Read this article to learn about the relationship between the central bank and commercial banks.
The central bank and commercial banks have their distinct identities and functions.
The central bank, through its function of the lender of the last resort, acts as an active agent of the government in implementing its monetary policies.
In developed countries, the efficient carrying out of this function is easy.
In developing economies, however, this is not so simple. Here a case is often made for entry of the central bank in some selected fields to promote the development of the economy; besides ensuring the growth of a sound banking structure to cope with the increasing needs of credit. Commercial bankers take this as an encroachment on their field.
They argue that the major part of the Central Bank’s funds comprise the reserves of the commercial banks meant for safeguarding their safety (liquidity). It would be immoral on the part of the central bank to compete in business with the commercial banks with their money. In view of the co-operation that the central bank often seeks from commercial banks for carrying out its policies, the central bank should not invite hostility from them by giving them unjust competition through its special privileges as the bankers’ bank and the banker of the government.
In spite of these arguments, opinion has gone in favour of undertaking of some commercial business by the central bank, especially in underdeveloped economies. A small amount of business can hardly affect the liquidity position of the ‘creator of liquidity’. It is not at all necessary that the central bank uses the commercial banks’ funds for this. It can set up a separate department for commercial business and create resources also.
In fact, it may organize a special agent bank as its favoured child for doing the arduous business necessary for economic development often avoided by commercial banks. Further, if the central bank feels that the steering wheel of credit control in its banks is loose and not functioning satisfactory, it may gain an edge of manoeuvrability by keeping in touch with the market through a limited amount of business.
Besides, in an agriculturally depressed economy like India, the central bank may take up the onus of developing a bill market, granting direct loans, or discounting good bills of exchange. As regards direct loans, it may be a bit difficult to democrat clearly the central bank’s field vis-a-vis that of the commercial banks.
The difficulty is removed if the central bank, while doing ordinary commercial business keeps in mind that in its operations, the public interest and not profit-earning motive, prevails; what it can get done through commercial banks it never undertakes doing itself.
The various quantitative and qualitative instruments of credit control should be judiciously used by the central bank. No doubt, the bank has the drastic weapons of reserve ratio requirements, open market operations or changes in the bank rate, etc. but none of them is fool-proof.
After all, it is bank official on the spot who can judge between the credits asked for socially desirable productive purposes or credit being taken in the name of bona-fide purposes, but to be used for some anti-social actions. Unless the commercial bank and the central bank provide willing co-operation, the one will be weakened and the other will be frustrated. This is why moral persuasion must be preferred now to direct action.
The relationship between the commercial banks and the central bank has to be based on reciprocity. The commercial banks should conform to the spirit of central bank directives rather than letters. On the other side, the central bank should invariably satisfy the genuine needs of the commercial banks in times of stresses and strains. A moral code of conduct between the two will have to be evolved, accepted and followed.