Functions of central bank – Bankers bank

The central bank supervises co-ordinates and controls the operations and activities of the commercial banks. In order to do so it undertakes the following functions.

a] Custodian of cash reserves

It is mandatory for all commercial banks have to keep a certain proportion of their demand and time deposits with the central bank of the country. This is known as the cash reserve ratio. This cash reserve ratio can be changed by the central bank. The central bank pays interest to the commercial banks on their reserve ratio balances.

The cash reserve ratio enables the central bank to advance funds to banks that face temporary liquidity crises. It is an instrument of credit control and therefore helps in controlling the money supply in the country.

In India the commercial banks are expected to kep a minimum of 3% of their demand and time deposits with the RBI.

b] Lender of the last resort

Commercial banks operate on the basis of low cash reserves and therefore even the well managed bank may run into difficulty especially when there is a sudden large demand for cash.

Therefore central bank acts as the lender of the last resort to the commercial banks. Whenever commercial bank faces liquidity problem, it ultimately approaches the central for assistance. The central bank provides funds by rediscounting bills of commercial banks.

This function of the central bank helps to control panic and infuse confidence among banks as well as the public.

c] Clearing house facility

The central bank acts as clearing house for all commercial banks. It helps to clear the day to day interbank transactions. Since all commercial banks have their accounts with the central banks, the claims of banks against each other are settled by simple transfer ie by debit and credit entries in their accounts.

Due to clearing house, interbank transfer of funds can be settled without using cash and therefore it is economical and time saving to the commercial bsnks.

Take an illustration. There is not one commercial bank in the country but there are several commercial banks.

Customers of Bank ‘A’ may draw cheques in favour of persons who have accounts with commercial Bank `B’ and customers with accounts in bank ‘B’ may draw cheques in favour of persons who have accounts in commercial bank ‘ A.

Let us suppose that in one month as a result of above transactions bank ‘A’ owes ` 50 lakhs to bank ‘B’ and bank ‘B’ owes ` 40 lakhs to bank ‘A’.

Now bank ‘A’ draws a cheque in favour of bank ‘B’ for` 10 lakhs only on the central bank of the country, where all commercial banks have their accounts.

Bank ‘A’s account is debited by ` 10 lakhs and bank ‘B’s account is credited by ` 10 lakhs.

Thus the clearing house system’ which becomes possible because all commercial banks keep their accounts with the central bank of the country, economizes use of cash and facilitates adjustment of dues between commercial banks by the Central Bank, with convenience to all commercial banks.

d] Adviser to commercial banks

The central bank advises and guides the commercial banks in all their activities.

Posted in General Economics