The Role of Central Banks in Economics - Assignment Example

Introduction Banks play critical roles in the economy. Their overall objective is to promote economic growth and development in the societies in which they operate. There are two main different types of banks operating in any given economy. They are commercial banks and central banks. Commercial banks are financial institutions that provide loans, savings and deposits accounts as well as transactional services to entities and individual members of a country. On the other hand, Central Bank is a supreme monetary bank in any country, which regulates and controls economic as well as monetary affairs in a specific country. Central Banks regulates money supply via specific monetary and non-monetary policies to maintain stable and robust macroeconomic environment. This is in order to enhance sustained economic growth and development across different sectors in the economy. Central banks and commercial banks play distinct roles in the economy. In general, the central banks supervise all financial institutions including commercial banks and advices government on what policy action to pursue to maintain robust and stable macro economic environment. Commercial banks provide both monetary and non-monetary services to members of the public and different entities (companies, societies and institutions). To understand the roles of banks in any given country, it is important to state and explain the different roles that different banks play. Therefore, this discussion is divided into two main parts. The first part describes the roles of central banks in any given economy and the second part describes the roles of commercial banks. Part I- The role of Central Banks According to Muralidharan (2009), a Central Bank is a public supreme monetary bank of any country mandated by country’s laws to create and issue currencies (legal tender), and regulate money supply to enable respective economies to perform appropriately. Examples of central banks include Bank of Canada, Central Bank of the republic of China (Taiwan), Bank of England and Federal Reserve System. Central banks are very important and considered necessary for effective and efficient functioning of the any given economy. Specific roles of Central Banks are listed and explained below. First, central banks issue and cancel currency (legal tender). They are the only banks with legal mandate to create and issue currencies inform of notes and coins. Central banks are responsible for regulating quantity of all notes and coins issued. They also protect internal and external value of national currency (Backhaus, 2005). Before the central banks issue notes and coins, it must fulfill certain requirements to avoid inflation, currency devaluations and shortage of money in the economy among others. For example, it must keep reserves against all the coins and notes issued at any given time. As a sole issuer of legal tender, central banks easily control credit creation, maintain confidence of the people because it has government backing and recognition, and ensure that all currencies issued are uniform and acceptable. Secondly, central banks act as a bank, an agent and an advisor of banks as well as other financial institutions. Central banks act as lender of last resort. This happens when commercial banks fail to secure loans or advances from other financial institutions to run it banking operations. IMF (2008) asserts that central banks provide funding to financial institutions as lender of last resort to restore confidence in the banking system and avoid fire sales of banks assets by providing liquidity to financial institutions. Central banks also act as custodians and clearing agent for commercial banks. Central bank collects statistical information regularly on matters touching money, public debt, inflation, foreign exchange, trade policies, government securities as well as banking among other information. The information collected and analysed by central banks is disseminated to relevant financial institutions to assist them make informed choices on what strategies to take to improve their operations. Third, central banks act as custodians of commercial banks’ cash reserves. Part of the deposits received by commercial banks is kept as reserves with the central banks. The percentage of cash reserves deposited by commercial banks with the central bank is determined by the central bank as dictated by economic conditions. It is the role of the commercial banks to ensure that reserves deposited with them by commercial banks are kept safe and available to commercial banks in the event that they desperately need some money to conduct their operations. Cash reserves guarantees commercial banks that they will receive loans from central banks at the time of need. Fourth, central banks act as custodians of foreign exchange balances. Central banks are also responsible for regulating foreign currency exchange rate in line with economic conditions of a specific country. Central banks ensure that they are sufficient foreign exchange currencies to enable a country trade with other countries. Therefore, they purchase foreign currencies when the country needs more to trade and dispose off foreign currencies when they are in excess. It is the role of central banks to regulate external value of country’s currency and ensure that it is valued fairly in relation with other currencies. Fifth, central banks control and regulate country’s banking system. The central bank is responsible for supervising, regulating and controlling all activities of financial institutions. This is because if financial institutions are allowed to operate without rules and guidelines, they may cause greater problems to the economy. For example, they may create too much credit, which may cause inflation and financial crisis. Therefore, it is necessary for central banks to influence the banking structure of a country positively by implementing specific actions and measures to strengthen country’s financial structure (Suri et al, 2005).The aim of those actions may be to promote savings and capital formation or increase international trade and tame inflation. Central banks also design policies that promote interbank lending. They also adjust monetary policies to stabilize economic performance and maintain health of country’s financial system. The central bank through its employees collect and arrange statistics that are used to develop policies and reports related to credit, money as well as foreign exchange among many others. Sixth, central banks control and regulate money supply (credit). It is the role of central banks to regulate money supply. Therefore, they dictate the volumes of loans or advances that financial institutions can give to their borrowers. This will ensure that banks do not grant to much or too little loans to borrowers. Instead, commercial banks should give out credit according to economic needs of a given country. Control of lending is done through various mechanisms. The central banks control credit through bank rate policy, open market operations, margin requirement on secured loans, variable portfolio ceiling and variable capital asset ratio. Central banks can control credit through adjustment of bank rate or discount rate policy. When the bank rate policy is increased, interest rates are expected to increase too. It follows then that less people will borrow money from the bank because cost of capital is higher. As a result, supply of credit will decrease. On the other hand, when bank rates are reduced by the central banks, cost of credit declines and people are encouraged to take loans. As a result, credit supply will increase. When there is too much credit in circulation, the central bank may refuse to discount discounted bills of commercial bank and vice versa. This is because discounting bills of exchange give commercial banks more money to give out to their borrowers. Central bank also uses open market operations as a tool to control money supply in an economy. Open market operations refer to an act of sale and purchase of securities. Securities can take the form of government bonds, treasury bills, and equity shares of companies, foreign exchange bills or gold among others. The government purchases securities from members of the public to increase availability of money in public domain. This increases money supply in the hands of members of the public and enables them purchase goods and services. On the other hand, when money supply is too much in the economy, the central bank sells securities to members of the public at very high rates to encourage people and companies to purchase them. When securities are purchased, excess money is taken away from the economy via government securities and reduces money in circulation. Sale of securities reduces money supply in two ways. The first way is by reducing the number of money that depositors can make to their banks and secondly, directly reducing the amount of money in circulation. When bank receive little deposits, it will lend less to borrowers. Variation of the reserve ratios can be an effective tool, which central bank can use to reduce money supply in a given economy. Law demands that commercial banks maintain a certain proportion of cash deposits they receive from customers with the central bank. Cash reserve ratio is dictated by the central bank in response to changes in the economy. If central bank wishes to raise the volume of credit in circulation, it fixes lower reserve ratio and vice versa. For example, reserve ratio can be 20:80. This means that commercial banks should keep at least 20 percent of all deposits it receives with the central bank. The central bank can increase the reserve ratio from 20:80 to 30:70 if there is too much money in circulation to reduce the amount of money lend out. Margin requirements on secured loans can be useful to reduce the amount of credit in circulation. Central bank prescribes margin requirements for different categories of securities. If the central bank finds it necessary to reduce the amount of money in circulation, it fixes higher rates of margin requirements (limits) and vice versa. For example the margin limit against vehicles can be 40%. If it wishes to reduce the amount of loans advanced, it can raise the margin limit to 60% percent to make banks lend less money to borrowers against vehicles. Central bank can also ration credit. This can be done through variable portfolio ceiling or variable capital asset ratio. Variable portfolio ceiling involves fixing a ceiling on the maximum amount on loans that banks can advance to their borrowers at a specific point in time. On the other hand, variable capital asset ratio refers to a system where central bank fixes a specific ratio, which the capital of the bank should have against its total assets. This limits the banks from lending money to their borrowers beyond their capital or total assets limits. For example, if the bank has capital base of twenty billion pounds, it is only required to lend loans to certain limits in relation to the capital or total assets. Seventh, central bank can regulate consumer credit. Commercial banks may give loans to borrowers to purchase durable items such as televisions, air-conditioners, washing machines, land, heavy machinery or motor vehicles. Central bank may regulate consumer credit by regulating the total volume of loans issued by commercial banks to their customers. Central bank control consumer through directives, refusing to rediscount commercial banks’ bills of exchange, charging penal interest rates, refuse to advance loans as a lender of last resort or by moral persuasion. Central banks may issue specific policies and guidelines to commercial banks to control their lending policies, divert credit to more productive purposes, and prohibit lending for specific purposes or fix maximum ceiling of loans granted for specific purposes. Central banks may refuse to rediscount bills of exchange to wayward commercial banks or change rediscounting conditions to be more stringent to reduce the amount of money available to commercial banks. Central banks may also refuse to lend to commercial banks that have exceeded their capital and reserves ceilings or heavily penalize the erring commercial banks to discourage their bad actions. Finally, central banks may use moral persuasion to ask commercial banks to regulate their lending to the public. However, if commercial banks fail to follow the moral persuasions (advice or request) no punitive action will be taken against them by the central bank. Eighth, central bank acts as government bank. Central banks act as an agent, which manages public debt. It receives tax revenues and other income on behalf of the government as well as collecting cheques and drafts belonging to the government accounts. It also receives deposits from the government agencies. Central bank also makes payments on behalf of the government for goods and services consumed by government departments. In addition, it helps the government to invest money or borrow money through sales of its securities (bonds and bills) to the public. Central bank also helps the government to coordinate monetary and fiscal policies appropriately. In addition, all important decisions are taken by government in consultation with the central bank. Central bank also represents government in many international organizations such as the International Monetary Fund and World Bank as well as in international conferences and seminars. Furthermore, they accept to pay interest on principles on monies advanced to the government by individuals or financial institutions and perform all other functions to ensure that public debt issues are dealt with as they occur so as not to discourage government’s lenders. Central banks also provide advice to the government on issues touching general economy, money supply, money markets, deficit financing, currency devaluation and public debt. Central bank provides foreign exchange currencies to the government to enable the government repay external debt or import necessary goods and services. The government is also advised on matters associated with foreign exchange, trade policies as well as sale and purchase of government securities by the central bank. Ninth, central bank acts as clearing house of financial institutions. Central bank acts as an intermediary between commercial banks and assist commercial banks to settle their mutual obligations by providing a clearing house facility. Commercial banks meet daily at central bank’s clearing house facility to present cheques and offset any claims or debts against each other. Differences that exist between commercial banks are settled via cheques drawn on commercial banks undertaken by the central bank using commercial banks’ accounts at with central bank. As a result, it acts a friend, supporter, guide and philosopher to the commercial banks operating in their jurisdiction. Eleventh, Central bank helps the developing countries to grow and develop. Developing countries usually lack enough capital to initiate development projects. As a result, central bank designs policies that will encourage people in a developing country to save and invest their income. In addition, it develops policies that promote economic growth and development. For example, it may develop policies that permit importation of capital assets and export of finished goods. Part II- The role of Commercial Banks Commercial banks play distinct roles in promoting economic growth and development of any country. The specific roles of commercial banks are numerous and varied depending on the type of the bank. Commercial bank roles are categorised into primary, secondary and general utility roles (Muralidharan 2009). Primary roles of the commercial banks a) Commercial banks accept deposits. Commercial banks accept deposits from entities and members of the public who have surplus income. This is because it is more convenient to keep extra money in a bank because their safety is assured. Commercial banks may also attract deposits to be used to lend to people or entities, which do not have adequate money but are in need money for personal or business transaction. People or entities deposit money to a bank for safe keeping or investment motives (earn interest). Commercial banks classify bank deposits into fixed and demand deposits. Fixed cash deposits refer to specified amount of cash that is deposited in a bank for a specified longer period of time, which could be one or more years. Fixed cash deposits earn interest and the longer the time for deposits, the higher the rate of interest. Commercial banks charge higher interest for fixed cash deposits lend to borrowers than interest rates depositors receive. Fixed deposits cannot be withdrawn before maturity. Demand deposits refer to temporary deposits because they can be withdrawn at any time by the depositor. Demand deposits are further divided into savings and current account. Saving account hold deposits temporarily but receives nominal rate of interest. Money can be withdrawn any time and in anywhere depending on the needs of the customer. Current account allows for regular withdrawals and do not earn interests. However, it allows unlimited withdrawals subject to minimum balance restrictions. It is ideal for traders and businesspersons who make numerous deposits and payments at a given day. Demand deposits account charge some withdrawal fees. b) Commercial banks create credit. One of the main functions of commercial banks is to create credit. This is a natural process of giving out loans to the borrowers. When commercial banks lend cash to the borrower, they open accounts in the names of the borrowers and credit the amount of the loan to customers’ accounts. Every time a bank advances a loan, it creates a bank deposit equal to the amount advanced. Therefore, a commercial bank can create many times credit as compared to real deposits subject to cash-reserve ratio (Mishra, 2009). c) Commercial banks grants loans and advances. The deposits that bank receive from entities or people with surplus income will be used to grant loans and advances to people or entities that require money to transact personal or business transactions. When commercial banks give credit to borrowers, they act as intermediaries between those who have surplus money and those who lack. Commercial banks offer loans to those who need them at higher rates of interest than those paid to depositors’ accounts. Loans are further classified as term loans, advance, cash credit, overdraft or bill discounting. Term loan refer to loans advanced for a longer period against assets as securities and are often paid in specified installment and within a specified period of time. Term loan are usually granted to customers who wish to purchase assets for their businesses. Advances are loans granted to bank’s customers for a shorter period to pay for daily requirements of business. Cash credit refers to a credit facility that allows borrowers to withdraw money to a specified limit. Overdraft is a short term loan facility that allow bank customer to overdraw from his or her bank account. Bill discounting refers to an act where bank (drawee) pays payee the amount drawn by the drawer at a discount before the maturity date of the bill at a discount. The bank will then collect the total amount from the drawer when the bill matures. Secondary roles of the commercial banks a) Commercial banks can act as agents or correspondents on behalf of their domestic or international clients. Commercial banks can transfer money from one place to the other as per the instructions of their customers. For example, commercial banks can remit funds to pay, taxes, bills or other charges such as interest, insurance premiums, rent or subscriptions through cash deposits, cheques or bank overdraft on behalf of their clients. Commercial banks can also collect and pay credit instruments such as promissory notes, cheques and bills of exchange on behalf of customers. It can also collect rent, dividends and interest on behalf of their customers at a fee. Commercial banks also perform the role of a trustee or an executor on behalf of their clients. b) Commercial banks execute standing orders. Standing orders (bankers’ orders) are instructions that account holders give to their bank to pay specific amount of money at regular intervals to another account. Standing orders are appropriate for payment of fixed term regular payments such as rent, insurance premiums, subscriptions, mortgages or employee salaries. Commercial banks charge a fee for providing this service on behalf of his or her client. c) Commercial banks can sale or purchase as well as safely keep securities such as shares, stocks or bonds on behalf of their customers. They underwrite shares, debentures and bonds on behalf of their clients. Companies that wish to issue secured debenture appoint commercial banks as trustees to take charge of debenture security and manage the interest of debenture holders on behalf of the company. d) Commercial banks also purchase and sale of foreign exchange. Commercial banks buy and sell foreign exchange on commission basis through their foreign exchange dealers and affiliates. Foreign exchange dealers are international departments within large commercial banks located major cities such as London, New York, Paris, Singapore and Zurich among others. Foreign exchange dealers have trading rooms fully equipped with telephones and telex machines to enable them communicate and transact their business. They also provide a forward exchange markets that enables international companies to trade effectively. In this way, they promote international trade. e) Commercial banks act as guarantors. They guarantee their customers to pay off their debts, when the customers are not able to pay off their debts. In addition, commercial banks provide banker’s acceptances that indicate that a commercial bank has agreed to take responsibility for future payment. Banker’s acceptances are useful for international trade transactions because exporters prefer to send goods to a person who has been accepted by a specific bank. Therefore, commercial banks facilitate international transactions by stamping accepted on a draft, which compel payment of specified sum of money to a specific account at a specified point in future. Exporters then hold banker’s acceptances to maturity date. However, they may sell acceptance before maturity date by discounting it (Madura 2008). f) Commercial banks may offer letter of references. The commercial banks can provide economic information concerning their clients to both domestic and international traders (business people) as well as economic information concerning specific traders to their customers when requested. Therefore, commercial banks assist their clients get acquainted to their business partners. Subsidiary and general utility roles of the commercial banks There are other roles that commercial banks play. a). Commercial banks provide safe deposit lockers. It is risky to keep valuable items such as important documents and jewelry in ones premise. This is because they can be stolen or destroyed easily. Therefore, it is important to ask the commercial banks to keep the valuable items in their safes to preserve them at a small fee. This enables the owner to rest easy and minimize the risks of attracting burglars or criminals to the house. b) Commercial banks issue travelers cheques to their clients and letters of credit. This enables their customers to travel without the risk of carrying money along with them. c) Commercial banks offer business advisory services to clients on specific requests. They assist their customers with information to enable them manage their business risks accordingly. They also act as savings or investment advisers to their esteem clients. Thus, it helps customers attain their long term goals for better life by building and protecting their savings or investments. Commercial banks also help their clients to appraise and certify fair market value of their valuable items. d) Commercial banks can act as trustees and executors of properties of their customers who may be corporate, government or members of the public. As trustees, commercial banks are able to defend the trust, invest trust assets, administer trust assets to beneficiaries according to expressed terms and avoid conflict of interest. When commercial banks have been appointed as trustees, they must be loyal and honest when dealing with trust assets. e) Commercial banks also promote economic development. Economic development is promoted by effective and efficient credit system. They give loans to unemployed youths, help in capital formation and development of rural sector. They can also provide business advisory services to their customers to enable them transact their businesses profitably. f) Commercial banks act as policy implementers. They are used by the central bank to implement government policies on both monetary and non-monetary issues aimed at encouraging savings in an attempt to speed up economic growth and pursuant of social goals. g) Commercial banks act as employment generators. Commercial banks are employing thousands of people. Employed people earn salaries and are empowered to pay for their needs and invest the surplus funds. h) Commercial banks offer treasury services. Commercial bank helps their clients to invest their monies. In addition, they provide trade logistics, commercial cards, escrow services and finance to their clients. They also value, clear and safeguard security portfolio on behalf of investors and broker dealers. Commercial banks also assist their clients to do business by providing online service tools, fast tracking clients implementations and providing streamed lined documentations to their clients. Conclusion Banks are extremely important to every economy. Central Banks are supreme monetary banks in every country. They issue currencies, act as a bank, an agent and an advisor of banks, custodians of commercial banks’ cash reserves and foreign exchange balances as well as government bank and clearing house of financial institutions. In addition, they control and regulate country’s banking system, money supply, consumer credit and help the developing countries to grow and develop. Commercial banks are financial institutions that offer financial and other services to the public. Role of commercial banks are classified as primary, secondary and general utility roles. Primary roles include receiving deposits, offering loans and creating credit. Secondary role include act as agents, trustees and dealers in foreign exchange among others. General utility roles include providing safe lockers, implementers of government policies, provide employment and provision of treasury services among others to the public. Bibliography Backhaus, GJ 2005, The Elgar companion to law and economics, 2nd edn, Edward Elgar Publishing, Cheltenham, UK. IMF 2008, Global Financial Stability Report: Apr-08, International Monetary Fund, Washington. Madura, J 2008, Financial markets and institutions, 8th edn, Cengage Learning, New York. Mishra, S 2009, Engineering Economics and Costing, PHI Learning Pvt. Ltd., New Delhi. Muralidharan 2009, Modern Banking: Theory and Practice, PHI Learning Pvt. Ltd. New Delhi. Suri, RK, Budhiraja, JK & Rajput, N 2005, A Text Book of Isc Economics Vol I, Pitambar Publishing, Bagh, New Delhi. Read More