Functions of a Central Bank. Main functions of a Central Bank are to act as governor of the machinery of credit in order to secure stability of prices. It regulates the volume of credit and currency, pumping in more money when market is dry of cash, and pumping out money when there is excess of credit. Broadly, a central bank has two departments, namely, issue department and banking department. We discuss below its main functions.
1. Issue of Currency. The central bank is given the sole monopoly of issuing currency in order to secure control over volume of currency and credit. These notes circulate throughout the country as legal tender money. Note-issuing is governed by Minimum Reserve System i.e. while issuing currency notes, a minimum fixed amount of gold and foreign currency is kept by Central Bank. It has to keep a reserve in the form of gold and foreign securities as per statutory rules against the notes issued by it. It may be noted that RBI issues all currency notes in India except one rupee note. Again it is under directions of RBI that one rupee notes and small coins are issued by government mints. Remember, central government of a country is usually authorised to borrow money from the central bank. When central government expenditure exceeds government revenue and Govt, is unable to reduce its expenditure, then it borrows from RBI. This is done by selling security bills to RBI which creates new currency notes for the purpose. This is called monetisation of budget deficit or deficit financing. The government spends new currency and puts it into circulation to meet its expenditure.
2. Banker to the Government. Central Bank functions as a banker to the government— both central and state governments. It carries out all banking business of the government. Governments keep their cash balances in the current account with the central bank. Similarly, central bank accepts receipts and makes payment on behalf of the governments. Also central bank carries out exchange, remittance and other banking operations on behalf of the government. Central bank gives loans and advances to governments for temporary periods, as and when necessary, and it also manages the public debt of the country.
3. Bankers’ Bank and Supervisor. There are usually hundreds of banks in a country. There should be some agency to regulate and supervise their proper functioning. This duty is discharged by the central bank. Central bank acts as banker's bank in three capacities : (i) it is custodian of their cash reserves. Banks of the country are required to keep a certain percentage of their deposits with the central bank; and in this way the central bank is the ultimate holder of the cash reserves of commercial banks. (ii) Central bank is lender of last resort. Whenever banks are short of funds, they can take loans from the central bank and get their trade bills discounted. Thus Central Bank is a source of great strength to the banking system. (iii) It acts as a bank of central clearance, settlements and transfers. Its moral persuasion is usually very effective so far as commercial banks are concerned.
4. Controller of Credit and Money Supply. It is an important function of a Central Bank to control credit and money supply through its monetary policy. There are two parts of monetary policy, viz., currency and credit. Central Bank has monopoly of issuing notes and thereby can control the volumes of currency. Main objective of credit control function of a Central Bank is stabilising of price level. It controls credit and money supply by adopting quantitative measures and qualitative measures, namely, (i) Bank Rate, (ii) Open Market Operations, and (iii) CRR which influence credit availability and credit creation.Credit creation refers to lending by commercial banks. Following are instruments of monetary policy of RBI.
Instruments of monetary policy:
(i) Bank rate (D 2009; 10C). Bank rate is the rate of interest at which Central Bank lends to commercial banks. Clearly by raising the bank rate, Central Bank raises the cost of borrowing. This forces the commercial banks to raise, in turn, the rate of interest from the public. As lending rate rises, demand for loans for investment and other purposes falls. Thus increase in bank rate by Central Bank adversely affects credit creation by commercial banks. A decrease in bank rate will have opposite effect. Presently — Feburary 2012 — Bank rate (also called Repo Rate) is 8.5% and Reverse Repo Rate (rate at which banks park their surplus funds with RBI) is 7.5%.
(ii) Open market operations. These refer to buying and selling of Government securities by Central Bank. This is done to influence the money supply in the country. Remember, sale of Government securities to commercial banks means flow of money into Central Bank which reduces cash reserves with the banks with the result credit availability of commercial banks is curtailed/controlled.
(iii) Cash Reserve Ratio (CRR). Every commercial bank under law has to deposit with Central Bank a minimum percentage of its demand deposit and time deposit. This percentage is called as CRR. A high CRR means smaller deposits and lesser loans. Higher the CRR, lesser is the banks capacity to create credit. By changing CRR, Central bank controls the lending capacity and credit availability of banks. At present CRR is 5.5% w.e.f. 28th January 2012. Statutory Liquidity Ratio (SLR) is another instrument adopted by RBI to control credit.
5. Lender of Last Resort. When commercial banks have exhausted all resources to supplement their funds at times of liquidity crisis, they approach Central Bank as a last resort. As lender of last resort Central Bank gives guarantee of solvency and provides financial accommodation to commercial banks (i) by rediscounting their eligible securities and bills of exchange, and (ii) by providing loans against their securities. This saves banks from possible failure and banking system from a possible breakdown. On the other hand, Central Bank, by providing temporary financial accommodation, saves the financial structure of the country from collapse.
6. Exchange Control. Another duty of a Central Bank is to see that the external value of currency is maintained. For instance, in India, the Reserve Bank of India takes steps to ensure external value of a rupee. It adopts suitable measures to attain this object. The exchange control system is one such measure. Under exchange control system, every citizen of India has to deposit all foreign currency or exchange that he receives with the Reserve Bank of India; and whatever foreign exchange he might need has to be secured from the Reserve Bank by making an application in the prescribed form.
7. Custodian of Foreign Exchange or Balance. It has been mentioned above that a Central Bank is the custodian of foreign exchange resources and nation’s gold. It keeps a close watch on external value of its currency and undertakes exchange management control. All the foreign currency received by the citizen has to be deposited with the Central Bank; and if citizens want to make payment in foreign currency, they have to apply to the Central Bank. Central Bank also keeps gold and bullion reserves.
8. Clearing House Function. Banks receive cheque drawn on the other banks from their customers which they have to realise from drawee banks. Similarly, cheques on a particular bank are drawn and pass into the hands of other banks which have to realise them from the drawee banks. Independent and separate realization to each cheque would take a lot of time; and. therefore, Central Bank provides clearing facilities, i.e., facilities for banks to come together everyday and set off their chequing claims.
9. Collection and Publication of Data. It has also been entrusted with the tasks of collection and compilation of statistical information relating to banking and other financial sectors of economy.
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