UNIT TWO

CENTRAL BANKING
2.1. INTRODUCTION

Central Bank refers to an institution, such as the Bank of England, the U.S. Federal Reserve
System, the Bank of France, or the Bank of Japan, that is entrusted with the power of regulating
the size of a nation’s money supply, the availability and cost of credit, and the foreign-exchange
value of its currency. Regulation of the availability and cost of credit may be non-selective or
may be designed to influence the distribution of credit among competing uses.

Definition: A central bank is an independent national authority that conducts monetary policy,
regulates banks, and provides financial services including economic research. Its goals are to
stabilize the nation's currency, keep unemployment low, and prevent inflation.

Most central banks are governed by a board consisting of its member banks.  The country's chief
elected official appoints the director.

The national legislative body approves him or her.  That keeps the central bank aligned with the
nation's long-term policy goals. At the same time, it's free of political influence in its day-to-day
operations.  The Bank of England first established that model.

History

Sweden created the world' first central bank, the Riks, in 1668. The Bank of England came next
in 1694. Napoleon created the Banquet de France in 1800. Congress established the Federal
Reserve in 1913. The Bank of Canada began in 1935, and the German Bundesbank was
reestablished after World War II. In 1998, the European Central Bank replaced all central banks
in the member countries of the eurozone.

2.2. Functions of Central Bank

The principal objectives of a modern central bank in carrying out these functions are to maintain
monetary and credit conditions conducive to a high level of employment and production, a
reasonably stable level of domestic prices, and an adequate level of international reserves.
Central banks also have other important functions, of a less-general nature. These typically
include acting as fiscal agent of the government, supervising the operations of the commercial
banking system, clearing checks, administering exchange-control systems, serving as
correspondents for foreign central banks and official international financial institutions, and, in
the case of central banks of the major industrial nations, participating in cooperative international
currency arrangements designed to help stabilize or regulate the foreign-exchange rates of the
participating countries.
Central banks are operated for the public welfare and not for maximum profit. The modern
central bank has had a long evolution, dating back to the establishment of the Bank of Sweden in
1668. In the process, central banks have become varied in authority, autonomy, functions, and
instruments of action. Virtually everywhere, however, there has been a vast and explicit
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broadening of central-bank responsibility for promoting domestic economic stability and growth
and for defending the international value of the currency. There also has been increased
emphasis on the interdependence of monetary and other national economic policies, especially
fiscal and debt-management policies. Equally, a widespread recognition of the need for
international monetary cooperation has evolved, and central banks have played a major role in
developing the institutional arrangements that have given form to such cooperation.
The broadened responsibilities of central banks in the second half of the 20 th century were
accompanied by greater government interest in their policies; in a number of countries,
institutional changes, in a variety of forms, were designed to limit the traditional independence of
the central bank from the government. Central-bank independence, however, really rests much
more on the degree of public confidence in the wisdom of the central bank’s actions and the
objectivity of the bank’s leadership than on any legal provisions purporting to give it autonomy
or to limit its freedom of action.
Central banks traditionally regulate the money supply by expanding and contracting their assets.
An increase in a central bank’s assets causes a corresponding increase in its deposit liabilities (or
note issue), and these, in turn, provide the funds that serve as the cash reserves of the commercial
banking system—reserves that commercial banks, by law or custom, must maintain, generally in
a prescribed proportion of their own deposit liabilities. As banks acquire larger cash balances
with the central bank, they are in a position to expand their own credit operations and deposit
liabilities to a point where the new, larger cash reserves no longer produce a reserve ratio greater
than the minimum set by law or custom. A reverse process occurs when the central bank
contracts the volume of its assets and liabilities.

8 Major Functions of Central Bank in an economy are as follows:

(1) Bank of Issue, (2) Banker, Agent and Advisor to Government, (3) Custodian of Cash
Reserves, (4) Custodian of Foreign Balances, (5) Lender of Last Resort, (6) Clearing House, (7)
Controller of Credit, and (8) Protection of Depositor’s Interest.

Function 1 -Bank of Issue:

Central bank now-a-days has the monopoly of note-issue in every country. The currency notes
printed and issued by the central bank are declared unlimited legal tender throughout the country.

Central bank has been given exclusive monopoly of note-issue in the interest of uniformity,
better control, elasticity, supervision, and simplicity. It will also avoid the possibility of over-
issue by individual banks.

The central banks, thus, regulate the currency of country and the total money-supply in the
economy. The central bank has to keep gold, silver or other securities against the notes issued.
The system of note-issue differs from country to country.

The main objects of the system of currency regulation in general are to see that:

(i) People’s confidence in the currency is maintained,

Function 2 - Banker, Agent and Adviser to the Government:

Central bank, everywhere, performs the functions of banker, agent and adviser to the
government.

“The central bank operates as the government’s banker, not only because it is more convenient
and economical to the government, but also because of the intimate connection between public
finance monetary affairs.”

As banker to the government, it makes and receives payments on behalf of the government. It
advances short-term loans to the government to tide over difficulties.

It floats public loans and manages the public debts on behalf of the government. It keeps the
banking accounts and balances of the government after making disbursements and remittances.
As an adviser to the government it advises the government on all monetary and economic
matters. The central bank also acts as an agent to the government where general exchange
control is in force.

Function 3 - Custodian of Cash Reserves:

All commercial banks in a country keep a part of their cash balances as deposits with the central
bank, may be on account of convention or legal compulsion. They draw during busy seasons and
pay back during slack seasons. Part of these balances is used for clearing purposes. Other
member banks look to it for guidance, help and direction in time of need.

It affects centralisation of cash reserves of the member banks. “The centralisation of cash
reserves in the central bank is a source of great strength to the banking system of any country.
Centralised cash reserves can at least serve as the basis of a large and more elastic credit
structure than if the same amount were scattered amongst the individual banks.

It is obvious, when bank reserves are pooled in one institution which is, moreover, charged with
the responsibility of safeguarding the national economic interest, such reserves can be employed
to the fullest extent possible and in the most effective manner during periods of seasonal strain
and in financial crises or general emergencies…the centralisation of cash reserves is conducive
to economy in their use and to increased elasticity and liquidity of the banking system and of the
credit structure as a whole.”

Function 4 -Custodian of Foreign Balances:

Under the gold standard or when the country is on the gold standard, the management of that
standard, with a view to securing stability of exchange rate, is left to the central bank.

After World War I, central banks have been keeping gold and foreign currencies as reserve note-
issue and also to meet adverse balance of payment, if any, with other countries. It is the function
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of the central bank to maintain the exchange rate fixed by the government and manage exchange
control and other restrictions imposed by the state. Thus, it becomes a custodian of nation’s
reserves of international currency or foreign balances.

Function 5 - Lender of Last Resort:

Central bank is the lender of last resort, for it can give cash to the member banks to strengthen
their cash reserves position by rediscounting first class bills in case there is a crisis or panic
which develops into ‘run’ on banks or when there is a seasonal strain. Member banks can also
take advances on approved short-term securities from the central bank to add to their cash
resources at the shortest time.

This facility of turning their assets into cash at short notice is of great use to them and promotes
in the banking and credit system economy, elasticity and liquidity.

Thus, the central bank by acting as the lender of the last resort assumes the responsibility of
meeting all reasonable demands for accommodation by commercial banks in times of difficulties
and strains.

De Kock expresses the opinion that the lending of last resort function of the central bank imparts
greater liquidity and elasticity to the entire credit structure of the country. According to Hawtrey,
the essential duty of the central bank as the lender of last resort is to make good a shortage of
cash among the competitive banks.

Function 6 -Clearing House:

Central bank also acts as a clearing house for the settlement of accounts of commercial banks. A
clearing house is an organisation where mutual claims of banks on one another are offset, and a
settlement is made by the payment of the difference. Central bank being a bankers’ bank keeps
the cash balances of commercial banks and as such it becomes easier for the member banks to
adjust or settle their claims against one another through the central bank.

Suppose there are two banks, they draw cheques on each other. Suppose bank A has due to it Rs.
3,000 from bank B and has to pay Rs. 4,000 to B. At the clearing house, mutual claims are offset
and bank A pays the balance of Rs. 1,000 to B and the account is settled. Clearing house function
of the central bank leads to a good deal of economy in the use of cash and much of labour and
inconvenience are avoided.

Function 7 -Controller of Credit:

The control or adjustment of credit of commercial banks by the central bank is accepted as its
most important function. Commercial banks create lot of credit which sometimes results in
inflation.

The expansion or contraction of currency and credit may be said to be the most important causes
of business fluctuations. The need for credit control is obvious. It mainly arises from the fact that
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money and credit play an important role in determining the level of incomes, output and
employment.

According to Dr. De Kock, “the control and adjustment of credit is accepted by most economists
and bankers as the main function of a central bank. It is the function which embraces the most
important questions of central banking policy and the one through which practically all other
functions are united and made to serve a common purpose.”

Thus, the control which the central bank exercises over commercial banks as regards their
deposits, is called controller of credit.

Function 8 - Protection of Depositors Interests:

The central bank has to supervise the functioning of commercial banks so as to protect the
interest of the depositors and ensure development of banking on sound lines.

The business of banking has, therefore, been recognized as a public service necessitating
legislative safeguards to prevent bank failures.

Legislation is enacted to enable the central bank to inspect commercial banks in order to
maintain a sound banking system, comprising strong individual units with adequate financial
resources operating under proper management in conformity with the banking laws and
regulations and public and national interests.

The National Bank of Ethiopia

The National Bank of Ethiopia was created by order No 30/1963 and reconstituted by the
Monetary and Banking Proclamation No 83/1994 as an autonomous organ, which is engaged in
the provision of regular banking services to the government and other banks and insurance
companies’. The main purpose of the bank is to forester monetary stability financial system and
such other credit and exchange conditions as are conducive to the balanced growth of the
economy of Ethiopia. / Art 6/
The bank will have the following powers and duties that will help it to achieve its purpose, /Art
7/
- Make coin, print and issue legal tender currency.
- Regulate the supply and availability of money and fix the minimum and maximum rates of
interest that banks and other financial institutions may charge for different types of loans,
advances and other credits and pay on various classes of deposits. (Art 7 and Art 30).
- Implement exchange rate policy, allocate foreign exchange, manage and administer the
international reserve fund of Ethiopia. This reserve fund consists of gold, silver, foreign
exchange and securities, which are used to pay for imports into the country and pay foreign
international debts and other commitments (Art 50).
- License, supervise and regulate banks, insurance companies and other financial institutions
such as savings and credit associations/co-operatives and postal savings.

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- Set limits on gold and foreign exchange assets that banks and other financial institutions,
which are authorized to deal in foreign exchange, can hold in deposits (Art 39).
- Set limits on the net foreign exchange position and on the terms and the amount of external
indebtedness of banks and other financial institutions.
- Make short and long term refinancing facilities available to banks and other financial
institutions.
- Accept deposits of any type from foreign sources.
- Act as banker, fiscal agent and financial advisor to the government/Art 24, 25/.
- Promote and encourage the dissemination of banking and insurance services throughout the
country.
- Prepare periodic economic studies together with forecasts of the balance of payment,
money supply, prices and other statistical indicators of the Ethiopian economy used for
analysis and for the formulation and determination by the bank of monetary, savings and
exchange policies.