Functions of Central Bank
Central banks are critical in ensuring a stable and healthy financial system, fostering economic growth, and promoting financial development. The main functions of a central bank are to regulate monetary policy, oversee banks and financial institutions, provide emergency funding to banks, Issue and manage the national currency, conduct economic analysis and research, manage payment systems for smooth transactions, promote economic growth and stability, etc. The article discusses the primary functions of the central bank and explains why those functions are crucial for uplifting a country’s economy.
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A country has only one central bank. In India, it is the Reserve Bank of India or RBI. The functions of the central bank are crucial, and they form the backbone of the banking system of any country. The central banks perform eight significant functions in an economy, which are –
Functions of Central Bank
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Listed are some of the crucial functions of the Central Bank.
- Bank of Issue
- Banker, Agent, and Advisor to the Government
- Custodian of Cash Reserves
- Custodian of Foreign Balances
- Lender of Last Resort
- Clearing House
- Controller of Credit
- Protection of Depositor’s Interests
1. Bank of Issue
Central banks nowadays have a monopoly over issuing notes in every country. In India, RBI is responsible for printing and issuing currency notes.
A single bank is given the exclusive monopoly of notes to ensure uniformity, better control, and simplicity. It will also ensure that no individual bank is over-issuing the notes.
The central banks, thus, regulate the country’s currency and the economy’s total money supply. The central bank keeps gold, silver, or other securities like properties against the notes issued. The system of note-issue varies from country to country.
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2. Banker, Agent, and Advisor to the Government
The RBI in India performs the functions of a banker, agent, and adviser to the government. It ensures a safe and intimate connection between public finance and monetary affairs while being convenient and economical.
Central banks also perform the below functions as a banker to the government –
- Receives and makes payments for the government
- Allocates short-term loans to the government in case of emergencies
- Floats public loans and manages public debts
- Maintains the banking accounts and balances of the government after disbursements and remittances
- Advises the government on economic matters
- Act as a government agency where general exchange control is in force
3. Custodian of Cash Reserves
Commercial banks of a country keep a part of their cash balances in the form of deposits with the central bank as a legal compulsion or convention. They draw the cash balances during busy seasons and pay them back during low seasons. These balances are used for clearing purposes. The central banks also help and guide other member banks in need.
It affects the centralization of the member banks' cash reserves. These centralized cash reserves form the base of a vast and flexible credit structure. Suh cash reserves would not be useful if scattered amongst the individual banks.
It is evident when bank reserves are pooled in one institution, which is, moreover, charged with safeguarding the country’s economic interests. Such reserves can be used to the fullest extent and most effectively during seasonal strain, financial crises, or general emergencies. The centralization of cash reserves is conducive to the economy in their use and increased elasticity and liquidity of the banking system.
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4. Custodian of Foreign Balances
The central bank is responsible for securing the stability of the exchange rate under the gold standard.
After World War I, central banks kept gold and foreign currencies as reserve notes issued and met adverse balances of payment with other countries whenever needed. The central bank also maintains the exchange rate fixed by the government and manages exchange control and other restrictions imposed by the state. Thus, it becomes a custodian of the nation’s international currency reserves or foreign balances.
5. Lender of Last Resort
The central bank helps the member banks strengthen their cash reserve position by rediscounting first-class bills in emergencies. Member banks can also take money or credit on approved short-term securities. These banks can then add this amount to their cash resources quickly. This way, the member banks can turn their assets into cash on short notice. Such a process promotes elasticity and liquidity in the banking and credit system economy.
Thus, the central bank is responsible for meeting commercial banks’ urgent and reasonable accommodation demands.
According to Sir Ralph George Hawtrey, the central bank's essential duty as the lender of last resort is to create a cash shortage among the competitive banks.
6. Clearing House
The central bank is a banker’s bank that keeps the cash balances of commercial banks and helps the member banks. It is also responsible for settling the accounts of commercial banks. Its function is that of a clearing house, an organization where the banks can offset their mutual claims against one another and settle by paying the difference.
Let us understand this through an example –
Suppose there are two banks. They draw cheques on each other. Suppose bank A has Rs. 10,000 from Bank B and is obligated to pay Rs. 12,000 to Bank B. At the clearing house, they can offset the mutual claims, where bank A pays off Rs. 2,000 to bank B, and the account is settled. The central bank’s clearinghouse contributes to the economy through cash, avoiding hectic communications and inconvenience.
7. Controller of Credit
Money and credits can play a huge role in determining income and employment levels. Currency expansion or contraction can lead to business fluctuations. Credit control is essential since commercial banks generate a lot of credit, resulting in higher inflation.
The central bank also controls or oversees commercial banks’ credit adjustment.
Central banks can influence commercial banks' deposits by performing open market operations and changing CRR to control various economic conditions. This control of the central bank over commercial banks, as regards their deposits, is called the controller of credit.
8. Protection of Depositor’s Interests
The central bank supervises the functioning of commercial banks to protect the interests of the depositors and ensure the development of banking on sound lines.
Therefore, the banking business has been recognized as a public service necessitating legislative safeguards to prevent bank failures.
The central bank is authorized to inspect commercial banks to ensure an efficient banking system with sufficient financial resources operating under proper management by the banking laws and regulations.
What will happen if the central banks do not perform their functions well?
If the central bank, such as the Reserve Bank of India (RBI), fails to function efficiently, the nation's economy might face certain issues. This is what might go wrong:
1. High Inflation or Deflation
What it means: Prices of goods and services can increase too rapidly (inflation) or decrease too drastically (deflation).
Why it happens: RBI regulates the money supply. If it prints excess or deficient money, prices become volatile.
2. Volatile Currency Value
What it means: The Indian Rupee's value in relation to other currencies can decline or fluctuate excessively.
Why it happens: The RBI operates the foreign exchange market. If it collapses, the rupee loses value, and imports become costly.
3. Fragile Banking System
What it means: Banks can turn unsafe, and individuals can lose confidence in keeping their money in banks.
Why it happens: The RBI monitors and controls banks. Weak monitoring can cause fraud, bad loans, or even bank failures.
4. Economic Slowdown
What it means: Employment can go down, firms can earn less, and the economy can grow very slowly.
Why it happens: The RBI controls interest rates and money flow. Incorrect decisions can render borrowing costly or cheap at the wrong moment.
5. Financial Crises
What it means: The nation can suffer severe economic issues, such as stock market collapses or bank failures.
Why it happens: The RBI should ensure financial stability. Failure to do so will lead to panic in the economic system.
6. Loss of Public Confidence
What it means: Individuals will lose faith in the banking system or government policies.
Why it happens: A robust central bank instils confidence in the economy, while its weak performance can lead to fear and uncertainty.
Conclusion
A central bank is the core of a country's financial system, ensuring stability, growth, and the smooth functioning of the economy. It lays the foundation for a strong and efficient banking system by performing key functions like regulating monetary policy, managing currency issuance, overseeing financial institutions, and safeguarding depositor interests. Its roles as the lender, custodian of reserves, and controller of credit further emphasize its role in solving financial crises and maintaining economic equilibrium. These functions of central bank are collectively crucial for a nation's economic health and long-term development.
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FAQs
How does a central bank regulate commercial banks?
Central banks regulate commercial banks by setting and enforcing prudential regulations, such as capital adequacy requirements, reserve ratios, and liquidity standards. They also conduct bank inspections and provide supervision to ensure the stability and soundness of the banking system.
What is the central bank's role in currency issuance and management?
A central bank has a monopoly on issuing currency within a nation. This role aims to regulate inflation control and provide confidence in the country's currency. The central bank upholds these principles:
- Issuing Legal Tender: A central bank alone can print and distribute currency notes with a view to uniformity and authenticity against counterfeits.
- Maintaining Currency Stability: The central bank ensures that there is not too much or too little currency in the system. Too much money creates inflation, whereas too little money can decelerate economic growth.
- Managing Foreign Exchange Reserves: The central bank holds foreign money reserves to stabilize the exchange rate and facilitate international trade.
How does a central bank contribute to economic growth?
Central banks contribute to economic growth by ensuring price stability, maintaining a stable financial system, and providing an enabling monetary policy environment. Central banks support economic growth by managing inflation, promoting stable financial conditions, and facilitating efficient payment systems.
Can a central bank influence the exchange rate?
A central bank can influence the exchange rate through its foreign exchange operations. By buying or selling foreign currencies in the market, a central bank can influence the supply and demand for its domestic currency, thus impacting the exchange rate.
How does a central bank act as a lender of last resort?
A central bank lends financial help to banks in times of liquidity crises. This role keeps banks from collapsing and safeguards the economy as a whole. The central bank does this in two ways:
- Direct Lending: In the short run, the central bank lends money to banks that cannot fulfil their commitments. This avoids panic within the banking sector.
- Upholding Public Confidence: In case the banks experience financial difficulties, the depositors can withdraw large cash withdrawals. The central bank comes to ensure stability by lending funds and upholding confidence in the banking sector.
What is the role of a central bank in regulating the money supply?
A central bank regulates the money supply to keep the economy stable. It employs several instruments, such as:
- Open Market Operations (OMO): Purchase and sale of government securities to manage liquidity.
- Cash Reserve Ratio (CRR) & Statutory Liquidity Ratio (SLR): Banks must hold some of their deposits as reserves in the central bank. Higher CRR contracts money supply, whereas lowering it expands liquidity.
- Repo Rate & Reverse Repo Rate: The central bank lends funds to commercial banks at a repo rate. The higher the repo rate, the more it discourages borrowing and tightens the money supply, while a lower repo rate encourages borrowing and enhances liquidity.
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