Central Banking Final 210

Central Bank

Central Bank

A central bank is an institution which is responsible for safeguarding the financial stability of the country.

Central banks – world view • Today almost all nations in the globe have their Central Banks’ • The idea of having central bank attained popularity during 20th century (although some central banks in existence earlier as well) • International Monetary Conference held in Brussels (1929) – strongly emphasized the need of central banking unit

Monopoly of note issue.

Controller of the credit

Lender of the last resort.

Banker to government.

Function of The Central Bank

1:Monopoly of note issue The central bank of a country is responsible for issuing currency notes for it.Methods of note issue: 1:Currency principle 2:Maximum fiduciary system 3:Proportional reserve system

Currency Principle

•Currency principle is concerned with the belief that the money supply or currency in circulation should be strictly related to the amount of gold deposited with the Bank

Maximum fiduciary system

Under the system, the central bank of the country is permitted to issue bank notes of a given amount without giving gold and silver to cover it. The fixed quantity of notes allowed by the law to be issued is too backed by the government securities only. . The amount of notes circulated in excess of the fiduciary limit must be 100% backed by gold.

Proportional Reserve System

• according to this system proportion of note issue is backed by metallic reserve and rest of the amount is backed by Govt. securities and bonds.

• CB issue notes 25% to 40% of which is backed by gold and rest of 60% to 75% is backed by Govt. securities. The proportional percentage is different from countries to countries. condition.

• minimum reserve system

• According to minimum reserve system the central bank is required to keep only a minimum amount of reserves in the form of gold and foreign exchange

central bank can expand the note issuance according to volume of business activities with out backing of gold.

2: Banker to the Government

Central Bank :Is a banker to the government of the country.

It performs all services which a commercial banks do for its customers.

like….Collect taxes on behalf of gov’t, pay

pensions and salaries to employees Advisor in financial matters to the

government Agent to the gov’t in international banking

and financial markets.

3:Lender of the last resort

The central Bank acts as lender of the last resort for the commercial banks.

It helps other banks during their financial difficulties.

For this purpose it advance loans to banks……..

4:Controller of credit

The most important function of central bank in modern times is that of controlling the credit operations of commercial banks by regulating their credit volume…

For controlling credit C.B use….

1:Bank rate policy

2:Change in reserve ratio

3:Credit rationing.

4: Direct action

Bank Rate Policy

• Bank rate, also referred to as the discount rate, is the rate of interest which a central bank charges on the loans and advances that it extends to commercial banks and other financial intermediaries. Changes in the bank rate are often used by central banks to control the money supply

Change in Reserve Ratios

• A cash reserve ratio (or CRR) is the percentage of bank reserves to deposits and notes. The cash reserve ratio is also known as the cash asset ratio or liquidity ratio

• The reserve ratio is sometimes used as a tool in the monetary policy, influencing the country's economy, borrowing, and interest rates

Effects on money supply… • * CRR is used as a tool in monetary policy,

influencing the country’s economy, borrowing and interest rates

• CRR works like brakes on the economy’s money supply

• * CRR requirements affect the potential of the banking system to create higher or lower money supply

•

SLR

• Every bank is required to maintain at the close of business every day, a minimum proportion of their Net Demand and Time Liabilities as liquid assets in the form of cash, gold The ratio of liquid assets to demand and time liabilities is known as Statutory Liquidity Ratio (SLR

REPO Rate

• The rate at which central bank repurchases government securities fro commercial banks

• Whenever the banks have any shortage of funds they can borrow it from RBI. Repo rate is the rate at which our banks borrow rupees from RBI. A reduction in the repo rate will help banks to get money at a cheaper rate. When the repo rate increases borrowing from RBI becomes more expensive.

• Repo (Repurchase) rate is the rate at which the RBI lends shot-term money to the banks. When the repo rate increases borrowing from RBI becomes more expensive. Therefore, we can say that in case, RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate; similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate

• Reverse Repo rate is the rate at which banks park their short-term excess liquidity with the RBI. The RBI uses this tool when it feels there is too much money floating in the banking system. An increase in the reverse repo rate means that the RBI will borrow money from the banks at a higher rate of interest. As a result, banks would prefer to keep their money with the RBI

Difference between Bank Rate and Repo Rate

• While repo rate is a short-term measure, i.e. applicable to short-term loans and used for controlling the amount of money in the market, bank rate is a long-term measure and is governed by the long-term monetary policies of the governing bank concerned.

Credit Rationing

• credit rationing describes the situation when a bank limits the supply of loans, although it has enough funds to loan out, and the supply of loans has not yet equaled the demand of prospective borrowers. Changing the price of the loans (interest rate) does not equilibrate the demand and supply of the loans. The bank finds that raising the interest rate beyond a certain level actually reduces its profitability.

Direct action policy

• Direct Action: The instrument of direct action is concerned with the policy of central bank against commercial banks. It can refuse to give loans to commercial banks. The central bank will not advance loan to commercial banks for the sectors which create inflation. Moreover, if commercial banks do not follow the instructions of the central bank, It will refuse to lend commercial banks

Credit Control(Monetary policy)

Credit control is necessary for economic stability in a country…

Central bank increase or decrease the credit according to the needs of a country for achieving

economic stability through controlling

supply of money.

Monetary policy is the oldest policy for the economic stability. It is a policy which is adopted by the central bank of the country to control the supply of money: We can say that all those methods which are adopted by central bank, of the country to control the supply of money are called the monetary policy. In simple words, monetary policy means monetary management.

Methods of Credit Control

It adopts various methods for this purpose…

Quantitative methods

Qualitative methods

Quantitative Methods:

Changes in Bank Rate Policy or Re discount Rate:,. By changing the rate of interest, the central bank can influence the supply of money in the country. To control inflation the central bank increases the rate of interest. The commercial banks will also increase their rate of interest. Accordingly, the loans will decrease, investment, output and prices will fall. In this way, inflation will be controlled. .

Open Market OperationUnder this technique, the central bank sells or purchases 'government securities. If the central bank finds that commercial banks are providing excessive loans which are creating inflation. To remove the inflation, the central bank sells the government securities. The commercial banks will purchase these securities to earn interest against such securities. In this way, the resources of commercial banks will go down. They will advance less loans. Accordingly, the inflation will be controlled.

Changes in Reserve Capital

Each commercial bank has to keep a certain ratio of its deposit with central bank.. By changing the reserve capital, a central bank can control the supply of money by commercial banks.When there is inflation in the economy. To remove this inflation, the central bank will increase the reserve ratio. As a result, lending of commercial banks will fall. As a result the supply of money will decrease.

5) Changes in Marginal Requirements

Commercial banks do not give loans against leaves, rather they ask for pledges to make. How much a person will have to pledge is settled by the central bank. This is given the name of marginal requirement. The central bank can bring changes in the marginal requirements. If there is inflation in the economy, the marginal requirements will increase. In this way, people will get less loans.

6) Credit Ceiling/Rationing of Credit

The central bTank can issue directions that loans will be given to commercial banks upto a certain limit. As a result, the commercial banks-will be careful in advancing loans to the people. But this is a very strict method, hardly adopted by the central bank. Moreover, if the commercial banks are having other sources to borrow, they will not bother for this policy.

2) Qualitative Methods

* Moral Suasion: It is concerned with just as a moral request by central bank to commercial banks that loans should not be given for unproductive fields which create inflation. Loans should not be given for speculative purposes and hoarding. But such like requests could be effective in the developed countries.

Consumers Credit Control: This instrument is applied during inflation. If the central bank wants to control the supply of money, it will issue directions to commercial banks that loans should not be advanced for consumption purposes or for consumer durables because they create inflation.

* Direct Action: The instrument of direct action is concerned with the policy of central bank against commercial banks. It can refuse to give loans to commercial banks. The central bank will not advance loan to commercial banks for the sectors which create inflation. Moreover, if commercial banks do not follow the instructions of the central bank, It will refuse to lend commercial banks

*

Reserve Bank of India

RBI: An Introduction

Established on 1st April 1935 under the reserve bank of India act.Headquarters in MumbaiIt has 22 regional offices mostly state capitalsCurrent governor is Dr. D. Subbarao

Brief HistoryIt was established on the

recommendations of the young commission

The RBI was initially a shareholder’s bank with a Paid up capital of 5 cror

Initially it was privately ownedWas nationalized in 1948 [vide Reserve Bank (Amendment) Act, 1948]The first Indian Governor was Sree D

Dheshmukh

OrganizationThe reserve bank of India's affairs are

governed by a central board of directors appointed by the government of India They are appointed for a period of four years

One each for the four regions of the country is the local board which is appointed for four years by the central government

The local board advices the central board on local matters

Governor – Central Board • 4 Deputy Governors • 10 Directors (nominated by the Central Government) • 4 Directors from Local Boards • 1 Government Representative (nominated by the Central Government) – Local Boards

• Delhi • Mumbai • Calcutta • Madras

Organisation

Functions of RBI

Bank of issue (of currency) • Banker to the government (including management of public debt) • Banker to commercial banks (lender of last resort) • Controller of volume of credit in India

Functions of RBI

Organization of ‘sound and healthy commercial banking system’

• Concerned with the development of

– Rural banking;

– Promotion of financial institutions;

– Development of money and capital markets

RBI – in its promotional role • The establishment of BILL MARKET scheme (1952) • Establishments of financial corporations – For agricultural sector; and – Industrial sector • Promotion of Regional Rural Banks (with the able assistance of commercial banks) • Assistance (to commercial banks) to open foreign branches • Establishment of Export-Import bank

RBI: The Monitory Policy

Objective- To formulate, implement and EXECUTE monetary policy

To maintain price stability and adequate flow of capital in the economy

Instruments- qualitative and quantitative

Quantitative Measure

Bank rate , Repo rateOpen market operationsVariation in cash reserve ratio

Qualitative Mesures

Moral SuationRationing of creditMarginal requirementsDirect Action

RBI: Regulator of the financial System

Objective-To maintain public confidence in the

systemProtect investor interestTo provide broad parameters of

banking The lender of the last resort

RBI & Commercial Banks • Controller to commercial banks – By virtue of Banking Regulation Act, 1949; and Reserve Bank of India Act, 1934

General control over commercial banks • License to commence banking business • Licensing the commercial banks – to open branches • Revoke the license – if the banking company is operating improperly • Power to inspect • Power to appoint additional directors on the Board of Directors

Controller of Foreign Exchange Reserves

Objective- To facilitate external trade and

encourage development of foreign exchange market

To control and manage foreign reserve To buy and sell foreign currency to

maintain the value of rupee as against other currencies

Issue of currency

ObjectiveTo ensure adequate supply of currencyIssue of new currency and destruction of

currency no longer fit for circulationMaintain minimum reserve for note issue

Devlopmental RolObjective

To develop the quality of banking system in India

To establish financial institutions of national importance like IDBI, NABRAD, Exim Bank, ICICI

Banker’s bank • Lender of last resort for – Commercial banks – Commercial co-operative banks – Regional rural banks • RBI offers – refinancing facility to its ‘scheduled banks’ –– Before admitting the banking company in to the schedule – RBI satisfies itself that such banking company is worth it – RBI also has the power to remove the bankiing company from the schedule

Banker of the Government

Collects taxes

Pays salaries and pensions

Advises he Government on financial issues

Publishes data and reports on the health of the economy

Issues directives to commercial banks