Central Bank – A Detailed Overview

You may learn about so many banks and the central bank that controls all the activities of these banks. 

But is it all that a central bank does? Doesn’t it have any other function? 

If you are coming across these questions, please visit the blog below to find all your answer. 

What Is a Central Bank?

A central bank is a financial institution or a type of bank that has given privileged control over the production and distribution of money and credit for a nation or a group of nations. In modern economies, the central bank is specifically responsible for the formulation of monetary policy in a nation and the regulation of member banks.

The central bank of a nation is an inherently non-market-based institution that doesn’t have any competition in the market. Although some of the central banks are nationalized, most of the central banks are actually not government agencies and are touted as being politically independent so often. 

However, even if a central bank is not legally owned by any government, the privileges of this bank are well-established and protected by law.

The critical feature of a central bank that distinguishes it from other banks—is the legal monopoly status of this bank, which provides it with the privilege to issue new banknotes and cash. 

On the other hand, various private commercial banks are permitted to issue only demand liabilities, such as checking deposits.

How Central Banks Work

Most of the central banks in the world are generally governed by a board that consists of its member banks. The chief elected official of the nation appoints the directors of the central bank.

The national legislative body of the country approves the directors. It keeps the central bank aligned with the long-term policy goals of the nation.

At the same time, this bank is also free of political influence in its day-to-day operations. Different works of a central bank are given below. 

Monetary Policy

Central banks affect the economic growth of a nation by controlling the liquidity in the financial system. There are generally three monetary policy tools to achieve this goal.

First, the central bank set a requirement for the reserve. Reserve refers to the amount of cash that the member banks must have on hand each night. In this way, the central bank controls the money of member banks and how much these banks can lend.

Second, the central bank applies open market operations to buy and sell all securities from member banks. This changes the amount of cash on hand without changing any reserve requirement. The central governing bank used this tool for the very first time during the 2008 financial crisis. Different banks buy government bonds and mortgage-backed securities to stabilize the system of banking

Third, the central bank set some targets on interest rates they charge their member banks. It guides the member banks to set interest rates for loans, mortgages, and bonds.

If interest rates start rising, it’s slower growth, preventing inflation. This is known as contractionary monetary policy. Lowering the interest rates, stimulates growth, preventing or shortening a recession. This is called expansionary monetary policy. 

Bank Regulation

Central banks are also responsible for regulating their member banks. These member banks may require enough reserves to cover potential loan losses. So they are solely responsible too. ensure financial stability and protect the funds of the depositor. 

Providing Financial Services

The central bank is not a bank for the public. It serves as the bank of different private banks and the nation’s government. It processes checks and lends money to its member banks.

The central bank also stores currency in its foreign exchange reserves. They use these foreign exchange reserves to change exchange rates. 

They add foreign currency to the nation’s currency especially the dollar or euro, to keep their own currency in alignment. It is called a peg, and it helps exporters to keep their prices competitive.

Central banks are also responsible to regulate exchange rates as a medium to control inflation. They usually buy and sell large quantities of foreign currency to affect the supply and demand of the nation. 

Functions of Central Bank

The central bank acts as the lender of the last resort. It is the important organ of the government that controls the major financial operations of the government. 

Through the various operations of the central bank, the objectives of this bank are to support the economic policy of a country by influencing the medium of financial institutions to behave.

The central bank of India is RBI fully named the Reserve bank of India and it is a statutory bank. The primary role of RBI in India is to print notes and currency and manage the money supply in the economy of India. 

Now let us delve into the functions of this bank where we will discuss the role of the central bank in the money market of a country. 

Regulator of Currency 

The primary and most important function of the central bank is to print notes and currency of a country and RBI has the sole right in India for this operation. In India, RBI prints all denominations of money apart from 1 rupee note. The ministry of finance of India issues 1 rupee note.

Banker and Advisor of the Government

The central bank acts as a fiscal agent to the government whereas, in India, the RBI keeps the deposits of both central and state governments. Apart from that, it also makes payments on behalf of the government and buys and sells foreign currencies.

The different functions of a reserve bank as an advisor to the central government is to tender useful suggestions and advice to the government regarding different monetary policies and other economic matters.

Custodian of Commercial Banks

As per law in different countries, different commercial banks require to keep a reserve that is equal to a certain percentage of the NDTL (net demand and time liabilities). These reserves help different commercial banks clear the cheques by transferring funds from one bank to another. 

The central bank or reserve bank in India facilitates these transactions and makes it easier as it acts as a custodian and lender of cash reserves to commercial banks.

Custodian and Manager of Foreign Exchange Reserves

In order to make the rates of foreign exchange stable, the reserve bank of India generally buys and sells foreign currencies at international prices. 

If the foreign currency supply decreases in an economy, the central bank sells the currencies at foreign exchanges, and in case of surplus supply, it buys them. It also acts as an official reservoir of different foreign currencies and gold. The central bank sells this gold to monetary authorities of other countries at fixed prices.

Lender of the Last Resort

The central bank also grants accommodation to different commercial banks, financial institutions, bill brokers, etc. in the form of collateral advances or re-discounts. This necessary step is generally taken in times of stress so that the financial structure of the country can be saved from collapsing.

This lending of money is generally done on the basis of government securities, treasury bills, government bonds, etc.

Controller of Credit

The central bank also acts as the controller of credit and controls the credit created by commercial banks. 

Generally, the credit flow in a country is regulated by means of two methods; quantitative method and qualitative method. 

The central bank applies tight monetary policies at different times when it notices that there is enough supply of money that may cause a situation of inflationary. To keep inflation in check It squeezes the money supply at that time. 

Transfer and Settlements

The central bank also acts as a “clearinghouse” for a country by providing free services to its commercial banks in transferring and settling their mutual claims. Since this bank holds reserves of commercial banks, it facilitates the clearing of cheques by transferring funds between banks. 

The principle of keeping of book is generally followed in this procedure to make transfer entries into the accounts of various commercial banks.

So there is a separate department operated by the central bank in different big cities and trade centers to transfer and settle these claims of one bank on the other.

Examples of Central Banks

Some of the well-known central banks throughout the world are

1. Federal Reserve in the USA

2. Reserve Bank of India 

3. People’s Bank of China China

4. Bank of England in the UK

5. European Central Bank in European Union

*image source from Google

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