Role of Central Bank

Central Bank
In every country, there is one bank which

acts as the leader of the money market supervising, controlling and regulating the
activities of Commercial Banks and other
financial institutions. It acts as a banker of
issue and is in close touch with the
government, as banker, agent and adviser to
the latter. Such a bank is known as the
Central Bank of the country.

Central Bank and Commercial Bank Differences

Central Bank does not work for profits though it might

secure profits. While Commercial Banks aim at

securing maximum profit for their shareholders, the
Central Bank aims at controlling the banking system
and supporting the economic policy of the government.
Central Bank is generally an organ of the government
and forms part of the govt. machinery. Commercial
Banks may be owned by the govt. or are privately
owned.
The Organization and Management of the Central Bank
is fully controlled by the Government.

Functions of a Central Bank

a.

i.
ii.
iii.
iv.

Bank of Issue
Central Bank has the exclusive monopoly of note issue
and the currency notes issued by the Central Bank are
declared unlimited legal tender throughout the country.
This monopoly brings about:
Uniformity of note issue which in turn facilitates trade
and exchange within the country
Enables the Central Bank to influence and control the
credit creation of Commercial Banks
Gives distinctive prestige to the currency notes
Enables govt. to appropriate partly or fully the profits of
note issue.

Functions of a Central Bank

b.

c.

Banker, Agent and Adviser to the Government

As Banker and Agent, RBI keeps the banking accounts of the
Central and State governments and makes and receives
payments on behalf of the government. It provides short-term
advances to the govt. (ways and means advances) to tide over
temporary shortage of funds. It advises the govt. on all
monetary and banking matters.
Custodian of the Cash Reserves of Commercial Banks
All Commercial Banks keep part of their deposits as reserves
with the Central Banks and hence the name Reserve Bank of
India. Centralised cash reserves serve as the basis of a larger
and more elastic credit structure and helps Commercial Banks
to meet crises and emergencies. Centralised cash reserves aids
the Central Bank to control credit creation and implement
monetary policy.

Functions of a Central Bank

d.

e.

Custodian of Foreign Balances of the Country

RBI holds the foreign exchange assets of all commercial and nonCommercial Banks of the country. It is the responsibility of RBI to
maintain the rate of exchange and manage exchange control and
other restrictions imposed by the State. It also maintains reserves
with the IMF and obtains normal drawing and special drawing
rights.
Lender of the last resort
Central Bank never refuses to accommodate any eligible
Commercial Bank experiencing cash shortage. In the absence of a
Central Bank, Commercial Banks will have to carry substantial
cash reserves which imply restricted lending and reduced income.
As a lender of last resort, Central Bank assumes the responsibility
of meeting directly or indirectly all reasonable demands for
accommodation by the Commercial Banks.

Functions of a Central Bank

f.

g.

Central Clearance, Settlement and Transfer

As the Central Bank keeps cash reserves of Commercial
Banks, it is easier for member banks to settle their mutual
claims in the books of the Central Bank. These are the clearing
house operations of RBI wherein cheques are cleared, claims
settled and funds transferred in the books of the member
banks. However, this function can also be performed by any
leading bank in a locality or area.
Controller of Credit
RBI controls the level of credit in the economy by either
expanding or contracting bank deposits. In modern times, bank
deposits have become the most important source of money in
the country. As controller of credit, RBI seeks to influence and
control the volume of bank credit and also to stabilize business
conditions in the country.

Functions of RBI
Monetary Authority

Formulates, implements and monitors the monetary

policy.
Objective: maintaining price stability and ensuring
adequate flow of credit to productive sectors.
Regulator and supervisor of the financial system
Prescribes broad parameters of banking operations within
which the countrys banking and financial system
functions.
Objective: maintain public confidence in the system,
protect depositors interest and provide cost-effective
banking services to the public.

Functions of RBI
Manager of Exchange Control

Manages the Foreign Exchange Management Act, 1999.

Objective: to facilitate external trade and payment and
promote orderly development and maintenance of
foreign exchange market in India.
Issuer of currency
Issues and exchanges or destroys currency and coins not
fit for circulation.
Objective: to give the public adequate quantity of
supplies of currency notes and coins and in good quality.

Functions of RBI
Developmental role

Performs a wide range of promotional functions to

support national objectives.
Related Functions
Banker to the Government: performs merchant
banking function for the Central and the state
governments; also acts as their banker.
Banker to banks
Maintains banking accounts of all scheduled banks.

Methods of Credit Control

Credit control is a very important function of RBI which

adopts a variety of methods to expand or contract credit

in the economy. Some of these methods are traditional
while some others are modern and contemporary.
Some of these methods are quantitative controls since
they control and adjust total quantity or the volume of
deposits created by Commercial Banks. They relate to
the volume and cost of bank credit in general without
relating to the purpose for which the bank credit is used.
There are other methods of credit control known as
selective or qualitative controls, since they control
certain types of credit and not all credits.

Methods of Credit Control

Quantitative controls consist of bank rate or
discount rate policy, open market operations
and reserve requirements. Qualitative
controls consist of regulation of margin
requirements, regulation of consumer credit,
rationing of credit, control through
directives, moral suasion and direct action.

Bank Rate Policy

Bank rate in the rate of interest that the

Central Bank levies while discounting or

rediscounting eligible bills and securities of
Commercial Banks to meet their funds
requirement. Since the Central Bank is the
lender of last resort, the Bank rate is related
closely to all other rates of interest in the
money market. The eligible bills or first class
bills or gilt-edged securities are treasury
bills/bonds and commercial bills.

Working of Bank Rate Policy

During inflationary times the bank rate is raised

resulting in the following consequences:

a. Businessmen who borrow from banks will find their
cost of funds increased due to a rise in bank rate. Their
profit margins are reduced.
b. Manufacturers and merchants hold large stocks of
inventories through bank loans. A rise in bank rate will
force them to liquidate their stocks to pay up bank
loans.
c. Stock exchanges transactions are usually financed by
loans from banks. Rise in bank rate will result in dealers
and brokers selling off their stocks to pay up bank loans.

Working of Bank Rate Policy

Hence, rise in bank rate increases interest rates,
curtails bank credit, decreases demand for goods
and services and finally reduces the price level.
Further, the most powerful influence of bank rate
is psychological bankers and businessmen
consider bank rate changes as authoritative
pronouncements of the Central Bank concerning
the credit situation at a very important time.
Radcliffe Report states:" the rise in the bank rate is
symbolical; it is evident that the authorities have
the determination to take unpleasant steps to check
inflation.

1.
2.
3.
4.
5.
6.

Bank Rate Policy Assumptions

Lending rates of Commercial Banks are related to

discount rates of the Central Bank.

Commercial Banks normally approach Central Bank for
additional funds.
Commercial Banks keep minimum cash reserves and
depend on Central Bank to overcome shortages.
They possess eligible securities in sufficient quantities.
Borrowing and investment activity of businessmen are
dependent on lending rates of Commercial Banks.
Prices, wages and employment are all flexible and are
responsive to changes in borrowing and investment.

Bank Rate Policy Limitations

1.

2.

Relationship between bank rate and other interest rates

Bank rate policy will be successful only if the lending
rates of banks change corresponding to the movement of
the bank rate. In developed countries, there is a close and
direct relationship so that every change in bank rate is
followed immediately by corresponding changes in the
lending rates. However, this relationship is quite tenuous
in developing countries because of market imperfections.
Existence of eligible bills In India, eligible bills
constitute only 3% of the total assets of Commercial
Banks. This is on account of an underdeveloped bill
market

Bank Rate Policy Limitations

3.

4.

Practice of rediscounting The bank rate policy can succeed

only if Commercial Banks have the practice of rediscounting
eligible bills with the Central Bank. However, Indian banks
have very few eligible bills or carry large cash balances
thereby reducing the efficacy of bank rate.
No direct relation between interest and investment
Compared to the role of other factors like availability of raw
material, skilled labor, cost of fixed assets and stocks and
administrative support, the role of interest rate to influence
investment in a developing country is insignificant.
Under these circumstances, the Bank Rate continues to be
important as a symbolic verdict of the Central Bank than as a
vital measure for policy correction. It is more a policy
statement of the Central Bank than as a tool of policy
correction.

Open market operations

Deliberate and direct buying of securities and bills by the

Central Bank in the money market, on its own initiative, is

called open market operations.
In periods of inflation, the Central Bank will sell in the market
first class bills in its possession to buyers like Commercial
Banks and others. This reduces the cash reserves of the
Commercial Banks which in turn will reduce its capability to
give loans and advances. Thereby, business activity in the
country will be cut short.
During recession, Central Bank buys bills from Commercial
Banks and thereby increases their cash reserves. Business
activity receives a fillip.
The Central Bank thus influences the lending operations of
Commercial Banks and ultimately influences business activity
and economic conditions in the country.

OMO - Advantages
Strategically, OMO as a method of

influencing money supply is effective

because the initiative to control the volume
of money supply in the country is kept by
the Central Bank itself. But the bank rate
policy is passive in the sense that its success
depends upon the willing response of the
Commercial Banks and their customers.

OMO - Limitations
Commercial Banks may prefer to operate with

high cash reserves rather than expand credit in the

economy though this might negatively impact their
profitability.
Commercial Banks will also have an optimal trade
off between excess cash reserves and buying low
yielding securities.
Credit expansion must be followed by the
willingness of businessmen to come forward to
borrow. However, their willingness might be
guided by real and not monetary factors in the
economy.

Cash Reserve Ratio

1.
2.
3.

According to the RBI Act 1934, every scheduled bank

has an obligation to maintain a certain portion of their
demand and time deposits as a reserve with the Central
Bank. This provision was fixed for three important
reasons
To ensure the liquidity and solvency of individual
Commercial Banks and of the banking system as a whole
To provide the Central Bank with supply of deposits for
local operations
To influence and ultimately restrict Commercial Banks
expansion of credit.
Hence CRR is an additional instrument of credit control
of the Central Bank

CRR and Bank Credit

Excess cash reserves will induce banks to expand credit

and reduction of cash reserves will result in contraction of

cash credit. Cash reserves with the Commercial Banks are
directly influenced by the CRR and hence the relationship
with the CRR and bank credit.
For instance, when the reserve requirement is 10% a
Commercial Bank will have to maintain a cash reserve of
Rs.100 for every deposit of Rs.1000 and hence can lend
only up to Rs.900. On the other hand, a cash reserve of
20% will permit a bank to lend only Rs.800. The higher the
cash reserve requirement, the smaller the amount available
for banks for loans and advances and investments.

Limitations of CRR
De Kock While it (reserve ratio) is a very prompt and

effective method of bringing about the desired changes in

the available supply of bank cash, it has some technical and
psychological limitations which prescribe that it should be
used with moderation and direction and only under obvious
abnormal conditions.
This technique is normally used to adjust the banking
structure to large scale changes in the countrys supply of
monetary reserves and is not used frequently to make small
adjustments in the supply of credit. Frequent changes in
reserve ratio will disturb the Commercial Banks and
complicate their book-keeping and their customary way of
doing business.

Selective Credit Controls

a.
b.
c.

The quantitative controls like bank rate, OMO and CRR

affect indiscriminately all sections of the economy which
depend on bank credit. Besides, there are some groups of
borrowers who are engaged in important spheres of
economic activity and whom the Central Bank would like
to insulate from these quantitative effects. Hence, Central
Banks have been adopting the tool of selective credit
controls or qualitative controls whose special features
are:They distinguish between essential and non-essential uses
of bank credit
Only non-essential uses are brought under the scope of
Central Bank controls
They affect not only the lenders but also the borrowers.

Types of Selective Controls

A. Margin Requirements

Banks do not lend the entire amount of the

project cost or security value. Part of the project
cost has to be met by the businessmen investing
in a venture. Margin money is the personal stake
of the investor in a given investment. Banks or
Central Bank can directly encourage or
discourage an activity by either decreasing or
increasing the margin requirements respectively.
For certain export related ventures, govt.
recommends even waiver of margin requirement.

Types of Selective Controls

B. Regulation of Consumer credit

The Central Bank can either limit the amount of

credit for the purchase of any article sought to be
regulated or limit the time for repaying the debt.
This reduces the quantum of loan available to the
customer and also hastens up the exposure of
bank credit to the customer. The end result is that
a particular kind of activity is sought to be
encouraged or discouraged by altering both the
quantum of loan and the repayment period
thereof.

Types of Selective Controls

C.

Control through directives : Direct action

RBI is empowered to give directives to Commercial
Banks in respect of (1) their lending policies (2) the
purposes for which advances may or may not be made
and (3) the margins to be maintained in respect of
secured loans. Direct action can also take the form of the
Central Bank charging a penal rate of interest for money
borrowed beyond the prescribed amount or refusing to
grant further rediscounting facilities to erring banks.
However, Commercial Banks are not always responsible
as the borrower can always divert the credit availed to
unspecified activities.

Types of Selective Controls

D.

Moral suasion:
Moral suasion implies persuasion and request made by
the Central Bank to the Commercial Banks to follow the
general monetary policy of the former. The effectiveness
of moral suasion is debatable. As a method of credit
control, it may have restraining influence, but when real
forces in favour of credit expansion or contraction are
very strong, persuasive tactics may be ineffective. While
this method has a psychological advantage as it does not
carry any threat or legal sanction, it may not be very
effective in times of serious business boom or depression
especially in developing countries.

Types of Selective Controls

E.

Rationing of credit
Credit rationing is a method of controlling and
regulating the purpose for which credit is granted by the
Commercial Banks. It may assume two forms. Firstly,
variable portfolio ceilings refer to the system by which
the Central Bank fixes a ceiling or maximum amount of
loans and advances for every Commercial Bank.
Secondly, variable capital assets ratio refers to the
system by which the Central Bank fixes the ratio which
the capital of the Commercial Bank should have to the
total assets of the bank. Rationing of credit may also be
in the form of the Central Bank allowing only a fixed
amount of accommodation to member banks by means
of rediscount.

Significance of Selective
Controls
Selective controls are flexible in nature and can

make credit policy more flexible. It can be

directed geographically to parts of the economy
that are susceptible to extreme fluctuations.
Besides, they can be used to restrain the demand
for credit. Monetary authorities have come to
depend more and more on selective controls in
recent years though they are normally used in
conjunction with the general instruments of credit
regulation and control.

Limitations of Selective
Controls
a.

b.
c.
d.

They can control only bank credit and investment and

trade finance through bank credit. However, there are
other sources of financing investment such as capital
issue, own capital, NBFIs and undistributed profits.
It may not always possible for Commercial Banks to
ensure that the loans granted by them are spent for the
purposes for which they have been sanctioned.
Commercial Banks, under the influence of profit motive,
may sanction loans for forbidden uses but enter them in
their books under different heads.
The Commercial Banks may ensure that loans are made
only for the prescribed purpose. However, they have no
influence over the purposes for which the resulting
additional purchasing power is used.