Banks: Commercial Bank and Central Bank

Question 1

Define a Central Bank. [2 marks]

A central bank is the apex institution in the banking and financial structure of the country.
It has the responsibility of supervising, regulating and developing the banking and financial
structure of the economy.
Examples: Reserve Bank of India is India’s Central Bank, Bank of England in England,
The Federal Reserve System in United Sates of America.

Question 2

State the functions of a Central Bank. (2/3/6 marks)

Issuing paper notes/Bank of Issue :

The Central Bank has the sole authority of issuing paper notes. In order to prevent
misuse of this power, commercial banks do not enjoy any such right. This is
because commercial banks are profit-maximising firms, who can manipulate the
amount of paper notes to suit its own objectives. Hence, this may not be conducive
to the economic interests of the country.
The Government of India also do not possess this power as there is a change of
Government from time to time, which may adversely affect the interests of the
economy.

Banker, fiscal agent and advisor to the Government:

- Banker – The Central Bank receives deposits of cash, cheques, drafts etc. from
the Government. It provides cash to the Government for paying salaries and
meeting other cash disbursements.
It also gives short-term loans to the Government and buys and sells foreign
currencies on behalf of the Government.

- Fiscal Agent – The Central Bank manages public debt, issues loans on behalf of
the Government, receives subscriptions for these loans, pays interest on them
and acts as the Government’s agent in enforcing exchange control.

- Advisor – It advises the Government on all financial and monetary matters and
in the formulation of economic policies such as policies for the control of

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 inflation or deflation, devaluation or revaluation of the currency, foreign trade
policy, budgetary policy etc.
Acting as a banker to banks:
- Commercial banks keep deposits with the Central Bank, which is a certain
percentage of their total deposits at a point of time. This percentage is
determined by the Central Bank.

- Commercial banks can borrow from the Central Bank if they need loans and
cannot raise the money from any other source. That is why the Central Bank is
known as the ‘Lender of the Last Resort’.

- Rediscounting bills of exchange is also a function of the Central Bank. If a

buyer in the market signs a bill, the seller can get the money from a commercial
bank by selling the bill to the bank. The bank will collect the amount from the
buyer after a period of 90 days. However, if the bank needs the money before
the maturity date, it can then go to the Central Bank and get it re-discounted.
However, the Central Bank would refuse to re-discount such bills unless the
original buyer is a well-known person or firm.

Custodian of nation’s foreign exchange reserves:

- All foreign exchange transactions are routed through the Central Bank which
controls both the receipts and payments of foreign exchange. This foreign
exchange helps to restore equilibrium in the balance of payments.

- It helps to maintain the stability of the exchange rate i.e. to minimise

fluctuations in the exchange rate, the Central Bank buys or sells foreign
currencies in the market.

- It also enforces exchange control regulations as prescribed by the Government

from time to time.

Lender of the Last Resort:

When commercial banks have exhausted their resources and are in need of funds,
they approach the Central Bank to tide over this financial crisis. The Central
Bank, in such times, assists the financial institutions through discounting of
approved securities and collateral loans and advances.

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Clearing House for transfer and settlement of mutual claims of
commercial banks:
- The customers of different banks issue cheques drawn on their banks, which
create the need for settling claims of different commercial banks.

- The Central Bank provides clearing house facilities in different cities and trade
centres for transfer and settlement of mutual claims of the bank. Since
commercial banks keep their cash reserves with the Central Bank, they clear and
settle claims on each other by making transfer entries in their accounts
maintained with the Central Bank.

Controller of credit:
- The supply of credit in an economy must be regulated so as to ensure the
smooth functioning of the economy. Thus, the Central Bank adopts various
quantitative and qualitative measures of credit control.

- The quantitative methods aim at controlling the cost and availability of credit,
while the qualitative methods influence the use and direction of credit.

Promotional and developmental functions:

- The Central Bank is entrusted with the responsibility of developing and
promoting a strong banking system. As result, it provides liberal and cheap
rediscounting facilities to commercial banks and also gives various types of
concessions.

- It assists the development of financial institutions like Development Banks to

provide funds for the development of agriculture and other sectors of the
economy.

- It also helps in the development of money and capital markets.

- It also pursues appropriate monetary policy to promote economic development.

Stabilising the value of money:

- The Central Bank stabilises the value of money i.e. stabilising the price level by
changing the supply of money in the economy. When it issues more paper notes
or increases the volume of credit in the economy, the supply of money
increases. When it draws paper notes out of circulation or reduces the volume of
credit in the economy, the supply of money decreases.

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 - During inflation, the Central Bank decreases the money supply by adopting
appropriate quantitative or qualitative methods of credit control.

- During deflation, the Central Bank increases the money supply by the use of
appropriate credit control instruments.

Supervising the working of financial institutions:

The Central Bank in order to carry out the responsibilities of supervising the
working of all financial institutions in the country can examine the account books or
inspect the activities of any financial institution at any time.

Publication of economic and statistical information-

The Central Bank collects and publishes periodical reports comprising of economic
and statistical information related to different aspects of the economy. This
information enables the Government to formulate appropriate economic policies to
promote economic development.

Question 3

Discuss the quantitative methods of credit control adopted by the Central

Bank in an economy. (2/3/6 marks)

Quantitative methods of credit control seek to control the overall quantity of

credit and cost of credit in general.

The various credit control instruments are:

Bank Rate:

- It is the minimum rate at which the Central Bank gives loans and advances to the
commercial banks or re-discounts the approved first class bills of exchange and
Government securities held by the commercial banks.

- To check inflationary pressure, the Central Bank increases the bank rate which
leads to an increase in the lending rates of commercial banks (i.e. the interest rate
charged by commercial banks on their loans given to customers). Thus, the
higher cost of credit discourages people to take loans resulting in a fall in
investment and thereby, income.

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- During deflationary situations, bank rates are lowered which leads to lower rates
of interest charged by commercial banks, thereby, encouraging credit.

Cash Reserve Ratio (CRR):

- Cash Reserve Ratio is the minimum percentage of the total deposits with the
commercial banks which they are required to maintain in the form of cash
reserves with the Central Bank.

- During inflationary situations, the CRR is increased which reduces the excess
reserves with the commercial banks. Thus, the commercial banks will be in a
position to create only a smaller amount of credit.

- During depression, the CRR is decreased which increases the volume of excess
reserves and thus, helps in generating more credit.

Statutory Liquidity Ratio (SLR):

- It refers to the proportion of total deposits that a commercial bank has to keep
with itself in the form of cash reserves, gold and government securities.

- If the Central Bank wants to reduce credit, then SLR is increased, compelling the
commercial banks to reduce its credit operations.

- If the Central Bank wants to expand credit, the SLR is reduced to increase the
volume of excess reserves with the commercial banks to help increase credit
operations.

Open Market Operations (OMO):

- It refers to the sale and purchase of Government and other approved securities
by Central Bank in the money and capital market.

- During times of inflation, the Central Bank sells the Government securities in
the open market to pump out excess liquidity from the system. Most of these
securities are purchased by the commercial banks and other financial institutions.
- During deflation, the Central Bank aims to expand credit by purchasing
Government securities from the commercial banks and other financial
institutions. This in turn increases the money supply in the economy

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 [For a question on Quantitative methods of credit control, the
above measures are to be mentioned.]

Liquidity Adjustment Facility (LAF):

- The Central Bank follows a LAF policy to regulate the fluctuations in the interest
rate in the market. The market rates of interest fluctuate because of the mismatch
between supply of and demand for liquid assets.

- If there is excess demand for liquidity, the Central Bank facilitates the flow of
credit supply in the economy by purchasing Government securities from the
commercial banks for a very short period (usually 7 days). An agreement takes
place between the commercial banks and Central Bank that the commercial
banks will re-purchase those securities at a given price after a given period of
time from the Central Bank. The interest rate charged by the RBI is called as the
‘repo-rate.’

- When the Central Bank wants to pump out excess liquidity from the market, it
sells the Government securities to the commercial banks with such re-purchasing
agreement. Interest rate charged in such a case is called as the ‘reverse
reporate’.

For understanding and reference:

In reality, the RBI has replaced the bank rate with ‘repo rate’ as
the monetary instrument to manage liquidity and interest rate in the
country.
Given below are the current interest rates as followed by RBI:

Ø Bank rate: 4.65 %

Ø CRR: 3%
Ø SLR: 18.50 %
Ø Repo rate: 4%
Ø Reverse repo rate: 3.35 %

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Question 4

Discuss the qualitative/selective methods of controlling credit by the

Central Bank in an economy. (2/3/6 marks)

Qualitative or Selective methods of credit control aim at regulating and

controlling the allocation of credit among various users rather than influencing
the general availability of credit.

The various credit control instruments are:

Regulation of Consumer Credit:

- It aims at regulating the consumer instalment credit on hire-purchase finance.

- In case of certain durable goods, a part of the price is paid as cash down-
payment and the remaining amount is financed by bank credit.
- During inflation, the bank raises the amount of down –payment and reduces the
maximum period of re-payment.
- When Central Bank wants to expand credit, the amount of down-payment is
reduced and the period of repayment is increased.

Regulation of margin requirement/Margin money:

- Commercial banks usually give loans to their customers against some

securities.
- The difference between the value of security and the amount of loan granted
against these securities is known as margin requirement.
- The Central Bank increases the margin requirement to curb bank credit and
reduces the margin requirement when it wants to expand credit.

Credit Rationing:

- This aims at limiting the maximum limit (ceiling) of loans for specific
purposes. - Rationing may take two forms-
• The Central Bank may fix the maximum amount of loans and advances
which can be given by a commercial bank.
• The Central Bank may fix the maximum ratio of loans and advances of
commercial banks to its total deposits.

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 Depending upon the need of the economy, the Central Bank may increase or decrease
the ceiling of bank credit through these two ways and thereby increase or decrease
the power of the commercial banks to create credit.

Direct Action:

This refers to the various directives issued by the Central Bank from time to time for
regulating credit of commercial banks. This policy is used by the Central Bank
against erring banks. Direct actions may take the form of refusal of loans from the
Central Bank, refusal of rediscounting facilities, charging a penal rate of interest
against the erring bank.

Moral Suasion:

It is a method of persuasion, request, informal suggestion and advice given by the

Central Bank to the commercial banks. The Central Bank may convene meetings for
heads of commercial banks and explain to them the various monetary policies and
the need to follow them. It is a moral appeal by the Central Bank to the commercial
banks urging them to restrain from certain lines of credit operations.

Publicity:

The Central Bank can put forward the various monetary and banking policies
through the media of publicity. This is not only used to influence credit policies of
commercial banks but also influence the public opinion of the country.

Differential rates of interest:

This relates to the discriminatory rate of interest charged on certain lines of

advances provided by commercial banks.

[Points have been mentioned in the order of their importance.]

Question 5

How do commercial banks differ from the Central Bank of a country?

(3/6 marks)

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 Central Bank Commercial Banks

1. It is the apex institution in the 2. A commercial bank is a constituent

banking structure of the country. unit in the banking structure of a
country, operating under the control
of the Central Bank.
3. It acts in the public interest for the 4. Its main objective is to maximise
economic welfare of the country. profits.

5. The Central Bank acts as a banker to 6. Commercial banks act as a banker to

all commercial banks. many individuals who keep deposits
with commercial banks.
7. The objective of the Central Bank is 8. Commercial banks mobilise savings
to ensure proper functioning of the and channelize these into proper use.
economy.

9. A Central Bank has the sole 10. Commercial banks have the power
monopoly of note issue. of creating deposit money.

11. A Central Bank acts as a banker, 12. The commercial banks have no
fiscal agent and advisor to the such responsibilities towards the
government. Government.

13. Every country has only one Central 14. There are number of commercial
Bank. banks in a country with a large
number of branches all over the
country.

15. The Central Bank is owned by the 16. Commercial banks may either be
State. owned by the State or by private
bodies.

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 Question 6

Distinguish between quantitative and qualitative methods of credit

control. [2/3/6 marks]

Quantitative Credit Control Qualitative Credit Control

1. This credit control measure aims at 1. This measure aims at controlling the flow
regulating the total volume of credit in the of credit in some selected or particular
economy. sectors of the economy.

2. It regulates the availability of loanable 2. It regulates the flow of credit from the
funds with the commercial banks and commercial banks on the basis of the purpose
controls investment in all sectors of the of investment or the credit-worthiness of the
economy. borrower.

3. This credit control measure uses 3. This credit control measure uses the credit
instruments like bank rate, cash reserve control instruments such as margin money,
ratio, statutory liquidity ratio and open differential rates of interest etc.
market operations.

4. This measure affects equally the 4. This measure encourages the flow of credit
backward and advanced sectors of an in some priority sectors and does not affect
economy. the backward rural economy of a country.

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