Central Bank and Its Functions
Central Bank and Its Functions
Central Bank and Its Functions
BANK: A bank is a financial institution whose demand deposits are widely accepted as money for making
payments and which has the power to create money.
TWO CHARACTERISTIC FUNCTIONS OF BANK
1) Bank deposits are chequable: Banks allow their depositors to withdraw their money without giving
any notice to the banks simply by writing cheques.
2) Banks create money: Banks demand deposits are a part of money supply. Banks lend money to the
borrowers by opening demand deposit accounts in their names. The borrowers are then free to use
this money by writing cheques.
CENTRAL BANK: It is a bank specially created by the government to serve as an apex bank to carry out
monetary policy of the country in public interest through the various functions assigned to it.
It was formed in 1935
2. Banker to the government: Central Bank functions as a banker to the Central and State
governments in the following manner:
a) It carries out all the banking business of the government by keeping the cash balance of the
government in the current account
b) It accepts deposits from the government and makes payments on its behalf.
c) It gives loans and advances to the government against treasury bills.
d) It works as an agent of the government by managing public debt by undertaking payment of
interest on this debt .It advises the government on the quantum, timing and terms of such loans.
e) It gives advice to the government regarding money market, capital market, government loans and
on economic policy matters.
f) It works as an agent in matters of collection of taxes etc.
SIGNIFICANCE: This function signifies mutual and common interest of the Central Bank and Govt.
3. Banker’s Bank and Supervisor/ Lender of last resort: It acts as the Banker’s bank in the
following manner:
a) It fixes the percentage of cash reserves which the commercial banks are required to keep with the
Central Bank from their demand deposits called as CRR. The central Bank uses these reserves to
meet the emergency cash needs of individual commercial banks by granting them loans.
b) It also fixes the percentage of cash reserves which the commercial banks are required to keep
with them from their demand deposits called SLR. These reserves ensure that commercial Banks
have enough cash to meet the daily demand of their depositors.
c) It supervises the functioning of commercial Banks by making rules regarding licensing,
management, branch expansion etc and also undertakes periodic inspection.
d) It acts as the lender of the last resort by rediscounting their eligible securities and bills of
exchange and providing loans against them.
e) It acts as a bank of central clearance,settlements and transfers.(It has a clearing house where
mutual indebtedness between banks is settled. The representatives of different banks meet daily
to settle interbank payments. These differences in payment are settled by transfer between their
respective accounts with the central bank.)
SIGNIFICANCE: It economises the use of money in the Banking Operations.
4. Controller of money supply and credit: Credit control is the most crucial function played by any central
bank in modern times. The central Bank can change the money supply and credit through a number of tools
and instruments which are as follows:
f) Varying Legal Reserve requirements: Legal reserve ratio refers to the minimum percentage of
deposits which the commercial banks are required to keep with themselves and with the
central bank. It has 2 components:
a) SLR is the minimum percentage of deposits to be kept by a commercial bank with
itself. It is kept in the form of cash, gold and government securities.
b) CRR is the minimum percentage of deposits to be kept by a commercial bank with the
central bank. It is also called the reserve ratio or required reserve ratio.
● If the central bank raises the amount of legal reserves i.e SLR and CRR, the amount of
effective deposits left with commercial banks is reduced. This reduces the capacity of
commercial banks to create credit. Lending falls and so falls the money supply in the
economy.
● When the Central Bank reduces CRR or SLR or both, more money is left with
commercial banks for lending. As lending increases, the money creation increases and
money supply in the economy increases.
(Note: Open market operations, CRR, SLR and reverse repo rate together determine the credit creation
capacity of commercial banks while Repo rate, Bank rate and margin requirements determine demand for
loans from banks.)
Commercial Banks are financial institutions which accept demand deposits from the general public,
transfer funds from one bank to another and create money. They accept deposits from the public and lend
out part of these funds to those who want to borrow. The interest rate paid by the banks to depositors is
lower than the rate charged from the borrowers. This difference between these two types of interest rates,
called the ‘spread’ is the profit appropriated by the bank.
All commercial banks can create deposits or credit which is much larger than their initial deposit. When a
Bank gives a loan to a customer and that customer deposits the loan amount in the bank itself, then total
bank deposits and therefore total money supply will rise. There is a limit to money or credit creation by
banks and this is determined by the Central bank (RBI). The RBI decides a certain percentage of deposits
which every bank must keep as reserves. This is done to ensure that no bank is ‘over lending’. This is a legal
requirement and is binding on the banks. This is called the ‘Required Reserve Ratio’ or the ‘Reserve Ratio’
or ‘Cash Reserve Ratio’ (CRR).
Cash Reserve Ratio (CRR) = Percentage of deposits which a bank must keep as cash reserves with the bank.
Apart from the CRR, banks are also required to keep some reserves in liquid form in the short term. This
ratio is called Statutory Liquidity Ratio or SLR. The statutory requirement of the reserve ratio acts as a limit
to the amount of credit that banks can create.
Thus, the total deposits that are created depend upon 2 factors:
● Amount of initial deposits
● Legal Reserve Ratio(LRR)/CRR
Suppose a new deposit of Rs 1000 is made in the bank. Let LRR be 10% then the bank would keep 10% i.e.
Rs 100 as the reserve and can advance loan upto Rs 900. This is the first round of credit creation.
Suppose the borrowers withdraw the entire amount of loan and spend the same on the goods and services
needed for investment and consumption. It means that the sellers of these goods and services receive Rs 900
of revenue and deposit the same in their respective bank accounts. The Banks get new deposits. Again they
keep 10% of these deposits i.e Rs 90 as cash and lend the remaining 810 RS. This is the second round.
In the same manner as above, the third round creation of deposits would mean cash reserve of Rs 81 and
loan of Rs 729.
Likewise, in each successive round, deposits would be created but they would become smaller and smaller
and ultimately virtually become zero. The sum total of all deposits would be equal to the money created.
Thus, Money creation = (1/ LRR ) * initial deposit (Money creation = (1/ CRR ) * initial deposit)
1/LRR is called the deposit multiplier or money multiplier. The multiple by which deposits can increase due
to an initial deposit is called money multiplier.
This way we can see that if LRR is 10% and initial deposit is Rs 1000, a commercial bank is able to create
10000 Rs worth of deposits. Deposit creation comes to end when total cash reserves become equal to the initial
deposit.
Round Deposits Loans Cash reserve
I 1000 900 100
II 900 810 90
III 810 729 81
ː ː ː
ː ː ː
Total 10000 9000 1000
DIFFERENCE:
CENTRAL BANK COMMERCIAL BANK
It is governed by the people connected with It can be governed by both government and
the government. private sectors
The primary objective of central bank is Its primary objective is maximisation of
monetary management of the economy profits.
It does not undertake ordinary banking It undertakes ordinary banking business with
business with the general public and deals the general public.
with the government only.
It adds to the money supply by printing new It adds to the money supply by creating
currency notes. demand deposits.
There is only one central bank in the economy. There can be many commercial banks in the
country.
ADDITIONAL READING...NCERT
Assume that there is only one bank in the country. Let us construct a fictional balance sheet for this bank.
Balance sheet is a record of assets and liabilities of any firm. Conventionally, the assets of the firm are
recorded on the left hand side and liabilities on the right hand side. Accounting rules say that both sides of
the balance sheet must be equal or total assets must be equal to the total liabilities.
Assets are things a firm owns or what a firm can claim from others. In the case of a bank, apart from
buildings, furniture, etc., its assets are loans given to the public. When the bank gives out a loan of Rs 100 to
a person, this is the bank’s claim on that person for Rs 100. Another asset that a bank has is reserves.
Reserves are deposits which commercial banks keep with the Central bank, Reserve Bank of India (RBI)
and its cash. These reserves are kept partly as cash and partly in the form of financial instruments (bonds and
treasury bills) issued by the RBI. Reserves are similar to deposits we keep with banks. We keep deposits and
these deposits are our assets, they can be withdrawn by us. Similarly, commercial banks like State Bank of
India (SBI) keep their deposits with RBI and these are called Reserves.
Assets = Reserves + Loans
Liabilities for any firm are its debts or what it owes to others. For a bank, the main liability is the deposits
which people keep with it.
Liabilities = Deposits
The accounting rule states that both sides of the account must balance. Hence if assets are greater than
liabilities, they are recorded on the right hand side as Net Worth.
Net Worth = Assets – Liabilities