Functions of a Central Bank

The modern banking system is two tiered. This means that at the bottom there are commercial banks i.e. the banks that we interact with on a day to day basis. They are then managed by a central bank which forms the next level in the hierarchy. The modern banking system provides central banks with considerably more rights and responsibilities.

In this article, we will study the core functions that are performed by the modern day central bank. The most important functions are as follows:

Monopoly over Issue of Currency Notes

Prior to the introduction of central banking, every bank could issue its own notes. As such, the economy would be flooded with thousands of different types of notes. The people accepting these notes would have very little idea of what the notes were worth or could be redeemed for. As such, there was less trust in the banking system as a whole.

This is when the central banks took over. Central banks, in modern times have been granted the sole rights to print and distribute currency notes. The notes that they print are considered to be legal tender. This means that they are the only legally accepted form of money and the courts will only enforce debts if they are denominated in terms of the established legal tender.

Therefore, modern day central banks have monopoly over the issue of currency notes. They are in a position to ensure its acceptability and maintain its value without the intervention of competing market forces.

Control over Monetary Policy

Central banks in today’s world, not only issue the currency notes but they also determine the amount and timings of such currency issue. The modern day monetary policy has virtually moved out of the realm of the government and into the realm of central banks. Central banks are supposed to be free of political influence. In theory this means that they would not inflate or deflate the currency of the nation to meet political objectives. It is for this reason that governments all across the world have minimal influence on monetary policy. Rather, it is the central banks that decide the quantum of money and credit that circulates within the economy at any time.

Banker’s Bank

The central bank provides stability to the financial system by controlling the actions of the commercial banks. The central bank does so by making it mandatory for commercial banks to have a certain percentage of their deposits maintained with itself.

By controlling the amount of loans that the commercial banks can make and the way in which they manage their deposits, central banks can prevent mismanagement of funds by their subordinates. This puts them in a position to guarantee a portion of these deposits to the general public which creates confidence in the banking system.

Lender of Last Resort

The central bank is considered to be the lender of last resort for all commercial banks under its domain. Many times banks face liquidity issues and in such scenarios a run on the bank becomes inevitable. Without the help of a central bank, an individual bank will collapse in the event of a bank run. However, a central bank quickly pumps money as and when demanded by the depositors, reinforcing their confidence, averting the run and keeping the system alive.

Payment Mechanism

Central banks have also made it possible to have a quick and efficient payment mechanism in the economy. This is because central banks have the ability to ensure that the payments made are irrevocable and guaranteed.

Thus, when a bank makes a payment to another bank, it is the central bank that debits one bank’s account and credits another bank’s account. Since the central bank performs the intermediary function, it frees the commercial banks from counterparty risks. Any commercial bank does not have to worry about not receiving promised payments from another bank. If it is due, the central bank will ensure it is paid. Therefore, the swift functioning of the fast payment system that we have today is implicitly guaranteed by the Central Bank.

Financier to the Government

The Central Bank also acts as financier to the government. When the government runs a budget deficit i.e. spends more than it has, the central bank manages the deficits. Thus the government does not have to depend on the mercy of the bond markets in the short run. However, in the long run the central bank cannot cover all of the government’s overspending. Central bank provides valuable support which enables functioning of the all of the welfare schemes which require government intervention in the form of money.

Forex Management

The central bank also manages foreign exchange reserves on behalf of the government and the common population. Thus, it is the central bank’s duty to ensure that the country always has enough foreign exchange on hand to import essential commodities from the international markets. It also has the power and the financial muscle required to maintain the value of its currency in the Foreign exchange markets. If the central bank senses a speculative attack on its currency, they resort to open market operations thereby maintaining the value at a stable level.

The central bank is therefore considered to be a central institution in the modern financial system. A modern financial system without a central bank is virtually unthinkable. Therefore, to understand banking, we must first understand the central bank.