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Class 11 Finance Chapter 4 Functions of Central Bank
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Functions of Central Bank
Chapter : 4
VERY SHORT TYPE QUESTIONS & ANSWERS
1. Which bank can issue notes?
Ans: The Reserve Bank.
2. What is banking in notes?
Ans: Banking is directly or indirectly connected with the trade of a country and the life of each individual. It is an industry that manages credit, cash, and other financial transactions. Banks also help to mobilise the savings of an individual, making funds accessible to businesses and help them to start a new venture.
3. What is issue of bank?
Ans: The central bank is the bank of issue. It has a monopoly of note issues. Notes issued by it circulate as legal tender money. It has its issue department which issues notes and coins to commercial banks. Coins are manufactured in the Government mint but they are put into circulation through the central bank.
4. What is soiled note?
Ans: Soiled notes are those which have become dirty and slightly cut. Notes which have numbers on two ends, i.e. notes in the denomination of Rs. 10 and above which are in two pieces, are also treated as soiled notes. The cut in such notes, should, however, not have passed through the number panels.
5. Are bank notes a liability?
Ans: A promissory note (IOU) that you signed would be your liability, but it would be an asset for the note’s holder or owner. Similarly, a bank deposit is a liability for the bank but an asset for the depositor.
6. What is lender of last resort in banking?
Ans: A lender of last resort is whoever you turn to when you urgently need funds and you’ve exhausted all your other options. Banks typically turn to their lender of last resort when they cannot get the funding they need for their daily business. In situations like that, central banks act as the lender of last resort.
7. Why is central bank known as the lender of last resort?
Ans: The Central Bank can act as a lender of last resort to prevent the government from suffering a liquidity shortage and failing to meet is short term spending commitments. Then the government would fail to sell sufficient bonds on this particular auction; this would cause a temporary shortage of money for the government.
8. Which bank started lender of last resort?
Ans: While the concept itself had been used previously, the term “lender of last resort” was supposedly first used in its current context by Sir Francis Baring, in his Observations on the Establishment of the Bank of England, which was published in 1797.
9. Who said the central bank is the lender of last resort?
Ans: The classical theory of lender of last resort was developed in the 19th century by Henry Thornton and Walter Bagehot. Both theorists stressed the need to protect the money stock, instead of individual banks, and allowing insolvent financial institutions to fail.
10. How is the central bank the banker of last resort?
Ans: A central bank is the lender of last resort because, in any country, its central bank offers an extension of credit to financial institutions experiencing financial difficulty that cannot obtain necessary funds elsewhere. Different institutions may act as a lender of last resort in different countries.
11. What is custodian of foreign exchange reserves?
Ans: The RBI acts as the custodian of the country’s foreign exchange reserves, manages exchange control and acts as the agent of the government in respect of India’s membership of the IMF.
12. What is custodian of cash reserve?
Ans: Commercial banks are required by law to keep reserves equal to a certain percentage of both time and demand deposits liabilities with the central banks. Thus the central bank acts as the custodian of the cash reserves of commercial banks and helps in facilitating their transactions.
13. Why was the SDR created?
Ans: The SDR was created as a supplementary international reserve asset in the context of the Bretton Woods fixed exchange rate system. The SDR is neither a currency nor a claim on the IMF. Rather, it is a potential claim on the freely usable currencies of IMF members. SDRs can be exchanged for these currencies.
14. What is variable reserve requirement?
Ans: In countries in which the traditional instruments are not available, variable reserve requirements may serve as a partial substitute for them. An increase in reserve requirements, like open market sales of securities by the central bank, may be employed as a means of making the central bank’s rediscount rate effective.
15. What is variation in reserve ratio?
Ans: Thus, variations in the reserve ratio reduce increases the liquidity and, consequently, the lending power of the banks also. Therefore, the cash reserve ratio is raised by the central bank when credit contraction is desired and lowered when credit is to be expanded.
16. What is margin requirement in banking?
Ans: Margin requirement refers to the difference between the current value of the security offered for loan (called collateral) and the value of loan granted. It is a qualitative method of credit control adopted by the central bank in order to stabilize the economy from inflation or deflation.
17. What is regulation of margin requirements?
Ans: FINRA Rule 4210 (Margin Requirements) describes the margin requirements that determine the amount of collateral customers are expected to maintain in their margin accounts, including both strategy based margin accounts and portfolio margin accounts.
18. What is meant by margin requirement? Why is it necessary?
Ans: Margin requirement refers to the difference between the current value of the security offered for loan (called collateral) and the value of loan granted. It is a qualitative method of credit control adopted by the central bank in order to stabilize the economy from inflation or deflation.
19. What is margin requirement in India?
Ans: The Securities and Exchange Board of India (Sebi)’s new mandate in margin trading, which was brought into effect last year in a phased manner, has increased upfront requirement to 100% from Wednesday. Sebi hiked the upfront margin requirement to 50% from 25% from 1 March 2021 and further to 75% in June.
20. What is the purpose of bank supervision and examination?
Ans: BSP’s role is primarily to evaluate the quality of oversight, the adequacy of policies and procedures, the robustness of the risk management system and the effectiveness of the internal audit function.
21. What is inspection in banking?
Ans: Bank inspection is the process of monitoring banks to ensure that they are carrying out their activities in a safe and sound manner and in accordance with laws, rules and regulations. It is a means of determining the financial condition and of ensuring compliance with laid down rules and regulations at any given time.
22. What is included in bank supervision?
Ans: Supervision involves examining the financial condition of individual banks and evaluating their compliance with laws and regulations. Bank regulation involves setting rules and guidelines for the banking system.
23. What is meant by bank supervision?
Ans: Bank supervision is a supervisory function charged with the responsibility of ensuring the safety and soundness of the banking system as a whole. Books and affairs of every licensed insured institution are examined as a means of meeting its supervisory mandate.
24. What is the important bank supervision?
Ans: Two major focuses of banking supervision and regulation are the safety and soundness of financial institutions and compliance with consumer protection laws. A bank that successfully manages risk has clear concise written policies. It also has internal controls, such as separation of duties.
25. What are the main objectives of inspection of banks by the RBI?
Ans: “The idea is to check if the bank is in compliance with all the regulatory requirements prescribed by RBI. The main aim is to ensure that the interests of the depositors are protected and that the business of the bank is conducted in a sound manner,” said Umarji.
26. Give the meaning of the Central Bank.
Ans: The Central Bank is the apex of the monetary structure of a country According to Kent, a Central Bank is an institution charged with the responsibility of managing the expansion and contraction of the volume of money in the interest of general Public Welfare.
27. State the meaning of margin requirement.
Ans: The term ‘marginal requirement’ refers to the proportion of the price of securities which banks and other security dealers are not permitted to lend. In other words, the difference between the ‘Loan value and the market value is known as the margin.’
28. Give the meaning of foreign exchange.
Ans: In a broad sense, the term foreign exchange refers to the mechanism in accordance with which foreign obligations are cleared. According to Mr. Hartley Withers “Foreign exchange is a mechanism by which international indebtedness is settled between one country and another.”
29. Give the meaning of Rationing of Credit.
Ans: Rationing of credit refers to the policy of a central bank to prescribe the maximum limit and amount of credit that commercial banks can grant. It is a selective method of credit control of the Central Bank.
30. State the meaning of Banker’s clearing house.
Ans: As the custodian of the cash reserves of the commercial banks, the Central Bank acts as the clearing house for these banks. Since all banks have their accounts with the central bank, the central bank can easily settle the claims of various banks.
SHORT & LONG TYPE QUESTIONS & ANSWERS
1. Explain the function of the Central Bank.
Ans: The functions of the Central Bank are as follows:
(a) Note issue: The Central Bank of a country is granted the monopoly power of note issue. This means that it is authorised by law to print currency notes.
A Central Bank is granted the exclusive right of note issue on account of the following reasons:
(i) A Central Bank which is given the monopoly of note issue is better equipped to control the undesirable credit expansion by commercial banks.
(ii) It lends to the currency notes a distinctive prestige.
(iii) When the central bank issues notes, they possess the merit of being uniform.
(iv) It is possible and easier for the states to exert control and to undertake supervision over the irregularities associated with the issue of notes.
(v) Since the central bank of a country looks after the monetary affairs of the state, it is better equipped to handle problems pertaining to the note issue. De Kock has mentioned four reasons for the concentration of note issue in a central bank.
These are:
(i) Uniformity in note circulation to attain effective state Supervision.
(ii) Control over undue credit expansion by the commercial banks.
(iii) To give a distinctive prestige to the note issue.
(iv) To provide for participation of the state in the profits of the central bank.
(b) Bankers to the government: The Central bank acts as a Banker to the government. It also acts as fiscal agents and advises the governments on fiscal matters. As a banker to the government, the central bank maintains the banking accounts of the government departments, state governments and government enterprises.
The Central Bank undertakes transactions for the government with regard to purchase and sale of foreign exchange. It gives short term loans to the government and at the times of crisis makes extraordinary advances. In its capacity as financial agent and advisor to the government, it manages the national debts and guides the government on matters pertaining to economic policy.
The ultimate responsibility for laying down the monetary policy and maintaining the monetary standard lies with the government. In the formulation of the monetary policy, the central bank is not only consulted by the government, but it is also given a free hand and assisted whenever possible by the government in carrying out such monetary policy.
(c) Banker’s Bank (2016): As a banker’s bank, the central bank acts as a custodian of member bank’s cash reserves. It is customary for commercial banks to hold a part of their demand and time deposits with the Central Bank. In return, the central bank re-discounts the bills of the commercial banks, and gives them remittance facilities, thereby providing credit to them on the basis of these reserves.
The advantages of centralisation of cash reserves are as follows:
(i) The centralisation of cash reserves with the central bank reinforces the confidence of the general public in the strength of the banking system of the country.
(ii) The centralisation of cash reserves in the central bank is a source of great strength to the banking system in the country.
(iii) When cash reserves accumulate with the central bank, it can make use of them in the interest of national welfare.
(iv) The centralisation of cash reserves also enables the central bank to control the creation of credit by the commercial banks.
(v) The central bank can provide additional funds on a temporary basis and short term basis to commercial banks to overcome their financial difficulties.
(iv) The reserves facilitate the central bank to re-discount the bills of exchange of commercial banks.
(d) Lender of the last resort (2017): This is one of the most important functions of the central bank. By granting accommodation in the form of re-discounts and collateral advances to commercial banks, bill brokers and dealers or other financial institutions, the central bank acts as the under of the; ast resort. The central bank under such institutions in order to help them in times of crisis so as to save the financial structure of the country from collapse. It acts as the lender of the last resort through discount houses on the basis of treasury bills, government securities and bonds “at the front door”.
The other method is to give temporary accommodation to the commercial banks directly through “the back door”. The difference between the two methods is that lending at the front door is at the bank rate and in the second case at the market rate. The central bank as lender of the last resort is a big source of cash and also influences prices and market rates.
(e) Custodian of foreign exchange reserves: The central bank keeps and manages the foreign exchange reserves of the country. It is an official reserve of gold and foreign currencies. It sells gold at fixed prices to the monetary authorities of other countries. It also buys and sells foreign currencies at international prices. It fixes the exchange rates of the domestic currency in terms of foreign currencies.
It holds these rates within narrow limits in keeping with its obligations as a member of the International Monetary fund and tries to bring stability in foreign exchange rates. It manages exchange control operations by supplying foreign currencies to importers and persons visiting foreign countries on business, studies etc. in keeping with the rules laid down by the government.
(f) Acting as clearing house (2017): The Central Bank acts as the clearing house for the commercial banks. Since it holds the cash reserves of the commercial banks, it becomes easier and more convenient for it to act as the clearing house of the country. All the commercial banks have their accounts with the Central Bank. Consequently, the Central bank can settle the claims and counterclaims of the commercial banks with the minimum use of cash.
Thus the clearing house functions of the Central Bank economises the use of cash by the banks. Another advantage accruing from the Central Bank in its capacity as the clearing houses is that it helps the commercial banks to create credit on a large scale because the demand for cash is automatically reduced consequent upon the functioning of the clearing system in the country.
(g) Controller of credit (2016): The control of credit is the most important of all the functions rendered by the Central Bank. It is the function which embraces the most important questions of central banking policy and the one through which practically all the other functions are united and made to serve a common purpose. This function has assumed importance with the growing popularity of bank credit. Commercial banks have the power to alter the total amount of money in circulation through the mechanism of credit creation.
2. Explain the different methods of credit control by the Central Bank.
Ans: The various methods or instruments of credit control used by a Central Bank may be classified into two broad categories:
(a) The quantitative or general methods. and
(b) The Qualitative or selective methods.
(c) The important quantitative methods of credit control are:
(i) Bank rate or Discount rate (2016): It means “the rediscounting of first class bills of exchange brought to the Central Bank by the discount houses and commercial banks at a certain maximum official rate.” It also implies “the varying of the terms and conditions under which the market can have a temporary access to the Central Bank either in the form of rediscounting or through secured advances”. By means of these methods, the Central Bank can influence the ‘cost as well as the availability of credit’.
The Central Bank tries to control credit, through the bank rate by influencing both the cost as well as the availability of credit. The cost of credit is influenced by changing the bank rate. The Central Bank raises the cost of credit and by lowering the bank rate, it lowers down the cost of credit. The Bank rate policy also affects the availability of credit by changing the conditions under which the central bank grants loans to commercial banks.
(ii) Open market Operation: Deliberate and direct buying and selling of securities and bills in the money market by the central bank, on its own initiative, is called open market operations. It implies the purchase and sale of government and other securities. In countries where the market for government securities is limited or the supply of government securities is inadequate, open market operations include purchase and sale of securities guaranteed by the government and municipal securities also.
Generally open market operations are confined to the purchase and sale of government securities. Open market operations are undertaken by the central bank to exercise a stabilising influence on the money market. It has been developed as a technique of credit control only after the First World War. The considerable increase in the volume of government securities has helped the open market operations to become a strong and successful weapon of credit control. In a wider sense, open market operations include purchase and sale by the Central Bank in the market of government securities, other securities, bankers acceptances and foreign exchange.
(iii) Variable reserve ratio: Variable reserve ratio refers to the system of credit control under which it is necessary for every bank to maintain a definite percentage of its deposits with the central bank. The central bank is free to vary the percentage within the limits defined in the statute.
When the Central Bank varies the reserve ratio, the cash reserves of the banks get altered which affect the volume of credit. If the central bank raises the reserve ratio, the banks have to maintain more cash reserves with the central bank. This reduces the cash with the banks, thereby reducing the capacity of the banks to lend. If the reserve ratio is lowered, the banks have to reduce the reserves with the central bank. This increases the cash with the banks and they are enabled to lend more.
(b) The important qualitative methods of credit control are:
(i) Margin requirement: According to this method, the commercial banks do not lend money to the borrower to the full value of the collateral securities provided by them against the loans. The general practice is to lend money upto a certain limit, and thus a margin is left. Suppose, the banks decide to fix the margin as 25% and if a borrower furnishes security work Rs. 100 then against such security, a bank will give credit only upto Rs. 75.
This is done primarily for two reasons – (a) There is a possibility of default in payment of interest as well as the principal amount. (b) Another is that the value of securities furnished does not remain constant. The volume of credit can be increased or decreased by making necessary changes in the margin requirement.
(ii) Rationing of credit: This method refers to the policy of a central bank to prescribe the maximum limit and amount of credit that commercial banks can grant. It may be called a variable capital asset ratio, means the central bank fixes the ratio which the capital of the commercial bank should have to the total assets of the bank.
(iii) Moral Suasion: As a method of credit control is used by central banks to exercise influence over the loan policy of commercial banks. In the modern age, the Central Bank is considered to be the apex financial institution and acts as an advisor and guide of commercial banks.
Hence a Central Bank tries to control credit by way of persuading the commercial banks to see to it that credit is not given for unnecessary, or undesirable purposes.
(iv) Directives: According to this method, the Central Bank gives directives to commercial banks that they should follow certain lending policies or they should provide loans only for certain purposes.
(v) Direct action: This method refers to the directions and restrictions enforced on the commercial banks by the central bank with regard to their lending and investment policies. It involves an element of computation. The directions of the Central Bank have a legal sanction. The offending banks can be penalised by the central bank which may include denial of accommodation, charging off penal rate of interest etc.
(vi) Inspection and Supervision: This system is most executive. The Central Banks of different countries are empowered to control the banking system of the country. According to this method the Central Bank can inspect and supervise other banks. As a result the central bank may know whether the banking business policy is efficiently managed or not and on the basis of that the Central Bank may suggest and advise.
3. Explain why the Central Bank is called Bankers Bank.
Ans: As a banker’s bank, the central bank acts as a custodian of member bank’s cash reserves. It is customary for commercial banks to hold a part of their demand and time deposits with the Central Bank. In return, the central bank re-discounts the bills of the commercial banks, and gives them remittance facilities, thereby providing credit to them on the basis of these reserves.
The advantages of centralisation of cash reserves are as follows:
(i) The centralisation of cash reserves with the central bank reinforces the confidence of the general public in the strength of the banking system of the country.
(ii) The centralisation of cash reserves in the central bank is a source of great strength to the banking system in the country.
(iii) When cash reserves accumulate with the central bank, it can make use of them in the interest of national welfare.
(iv) The centralisation of cash reserves also enables the central bank to control the creation of credit by the commercial banks.
(v) The central bank can provide additional funds on a temporary basis and short term basis to commercial banks to overcome their financial difficulties.
(vi) The reserves facilitate the central bank to re-discount the bills of exchange of commercial banks.
4. Describe the methods of issuing notes by the Central Bank.
Ans: There are two schools of thought regarding the principle of note issue. One school represents the currency principle and the other, the banking principle. Combining the merits of both the banking and the currency principles, different systems of note issue have been evolved to regulate note issue.
They are as follows:
(i) Partial or fixed fiduciary system: This system was first introduced in England in 1844 and subsequently adopted by several countries. Under this system, a fixed amount laid down by law need only be covered by government securities while all notes issued in excess of this amount must be fully covered by gold.
The fixed amount laid down by law is called the fiduciary system. The purpose of fixing the fiduciary limits is to conserve that amount of gold without affecting the convertibility of notes. In India notes were issued by this system in between 1861-1920.
(ii) Maximum Fiduciary System: This system fixes the maximum limit up to which the central bank can issue notes without any gold backing. The maximum limit may be altered depending on the circumstances. The system was in vogue in France before 1928 and it was introduced in England in 1939.
The main features of this system is to leave to the central bank the discretion of determining the limit, in the light of the monetary requirements of the country. It is claimed that this system provides for a high degree of elasticity in the note circulation.
(iii) Proportional Reserve System: Under this system the central bank is to maintain a certain percentage of the total note issue in gold. This percentage varies from 25 to 40. The rest of the note issue is to be covered by sound collateral securities. This system was adopted in India in 192756 and in France 1938.
(iv) Minimum Reserve System: Under this system the Central Bank has to maintain minimum reserves of gold or foreign securities or both. No maximum limit is placed on the amount of note issued. The central bank is free to adjust the total volume of currency in circulation according to the needs of trade. Even the minimum reserve is prescribed only to create a sense of confidence in the minds of the people.
In 1956 the Reserve Bank of India Act amended to introduce the minimum reserve system to enable the Reserve Bank to expand the money supply to meet expenditure in connection with the implementation of the five year plans. Under the existing provision, the Reserve Bank should maintain a minimum reserve of Rs. 200 crores worth of gold and foreign securities of which the value of gold shall be not less than Rs. 115 crores and the rest may consist of foreign securities.
5. Explain the functions of a Central Bank as (a) Banker’s to the government and (b) Controller of credit.
Ans: The Central bank acts as a Banker to the government. It also acts as fiscal agents and advises the governments on fiscal matters. As a banker to the government, the central bank maintains the banking accounts of the government departments, state governments and government enterprises.
The Central Bank undertakes transactions for the government with regard to purchase and sale of foreign exchange. It gives short term loans to the government and at the times of crisis makes extraordinary advances. In its capacity as financial agent and advisor to the government, it manages the national debts and guides the government on matters pertaining to economic policy.
The ultimate responsibility for laying down the monetary policy and maintaining the monetary standard lies with the government. In the formulation of the monetary policy, the central bank is not only consulted by the government, but it is also given a free hand and assisted whenever possible by the government in carrying out such monetary policy.
The control of credit is the most important of all the functions rendered by the Central Bank. It is the function which embraces the most important questions of central banking policy and the one through which practically all the other functions are united and made to serve a common purpose. This function has assumed importance with the growing popularity of bank credit. Commercial banks have the power to alter the total amount of money in circulation through the mechanism of credit creation.
6. State the meaning of selective credit control.
Ans: Regulation or control of credit for specific purposes or branches of economic activity is termed as selective or Qualitative credit control. It attempts to distinguish between productive and unproductive uses to which bank credit is put. It encourages credit for essential purposes and discourages credit for non-essential purposes.
It aims at regulating not only the total volume of credit but also the amount of credit available for each sector of the economy. Selection credit control affects both lenders as well as borrowers in a particular manner. The selective credit control resources are Margin requirement, Regulation of Consumer credit, Moral Suasion, Rationing of Credit, Directives, Direct action, Publicity etc.
7. Discuss briefly the management system of the Reserve Bank of India.
Ans: The general superintendence and direction of the affairs of the Reserve Bank of India are vested in the Central Board of Directors, which consist of 20 members as:
(a) A governor and four deputy governors appointed by the central government.
(b) Four Directors nominated by the Central government.
(c) Ten other Director. and
(d) One government official nominated by the Central government.
Governor of the Reserve Bank of India acts as the chairman of the central board of directors of the bank and its chief executive authority. The governor can exercise all the powers, which can be exercised by the bank under the act. However his powers are subject to the regulations made by the central board of directors from time to time. In the performance of his duties, the deputy governor and the executive directors assist him. Each deputy governor is responsible for certain specific operations of the Bank. The Deputy governors are appointed by the central government for a period not exceeding 5 years. They are eligible for reappointment. They are full time officers of the bank.
Central Board of Directors (20 Members): Governor (one) → Deputy governors (four) → Directors (Four) → Executive Directors (ten) → Government official Nominated by central government (one).
There are Local Boards to form regions of the country such as Western, Eastern, Northern and Southern regions. The headquarters of the Local Hoards are situated at Mumbai, Kolkata, Chennai and New Delhi. Each Local board consists of five members and they are appointed by the central government for the time period of four years.
8. Discuss the various essential conditions for successful Open Market Operation.
Ans: Open market operations is a tool that the RBI uses to smoothen liquidity conditions through the year and regulate money supply in the economy.
(a) The central bank should have a large volume and variety of securities so that it can buy and sell them to the extent needed. A wide maturity range also helps the central bank in reaching a larger number of potential buyers and sellers.
(b) Success of OMO also depends upon the level of development of the financial market and their sensitivity of responsiveness to changes in demand and supply of individual instruments.
(c) Depending upon the manner in which they are used OMO are expected to be effective in both expansion and contraction of the economy.
(d) There can be situations in which the banks may be able to partially counteract the variation in their cash balances by adjusting the composition of their remaining assets.
(e) There is no fixed or stable quantitative relationship between OMO and their effect on the volume of money and credit and rate of interest. The cash deposit ratio maintained by banks varies with other circumstances.
