Lecture 7

CENTRAL BANKINGWhat is Central Banking System?

Before the World War First, there were only a few countries which had their own central banks. After the War, the number of central banks has increased and now there is not a single country in the world which does not have its own central bank.

There were many considerations underlying the establishment of a central bank. After the First War, there was complete confusion in currency & exchange markets. There were large withdrawals

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of money from banks. The bank reserves fell below the needed levels. There was no institutions which could supervise the working of banks and also serve as a fiscal agent. In addition to the above difficulties, there was rigidity or lack of elasticity in the supply of currency.

In order to solve the monetary problems of the countries and set them on healthy footings, a Conference was held at Brussels in 1920. it was decided in that Conference that to control the supply of money and credit in the economy and


maintain stable business conditions, each country must establish its own central bank.Evolution & Growth:The Riksbank of Sweden was set up in 1656 and declared as central bank in 1668 and is considered to be the oldest of the central banks. The Bank of England was established in 1694. it is also called the Mother of central banks. The Bank of France was set up in 1800. The National Bank of Denmark was opened in 1818 and National Bank of Belgium in 1850. The Reichs Bank of Germany was made in


1876. In U.S.A Federal Reserve System was set up in 1914. The Reserve Bank of India was formed in 1935.

The Central Bank of Pakistan named as “State Bank of Pakistan (SBP)” was established in July 1, 1948. It is the main monetary authority in our country. According to the State Bank of Pakistan Act 1956, the SBP is charged with regulating the monetary and credit system of Pakistan.


Definitions:R.P. Kent: “An institution, which is charged with the responsibility of managing the expansion and contraction of the volume of money in the interest of the general public welfare.”Comprehensively: “The Bank in any country authorized by the Government to control the amount of credit and to supervise the operations of the commercial banks. It carries out the business of the Government and maintains its account. It controls the issue of notes and


country’s reserves and takes steps to preserve the value of the country’s currency and the foreign exchange.”State Bank of Pakistan:

The State Bank of Pakistan as envisaged in the State Bank Order is not guided by profit motive in its operation. It is to regulate the monetary and credit system of Pakistan and to foster its gowth in the best national interest with a view to securing monetary stability and fuller utilization of the country’s productive resources.


Organization Structure:The general supervision and direction of the

affairs of the Bank vests in a Central Board of Directors which consists of one Governor, one Deputy Governor, and eight Directors. There is also an Executive Committee which is empowered to transact business on behalf of Central Board of Directors.


Major Responsibility to Regulate Banking System:In order to regulate and monitor the banking system, SBP issues laws and regulation from time to time. These regulations provide guidelines for opening of accounts, limit against advances, setting up internal audit system, requirement for minimum capital and reserves for banking company, maintaince of liquid assests for every banking company etc.

In short State Bank of Pakistan is an apex institution in the country. Its objective are to oversee the banking system in Pakistan by acting


as a banker to the central Govt. it is fully charged with the responsibility for maintaining the internal and external stability of the country. However in developing countries the central bank is also responsible for directly contributing in the promotion of planned economic development of the economy.


Principles/Objectives of Central Bank1. Economic Stability:

Central bank basically works for the fulfillment of the financial needs, economic stability and for the growth of banking system. If any sector of economy faces problems, special treatment is given by the central bank to consolidate its financial position.

2. National Interest:The basic object of central bank is not to earn the profit rather to work in the best interest of the nation. Central Bank always prefers national 10Operations of Banks & Financial Institutions

interest to all other things. Beside it, central bank also pursues the other member banks to work earnestly in the best interest of the nation.3.Effective Policy:

Central bank implements effective policies to control the undue expansion or contraction of credit in the country. The central bank uses its powers to subdue the commercial banks in order to enforce the devised policies.


4. Special Authorities:Central bank has special authorities to perform its functions effectively including issuance of currency notes, control of credit and different other functions being a Govt Bank etc. The central bank uses its authorities to strengthen the economy of the country with a great responsibility.

5. Constitutional Limitations:Central bank works according to the framed rules and regulations of the government and its all dealings always remain within the said rules. The


Central bank not only observes the constitutional limits but also instruct the other banks and financial institutions to observe the said limits.6.Free From Political Pressure:

Central bank does not accept any kind of pressure of any poltical party or group while rendering its duties for the better interest of the country. Unfortunately, if the central bank becomes an instrument of any subversive group then the country can face an irreparable loss.


7. Custodian of Banking System:Central bank is responsible for the protection and growth of banking system. So the central bank not only keeps a watchful eye on the economic affairs of the country but also plays a vital role to strengthen and secure the present banking system.

8. Custodian of Credit System:Central bank is also responsible for the protection and stability of credit system. So, these factors always kept in view deciding the matters.


Functions of a Central BankCentral banks of a country look after the national interest rather than the profit. It is the banker of government and banker’s bank. It does not deal with the public deposits or loans and advances to the public. The functions of central bank, as mentioned by banking experts, are performed almost by all the central banks of the several countries of the world although there may be variations in degree of functions.


1. Sole Right of Issuance the Currency Notes:Central bank has the monopoly to issue currency notes. The main reasons for delegating the authority of note issue to the central bank in a country are as follows;

i. It brings uniformity in the system of note issue.ii. The central bank can exercise better control

over the money supply in the country and the basis of monetary management is closely related with its monopoly power of note issue.


iii. It increases the public confidence in the monetary system of the country.

iv. It enables central bank to control the lending operations of the commercial banks.

2. Bankers, Agent and Adviser to the Government:

i. The central bank acts as banker to the government, it receives deposits, cheques and drafts deposited in the government account.

ii. It makes short term advances to the government.

iii. It provides foreign exchange to government17Operations of Banks & Financial Institutions

for the purchase of foreign goods, repaying external debts etc.

iv. As financial agent, it collects taxes and other payments on behalf of the government and makes investments in Long-term Government securities.

v. As adviser to the government, it gives advice on all monetary & economic matters such as controlling inflation or deflation, devaluation or revaluation of currency, foreign exchange policy etc.


3. Banker to Commercial Banks:As banker to commercial banks, the

central bank performs the following functions;i. It keeps the cash reserves and deposits of the

commercial banks.ii. It rediscounts the bills of exchange of their

member banks in the time of need.iii. It influence the creation of credit by the

commercial banks in the best interest of the country.

iv. It regulates the policies of advancing loans for commercial banks.


v. A new bank or a branch of an existing bank cannot be established or start its operations without the prior permission/license of central bank.

vi. It is the duty of central bank to promote the growth of the over all banking system on sound footing.


4. Clearing Agent:As the custodian of the cash reserves of commercial banks, the central bank acts as a clearing house for commercial banks. As all schedule banks have their accounts with the central bank, the central bank can easily settle the claims of various banks against each other with least use of cash. The clearing house functionof the central bank has the following advantages;

i. It can settle the claims & counter claims between the banks without using cash. 21Operations of Banks & Financial Institutions

ii. It strengthens the banking system by reducing withdrawals of cash in times of need.

iii. It keeps the central bank fully informed about the liquidity position of the commercial banks.

5. Lender of The Last Resort:The central bank is the supreme bank of the country. If the commercials banks are at any time in need of money and are not able to meet their financial requirements from any other source, they can approach the central bank for financial accomodation. The central


bank as lender of last resort provides financial help to the commercial bank by rediscounting their bills of exchange. The central bank functioning as lender to last resort increase the elasticity and liquidity of the whole credit structure of the economy.6.Controller of Credit:

Another important function of central bank is to control the availability and cost of credit in the country. Central bank makes policies and takes decisions to avoid undue expansion or contraction


of credit and to stable the credit or money supply in the country. The steps taken or methods adopted by central bank in this regard are called monetary policy.7.Controller of Foreign Exchange:

The central bank is responsible for the management of foreign exchange and maintenance of the value of home currency. Moreover, foreign exchange reserves are also kept with the central bank. It prepares the balance of payments accounts of the country, and helps the


Government to keep the balance favourable.8.Representative of Foreign Trade:

Central bank acts as the representative of Government in international trade & business. Due to such involvement on the part of central bank in these trades makes the country enable to prosper.9.Exchange Rate Stability:

The central bank fixes the exchange rate of the domestic currency in terms of foreign curriencies. It holds these rates within narrow


limits in keeping with its obligations as a member of the International Monetary Fund and tries to bring stability in foreign exchange rates.10. Development Role:

In developing countries of the world, the central bank besides perforimg the traditional functions, also performs developmental and promotional functions. The central bank undertakes the responsibility of economic growth with stability in the economy. It ensures that the funds available flow to the various priority sectors


such as agricultures, exports, small scale industry etc.11. Miscellaneous Functions:i.Central bank not only provides the modern training to the staff working in various banking institutions but also establishes training institutes in this regard. e.g: Institute of Bankers Pakistan. Etcii.It maintain relations with international agencies such as IMF, World Bank etc.iii.Central bank makes plans & adopt various


methods to promote the habit of saving among the people of country.iv. It conducts seminars, surveys and publishes

annual reports giving real economic picture of the economy.


Central Bank’s Monopoly of Note Issue

Central bank has the monopoly of note issue in the every country of the world now, the concentration of note issue in a central bank has the following advantages;

1) Uniformity in note circulation: it brings uniformity in the circulation of currency.

2) Control over money supply: The central bank is in a better position to exercise control over the money supply in the country


3) Control over commercial banks: The sole power to issue notes enables the central bank to control the lending operations of the commercial banks.

4) Public Confidence: The right to note issue is regulated by law. Therefore it increases public confidence in the monetary system of the country.


Principles of Note IssueThere are two principles of note issue, one is called the Currency Principle and the other is named as Banking Principle. Both of these principles are contradictory to each other. One school of thought says that there should be full convertibility of notes into gold bullion. The second gives importance to the elasticity of supply. Now we discuss the two principles one by one.


1. Currency Principles:According to the currency principle, the central bank of the country should keep 100% gold for every note issued. In other words, their should be full convertibility for the amount of legal tender currency. It assumes full convertibility of notes because every note issued is covered by gold reserve.

Advantagesi. Safety & Security: Currency principle assures

maximum safety & security to the paper currency.32Operations of Banks & Financial Institutions

ii. No Danger of Inflation:There is no danger of over-issue of the currency, which is an effective check to the possibilities of inflation.

iii. Public Confidence:The currency principle provides greater confidence to the public, because it provides assurance in case of convertibility of notes.


Disadvantagesi. Inelastic:

it makes the supply of money highly inelastic, because the issuance of notes is only possible on the availability of gold. So, the government cannot issue note in case of emergency.

ii. Dependent:According to this principle, paper cuurency can only be printed and issued if there is 100% gold cover is available against it. The issuance of currency thus completely depends upon the34Operations of Banks & Financial Institutions

availability of gold rather than the trade & industry need.

iii.Lock up of Gold:There is unnecessary lock up of gold for

the currency, which may be used for some other purposes.


2. Banking Principle:According to this principle, there is no need to keep 100% gold or silver against notes issued. The notes issued should have a guarantee of convertibility into gold. It is sufficient to keep only a certain percentage of total paper currency in the form of gold and silver reserves. The notes issued in the country should be according to the needs of trade & industry.


Advantagesi. Elastic System:

The banking principle is elastic because it does not require 100% metallic backing against the note issue, however the gurantee of convertibility also acts as a regulator of note issue.

ii. Government Needs:This system is best fit for meeting the government needs in case of emergencies.


Disadvantagesi. Over-Issue:

In order to meet the demands of the money, there may be a further issue of notes beyond to a certain limit which may leads to the possibility of inconvertibility of excess notes and undue inflation.

ii. Public Confidence:Under this system there is chance to lose the public confidence in the currency and monetary instability. 38Operations of Banks & Financial Institutions

Methods of Note IssueThere are different methods of note issue adopted

by different countries of the world at different time. The most important of them are as under:

1.Fixed Fiduciary System:Under fixed fiduciary system, the

government fixes a fixed amount of notes without keeping any metallic reserve. But this portion of currency must be backed by government securities, which is called fiduciary limit. The notes issued other than fiduciary limit must be fully backed by gold or silver reserves.


This system was introduced by England in 1844. Norway and Japan was also adopted this method. This system provides security for the convertibility of notes but at the same time it lacked elasticity and was not capable of satisfying the needs of trade and industry. This system was abandoned in 1913 in favour of propotional reserve system.

2.Propotional Reserve System:Under this system, the central bank is

required to keep certain percentage of note


issued in form of gold and the remainder is to be covered by sound government securities. The reserve proportion is usually from 30% to 40%. It means a central bank can issue Rs. 1000 note after keeping the gold value of Rs.300 or 400.

This system remained prevalent in USA, Britain and over a large part of the world. It was first adopted by Germany in 1876. The proportional reserve system was also adopted by State Bank of Pakistan (SBP) and it remained enforced till December 1965. This system was


abandoned in 1965 as it was rigid and lacked elasticity. The State Bank of Pakistan could not give guarantee for full convertibility of notes. The SBP has now adopted a new system of note issue named as Minimum Reserve System.

3.Minimum Reserve System:The proportional reserve system of note

issue has been replaced by minimum reserve system in Pakistan in 1965. According to this system, the central bank is required to keep only a minimum amount of reserve in the form


of gold and foreign exchange securities. The central bank can expand note issue in accordance with the volume of business activities without backing of gold. The merit of this system is that it ensure an adequate supply of currency to meet the business demands of the country. In other words, the method of the note issue is sufficiently elastic. The demerit is that paper currency issued is practically inconvertible in this system.


Clearing House/Clearing ProcessA clearing house is an association of commercial banks set up in a given locality for the purpose of interchange and settlement of credit claims. The function of a clearing house is performed by the central bank of a country by tradition or by law. In Pakistan the clearing system was operated by the State Bank of Pakistan. But now it is performed by the National Institutional Facilitation Technologies (Pvt.). Ltd. (NIFT)


About NIFT:NIFT - National Institutional Facilitation Technologies (Pvt.). Ltd. was incorporated in September 1995 as joint venture between association of six banks and entrepreneurs from the private sector. All commercial banks and all of their branches in major cities avail NIFT's services. As of January 2014, 38 commercial banks and their 8382 branches in 273 major cities, and towns utilize NIFT's services through 28 Data Centers.


After the World War II, there has taken place a rapid growth in the banking institutions. The use of cheques in making payments has also widely increased. The collection and settlement of mutual obligations in the form of cheques is now a big task for all the commercial banks. The mechanism, whereby cheques are exchanged in bulk and the cross obligations of the banks are offset, is explained in brief.

Cheques as we know, is an effective method of making payments. When cheques are drawn on one bank and the holder (payee) 46Operations of Banks & Financial Institutions

deposits the same in his account at the bank of drawer, the mutual obligations are settled by the bank “Internal Transfer” and there arises no inter bank debits from the use of cheques.

In practice, the person receiving the cheque is rarely a depositor of the cheque at the same bank as the drawer. He deposits the cheque with his bank(other than of the payer) for the collection of the amount. Now the bank in which the cheque has been deposited becomes a creditor of the drawer’s bank.


the debtor bank will pay his amount of the cheque by transfering it from cash reserves if there is no offsetting transactions. In the course of everyday life, there are large number of cheques drawn on bank but deposited in other banks. The bank on which the cheques are drawn become in debt to the banks in which the cheques are deposited.

At the same time, the creditor banks receives large amounts of cheques drawn on other banks giving claims of payments by them, it will become uneconomical and confusing if 48Operations of Banks & Financial Institutions

banks had to transfer cash for meeting each other liability. “The easiest, safe and the most efficient way is to offset the reciprocal claims against one another and receives only the net amount owned by them. This facility of net inter bank payments is provided by the clearing house.”


Let’s deeply understand the working of clearing house with the help of an example:Suppose Mr. Ali gives the cheque of his personal account maintain at Bank Alfalah for Rs.100,000 to Mr.Imran to pay off his obligations. Mr.Imran having the personal bank account in Meezan Bank and he deposited the cheque in his bank (which is drawn on Bank Alfalah) from the collection of funds.

At the same time Mr. Zeeshan issues the cheque of Meezan Bank for Rs.80,000 to


Mr. Salman(Supplier) against his business payment. And Mr. Salman depositedthe same cheque for collection of funds in his account maintained at Bank Alfalah. In the above situation, Bank Alfalah has to transfer the funds of worth Rs.100,000 to Meezan Bank and Meezan Bank has to pay the funds of Rs.80,000 to Bank Alfalah. So the net differences between both the bank balance will be settled by transfer Rs.20,000 by Bank Alfalah to Meezan Bank. Such inter bank net claims are


only possible to settled with the presence of Automated Clearing System which is known as Real Time Gross Settlements (RTGS).


Lecture 7

Education

Transcript of Lecture 7