Sunday, February 28, 2016

AHSEC - Class 11: Unit 4 Central Banking

1. What do you mean by a Central Bank? Explain the nature of central bank.
Ans: Central Bank: The central bank is the supreme monetary institution of the country. It is established, owned, controlled and financed by the govt. of the country. The design and control of the country’s monetary policy is its main responsibility. India’s central bank is the Reserve Bank of India. The nature of Central Bank is as follows:
a)      It is the head of all the banks of India. It is the supreme monetary institution of the country.
b)      They always work for national welfare of a country. They do not aim at earning profits.
c)       It is established, owned, controlled and financed by the govt. of the country.
d)      It does not compete with other financial institutions in the market.
2. Who is authorized to issue notes in India?
Ans: Central Bank except one rupee currency which is issued by the Ministry of Finance.
3. Why is the established of Central Bank necessary in a country?
Ans: The Central Bank plays a vital role in economic development of a country. It controls the whole monetary system and credit supply of a country. If there is absence of Central Bank, then the whole economic system of that country. So, a Central Bank is necessary in a country because:
a)      To issue currency notes in a country.
b)      To control the supply and creation of credit in the economy to maintain stability in the monetary system.
c)       To meet the financial requirements of the sectors of the economy.
d)      To successfully implement the monetary policies of the govt. of the country.
e)      To promote the foreign trade of the country through various policies.


4. What are the functions of Central Banks?
Ans: The main functions of the Central Banks are:
a)      Issue of paper currency.
b)      Banker to the government.
c)       Banker to the bank.
d)      Credit control.
e)      Supervision and inspection of banks.
f)       Development and promotional functions.
g)      Custodian of the Nation’s Gold and foreign exchange reserves.
5. Explain the function of Bank as the issuer of Currency Notes. Explain two methods for issuing currency.
Ans: The first function or the primary function of money is to issue paper currency. The Central Bank has the sole power to issue paper currency. The notes are legal tender money. In India, the RBI issue currency notes of all types except One Rupee note which are issued by the Ministry of Finance, Govt. of India. But the notes are issued following some methods. The Central Banks follows different methods or system according to the currency or banking regulations to issue notes. These systems are:
a)      Proportional reserve system.
b)      Simple Deposit system.
c)       Fixed fiduciary system.


d)      Minimum reserve system.
e)      Maximum reserve system.
Simple deposit system of issuing currency: The simple deposit system is also knows as full reserve system. Under this system, the Central Bank is required to keep 100% of metal, either gold or silver or both as reserve for every note issued. The notes so issue becomes representative paper money. The advantage of this system is that it enjoys a public confidence but it is very costly and money supply cannot be increase as and when required.
Fixed Fiduciary System of issuing currency: Under this system, the Central Bank issue currency notes up to a certain limit against reserves of Govt. securities. The notes issued beyond the limit set by the law have to be fully banked by metallic reserves.
Proportional system of issuing currency: The proportional system of issuing currency is very simple and elastic. According to this system, the notes issued by Central Bank are banked by both metallic reserves and securities. A certain percentage (25 to 40%) of the total notes issued has to be backed by gold or silver reserves and the remaining by Govt. securities.
6. How does the Central Bank acts as the banker to the Government?
Ans: The Central Bank is the banker to the Govt. of that country. It performs the same function for the Govt. as the commercial banks performs for their customers. The Central Banks plays the role of the banker to the Govt. in the following three ways:
a)      As a banker: The Central Bank is the banker to the Govt. Under this, it maintains the accounts of the Govt., accepts deposits of the Govt. without interest, provides short term loans to the Govt., undertakes transactions of the Govt. related to purchase and sale of foreign exchange, etc.
b)      As an agent: The Central Bank also acts as the agent to the govt. In this, it recovers taxes and other payments from the public, floats loans and manages public debt etc.
c)       As an advisor: The Central Bank is the financial adviser of the Govt. It advices the Govt. on important economic fiscal and monetary matters such as controlling of inflation or deflation, deficit financing, trade policy, etc.
7. Explain the function of Central Bank as the Banker to the banks?
Ans: The Central Bank is a banker to all the other banks. It is the supreme bank of all the banks. As the supreme bank it performs various functions. Some of the functions are:
a)      Custodian of cash reserve of the bank: The Central Bank acts as the custodian of cash reserve of the banks. Every Commercial bank has to keep a certain portion of their deposits and time and demand liabilities to the Central Bank in the form of cash reserves. The Central Bank maintains this cash reserve as the custodian and grants money to the commercial bank in times of emergency.
b)      Lender of the last resort: The Central Bank is the Lender of the last resort of the commercial banks. When the other banks shortage of funds, then they can approach to the Central Bank for financial assistance. The Central Bank lends money to them by discounting their bills. This enables the Central Bank to establish control over the banking system of the country.
c)       Clearing agent: The Central Bank acts as the clearing house of the commercial banks. It maintains the accounts of the banks and settles their claims and counter claims by minimum use of money or cash.
8. How does the Central Bank controls and manages the Gold and Foreign Reserves of the country?
Ans: The Central Bank is the official reserve or of gold and foreign exchange currencies of the country. It has been entrusted to keep and manage the foreign exchange reserves of the country.
9. What are the supervisory and inspectional powers of the Central Banks?
Ans: The Supervisory and Inspectional powers of the Central Bank are:


a)      Licensing and Establishment of banks.
b)      Regulation of Branch expansion.
c)       Maintenance of minimum paid up capital and reserves as provided by law by banks.
d)      Management of the banks.
e)      Inspection and auditing of the books of accounts of the banks, etc.
10. Explain the Development and Promotional functions of the Central Banks.
Ans: The Development and Promotional functions of the Central Banks are:
a)      To make provision for adequate credit facilities to industry, agriculture and other sectors.
b)      To make banking services development oriented.
c)       To maintain internal price and exchange rate stability.
d)      To protect the market for Govt. securities.
11. What are the principles of issuing notes?
Ans: The three principles of issuing notes are Uniformity, Elasticity and Security.
12. What do you mean by Banker’s clearing house?
Ans: A Banker’s clearing house is an institution where the inter-bank claims of all the banks are settled down. The claims are settled by Central Bank by means of cross entries in the book of Central Bank on the principle of Book-keeping.
13. What do you mean by Credit Control? What are its objectives?
Ans: The regulation of credit creation capacity of the commercial banks and other banking institutions by the Central Bank to achieve some definite objectives is known as Credit Control.
The objectives of the Central Bank for Credit Control of the other banks are:
a)      To establish stability in the internal price level by adjusting the supply of credit.
b)      To maintain stability in the foreign exchange rates by eliminating fluctuations in the exchange rates.
c)       To eliminate cyclical fluctuations in the production, employment and prices of goods.
d)      To stabilize money market of the economy.
e)      To achieve full employment of resources and accelerate economic growth with stability.
14. What are the principle methods or instruments of Credit Control used by the Central Bank?
Ans: The principle methods or instruments of Credit Control used by the Central Bank are:
1)      Quantitative or General Methods
2)      Qualitative or Selective methods
1)      Quantitative or General Methods: These are the traditional or general methods of credit control. These methods one used by Central Bank to expand or contract the total volume of credit in the economy neglecting the purpose for which it is used. These methods are :-
a)      Variation in the bank rate
b)      Open Market operations:
c)       Variation in cash reserve ratio:
d)      Variation in the statutory liquidity ratio:
e)      ‘Repo’ Transactions:


a)      Variation in the bank rate: Bank rate or discount rate is the rate at which the Central Bank of a country makes advances to the banks against approved securities or rediscounts the eligible bills. The purpose of change in the rate is to make the credit cheaper or expensive   depending upon whether the purpose is to expand or control credit. An increase in bank rate result, in increase in lending rate of commercial banks lending to contraction of credit while a decrease in bank rate leads to decrease in lending rates of commercial banks lending to expansion of credit.
b)      Open Market operations: Open market operations means deliberate and direct buying and selling of securities and bills in the market by the Central Bank. The open market operations of the RBI are mostly confined to government securities. In order to increase money supply in the market, the RBI purchases securities in the open market. On the other hand, in order to contract credit, the RBI starts selling the securities in the open market.
c)       Variation in cash reserve ratio: Every scheduled bank in India is required to maintain a minimum percentage of their deposits with the RBI. Larger the reserve, lesser is the power of the banks to create credit and smaller the reserves, greater is the power of the banks to create credit.
d)      Variation in the statutory liquidity ratio: Statutory liquidity ratio is another reserve requirement used by the RBI to control money supply. In India, besides maintaining the cash reserve, every bank has to maintain a statutory reserve of liquid assets in terms of cash, gold or unencumbered securities. This is termed as statutory liquidity ratio. In increase in the liquidity ratio implies a transfer of banking funds to Government and corresponding reduction in credit available to the borrowers.
e)      ‘Repo’ Transactions: ‘Repo’ stands for repurchase. Repo or repurchase transactions are undertaken by the Central Bank in the money market to manipulate short term interest rates and to manage liquidity levels. In case the RBI desire to inject fresh funds in the economy it conducts ‘Repo’ transactions. On the other hand, to absorb liquidity the RBI ‘Reserve Repo’ transactions. The securities eligible for carrying out this operation are selected by the RBI. It includes government promissory notes, treasury bills and public sector bonds.
3)      Qualitative or Selective Methods: These are basically the selective and general methods of credit control. These methods are used for controlling the use and direction of credit. They have nothing to do with the control of the total volume of credit in economy. These methods are :-
a)      Direction
b)      Margin Requirement
c)       Consumer Credit Regulations
d)      Publicity
e)      Credit Rationing
f)       Moral Suasion.
g)      Direct Action.
a)      Directions: Sec. 21 of the Banking Regulation Act gives wide power to the RBI for controlling granting of advances by an individual bank or by banking as a whole. The RBI can give directors to any particular bank or all banks in general in regard to the purposes for which advances may or may not be made, the maximum amount of advance to any individual, firm or company etc.
b)      Margin requirement: Margin means the difference between the market price of security and loan amount. Changing margin requirement is another credit control method followed by the RBI. This system was introduced in 1956. By requiring higher margin while accepting a commodity as a security, the RBI can decrease the flow of credit to particular sector or vice versa.
c)       Consumer Credit Regulation: Under this method, consumer credit supply is regulated through hire-purchase and installment sale of consumer goods. Under this method the down payment, installment amount, loan duration, etc is fixed in advance. This can help in checking the credit use and then inflation in a country.
d)      Publicity: This is yet another method of selective credit control. Through it Central Bank (RBI) publishes various reports stating what is good and what is bad in the system. This published information can help commercial banks to direct credit supply in the desired sectors. Through its weekly and monthly bulletins, the information is made public and banks can use it for attaining goals of monetary policy.
e)      Credit Rationing: Central Bank fixes credit amount to be granted. Credit is rationed by limiting the amount available for each commercial bank. This method controls even bill rediscounting. For certain purpose, upper limit of credit can be fixed and banks are told to stick to this limit. This can help in lowering banks credit exposure to unwanted sectors.
f)       Moral suasion: It implies to pressure exerted by the RBI on the Indian banking system without any strict action for compliance of the rules. It is a suggestion to banks. It helps in restraining credit during inflationary periods. Commercial banks are informed about the expectations of the central bank through a monetary policy. Under moral suasion central banks can issue directives, guidelines and suggestions for commercial banks regarding reducing credit supply for speculative purposes.
g)      Direct action: Under this method the RBI can impose an action against a bank. If certain banks are not adhering to the RBI's directives, the RBI may refuse to rediscount their bills and securities. Secondly, RBI may refuse credit supply to those banks whose borrowings are in excess to their capital. Central bank can penalize a bank by changing some rates.

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