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Central Bank

EVOLUTION

In this last lap of the 20th century, there is no country in the world without its central bank. A central bank, as the name suggests, is central to the entire banking system. It is the apex financial institution of a country's economy through which the economic policy of the country in general, and monetary policy in particular are implemented. Due to the increasing importance of the central banking functions some of the economists have gone to the extent of describing the central bank as the third most important inventions of mankind after fire and wheel. However, the growth of the central bank is only a phenomenon of the 19th and 20th centuries. The Riks Bank of Sweden was established in 1656. The Bank of England was established in 1694, but at that time it was only one of the many banks. For more than a century it continued to function like all other banks. During the early half of the century, it started assuming important functions which are now recognised as central banking functions. By the last quarter of the 19th century, it started functioning as a true central bank and by the end of the century almost all the countries of Europe followed suit.

In the rest of the world, central banks were established only in the 20th century. India established the Reserve Bank of India as its Central Bank in 1934. In fact, a great push to the establishment of central banks was given by the International Financial Conference held at Brussels in 1920. It resolved: "All those countries which had not yet established a central bank should proceed to do so as soon as possible, not only with a view to facilitating the restoration and maintenance of stability in their monetary and banking systems but also in the interest of world co-operation. "

Establishment of International Monetary Fund (IMF) after the Second World War gave a further fillip to the establishment of central banks as it became necessary to establish such a financial institution to deal with the I. M. F.

DEFINITION OF THE CENTRAL BANK

The central bank enjoys the pivotal position in an economy as it performs certain peculiar functions. Thus a central bank can be defined differently by different economists each emphasising its some important function. According to Vera Smith, "The primary definition of a central bank is a banking system in which a single bank has either a complete or a residuary monopoly of note issue. " The definition recognises note issue as the main function of a central bank. Kent has defined a central bank as "an institution which is charged with the responsibility of managing the expansion and contraction of the volume of money in the interest of general public welfare. "

A similar definition has been given by statutes of Bank of International Settlement in the following words, "A central bank is the bank in any country to which has been entrusted the duty of regulating the volume of currency and credit in that country, " C. H. Kreps and O. S. Pugh in their book 'Money, Banking and Monetary Policy' have given the following definition, "A central bank is a national financial institution created to operate, not for profit, but for the public purpose of influencing the economy in desirable directions through monetary means. "

The definition clearly brings out the main characteristics of a central bank, i.e .

CHARACTERISTICS OF CENTRAL BANK

(1) It is a national (apex) financial institution,

(2) Its motive is not profit, but

(3) Influencing the economy is desirable directions, and

(4) It does so through monetary means.

Nobel Laureate Paul Samuelson recognised the main function of a central bank in the following words, "Every central bank has one function. It operates to control economy, supply of money and credit. " Hawtrey recognises a central bank as a 'lender of the last resort '.

In nutshell, a central bank is the apex bank in an economy, which issues currency notes, controls the economy by controlling the money supply through monetary means in the interest of public and is the lender of the last resort.

DIFFERENCES BETWEEN A CENTRAL BANK AND A COMMERCIAL BANK

The main differences between a central bank and a commercial bank are the following :

1.A central bank aims at maximising the public welfare through monetary means. It has no profit motive. M.H.De Lock has stated that a central bank "should act only in the public interest and for the welfare of the country as a whole and without regard to profit as primary consideration. "

2. Generally, a central bank does not deal with public directly. A commercial bank can exist only by dealing directly with the public.

3. Modern central banks have the monopoly over notes issue.

4. The central bank is generally a state owned institution but the commercial banks are generally private joint stock banks.

5. The central bank does not compete with commercial banks, rather it comes to their rescue as the lender of the last resort. For this reason it is called a banker's bank .

6. The central bank is generally the custodian of the foreign exchange of a country. Commercial banks are only the authorised dealers.

7. The central bank controls the entire banking system, thus commercial banks function under its control.

8. Generally, it acts as banker to bankers.

9. As banker of banks it acts as a clearing house.

FUNCTIONS OF THE CENTRAL BANK

In his book 'Central Banking', De Kock made an attempt to give a comprehensive definition of central banking in which he recognised the following main functions of a central bank.

1.Bank of issue. The modern central bank enjoys monopoly over printing or issuing of currency notes. No other bank is permitted to issue notes. Vera Smith recognised it as the single most important function of central banking and considered it to be the 'essence of central banking '. The main reasons for granting monopoly right of note issue to the central bank are given below :

(1) Money is a good servant but a bad master. It was realised that the money supply in the economy of a country, both in the form of currency and deposits, must be kept under control. Credit control function has been assigned mainly to the central bank, and it can exercise better control if it is the sole authority in the matter of issue of notes.

(2) The central bank brings uniformity in its notes, which is essential for proper regulation.

(3) Monopoly over note issue by the central bank adds a distinctive prestige and advantage. People value it more because it has only one source, i.e. the central bank. Prestige gets enhanced with the backing of the government.

(4) It is easier to supervise the note issue. Any practices or irregularities are easily detected.

(5) Monetary management of currency notes become easier.

(6) Another advantage of vesting authority of note issue with the central bank was recognised by Kisch and Elkin, i.e. the political interference in the matter of note issue, political considerations and the peculiar needs of the state rather than considerations of sound monetary economy are likely sooner or later to become the determining factors. "

2. Banker, agent and advisor to the government. The central bank acts as a banker, agent and financial advisor to the government - both national and provincial. What a commercial bank is to the public, the central bank is to the government. It accepts the deposits from central or state government (s), makes collections and payments on their behalf, grants the short term loans, especially loans in the nature of 'bridge loans'. Such short term loans are granted in anticipation of realisation of taxes or mobilisation of resources through public debts and securities. Such short term financing of the government needs is also called 'ways and means advances '. The central bank also makes long term loans, especially during the extraordinary situation like wars and depressions. In fact, these functions were performed even before the emergence of the central bank in its modern form.

The central bank also acts as an agent to the government. On behalf of the government, it manages national debts and issue of securities and loans. The purchase-sale of treasury bills and issue of securities and loans. The purchase-sale of treasury bills and issue of securities and loans. The purchase-sale of treasury bills and other securities so as to maintain adequate money supply with the public is also under the control of the central bank. The control and regulations of these securities is vested with the central bank. As an agent of the government, it collects the taxes and makes disbursements on its behalf.

The central bank is a financial advisor to the government. It advises the government on all policy matters relating to the economy i.e. deficit financing, monetary policy, trade policy, etc.

3.Custodian of the cash reserves of the commercial banks. The central bank is the banker's bank. It keeps the cash reserves of the banks with it and acts as the custodian of these cash reserves. Initially, the cash reserves with the central bank were maintained by commercial banks to facilitate the day-to-day functions. These reserves were used for making payments and replenishing them with the funds that were received. However, now-a-days, most of the countries have made it statutory for commercial banks to maintain a certain percentage of their reserves as cash reserves with the central bank. These reserves provide an effective support to the country's credit and banking system.

De Kock recognised the significance of these cash reserves with the central bank in the following words :" The centralisation of cash reserves in the central bank is a source of great strength to the banking system of any country. Centralised cash reserves can at least serve as the basis of a larger and more elastic credit structure than if the same amount were scattered among the individual banks. It is obvious that, when bank reserves are pooled in one institution, which is moreover charged with the responsibility of safeguarding the national economic interests, such reserves can be employed to the fullest extent possible and in the most effective manner during periods of seasonal strain and in financial crises or "general emergencies".