CHAPTER – Two

2.1 MEANING AND DEVELOPMENT OF CENTRAL BANKING

According to Will Rogers, Central Bank is one of the three great inventions in the human
development, with fire and wheel. It may not be accepted by others even if the importance
is known for certainty by all.
Today, central bank is the central arch of the monetary and fiscal framework in every
country of the world and its activities are essential for the proper functioning of the
economy and indispensable for the fiscal operations for the government.
 Con’ed

Central banking is mostly a recent development being essentially a product of the

nineteenth century. The following cases can be considered here:
- Riksbank of Sweden – established in 1668
- Bank of England – established in 1694 – serve as a central bank in 1844
- Bank of France – established in 1800
- Reichs bank of Germany – established in 1876
- Bank of Netherlands – established in 1814 – on the ruins of old bank of Amsterdam
- National bank of Austria – established in 1817 – reorganized as the bank of Austria-
Hungary in 1877
 Con’ed

- The bank of Norway – established in 1817

- The national bank of Denmark - established in 1818
- The national bank of Belgium - established in 1850
- The bank of Spain - established in 1856
- The bank of Russia - established in 1860
- The bank of Japan - established in 1882
- The bank of Italy - established in 1893
- The Swiss national bank - established in 1907
 Con’ed

In 1920, The International Financial Conference held at Brussels resolved

that “All those countries which had not yet established a central bank should
proceed to do so as soon as possible, not only with a view to facilitating the
restoration and maintenance of stability in their monetary and banking
systems but also in the interest of world cooperation.”


Hence, a number of Central Banks were added to the list of central banks in
the world and there is no independent country with out a central bank.
 2.2. Nature and Function of Central Bank

Economists have defined central bank differently, emphasizing its one function or the other.
 Vera Smith – The primary definition of central banking is a banking system in which a
single bank has either complete or a residuary monopoly of note issue.
 Show – The Central Bank is a bank which controls credit.
 Haultrey – Central Bank is a bank which controls credit.
 Statutes of the bank for international settlements – A Central Bank is the bank in any country
to which has been entrusted the duty of regulating the volume of currency and credit in the
country.
 Kisch and Elkin – A Central Bank is a bank whose essential duty is to maintain stability of
the monetary standard.
 2.3. Difference between Central Bank and Commercial Bank

A central bank is basically different from a commercial bank in the following

ways:
1. The Central Bank is the apex institution of the monetary and banking structure
of the country. The commercial bank is one of the organs of the money market.
2. The Central Bank is a non-profit institution which implements the economic
policies of the government. But the commercial bank is a profit-making
institution.
3. The Central Bank is owned by the government, whereas the commercial bank
is owned by shareholders.
4. The Central Bank is a banker to the government and does not engage itself in ordinary banking activities.
The commercial bank is a banker to the general public.
5. The Central Bank has the monopoly of note issue, while the commercial bank can issue only cheques.

6. The Central Bank is the banker’s bank.

7. CB controls credit in accordance with the needs of business and economy CMB creates credit
8. Every country has only one Central Bank with its offices at important centers of the country.
9. The Central Bank is the custodian of the foreign currency reserves of the country while the Commercial
Bank is the dealer.
10. The chief executive of the central bank is designated as “Governor” whereas the chief executive of a
Commercial Bank is called “chairman” or “president” or “managing director”.
11. The Central Bank helps the expansion of Commercial Banks whereas Commercial Bank facilitates the
expansion of industries by underwriting.
 2.4 Functions of a Central Bank

A. Bank of Issue/Regulator of Currency

 The central bank is the monopoly of bank note issue. The reasons for granting the exclusive monopoly
of note issue to the central bank are:
a) for credit control purpose
b) To impart the notes a distinctive prestige i.e., it brings stability in the monetary system and creates
confidence among the public.
c) To ensure uniformity in the notes issued which helps in facilitating exchange and trade within the
country.
d) To make it easy for the state to supervise and control the irregularities and malpractices committed by
the central bank in issuing notes.
e) To restrict or expand the supply of cash according to the requirements of the economy.
f) To control the banking system by being the ultimate source of cash.
 B. Government Banker, Fiscal Agent and Advisor

a) As banker to the government the Central Bank keeps deposits of the Federal
and regional governments makes payments on behalf of governments, but it
does not pay interest on government deposits. It buys and sells foreign
currencies on behalf of the government and keeps the stock of gold of the
government.
b) As a fiscal agent, the central bank makes short-term loans to the government
for a period not exceeding 90 days.
c) As advisor, the central bank advises the government on such economic and
money matters.
 C. Custodian of commercial banks cash reserves

 The purpose of keeping reserves at the central banks is:

a) For transfer of funds between commercial banks through the clearinghouse.
b) As a source of great strength to the banking system of the country.
c) As the basis of a large and more elastic credit structure than if the same amount were scattered
among the individual banks.
d) Centralized cash reserves can be utilized fully and most effectively during periods of seasonal
strains and in financial crises or emergencies.
e) By varying these cash reserves the central bank can control the credit creation by commercial
banks.
f) The central bank can provide additional funds on a temporary and short term basis to commercial
banks to overcome their financial difficulties.
 D. Custody and Management of Foreign Exchange Reserves

 It is an official reservoir of gold and foreign currencies.

 It buys and sells foreign currencies at international prices.
 It sells gold to the monetary authorities of other countries.
 It fixes the exchange rates of the domestic currency in terms of foreign
currencies and tries to bring stability in foreign exchange rates. It manages
exchange control operations by supplying foreign currencies to importers and
persons visiting foreign countries on business, studies, etc.
 E. Lender of the Last Resort

 In its capacity of lender of the last resort, the central bank meets directly
or indirectly all reasonable demands for financial accommodation from
the commercial banks, discount houses, and other credit institutions
subject to certain terms and conditions which constitute its discount rate
policy.
 F. Bank of Central Clearance, Settlement and Transfer

 As a bankers’ bank, the central bank acts as a clearing house for transfer
and settlement of mutual claims of commercial banks. Since commercial
banks keep their surplus cash reserves in deposits with the central bank
it is far easier to clear and settle claims between them by making transfer
entries in their accounts maintained with the central bank.
 This function of the central bank is sometimes granted by law where as
some other times by customary functions of banks. It saves time and
creates contingency plus test at any time the degree of liquidity of banks.
 G. Controller of Credit

 The most important function of the central bank is to control the credit creation power

of commercial banks in order to control inflationary and deflationary pressures within

the economy.

 For this purpose, it adopts quantitative and qualitative methods.

 Quantitative methods aim at controlling the cost and quantity of credit by adopting

bank rate policy, open market operations and variations in reserve ratio of commercial

bank.
 Cont’ed

Qualitative methods control the use and direction of credit. It involves

selective credit controls and direct action.
Besides to these, the central bank in a number of developing countries has been
entrusted with the responsibility of developing a strong banking system to meet
the expanding requirements of agriculture, industry, trade and commerce.
 Cont’ed
Additional powers given for central bank:-
- supervision and control over the commercial banks
- issuing licenses to newly established financial institutions
- the regulation of branch expansion by commercial banks
- see that every bank maintains the minimum paid up capital and reserves as
provided by law
- inspecting or auditing the accounts of banks
- approve the appointment of chairmen and directors of such banks in accordance
with the rules and qualifications
 Cont’ed

- to control and recommend merger of weak banks in order to avoid their

failure and protect the interest of depositors
- to recommend nationalization of certain banks to the government in public
interest
- to publish periodical reports relating to different aspects of monetary and
economic policies for the benefit of banks and the public, and
- to engage in research and train banking personnel, etc
 i. Objective of Credit Control

 The central bank controls credit to achieve the following objectives

a) To stabilize the internal price level
 Inflationary or deflationary trends need to be prevented. This can be achieved
by adopting a judicious policy of credit control. As price rise the
central bank decreases money in circulation and as price
decline it increases the money supply.
 b) To stabilize the rate of foreign exchange

 With the change `in the internal prices level, exports and imports of the
country are affected. When price decline exports increase and imports decline
which leads to increase in the demand for domestic currency in the foreign
markets and exchange rate also increased. When price rise in the
domestic market export decline and imports increase. This
leads to an increase in the demand for foreign currency and
decline in demand for domestic currency which in turn leads
to a decline in exchange rate.
 c) To protect the outflow of gold

 The central bank holds the gold reserves of the country

in its vaults (domes). Increase in bank credit
leads to increase in prices and decline in exports and
rise in imports. This create an unfavorable balance of
payments. This necessitates the export of gold to other
countries in order to have an equilibrium balance of
payments.
 d) To control business cycles
 Business cycles are characterized by alternating periods of prosperity
and depression.
 During prosperity – Large expansion in the volume of credit;
production, employment and prices rise
 During depression – Credit contracts: production, employment and
price fall. The central bank can counteract such cyclical fluctuations
through contraction of bank credit during boom periods, and expansion
of bank credit during depression.
 e) To meet business needs

 Credit is needed to meet the requirements of trade and industry. As

business expands, larger quantity of credit is needed and when business
contracts, less credit is needed. Therefore, it is the central bank which can
meet the requirements of business by controlling credit.
f) To have growth with stability
 The principal objective of credit control is to have growth with stability;
price stability foreign exchange rate stability, to help in achieving full
employment, and accelerate growth with stability in the economy without
inflationary pressures and balance of payments defects.
 ii) Methods of Credit Control

 The central bank adopts two methods of credit control. They are:
1. The quantitative methods
 Which aims at controlling the cost and quantity of credit by adopting
such techniques as variations in the bank rate, open market operations
and variations in the reserve ratios of commercial banks.
 Bank rate or discount rate policy

The central bank controls credit by making variations in the bank rate.
 If the need of the economy is to expand credit; central bank lowers the bank
rate thus borrowing from the central bank will be cheaper and easy, commercial
banks will borrow more. They will intern advance loans to customers at a lower
rate. The market rate of interest will be reduced which encourages the business
activity and the expansion of credit.
 Cont’ed
=> If the need of the economy is to contract credit: Central bank raises the
bank rate, making borrowing costly for commercial banks. The banks
borrow less and raise their lending rates to customers. The market rate of
interest also raise which discourages fresh loans and puts pressure on
borrowers to pay their past debts and discourage business activity.
Lowering the bank rate offsets deflationary tendencies
and raising the bank rate controls inflation
 The significance of central bank’s bank rate policy

1. The bank rate indicates the rate at which the public should be able to obtain financial
accommodation against the approved securities from the commercial banks.
2. The bank rate indicates the rate of interest at which the commercial banks can borrow
funds from the central bank against the security of government and other approved
securities.
3. The bank rate acts as a barometer of the economic situation in the country. A rise bank
rate is a danger signal while a fall shows clear path.
 The bank rate policy proves more ineffective during depression than during the boom
 Limitations of bank rate policy

1.Market rates do not change with bank rate:

2.Wages, costs and prices are not elastic: when bank rate rise wages,
costs and prices should automatically be lower.
3. Banks do not approach central bank:.
4. Bills of exchange is not used:
 cont’ed

5. Pessimism or optimism of business men: If they are pessimism,

even if bank rate fall, they do not need the bank loan.
6. Power to control deflation is limited:
7. Level of bank rate in relation to market rate:
8. Not successful in controlling BOP (Balance of Payment)
disequilibrium: Because it requires the removal of restrictions on
foreign exchange and movements of international capital.
 Open Market Operations

 There are two principal motives of open market operations

1. To influence the reserves of commercial banks in order to control their
power of credit creation, and
2. To affect the market rates of interest so as to control the commercial bank
credit.
 The method of operation is used as follows
To control inflationary pressures: Central bank sells securities, bills and
bonds in the open market. The buyer (the commercial bank or the public)
pay the value of these documents with cheques drawn on the commercial
bank. This reduces the reserve of commercial banks at the central bank and
curtails their lending abilities as the reserve determines the credit creation
capacity of commercial banks.
 Cont’ed
 To control depression of the economy expansionary policy is used: central
bank purchases securities from commercial banks and other government
and private institutions.
 A decrease in the money supply leads to rise in rates of interest and
increase in the money supply leads to a decline in the rate of interest.
 Limitations of open market operations

The success of the system depends upon the existence of a number of conditions
a) Availability of securities market & the central bank must have enough saleable
securities with it.
b) Stability of cash reserve ratio by the commercial banks. Commercial banks
should be able to sensitive to the central bank policy. However, in actuality,
commercial banks usually have excess reserves and become non-responsive to
the central bank policies.
c) Penal bank rate. Penal bank rate should be available to control the credit creation
of commercial banks whenever there is higher credit interest from the public.
 Cont’ed
d) The act of others should be similar with the central bank. But in actuality this
may not be possible.
e) Pessimistic or optimistic attitude of borrowers
 During depression, even if the central bank purchases securities and increase
the supply of bank money, businessmen may not be willing to take loans –
pessimistic situation. During boom, even if the central bank sells securities
and decrease the supply of bank money, and rise the market rate of interest,
businessmen may not be discouraged to take loans – optimistic situation.
f) Non constant velocity of credit money
 Variable reserve ratio

Alternatively, known as required reserve ratio, or legal minimum

requirements
Every commercial bank is required by law to maintain a minimum
percentage of its deposits with the central bank. This amount may be a
percentage of its time and demand deposits together or separately.
 Limitations of variable reserve ratio
a) Excess reserves by commercial bank. Commercial banks possess higher/large excess
reserves and they are not responsive to the reserve ratio requirements of the central bank.
b) Clumsy method. The method does not clearly define the area, place and time when it is
applied.
c) Discriminatory. It affects only banks with lower excess reserve but not banks with large
excess reserves. In addition, non-banking financial intermediaries are not affected by this
policy like
- co-operative societies - building societies
- insurance companies - development banks, etc.
a) Inflexibility. This policy is applicable at a time to all banks in a country.
 Variable reserve ratio Vs open market operations
The Variable reserve ratio
- Affects the power of the commercial banks more directly, immediately and
simultaneously than open market
- It is not time consuming – simply declaring the change of RRr
- It is meant for making major and long run adjustments in the liquidity
position of the commercial banks. Therefore, they are not suitable for short-
term adjustments.
- It is used in underdeveloped or developed countries.
 The open market operations
- It affects non-banking financial intermediaries. They are outside the legal
control of the central bank. Therefore, they are not required to deposit a
reserve with the central bank. But they buy and sell government or private
organizational securities.
- Its success depends upon the existence of broad and well-organized market
for securities. Therefore, it is successful only in developed countries
- It has a loss in buying and selling securities on a day-to-day and week-to-
week basis.
 Selective/Qualitative Credit Controls
The aim of selective credit controls is to channelize the flow of bank
credit from speculative and other undesirable purposes to socially
desirable and economically useful activities. They also restrict the demand
for money by laying down certain conditions for borrowers. The main
types of selective credit controls used by the central banks in different
countries are discussed as follows.
 Regulation of Margin Requirements

 Its purpose is to prevent excessive use of credit to purchase or carry securities by

speculators. The central bank fixes minimum margin requirements on loans for
purchasing or carrying securities.
 Advantages
1. It is non-discriminatory – applied equally to borrowers and lenders to commercial banks
and non-banking financial intermediaries. It affects all financial institutions uniformly.
2. It increases the supply of credit for more productive uses.
3. It controls the expansion of credit in those sectors of the economy which breed inflation
4. It is simple and easy to administer.
 Disadvantages

1. A borrower may not show his intention clearly

2. A borrower may purchase stocks with his own source and borrow to finance
other activities.
3. Non-banking financial intermediaries may increase their security loans when
others are being controlled by high margin requirements.
 Regulation of Consumer Credit

It aims at the regulation of consumer installment credit or hire purchase

finance. Its main objective is to regulate the demand for durable consumer
goods in the interest of economic stability. It employees two devices: Minimum
down payment and Maximum periods of repayment
 It is technically defective and difficult to administer because it has a narrow

base. It affects only a particular class of borrowers whose demand for credit
forms an insignificant part of the total credit requirements.
 Rationing of Credit

There are two types of credit rationing methods

1. Variable portfolio ceiling. The central bank fixes a ceiling on the aggregate
portfolios of the commercial banks and they cannot advance loans beyond
this ceiling.
2. Variable capital assets ratio. This is the ratio which the central bank fixes in
relation to the capital of a commercial bank to its total assets.
 Direct Action

 The central bank resort to direct the action of commercial banks by issuing
“directives”. For example,
 The central bank may refuse rediscounting facilities to certain banks which
may be granting too much credit for speculative purposes.
The central bank may also charge a penal rate of interest form those banks
which want to borrow from it beyond the prescribed limit.
The central bank may even threaten commercial bank to be taken over by it in
case it fails to follow its policies and instruction.
 Moral Suasion (Strong recommendation not an order)

 It is the method of persuasion, of request, of informal suggestion and advice to the commercial
bank usually adopted by the central bank.
 Limitations
 It is a method “without any teeth” and hence its effectiveness is limited to
1. The extent to which commercial banks accept central bank as a leader and need accommodation
from it
2. The excess reserve maintained by the commercial banks. If the commercial banks possess
excessive reserves, they may not follow its advice.
3. The economic condition. It may not be successful during booms and depression when there is a
wave of pessimistic and optimistic situations
 It is not a controlling device at all, as it involves cooperatives by the commercial banks.
 Publicity
 It publishes weekly or monthly statements of the assets and liabilities of
the commercial bank for the information to the public.


 It also publishes statistical data relating to money supply, prices,

production and employment, capital and money market, etc at making the
public aware to the policies being adopted by the commercial bank vis-à-
vis the central bank in the light of the prevailing economic condition in
the country. It needs well educated public that can understand and act
according to the requirement.
 Limitations of selective credit controls

1. Limited coverage. They are only applicable to the commercial banks but not to non-
banking financial institutions.
2. No guarantee for use of specific purpose. There is no guarantee that the bank loans would
be used for the specific purpose for which they are sanctioned.
3. Difficult to distinguish between essential and non-essential factors.
4. Require large staff by the central bank to check the credits given by the commercial banks
5. Discriminatory. It unnecessarily restrict the freedom of borrowers and lenders.
6. Mal-allocation of resources. When they are applied to selected sectors, areas and
industries while leaving others to operate freely, leads to mal-allocaiton of resources.
 5. Role of Central Bank in a Developing Economy

 The central bank in a developing economy performs the activity of note

issue, banker to the government, banker’s bank, lender of the last resort,
controller of credit and maintaining stable exchange rate.
 It aims at the promotion and maintenance of a rising level of production,

employment, and real income in the country. It is given a wider power to

promote the growth of economies in underdeveloped countries.
 Cont’ed
They, therefore, perform the following functions towards this end.
1. Creation and expansion of financial institutions
2. Proper adjustment between demand for and supply of money
3. Creating a suitable interest rate policy
4. Debt management
5. Credit control
6. Open market operations
7. Solving the balance of payments problem
The End