Functions of Central

Bank

Central Bank

In every country, there is one bank which acts as the leader

of the money market - supervising, controlling and
regulating the activities of Commercial Banks and other
financial institutions. It acts as a banker of issue and is in
close touch with the government, as banker, agent and
adviser to the latter. Such a bank is known as the Central
Bank of the country.

Central Bank and Commercial Bank Differences

Central Bank does not work for profits though it might secure
profits. While Commercial Banks aim at securing maximum
profit for their shareholders, the Central Bank aims at
controlling the banking system and supporting the economic
policy of the government.

Central Bank is generally an organ of the government and

forms part of the govt. machinery. Commercial Banks may be
owned by the govt. or are privately owned.

The Organization and Management of the Central Bank is

fully controlled by the Government.

Functions of a Central Bank

a.

i.
ii.
iii.
iv.

Bank of Issue
Central Bank has the exclusive monopoly of note issue
and the currency notes issued by the Central Bank are
declared unlimited legal tender throughout the country.
This monopoly brings about:
Uniformity of note issue which in turn facilitates trade
and exchange within the country
Enables the Central Bank to influence and control the
credit creation of Commercial Banks
Gives distinctive prestige to the currency notes
Enables govt. to appropriate partly or fully the profits of
note issue.

Functions of a Central Bank

b.

Banker, Agent and Adviser to the Government

As Banker and Agent, RBI keeps the banking accounts of the
Central and State governments and makes and receives payments
on behalf of the government. It provides short-term advances to
the govt. (ways and means advances) to tide over temporary
shortage of funds. It advises the govt. on all monetary and banking
matters.

c.

Custodian of the Cash Reserves of Commercial Banks

All Commercial Banks keep part of their deposits as reserves with
the Central Banks and hence the name Reserve Bank of India.
Centralised cash reserves serve as the basis of a larger and more
elastic credit structure and helps Commercial Banks to meet crises
and emergencies. Centralised cash reserves aids the Central Bank
to control credit creation and implement monetary policy.

Functions of a Central Bank

d.

Custodian of Foreign Balances of the Country

RBI holds the foreign exchange assets of all commercial and nonCommercial Banks of the country. It is the responsibility of RBI to
maintain the rate of exchange and manage exchange control and
other restrictions imposed by the State. It also maintains reserves
with the IMF and obtains normal drawing and special drawing rights.

e.

Lender of the last resort

Central Bank never refuses to accommodate any eligible Commercial
Bank experiencing cash shortage. In the absence of a Central Bank,
Commercial Banks will have to carry substantial cash reserves which
imply restricted lending and reduced income. As a lender of last
resort, Central Bank assumes the responsibility of meeting directly or
indirectly all reasonable demands for accommodation by the
Commercial Banks.

Functions of a Central Bank

f.

Central Clearance, Settlement and Transfer

As the Central Bank keeps cash reserves of Commercial Banks, it
is easier for member banks to settle their mutual claims in the
books of the Central Bank. These are the clearing house
operations of RBI wherein cheques are cleared, claims settled and
funds transferred in the books of the member banks. However, this
function can also be performed by any leading bank in a locality
or area.

g.

Controller of Credit
RBI controls the level of credit in the economy by either
expanding or contracting bank deposits. In modern times, bank
deposits have become the most important source of money in the
country. As controller of credit, RBI seeks to influence and control
the volume of bank credit and also to stabilize business conditions
in the country.

Functions of RBI

Monetary Authority
Formulates, implements and monitors the monetary
policy.
Objective: maintaining price stability and ensuring
adequate flow of credit to productive sectors.

Regulator and supervisor of the financial system

Prescribes broad parameters of banking operations within
which the countrys banking and financial system
functions.
Objective: maintain public confidence in the system,
protect depositors interest and provide cost-effective
banking services to the public.

Functions of RBI
Manager

of Exchange Control
Manages the Foreign Exchange Management Act, 1999.
Objective: to facilitate external trade and payment and
promote orderly development and maintenance of foreign
exchange market in India.

Issuer

of currency
Issues and exchanges or destroys currency and coins not
fit for circulation.
Objective: to give the public adequate quantity of supplies
of currency notes and coins and in good quality.

Functions of RBI

Developmental role
Performs a wide range of promotional functions to support
national objectives.

Related Functions
Banker to the Government: performs merchant banking
function for the Central and the state governments; also acts
as their banker.

Banker to banks
Maintains banking accounts of all scheduled banks.

Methods of Credit Control

Credit

control is a very important function of RBI which

adopts a variety of methods to expand or contract credit in
the economy. Some of these methods are traditional while
some others are modern and contemporary.
Some of these methods are quantitative controls since they
control and adjust total quantity or the volume of deposits
created by Commercial Banks. They relate to the volume
and cost of bank credit in general without relating to the
purpose for which the bank credit is used. There are other
methods of credit control known as selective or qualitative
controls, since they control certain types of credit and not
all credits.

Methods of Credit Control

Quantitative controls consist of bank rate or discount
rate policy, open market operations and reserve
requirements. Qualitative controls consist of regulation
of margin requirements, regulation of consumer credit,
rationing of credit, control through directives, moral
suasion and direct action.

Bank Rate Policy

Bank

rate in the rate of interest that the Central Bank

levies while discounting or rediscounting eligible bills
and securities of Commercial Banks to meet their funds
requirement. Since the Central Bank is the lender of last
resort, the Bank rate is related closely to all other rates of
interest in the money market. The eligible bills or first
class bills or gilt-edged securities are treasury bills/bonds
and commercial bills.

Working of Bank Rate Policy

During inflationary times the bank rate is raised resulting in
the following consequences:
a. Businessmen who borrow from banks will find their cost of
funds increased due to a rise in bank rate. Their profit
margins are reduced.
b. Manufacturers and merchants hold large stocks of inventories
through bank loans. A rise in bank rate will force them to
liquidate their stocks to pay up bank loans.
c. Stock exchanges transactions are usually financed by loans
from banks. Rise in bank rate will result in dealers and
brokers selling off their stocks to pay up bank loans.

Working of Bank Rate Policy

Hence, rise in bank rate increases interest rates, curtails
bank credit, decreases demand for goods and services and
finally reduces the price level. Further, the most powerful
influence of bank rate is psychological bankers and
businessmen consider bank rate changes as authoritative
pronouncements of the Central Bank concerning the credit
situation at a very important time. Radcliffe Report states:"
the rise in the bank rate is symbolical; it is evident that the
authorities have the determination to take unpleasant steps
to check inflation.

Bank Rate Policy - Assumptions

1.
2.
3.
4.
5.
6.

Lending rates of Commercial Banks are related to discount rates

of the Central Bank.
Commercial Banks normally approach Central Bank for
additional funds.
Commercial Banks keep minimum cash reserves and depend on
Central Bank to overcome shortages.
They possess eligible securities in sufficient quantities.
Borrowing and investment activity of businessmen are dependent
on lending rates of Commercial Banks.
Prices, wages and employment are all flexible and are responsive
to changes in borrowing and investment.

Bank Rate Policy - Limitations

1.

2.

Relationship between bank rate and other interest rates

Bank rate policy will be successful only if the lending
rates of banks change corresponding to the movement of
the bank rate. In developed countries, there is a close
and direct relationship so that every change in bank rate
is followed immediately by corresponding changes in
the lending rates. However, this relationship is quite
tenuous in developing countries because of market
imperfections.
Existence of eligible bills In India, eligible bills
constitute only 3% of the total assets of Commercial
Banks. This is on account of an underdeveloped bill
market

Bank Rate Policy - Limitations

3.

Practice of rediscounting The bank rate policy can succeed only

if Commercial Banks have the practice of rediscounting eligible
bills with the Central Bank. However, Indian banks have very few
eligible bills or carry large cash balances thereby reducing the
efficacy of bank rate.

4.

No direct relation between interest and investment Compared to

the role of other factors like availability of raw material, skilled
labor, cost of fixed assets and stocks and administrative support,
the role of interest rate to influence investment in a developing
country is insignificant.
Under these circumstances, the Bank Rate continues to be
important as a symbolic verdict of the Central Bank than as a vital
measure for policy correction. It is more a policy statement of the
Central Bank than as a tool of policy correction.

Open market operations

Deliberate and direct buying of securities and bills by the Central

Bank in the money market, on its own initiative, is called open
market operations.
In periods of inflation, the Central Bank will sell in the market first
class bills in its possession to buyers like Commercial Banks and
others. This reduces the cash reserves of the Commercial Banks
which in turn will reduce its capability to give loans and advances.
Thereby, business activity in the country will be cut short.
During recession, Central Bank buys bills from Commercial Banks
and thereby increases their cash reserves. Business activity receives
a fillip.
The Central Bank thus influences the lending operations of
Commercial Banks and ultimately influences business activity and
economic conditions in the country.

OMO - Advantages
Strategically, OMO

as a method of influencing money

supply is effective because the initiative to control the
volume of money supply in the country is kept by the
Central Bank itself. But the bank rate policy is passive in
the sense that its success depends upon the willing
response of the Commercial Banks and their customers.

OMO - Limitations
Commercial

Banks may prefer to operate with

high cash reserves rather than expand credit in the
economy though this might negatively impact their
profitability.
Commercial Banks will also have an optimal trade
off between excess cash reserves and buying low
yielding securities.
Credit expansion must be followed by the
willingness of businessmen to come forward to
borrow. However, their willingness might be
guided by real and not monetary factors in the
economy.

Cash Reserve Ratio

1.
2.
3.

According to the RBI Act 1934, every scheduled bank has an

obligation to maintain a certain portion of their demand and time
deposits as a reserve with the Central Bank. This provision was
fixed for three important reasons
To ensure the liquidity and solvency of individual Commercial
Banks and of the banking system as a whole
To provide the Central Bank with supply of deposits for local
operations
To influence and ultimately restrict Commercial Banks
expansion of credit.
Hence CRR is an additional instrument of credit control of the
Central Bank

CRR and Bank Credit

Excess

cash reserves will induce banks to expand credit

and reduction of cash reserves will result in contraction of
cash credit. Cash reserves with the Commercial Banks are
directly influenced by the CRR and hence the relationship
with the CRR and bank credit.
For instance, when the reserve requirement is 10% a
Commercial Bank will have to maintain a cash reserve of
Rs.100 for every deposit of Rs.1000 and hence can lend
only up to Rs.900. On the other hand, a cash reserve of
20% will permit a bank to lend only Rs.800. The higher
the cash reserve requirement, the smaller the amount
available for banks for loans and advances and
investments.

Limitations of CRR
De

Kock While it (reserve ratio) is a very prompt and

effective method of bringing about the desired changes in
the available supply of bank cash, it has some technical and
psychological limitations which prescribe that it should be
used with moderation and direction and only under obvious
abnormal conditions.
This technique is normally used to adjust the banking
structure to large scale changes in the countrys supply of
monetary reserves and is not used frequently to make small
adjustments in the supply of credit. Frequent changes in
reserve ratio will disturb the Commercial Banks and
complicate their book-keeping and their customary way of
doing business.

Selective Credit Controls

a.
b.
c.

The quantitative controls like bank rate, OMO and CRR

affect indiscriminately all sections of the economy which
depend on bank credit. Besides, there are some groups of
borrowers who are engaged in important spheres of
economic activity and whom the Central Bank would
like to insulate from these quantitative effects. Hence,
Central Banks have been adopting the tool of selective
credit controls or qualitative controls whose special
features are:They distinguish between essential and non-essential
uses of bank credit
Only non-essential uses are brought under the scope of
Central Bank controls
They affect not only the lenders but also the borrowers.

Types of Selective Controls

A.

Margin Requirements
Banks do not lend the entire amount of the
project cost or security value. Part of the project
cost has to be met by the businessmen investing
in a venture. Margin money is the personal stake
of the investor in a given investment. Banks or
Central Bank can directly encourage or
discourage an activity by either decreasing or
increasing the margin requirements respectively.
For certain export related ventures, govt.
recommends even waiver of margin requirement.

Types of Selective Controls

B.

Regulation of Consumer credit

The Central Bank can either limit the amount of
credit for the purchase of any article sought to be
regulated or limit the time for repaying the debt.
This reduces the quantum of loan available to
the customer and also hastens up the exposure of
bank credit to the customer. The end result is that
a particular kind of activity is sought to be
encouraged or discouraged by altering both the
quantum of loan and the repayment period
thereof.

Types of Selective Controls

C.

Control through directives : Direct action

RBI is empowered to give directives to Commercial
Banks in respect of (1) their lending policies (2) the
purposes for which advances may or may not be made
and (3) the margins to be maintained in respect of
secured loans. Direct action can also take the form of the
Central Bank charging a penal rate of interest for money
borrowed beyond the prescribed amount or refusing to
grant further rediscounting facilities to erring banks.
However, Commercial Banks are not always responsible
as the borrower can always divert the credit availed to
unspecified activities.

Types of Selective Controls

D.

Moral suasion:
Moral suasion implies persuasion and request made by
the Central Bank to the Commercial Banks to follow the
general monetary policy of the former. The
effectiveness of moral suasion is debatable. As a method
of credit control, it may have restraining influence, but
when real forces in favour of credit expansion or
contraction are very strong, persuasive tactics may be
ineffective. While this method has a psychological
advantage as it does not carry any threat or legal
sanction, it may not be very effective in times of serious
business boom or depression especially in developing
countries.

Types of Selective Controls

E.

Rationing of credit
Credit rationing is a method of controlling and
regulating the purpose for which credit is granted by the
Commercial Banks. It may assume two forms. Firstly,
variable portfolio ceilings refer to the system by which
the Central Bank fixes a ceiling or maximum amount of
loans and advances for every Commercial Bank.
Secondly, variable capital assets ratio refers to the
system by which the Central Bank fixes the ratio which
the capital of the Commercial Bank should have to the
total assets of the bank. Rationing of credit may also be
in the form of the Central Bank allowing only a fixed
amount of accommodation to member banks by means
of rediscount.

Significance of Selective Controls

Selective

controls are flexible in nature and can make

credit policy more flexible. It can be directed
geographically to parts of the economy that are
susceptible to extreme fluctuations. Besides, they can be
used to restrain the demand for credit. Monetary
authorities have come to depend more and more on
selective controls in recent years though they are
normally used in conjunction with the general instruments
of credit regulation and control.

Limitations of Selective Controls

a.

b.

c.

d.

They can control only bank credit and investment and

trade finance through bank credit. However, there are
other sources of financing investment such as capital
issue, own capital, NBFIs and undistributed profits.
It may not always possible for Commercial Banks to
ensure that the loans granted by them are spent for the
purposes for which they have been sanctioned.
Commercial Banks, under the influence of profit
motive, may sanction loans for forbidden uses but enter
them in their books under different heads.
The Commercial Banks may ensure that loans are made
only for the prescribed purpose. However, they have no
influence over the purposes for which the resulting
additional purchasing power is used.

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