Functions of Central Bank

What is Central Bank?

An apex body that controls, operates, regulates, and directs a country’s banking and monetary structure is known as a Central Bank. As the functions of a central bank are peculiar, there is only one central bank in a country. Every financially developed country has its own central bank. For example, the central bank of the UK is the Bank of England, and India is the Reserve Bank of India (RBI). The Reserve Bank of India was established on April 1, 1935, under the Reserve Bank of India Act, 1934.

Functions of Central Bank

The Central Bank of India; i.e., the Reserve Bank of India performs the following functions:

1. Currency Authority (Bank of Issue)

The sole authority to issue the currency in the country lies with the Central Bank. In India, the sole right of issuing paper currency notes except one rupee note and coins is in the hands of the Reserve Bank of India. One rupee note and coins are issued by the Ministry of Finance. The currency issued by the Central Bank (RBI) is its monetary liability. It means that the Central Bank has the obligation to back the country with assets of equal value so that they can have public confidence in paper currency. Assets here consist of gold coins, foreign securities, domestic government’s local currency securities, and gold bullions. 

Advantages of Sole Authority of Note Issue with RBI:

Various benefits of RBI having the sole authority of Note Issue are as follows:

1. It brings uniformity in note circulation.
2. It helps in ensuring public faith in the currency system.
3. It helps in stabilising internal and external value of currency.
4. It gives power to the central bank in influencing money supply in the economy because it consist of currency with public.
5. It also enables the government to supervise and control the central bank when it comes to issue of notes.

Central Government has the authority to borrow money from the Central Bank. It means that when the government incurs a deficit in the budget, it borrows money from Central Bank by selling its treasury bills. After acquiring these securities, the Central Bank issues new currency. It is known as Deficit Financing or Monetizing the Government’s Debt.

2. Banker to the Government

The Central Bank (RBI) acts as a banker, agent, and financial advisor to the Central Government and all State Governments (including the Union Territories of Puducherry and Jammu and Kashmir). 

As a banker, the Central bank carries out every banking business of the government, such as:

• To keep the cash balances of the Central and State Governments, the Central Bank maintains a current account.
• It accepts receipts and makes payments for the government, and also carries out exchange, remittance, and other banking operations of the Central and State Governments.
• Ultimately, it gives loans and advances to the government for temporary periods. The government sells its treasury bills to the Central Bank in order to borrow money.

As an agent, the Reserve Bank of India (Central Bank) is responsible for the management of public debt.

As a financial advisor, it gives advice to the government from time to time on financial, monetary, and economic matters.

3. Banker’s Bank and Supervisor

There are several commercial banks in a country, and it is necessary that some agency regulates and supervises their functioning. As the central bank (RBI) is the apex bank, it acts as the banker to other banks of the country. In simple terms, the relationship between the central bank and commercial banks is the same as the relationship between commercial banks and the general public. 

As the banker’s bank, the central bank performs the following three functions:

• Custodian of Cash Reserves: It is essential for commercial banks to keep a certain part of their deposits, also known as CRR or Cash Reserve Ratio, with the central bank. By keeping this proportion of money, the central bank (RBI) acts as a custodian of cash reserves of commercial banks.
• Lender of the Last Resort: When commercial banks are unable to meet their financial requirements from other sources, they approach the central bank (RBI) to give them loans and advances as lender of the last resort. By discounting the approved securities and bills of exchange, the central bank assists the commercial banks.
• Clearing House: As the central bank has to hold the cash reserves of all commercial banks, it becomes convenient and easier for the central bank to act as a clearing house of these commercial banks. It means that every commercial bank has an account with the central bank through which the central bank can easily settle their claims against each other by making credit and debit entries in their accounts.

As a supervisor, the central bank (RBI) controls and regulates commercial banks. The regulation of commercial banks can be related to their branch expansion, licensing, management, merging, liquidity of assets, winding up, etc. The central bank controls the commercial banks by inspecting them and the returns filed by them on a periodic basis.

Advantages of Centralised Cash Reserves with Central Bank:

The main advantages of keeping centralised cash reserves with the central bank are as follows:

1. It results in the effective utilisation of the country’s cash reserves.
2. It enables the central bank in controlling credit creation done by the commercial banks by making changes in the cash reserve requirements.
3. It also enforces public’s confidence in the strength of the country’s banking system.
4. Ultimately, the commercial banks can get financial help during temporary difficulties from the central bank.

Besides these advantages, the commercial banks do not favour this system because it reduces their liquid funds and do not carry any interest.

4. Controller of Money Supply and Credit

RBI has the sole monopoly in the issuance of currency through which it can control money supply and credit whenever there is economic fluctuation. To do so, the Reserve Bank of India uses the following methods of credit control:

A. Repo (Repurchase) Rate: The rate at which a country’s central bank (in the case of India, RBI) lends money to commercial banks to meet their short-term financial needs is known as the repo rate. The central bank advances loans to commercial banks against approved securities or eligible bills of exchange. An increase in the repo rate increases the cost of borrowing from the central bank, which ultimately forces the commercial banks to increase their lending rates, discouraging the borrowers from taking loans from the commercial banks and vice-versa. 

Reverse Repo Rate: It is the exact opposite of repo rate. It means that Reverse Repo Rate is the rate at which the Reserve Bank of India borrows money from commercial banks. RBI borrows money from commercial banks when it feel that there is excess money supply in the banking system of the country. Besides, banks also happily lends money to the central bank as there money is in safe hands and they also get a good interest rate. An increase in the reverse repo rate induces the commercial banks to transfer more money to RBI because of the attractive interest rates.

B. Bank Rate(or Discount Rate): The rate at which a country’s central bank (in the case of India, RBI) lends money to commercial banks to meet their long-term financial needs is known as the bank rate. Bank Rate has the same effect on credit as that of Repo Rate. Simply put, an increase in the Bank Rate increases the cost of borrowing from the central bank, which ultimately increases the lending rates by commercial banks discouraging the borrowers from taking loans. 

C. Open Market Operations: OMO or Open Market Operations means buying and selling of government securities by the Central Bank from/to the commercial banks and the general public, respectively. The Reserve Bank of India has the authority to sell or purchase government securities and treasury bills, whether bought or sold to the banks or the general public. It is because the amount given or received will ultimately be deposited in or transferred from some bank. By selling securities, the central bank reduces commercial banks’ reserves, which has an adverse impact on their ability to create credit, ultimately decreasing the money supply in the economy. By purchasing securities, the central bank increases the reserves and raises the ability of the banks to give credit.

The four essential conditions required for the success of Open Market Operations are as follows:

• A well-developed and organised security market should exist.
• The value of government securities should not show frequent fluctuations.
• In order to influence the money supply in the economy, the central bank should hold adequate securities.
• Ultimately, the sale and purchase of securities should have an impact on the reserves of commercial banks.

D. Legal Reserve Requirements (Variable Reserve Ratio Method): According to the requirements of Legal reserve, commercial banks have the obligation to maintain reserves. It is a quick and direct method used by the central bank to control the credit-creating power of commercial banks. Commercial banks have to maintain reserves on two accounts; viz., Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR).

• Cash Reserve Ratio (CRR): It is the minimum percentage of the net demand and time liabilities that commercial banks have to keep with the central bank. By changing the cash reserve ratio, the central bank affects the ability of commercial banks to create credit. For example, if there is an increase in the cash reserve ratio, it reduces the excess reserves of commercial banks and limits their credit-creating power.
• Statutory Liquidity Ratio (SLR): It is the minimum percentage of net demand and time liabilities that commercial banks have to maintain with themselves. Commercial banks have to maintain SLR in the form of designated liquid assets, like excess reserves, current account balances with other banks, or unencumbered, government and other approved securities. By changing SLR, the central bank affects the freedom of commercial banks to borrow against the government securities or sell them to the Central Bank. It means that, if there is an increase in the statutory liquidity ratio, it reduces the ability of the banks to give credit and vice-versa.

Simply put, by making changes in the Cash Reserve Ratio and Statutory Liquidity Ratio, the Reserve Bank of India can influence the credit creation power of commercial banks.

Unencumbered Securities are those securities which do not act as security for loans from Central Bank.

Approved Securities are the securities for which the government guarantees repayment.

E. Margin Requirements: The difference between the loan amount and the market value of the security offered by the borrower against the loan is known as the margin requirement. It means that if the central bank fixes the margin as 30%, then the commercial banks are allowed to give a loan up to 70% of the value of the security. Margin is essential because if a bank gives a loan equal to the full value of the security, then it will suffer a loss if the price of a security falls. Hence, by making changes in the margin requirements, the central bank (RBI) can alter the loan amount made against the securities by the banks. 

If there is an increase in the margin, it reduces the borrowing capacity and money supply in the economy. If there is a reduction in the margin, it encourages people to borrow more. The central bank may prescribe different margin requirements for different types of borrowers against the security of the same commodity.  

5. Custodian of Foreign Exchange Reserves

The central bank (RBI) also acts as the custodian of the country’s foreign exchange reserves and gold stock. By acting as the custodian of foreign exchange reserves, the central bank can exercise reasonable control over foreign exchange. The regulations of foreign exchange state that all foreign exchange transactions must be routed through the central bank (RBI). 

Two major objectives behind the centralisation of foreign exchange transactions with the Reserve Bank are:

• It helps the bank stabilise the external value of the currency.
• It helps the bank in pursuing a coordinated policy towards the country’s balance of payment situation.

Other Instruments of Credit Control

1. Moral Suasion: In order to get the commercial banks to act according to the policy, the Central Bank (RBI) applies a combination of persuasion and pressure on them, which is known as moral suasion. The central bank exercises moral suasion through letters, discussions, hints, and speeches to banks. The Reserve Bank of India announces its policy position frequently and urges commercial banks to cooperate in the implementation of these credit policies. The central bank can use moral suasion for both quantitative as well as qualitative credit control. In general, the central bank successfully convinces the banks, as it acts as their lender of last resort. However, if the commercial banks do not follow the advice or request of the central bank, no punitive action is taken against them. 

2. Selective Credit Controls: Under this instrument of credit control, the Reserve Bank of India directs other banks regarding giving or not giving credit to specific sectors for certain purposes. The method of selective credit control can be applied in positive as well as negative manners. In a positive manner, it means using the measures in channelising credit to the priority sectors, which include exports, agriculture, small-scale industries, etc. In a negative manner, it means using measures in restricting the flow of credit to specific sectors.

Quantitative v/s Qualitative Instruments of Credit Control of RBI

The Reserve Bank of India controls credit through different methods, which are categorised as quantitative and qualitative methods:

Basis	Quantitative Instruments	Qualitative Instruments
Includes	Quantitative instruments of credit control consist of bank rate policy, repo rate policy, open market operations, reverse repo rate policy, and varying reserve requirements.	Qualitative instruments of credit control consists of Moral suasion, margin requirements, and selective credit controls.
Nature	These are general in nature and have an impact on all sectors which make use of bank credit.	These are specific in nature and have an impact on the flow of credit for a specific use.
Regulation	The quantitative controls are designed for the regulation of the total volume of credit.	The qualitative controls are designed for the regulation of the direction of credit.
Another Name	Another name for quantitative instruments is Traditional Methods of Control.	Another name for qualitative instruments is Selective Methods of Control.