Md Amzad Hossain*
Chapter# Central Bank & Commercial Banks
Meaning of Central Bank
In every country there is one bank which acts as the leader of the money market, supervising,
controlling and regulating the activities of commercial banks and other financial institutions. It
acts as a bank of issue and is in close touch with the government, as banker, agent and adviser to
the latter. Such a bank is known as the central bank of the country.
Definition of Central Bank
A banking institution can more easily be identified by the functions that it performs. According
to Vera Smith, “the primary definition of central banking is a banking system in which a single
bank has either a complete or residuary monopoly in the note issue.” Kisch and Elkin believe
that “the essential function of a central bank is the maintenance of the stability of the monetary
standard.” In the statutes of the Bank for International Settlements a central bank is defined as
“the bank of the country to which has been entrusted the duty of regulating the volume of
currency and credit in that country.” De Kock gives a very comprehensive definition of central
bank. According to De Kock, a central bank is a bank which constitutes the apex of the monetary
and banking structure of its country and which performs, best it can in the national economic
interest, the following functions:
a) The regulation of currency in accordance with the requirements of business and the
general public, for which purpose it is granted either the sole right of note issue or at least
a partial monopoly thereof.
b) The performance of general banking and agency services for the state.
c) The custody of cash reserves of the commercial banks.
d) The custody and management of the nation’s reserves of international currency.
e) The granting of accommodation, in the form of rediscounts, or collateral advances, to
commercial banks, bill brokers and dealers, or other financial institutions, and the general
acceptance of the responsibility of lender of last resort.
f) The settlement of clearances between the banks.
g) The control of credit in accordance with the needs of business and with a view to carrying
out the broad monetary policy adopted by the state.
The nature of function of a central bank differs in a developed economy as compared to those in
a developing economy.
Functions of the Central Bank
The functions of the central bank differ from country to country in accordance with the
prevailing economic situation. But there are certain functions which are commonly performed by
the central bank in all countries. According to De Kock, there are six functions which are
performed by the central bank in almost all countries.
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Lecturer in Finance; DBA, IIUC, www.mahiiuc.weebly.com
Md Amzad Hossain*
1. Monopoly of Note Issue: The issue of money was always the prerogative of the
government. Keeping the minting of coins with itself, the government delegated the right
of printing currency notes to the central bank. In fact the right and privilege of note issue
was always associated with the origin and development of central banks which were
originally called as banks of issue. Nowadays, central banks everywhere enjoy the
exclusive monopoly of note issue and the currency notes issued by the central banks are
declared unlimited legal tender throughout the country. At one time, even commercial
banks could issue currency notes but there were certain evils in such a system such as
lack of uniformity in note issue, possibility of over-issue by individual banks and profits
of note issue being enjoyed only by a few private shareholders. But concentration of note
issue in the central bank brings about uniformity in note issue, which, in turn, facilitates
trade and exchange within the country, attaches distinctive prestige to the currency notes,
enables the central bank to influence and control the credit creation of commercial banks,
avoids the over issue of notes and, lastly, enables the government to appropriate partly or
fully the profits of note issue. The central bank keeps three considerations in view as
regards issue of notes-uniformity, elasticity (amount according to the need for money),
and safety.
2. Custodian of Exchange Reserves: The central bank holds all foreign exchange reserves-
key currencies such as U.S. dollars, British pounds and other prominent currencies, gold
stock, gold bullion, and other such reserves-in its custody. This right of the central bank
enables it to exercise a reasonable control over foreign exchange, for example, to
maintain the country’s international liquidity position at a safe margin and to maintain the
external value of the country’s currency in terms of key foreign currencies.
3. Banker to the Government: Central banks everywhere perform the functions of banker,
agent and adviser to the government. As a banker to the government, the central bank of
the country keeps the banking accounts of the government both of the Centre and of the
States performs the same functions as a commercial bank ordinarily does for its
customers. As a banker and agent to the government, the central bank makes and receives
payments on behalf of the government. It helps the government with short-term loans and
advances (known as ways and means advances) to tide over temporary difficulties and
also floats public loans for the government. It also manages the public debt (i.e., floats
services and redeems government loans). It advises the government on monetary and
economic matters.
4. Banker to Commercial Banks: Broadly speaking, the central bank acts as the banker’s
bank in three different capacities: (a) It acts as the custodian of the cash reserves of the
commercial banks (b) It acts as the lender of the last resort (c) It is the bank of central
clearance, settlement and transfer. We shall now discuss these three functions one by one.
a) It acts as the custodian of the cash reserves of commercial banks: Commercial banks
keep part of their cash balances as deposits with the central bank of a country known as
centralisation of cash reserves. Part of these balances are meant for clearing purposes,
*
Lecturer in Finance; DBA, IIUC, www.mahiiuc.weebly.com
Md Amzad Hossain*
that is, payment by one bank to another will be simple book entry adjustment in the
books of the central bank. There are many advantages when all banks keep part of their
cash reserves with the central bank of the country. In the first place, with the same
amount of cash reserves, a large amount of credit creation is possible. Secondly,
centralised cash reserves will enable commercial banks to meet crises and emergencies.
Thirdly, it enables the central bank to provide additional funds to those banking
institutions which are in temporary difficulties. Lastly, it enables the central bank to
influence and control the credit creation of commercial banks by making the cash
reserves of the latter more or less.
b) Lender of the last resort: As the banker’s bank, the central bank can never refuse to
accommodate commercial banks. Any commercial bank wanting accommodation from
the central bank can do so by rediscounting (selling) eligible securities with the central
bank or can borrow from the central bank against eligible securities. By lender of the last
resort, it is implied that the latter assumes the responsibility of meeting directly or
indirectly all reasonable demands for accommodation by commercial banks in times of
difficulties and crisis.
c) Clearing agent: As the central bank becomes the custodian of cash reserves of
commercial banks, it is but logical for it to act as a settlement bank or a clearing house
for other banks. As all banks have their accounts with the central bank, the claims of
banks against each other are settled by simple transfers from and to their accounts. This
method of settling accounts through the central bank, apart from being convenient, is
economical as regards the use of cash. Since claims are adjusted through accounts, there
is usually no need for cash. It also strengthens the banking system by reducing
withdrawals of cash in times of crisis. Furthermore, it keeps the central bank of informed
about the state of liquidity of commercial banks in regard to their assets.
5. Controller of Credit: Probably the most important of all the functions performed by a
central bank is that of controlling the credit operations of commercial banks. In modern
times, bank credit has become the most important source of money in the country,
relegating coins and currency notes to a minor position. Moreover, it is possible, as we
have pointed out in a previous chapter, for commercial banks to expand credit and thus
intensify inflationary pressure or contract credit and thus contribute to a deflationary
situation. It is, thus, of great importance that there should be some authority which will
control the credit creation by commercial banks. As controller of credit, the central bank
attempts to influence and control the volume of bank credit and also to stabilise business
conditions in the country.
6. Promoter of Economic Development: In developing economies the central bank has to
play a very important part in the economic development of the country. Its monetary
policy is carried out with the object of serving as an instrument of planned economic
development with stability. The central bank performs the function of developing long-
term financial institutions, also known as development banks, to make available adequate
*
Lecturer in Finance; DBA, IIUC, www.mahiiuc.weebly.com
Md Amzad Hossain*
investible funds for the development of agriculture, industry, foreign trade, and other
sectors of the economy. The central bank has also to develop money and capital markets.
In addition, the central bank may also undertake miscellaneous functions such as providing
assistance to farmers through co-operative societies by subscribing to their share capital,
promoting finance corporations with a view to providing loans to large-scale and small-scale
industries and publishing statistical reports on tends in the money and capital markets. In short, a
central bank is an institution which always works in the best economic interests of the nation as a
whole. In view of all these functions, as discussed above, it follows that a modern central bank is
much more than a Bank of Issue.
Commercial Bank
Commercial banks are very popular almost in every country because of the service they provide
to individuals, commerce and industry. A commercial bank may be defined as a financial
institution which accepts deposits against which cheques can be drawn, lends money to
commerce and industry and renders a number of other useful services to the customers and the
society. Commercial banks borrow money from those who have surplus funds and lend to those
who need funds for commercial and industrial purposes. Thus, they act as dealers in loanable
funds of the society. Commercial banks receive deposits in the form of fixed deposits, savings
bank accounts and current accounts and advance money, generally for short periods, in the form
of cash credits, overdrafts and loans. They also render a number of service to their customers,
such as collection of cheques, safe custody
Functions of Commercial Banks
Commercial banks have to perform a variety of functions which are common to both developed
and developing countries. These are known as ‘General Banking’ functions of the commercial
banks. The modern banks perform a variety of functions. These can be broadly divided into two
categories: (a) Primary functions and (b) Secondary functions.
Commercial Banks
Primary Functions Secondary Functions
Acceptance of Deposits Agency Services General Utility Services
Advancing Loans
Creation of Credit Overdraft Term
LoansBrowalliaUP
Clearing of Cheques Conumer Credit
Cash Credit
Financing of Funds
Discounting Trade Bills Miscellaneous
Advances
Remittance of Funds
Money at Call
*
Lecturer in Finance; DBA, IIUC, www.mahiiuc.weebly.com
Md Amzad Hossain*
A. Primary Functions
Primary banking functions of the commercial banks include:
1. Acceptance of deposits
2. Advancing loans
3. Creation of credit
4. Clearing of cheques
5. Financing foreign trade
6. Remittance of funds
1. Acceptance of Deposits:
Accepting deposits is the primary function of a commercial bank mobilise savings of the
household sector. Banks generally accept three types of deposits viz., (a) Current Deposits
(b) Savings Deposits, and (c) Fixed Deposits.
(a) Current Deposits: These deposits are also known as demand deposits. These deposits
can be withdrawn at any time. Generally, no interest is allowed on current deposits,
and in case, the customer is required to leave a minimum balance undrawn with the
bank. Cheques are used to withdraw the amount. These deposits are kept by
businessmen and industrialists who receive and make large payments through banks.
The bank levies certain incidental charges on the customer for the services rendered
by it.
(b) Savings Deposits: This is meant mainly for professional men and middle class people
to help them deposit their small savings. It can be opened without any introduction.
Money can be deposited at any time but the maximum cannot go beyond a certain
limit. There is a restriction on the amount that can be withdrawn at a particular time
or during a week. If the customer wishes to withdraw more than the specified amount
at any one time, he has to give prior notice. Interest is allowed on the credit balance
of this account. The rate of interest is greater than the rate of interest on the current
deposits and less than that on fixed deposit. This system greatly encourages the habit
of thrift or savings.
(c) Fixed Deposits: These deposits are also known as time deposits. These deposits
cannot be withdrawn before the expiry of the period for which they are deposited or
without giving a prior notice for withdrawal. If the depositor is in need of money, he
has to borrow on the security of this account and pay a slightly higher rate of interest
to the bank. They are attracted by the payment of interest which is usually higher for
longer period. Fixed deposits are liked by depositors both for their safety and as well
as for their interest. In Bangladesh, they are accepted between three months and ten
years.
2. Advancing Loans:
The second primary function of a commercial bank is to make loans and advances to all types
of persons, particularly to businessmen and entrepreneurs. Loans are made against personal
*
Lecturer in Finance; DBA, IIUC, www.mahiiuc.weebly.com
Md Amzad Hossain*
security, gold and silver, stocks of goods and other assets. The most common way of lending
is by:
a) Overdraft Facilities: In this case, the depositor in a current account is allowed to draw
over and above his account up to a previously agreed limit. Suppose a businessman has
only Tk. 30,000/- in his current account in a bank but requires Tk. 60,000/- to meet his
expenses. He may approach his bank and borrow the additional amount of Tk. 30,000/-.
The bank allows the customer to overdraw his account through cheques. The bank,
however, charges interest only on the amount overdrawn from the account. This type of
loan is very popular with the Bangladeshi businessmen.
b) Cash Credit: Under this account, the bank gives loans to the borrowers against certain
security. But the entire loan is not given at one particular time, instead the amount is
credited into his account in the bank; but under emergency cash will be given. The
borrower is required to pay interest only on the amount of credit availed to him. He will
be allowed to withdraw small sums of money according to his requirements through
cheques, but he cannot exceed the credit limit allowed to him. Besides, the bank can also
give specified loan to a person, for a firm against some collateral security. The bank can
recall such loans at its option.
c) Discounting Bills of Exchange: This is another type of lending which is very popular
with the modern banks. The holder of a bill can get it discounted by the bank, when he is
in need of money. After deducting its commission, the bank pays the present price of the
bill to the holder. Such bills form good investment for a bank. They provide a very liquid
asset which can be quickly turned into cash. The commercial banks can rediscount, the
discounted bills with the central banks when they are in need of money. These bills are
safe and secured bills. When the bill matures the bank can secure its payment from the
party which had accepted the bill.
d) Money at Call: Bank also grant loans for a very short period, generally not exceeding 7
days to the borrowers, usually dealers or brokers in stock exchange markets against
collateral securities like stock or equity shares, debentures, etc., offered by them. Such
advances are repayable immediately at short notice hence, they are described as money at
call or call money.
e) Term Loans: Banks give term loans to traders, industrialists and now to agriculturists
also against some collateral securities. Term loans are so-called because their maturity
period varies between 1 to 10 years. Term loans, as such provide intermediate or working
capital funds to the borrowers. Sometimes, two or more banks may jointly provide large
term loans to the borrower against a common security. Such loans are called participation
loans or consortium finance.
f) Consumer Credit: Banks also grant credit to households in a limited amount to buy some
durable consumer goods such as television sets, refrigerators, etc., or to meet some
*
Lecturer in Finance; DBA, IIUC, www.mahiiuc.weebly.com
Md Amzad Hossain*
personal needs like payment of hospital bills etc. Such consumer credit is made in a lump
sum and is repayable in instalments in a short time.
g) Miscellaneous Advances: Among other forms of bank advances there are packing credits
given to exporters for a short duration, export bills purchased/discounted, import finance-
advances against import bills, finance to the self employed, credit to the public sector,
credit to the cooperative sector and above all, credit to the weaker sections of the
community at concessional rates.
3.Creation of Credit:
A unique function of the bank is to create credit. Banks supply money to traders and
manufacturers. They also create or manufacture money. Bank deposits are regarded as
money. They are as good as cash. The reason is they can be used for the purchase of goods
and services and also in payment of debts. When a bank grants a loan to its customer, it does
not pay cash. It simply credits the account of the borrower. He can withdraw the amount
whenever he wants by a cheque. In this case, bank has created a deposit without receiving
cash. That is, banks are said to have created credit. Sayers says “banks are not merely
purveyors of money, but also in an important sense, manufacturers of money.”
4.Promote the Use of Cheques:
The commercial banks render an important service by providing to their customers a cheap
medium of exchange like cheques. It is found much more convenient to settle debts through
cheques rather than through the use of cash. The cheque is the most developed type of credit
instrument in the money market.
5.Financing Internal and Foreign Trade:
The bank finances internal and foreign trade through discounting of exchange bills.
Sometimes, the bank gives short-term loans to traders on the security of commercial papers.
This discounting business greatly facilitates the movement of internal and external trade.
6.Remittance of Funds:
Commercial banks, on account of their network of branches throughout the country, also
provide facilities to remit funds from one place to another for their customers by issuing bank
drafts, mail transfers or telegraphic transfers on nominal commission charges. As compared
to the postal money orders or other instruments, bank drafts have proved to be a much
cheaper mode of transferring money and have helped the business community considerably.
B. Secondary Functions
Secondary banking functions of the commercial banks include:
1. Agency Services
2. General Utility Services
These are discussed below.
*
Lecturer in Finance; DBA, IIUC, www.mahiiuc.weebly.com
Md Amzad Hossain*
1.Agency Services:
Banks also perform certain agency functions for and on behalf of their customers. The
agency services are of immense value to the people at large. The various agency services
rendered by banks are as follows:
(a) Collection and Payment of Credit Instruments: Banks collect and pay various credit
instruments like cheques, bills of exchange, promissory notes etc., on behalf of their
customers.
(b) Purchase and Sale of Securities: Banks purchase and sell various securities like shares,
stocks, bonds, debentures on behalf of their customers.
(c) Collection of Dividends on Shares: Banks collect dividends and interest on shares and
debentures of their customers and credit them to their accounts.
(d) Acts as Correspondent: Sometimes banks act as representative and correspondents of
their customers. They get passports, traveller’s tickets and even secure air and sea
passages for their customers.
(e) Income-tax Consultancy: Banks may also employ income tax experts to prepare income
tax returns for their customers and to help them to get refund of income tax.
(f) Execution of Standing Orders: Banks execute the standing instructions of their
customers for making various periodic payments. They pay subscriptions, rents,
insurance premium etc., on behalf of their customers.
(g) Acts as Trustee and Executor: Banks preserve the ‘Wills’ of their customers and execute
them after their death.
2.General Utility Services:
In addition to agency services, the modern banks provide many general utility services for
the community as given.
(a) Locker Facility: Bank provide locker facility to their customers. The customers can keep
their valuables, such as gold and silver ornaments, important documents; shares and
debentures in these lockers for safe custody.
(b) Traveller’s Cheques and Credit Cards: Banks issue traveller’s cheques to help their
customers to travel without the fear of theft or loss of money. With this facility, the
customers need not take the risk of carrying cash with them during their travels.
(c) Letter of Credit: Letters of credit are issued by the banks to their customers certifying
their credit worthiness. Letters of credit are very useful in foreign trade.
(d) Collection of Statistics: Banks collect statistics giving important information relating to
trade, commerce, industries, money and banking. They also publish valuable journals and
bulletins containing articles on economic and financial matters.
(e) Acting Referee: Banks may act as referees with respect to the financial standing, business
reputation and respectability of customers.
*
Lecturer in Finance; DBA, IIUC, www.mahiiuc.weebly.com
Md Amzad Hossain*
(f) Underwriting Securities: Banks underwrite the shares and debentures issued by the
Government, public or private companies.
(g) Gift Cheques: Some banks issue cheques of various denominations to be used on
auspicious occasions.
(h) Accepting Bills of Exchange on Behalf of Customers: Sometimes, banks accept bills of
exchange, internal as well as foreign, on behalf of their customers. It enables customers
to import goods.
(i) Merchant Banking: Some commercial banks have opened merchant banking divisions to
provide merchant banking services.
C. Fulfillment of Socio-Economic Objectives
In recent years, commercial banks, particularly in developing countries, have been called upon to
help achieve certain socio-economic objectives laid down by the state. For example, the
nationalized banks in Bangladesh have framed special innovative schemes of credit to help small
agriculturists, village and cottage industries, retailers, artisans, the self employed persons through
loans and advances at concessional rates of interest. Under the Differential Interest Scheme
(D.I.S.) the nationalized banks in Bangladesh advance loans to persons belonging to scheduled
tribes, tailors, rickshaw-walas, shoe-makers at the concessional rate of 4 per cent per annum.
This does not cover even the cost of the funds made available to these priority sectors. Banking
is, thus, being used to subserve the national policy objectives of reducing inequalities of income
and wealth, removal of poverty and elimination of unemployment in the country. It is clear from
the above that banks help development of trade and industry in the country. They encourage
habits of thrift and saving. They help capital formation in the country. They lend money to
traders and manufacturers. In the modern world, banks are to be considered not merely as dealers
in money but also the leaders in economic development.
Relationship between the Central Bank and Commercial Banks
The Central Bank is the head of the financial system. All financial institutions including
commercial banks are regulated and monitored by the Central Bank.
All commercial banks must keep an account with the Central Bank. These balances are used for
cheque clearing purposes between banks. Payments for cheques between banks are set off at the
Central Bank’s clearing house. The Central Bank can also demand commercial banks to deposit
a certain percentage of their total deposits with the central bank in order to control the money
supply.
The Central Bank is a lender of last resort and will aid commercial banks when needed. The
Central Bank dictates the interest rate that commercial banks can offer by setting the bank rate.
This is the interest rate set by the Central Bank and the rate at which commercial banks and the
Central Bank do business, e.g. loans offered by the Central Bank to commercial bank.
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Lecturer in Finance; DBA, IIUC, www.mahiiuc.weebly.com
