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...
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