Central Bank In every country, there is one bank which acts as the leader of the money market - supervising, controlling and regulating the activities of Commercial Banks and other financial institutions. It acts as a banker of issue and is in close touch with the government, as banker, agent and adviser to the latter. Such a bank is known as the Central Bank of the country.
Central Bank and Commercial Bank - Differences Central Bank does not work for profits though it might secure profits. While Commercial Banks aim at securing maximum profit for their shareholders, the Central Bank aims at controlling the banking system and supporting the economic policy of the government. Central Bank is generally an organ of the government and forms part of the govt. machinery. Commercial Banks may be owned by the govt. or are privately owned. The Organization and Management of the Central Bank is fully controlled by the Government.
Functions of a Central Bank a. Bank of Issue Central Bank has the exclusive monopoly of note issue and the currency notes issued by the Central Bank are declared unlimited legal tender throughout the country. This monopoly brings about: i. Uniformity of note issue which in turn facilitates trade and exchange within the country ii. Enables the Central Bank to influence and control the credit creation of Commercial Banks iii. Gives distinctive prestige to the currency notes iv. Enables govt. to appropriate partly or fully the profits of note issue.
Functions of a Central Bank b. Banker, Agent and Adviser to the Government As Banker and Agent, RBI keeps the banking accounts of the Central and State governments and makes and receives payments on behalf of the government. It provides short-term advances to the govt. (ways and means advances) to tide over temporary shortage of funds. It advises the govt. on all monetary and banking matters. c. Custodian of the Cash Reserves of Commercial Banks All Commercial Banks keep part of their deposits as reserves with the Central Banks and hence the name Reserve Bank of India. Centralised cash reserves serve as the basis of a larger and more elastic credit structure and helps Commercial Banks to meet crises and emergencies. Centralised cash reserves aids the Central Bank to control credit creation and implement monetary policy.
Functions of a Central Bank d. Custodian of Foreign Balances of the Country RBI holds the foreign exchange assets of all commercial and non- Commercial Banks of the country. It is the responsibility of RBI to maintain the rate of exchange and manage exchange control and other restrictions imposed by the State. It also maintains reserves with the IMF and obtains normal drawing and special drawing rights. e. Lender of the last resort Central Bank never refuses to accommodate any eligible Commercial Bank experiencing cash shortage. In the absence of a Central Bank, Commercial Banks will have to carry substantial cash reserves which imply restricted lending and reduced income. As a lender of last resort, Central Bank assumes the responsibility of meeting directly or indirectly all reasonable demands for accommodation by the Commercial Banks.
Functions of a Central Bank f. Central Clearance, Settlement and Transfer As the Central Bank keeps cash reserves of Commercial Banks, it is easier for member banks to settle their mutual claims in the books of the Central Bank. These are the clearing house operations of RBI wherein cheques are cleared, claims settled and funds transferred in the books of the member banks. However, this function can also be performed by any leading bank in a locality or area. g. Controller of Credit RBI controls the level of credit in the economy by either expanding or contracting bank deposits. In modern times, bank deposits have become the most important source of money in the country. As controller of credit, RBI seeks to influence and control the volume of bank credit and also to stabilize business conditions in the country.
Functions of RBI Monetary Authority Formulates, implements and monitors the monetary policy. Objective: maintaining price stability and ensuring adequate flow of credit to productive sectors. Regulator and supervisor of the financial system Prescribes broad parameters of banking operations within which the country’s banking and financial system functions. Objective: maintain public confidence in the system, protect depositors’ interest and provide cost-effective banking services to the public.
Functions of RBI Manager of Exchange Control Manages the Foreign Exchange Management Act, 1999. Objective: to facilitate external trade and payment and promote orderly development and maintenance of foreign exchange market in India. Issuer of currency Issues and exchanges or destroys currency and coins not fit for circulation. Objective: to give the public adequate quantity of supplies of currency notes and coins and in good quality.
Functions of RBI Developmental role Performs a wide range of promotional functions to support national objectives. Related Functions Banker to the Government: performs merchant banking function for the Central and the state governments; also acts as their banker. Banker to banks Maintains banking accounts of all scheduled banks.
Methods of Credit Control Credit control is a very important function of RBI which adopts a variety of methods to expand or contract credit in the economy. Some of these methods are traditional while some others are modern and contemporary. Some of these methods are quantitative controls since they control and adjust total quantity or the volume of deposits created by Commercial Banks. They relate to the volume and cost of bank credit in general without relating to the purpose for which the bank credit is used. There are other methods of credit control known as selective or qualitative controls, since they control certain types of credit and not all credits.
Methods of Credit Control Quantitative controls consist of bank rate or discount rate policy, open market operations and reserve requirements. Qualitative controls consist of regulation of margin requirements, regulation of consumer credit, rationing of credit, control through directives, moral suasion and direct action.
Bank Rate Policy Bank rate in the rate of interest that the Central Bank levies while discounting or rediscounting eligible bills and securities of Commercial Banks to meet their funds requirement. Since the Central Bank is the lender of last resort, the Bank rate is related closely to all other rates of interest in the money market. The eligible bills or first class bills or gilt-edged securities are treasury bills/bonds and commercial bills.
Working of Bank Rate Policy During inflationary times the bank rate is raised resulting in the following consequences: a. Businessmen who borrow from banks will find their cost of funds increased due to a rise in bank rate. Their profit margins are reduced. b. Manufacturers and merchants hold large stocks of inventories through bank loans. A rise in bank rate will force them to liquidate their stocks to pay up bank loans. c. Stock exchanges transactions are usually financed by loans from banks. Rise in bank rate will result in dealers and brokers selling off their stocks to pay up bank loans.
Working of Bank Rate Policy Hence, rise in bank rate increases interest rates, curtails bank credit, decreases demand for goods and services and finally reduces the price level. Further, the most powerful influence of bank rate is psychological – bankers and businessmen consider bank rate changes as authoritative pronouncements of the Central Bank concerning the credit situation at a very important time. Radcliffe Report states:" the rise in the bank rate is symbolical; it is evident that the authorities have the determination to take unpleasant steps to check inflation”.
Bank Rate Policy - Assumptions 1. Lending rates of Commercial Banks are related to discount rates of the Central Bank. 2. Commercial Banks normally approach Central Bank for additional funds. 3. Commercial Banks keep minimum cash reserves and depend on Central Bank to overcome shortages. 4. They possess eligible securities in sufficient quantities. 5. Borrowing and investment activity of businessmen are dependent on lending rates of Commercial Banks. 6. Prices, wages and employment are all flexible and are responsive to changes in borrowing and investment.
Bank Rate Policy - Limitations 1. Relationship between bank rate and other interest rates – Bank rate policy will be successful only if the lending rates of banks change corresponding to the movement of the bank rate. In developed countries, there is a close and direct relationship so that every change in bank rate is followed immediately by corresponding changes in the lending rates. However, this relationship is quite tenuous in developing countries because of market imperfections. 2. Existence of eligible bills – In India, eligible bills constitute only 3% of the total assets of Commercial Banks. This is on account of an underdeveloped bill market
Bank Rate Policy - Limitations 3. Practice of rediscounting – The bank rate policy can succeed only if Commercial Banks have the practice of rediscounting eligible bills with the Central Bank. However, Indian banks have very few eligible bills or carry large cash balances thereby reducing the efficacy of bank rate. 4. No direct relation between interest and investment – Compared to the role of other factors like availability of raw material, skilled labor, cost of fixed assets and stocks and administrative support, the role of interest rate to influence investment in a developing country is insignificant. Under these circumstances, the Bank Rate continues to be important as a symbolic verdict of the Central Bank than as a vital measure for policy correction. It is more a policy statement of the Central Bank than as a tool of policy correction.
Open market operations Deliberate and direct buying of securities and bills by the Central Bank in the money market, on its own initiative, is called open market operations. In periods of inflation, the Central Bank will sell in the market first class bills in its possession to buyers like Commercial Banks and others. This reduces the cash reserves of the Commercial Banks which in turn will reduce its capability to give loans and advances. Thereby, business activity in the country will be cut short. During recession, Central Bank buys bills from Commercial Banks and thereby increases their cash reserves. Business activity receives a fillip. The Central Bank thus influences the lending operations of Commercial Banks and ultimately influences business activity and economic conditions in the country.
OMO - Advantages Strategically, OMO as a method of influencing money supply is effective because the initiative to control the volume of money supply in the country is kept by the Central Bank itself. But the bank rate policy is passive in the sense that its success depends upon the willing response of the Commercial Banks and their customers.
OMO - Limitations Commercial Banks may prefer to operate with high cash reserves rather than expand credit in the economy though this might negatively impact their profitability. Commercial Banks will also have an optimal trade off between excess cash reserves and buying low yielding securities. Credit expansion must be followed by the willingness of businessmen to come forward to borrow. However, their willingness might be guided by real and not monetary factors in the economy.
Cash Reserve Ratio
According to the RBI Act 1934, every scheduled bank has an obligation to maintain a certain portion of their demand and time deposits as a reserve with the Central Bank. This provision was fixed for three important reasons 1. To ensure the liquidity and solvency of individual Commercial Banks and of the banking system as a whole 2. To provide the Central Bank with supply of deposits for local operations 3. To influence and ultimately restrict Commercial Banks’ expansion of credit. Hence CRR is an additional instrument of credit control of the Central Bank
CRR and Bank Credit Excess cash reserves will induce banks to expand credit and reduction of cash reserves will result in contraction of cash credit. Cash reserves with the Commercial Banks are directly influenced by the CRR and hence the relationship with the CRR and bank credit. For instance, when the reserve requirement is 10% a Commercial Bank will have to maintain a cash reserve of Rs.100 for every deposit of Rs.1000 and hence can lend only up to Rs.900. On the other hand, a cash reserve of 20% will permit a bank to lend only Rs.800. The higher the cash reserve requirement, the smaller the amount available for banks for loans and advances and investments.
Limitations of CRR De Kock “While it (reserve ratio) is a very prompt and effective method of bringing about the desired changes in the available supply of bank cash, it has some technical and psychological limitations which prescribe that it should be used with moderation and direction and only under obvious abnormal conditions.” This technique is normally used to adjust the banking structure to large scale changes in the country’s supply of monetary reserves and is not used frequently to make small adjustments in the supply of credit. Frequent changes in reserve ratio will disturb the Commercial Banks and complicate their book-keeping and their customary way of doing business.
Selective Credit Controls
The quantitative controls like bank rate, OMO and CRR affect indiscriminately all sections of the economy which depend on bank credit. Besides, there are some groups of borrowers who are engaged in important spheres of economic activity and whom the Central Bank would like to insulate from these quantitative effects. Hence, Central Banks have been adopting the tool of selective credit controls or qualitative controls whose special features are:- a. They distinguish between essential and non-essential uses of bank credit b. Only non-essential uses are brought under the scope of Central Bank controls c. They affect not only the lenders but also the borrowers.
Types of Selective Controls A. Margin Requirements – Banks do not lend the entire amount of the project cost or security value. Part of the project cost has to be met by the businessmen investing in a venture. Margin money is the personal stake of the investor in a given investment. Banks or Central Bank can directly encourage or discourage an activity by either decreasing or increasing the margin requirements respectively. For certain export related ventures, govt. recommends even waiver of margin requirement.
Types of Selective Controls B. Regulation of Consumer credit – The Central Bank can either limit the amount of credit for the purchase of any article sought to be regulated or limit the time for repaying the debt. This reduces the quantum of loan available to the customer and also hastens up the exposure of bank credit to the customer. The end result is that a particular kind of activity is sought to be encouraged or discouraged by altering both the quantum of loan and the repayment period thereof.
Types of Selective Controls C. Control through directives : Direct action RBI is empowered to give directives to Commercial Banks in respect of (1) their lending policies (2) the purposes for which advances may or may not be made and (3) the margins to be maintained in respect of secured loans. Direct action can also take the form of the Central Bank charging a penal rate of interest for money borrowed beyond the prescribed amount or refusing to grant further rediscounting facilities to erring banks. However, Commercial Banks are not always responsible as the borrower can always divert the credit availed to unspecified activities.
Types of Selective Controls D. Moral suasion: Moral suasion implies persuasion and request made by the Central Bank to the Commercial Banks to follow the general monetary policy of the former. The effectiveness of moral suasion is debatable. As a method of credit control, it may have restraining influence, but when real forces in favour of credit expansion or contraction are very strong, persuasive tactics may be ineffective. While this method has a psychological advantage as it does not carry any threat or legal sanction, it may not be very effective in times of serious business boom or depression especially in developing countries.
Types of Selective Controls E. Rationing of credit Credit rationing is a method of controlling and regulating the purpose for which credit is granted by the Commercial Banks. It may assume two forms. Firstly, variable portfolio ceilings refer to the system by which the Central Bank fixes a ceiling or maximum amount of loans and advances for every Commercial Bank. Secondly, variable capital assets ratio refers to the system by which the Central Bank fixes the ratio which the capital of the Commercial Bank should have to the total assets of the bank. Rationing of credit may also be in the form of the Central Bank allowing only a fixed amount of accommodation to member banks by means of rediscount.
Significance of Selective Controls Selective controls are flexible in nature and can make credit policy more flexible. It can be directed geographically to parts of the economy that are susceptible to extreme fluctuations. Besides, they can be used to restrain the demand for credit. Monetary authorities have come to depend more and more on selective controls in recent years though they are normally used in conjunction with the general instruments of credit regulation and control.
Limitations of Selective Controls a. They can control only bank credit and investment and trade finance through bank credit. However, there are other sources of financing investment such as capital issue, own capital, NBFIs and undistributed profits. b. It may not always possible for Commercial Banks to ensure that the loans granted by them are spent for the purposes for which they have been sanctioned. c. Commercial Banks, under the influence of profit motive, may sanction loans for forbidden uses but enter them in their books under different heads. d. The Commercial Banks may ensure that loans are made only for the prescribed purpose. However, they have no influence over the purposes for which the resulting additional purchasing power is used.