Central Bank: Definition, History, Functions, and Limitations

Central Bank Definition
Central Bank: Definition, History, Functions and Limitations

A  central bank is a  financial institution with exclusive authority over creating and distributing currency and credit for a country or set of countries.

Central banks are independent of political influence, but still, their powers can be limited by executive and legislative bodies. To protect the stability of member institutions, most central banks have regulatory and supervision functions to prevent situations like bank frauds and bank runs(which occur when numerous clients withdraw their money at the same time).

The oldest form of the central bank started to fund costly government military endeavors, the Bank of France under Napoleon and the Reichsbank in Germany are some of its examples. The Bank of England and the Swedish Riksbank, which date back to the 17th century, served as the original models for contemporary central banks. The Bank of England was the first to accept the importance of an entity that could lend loans to other banks during difficult times. This entity is also known as a lender of last resort(LoR), this function is performed by the Federal Reserve in the United States of America.

There are certain limitations in the case of central banking as well, monetary policies play a minimal role in the economic growth of a country. For example, The Reserve Bank, which is the national central bank of India, just like other developing countries, has not been able to manage inflationary pressure. Because of this, it was unsuccessful in reaching the goal of successful growth.

What is the Central Bank?

A central bank is an independent institution that oversees the money supply, or the total amount of money in circulation, as well as the management of a nation’s or set of nations’ currencies.

A central bank cannot be used by an individual to open an account or request a loan, and being a public institution, it is not profit-driven, the main purpose of the central bank is to manage all the individual commercial banks. 

The central bank manages the economy’s flow of money and credit to achieve stable growth. By monitoring commercial banks to ensure that the borrowers are not taking excessive risks, the central banks also help maintain the stability of the country’s financial system.

How does the Central Bank work?

The central bank’s main task is to manage the actual cost of money. The central bank is responsible for making and implementing monetary laws.

How does the Central Bank work
How does the Central Bank work

A central bank is a source of credit for commercial banks, typically to meet very urgent needs. They must provide collateral, such as a valuable asset like a government bond or corporate bond, to the central bank to borrow money from it. Collateral serves as a guarantee that the borrower will pay back the loan.

Commercial banks may take long-term loans in exchange for short-term deposits, but they can experience liquidity issues, which arise when they have the funds on hand to pay off debts but cannot do so quickly. A central bank can act in this situation as a lender of last resort (LoR).

In most cases, commercial banks avoid taking loans from LoRs, because this would indicate that the bank is in crisis, and the clients would ultimately lose trust in the bank. At the same time, LoR also allows commercial banks to take risks as the consequences of a failure become less severe.

When did the Central Bank start?

The history of central banking dates at least to the seventeenth century, when the Swedish Riksbank, the first organization officially recognized as a central bank, was established. It was incorporated as a joint stock bank in 1668 and granted a charter to lend money to the government and serve as a clearing house for trade.

Initially, the central banks were started in the European region just because the European central banks made it simpler to fund various governmental activities like wars, etc. Thomas Jefferson in the United States of America opposed starting a central bank, despite his opposition, the United States did have multiple state-chartered banks during the early decades of its existence in addition to its official national banks.

To stabilize financial activity and banking operations, the U.S. Congress established the Federal Reserve System and 12 regional Federal Reserve Banks in 1913.

The new Fed issued Treasury bonds to aid in financing World War I and World War II.

The Hilton Young Commission’s recommendations served as the foundation for establishing The Reserve Bank of India. The Bank’s operation is governed by the Reserve Bank of India Act, 1934 (II of 1934), which went into effect on April 1, 1935.

Where is the first Central Bank?

The first central bank in the world was the Swedish Riksbank. It was incorporated as a joint stock bank in 1668 and granted a charter to lend money to the government and serve as a clearing house for trade. The bank has gone through several challenges, including war, as well. Many individuals deposit money in the Sveriges Riksbank of the Realm while the war is going well. After the defeat at Poltava, they try to withdraw it, but there is no money to be had. Simply put, the Bank freezes its depositors’ accounts during the early 1700s.  But the bank survived all the hardships to still exists as an important institution. 

What are the functions of the Central Bank?

The central bank is recognized as the supreme financial institution in the banking system. It is seen as an essential component of a country’s economic and financial system.

functions of the Central Bank
Factors that affect Stock Market Price

The nation’s monetary and banking system must be controlled, regulated, and stabilized by the central bank, which operates as a separate entity.

1. Lends the last resort

The Central Bank is a major source of assistance and support for the other national banks in times of need. This support could take the shape of a loan secured by the security. Through a rediscount of bills of exchange, the bank prefers approved securities.

Thus, in times of financial difficulty, the Central Banks serve as the “Lender of last resort” for other banks because there is no other option for assistance.

2. Controls credit

The regulation of credit in the economy is another role played by central banks. Commercial banks occasionally produce a large amount of credit in the economy, which raises inflation.

The central bank regulates how commercial banks create credit by engaging in open market operations or by altering the CRR to regulate the process.

3. Currency regulator

In an economy, central banks have the sole authority to print money. Every global central bank participates in the issuance of currency to the economy.

The central bank is also referred to as the bank of an issue because it is one of its most crucial economic roles.

Before, all banks were permitted to print their currency, which led to an unorganized economy. Governments all around the world gave central banks the authority to issue money to avoid this predicament, which led to uniform currency circulation and a steady flow of cash into the economy.

4. Bank to the government

The central bank’s role as the government’s bank is one of its key responsibilities. The central bank receives deposits and provides the government with money. The government also takes part in sending and receiving funds. For the government to recover from difficult economic times, central banks also provide short-term loans to the government.

In addition to serving as the government’s bank, it also represents and advises the government by offering guidance on matters related to economic policy, the capital market, the money market, and government loans.

5. Custodian of Cash reserve

Every Commercial Bank is required by law to deposit a specific amount (as fixed) of time and demand deposits with the Central Banks. Here, the Central Bank oversees the Commercial Banks’ cash reserves and assists in making transactions possible.

This kind of deposit enables the Central Bank to give Commercial Banks extra money on a temporary and short-term basis to help them get through tough times financially.

6. Custodian of International Currency

The central bank’s responsibility to keep a minimum balance of the foreign currency is crucial. Maintaining such a balance is necessary to deal with unforeseen or urgent foreign reserves needs and address any unfavorable balance of payments deficits.

7. Protecting the depositor’s interests

To safeguard the interests of depositors, the central bank must also monitor how commercial banks operate. The Central Bank gives loans to commercial banks during uncertainty to protect the depositor’s trust.

8. Clearing house for transfer and settlement

The central bank serves as a clearing house for commercial banks and aids in resolving their shared debt. The representatives of various banks gather at a clearing house to settle interbank transactions.

What are the limitations of the Central bank?

The central bank’s function is very minimal. The central bank is expected to ensure that lack of sufficient funding will not obstruct the process of economic development.

The effectiveness of the monetary policies developed by the central bank is hampered by the presence of black money in the economy. Since lenders and borrowers keep their transactions private, black money is not recorded. As a result, the monetary policy’s planned balance between money supply and demand is likewise not being maintained.

The biggest limitation of central banks is their ignorance of non-monetary factors.

Monetary policy can never be the main regulating element to control inflation driven by real forces, deficit finance, and foreign exchange resources.

The availability of credit control tools is only one factor in the successful application of central bank decisions. Additionally, timing and the level of constraint used or relaxation permitted are matters of judgment.

However, the history of credit limits by central banks demonstrates that they have never reached the necessary level of control. In the area of monetary regulation, the Bank has taken a cautious stance.

How do central banks govern the banking industry?

The duties of central banks vary significantly based on their location. Central banks control and manipulate the national money supply, setting interest rates on bonds and loans and printing money. Interest rates are raised by central banks to prevent inflation and hinder growth while they are decreased to promote these goals. They control monetary policy in this way to direct the nation’s economy and attain economic objectives.

In addition, they maintain foreign exchange reserves and lend money to a country’s banks and government.

A central bank serves as an emergency lender to struggling commercial banks and other entities. When a government needs to raise more money, the central bank can offer a politically appealing alternative to taxation by buying government debt obligations, for instance. They control member banks via capital and reserve requirements.

How many Central Banks are there?

There are around 221 Central Banks all around the world. Some of these are not recognized globally because some countries are only partially recognized. Countries like Panama still do not have any Central Bank. These Central Banks are called by different names in different countries, like the Eastern Caribbean Central Bank, Bank of the Republic, etc.

Does every country have Central Bank?

No, In reality, certain nations don’t have their central bank. Most nations worldwide have a central bank, especially those that print their own money. In actuality, even non-state entities like Abkhazia have central banks. Despite having all these benefits, some countries still don’t have a Central Bank. Following is the list of countries that still not have a Central Bank:

  • Andorra
  • Isle of Man
  • Kiribati
  • Marshall Islands
  • Micronesia
  • Monaco
  • Nauru
  • Palau
  • Panama
  • Tuvalu

Does the Central Bank regulate the SEC?

No. The U.S. Securities and Exchange Commission (SEC) is an independent federal government regulatory body in charge of upholding the fair and orderly operation of the securities markets and protecting investors.

The SEC encourages full public disclosure, defends investors from dishonest and market-manipulating operations, and keeps an eye on corporate takeover activities in the United States.

The Securities Exchange Act of 1934 created the SEC, a free-standing federal body run by a five-member Commission. The President appoints the Commissioners, and the Senate confirms them. One of the Commissioners is chosen by the President to serve as Chairman. So the SEC is an independent entity.

Is the Central Bank responsible for regulating cryptocurrency?

No. A cryptocurrency is a form of decentralized asset which is encrypted to keep all transactions anonymous. The fact that cryptocurrencies are often not issued by any central authority makes them potentially impervious to intervention from or manipulation by governments. So Central Banks have no role in the regulation or creation of cryptocurrencies. These cryptocurrencies are based on the blockchain system, which allows them to be completely virtual with no physical existence, unlike conventional currencies. Cryptocurrencies can either be mined or bought at crypto exchanges.

Every cryptocurrency asserts that it has a unique purpose and specification. Ether, for instance, is promoted as gas for the underlying smart contract platform. Banks use Ripple’s XRP to enable transactions between different geographical areas.

Central Banks are trying to build digital assets which are centrally controlled like CBDTs, Central Bank Digital currencies are digital tokens that are issued by a central bank and resemble cryptocurrencies. They are linked to the value of the fiat money used in that nation.

CBDCs are being developed by numerous nations, and some have even put them into practice.

What is the difference between a Central Bank and a Commercial Bank?

  • The country’s banking and monetary systems are governed by the Central Bank, which is the top financial institution in the land. It was established to promote monetary stability, print money, and preserve the value of a nation’s currency on the world market. It oversees the country’s monetary and credit systems.
  • The central bank can issue currency notes except for coins and small-scale notes.It has the authority to manage, oversee, and direct commercial banks. Furthermore, it aids them when they are in need.
  • Commercial Banks are organizations that offer banking and financial services to a sizable population. They serve as a go-between for savers and borrowers. Commercial banks take deposits from the general population and lend the money to people and organizations at high-interest rates. Savings are mobilized in this way, and the economic cycle continues without any problems.
  • While the Commercial Bank may be privately or publicly held, the Central Bank is a publicly owned entity. Economic growth and the general public’s welfare are the central bank’s core goals. The central bank is responsible for making monetary policies for the country. Commercial banks, in contrast, operate for profit. While the Commercial Bank may be privately or publicly held, the Central Bank is a publicly owned entity. Usually, a country only has one central bank, but there can be numerous privately owned commercial banks in the country.
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