Chpater II.ppt

8/18/2019 Chpater II.ppt

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Unit II

Central Bank


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Central Bank

In every country, there is one bank which

acts as the leader of the money market -

supervising, controlling and regulating theactivities of Commercial Banks and other

financial institutions. It acts as a banker of

issue and is in close touch with thegovernment, as banker, agent and adviser to

the latter. Such a bank is known as the

Central Bank of the country.


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Central Bank and Commercial Bank -

ifferences

Central Bank does not work for profits though it mightsecure profits. !hile Commercial Banks aim atsecuring ma"imum profit for their shareholders, the

Central Bank aims at controlling the banking systemand supporting the economic policy of the government.

Central Bank is generally an organ of the governmentand forms part of the govt. machinery. Commercial

Banks may be owned by the govt. or are privatelyowned.

#he $rgani%ation and &anagement of the Central Bankis fully controlled by the 'overnment.


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(unctions of a Central Bank

a. Bank of Issue

Central Bank has the e"clusive monopoly of note issueand the currency notes issued by the Central Bank are

declared unlimited legal tender throughout the country.#his monopoly brings about)

i. Uniformity of note issue which in turn facilitates tradeand e"change within the country

ii. *nables the Central Bank to influence and control the

credit creation of Commercial Banksiii. 'ives distinctive prestige to the currency notes

iv. *nables govt. to appropriate partly or fully the profits ofnote issue.


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b. Banker, +gent and +dviser to the 'overnment

+s Banker and +gent, B* keeps the banking accounts of theCentral and State governments and makes and receives

payments on behalf of the government. It provides short-termadvances to the govt. ways and means advances to tide overtemporary shortage of funds. It advises the govt. on allmonetary and banking matters.

c. Custodian of the Cash /eserves of Commercial Banks

+ll Commercial Banks keep part of their deposits as reserves

with the Central Banks. Centralised cash reserves serve as the basis of a larger and more elastic credit structure and helpsCommercial Banks to meet crises and emergencies.Centralised cash reserves aids the Central Bank to controlcredit creation and implement monetary policy.


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d. Custodian of (oreign Balances of the Country

B* holds the foreign e"change assets of all commercial and non-Commercial Banks of the country. It is the responsibility of B*to maintain the rate of e"change and manage e"change control and

other restrictions imposed by the State. It also maintains reserveswith the I&( and obtains normal drawing and special drawingrights.

e. 0ender of the last resort

Central Bank never refuses to accommodate any eligibleCommercial Bank e"periencing cash shortage. In the absence of a

Central Bank, Commercial Banks will have to carry substantialcash reserves which imply restricted lending and reduced income.+s a lender of last resort, Central Bank assumes the responsibilityof meeting directly or indirectly all reasonable demands foraccommodation by the Commercial Banks.


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f. Central Clearance, Settlement and #ransfer

+s the Central Bank keeps cash reserves of CommercialBanks, it is easier for member banks to settle their mutualclaims in the books of the Central Bank. #hese are the clearinghouse operations of B* wherein che1ues are cleared, claimssettled and funds transferred in the books of the member

banks. 2owever, this function can also be performed by anyleading bank in a locality or area.

g. Controller of Credit

B* controls the level of credit in the economy by eithere"panding or contracting bank deposits. In modern times, bankdeposits have become the most important source of money inthe country. +s controller of credit, B* seeks to influenceand control the volume of bank credit and also to stabili%e

business conditions in the country.


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(unctions of B*

&onetary +uthority

(ormulates, implements and monitors the monetary policy.

$b3ective) maintaining price stability and ensuringade1uate flow of credit to productive sectors.

/egulator and supervisor of the financial system

4rescribes broad parameters of banking operations within

which the country5s banking and financial systemfunctions.$b3ective) maintain public confidence in the system,

protect depositors5 interest and provide cost-effective banking services to the public.


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(unctions of B*

&anager of *"change Control

&anages the (oreign *"change.

$b3ective) to facilitate e"ternal trade and payment and promote orderly development and maintenance offoreign e"change market in *thiopia.

Issuer of currency

Issues and e"changes or destroys currency and coins not

fit for circulation.

$b3ective) to give the public ade1uate 1uantity ofsupplies of currency notes and coins and in good 1uality.


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(unctions of B*

evelopmental role

4erforms a wide range of promotional functions to

support national ob3ectives. /elated (unctions

Banker to the 'overnment) performs merchant

banking function for the Central and the state

governments6 also acts as their banker.

Banker to banks

&aintains banking accounts of all scheduled banks.


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&ethods of Credit Control

Credit control is a very important function of B* whichadopts a variety of methods to e"pand or contract creditin the economy. Some of these methods are traditional

while some others are modern and contemporary.Some of these methods are 1uantitative controls sincethey control and ad3ust total 1uantity or the volume ofdeposits created by Commercial Banks. #hey relate to thevolume and cost of bank credit in general withoutrelating to the purpose for which the bank credit is used.#here are other methods of credit control known asselective or 1ualitative controls, since they control certaintypes of credit and not all credits.


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&ethods of Credit Control

7uantitative controls consist of bank rate or

discount rate policy, open market operations

and reserve re1uirements. 7ualitativecontrols consist of regulation of margin

re1uirements, regulation of consumer credit,

rationing of credit, control throughdirectives, moral suasion and direct action.


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Bank /ate 4olicy

Bank rate in the rate of interest that theCentral Bank levies while discounting or

rediscounting eligible bills and securities ofCommercial Banks to meet their fundsre1uirement. Since the Central Bank is thelender of last resort, the Bank rate is related

closely to all other rates of interest in themoney market. #he eligible bills or first class

bills or gilt-edged securities are treasury bills8bonds and commercial bills.


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!orking of Bank /ate 4olicy

uring inflationary times the bank rate is raisedresulting in the following conse1uences)

a. Businessmen who borrow from banks will find their

cost of funds increased due to a rise in bank rate. #heir profit margins are reduced.

b. &anufacturers and merchants hold large stocks ofinventories through bank loans. + rise in bank rate willforce them to li1uidate their stocks to pay up bank

loans.c. Stock e"changes transactions are usually financed by

loans from banks. /ise in bank rate will result in dealersand brokers selling off their stocks to pay up bank loans.


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!orking of Bank /ate 4olicy

2ence, rise in bank rate increases interest rates,curtails bank credit, decreases demand for goodsand services and finally reduces the price level.

(urther, the most powerful influence of bank rateis psychological 9 bankers and businessmenconsider bank rate changes as authoritative

pronouncements of the Central Bank concerningthe credit situation at a very important time./adcliffe /eport states): the rise in the bank rate issymbolical6 it is evident that the authorities havethe determination to take unpleasant steps to checkinflation;.


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Bank /ate 4olicy 9

+ssumptions

. Commercial Banks keep minimum cash reserves anddepend on Central Bank to overcome shortages.

?. #hey possess eligible securities in sufficient 1uantities.

@. Borrowing and investment activity of businessmen are

dependent on lending rates of Commercial Banks.A. 4rices, wages and employment are all fle"ible and are

responsive to changes in borrowing and investment.


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Bank /ate 4olicy -

0imitations


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Bank /ate 4olicy -

0imitations

>. 4ractice of rediscounting 9 #he bank rate policy can succeedonly if Commercial Banks have the practice of rediscountingeligible bills with the Central Bank. 2owever, *thiopian

banks have very few eligible bills or carry large cash balances

thereby reducing the efficacy of bank rate.?. o direct relation between interest and investment 9

Compared to the role of other factors like availability of rawmaterial, skilled labor, cost of fi"ed assets and stocks andadministrative support, the role of interest rate to influenceinvestment in a developing country is insignificant.

Under these circumstances, the Bank /ate continues to beimportant as a symbolic verdict of the Central Bank than as avital measure for policy correction. It is more a policystatement of the Central Bank than as a tool of policycorrection.


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$pen market operations

eliberate and direct buying of securities and bills by theCentral Bank in the money market, on its own initiative, iscalled open market operations.

In periods of inflation, the Central Bank will sell in the market

first class bills in its possession to buyers like CommercialBanks and others. #his reduces the cash reserves of theCommercial Banks which in turn will reduce its capability togive loans and advances. #hereby, business activity in thecountry will be cut short.

uring recession, Central Bank buys bills from CommercialBanks and thereby increases their cash reserves. Businessactivity receives a fillip.

#he Central Bank thus influences the lending operations ofCommercial Banks and ultimately influences business activityand economic conditions in the country.


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$&$ - +dvantages

Strategically, $&$ as a method of

influencing money supply is effective

because the initiative to control the volumeof money supply in the country is kept by

the Central Bank itself. But the bank rate

policy is passive in the sense that its successdepends upon the willing response of the

Commercial Banks and their customers.


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$&$ - 0imitations

Commercial Banks may prefer to operate withhigh cash reserves rather than e"pand credit in theeconomy though this might negatively impact their

profitability. Commercial Banks will also have an optimal trade

off between e"cess cash reserves and buying lowyielding securities.

Credit e"pansion must be followed by thewillingness of businessmen to come forward to borrow. 2owever, their willingness might beguided by real and not monetary factors in theeconomy.


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Cash /eserve /atio

+ccording to the B*, every bank has an obligation tomaintain a certain portion of their demand and timedeposits as a reserve with the Central Bank. #his

provision was fi"ed for three important reasons

. #o influence and ultimately restrict Commercial Banks5e"pansion of credit.

2ence C// is an additional instrument of credit controlof the Central Bank


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C// and Bank Credit

*"cess cash reserves will induce banks to e"pand credit andreduction of cash reserves will result in contraction of cashcredit. Cash reserves with the Commercial Banks are

directly influenced by the C// and hence the relationshipwith the C// and bank credit.

(or instance, when the reserve re1uirement is


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0imitations of C//

e Fock G!hile it reserve ratio is a very prompt andeffective method of bringing about the desired changes inthe available supply of bank cash, it has some technical and

psychological limitations which prescribe that it should beused with moderation and direction and only under obviousabnormal conditions.;

#his techni1ue is normally used to ad3ust the bankingstructure to large scale changes in the country5s supply of

monetary reserves and is not used fre1uently to make smallad3ustments in the supply of credit. (re1uent changes inreserve ratio will disturb the Commercial Banks andcomplicate their book-keeping and their customary way ofdoing business.


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Selective Credit Controls

#he 1uantitative controls like bank rate, $&$ and C//affect indiscriminately all sections of the economy whichdepend 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 liketo insulate from these 1uantitative effects. 2ence, CentralBanks have been adopting the tool of selective creditcontrols or 1ualitative controls whose special featuresare)-

a. #hey distinguish between essential and non-essential usesof bank credit

b. $nly non-essential uses are brought under the scope ofCentral Bank controls

c. #hey affect not only the lenders but also the borrowers.


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#ypes of Selective Controls

+. &argin /e1uirements 9

Banks do not lend the entire amount of the pro3ect cost or security value. 4art of the pro3ect

cost has to be met by the businessmen investingin a venture. &argin money is the personal stakeof the investor in a given investment. Banks orCentral Bank can directly encourage or

discourage an activity by either decreasing orincreasing the margin re1uirements respectively.(or certain e"port related ventures, govt.recommends even waiver of margin re1uirement.


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B. /egulation of Consumer credit 9

#he Central Bank can either limit the amount ofcredit for the purchase of any article sought to beregulated or limit the time for repaying the debt.#his reduces the 1uantum of loan available to thecustomer and also hastens up the e"posure of

bank credit to the customer. #he end result is that

a particular kind of activity is sought to beencouraged or discouraged by altering both the1uantum of loan and the repayment periodthereof.


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C. Control through directives ) irect action

B* is empowered to give directives to CommercialBanks in respect of the margins to be maintained in respect ofsecured loans. irect action can also take the form of theCentral Bank charging a penal rate of interest for money

borrowed beyond the prescribed amount or refusing to

grant further rediscounting facilities to erring banks.2owever, Commercial Banks are not always responsibleas the borrower can always divert the credit availed tounspecified activities.


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. &oral suasion)

&oral suasion implies persuasion and re1uest made bythe Central Bank to the Commercial Banks to follow the

general monetary policy of the former. #he effectivenessof moral suasion is debatable. +s a method of creditcontrol, it may have restraining influence, but when realforces in favour of credit e"pansion or contraction arevery strong, persuasive tactics may be ineffective. !hile

this method has a psychological advantage as it does notcarry any threat or legal sanction, it may not be veryeffective in times of serious business boom or depressionespecially in developing countries.


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*. /ationing of credit

Credit rationing is a method of controlling andregulating the purpose for which credit is granted by the

Commercial Banks. It may assume two forms. (irstly,variable portfolio ceilings refer to the system by whichthe Central Bank fi"es a ceiling or ma"imum amount ofloans and advances for every Commercial Bank.Secondly, variable capital assets ratio refers to thesystem by which the Central Bank fi"es the ratio which

the capital of the Commercial Bank should have to thetotal assets of the bank. /ationing of credit may also bein the form of the Central Bank allowing only a fi"edamount of accommodation to member banks by meansof rediscount.


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Significance of Selective

Controls

Selective controls are fle"ible in nature and can

make credit policy more fle"ible. It can be

directed geographically to parts of the economy

that are susceptible to e"treme fluctuations.

Besides, they can be used to restrain the demand

for credit. &onetary authorities have come to

depend more and more on selective controls inrecent years though they are normally used in

con3unction with the general instruments of credit

regulation and control.


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0imitations of Selective

Controls

a. #hey can control only bank credit and investment andtrade finance through bank credit. 2owever, there areother sources of financing investment such as capitalissue, own capital, B(Is and undistributed profits.

b. It may not always possible for Commercial Banks toensure 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. #he Commercial Banks may ensure that loans are made

only for the prescribed purpose. 2owever, they have noinfluence over the purposes for which the resultingadditional purchasing power is used.

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Chpater II.ppt