Study Notes on Central Bank: Meaning, Origin and Functions

After reading this article you will learn about: 1. Meaning of Central Bank 2. Origin of the Central Bank 3. Functions.

Meaning of Central Bank:

It is very difficult to suggest a precise definition of a central bank. However, a central bank can best be defined with reference to its functions.

It can be defined as the bank which stands as the leader of the money market—also called the financial market—issues notes and coins, supervises, controls and regulates the activities of the banking system and acts as the banker of the government. In our pyramidal financial structure, the central bank sits at the top.

A central bank is a bank which constitutes the apex of the monetary and banking structure. It manages the economy in the interest of general public welfare, but not maximization of profit. According to W. A. Shaw, the central bank is the bank which controls credit.

Samuelson defines central bank “…as a bank of bankers. Its duty is to control the monetary base and through control of this ‘high-powered money’ to control the community’s supply of money.” But as a private citizen, no one—even the Head of the country—either can open a bank account or borrow money from the central bank.

Origin of the Central Bank:

The establishment of a central bank in a modern economy is essential as it is the apex institution of a country’s financial as well as monetary system. Its action affects money supply, the volume of credit, interest rates, etc. All these have direct impacts not only on financial markets but also on national output and inflation (deflation). Thus the central bank plays an important role in any economy.

In fact, every independent country must have a central bank for organizing, running, supervising, regulating and developing the monetary- financial system of the country.

Implemen­tation of the government’s economic policy requires the presence of the central bank which stands as the undisputed leader of the money market. In view of this, some people feel that the central bank is one of the great inventions of modern civilization.

In most countries, the central bank is a nationalized institution. It is the main agent of the government for the purpose of administering its monetary and banking policies. Unlike commercial banks, its aim is not to make profit for its shareholders. So, it does not compete with the commercial banks for ordinary banking business.

The first central bank was established in the 18th century. Though the Riks Bank of Sweden was set up in 1656 and the Bank of England in 1694, the Bank of England started functioning as the central bank of England in 1844. It is said that the Bank of England is the oldest central bank of the world.

In America, Federal Reserve Banks started functioning as the central bank in 1913. The post-World War II period witnessed a phenomenal growth of central banks all over the world. At present, there are more than 150 central banks operating in various countries.

It will not be out of place to mention here that in the USA, there is a federal form of central banking. The USA is the exception in as much as there is not one central bank; there are 12 central banks, called Federal Reserve Banks.

The coordinating central body of these 12 banks is the Federal Reserve Board. One must not call the Federal Reserve Board the central bank. The Reserve Bank of India—the central bank of our country— was set up in 1935. The Bank of Pakistan is the name of the central bank of Pakistan.

On the question of issuing notes, we trace the evolution of central banking. In the 19th century, commercial banks were entrusted to issue notes. But notes issued by them involved difficulties, like lack of uniformity and over-­issue or under-issue of notes.

To avoid these difficulties, the note-issuing power was given to the central bank. The Central Bank of Holland in 1814 and the Bank of England in 1844 were given the monopoly power of note issue. Thus, the central bank is defined as the note-issuing authority.

Functions of Central Bank:

One can find some differences in the style of functioning of a central bank. Its functions in an under­developed country differ from those in a developed country. But the central bank performs the following common but vital functions in every country.

The most important ones are:

(a) Monopoly Power of Note Issue:

In the 19th century, commercial banks in many countries enjoyed the right to issue notes.

As the notes issued by them lacked uniformity, governments could not be prevented from over-issuing (or under-issuing) of notes. In view of these problems, the central bank has been given the monopoly power of note issue. It has been empowered to do so in the interest of uniformity and to bring a balance between demand for money and supply of money (i.e., prevention of over-issue or under-issue of notes).

The notes issued by the central bank are considered as legal tender money of the country and form the cash basis of the credit of commercial banks. Being the sole supplier of money in the economy, the central bank regulates the volume of currency of the country. It has also the power to withdraw worn and torn notes from circulation in exchange for new ones, so that good quality notes and coins circulate in the economy.

(b) Bankers’ Bank:

Commercial banks are required, by law or convention, to keep a certain percentage of their deposits are serves with the central bank. In this way, it acts as a custodian of cash reserves. Banks draw cash balances from the central bank as and when the situation demands.

As a bankers’ bank, it acts as a lender of the last resort. If commercial banks face serious liquidity crisis they approach the central bank and it stretches its lending hand to them—either by discounting bills or buying securities from them. This sort of accommodation makes the central bank a lender of the last resort. This is essential to prevent bank failure.

It gives advice to banks on good/sound banking practice. A central bank usually discusses government policy with them and reports back to the government. Thus, a central bank closely monitors the activity of commercial banks.

(c) Banker, Agent and Adviser to the Government:

The central bank acts as a banker, agent and adviser to any government. As a banker of the government, it has to maintain banking accounts of both central and state governments. It makes and receives payments on behalf of the government as it acts as the agent of the government.

Truly speaking, government (central, state, and union territories) expenditure (say, on road building, hospital construction, etc.,) and revenue (say from income tax, excise duty, etc.,) pass through the central bank. In brief, it performs merchant banking functions for the government.

It also provides short-term loans and advances (known as ways and means advances) to the government to enable the latter to tide over its financial difficulties. It also advises the government on necessary monetary and financial matters such as market borrowing, loan repayment, deficit financing, control of inflation.

(d) Controller of Credit:

The central bank of a country prescribes broad parameters of banking operations within which the country’s banking and finance system operates. In a modern credit-oriented economy, credit is an important component of money supply. Being profit-making institutions, commercial banks may adopt the policy of undue expansion or contraction of credit to suit their needs.

This may lead to inflation or deflation. Neither of the two is desirable. To ensure price stability, credit supply is to be regulated. And, this task has been entrusted with the central bank. The central bank, through its credit control policy, intends to curb the lending potential of commercial banks.

Actually, it keeps the creation of credit within limits. It is accepted that this is its most important function. However, for controlling credit, it uses several official instruments like the bank rate, open market operations, and so on.

(e) Custodian of Foreign Exchange Reserves:

With the aim of facilitating foreign trade and payment and promoting orderly development and maintenance of foreign exchange market, a central bank acts as the manager of foreign exchange. The central bank acts as the sole custodian of gold and foreign currencies for the purpose of issuing notes and for correcting an adverse balance of payments situation.

In this connection, one may note that, by holding gold and foreign currencies, the central bank intends to stabilize foreign exchange rate. Like internal price stability, stability in foreign exchange rate is equally vital. A central bank aims at affecting the foreign exchange rate (i.e., the rate at which one currency is converted into another currency) by buying and selling foreign currencies in the foreign exchange market.

In addition to these functions, the central bank:

I. Acts as a clearing house for the settlement of accounts of commercial banks;

II. Studies different aspects of economic problems, compiles data and informa­tion and publishes reports and periodi­cals, etc.

(f) Promotional and Developmental Functions:

In an underdeveloped economy, a central bank, in addition to the above noted traditional functions, acts as a potential development agency. It is not only a controller and regulator of credit but also a promoter.

Its task in LDCs is:

(i) To develop the money and capital markets

(ii) To strengthen the banking structure

(iii) To meet the genuine financial needs of agriculture and industry, and so on.

It protects the interest of depositors and provides cost-effective banking services to the public. In brief, it corrects the defects and removes the inefficiencies of the country’s monetary- financial system. These activities are called promotional or non-traditional activities of a central bank of LDCs. Thus, the pattern of economic development in low-income countries like India is largely determined by the central bank.

To conclude, it is futile to single out the most important function of a central bank. In fact, all its functions are important from the point of view of developing countries. Further, as far as the objective of growth with stability is concerned, there is no hard and fast rule to delimit the functions of a central bank. Its role and functioning keep on changing with the passage of time.

The preamble of the Reserve Bank of India (being the country’s central bank) describes the basic functions of the RBI as:

“…to regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage.”