Central Banks differ 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:
(i) Issuing of notes and regulating the volume of currency
(ii) Acts as banker to the government
(iii) Acts as banker to the banks
(iv) Acts as custodian of Nation’s reserves
(v) Acts as the lender of last resort
(vi) Functions as National Clearing House
(vii) Acts as controller of credit
(viii) Publishes economic statistics and other information
(ix) Development functions
(x) Supervises the activities of financial institutions.
The Central Bank is legally empowered to issue currency notes. The Central Bank is charged with the responsibility of maintaining price stability, inflation 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:
(a) Enhance the public confidence on the monetary system.
(b) Maintaining uniformity in the monetary system throughout the country.
(c) Flexibility in the monetary system. By the function of note issue the Central Bank can maintain the circulation of the economy at desired level.
(d) 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.
(e) 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,
(a) Fixed fiduciary system
(b) Minimum fiduciary system
(c) Proportional Reserve system
(d) Foreign exchange reserve system
(i) Minimum Reserve system
Whatever may be the system three basic principles are to be followed. They are (i) Uniformity (ii) Security and (iii) 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 elastic.
The Central Bank must be able to expand or to contract the supply of currency according to the changing needs from time to time.
(ii) 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 over 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 governments
As the financial adviser, the Central Bank provides valuable advice to the government on important financial matters like, foreign exchange policy, commercial policy, rising of funds from market, etc.
(iii) Banker to the banks:
The Central Bank Acts as the bankers’ bank. As such it performs the following functions:
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. It secures the advantage of centralized cash reserves. In India the Central Bank is authorized to vary these reserve requirements within certain limits. Such cash reserves with the Central Bank have the following advantages:
(a) 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
(b) Centralized reserves can be used effectively and quickly in times of emergency.
(c) This ensures liquidity and imparts economy in the credit structure of the country.
(d) These reserves promote liquidity of commercial banks as they enable the Central Bank to undertake rediscounting of bills on a more extensive scale for the purpose of meeting the requirements of the money market.
(e) The Central Bank can control credit by varying the cash reserves that commercial banks should keep with it.
(iv) 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 license 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.
(v) 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.
(vi) 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 inter-bank 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 settled by mere transfers between their respective accounts at the Central Bank.
The clearing houses facilitate expeditious and economical settlement of inter-bank 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.
Technique of Clearance
The technique of settling the inter-bank indebtedness is simple. The clearing house operates as follows. The representatives of various member banks of a clearing house meet at the clearing house at a particular time.
Every representative delivers to others the cheque and other claims which his bank holds against them. Similarly, he receives from others the claims which they hold against his banks. Cheques dishonored are returned to the concerned representatives. The amount receivable and payable are added.
The net clearing balances of banks are settled by debtor banks by issuing cheques against their accounts with the central bank in favour of creditor banks. Thus, the inter-bank claims are settled by mere book entries in the accounts maintained with the central bank. These days the payment system operates more efficiently through computerized operations.
Advantages of Clearing House
Central Banks’ function of clearing house provides the following advantages:
(a) Clearing houses reduce the cost involved in the collection of cheques and claims.
(b) They avoid the delay in the clearing of cheques.
(c) They ensure convenience and economy in the settlement
(d) They minimise the risk involved in the realisation of cheques.
(e) They minimise the necessity of holding large cash balances by commercial banks.
(f) They can be used as a common platform for the discussion of the problems of member banks.
(g) They promote co-operation among member banks.
(h) Central Banks also get information about the liquidity position of commercial banks.
(i) Clearing houses offer valuable data to know the trends in the operations of commercial banks.
(vii) Act as the controller of credit: The Central Bank functions as the controller of credit in the country. According to De Kick, this function is considered as 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 limits that leads to inflation and if 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,
(a) Bank Rate Policy
(b) Open Market Operations
(c) Variation of cash reserves
(d) Credit rationing
(e) Variation of margin requirements
(f) Regulation of consumer’s credit
(g) Moral suasion
(h) Direct action
(i) 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 publishes the statistics regarding various economic activities of the government, banking system, etc. Further it provides useful information regarding government policies.
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
(i) Provision of credit facilities to agricultural industry and other priority sectors through commercial banks and co-operative banks.
(ii) Expansion of banking facilities in the country.
(iii) Maintaining price stability in the country.
(iv) 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 developmental role of Reserve Bank of India was gradually branched out into separate development financial institutions, such as IDBI and NABARD and investment institutions like UTI over a period of time.