of note issue to the central bank, the government is able to earn profits from printing notes whose cost is very low as compared with their face value.
Banker, fiscal agent and adviser to the government:
Central banks everywhere act as bankers, fiscal agents and adviser to their respective government. As banker to the government, the central bank keeps the deposits of the central and state government and makes payments on behalf of government. But it does not pay interest on government deposits. It buys and sells foreign currencies on behalf of the government; it keeps the stock of gold of the government.
Thus it is the custodian of government money and wealth. As a fiscal agent, the central bank makes short term loans to the government for a period not exceeding 90 days. It floats loan, pays interest on them, and finally repays them on behalf of the government. Thus it manages the entire public dept.
The central bank also advises the government on such economic and money matters as controlling inflation or deflation, devaluation or revaluation of the currency, deficit financing, balance of payment, etc. as pointed out by de kock “central banks everywhere operates as bankers to the state not only because it may be more convenient and economical to the state, but also because of the intimate connection between public finance and monetary affairs.
Custodian of cash reserves of commercial banks:
Commercial banks are required by law to keep reserve equal to a certain percentage of both time and demand deposits liabilities with the central bank. It is on the basis of these reserves that the central bank transfer funds from one bank to another to facilitate the clearing of cheques. Thus the central bank acts as the custodian of the cash reserve of commercial banks and helps in facilitating their transactions.
There are many advantages of keeping the cash reserve of the commercial banks with the central bank. Firstly, the centralization of cash reserve in the central bank is a source of great strength to the banking sector and sector of a country.
Secondly, centralized cash reserve can serve as the basis of a large and more elastic credit structure than if the same amount were scattered among the individual bank.
Thirdly, centralized cash reserve can be utilized fully and most effectively during periods of seasonal strains and in financial crisis or emergencies.
Fourthly, by varying these cash reserves the central bank can control the credit creation by commercial banks.
Lastly, the central bank can provide additional funds on a temporary and short term basis of commercial banks to overcome their financial difficulties.
Custody and management of foreign exchange reserve:
The central bank keeps and manages the foreign exchange reserve of the country. It is an official reservoir of gold and foreign currencies. It sells gold at fixed prices to the monetary authorities of other counties. It also buys and sells foreign currencies at international prices.
Further, it fixes the exchange rate of the domestic currency in terms of foreign currencies. It holds there rates within narrow limits in keeping with its obligations as member of the international monetary fund and tries to bring stability in the foreign exchange to importers and persons visiting foreign countries on business, studies, etc. in keeping with the rules laid down by the government.
Lender of the last resort:
De kock regards this function as a sine qua non of central banking. By granting accommodation in the form of rediscount and collateral advances to commercial banks, bill brokers and dealers, or other financial institution, the central bank act as the lender of the last resort. The central bank lends to such institutions in order to help them in time of stress so as to save the financial structure of the country from collapse. It acts as lender of last resort through discount houses on the basis of treasury bills, government securities and bonds at the “front door”.
The other method is to give temporary accommodation to the commercial banks or that lending at the front door is at the bank rate and in the second case at the market rate.
Thus the central bank as lender of the last resort is a big source of cash and also influences prices and market rates
Clearing house for transfer and settlement:
As bankers bank, the central bank acts as a clearing house for transfer and settlement of mutual claims of commercial banks. Since the central bank holds reserve of commercial banks, it transfers funds from one bank to other banks to facilitate clearing of cheque. This is done by making transfer entries in their accounts on the principle of bookkeeping.
To transfer and settle claims of one bank upon others, the central bank operates a separate department in big cities and trade centers. This department is known as the “clearing house” and it renders the services free to commercial banks.
When central bank acts as a clearing agency, It is time saving and convenient for the commercial banks to settle their claims at one place. It is also economies the use of money. “it is not only a means of economizing cash and capital but also a means of testing at any time the degree of liquidity which the community is maintaining.”
Controller of credit:
The most important function of the central bank is to control the credit creation power of commercial bank in order to control inflationary and deflationary pressures within the economy. For this purpose, it adopts quantitative methods, Quantitative method of control aim at controlling the cost and quantity of credit by adopting bank rate policy, open market operations, and by variation in reserve ratios of commercial banks. Qualitative methods by adopting such methods, the central bank tries to influence and control credit creation by commercial banks in order to stabilize economic activity in the country.
Other functions:
Besides the above noted functions, the central banks in a number of developing countries have been entrusted with the responsibility of developing a strong banking system to meet the expanding requirements of agriculture, industry, trade and commerce. Accordingly, the central banks posses some additional powers of supervising and control over the commercial banks.
They are the issuing of license; the regulation of branch expansion, to see that every bank maintains the minimum paid up capital and reserves as provided by law; inspecting or auditing the accounts of banks; to approve the appointment of chairman and directors of such banks in accordance with the rules and qualifications; to control and recommend merger of weak banks in order to avoid their failures and to protect the interest of depositors; to recommend nationalization of certain banks to the government in public interest; to publish periodically reports relating to deferent aspects of monetary and economic policies for the benefits of banks and the public; to engage in research; and to train banking personnel. Etc.
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