43. Functions of the Central Bank – Business Environment

43

FUNCTIONS OF THE CENTRAL BANK

In this chapter, we study the organization and management of the central bank as the government's bank, the bankers' bank and as the controller of credit. We also study both the quantitative weapons and selective credit control measures employed by the central bank to control credit. After reading this chapter, you will be able to understand the functions of central bank clearly.

The central bank is the premier banking institution and heads the list of all institutions that have an impact on the monetary policy of any nation. The functions of the central bank vary from country to country depending upon its stage of economic development, the nature and development of economic growth and activity, the banking habits of the people, the type of relationship that exists between commercial banks and the central bank, and the state of development of the money and capital markets. In spite of many differences, we can observe certain fundamental functions that are uniformly followed by all central banks. De Kock in his famous book Central Banking enumerates the following functions as being basic to all central banks. A central bank regulates currency in accordance with the requirements of business and the general public for which purpose it is granted either the sole right of note issue or at least a partial monopoly thereof; it performs certain banking and agency services for the State; it keeps the cash reserves of commercial banks; it maintains and manages the nation's reserve of international currency; it often acts as a clearing house for commercial banks; and it controls the credit in consonance with the needs of business within the framework of the monetary policy adopted by the State.1 But we can conveniently categorize the functions of the central bank as those pertaining to the central bank acting as a (i) government's bank, (ii) banker's bank and (iii) controller of credit. Figure 43.1 lists the primary functions of the central bank.

India's central bank is the Reserve Bank of India. The RBI was established in 1935 as a private shareholder bank, as recommended by Hilton Young Commission. RBI started its functions effective from April 1935 on the terms of the Reserve Bank of India Act 1934. The preamble of the Act started: “whereas it is expedient to constitute a Reserve Bank for India to regulate the issue of bank notes and the 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.”2 In January 1949, the government nationalized it under the Reserve Bank (Transfer to Public Ownership) of India Act 1948. The Act empowered the Central Government to issue such directions to RBI as it might consider necessary in public interest. The governor of RBI and all deputy governors are appointed by the Central Government. Since its establishment, the RBI has been guiding, monitoring, regulating, controlling and promoting the financial and monetary system of the country.

ORGANIZATION AND MANAGEMENT

The general management, administration and direction of the Bank is entrusted to the Central Board of Directors of 20 members, comprising the governor, 4 deputy governors, 1 government official from the Ministry of Finance, 10 nominee directors appointed by the government of India to give representation to important areas in the economic life of the country, and 4 directors nominated by the central government to represent the four local boards. Besides the central board, there are four local boards with headquarters at Mumbai, Kolkata, Chennai and New Delhi. Local boards consist of five members, each appointed by the central government for a term of 4 years to represent territorial and economic interests and the interests of cooperative and indigenous banks. By the Reserve Bank of India Act of 1934, all the important functions of a central bank as explained in the following pages have been entrusted to the Reserve Bank of India.

THE GOVERNMENT'S BANK

A central bank performs the following functions as a government bank: (i) bank of issue; (ii) custodian of national reserves; (iii) banker, agent and financial advisor to the state; (iv) miscellaneous functions. The following sections discuss the functions in detail.

Bank of Issue

The monopoly of note issue is enjoyed by central banks all over the world. The reasons why governments everywhere give the privilege of note issue to central banks are many: a bank that has the responsibility of controlling credit and establishing stable price levels should have the exclusive right to issue notes which is the greatest single cause of changing prices; the concentration of the right of note issue imparts uniformity and a distinctive prestige and instils confidence in the minds of public in the notes issued by it. Thus, the monopoly of bank note issue is a zealously guarded privilege of central banks. However, this privilege is interspersed with a responsibility of securing the stability of prices. It regulates the volume of currency and credit, pumping in more money when the market is dry of cash and pumping out money when there is excess of credit. The monopoly of note issue enables the central bank to perform the function of controller of currency and credit and succeeds in maintaining both internal and external stability of money. It can also control money market and keep the lending activities of commercial banks at a desired level.

 

 

Figure 43.1 The Functions of a Central Bank

 

It must not be understood, however, that all central banks have absolute monopoly of note issue and that such a power is total. There are many countries where the central bank has only a residuary monopoly of note issue which means that there are other banking institutions that have the right to issue notes though within a prescribed limit. Even those central banks whose power to issue notes is absolute have to function within certain conditions imposed by law. The size and composition of the paper currency reserves, the maximum amount of notes to be issued, the amount of backing, the fiduciary portion and such other rules and regulations are all laid down by law, and restrict the powers of the central bank. However, these restrictions are of a general nature, and within these general limitations the central bank's power to alter the supply of currency is complete.

Custodian of National Reserves

The central bank also acts as a custodian of national reserves, including currency and foreign exchange.

  1. National reserves: The central bank of a country is usually entrusted with the custody of the nation's reserves. This function is derived from the role of the central bank as the sole authority of note issue and the custodian of the cash reserves of commercial banks. The reserves are kept mainly in the form of gold or silver or foreign exchange in addition to the reserves of local currency belonging to the commercial banks. The central bank is also enjoined to keep a portion of the currency gold or foreign securities. In India, for instance, the Reserve Bank has assets consisting of gold coins and bullion, foreign securities, rupee coins, Government of India rupee securities and such bills of exchange and promissory notes payable India as are eligible for purchase by the RBI. The existing law prescribes that the aggregate value of gold coins, gold bullion and foreign securities held by the bank should not at any time be less than INR 2 billion; of this, the value of gold (bullion plus coin) was not to be less than INR 1.15 billion. This is the minimum amount that the central bank has to keep against the issue of currency. As such, this amount of gold and foreign securities is immobilized and is not available for the purpose of balancing international accounts.
  2. Reserves of international currency: In addition to the reserves kept against the issue of currency, the central bank also keeps bullion and foreign exchange. The obvious purpose of the central bank keeping gold or foreign exchange is to meet any adverse balance of payments and to maintain stability of the external value of the country's currency. The central bank arranges to buy and sell foreign exchange so as to directly control the exchange rate or change its bank rate.
  3. Control of foreign exchange: In addition to dealing in foreign exchange, central banks in the developing countries, including India, find it necessary to employ measures to regulate directly the demand by nationals for foreign exchange as well as the disposal by them of the foreign exchange earned. The object of exchange control is to restrict the demand for foreign exchange within the limits of the available supplies. Exchange control becomes necessary when the country's external reserves, even when supplemented by borrowings from international institutions and from other countries, are not adequate to meet the demand for foreign exchange. It involves a rationing of foreign exchange among various competing demands for it. The rationale of such rationing is that at the prevailing rate of exchange, the supply of foreign exchange is not forthcoming at a pace equal to the current demand. Exchange control may be imposed either on payments or on receipts or (more usually) on both. The purpose of control on payment is to curtail the demand for foreign exchange. Exchange control on receipts is imposed to centralize a country's means of external payments in a common pool in the hands of the monetary authorities.

As a Banker, Agent and Advisor to the Government

M. H. De Kock observes, “As the government's banker, the central bank conducts the banking accounts of the government departments, boards and enterprises; it makes temporary advances to the government in anticipation of the collection of taxes, or the raising of loans from the public, and extra-ordinary advances during a depression, war or other emergency; and it carries out the government's transactions involving purchase or sale of foreign currencies. The central bank is also called upon to perform various services as the government's financial agent, and it acts generally as a financial advisor of the government.” 3

Banker to the Government

The central bank is entrusted with the conduct of all banking businesses of governments at various levels, central, state and other public agencies. The bank accordingly undertakes to accept money on account of the government, to make payments on its behalf and also to carry out its exchange, remittance and other banking operations including the management of the internal as well as external public debt. The central bank also undertakes to issue loans and treasury bills on behalf of governments. In keeping the banking accounts of government departments and institutions, the central bank performs the same functions as the commercial banks ordinarily perform for its customers. It accepts the deposits of cash, cheques and drafts drawn on other banks. The treasury and other public institutions keep their balances with the central bank. These balances appear in the bank's published statement of account as public deposits. All receipts and payments on behalf of the government and its institutions are made by the central bank and credited to their accounts. The central bank also transfers funds either from one account to another or from one place to another.

Just as any other bank lends money to its customers, the central bank lends money to the government. In fact, many of the older central banks, such as the Bank of England, were originally started as institutions to give loans to their respective governments. The liability of lending was compensated by the privilege of note-issue. This is, therefore, the oldest function of the central bank. The central bank gives short-term loans known as “ways and means advances” to the government. These advances repayable not later than 3 months from the date of making the advance are given in anticipation of tax receipts. The central bank can also provide short-term finance to the government by purchasing its treasury bills. Long-term loans are also not infrequent. In emergency conditions such as a war, the central bank purchases government's bonds and securities. Besides, a greater portion of deficit expenditure calls for the assistance of central bank to provide the necessary finances for the government.

Agent of the Government

The central bank acts as an agent of the government and carries out its instructions pertaining to monetary matters. It also acts as a financial agent of the government. In those countries which have introduced exchange stabilization or equalization funds or payments or clearing agreements with other countries, the central banks have been entrusted with the administration of these funds and agreements keeping separate banking account for these purposes and carrying out all the transactions in gold and foreign exchange connected therewith. Besides, when the government orders an amendment in its banking policy or proposes a shift in its monetary policy, the central bank as an agent of the government and as a premier banking institution gives a lead in executing such decisions. If the government is the ultimate authority responsible for laying down the monetary policy and the monetary standard of the country, the central bank as its monetary agent is responsible for carrying out such a policy and thus safeguarding the welfare of the people.

Advisor to the Government

The central bank acts generally as a financial advisor to the government. In this case again, the central bank performs the same function in relation to government, as a commercial bank does to private individuals and firms. The central bank has the best experts and expertise on monetary matters of the country. The central bank is in the best position to advise the government when and how to float a loan, when to convert it and when to redeem it. It also gives the government very essential advice on important matters of economic policy, such as deficit financing in relation to economic planning, devaluation of the currency, trade policy, etc. The government is usually guided by this advice.

Like all central banks, the Reserve Bank of India too acts as advisor to government not only on banking and financial matters, but also on a wide range of economic issues including those in the field of planning and resource mobilization. It has, of course, a special responsibility in respect of financial policies and measures concerning new loans, agricultural finance, cooperative organization, industrial finance and legislation affecting banking and credit. The Bank's advice is also sought on certain aspects of formulation of the country's Five Year Plans such as the financing pattern, mobilization of resources, and institutional arrangements with regard to banking and credit matters. The Bank has also to render advice to government on various matters of international finance. For the effective discharge of this advisory role, the Bank has built up a fairly large research and statistical organization. The Bank also keeps the government informed of developments in the financial markets periodically.4

Miscellaneous Functions

The central bank as a banker to the government and as the primary monetary authority performs certain miscellaneous functions such as carrying out research on monetary matters, issuing journals and bulletins pertaining to monetary affairs and giving shape to the baking policies of the government and also undertaking specially assigned jobs to improve the performance of certain sectors of the economy. The Reserve Bank of India, for instance, issues the Reserve Bank of India Bulletin, the Report on Currency and Finance, the Report on the Trend and Progress of Banking in India, the Banking and Monetary Statistics of India, the Statistical Tables relating to banks in India, the Review of the Cooperative Movement in India, the statistical statements relating to the Cooperative Movement in India and other such prestigious publications.

In addition to these functions, the Reserve Bank plays a pivotal role in the sphere of rural finance which is occasioned by the predominantly agricultural basis of the Indian economy and the urgent need to expand and coordinate the credit facilities available to the agricultural sector. To strengthen its activity in this vital sphere of the Indian economy, it has established a special Agricultural Credit Department (a) to maintain an expert staff to study all questions of agricultural credit and be available for consultation by the central government, state governments, state cooperative banks and other banking organizations, and (b) to coordinate the operations of the Bank in connection with agricultural credit and its relations with state cooperative banks and any other banks or organizations engaged in the business of agricultural credit.

An active role in the field of industrial finance is yet another noteworthy feature of Indian central banking. In the absence of a sufficiently broad domestic capital market, there was need for adapting and enlarging the institutional structure to meet the medium- and long-term credit requirements of the industrial sector. It was in this context that the Reserve Bank of India took the initiative in setting up statutory corporations at the all India and regional levels to function as specialized financial agencies for providing medium- and long-term credit. Some such institutions are the Industrial Finance Corporation of India, The Refinance Corporation for Industry Private Limited and 17 State Financial Corporations. RBI also set up the Deposit Insurance Corporation in 1962, The Agricultural Refinance Corporation of India in 1963, The Unit Trust of India and The Industrial Development Bank of India also in 1964, and the Industrial Reconstruction Corporation of India in 1972, and National Bank for Agriculture and Rural Development in 1981.

THE BANKERS' BANK

The central bank's position as a banker to commercial banks is very essential to dovetail the monetary and banking sectors of the economy. It lends uniformity of purpose and is able to channel the two sectors effectively to improve the working of the economy. The central bank is the nerve-centre of the money market. It is not only a bank amongst banks, but the bank of banks. Central banks do not compete with commercial banks; they neither accept deposits nor lend to individual depositors as commercial banks do. State-owned central banks are not profit-seeking institutions as privately owned commercial banks are. As such, they are not to be regarded as rivals or competitors of commercial banks; in fact, they coordinate the activities of the commercial banks. The functions of central banks pertaining to commercial banks can be categorized as (i) supervision of banks, (ii) lender of last resort, (iii) custodian of member banks' cash reserves, and (iv) bank of central clearance, settlement and transfer. The following sections discuss these functions in detail.

Supervisor of Banks

Especially in developing countries such as India, the central bank's responsibilities extend beyond traditional banking functions to include the development of an adequate and sound banking system catering to the needs of trade, commerce, industry and agriculture. For instance, in India, every bank wishing to commence banking business is required to obtain a licence from the Reserve Bank. This requirement was intended to ensure the continuance and growth only of banks which were established and were operating on sound lines and to prevent indiscriminate growth of banks. Before the grant of a licence, the RBI generally satisfies itself by an inspection of the bank's books and accounts and methods of operation, that the bank is or will be in a position to pay its present or future depositors in full as their claims accrue, and that its affairs are not being or are not likely to be conducted in a manner detrimental to the interests of its present or future depositors. To ensure a sound banking system, the central bank is also empowered to inspect, make an enquiry or determine the position in matters concerning the opening of branches, amalgamations, suspension of business, etc. Central banks also generally exercise strict control for ensuring that banks do not fritter away funds in improper investments and injudicious advances. The central bank's efforts to safeguard the interests of bank depositors are not confined to the operations of banks during their life but also extend to the period following their liquidation. In case a bank is to be wound up, the central bank appoints the official liquidator and ensures the speedy disposal of winding up proceedings. The Reserve Bank also helps the commercial banks by running training colleges for the benefit of personnel to be employed in these institutions.

The Lender of Last Resort

From the commercial banks' point of view, the central bank is known as the lender of the last resort, i.e., they approach the central bank for financial accommodation when all other avenues have been explored; and the central bank as a bankers' bank invariably comes to their rescue. This function is considered so important that Sayers observes: “The willingness to act as the lender of the last resort is fundamental to central banking.” 5 As a lender of the last resort, the central bank gives financial accommodation to banks just as the latter would extend its depositors overdrafts in times of emergency. The central bank is eminently suited to act as the ultimate source of credit not only to banks, but also to the government and to the public at large as well. It imparts monetary liquidity in the economy. It is this power that gives the central bank a stature and authority in addition to its privilege of note issue amongst the other banks and enables it to control the credit when the occasion demands. The commercial banks, on the other hand, do not and cannot depend on the central bank only when they are unable to meet their cash requirements from normal channels. There are times, though rare, such as festive seasons and time of business buying when the community's cash requirements exceed the amount the bankers keep for day-to-day needs. When their cash reserves are very low and there is an added strain of impending cash withdrawals, the commercial banks approach the central bank for replenishment of cash reserves. They can also acquire cash by selling some of the securities they hold, but that will reduce their income-earning assets. At such times, the short-term financial accommodation granted by the central bank becomes very handy.

The central bank extends financial accommodation through the rediscounting of first class bills of exchange, government securities and such other eligible papers. Before the First World War, the bills of exchange were the most important instruments of credit on the basis of which central bank lent money to banks. These bills especially attracted the central bank because of their self-liquidating character. These were also held in high esteem as they were drawn for genuine commercial transactions that represented goods in different stages of production and distribution. However, in recent times, with the decline in the importance of bills of exchange and the increasing monetary needs of business community, central banks had to relax their eligibility rules and extend rediscounting facilities against treasury bills and loans against government securities. The provision of rediscounting facilities promotes economy in the use of cash and enables the banks to conduct their business with smaller cash reserves. The rate at which central bank rediscounts approved bills is called the bank rate which is one of the weapons in the armoury of central banks to control the volume of credit.

The Custodian of Member Banks' Cash Reserves

One of the functions of the central bank is to hold the cash reserves of commercial and other types of banks that constitute the ultimate cash reserves of the country and which support its credit and banking system. The banks hold deposits with the central bank which rediscounts their bills against the security of these deposits. It thus affects centralization of cash reserves of the member banks in the community. De Kock observes: “The centralization of cash reserves in the central bank is a source of great strength to the banking system of any country. Centralized cash reserves can at least serve as the basis of a larger and more elastic credit structure than if the same amount were scattered among the individual banks. It is obvious that, when bank reserves are pooled in one institution which is moreover, charged the responsibility of safeguarding the national economic interest, such reserves can be employed to the fullest extent possible and in the most effective manner during periods of seasonal strain and in financial crises or general emergencies.” 6

The Bank of Central Clearance, Settlement and Transfers

W. A. Shaw in Theory and Principles of Central Banking asserts: “A central bank will operate as a clearing house for all its member banks as a mere matter of mechanism or book keeping.”7 Others agree with this view and hold it necessary for the central bank to set up machinery for clearance of drafts and settlement of internal accounts as it is suitably qualified with its capacity as holder of the balances of the commercial banks. The gist of the whole function is, the central bank settles or clears inter-bank cash reserves or indebtedness. Just as a commercial bank clears and settles accounts of different customers, the central bank clears indebtedness between banks by means of debit and credit entries in their respective accounts with the central bank. The clearance of inter-bank indebtedness by making book entries through transfers from one account to another enables the central bank to have first-hand information concerning the liquidity position of member banks and to take appropriate steps to effectively control credit and safeguard the interests of depositors.

THE CONTROLLER OF CREDIT

The function of credit control is accepted as the major important function of central banks by bankers and economists. In the words of De Kock M. H., “It is the function which embraces the most important question of central banking policy, and the one through which all other functions are united and made to serve a common purpose. The need for credit control is universally recognised due to its powerful influence for good or for evil in the present day economy. It is said that the cyclical fluctuations in the economy can be avoided only if the central bank controls deliberately the volume of credit.” 8

The need for controlling credit is “obvious”. Credit has come more significant than money itself. Unwarranted fluctuations in the volume of credit will cause a change in the value of money bringing about great social, political and economic upheavals. The experience of the first 50 years bears ample testimony to the need of controlling credit in the interest of maintaining the economic and political stability in the society.

Credit control is an economic instrument through which the central bank implements its monetary policy. Monetary policy is the management of the expansion and contraction in the volume of money for attaining specific objectives. These objectives could be: (i) stability of exchange rates; (ii) stability of prices; (iii) economic stability; (iv) full employment; (v) economic growth and (vi) reduction in inequalities of income and concentration of economic power. Though all these objectives are important, some of them are given greater prominence due to their ramifications in the economy. In highly developed economies such as USA, monetary policy is chiefly concerned with the expansion and contraction of credit as banks are the principal creators of money. This is the reason why monetary policy is often indistinguishable from credit control.

The objective of credit control can be realized by what have now come to be known as (i) quantitative or general weapons. These are traditional methods of credit control, while (ii) qualitative or selective credit control measures are methods evolved in recent times. Figure 43.2 shows the methods of credit control by the central bank.

 

 

Figure 43.2 Methods of Credit Control

Quantitative Weapons

The central banks may control the volume of credit without regard to the purpose for which it is used. Monetary control is exercised through changes in the liquidity of commercial banks by changing the supply of cash. The expansion and contraction of cash by the central bank is done through: (i) the bank rate or discount rate changes, (ii) open market operations and (iii) the variable reserve ratio. Through the functions as the bankers' bank, the lender of the last resort and the manager of public debts, the central bank exercises the power to control the overall supply of credit and the terms on which credit is available. However, it is important to stress that these are closely inter-related and have to be operated in coordination. All of them affect the level of bank reserves. Open-market operations and reserve requirements directly affect the reserve base while the Bank Rate produces its impact indirectly through variations in the cost of requiring the reserves. The use of one instrument rather than another at any point of time is determined by the nature of the situation and the range of influence it is desired to wield as well as the rapidity with which the change is required to be brought about. Open market operations, for instance, are suited to carry out day-to-day adjustments on even the smallest scale. Changes in reserve requirement produce an impact at once and would affect banks generally. The effects of bank rate changes are not confined to the banking system and the short-term money market; they produce wider repercussions on the economy as a whole.

Bank Rate

The bank rate or the discount rate is the standard rate at which the central bank is prepared to buy or rediscount bills of exchange or other commercial paper eligible for purchase. The Bank Rate Policy is defined as the varying of the terms and of the conditions under which the market may have temporary access to the central bank. The central bank lends to financial institutions either by rediscounting bills of approved quality or by lending against the security of such bills or short-dated government paper. The Bank Rate is announced by the bank at fixed intervals, generally every week. Alterations are made in the rate whenever a desired change is to be brought about. For instance, when the bank rate is raised, borrowing becomes more costly and credit is tightened; when it is lowered borrowing is encouraged and credit becomes cheaper and easier to obtain. When the central bank is of the opinion that the commercial banks are unduly expanding credit, it may raise the bank rate. This will increase the cost of borrowing of the banks which will subsequently raise their lending rate. The increased market rate of interest will discourage businessmen from borrowing as easily as they did in the past. Checked investments, unemployment, reduced incomes, lower demand for goods and consequent fall in prices will follow in quick succession. Thus, an increase in the bank rate is followed by a fall in the volume of money in circulation, a reduction in money incomes and prices and a general showing down of economic activities. Conversely, a decrease in the bank rate will be accompanied by increased borrowings, enhanced money incomes and prices, and expanded business activities. The bank rate can, thus, be used for regulating domestic situation and to bring about internal price stability.

Bank Rate Policy presupposes the existence of the following conditions in an economy: (i) The existence of a well-developed money market; (ii) The dependence of commercial banks upon the central bank for rediscounting facilities and for financial accommodation and (iii) A good deal of cooperation between the central bank and other banking institutions.

The importance of Bank Rate has considerably declined in recent times. Its importance as a regulator of cost-price structure also is insignificant. The following are the limitations of the bank rate policy as an effective weapon of credit control:

  1. The success or otherwise of bank rate policy depends on its power to influence the market rate at which all loans are given. This requires a highly developed money market which is not found in many developing countries, including India.
  2. The relationship between the central bank and other monetary institutions is not such that the latter look to the former in times of financial stringency.
  3. The bank rate policy pre-supposes a kind of dynamic economy in which a variation in credit policy is quickly followed by changes in prices, wages, production, etc., but this is not the case always.
  4. A change in the bank rate is effective only when there is a mild inflation or deflation; it fails to produce the desired effect at other times.
  5. The effectiveness of the bank rate is also determined by the necessity of commercial banks to approach the central bank for financial accommodation. It is more than likely that the commercial banks have ample liquid resources at their disposal which makes it unnecessary for them to approach the central bank for rediscounting facilities.
  6. Today a large chunk of economic activity is carried on by public enterprises which do not depend on borrowings from the market. Thus, the change in the interest rates will have a remote influence on them and when they have a large share in the productive system, its influence will be negligible on the economic activity as a whole.

The efficacy of the bank rate as an instrument of credit control continues to evoke considerable controversy not only among economists but also in central banking circles. In most countries, fiscal policies and direct control measures seem to have far greater impact on investment decisions than changes in discount rates. This does not mean that there is no importance of the Bank Rate altogether. Discount rate change do have an impact on the movement of short-term funds to and from the country; but in developing countries such movements are of modest dimensions and can be largely regulated through exchange control measures. Discount rate changes also seem to possess some psychological advantage, as an indication of a tightening or a relaxation of credit policies. In the developed countries, in recent years, discount rate changes have been both, frequent and sharp. The approach of the Reserve Bank of India so far has been to make a modest use of this instrument.

Open Market Operation

Open market operations refer broadly to the purchase and sale by the central bank of a variety of assets such as foreign exchange, gold, government securities and even company shares. In actual practice, however, they are confined to the purchase and sale of government securities. Open market operations work this way: when there is inflation or boom leading to economic instability, the central bank sells in the market eligible securities which it has held in possession to reduce the supply of money. Buyers of these bills, which include commercial banks, insurance companies and even individuals, make payments to the central bank by drawing upon their cash deposits in the banks. As the banks themselves hold deposits with the central bank, payment by the former to the latter involves reduction in the size of the member bank's deposits held with the central bank. Reduction of their cash reserves forces the banks to reduce their advances and issue of further loans. This will have an adverse effect on investments and will reduce considerably the impact of boom and inflationary conditions in the economy.

In times of depression and falling prices, the central bank buys the approved securities in the market for which it pays by issuing cheques drawn on itself to the individual and institutional sellers of securities. The individuals deposit these cheques with the commercial banks, which finding their cash reserves increased, use these for granting additional loans. Bank credit is expanded. This in turn leads to greater investment, more employment and rising prices. Thus, by buying or selling securities in the money market, the central bank influences the capacity of creation of credit of commercial banks through which it tries to achieve the desired effects on the economy of the country.

The success or otherwise of open market operations depends on a number of conditions:

  1. The effectiveness of open market operations as an instrument of credit control is often limited by the absence of a well-developed money market. Besides, in most countries the market for government securities is so small that a large-scale purchase or sale of these by the central bank cause unduly wide fluctuations in their prices without affecting the cash reserves of banks.
  2. The capacity of the central bank to control credit through this weapon is limited by its current supply of suitable securities. They often have only government securities and not the other types of bills that are attractive to intending buyers.
  3. The central banks must be prepared to purchase securities at high prices to check falling prices and incur losses by selling them at low prices to check boom. Even if the central bank is prepared to make a sacrifice by suffering a loss in order to stabilize the economy, it may not have adequate supply of securities in its portfolio to have any appreciable impact on the economy.
  4. It is assumed that when the central bank sells securities, there is a diminution in the quantity of money in circulation and in the amount of cash reserves held by commercial banks as the excess money is siphoned off into the central banks' vaults. Likewise, when it buys securities, central bank releases money with the public. However, this may not always happen due to the operation of certain forces. For instance, an outflow of capital or a withdrawal of notes by the public for hoarding purposes may accompany the buying of securities by the central bank and thereby offset the intended effect on the control of credit. Likewise, an inflow of capital or return of notes from circulation may neutralize the effect of sale of securities.
  5. The effectiveness of the open market operations depends on the assumption that the banks will always expand their credit portfolio whenever they get additional cash and contract it whenever their cash reserves diminish. In actual practice, however, this may not be the case. Credit expansion or contraction reflects the prevalent psychology of investors at that time. The demand for credit depends on a variety of factors one of which is the rate of interest. Therefore, consequent upon the open market operations, the demand for credit may not change as expected.
  6. Sometimes what the central bank does as the controller of credit through open market operations and other weapons may be nullified by its acting as the lender of last resort. This will happen if the commercial banks replenish their cash reserves by getting their bills of exchange rediscounted by the central bank rather than sell the securities held by them.

In spite of the limitations of open market operations, they play a significant role in credit control. Some economists argue that they constitute a more direct and an effective way of controlling credit than the bank rate policy. Countries such as USA and UK which have well-developed and highly sensitive money and capital markets have used this weapon to their great advantage. In Germany, open market operations were frequently employed by the Reisch Bank for exercising control over the money and capital markets. In other countries, such as France, Japan and India where the money markets are not so well developed, open market operations as instruments of monetary regulation are relatively unimportant.

Variable Reserve Ratio

As we have already seen, the two traditional weapons—the bank rate policy and the open market operations—are not very effective in controlling credit. This has compelled the central banks to adopt new methods of credit controls. One such new method adopted by central banks is that of variable reserve ratios.

This method of credit control works as follows: Every commercial bank is enjoined either by law or by custom to keep certain percentage of its total deposit liabilities with the central bank in the form of minimum legal cash reserves. In India, for instance, scheduled banks are required to maintain with the Reserve Bank at the close of business on any day a minimum cash reserve of 3 per cent of their aggregate demand and time liabilities. But whenever the occasion demands it, the Reserve Bank is empowered to vary the cash ratio between 3 per cent and 15 per cent of the total demand and time liabilities. Variations in the ratio reduce or increase the liquidity of banks and consequently the lending power of the banks. The ratio of the reserve to be kept by banks with the central bank is raised when bank credit is to be contracted, and lowered when credit is to be expanded.

The original object of reserve requirements was to enforce the commercial banks to have sufficient liquidity. However, there is a change in the object in recent times. Reserve requirements today serve primarily not as a means of banks maintaining their liquidity but as a medium through which credit can be expanded or contracted. This weapon enables the central bank to prevent unwarranted credit expansion or contraction by varying the reserve ratios.

This method is very useful especially if it is used along with other instruments. It is more direct and achieves prompt results than open market operations. By a mere stroke of pen, the central bank can have the desired effect. There are certain limitations, however, in the use of this weapon. It is possible that many banks may have surplus funds and will not worry when they have to keep higher margins with the central bank. They might also conduct their operations with a lower cash ratio if they are optimistic of future, while any amount of decrease in the reserve ratio may not induce them to lend in depression. The technique of variable reserve requirements has so far been used only once in India. In 1960, this instrument was pressed into service in the context of the sharp rise in price and in aggregate monetary demand. It took the form of requiring the bank to maintain with the Reserve Bank additional cash reserves on the increase in demand and time liabilities over a specified base date. This had only a limited success since the banks managed to minimize its impacts on credit largely by recourse to borrowings from Reserve Bank and partly by liquidating government securities.

Selective Credit Control

We have already observed that credit control measures can be broadly categorized as quantitative and qualitative. Quantitative credit control measures aim to affect the cost of credit in general without any aim to affect its distribution in particular directions. But the problem of credit control is to not only regulate the quantity or cost of credit, but also restrict its flow in particular directions. Qualitative or selective credit controls aim at regulating credit for specific purposes in certain sectors of the economy. Its object is to encourage such forms of economic activity as are considered essential and to curb those that are non-essential, undesirable or anti-social. Qualitative control measures should be used when it is desired to direct credit for purposes or forms which are considered desirable or to check credit when it flows into directions not considered worthwhile or harmful to the economy. It may be mentioned that some element of selectivity can be imparted to general credit controls also by giving concessions to priority sectors or activities; this has been so in India. For instance, such controls have been used to prevent speculative hoarding of commodities like food grains and essential raw materials to check an undue rise in their prices. Central banks in many countries use a wide range of selective credit instruments such as rationing of credit, direct action, regulation of consumer credit, regulation of marginal requirements, minimum secondary reserve requirements, moral suasion, etc., either independently of, or sometimes in conjunction with, quantitative credit control measures. In fact, they are more effective when used in combination with quantitative weapons. Some of the so-called selective control measures even produce effects of quantitative weapons. The qualitative weapons of credit control are discussed in the following sections.

Rationing of Credit

The central bank as a lender of last resort has the option also to refuse rediscounting facilities, if it so chooses, beyond a certain limit, especially in times when financial discipline is called for. In addition to its refusal to rediscount bills, the central bank can also enforce “variable ceilings”, i.e., limiting the number of loans and advances each bank can give.

Credit rationing is not a normal or routine instrument of credit control. It should be used as a temporary measure or an instrument used to tackle an abnormal credit situation or as a part of comprehensive scheme of national planning.

Moral Suasion

The central bank of a country by virtue of its being the primary monetary authority, bankers' bank and lender of the last resort has a stature with the commercial banks. By making use of this high standing and also of its persuasive powers, the central bank tries to exert indirect influence on the lending policies of banks. It tells other banks what type of policy is desirable in the interests of the country and uses its moral force to ask them to toe the line. It may request them to follow a type of policy that will be good for country; it may even warn them of the possible consequences of non-compliance of its dictum. The central bank may discourage commercial banks from lending in amounts and for purposes considered undesirable by it.

Moral suasion is generally talked of as a measure of selective credit policy. But just as it is used for particular purposes, it may be also extended as an instrument of general credit policy. The central bank may use its moral force in urging the banks to curb undue expansion of credit in times of rising prices as well as in goading them to increase it when contractionist tendencies exist. As a measure of selective control, moral suasion is used to reduce the volume of credit for speculative and non-essential purposes.

The Reserve Bank of India has made a generous use of this instrument in recent times. It sends letters periodically to banks urging them to exercise control over credit in general or advances against particular commodities or unsecured advances. Discussions are also held with bankers for the same purpose. Moral suasion, backed as it is by the Reserve Bank's vast powers of direct regulation, has proved quite useful. Of course, the use of this instrument is facilitated by the concentration of banking business in the hands of about 15 nationalized banks.

There are economists like Clark who hold the view that “persuasion as means of credit control has not been successful. This is mainly because the commercial banks might resent the discriminating interference of the central bank in their normal banking affairs and so on and refuse to cooperate with it.”

Publicity

In addition to moral suasion, the central bank may resort to wide publicity as to what it considers good banking policy addressed to the public at large and bankers in particular, so that it would create an awareness and awakening in this sensitive sphere of economy. It exerts a sort of moral pressure on the banking system by propagating its view on what is vicious and unhealthy in the monetary system and should be curbed and what is sound policy and therefore, should be encouraged. But this type of credit instrument is doomed to fail in an underdeveloped and vastly unlettered country such as ours. Even in many Western countries, this weapon is not taken very seriously in central banking circles.

Direct Action

This is a coercive measure used by central banks to make the commercial banks to its line of banking policy. When publicity and even moral suasion have no impact on the credit policy of banks, this method may be resorted to. Direct action involves coercive measures such as the refusal to rediscount or to grant further rediscounting facilities to banks that follow unsound credit policies. Direct action too has its quota of deficiencies. According to De Kock, direct action has “several limitations to be reckoned with, namely, the difficulty for both central and commercial banks to make clear-cut distinction between essential and non-essential industries, productive and unproductive activities, investment and speculation or between legitimate and excessive speculation or consumption; the further difficulty of controlling the ultimate use of credit by second, third or fourth parties; the dangers involved in the division of responsibility between the central bank and commercial banks for the soundness of the lending operations of the latter; and the possibility of forfeiting the wholehearted and active cooperation of the commercial banks as a result of undue control and intervention”.

Minimum Secondary Reserve Requirements

By this method, the central bank enjoins the commercial banks to keep with it a certain minimum secondary or supplementary reserves over and above the usual minimum statutory cash reserves. The underlying idea behind this principle is to further curtail the capacity of banks to expand credit.

Regulation of Consumer Credit

This is a device of central banks to regulate the terms and conditions under which credit repayable in instalments could be extended for purchasing consumer durable goods. The central bank many either ban the credit granted by the banks to its customers to buy consumer durable goods such as TVs, radios, furniture, etc. or reduce the number of instalment within which the amount has to be repaid, in times of inflation and let the banks grant easy loans under the hire-purchase system in times of deflation or depression. This method is very significant in combating inflation by restricting the consumer demand for goods which are in short supply in advanced countries where consumer credit is largely used to finance purchase of consumer durable goods. But this system will not have much relevance in underdeveloped countries like India.

Regulation of Marginal Requirements

When the central bank has acquired the authority to lay down the cover percentage of a loan, it can restrain the credit granted for a specific purpose by increasing the percentage. This method is used very effectively against speculative practices on the stock exchange. The central bank also can indirectly check the hoarding of food grains and essential raw materials by increasing the cover requirements to advances granted by banks for such purposes.

Limitations of Weapons of Credit Control

Though many of the weapons are useful and are significant, they are not always as effective as expected. That is so because of certain limitations. Bank credit is only one type of credit. In India, for instance, the unorganized banking sector provides more credit than the organized sector; the commercial banks do not always obey the directives of central banks: often they attempt too much and in too vast an area and encounter failure; business psychology is an important constituent of credit mechanism and the central bank cannot influence it much. Dichotomy of the banking industry produces often weak results; and a well-developed money and capital market, a sine que non for the success of these weapons, is absent in most countries including some of the advanced countries.

SUMMARY
  • The central bank is the premier banking institution and heads the list of all institutions that have an impact on the monetary policy of any nation. The functions of the central bank vary from country to country depending upon its stage of economic development, the nature and development of economic growth and activity, the banking habits of the people, the type of relationship that exists between commercial banks and the central bank, and the state of development of the money and capital markets.
  • India's central bank is the Reserve Bank of India. The RBI was established in 1935 as a private shareholder bank, as recommended by Hilton Young Commission. RBI started its functions effective from April 1935 on the terms of the Reserve Bank of India Act 1934. The Act empowered the Central government to issue such directions to RBI as they might consider necessary in public interest. By the Reserve Bank of India Act 1934, all the important functions of a central bank have been entrusted to the Reserve Bank of India.
  • The monopoly of note issue is enjoyed by central banks all over the world, through all central banks do not have absolute monopoly of note issue and that such a power is not total. The central bank of a country is usually entrusted with the custody of the nation's reserves, mainly in the form of gold or silver or foreign exchange in addition to the reserves of local currency belonging to the commercial banks.
  • Central banks in developing countries regulate directly the demand by nationals for foreign exchange as well as the disposal by them of the foreign exchange earned. As the government's banker, the central bank conducts the banking accounts of the government departments, boards and enterprises; it makes temporary advances to the government in anticipation of the collection of taxes, or the raising of loans from the public, and extra-ordinary advances during a depression, war or other emergency; and it carries out the government's transactions involving purchase or sale of foreign currencies. It is entrusted with the conduct of all banking businesses of governments at various levels, central, state and other public agencies. Just as any other bank lends to its customers, the central bank lends money to the government. The liability of lending has been compensated by the privilege of note issue. This is the oldest function of the central bank. It acts as an agent of the government and carries out its instructions pertaining to monetary matters. The central bank acts generally as a financial advisor to the government.
  • Like all central banks, the Reserve Bank of India too acts as advisor to government not only on banking and financial matters, but also on a wide range of economic issues including those in the field of planning and resource mobilization. The central bank as a banker to the government and as the primary monetary authority performs certain miscellaneous functions such as carrying out research on monetary matters, issuing of journals and bulletins pertaining to monetary affairs and giving shape to the baking policies of the government and also undertaking specially assigned jobs to improve the performance of certain sectors of the economy. Further, the Reserve Bank plays a pivotal role in the sphere of rural finance which is occasioned by the predominantly agricultural basis of the Indian economy and the urgent need to expand and coordinate the credit facilities available to the agricultural sector. The central bank's position as a banker to commercial banks is very essential to coordinate the monetary and banking sectors of the economy.
  • In developing countries such as India, the central bank's responsibilities include the development of an adequate and sound banking system for catering to the needs of trade, commerce, industry and agriculture. From the commercial banks' point of view, the central bank is known as the lender of the last resort, i.e., they approach the central bank for financial accommodation when all other avenues have been explored; and the central bank as a bankers' bank invariably comes to their rescue. The central bank extends financial accommodation through the rediscounting of first class bills of exchange, government securities and such other eligible papers.
  • One of the functions of the central bank is to hold the cash reserves of commercial and other types of banks that constitute the ultimate cash reserves of the country and which support its credit and banking system. The central bank has set up machinery for clearance of drafts and settlement of internal accounts as it is suitably qualified with its capacity as holder of the balances of the commercial banks. The central bank extends financial accommodation through the rediscounting of first class bills of exchange, government securities and such other eligible papers.
  • The function of credit control is the major important function of central banks. Credit control is an economic instrument through which the central bank implements its monetary policy. Monetary policy is the management of the expansion and contraction in the volume of money for the attainment of specific objectives. The objective of credit control can be realized by (1) Quantitative or General Weapons. These are traditional methods of credit control, while (2) Qualitative or Selective credit control measures are methods evolved in recent times.
  • The expansion and contraction of cash by the central bank is done through: (1) the Bank Rate or Discount Rate changes, (2) Open Market Operations, and (3) the Variable Reserve Ratio. The Bank Rate or the Discount Rate is the standard rate at which the central bank is prepared to buy or rediscount bills of exchange or other commercial paper eligible for purchase. It presupposes the existence of (i) the existence of a well-developed money market; (ii) the dependence of commercial banks upon the central bank for rediscounting facilities and for financial accommodation; and (iii) a good deal of cooperation between the central bank and other banking institutions. Open market operations refer broadly to the purchase and sale by the central bank of a variety of assets such as foreign exchange, gold, government securities and even company shares. In actual practice, however, they are confined to the purchase and sale of government securities. Variable Reserve Ratios works as follows: Every commercial bank is enjoined either by law or by custom to keep certain percentage of its total deposit liabilities with the central bank in the form of minimum legal cash reserves. Variations in the ratio reduce or increase the liquidity of banks and consequently the lending power of the banks. The ratio of the reserve to be kept by banks with the central bank is raised when bank credit is to be contracted, and lowered when credit is to be expanded.
  • Qualitative or selective credit controls aim at regulating credit for specific purposes in certain sectors of the economy. Its objective is to encourage such forms of economic activity as are considered essential and to curb those that are non-essential, undesirable or anti-social. Rationing of credit: The central bank as a lender of last resort has the option also to refuse rediscounting facilities, if it so chooses, beyond a certain limit, especially in times when financial discipline is called for moral suasion: The central bank of a country by virtue of its being the primary monetary authority, bankers' bank and lender of the last resort, has a stature with the commercial banks. By making use of this high standing and also of its persuasive powers, the central bank tries to exert indirect influence on the lending policies of banks. In addition to moral suasion, the central bank may resort to wide publicity as to what it considers good baking policy addressed to the public at large and bankers in particular, so that it would create an awareness and awakening in this sensitive sphere of economy. Direct action is a coercive measure used by central banks to make the commercial banks toe its line of banking policy. Minimum secondary reserve requirements: By this method, the central bank enjoins the commercial banks to keep with it a certain minimum secondary or supplementary reserves over and above the usual minimum statutory cash reserves. The underlying idea behind this principle is to further curtail the capacity of banks to expand credit. Regulation of consumer credit is a device of central banks to regulate the terms and conditions under which credit repayable in instalments could be extended for purchasing consumer durable goods. Regulation of marginal requirements: When the central bank has acquired the authority to lay down the cover percentage of a loan, it can restrain the credit granted for a specific purpose by increasing the percentage. This method is used very effectively against speculative practices on the stock exchange.
KEY WORDS
Bank of England bank of issue bank rate policy
banker to the government banking organizations central clearance
clearing agreements direct action discount rate
equalization funds foreign exchange international currency
lender of last resort minimum secondary reserve
monopoly of note issue national reserves open market operation
rationing of credit variable reserve ratio  
DISCUSSION QUESTIONS
  1. What are the functions of a central bank? How do they differ from the functions of a commercial bank?
  2. Discuss the need and importance of a central bank in a modern economy. What role does a central bank plays as the banker to government and lender of last resort?
  3. Explain the significance of the functions of a central bank as a bankers' bank and as a banker to the government.
  4. Discuss to the full the duties of a central bank towards (a) the government of a country; (b) other banks; (c) the people.
  5. Why does a modern state requires a central bank? Explain how a central bank controls the supply of money and credit.
  6. Explain how a central bank by acting as a bankers' bank and as a banker to the government controls the volume of credit.
  7. Explain fully the various methods which a central bank' can employ to control quantity and quality of credits.
  8. Bring out the difference between quantitative and qualitative controls over credit and explain the use of open market operations and variable reserve ratios as instruments of credit control.
  9. Distinguish between the quantitative and qualitative (selective) methods credit control. Discuss the working of open market operations.
  10. “The function of a central bank is to not only control the flow of credit but also its directions”. Comment.
SUGGESTED READINGS

Desai, V. Indian Banking—Nature and Problems. Bombay: Himalaya Publishing House, 1980.

Downes, Patrick. The Evolving Role of Central Banks. Washington, D.C.: IMF Publication, 1991.

Joshi, N. C. Indian Banking. New Delhi: Ashish Publishing House, 1978.

Kohli, V. S. “Indian Banking Industry: Emerging Challenge”, IBA Bulletin XXIII(3), March 2001.

Mohan, Rakesh. “Transforming Indian Banking: In Search of a Better Tomorrow”, RBI Bulletin, 2003.

Nagam, B. M. L. Banking and Economic Growth. Bombay: Vora & Co, 1987.

Pai, D.T. “Indian Banking-Changing Scenario”, IBA Bulletin XXIII(3), March 2001.

Panandikar, S. G. Banking in India. Bombay: Orient Longman, 1975.

Rao, N. V. “Changing Indian Banking Scenario: A paradigm Shift”, IBA Bulletin XXIV(1), 2000.

RBI. Reserve Bank of India: 50 Years of Central Banking. Bombay: RBI, 1991.

RBI: Review of the Working of the Monetary System. Reserve Bank of India: Report on Currency and Finance, 1996–97 and 2000–01.

Talwar, S. P. “Competition, Consolidation and Systemic Stability in the Indian Banking Industry”, in BIS papers, No. 4—The Banking Industry in the Emerging Market Economies: Competition, Consolidation and Systemic Stability, Bank for International Settlement, Basel, http://www.bis.org/pub1/bispap04.htm.

Vittal, N. “The Emerging Challenges: Strategies and Solutions for Indian Banking”, IBA Bulletin XXIII(3), March 2001.