Definition: It is a bank which is responsible for the financial and economic stability of a country. The bank is a symbol of its sovereignty and solidarity. Every country, whether developed or not, capitalist or otherwise must have a central bank. It has a pivotal position in the banking system and regulates and formulates policies for the scheduled commercial banks in a country. In Pakistan the central bank is known as State Bank of Pakistan.
Origin and Growth: The origin of the central banking system can be traced back to 1694 when the Bank of England came into being as the first ever central bank. The bank was established to help the King William III out of his government’s financial crisis.
FUNCTIONS OF THE CENTRAL BANK
The functions of a central bank can be placed in two broad categories:
1. Government’s bank
2. Banker’s bank
I. Government’s Bank: As a government’s bank, the central bank performs the following functions:
1. Monopoly of note issue
2. Controller of credit
3. Custodian of foreign exchange
4. Issue and management of public debts
5. Development of financial institutions
1. Monopoly of Note Issue: One of the most important functions of the central bank is to issue currency notes for the country. Earlier this function would be performed by commercial banks individually. Every commercial bank could issue its own currency notes. This system was inherited with lack of uniformity, loss of public confidence, inflation, and different purchasing power of the different banks notes of the same denominations. Then followed the existing modern banking system which requires the note issue only by a central bank of the country to overcome the above evils. Notes are now issued on certain principles including a fixed ration of a reserve of gold, silver, and approved foreign exchange to back the issue of every note. Under the modern banking practices, the following note issue systems are followed:
i. Fixed fiduciary system
ii. Proportional reserve system
iii. Minimum reserve system
2. Controller of Credit: The central bank controls and regulates credit money in the country in order to expand or contract it to the requirement of the economy. Credit money is the bank money created by the use of cheques and its expansion or contractions has no direct relation with the amount of currency in circulation. The central bank controls the credit money for keeping it at certain level by using one or more of the following methods.
a. Bank rate policy
b. Open market operations
c. Bank reserve ratio
d. Rationing of credit
e. Other miscellaneous methods
3. Custodian of Foreign Exchange: Every country exports goods and services to earn foreign exchange. This earned and other foreign exchange is held in the custody of the central bank – which in turn, uses it to finance the imports.
When businessmen export their goods they earn foreign exchange which is not handed in to them and instead it is held with the central bank. The bank pays to them in the local currency equivalent to the earned foreign exchange.
4. Issue and Management of Public Debts: When the central or the provincial government issues public debts, the central bank, on behalf of it, manages its issue, payment of interests, and retirement. Public debts are usually issued annually to general public. This function is performed by the central bank. It maintains its record, pays annual interests, and returns the principal amount on maturity. Above all, it hold the cash thus received and the government utilizes this cash according to its requirements.
5. Development of Financial Institutions: The central bank is responsible to develop financial institutions, which play a vital role in industrial, agricultural, and capital development of the country. It also facilitates the establishment and running of money markets and stock exchanges. In Pakistan, it helped establish National Bank of Pakistan, and provided million of rupees to Agricultural Development of Pakistan and other DFIs (development financial institutions).
II. Banker’s Bank: The central bank also acts as banker’s bank. In this capacity it performs valuable services to its scheduled commercial banks. These indispensable services are as under:
1. Lender of the last resort
2. Rediscounting of bill of exchange
3. Clearing house services
4. Cash reserve
5. Counseling services
1. Lender of the Last Resort: A friend in need is a friend indeed, as a popular saying goes. It exactly applies to the relations of the central and commercial banks. In crisis, when a commercial bank has exhausted all its resources and still finds itself unable to meet all its obligations and outstanding dues the central bank comes forward to rescue it. The central bank provides loans to the bank in crises to enable it to discharge its liabilities and thus prevents it to go bankrupt. One of the ways to help is to rediscount bills of the commercial bank. Rediscounting refers to again discount the bills of exchange which the commercial bank has already discounted for its clients.
2. Rediscounting Bills of Exchange: Another invaluable service performed by the central bank is to rediscount bills of exchange. Commercial banks discount bills of exchange of businessmen. Discounting means encashment of the bill before it matures, at a certain rate of interest. As a result commercial banks fall short of cash. This shortage may create many problems for them so they approach the central bank for rediscounting of the same bills. By this exercise they overcome their cash shortage.
3. Clearing House Serves: The central bank provides clearing house facility to commercial banks. Every bank receives cheques on other banks, because of which every bank becomes creditor ordebtor to the other bank or banks. All these cheques are sent to the central bank where it settles all the accounts of the banks by adjusting their debit or credit balances. Clearing service is possible because the central bank possess cash reserves of the commercial banks.
4. Cash Reserves: Under banking law, every commercial scheduled bank is bound to deposit a certain percentage of all its deposits (time and demand deposits) with the central bank. This cash reserve serves many objectives. Firstly it provides safety to the accounholders of the commercial bank. Secondly the central bank finds itself in a better position to control credit money. Thirdly, this reserve may be used to help scheduled bank in need of cash. And, lastly this reserve serves as means to settle banks obligations to one another, the practice which is known as a clearing service.
5. Counseling Services: The central bank offers precious advice and counseling services. In the light of its expert opinions and advice commercial banks formulate and readjust their policies.