Differences between a Central

Bank and Commercial Bank

Central Bank:
1. Work for the public welfare and economic development of a country.
A central bank is governed by the government of a country.

2. Controls and regulates the entries banking system of a country.

3. Does not deal directly with the public. It issue guidelines to

commercial banks for the economical development of the country.

4. Issues currency and control the supply of money in the Market.

5. Acts as a state owned institution.

6. Act as a custodian of a foreign exchange of the country.

7. Act as a banker to the Government.

8. Controls credit creations in the economy, thus acts as a clearing

house of other banks.
Commercial Bank:
1. Operates for Profit Motive. The Majority of Stake is held by the
government as well as the private sector.

2. Operates under the direct control and supervision of the central

bank. In India all the commercial banks works under the guidelines
issued by RBI.

3. Deals directly with the Public. It serves the financial requirement of

the public by providing short and medium terms loans and depositing
and securing money that can be drawn on demand.
4. Does not Issue currency, but only adds to the approval of the central
bank.

5. Acts as a state or private owned institution.

6. Perform foreign exchange business only on the approval of the

central bank.

7. Acts as agents of the central bank.

8. Acts as a clearing house only as a agent of the central bank.

Functions and Responsibilities

of the Central Bank and
Commercial Banks
The Central Bank
The primary function of the central bank is to control the money supply in the economy. It is
responsible for issuing currency on behalf of the government. In addition to this primary function, the
central bank performs the following duties:
1. It receives the state revenues, keeps deposits of various departments and makes payments on
behalf of the government.
2. It keeps the cash reserves of the commercial banks, acts as a clearing-house for the inter-bank
transactions and as a lender of last resort. It supervises the commercial banking system and
ensures its smooth running.
3. It controls the money and capital markets by changing the supply of money and thereby the
rate of interest. The objective is to keep equilibrium in these markets.
4. It is the custodian of the foreign exchange. It has to keep a closer check on the external value
of the domestic currency and prevent its deterioration.
5. It is the adviser to the government in all the monetary affairs. It is responsible for the
formulation and implementation of the monetary policy.
The objective of the central bank is to ensure the internal and external stability of the currency.
Internal stability means keeping the purchasing power of the money intact and preventing its
deterioration. In other words, it has to maintain the rate of inflation within tolerable limits, if its
curtailment is not feasible altogether. External stability implies keeping a balance between export
and import or prevention of the foreign exchange value of domestic currency from depreciation. In
developing countries, the central bank is also concerned with the progress and development of the
economy. It provides financial support to various development programs of the government. The
central bank adopts various measures to control the money supply and commercial credit. The bank
exercises its authority via different instruments of credit control. We discuss these measures very
briefly.

Quantitative Measures or Instruments of Credit Control:

These measures directly affect the quantity of money supply in the economy:
1. Open market operations: This is the most frequently used instrument or the routine practice to
control the money supply. However, its effectiveness depends on the perfection of the capital
and money markets. The central bank sells government securities (called treasury bills) to the
general public if a contractionary policy is desired. In contrast, it buys back these bonds and
diffuses extra money into the economy if an expansionary policy is to follow. This is the medium
of government borrowing at the market rate of interest.
2. The bank rate policy: The rate of interest at which the central bank offers loans to commercial
banks or discounts their bills is called ‘Bank Rate’ and the rate at which the commercial banks
extend loans to the general public is called the ‘Market Rate’. A change in the bank rate is
followed by a corresponding change in the market rate. Thus it is another powerful instrument
of credit control; however, it is rarely used.
3. Variation in Capital Reserves: All commercial Banks are required (by law) to keep a fixed
proportion of deposits as reserves with the central banks. This is known as a reserve ratio; the
power of the commercial banks to extend loans is reduced. This instrument is also rarely used.
4. Variation in Cash Reserves: The commercial Banks are also required to keep a fixed
proportion of their total deposits in cash form, standing ready to honor the Checks of customers
and to avoid solvency problem. By increasing this cash-reserve proportion, the central bank
can limit the autonomy of the commercial banks to credit. However, the banks may not strictly
follow the advice of the central bank in this case.
These measures do not affect the quantity of money/ credit percent, rather these can redirect the
flow of credit to particular purposes/ channels. These include:
1. Moral Persuasion: The central bank can advise the commercial banks to follow either a loose
or tight credit policy, i.e. to extend loans on easy terms for one purchase/time and on tight
terms for some other purchase/time. However, the commercial banks are not obliged to follow
such instructions very strictly. If this is the case, then credit rationing may be applied.
2. Direct Action: The central bank may take a direct action in case the commercial banks do not
respond to its instructions carefully. It may refuse to discount the bills of a particular bank or
even may blacklist it /debar it from the business.

The Commercial Banks

The commercial bank is an organized financial institution that deals with the business of credit
(borrowing and lending of money). The commercial banks are financial intermediaries between
savers and investors. Like other business firms, the main objective of commercial banks is to earn
profits. The bank accepts deposits from its customers and thus raises large funds that can be loaned
out. These may be in the form of demand deposit (readily available for checking: often called current
accounts on which the banks pay no interest), or time deposits (which can be available only for
business/loan extension). The saving deposits fall in between the two, which can be withdrawn
occasionally. The deposits accepted by a bank are its liability and the loan extended to the clients as
well as the bonds/shares of firms held by the bank constitute its assets. The bank earns
interest/profit on its investment a part of which is passed on to the depositors and the remaining is
appropriated.

The Process of Credit Creation

The commercial banks provide an easy medium of exchange in the form of checks, drafts, credit
cards etc. These are called bank notes or instruments of credit. These constitute a considerable part
of the total money supply in the economy. Anyhow, the banks cannot create money from thin air;
they convert physical wealth into liquid money. There must be an initial deposit with the bank to start
the process. Further, the power of the banks to create credit is limited by the reserve requirements.
A simple example: Suppose the central bank decides to expand money supply in the economy and
purchase back government bonds held by the general public: ∆H=100 thousands. The individuals
concerned get checks which they deposit in their accounts held in the commercial banks. The
process of credit creation starts since the commercial banks are now in a position to offer loans to
interested parties against collateral (documents of physical assets). The banks will transfer a fraction
of deposits to the central as legal reserves: z=20% and open ‘supposed account’ worth 80 thousand
at the credit of clients and allow them to draw, as they wish, through checks. Suppose further that
the borrowers have to make payments to some other parties and the payments are again made
through checks drawn on the commercial banks concerned. A such the banks will receive fresh
deposits and therefore enabled to advance further loans against collaterals. The process may
continue in geometric progression indefinitely.

The total increase in money supply by the end of the process will be many folds as compared to the
original step taken by the central bank. The above model is based on the assumption that all
transactions are made through checks and the banks can find individuals at each stage borrowing
against collateral. The process will break if these conditions are not fulfilled.