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Explain the concept of Central Banking

Today all the countries have a Central Bank, which controls their entire banking system. The first Central Bank was the Swedish Risks Bank established in 1688. The Bank of England was established in 1694 and nationalized in 1946 under Bank of England Act, 1946. There banks were established not to provide direct credit to trade and commerce, but to provide money to their governments and they were given special privileges over the issue of notes. In course of time the range of their operations widened and they began to render their governments a variety of services. In the 19th century many other European countries established their own Central Banks. But the current Central Banking is the idea of 20th century and look several decades to mature into the present form. The Federal Reserve Bank of USA was established in 1914. An International Conference on Monetary System was held in 1920 at Brussels to consider the currency chaos after the First World War. It recommended that every country having a currency of its own should have Central Bank. Now there is no civilized country which does not possess a Central Bank. In India the Reserve Bank of India Act was passed in 1934 and Bank began functioning from April, 1935.

The name Central Bank is given to that bank which is entrusted with the task of controlling the issue of money and regulating all the other banks of the country. Here the task controlling involves the managing of both expansion and contraction of the volume of money in the country.

Definitions of Central Bank

The Central Bank is defined by various authorities as follows:

  • RG. Hawtrey defnies Central Bank as lithe lender of last resort.
  • Kisch and Elvin holds the view that the essential function of a Central Bank is the maintenance of the stability of monetary standard.
  • Whaw W.A. defines the Central Bank as ‘the bank’ whose main function is control of credit.
  • Vera Smith holds as, “the primary definition of central banking is a system in which a single bank has either a complete or a residuary monopoly in the note issue”.
  • Sayers RS claimed as, “the business of a Central Bank is to control the commercial banks in such a way as to promote the general monetary policy of the state”.

The above definitions are not sufficient because they do not provide the entire picture and idea of the Central Bank. Thus, it can be defined as, “the strategic level, banking and monetary institutions primarily engaging in controlling, anti regulating the banking and monetary systems of the country for the progress of the economy”.

Nature of Central Banking

The basic nature of Central Banking can be enumerated as follows:

  1. The Central Bank does not aim at profits but aims at national welfare.
  2. The Central Bank does not compete with the member banks.
  3. The Central Bank has special relationship with government and with commercial banks.
  4. The Central Bank is generally free from political influence.
  5. The Central Bank is the apex body of the banking structure of the country.
  6. The Central Bank should have overall control over the financial system.

Functions of The Central Bank

Central Banks differs from country to country in their structure and organization, in their policies and techniques. But their functions are very similar. The Central Bank renders the following important functions in almost all countries.

  1. Issuing of notes and regulating the volume of currency.
  2. Acts as banker to the government.
  3. Acts as banker to the banks.
  4. Acts as custodian of Nation’s reserves.
  5. Acts as the lender of last resort.
  6. Functions as National Clearing House.
  7. Acts as controller of credit.
  8. Publishes economic statistics and other information.
  9. Development functions.
  10. Supervises the activities of financial institution.

Issue of notes and regulation of the volume of currency

The Central Bank is legally empowered to issue currency notes. The Central Bank is charged with the responsibility of maintaining price stability, inflations level, i.e., the domestic value of its money as well as its external value. The supply of money consists of the legal lender money and the bank money. The Central Bank has the monopoly power of the note issue to regulate the supply of legal tender money. This enables it to impart elasticity to the currency system and to maintain stability in the circulation of money. In Hong Kong the responsibility of issuing currency notes has been entrusted with a private sector bank, viz. Hong Kong and Shanghai Banking Corporation (HSBC). By the function of note issue the central bank achieves the following merits :

  1. Enhance the public confidence on the monetary system.
  2. Maintaining uniformity in the monetary system throughout the country.
  3. Flexibility in the monetary system, By the function of note issue at desired level.
  4. Credit creation can be effectively controlled. The sole right of note issue enables the Central Bank to regulate the creation of credit by commercial banks and adjust the supply of money to the demand for it.
  5. Maintaining the internal and external value of money.

The Central Bank follows different systems of note issue according to the currency regulations. The different systems of currency are,

  1. Fixed fiduciary system
  2. Minimum fiduciary system
  3. Proportional Reserve system.
  4. Foreign exchange reserve system.
  5. Minimum Reserve System.

Whatever may be the system three basic principles are to be followed. They are:

  1. Uniformity
  2. Security and
  3. elasticity.

The currency issued must be uniform and a single authority must, be vested with the power of note issue to achieve uniformity. There must be security for the currency without any dangers of over issue. Public must have confidence in the currency, which to some extent, depends upon the gold and foreign exchange reserves it holds. At the same time the currency supply must be clastic. The Central Bank must be able to expand or to contract the supply of currency according to the changing needs from time to time.

Banker to the Government

The Central Bank acts as the banker, financial agent and advisor to the government. The surplus money of the government is kept with the Central Bank. It lends money to both central and state governments. It helps the government to tide the time gap between their expenditure and collection of taxes. The Central Bank is usually required to make temporary advances to the government in anticipation of collection of revenues. These advances are known as ways and means advances in India and are made for short periods. The Central Bank also undertakes to provide the government with necessary foreign exchange for making payments abroad.

It is necessary that there should be close co-operation between the Central Bank and the government. The government is the ultimate authority for laying down the broad monetary policies of the country and Central Bank is the institution for carrying out of such policies.

The Central Bank as a fiscal agent to the government accepts loans and manages public debts, receives taxes and other payments from the public. The government bonds and treasury bills are issued by the Central Bank on behalf of the government.

As the financial adviser, the Central Bank provides valuable advice to the government on important financial matters like, foreign exchange policy, commercial policy, raising of funds from market, etc.

Banker to the banks

The Central Bank Acts as the bankers bank. As such it performs the following functions :

  1. Custodian of cash reserves of commercial banks. The commercial banks of the country are required to keep a certain percentage of their deposits with the Central Bank.
  2. It secures the advantage of centralized cash reserve. In India the Central Bank is authorized to vary these reserve requirement within certain limits. Such cash reserves with the Central Bank has the following advantages.
    1. The centralization of cash reserve is a source of great strength to the banking system of the country as it strengthens the confidence of the public.
    2. Centralised reserves can be used effectively and quickly in times of emergency.
    3. This ensures liquidity and import economy in the credit structure of the country.
    4. These reserve promote liquidity of commercial banks as they enable the Central Bank to underrate rediscounting of bills on a more extensive scale for the purpose of meeting the requirements of the money market.
    5. The Central Bank can control credit by varying the cash reserves that commercial banks should keep with it.

Act as custodian of National reserves

Central Bank is the custodian of nation’s gold and foreign exchange reserves. Previously, to some extent the value of a currency depends upon the gold reserves or foreign exchange reserves held as the backing for the currency. As such, it is the responsibility of the Central Bank to maintain sufficient reserves and to prevent their depletion. The Central Bank manipulates the bank rates and takes other steps to conserve the reserves of gold and foreign exchange. Some Central Banks have absolute powers to control the foreign exchange reserves and to licence the various uses to which the foreign exchange reserves and to licence the various uses to which the foreign exchange is put to use. In modern times, the foreign exchange control has become the essential function of the Central Bank.

Acts as Lender of last resort

The Central Bank acts as the lender of last resort and as the bank of rediscount. Rediscounting can be defined as conversion of bank credit into Central Bank Credit. The commercial banks approach the Central Bank for its financial needs as it is the lender of the last resort or the ultimate source of finance. It lends to the commercial banks by rediscounting the eligible bills. The rediscounting facilities given by the Central Bank impart elasticity and liquidity to the entire credit structure of the country. It helps the commercial banks in a big way to prevent them from bank failures. But its assistance is limited only to the banks which suffer from technical insolvency and not to those unsound and really insolvent banks.

Moreover, a commercial bank is not entitled to financial accommodation simply because it has eligible paper or approved securities. Unless it is conducting its business according to sound banking principles, the Central Bank refuses accommodation. Thus, the Central Bank is able to control credit while discharging the function of lender of last resort. The Central Bank is also regarded as performing the function of last resort when it grants accommodation to the government in times of monetary stringency.

Functions as National clearing house

The Central Bank acts as the national clearing house. The maintenance of accounts by all commercial banks with the Central Bank enables it to settle interbank indebtedness.

A clearing house is an institution where interbank claims, i.e., claims of banks against one another are settled. The net balances or differences called the clearing balances are settle by more transfers claims. The Central Bank acts as a bank of clearance, settlement and transfer and establishes clearing houses in the important cities and towns in the country. They are housed in the premises of the Central Bank administered by it or at their Agent banks.

Clearing houses are established in the important cities and towns of a country by the respective local banks. If the Central Bank has no offices of its own, the clearing houses are housed in the premises of the agents of the Central Bank.

Act as the controller of credit

The Central Bank functions as the controller of credit in the most important function of the Central Bank. The credit creation by the commercial banks has a direct impact on the economy. If the banks expand the credit limit that leads to inflation and it they unduly contract credit it leads to deflation. Thus the central bank is empowered to control the credit creation of the commercial banks. The commonly used methods of credit control are:

  1. Bank Rate Policy
  2. Open Market Operations
  3. Variation of cash reserves (d) Credit rationing
  4. Variation of margin requirements
  5. Regulation of consumers credit
  6. Moral suasion
  7. Direct action
  8. Selective credit control.

By adopting these methods, the Central Bank controls both the quantity and quality of credit created by the banks.

Publishes economic statistics and other information

The Central Bank regularly collects and published the statistics regarding various economic activities of the government, banking system, etc. Further it provides useful information regarding government policies.

Development functions

The Central Bank Acts as the catalyst of economic growth of the country. It acts as an agency of economic growth. It renders various developmental functions such as:

  1. Provision of credit facilities to agricultural industry and other priority sectors through commercial banks and co-operative banks.
  2. Expansion of banking facilities in the country.
  3. Maintaining price stability in the country.
  4. Mitigating the effects of trade cycles by its effective monetary policies, etc.


The responsibility of the Central Bank is increasing every day and its functions are expanding. The well administered central banking functions are necessary for all the countries especially for the developing countries to maintain price stability and economic growth. However, the into separate development financial institutions, such as IDBI and NABARD and investment institutions like UTI over a period of dine. This like regulating money supply, ensuring price stability and protecting the external value of its currency.

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