Central Bank Functions and Commercial Bank Functions Explained
Central Bank Functions
A central bank is the supreme bank of a country. It is the apex monetary authority which regulates, guides, and develops the banking system in the country. Its functions are:
1. Monopoly of Note Issue
The primary function of a central bank is to issue notes in the country. It has the monopoly rights of issuing bank notes subject to certain safeguards imposed by law. In Nepal, Nepal Rastra Bank issues the notes under a proportional reserve system. The monopoly of note issue became a recognized function of central banks of the concerned countries. Till now, Nepal Rastra Bank has issued bank notes of Re 1, Rs 2, Rs 5, Rs 10, Rs 20, Rs 25, Rs 50, Rs 100, Rs 250, Rs 500, and Rs 1000.
2. Government’s Banker, Agent and Advisor
Central banks everywhere fulfil the functions of banker, agent and advisor of the government. As the government’s banker, the central bank maintains the banking accounts of government departments, boards, and enterprises. It makes temporary advances to the government in case of need. It carries out government transactions involving the purchase or sale of foreign currencies. As an agent of the government, it purchases and sells government securities such as treasury bills. Likewise, it acts as the advisor of the government, advising it to formulate monetary and fiscal policies for the country.
3. Bank of All Banks or Bankers’ Bank
The central bank is also called the bank of all banks of the country. It keeps the cash reserves of commercial banks. All commercial banks and other banks have their accounts in the central bank. So, the central bank performs as a bankers’ bank. In every country, commercial banks keep a certain portion of their total deposits in the central bank.
4. Lender of the Last Resort
The central bank acts as a lender of the last resort. By granting loans in the form of rediscounts and collateral advances to commercial banks and financial institutions, the central bank acts as the lender of last resort. It is the ultimate source of funding for commercial banks. During hard times, when commercial banks cannot make payments to their customers because of a lack of liquidity, the central bank advances loans to them. This is known as lender of the last resort.
5. Provides Clearing House Facilities
The central bank also acts as a settler of the financial claims of a bank against others. Each commercial bank should maintain its account in the central bank. The central bank clears each other’s claims from their respective accounts. When any two commercial banks claim to settle their transactions, the central bank clears them.
6. Custodian of Foreign Currency and Metallic Reserves
The central bank is the custodian of the national reserves of foreign currencies. It keeps and manages the foreign exchange reserve of a country. It purchases and sells foreign exchange on behalf of the government. If there is high demand for foreign currency in the domestic market, it sells foreign currency, even buying it from the international market. On the other hand, if there is high supply of foreign currency in the domestic market, the central bank purchases it from the domestic market. By doing so, the central bank maintains the stability of the foreign exchange rate. Likewise, it is the custodian of metallic reserves such as gold, silver, and other precious metals.
7. Control of Credit
One of the most important functions of the central bank is to control credit in the economy in order to achieve a healthy financial system and economic progress. Credit control refers to the management of credit according to the requirements of the economy. The central bank controls credit by using credit control instruments such as open market operations, changes in the statutory reserve requirements of banks, bank rate policy, and control over interest rates.
8. Foreign Exchange Control
The central bank of any country holds the absolute right to regulate and control foreign exchange operations. The foreign exchange rate is determined with the help of the demand for and supply of foreign currency under a flexible exchange regime. Likewise, the exchange rate is determined by mutual agreement under a fixed exchange rate regime. The central bank can manage its exchange rate in case of any economic problem.
Commercial Bank Functions
Generally, the term bank refers to a commercial bank. It is one of the oldest types of banks in the world. It is a profit-seeking institution that borrows money at a lower interest rate and lends it at a higher interest rate. The difference between the borrowing rate and the lending rate is its main source of income. Some functions of a commercial bank are discussed below.
Primary Functions
Basically, a commercial bank performs two primary functions, namely accepting deposits and advancing loans.
1. Accepting Deposits
The primary function of a commercial bank is to accept deposits from the general public. A commercial bank accepts three types of deposits on three different accounts:
- a) Current account: A commercial bank accepts demand deposits in a current account. Depositors can withdraw their deposits on demand without prior notice to the bank. In this account, the bank does not pay any interest to depositors. Generally, businesspeople who need to make many payments every day deposit in this account. Depositors keep their money here just for security rather than to earn interest.
- b) Savings account: A commercial bank accepts deposits in a savings account. Generally, small savers deposit their savings in such an account for dual purposes. On the one hand, depositors like to earn interest; on the other hand, they want to withdraw their deposits in case of need. Banks pay some interest on such accounts. Normally, this account is maintained by middle-class people.
- c) Fixed account: The name of the account itself suggests that depositors deposit their money for a fixed period of time. Since the time is fixed, the deposit is also known as a fixed deposit. In this account, banks pay a relatively higher rate of interest than in a savings account. However, depositors are obliged to keep their deposit for the stated time period. If the depositor wishes to withdraw before the maturity period, the bank levies some charge.
2. Providing Loans
The next important primary function of a commercial bank is credit creation, or advancing loans for commercial purposes to businessmen, traders, producers, and others. Here, commercial purpose indicates that the commercial bank charges a higher rate of interest to borrowers than it pays to depositors. Commercial banks offer short-term, medium-term and long-term loans.
The major loans provided by commercial banks are as follows:
- a) Cash credit: This is one of the most widely used forms of loans provided by commercial banks. Cash credit is provided against collateral or security deposits. The bank issues the loan in the form of cash money.
- b) Overdraft: Commercial banks provide a facility for withdrawing money in excess of the deposited amount in one’s account. This is called an overdraft. Commercial banks do not provide this facility to all customers. They provide it only to selected customers, charging a certain rate of interest on the overdraft amount.
- c) Call loan: This is a loan provided for a very short period of time. If a person is looking for a loan for a very short period, he deposits collateral and the commercial bank provides the loan, charging a certain rate of interest. This type of loan is not widely applicable in Nepal except in the inter-banking sector.
- d) Discounting bill of exchange: Under this scheme, the bill holder may use the bill as collateral to get a loan in case of financial problems. Different types of bills, such as bills of exchange and promissory notes, are discounted, and the needy person can receive a certain percentage of the bill’s value as a loan.
Secondary Functions
The secondary functions of a commercial bank are described below.
3. Collection and Payment of Credit Instruments
Commercial banks collect different types of credit instruments, such as cheques and drafts, and make payments on them. Such instruments include bills of exchange and promissory notes as well.
4. Remittance of Money
One of the major businesses of today’s commercial banks is sending and receiving money from one place to another, both within and outside the country. This is called remittance of money.
5. Income Receiving and Payments
Today’s commercial banks receive income on behalf of their customers, such as dividends, bond interest, and rent. Likewise, these banks make payments of bills on behalf of account holders, such as insurance premiums, income tax, electricity bills, and telephone bills.
6. Purchase and Sale of Securities
Commercial banks may purchase and sell securities such as shares, debentures, and bonds on the request of their customers.
Contingent Functions
The following are the contingent functions of a commercial bank.
7. Safety of Valuable Goods
Commercial banks provide safety lockers for valuable items such as gold, silver, diamonds, and important documents.
8. Issuing Credit Instruments
Commercial banks perform the function of issuing various credit instruments, such as demand drafts, letters of credit (LC), traveler’s cheques, credit cards, and so on.
9. Foreign Exchange Operations
Commercial banks deal in foreign currency exchange operations under the direction of the central bank. They purchase and sell foreign currencies following the rules and regulations of the central bank of the country.
10. Publications
Commercial banks publish their information in daily, monthly, and yearly bulletins to show their financial status to the central bank, their customers, and the general public.