Functions of Central Bank

Lender of Last Resort

Central Bank Acts as guarantee for commercial banks

It gives guarantee to depositors that If a bank defaults in making payment to them,there is no need to panic

Suppose a bank does not have money to give to depositors, then it can borrow money from Central Bank to pay to depositors

Central Bank will ensure that depositors receive their money and there is no default

Deficit Financing

Central Bank Acts as Banker to Government

Suppose Revenue of a government is less than expenses

Difference is called deficit

To meet this deficit, Govt will ask Central Bank to print notes

For this, govt sells govt securities to Central Bank and Central Bank issues currency notes

This currency money ultimately comes into hands of people (as salary received from govt or Sale proceeds received from govt)

Quantitative Measures

Open Market Operations

It refers to buying or selling of govt securities by Central Bank

Central Bank is authorized to sell or buy, govt securities to/from Banks or Public

If Central Bank sells govt securities in market, public will purchase these securities reducing money supply in economy

If Central Bank purchase govt securities, public will sell these securities and receive money, hence increasing money supply in economy

Bank Rate Policy/ Repo Rate

Central Bank keeps on increasing and decreasing Bank Rate (Rate of int to be paid by commercial banks to Central Bank)

If Bank Rate increase, banks will have to pay more int to Central Bank.

Banks will also charge more interest from public, so less money will be available in market

Similarly if Bank rate decreases, bank will charge less interest from public, so more money will be available in market

Sterilization by Central Bank

Central Bank Sterilizes the economy against external shocks

Suppose foreign investors want to Purchase investment in Indian Company Bonds

They cant purchase it in dollar

They will first get Dollars converted into Rupees from Indian Banks

These Indian Banks will deposit these foreign currency with Central Bank

This will lead to increase in deposits of bank with Central Bank (increase in high powered money in economy)

More money in economy may lead to increase in prices (inflation)

To counter it, Central Bank will sell govt securities in market

When people will purchase these govt securities, money supply will be regulated

Hence economy is sterilized from external shocks (foreign investment in India)

Increases or Decreases Money Supply by changing Different Ratios

Central Bank increases Cash Deposit Ratio and Statutory liquidity Ratio

Thus banks are able to issue less loans and money supply decreases

Similarly Central Bank Decreases these ratios which make it easier for banks to give loans

Hence, money supply in economy increases

Margin Requirement

It is difference between Value of Security and Value of Loan Sanctioned by bank

Example

Suppose a person wants to buy Property of Rs100 lakhs

Margin fixed by bank is 30%

Margin in Rupees = 30%*100 lakhs = 30 lakhs

It means Bank can give a maximum loan of Rs70 lakhs in this case

Central Bank Controls the credit by changing Margin Requirement

Suppose Central Bank increases Margin to 40%

Margin in Rupees = 40%*100 lakhs = 40 lakhs

Bank can now give loan of only Rs60 lakhs

Suppose Central Bank decreases Margin to 20%

Margin in Rupees = 20%*100 lakhs = 20 lakhs

Bank can now give loan of Rs 80 Lakhs

Qualitative Measures

Moral Suasion

This refers to the pressure or persuasion applied by the Central Bank on Commercial Bank to act as per their instructions.

Example

Central Bank may ask banks to give more loans to weaker sections of society

Central Bank Persuades and advices banks to give or not give loans to particular group of people

Selective Credit Controls

Central Bank may ask banks not to give loan to particular sector of economy

Example

Central Bank asked banks not to give loans to construction sector

NCERT Questions

Question 9

What are the instruments of monetary policy of RBI?

Question 11

What role of RBI is known as ‘lender of last resort’?

Ans

RBI Acts as guarantee for commercial banks

It gives guarantee to depositors that If a bank defaults in making payment to them, there is no need to panic

Suppose a bank does not have money to give to depositors, then it can borrow money from RBI to pay to depositors

RBI will ensure that depositors receive their money and there is no default

Other Books

Question 1

In the following questions, select the correct answers:

This function of Central Bank involves buying and selling of government securities from or to the public and

commercial banks.

a. Selective Credit Control

b. Legal Reserve Requirements

c. Open Market Operations

d. None of these

Question 2

Name the credit control method which refers to difference between the amount of loan and market value of the security offered

by the borrower against the loan.

a. Selective Credit Control

b. Moral Suasion

c. Margin Requirements

d. Open Market Operations

Question 3

In order to reduce credit in the country, RBI may:

a. Buy securities from the open market

b. Sell securities in the open market

c. Reduce cash reserve ratio

d. Increase Repo Rate

Question 4

Which of the following cannot be used by Central Bank to control money supply?

a. Open Market Operations

b. Bank rate

c. Repo rate

d. Government Spending

Question 5

What happens where there is an increase in the margin requirements?

a. It reduces the borrowing capacity and money supply

b. Encourages people to borrow more and money suppy rises

c. No change in money supply

d. None of these

Question 6

In order to control the money supply in the economy, the Central Bank may ____.

a. Buy Securities from the open market

b. Reduce Cash Reserve Ratio

c. Sell Securities in the open market

d. Reduce Repo Rate

Oswaal Questions

Question 1

In the present COVID-19 situation, many economists have raised their concerns that Indian economy may have to face a deflationary situation due to reduced economic activities in the country.

Suppose you are a member of the high-powered committee constituted by the Reserve Bank of India (RBI).

You have suggested that as the supervisor of commercial banks, ................ (restriction/release) of the money supply be ensured by the Reserve Bank of India (RBI).

a. Restriction

b. Release

c. Either (A) or (B)

d. Neither (A) nor (B) C

Question 2

Read the below case and answer the questions that follow:

On March 5, 2020, the Reserve Bank of India (RBI) imposed a 30-day moratorium on YES Bank, superseded the private-sector lender's board, and appointed Prashant Kumar, who was serving as chief financial officer and deputy managing director at State Bank of India (SBI), as an administrator.

Under the terms of the moratorium, deposit withdrawals were capped at Rs50,000 per person.

The central bank proposed a reconstruction scheme under which SBI might take a maximum of 49% stake in the restructured capital of the bank.

Analysts believed the new management of YES Bank, headed by former Deutsche Bank India head Ravneet Gill, who joined the bank in early 2019, could turn around the ship.

Gill, however, has struggled to do so.

The bank's loan book on March 31, 2014, was Rs55,633 crore, and its deposits were Rs74,192 crore.

Since then, the loan book has grown to nearly four times as much, at Rs 2.25 trillion as on September 30, 2019.

The bank's asset quality also worsened and it came under regulator RBI's scanner.

YES Bank has a substantial exposure to several troubled borrowers, including the Anil Ambani-led Reliance group, DHFL and IL&FS.

The tipping point came when one of the bank's independent directors Uttam Prakash Agarwal, resigned from the board in January 2020 citing governance issues. - "What is YES Bank Crisis?" - Business Standard

Question 1

Which of the following function has been performed by the RBI in the above case study?

a. Banker to the Commercial Bank, here YES Bank

b. Supervision and Regulation of the Commercial Bank, here YES Bank.

c. Controlling the credit creation in the economy.

d. Managerial function

Question 2

Under the moratorium, the deposit withdrawal was capped at _______________.

a. Rs10,000

b. Rs25,000

c. Rs30,000

d. Rs50,000

Question 3

Read the following statements - Assertion (A) and Reason (R).

Assertion (A): YES Bank put into the check of the RBI.

Reason (R): The loan book has grown to nearly four times and deposit failed to grow.

Select the correct alternative from the following:

A. Both Assertion (A) and Reason (R) are true, and Reason (R) is the correct explanation of Assertion (A).

B. Both Assertion (A) and Reason (R) are true, but Reason (R) is not the correct explanation of Assertion (A).

C. Assertion (A) is true, but Reason (R) is false.

D. Assertion (A) is false, but Reason (R) is true.

Question 4

What another role does the RBI play for the Commercial Bank like YES Bank?

a. Advisor to the Bank

b. Banker to the Bank

c. Controls the credit created by the bank

d. All of the above