Central banking functions have evolved gradually over decades. Their evolution has been guided by ever-changing need to find new methods of regulating, guiding and helping the financial system (particularly, the banks). In other words, the evolution of central banking functions has tended to coincide with the evolution of the financial systems of the world economies. Let us recount the leading functions.
1. Note Issue:
It is considered one of the primary functions of a central bank. The entire financial system of a country, with ever-increasing volume and variety of the financial instruments, institutions and markets, needs a stable supply of legal tender money. This legal tender should tend to vary, both in volume and composition to the changing requirements of the economy. Accordingly, the central bank of the country is granted the sole right to issue currency (including that of the government of the country) and (ii) a monopoly of issuing bank notes (which are its promises to pay).
2. Banker’s Bank:
The second main function of a central bank is that of being a bank of the banks. This function includes the following interrelated sub-functions. (a) The first sub-function is its being a custodian of the cash reserves of the commercial banks. The exact form of this function has varied from country to country and in terms of legal provisions. Historically, commercial banks discovered that it was convenient and economical to hold deposit balances with the central bank for making payments to each other.
In some countries, however, the banks are compelled by law to hold deposit balances with the central bank and this gives it an additional tool to regulate credit creation by them. The legal provision to this effect was first introduced in US. Later, it was adopted in India also. RBI has found it a very effective regulatory tool and has used it very extensively. To begin with, bank deposits were categorised into demand deposit liabilities and time deposit liabilities. The minimum cash balances to be maintained with RBI were to be between 2% and 8% of the time deposit liabilities and between 5% and 20% of demand deposit liabilities.
The choice of exact percentages and their revision was left to the discretion of the RBI. Later on, the provision relating to minimum cash balances (called ‘cash reserve ratio’, or CRR) was modified to the effect that now a uniform percentage (between 3% and 15%) is applicable to all bank deposits. Again, the choice of exact percentage and its revision is left to the discretion of the RBI. (b) The second sub-function is that of clearance. When individual banks maintain deposit balances with the central bank and use them to make payments to each other, the system of interbank clearance emerges.
The interbank clearance and remittances result in appropriate adjustments in the deposit balances of the banks with the central bank. Actually, the basic motive, which induces the commercial banks in maintaining deposit balances with the central bank, is the convenience and economy of making payments to each other. This function was first developed by the Bank of England in mid 19th century. Currently, it is one of the primary functions of every central bank of the world.
3. The Central Bank:
The central bank is the final source of the supply of legal tender. It is the lender of the last resort. For this reason, it should be able to adjust the availability of currency with the market in line with the changing needs of the latter. When the economy expands and it needs additional money and credit, the central bank can adopt a policy of pumping in additional currency in the market. Similarly, it can try to curtail the supply of available currency when the economy in a phase of contraction.
The central bank adjusts the volume of currency in two ways. (i) The banks can approach it for cash loans. It can tighten the terms of issue of such loans (including the rate of interest to be charged) if it wants to restrict the money supply. Alternatively, it can make it easier and cheaper for the banks to borrow if it wants to increase the supply of money and credit. (ii) The amount of money needed by the market is also reflected in the bills drawn by the seller upon the buyers and the central bank can take steps to alter the money supply in the market by adjusting the volume of bills discounted/ re-discounted by it.
For example, when the volume of bills drawn is increasing during an expansionary phase of the economy, the central bank can adopt the policy of discounting more of them and pumping additional currency in the market. Similarly, when the economy is passing through a phase of contraction, the volume of bills drawn decreases. In this case, the central bank can drain the market of excess money supply by collecting the earlier discounted bills and discounting less of fresh bills. In addition, it can also adopt the policy of adjusting its discount rate to encourage or discourage the discounting of bills, as the need be.
4. Banker to the Government:
The central bank of the country happens to be a banker to the government. This function normally involves two things: (i) providing ordinary banking services to the government, and (ii) being a public debt agent and underwriter to the government. Let us consider each of these with reference to the Reserve Bank of India.
5. Custodian of Foreign Exchange Reserves:
Central bank of a country is also a custodian of its official foreign exchange reserves. This arrangement helps the authorities in managing and co-ordinating the monetary matters of the country more effectively. This is because there is a direct association between foreign exchange reserves and quantity of money in the market. The foreign exchange reserves are influenced by international capital movements, international trade credits and so on. Because of the interaction between the domestic money supply, price level and exchange reserves, the central bank frequently faces several contradictory tendencies which have to be reconciled.
6. Regulation of Exchange Rate:
A related function, which is assigned to the central bank, is the regulation and stabilization of the exchange rate. This task is facilitated when the central bank is also the custodian of official foreign exchange reserves. The need for a stable exchange rate is more in the case of a paper standard than under a metallic standard. In this context, we should specifically note two things: (i) the justification for having a stable exchange rate and avoiding violent and wide fluctuations in it; and (ii) the need to assign this task to an expert and competent agency.
As regards expertise and competence central bank of the country is the best agency to which the task of regulating and stabilizing exchange rate should be assigned. The central bank happens to be the apex institution of the entire financial system of the country. It is in possession of maximum data and has the expertise ‘of estimating the financial trends and the type of corrective measures needed. Moreover, it possesses several regulatory powers over the financial system. It can contemplate and take the complementary measures needed for ensuring the success off the steps taken in the area of exchange rate.
A stable exchange rate is of great help in promoting external trade and orderly capital flows. The volatility of exchange rate tends to increase if there is complete capital convertibility (that is, capital can flow in and out of the country without specific permission of the authorities). If the central bank is given the authority to regulate the use of foreign exchange (that is, if it has the authority to apply exchange control to the extent it decides), the task of stabilising exchange rate becomes easier for it.
7. Credit Control:
Over the years, credit control has become a leading function of a modern central bank. In earlier days, the term credit control referred to the regulation of only the “volume” of money and credit. Currently, the term is used in a wider meaning and covers not only the “volume” of money and credit, but also its components, its flows, its allocation between alternative uses and borrowers, terms and conditions attached to credit and so on.
The need for credit control arises because it is observed that “money cannot manage itself. Left to unregulated market forces, flows of money and credit have the tendency to accentuate cyclical fluctuations. Moreover, in underdeveloped countries, unregulated credit flows strengthen inter-sectoral imbalances, speculative forces and other distortions. Details of credit control and instruments used by the central bank will be discussed later in this Unit.