Central Banking: Meaning, Difference and Other Details

Read this article to learn about the meaning, difference, rationing of credit and economic fluctuations of central banking.

Meaning:

In almost all countries of the world, there is a central bank today. It differs from the ordinary commercial banks on account of its distinctive functions.

It is the supreme monetary and banking authority. According to De Kock, “a central bank is a bank which constitutes the apex of the monetary and banking structure.”

Shaw believes that the central bank is that bank which controls credit. Hawtrey expressed the view that the central bank is the lender of the last resort.

According to D.C. Rowan, “The Central Bank is an institution, often but not always owned by the state, which has the overriding duty of conducting the monetary policy of the government.” According to R.P. Kent, “Central Bank is an institution charged with the responsibility of managing an expansion and contraction of the volume of money in the interest of general public welfare.” Central bank has been a matter of slow and gradual evolution. At present, there is no country in the world, save a few exceptions, which has not set up a central bank.

Central banks were started as privately owned and privately managed joint stock banks. But on account of their influence on economic activities and their power to control credit, governments show great willingness to participate in the affairs of the central banks. At present, central banks in most of the countries are either completely nationalized or government owns 50 per cent or more interest in the shares, only in a few countries like USA, the governments do not have any interest in the ownership of central banks.

Difference between Commercial Banks and Central Bank:

According to Prof. R.S. Sayers, “The distinction between central and commercial banks turns essentially on their objects. The commercial bank thinks primarily of profit making, whereas the central banks thinks of the effects of its operations on the working of the economic system…………. The commercial banks may be a few or many. They trade with the general public. There is only one central bank in each country, and it does little, if any, ordinary banking business for the general public, it restricts itself, in the main, to controlling the operation of the banking system.” Thus, we find that the activities of central banks are quite different from those of commercial banks.

The former are constituted for public service, while the latter aim at profit motive. Moreover, central bank acts as the banker to the government and as such stands in a special relation to the government. Again, the central bank functions as a banker’s bank and as such does not deal with public directly.

Drawing a distinction between the functions of a central bank and commercial bank, De Kock remarks, “A further requisite of a real central bank is that it should not, to any great extent, perform such banking functions as accepting deposits from the general public and accommodating regular commercial customers with discounts and advances. It is now almost generally accepted that a central bank should conduct direct dealings with the public only in such forms and to such extent as, in the circumstances of a particular country it considers absolutely necessary for the purpose of carrying out its monetary and banking policy.”

Direct Action, Rationing of Credit and Publicity:

Direct action and rationing of credit followed by publicity are extensively used methods of credit control. Direct action refers to all those directions and restrictive measures which the central bank may enforce on all the banks concerning lending and investment. Under it, the central bank may even refuse rediscounting facilities and may even penalize the offending bank. The Reserve Bank of India made use of this method and issued directions in 1956, 1958 and 1988 prohibiting the commercial banks to grant excessive advances against commodities like wheat and rice to stop speculation in them.

But, the method of friendly advice is considered better because direct action may compel member banks to resort to illegal methods and underhand means with a view to ignoring the directives of the central bank. As non-deposits bank and other financial institutions have grown in importance, direct controls have been applied to them and also to the deposit banks. Finally, ‘requests’ concerning the level and direction of bank lending have been a regular feature of monetary control in Britain.

Rationing of credit implies the power of a central bank to allow only a fixed amount of accommodation to members bank by means of rediscount facilities. In Mexico and even in socialist countries credit rationing was used as the chief method of credit regulation. Usually, it is not used in free capitalist economies as it is not considered compatible with the function of the central bank as the lender of the last resort.

It is used sparingly to control excessive credit expansion, though in recent times the use of this method seems to be on the increase. Rationing of credit and capital is a logical consequence of the intensive and extensive planning methods adopted in controlled or socialist and backward economies. Besides these methods, the method of publicity and propaganda is followed in order to make known the views of the central bank regarding a particular financial policy and to lessen opposition to its views.

Central Bank and Economic Fluctuations:

Economic fluctuations are quite a normal feature of modern industrial societies. Changes do occur in some branches of economic activity which do not quite harmonise with corresponding change in other branches of economic activity. In periods of prolonged depression general unemployment becomes quite marked. Many factors cause these fluctuations.

The most important monetary cause is the expansion of bank credit by lowering the rate of interest. Businessmen are encouraged to brow and invest at low rates of interest. The aggregate income of the community increases leading to; rise in the demand for goods as a result of which price rise and inflation becomes self-invigorating. This cannot continue forever. The central bank will raise the bank rate to control credit and to curb the inflationary spiral. Thus, central banks, through the monetary policies followed by them, try to control the economic fluctuations.

Central Banking in an Underdeveloped Economy:

In underdeveloped countries central banking institutions are of recent origin. “Even though recently established, most of them are equipped with all the legal powers—even perhaps more—common to their counterparts in the highly developed countries.” But the effectiveness of central banking is very much reduced on account of a large non-monetized sector, un-organised money market, underdeveloped stocks and shares, bonds and securities markets.

Along with these, there exists an organised sector, on which the central banking authorities have little or no control, because there is no organic connection between the different rates in the money market. The various weapons of credit control and credit expansion either do not work or work with little efficacy. Interest rates are institutionally determined and, therefore, cannot be varied by changes in bank rates. Even in a developed money market they are amenable only in the upward direction.

Open market operations are rendered ineffective owing to lack of an organized market for government securities. The market for government securities, in such countries, lacks depth, breadth and elasticity. Besides, a good number of banks and money lenders do not come within the purview of the central bank.

The objectives of central banking in underdeveloped or developing economies are the same as they are in developed economies, namely, maintenance of stable price level, preservation of exchange rate and foreign balances, promotion of high levels of income, output, employment and economic development. In an economy, where the banking system has either not developed or has developed scantily, central bank has to play a more positive role not only in the development of the banking system, but also in the matter of supplementing ordinary banking facilities and integrating the commercial banking system of the country.

The development of commercial banking can be encouraged partly by providing cheap, liberal and large-scale rediscounting facilities to commercial banks and partly by giving a subsidy to the newly started banks. Subsidy may be given by the government through, and on the advice of, the central bank of a country.

In addition to promoting the growth of banking system and new financial institutions and markets, the central bank, in such economies, has to maintain interest rates at reasonably low levels, to enable the government to finance both its outstanding debt and current deficits at low rates and to regulate the allocation of credit amongst its various possible uses.

Despite many difficulties, central bank in most of the underdeveloped countries have not only helped the establishment of new commercial banks along with the development of branch banking but have also lent a hand in the establishment of a wide array of other financial institutions, such as saving banks, rural credit agencies, mortgage banks, development banks and even banks to supply medium and long-term credit needs of tire businessmen. Besides, the instruments of credit control like credit rationing, discount rate and raising cash reserves ratio, have worked well in some of these countries.