Functions of Central Bank

[Monirul Islam]

We discuss below its main functions:

1. Issue of Currency:
The central bank is given the sole monopoly of issuing currency in order to secure control over volume of currency and credit. These notes circulate throughout the country as legal tender money. It has to keep a reserve in the form of gold and foreign securities as per statutory rules against the notes issued by it.

It may be noted that RBI issues all currency notes in India except one rupee note. Again, it is under the directions of RBI that one rupee notes and small coins are issued by government mints. Remember, the central government of a country is usually authorised to borrow money from the central bank.

When the central government expenditure exceeds government revenue and the government is unable to reduce its expenditure, then it borrows from the RBI. This is done by selling security bills to RBI which creates new currency notes for the purpose. This is called monetisation of budget deficit or deficit financing. The government spends new currency and puts it into circulation to meet its expenditure.

2. Banker to Government:
Central bank functions as a banker to the government—both central and state governments. It carries out all banking business of the government. Government keeps their cash balances in the current account with the central bank. Similarly, central bank accepts receipts and makes payment on behalf of the governments.

Also, central bank carries out exchange, remittance and other banking operations on behalf of the government. Central bank gives loans and advances to governments for temporary periods, as and when necessary and it also manages the public debt of the country. Remember, the central government can borrow any amount of money from RBI by selling its rupees securities to the latter.

3. Banker's Bank and Supervisor:
There are usually hundreds of banks in a country. There should be some agency to regulate and supervise their proper functioning. This duty is discharged by the central bank.

Central bank acts as banker's bank in three capacities:

(i) It is the custodian of their cash reserves. Banks of the country are required to keep a certain percentage of their deposits with the central bank; and in this way the central bank is the ultimate holder of the cash reserves of commercial banks, (ii) Central bank is lender of last resort. Whenever banks are short of funds, they can take loans from the central bank and get their trade bills discounted. The central bank is a source of great strength to the banking system, (iii) It acts as a bank of central clearance, settlements and transfers. Its moral persuasion is usually very effective so far as commercial banks are concerned.

4. Controller of Credit and Money Supply:
Central bank controls credit and money supply through its monetary policy which consists of two parts—currency and credit. Central bank has monopoly of issuing notes (except one-rupee notes, one-rupee coins and the small coins issued by the government) and thereby can control the volume of currency.

The main objective of credit control function of central bank is price stability along with full employment (level of output). It controls credit and money supply by adopting quantitative and qualitative measures as discussed in Section 8.25. Following three quantitative measures of credit control by RBI are recalled for ready reference.

Instruments of money policy:

(i) Bank Rate (02009, 10C):
This is the rate of interest at which the central bank lends to commercial banks. It is, in a way, cost of borrowing. Cheap credit promotes investment whereas dear money discourages it. In a situation of excess demand and inflationary pressure, central bank increases the bank rate. High bank rate forces the commercial banks to raise, in turn, the rate of interest which makes credit dear. As a result, demand for loans and other purposes falls.

Thus, increase in bank rate by the central bank adversely affects credit creation by commercial banks. A decrease in bank rate will have the opposite effect. At present (Feb., 2013), bank rate (also called repo rate, i.e. the rate at which banks borrow from RBI) is 7.75% and Reverse Repo Rate (rate at which banks park their surplus funds with RBI) is 7.0%.

(ii) Open Market Operations:

These refer to buying and selling of government securities by central bank to public and banks. This is done to influence money supply in the country. Mind, sale of government securities to commercial banks means flow of money into the central bank which reduces cash reserves. Consequently, credit availability of commercial banks is curtailed / controlled. When central bank buys securities, it increases cash reserves of the banks and their ability to give credit.

(iii) Cash Reserve Ratio (CRR):

Commercial banks are required under the law to keep a certain percentage of their total deposits with the central bank in the form of cash reserves. This is called CRR. It is a powerful instrument to control credit and lending capacity of the banks. Presently (Feb., 2013), CRR is 4.0%.

To curtail the credit giving capacity of the banks, central bank raises the CRR but when it wants to enhance the credit giving powers of the bank, it reduces the CRR. Similarly, there is another measure called Legal Reserve Ratio (A2012)—LRR which has two components—CRR and SLR. According to Statutory Liquidity Ratio or SLR, every bank is required to keep a fixed percentage (ratio) of its assets in cash called liquidity ratio. SLR is raised to reduce the ability of the banks to give credit. But SLR is reduced when the situation in the economy demands expansion of credit.

5. Exchange Control:
Another duty of a central bank is to see that the external value of currency is maintained. For instance, in India, the Reserve Bank of India takes steps to ensure external value of a rupee. It adopts suitable measures to attain this object. The exchange control system is one such measure.

Under exchange control system, every citizen of India has to deposit with the Reserve Bank of India all foreign currency or exchange that he receives. And whatever foreign exchange he might need has to be secured from the Reserve Bank by making an application in the prescribed form.

6. Lender of Last Resort:
When commercial banks have exhausted all resources to supplement their funds at times of liquidity crisis, they approach central bank as a last resort. As lender of last resort, central bank guarantees solvency and provides financial accommodation to commercial banks (i) by rediscounting their eligible securities and bills of exchange and (ii) by providing loans against their securities. This saves banks from possible failure and banking system from a possible breakdown. On the other hand, central bank, by providing temporary financial accommodation, saves the financial structure of the country from collapse.

7. Custodian of Foreign Exchange or Balances:
It has been mentioned above that a central bank is the custodian of foreign exchange reserves and nation's gold. It keeps a close watch on external value of its currency and undertakes exchange management control. All the foreign currency received by the citizens has to be deposited with the central bank; and if citizens want to make payment in foreign currency, they have to apply to the central bank. Central bank also keeps gold and bullion reserves.

8. Clearing House Function:
Banks receive cheques drawn on the other banks from their customers which they have to realise from drawee banks. Similarly, cheques on a particular bank are drawn and passed into the hands of other banks which have to realise them from the drawee banks. Independent and separate realisation to each cheque would take a lot of time and, therefore, central bank provides clearing facilities, i.e., facilities for banks to come together every day and set off their chequing claims.

9. Collection and Publication of Data:
It has also been entrusted with the task of collection and compilation of statistical information relating to banking and other financial sectors of the economy.

Source: http://www.economicsdiscussion.net/banks/top-9-functions-of-central-bank-explained/613