BCom Notes Part II Banking and Finance Central Banking
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Central Banking
Define Central Bank. State the origin and growth of central bank. OR
What is credit control, explain the various methods of credit control followed by the central bank of a country?
Definition of Central Bank
In every country, there is a principal bank who is responsible for guidance and regulation of the financial system in the country. Such type of bank is known as Central Bank.
A Central Bank may be defined as
The principle banking institution of a country operating under some degree of state control and entrusted with the special responsibility of maintaining economic equilibrium and stability in the prices and in the over all interest of the country.
Nature of Central Bank
From the above definition we find the following main features of Central Bank:
1. The Central Bank is the principle banking institution of a country.
2. It is operated under some degree of state control. But in practice, the structure of central banks vary from country to country. In U.K. and France, the bank of England and Bank of France are solely owned, managed controlled by the state on the other hand, Federal Reserve System, the Central Bank of the U.S.A is owned, managed and controlled by the private share holders. Of course, there are some central banks which are owned, managed and controlled jointly by the Government and the private share holders. e.g., State Bank of Pakistan before nationalization 1974.
3. The Central Bank is entrusted with the responsibility of maintaining economic equilibrium and stability in prices by controlling money supply and volume of credit with in the country.
4. A central bank does its works not for making profit but in the overall interest of the country.
5. The central bank is reservoir of credit. All other banks can look to it for accommodation.
Functions of Central Bank
The central bank is the pivoted of all the banking system. The chief functions of a central bank may be described as follows:
1. Issuing Notes
The central bank has the sole responsibility and monopoly of issuing notes within the country. It is the sole currency authority. The central bank is required to keep a certain percentage of gold reserves against issue of notes. Usually, it keeps 30% to 40% gold as reserve. It undertakes expansion and contraction of the currency along-with business demand. Money supply is raised by issuing notes. On the other hand, it can decrease money supply by selling government securities. By enjoining monopoly of note issue it gives uniformity to the system of note issue in the country.
2. Governments Banker
The central bank acts as a financer of the government of the government. It is a government banker not only collecting and paying money on behalf of the government but it also manages the public debts. It keeps the government funds in the custody free of interest. On the other hand it gives loans to the government without limitation of amount. It is the fiscal agent of the government. It helps the government in designing a fiscal policy for the country so its also plays the role of financial adviser to the government.
3. Banker’s Bank
It acts as the custodian of cash reserves or balances deposited compulsorily by the scheduled banks. Either by law or custom the member banks are to keep certain portion of their deposits with the central bank as reserve. For example in our country the scheduled or commercial banks are to keep cash reserve with State Bank of Pakistan to the extent of 5% of their deposits. Central Bank also provides short term credit to commercial banks by rediscounting first class bills and other securities. So it plays the role of banker’s bank.
4. Management of Gold Standard
Where the currency of a country is on gold standard, it is the responsibility of the central bank to manage the gold standard in order to control the stability of exchange rate. It regulates and checks the movement of gold in the country. The management of gold standard is not so vital and important these days.
5. Credit Control
It is another important function of central bank. It controls the flow of credit in accordance with the needs of business in the country. Credit plays an important role as the medium of exchange, so its expansion or contractors effects the price level in the country. In order to maintain stability in the price level, central bank controls the volume of credit. Usually, it controls credit by changing bank rate, purchasing and selling securities and by changing reserve rates of the member banks. In this way central bank attempts to control the volume of credit and stablishes the business conditions in the country.
6. Clearing House
It is the Clearing House of the bankers. Under this function central bank of facilitates the settlement of bills and cheques of other banks.
7. Exchange Control
It is the responsibility of the central bank of control foreign exchange and maintain the rate of exchange. It purchases and sells approved foreign currencies at the current or fixed rate. It also acts as the custodian of foreign exchange reserve.
8. Lender of Last Resort
As lender of last resort, it is implicit that the central bank assumes the responsibility of meeting directly or indirectly all reasonable demands for accommodation by commercial banks in the times of difficulties and crises. If any commercial bank faces any serious financial difficulty for any reason, it is central bank who comes forward to help it.
9. Custodian of National Reserve
The Central Bank acts as the trustee of the entire economy of the country and thus keeps in its custody all national reserves in form of gold, silver and securities.
Credit Control
Credit plays an important role in maintaining and changing the price level as medium of exchange. It is the responsibility of the central bank to regulate the volume of credit and its direction to maintain stability in the price level.
Following are the main objectives of credit control by central bank
1. Safe Guarding the Gold Reserves
The central bank adopts various measures of credit control to safe guard the gold reserves against internal and external drains.
2. Stability in Price Level
Credit control provides stability in price level in the country.
3. Exchange Stability
Another objective of credit control is to achieve the stability of foreign exchange rate. If the foreign exchange rate is stabilized, it indicates the stable economic conditions of the country.
4. Stability in Investment and Production
Control of credit by central bank also provides stability in the investments and production by making price level stable.
’5. Cooperation
Control of credit is done to promote cooperation with other countries for the purpose of maintaining world economic stability.
Methods Or Techniques of Credit Control
The central bank usually controls the volume of credit through the two types of methods, quantitative and quantitative.
1. Bank Rate Policy
It is also known Discount Rate Policy. Bank rate is the rate of interest which is charged by the central bank on rediscounting the first class bills of exchange and advancing loans against approved securities. This facility is provided to other banks.
Importance
The bank rate is different than the money market interest rate. The charges in bank rate are followed by other banks in the country in changing their interest rate. If the bank rate is raised by central bank, other rates of money also go up. Conversely, the market rate of interest and other rates go down, when central bank decreases its bank rate. These changes effect the supply of and demand for money. Borrowing is discouraged when the rate of interest increases and encouraged when the rate decreases.
Effects of Changes in Bank Rate
The changes in the bank rate may cause the following effects.
a. Changes in Deposit Volume
When the central bank increases the bank rate, commercial banks also increase the rate of interest and consequently the deposits of the banks also increase. Conversely, when bank rate is decreased the deposits of commercial bank also decrease.
b. Controls the Borrowings
When the bank rate is raised, the rate of interest and discount of other banks goes up margin of profit falls and it discourages the businessmen to borrow money and thus the volume of loans and discounting of bills is minimized. On the other hand a fall in the bank rate encourages loans and bill discounting.
c. Changes in the Prices of Shares and Securities
A rise in bank rate makes shares and securities in the market cheaper and conversely, by a fall in the bank rate, shares and securities becomes dearer.
d. Changes in the Volume of Speculative Business
A rise in the bank rate restricts the volume of credit and discourages speculative business. But the volume of speculative business is expended due to the increase in the credit supply.
e. Changes in the Foreign Trade
A rise in the bank rate encourages export and discourages import. A fall in the bank rate encourages import and discourages export. When the bank rate is raised, the demand for home currency goes up and the demand for home currency falls with in the bank rate.
f. Changes in Balance of Payment
Due to rise in the export trade, a rise in bank rate causes a favorable balance of payment. But a fall in bank rate causes an unfavorable balance of payment.
2. Open Market Operation
The open market operation means the buying and selling of securities by the central bank in order to influence the money and credit supply in the country. This technique is effective up-to some extent in both conditions of inflation and deflation.
3. Change in Reserve Ration
The member banks of central bank are required either by law or custom to keep a certain percentage of their deposits with the central bank. It is called as Cash Reserve Ratio. The central bank may controls credit by changing the reserve ratio. When the reserve ratio is increased the member banks to some extent are discouraged to bank money. When this ratio is falls, the member banks are encouraged to expend credit.
Clearing House
The central bank manages and supervises the clearing house to facilitate the clearing of cheques between banks. Every banker usually receives number of cheques drawn on other banks from his customers as deposits. In other words banks receives cheques drawn on other banks from their account holders. As a result, there arises inter bank indebtedness. For example National Bank of Pakistan receives deposit of cheques worth Rs. 6,000/= drawn on Habib Bank Limited, Habib Bank on the other hand, receives cheques worth Rs. 5,000/= drawn on National Bank of Pakistan. Thus National Bank owes Rs. 5,000/= to Habib Bank and Habib Bank owes Rs. 6,000/= to National Bank.
Inter bank indebtedness's are settle through a central organization known as Clearing House. “A clearing house is a general organization of banks of a given place, having for its main purpose, the off setting of cross obligations in the form of cheques. The indebtedness's of the member banks are settled only by paying the differences. Generally central bank of the country performs the function of clearing house. In Pakistan, State Bank of Pakistan performs the duty of clearing house.
Role of Central Bank in Economic Development
The economic stability of a country is solely dependent on the Central Bank. It is the only financial institution in the country which is responsible for regulating the banking and monetary system of the country. The need of a central bank in a country is essentially felt considering the following services rendered by a central bank for economic development of a developing country.
1. Capital Formation
Economic progress of a country requires adequate amount of capital. Capital is required for agriculture, industrial and commercial development. But in a developing country like Pakistan. It is a chronic problem to procure capital. Central Bank as a national institution plays prime role in capital formation in the interest of the nation as a whole. As the guardian of the money market, it regulates the capital flow in the country in proper form and suitable time.
2. Credit Control
Credit is one of the most important source of financing trade and industry. The central bank as the controller of credit can encourage a particular sector of economy by adopting selective credit control.
3. Developing Banking System
As a guardian of all banks, the central bank works for the development of banking system of the country.
4. Protecting Interest of the Depositors
The central bank protects the interest of the depositors in banks by guiding, controlling and checking the member banks operations in the country.
5. Stability in Prices
The central bank keeps the price level stable in a country by controlling money and credit supply.
6. Advice to the Government
The Central Bank extends valuable suggestions and advices to the Government in respect of economic and monetary policies.
7. Personnel Training
The central bank in some countries provides training facilities to the bank personnel.
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