The Central Bank
The Central bank is the apex institution of a country’s monetary system. The design and the control of the country’s monetary policy is its main responsibility. India’s Central Bank is the Reserve Bank of India.
The Central Bank performs the following functions:
1. Currency Authority
The Central Bank is the sole authority for the issue of currency in the country. All the currency issued by the Central Bank is its monetary liability. This means that the Central Bank is obliged to back the currency with assets of equal value. These assets usually consist of gold coins, gold bullions, foreign securities, and the domestic government’s local currency securities. The country’s Central Government is usually authorized to borrow money from the Central Bank.
Government does this, by selling local currency securities to the Central Bank. The effect of this is to increase the supply of money in the economy. When the Central Bank acquires these securities, it issues currency. This authority of the government gives it flexibility to monetize its debt. Monetizing the government’s debt (called public debt) is the process of converting its debt (whether existing or new), which is a non-monetary liability, into Central BanK currency, which is
a monetary liability. Putting and withdrawing currency into and from circulation is also the job of its banking department. For example, when the government incurs a deficit in its budget, it borrows from the Central Bank. This is done by selling treasury bills to the Central Bank, the latter paying for the bills by drawing down its stock of currency or printing currency against equal transfer of the said securities. The government spends the new currency and puts it into circulation.
2. Banker to the Government
The Central Bank acts as a banker to the government - both Central as well as State governments. It carries out all the banking business of the government, and the government keeps its cash balances on current account with the Central Bank.As the banker to the government, the Central Bank accepts receipts and makes payments for the government, and carries out exchange, remittance and other banking operations. The Central Bank also provides short-term credit to the government, so that the government can meet any shortfalls in receipts over disbursements. The government borrows money by selling treasury
bills to the Central Bank. The government carries on short term borrowing by selling ad-hoc treatury bills to the Central Bank. As the government’s banker, the Central Bank also has the responsibility of managing the public debt. This means that the Central Bank has to manage all new issues of government loans.
The Central Bank also advises the government on banking and financial matters.
3. Bankers’ Bank and Supervisor
As the banker to banks, the Central Bank holds a part of the cash reserves of banks, lends them short-term funds and provides them with centralized clearing and remittance facilities. The banks are required to deposit a stipulated ratio of their net total liabilities (the CRR) with the Central Bank. The purpose of this stipulation is to use these reserves as an instrument of monetary and credit control. In addition to this the bank holds excess reserves with the Central Bank to meet any clearing drains due to settlement with other banks or net withdrawals by their account holders. The pool of funds with the Central Bank serves as a source from which it can make advances to banks temporarily in need of funds, acting in its capacity as lender of last resort.
The Central Bank supervises, regulates and controls the commercial banks. The regulation of banks may be related to their licensing, branch expansion, liquidity of assets, management, amalgamation(merging of banks) and liquidation (the winding up of banks). The control is exercised by periodic inspection of banks and the returns filled by them.
4. Controller of Money Supply and Credit
The Central Bank controls the money supply and credit in the best interests of the economy. The bank does this by taking recourse to various instruments. Generally they are categorised as quantitative and qualitative instruments. Let us first detail with the instruments of quantitative control. i.e. those that affect only the quantity of the particular variable :
1. Bank Rate Policy :
The bank rate is the rate at which the central bank lends funds as a ‘lender of last resort’ to banks, against approved securities or eligible bills of exchange. The effect of a change in the bank rate is to change the cost of securing funds from the central bank. An increase in the bank rate increases the costs of borrowing from the central bank. This will reduce the ability of banks to create credit. A rise in the bank rate will then cause the banks to increase the rates at which they lend. This will then discourage businessmen and others from taking loans, thus reducing the volume of credit. A decrease in the bank rate will have the opposite effect. In actual practice however, the effectiveness of bank rate policy will depend on (a) the degree of banks’ dependence on borrower reserves (positive relationship). (b) the sensitivity of banks’ demand for borrowed funds to the differential between the banks lending rate and their borrowing rate (positive relationship), (c) the extent to which other rates of interest in the market change and (d) the state of supply and demand of funds from other sources.
2. Open Market Operations :
OMO is the buying and selling of government securities by the Central Bank from / to the public and banks. It does not matter whether the securities are bought or sold to the public or banks because ultimately the amounts will be deposited in or transferred from some bank. The sale of government securities to banks will have the effect of reducing their reserves. When the bank gives the Central Bank a cheque for the securities,
the Central Bank collects the amounts by reducing the bank’s reserves by the particular amount.
This directly reduces the bank’s ability to give credit and therefore decrease the money supply in the economy. When the Central Bank buys securities from the banks it gives the banks a cheque drawn on itself in payment for the securities. When the cheque clears, the Central Bank increases the reserves of the bank by the particular amount. This directly increases the bank’s ability to give credit and thus increase the money supply. Successful conduct of OMO as a tool of monetary policy requires first that a well functioning securities market exists. If
banks regularly and routinely resort to keeping excess reserves then the utility of such a policy will be doubtful.
3. Varying Reserve Requirements :
Banks are obliged to maintain reserves with the Central Bank on two accounts. One is the Cash Reserve Ratio or CRR and the other is the SLR or Statutory Liquidity Ratio. Under CRR the banks are required to deposit with the Central Bank a percentage of their net demand and time liabilities. Varying the CRR is a tool of monetary and credit control. An increase in the CRR has the effect of reducing the banks excess reserves and thus curtails their ability to give credit. The SLR requires the banks to maintain a specified percentage of their net total demand and time liabilities in the form of designated liquid assets which may be (a) excess reserves
(b) unencumbered (are not acting as security for loans from Central Bank) government and other approved securities (securities whose repayment is guaranteed by the government) and
(c) current account balances with other banks.
Varying the SLR affects the freedom of banks to sell government securities or borrow against them from the Central Bank. This affects their freedom to increase the quantum of credit and therefore the money supply. Increasing the SLR reduces the ability of banks to give credit and vice versa.
We now deal with instruments of qualitative credit control, which deal with the allocation of credit between alternative uses.
1. Imposing margin requirement on secured loans :
A margin is the difference between the amount of the loan and market value of the security offered by the borrower against the loan. If the margin imposed by the Central Bank is 40%, then the bank is allowed to give a loan only up to 60% of the value of the security. By altering the margin requirements, the Central Bank can alter the amount of loans made against securities by the banks. The advantages of this instrument are manifold. High margin requirements discourage speculative activities with bank credit and therefore divert resources from unproductive speculative activities to productive investments. By reducing speculative activities, there is reduction in the fluctuation of prices.
2. Moral Suasion :
This is a combination of persuasion and pressure that the Central Bank applies on the other banks in order to get them to fall in line with its policy. This is exercised through discussions, letters, speeches and hints to banks. The Central Bank frequently announces its policy position and urges the banks to fall in line. Moral suasion can be used both for quantitative
as well as qualitative credit control.
3. Selective Credit Controls (SCCs) :
These can be applied in both a positive as well as a negative manner. Application in a positive manner would mean using measures to channel credit to particular sectors, usually the priority sectors. Application in a negative manner would mean using measures to restrict the flow of credit to particular sectors.
Source : CBSE Notes
