ECONOMICS

Functions Of Central Bank

Submitted to : Miss Sheerin Ejaz

Ayesha Tahir Baig

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 Central Bank
A bank, as the Federal Reserve Bank, that holds basic banking reserves, issues currency, and
acts as lender of last resort and controller of credit.

Origin of central bank:

The origin of central bank can be traced back to 1964, when the bank of England came into
being as the first ever central bank. The bank was established to help King William III out of his
government’s financial crises.

Earlier the functions of the central bank included the issue of currency notes, would be
performed by several commercial banks separately. Every bank's notes were different from
each other's in color, size, and value and even market good will. That is, the notes lacked
uniformity, producing an immense chaos in the smooth running of the trade. Consequently, the
paper currency system was unstable, unreliable, and used to yield to gold and silver currencies.
However, the metallic currency system could not keep pace with the industrial revolution and
later the fast industrial development and fast pace of trade and industry phenomenon and
resultant commercial banking role spurred the need for a bank to centrally issue currency notes.
So this function fell into the central bank. The shift of this function strengthened the concept of
the financial and economic aspects of the paper currency, uniformity and public confidence.

In the beginning the central bank was mainly confined to issuing paper currency, but at later
stages it was entrusted with other crucial functions like credit control, clearing house,
management of public debts, rediscounting of bills, custodian of foreign exchange, and the like.

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Central bank Liquidity Management Processes

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 Functions of Central Banks
1.           Banker to the Government:  As banker to the government, SBP:

a. Receives deposits (taxes, fees, fines, etc.) on behalf of the federal government.

b. Disburses payments (tax refunds, interest, etc.) on behalf of the federal government.

c. Manages the national debt—buys, sells, and cashes    government securities and pay
interest/profit on them.

d. Lends money to the federal government as needed.

 2.  Banker to Banks:  As banker to the scheduled banks, SBP:

     a. Holds deposits made by them as a part of their required reserves—5% at this time.   

     b. Lends them funds as a “lender of the last resort” to meet their pressing needs by
discounting their bills of exchange and other

3.  Acts as a Clearing House:

Provides facilities, physical and/or electronic, to scheduled banks to clear cheques and other
claims drawn against each other—deposited by their customers for collection--by adding up
what they owe or owed them and transfer funds from their accounts at SBP.

4.Supervisor of Banks and other Financial Institutions:

One of the fundamental responsibilities of the State Bank is regulation and supervision of   the
financial system to ensure its soundness and stability as well as to protect the   interests of
depositors. The banking activities are now being monitored through a system of ‘off-site’
surveillance and ‘on-site’ inspection and supervision. Off-site surveillance is conducted through
regular checking of various returns regularly received from the different banks. On other hand,
on-site inspection is undertaken by the State Bank in the premises of the concerned banks
when required.

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To broaden financial markets as also to diversify the sources of credit, a number of non-bank
financial institutions were allowed to increase substantially. The State Bank has also been
charged with the responsibilities of regulating and supervising of such institutions.

5. Issuer of Paper Currency:

State Bank has the sole authority to issue paper notes.  It has the prime responsibility  to 
control its supply in order to ensure a stable price of money, i.e., its value  or  purchasing
power.  Its notes, however, are not convertible into gold or silver.

6. Exchange Rate Management and Balance of Payment:

The Bank is responsible to keep the exchange rate of the rupee at an appropriate level  and
prevent it from wide fluctuations in order to maintain competitiveness of our exports and
maintain stability in the foreign exchange market.  As the custodian of country’s external
reserves, it is responsible for management of the foreign exchange reserves.

7. Developmental Role of SBP:

     The Bank’s participation in the development process has been widened in the form of
rehabilitation of banking system, development of new financial institutions and debt instruments
in order to promote financial intermediation, establishment of Development Financial
Institutions, directing the use of credit according to selected development priorities, providing
subsidized credit, and development of the capital market.

8. Non-traditional Role: The non-traditional or promotional functions, performed by the

State Bank include development of financial framework, institutionalization of savings and
investment, provision of training facilities to bankers, and provision of credit to priority sectors.
The State Bank also has been playing an active part in the process of Islamization of the
banking system.

 9. To Formulate and Implement the Monetary Policy: The Bank is also in charge
of conducting monetary policy which means changing the supply of money in the economy.  The
tools of the monetary policy are:

a.     Changing the monetary base: This directly changes the total amount of money
circulating in the economy. The State Bank can use open market operations to change the
monetary base. The Bank would buy/sell bonds in exchange for hard currency. When the
central bank sells government bonds it receives hard currency in payment, thus reducing the
money supply. It buys government bonds and pays hard cash to the sellers, thus, increasing the
money supply.

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b.     Changing the reserve requirements:  Monetary policy can be implemented by
changing the proportion of total assets that banks must hold in reserve with SBP. Banks only
maintain a small portion of their assets as cash available for immediate withdrawal; the rest is
invested in illiquid assets like mortgages and loans. By changing the proportion of total assets to
be held as liquid cash, the SBP changes the availability of loan able funds. This acts as a
change in the money supply.

c.     Changing the discount rate:  Banks borrow money from the State Bank by cashing
or discounting credit instruments, such as bills of exchange.  By raising the discount rate SBP
discourages banks to borrow money.  If and when the goal is to increase the money supply, the
Bank lowers its discount rate to encourage borrowing by the banks and, thus, helps increasing
the money supply. 

Also by calling in existing loans or extending new loans, the monetary authority can   directly
change the size of the money supply.

Affecting a change in nominal interest rates: 

The contraction of the monetary supply can be achieved indirectly by increasing or decreasing
the nominal interest rates.  By changing the Discount Rate and by conducting Open Market
Operations a change in money supply would affect the nominal interest rates.  A tight money
supply tends to increase nominal interest rates while an increase in money supply can help
bring down the interest rates.  A change in the nominal interest rates influences the overall
economic activity, rate of inflation, GDP, and economic growth.

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 List of central banks

1. Reserve bank of India

2. Reserve bank of New Zealand
3. Hong Kong Monetary Authority (HKMA)
4. The Afghanis Saudi Arabian Monetary Agency (SAMA)
5. Reserve Bank of Zimbabwe