The Banking System
What is the Central Bank?
It refers to the supreme bank of a country. It is owned by the government to oversee and manage the nation’s money supply and banking systems.
Functions of central bank
- It acts as a lender of last resort – Provides loans and liquidity to commercial banks during financial difficulty.
- It ensures the monopoly of coins and notes issues – The central bank has the sole right to issue legal tender (banknotes and coins).
- Control Money supply – Controls the money supply and interest rates to maintain price stability, control inflation, and support economic growth. It uses tools such as Repo rates/policy interest rates, Open Market Operations (OMOs), Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR)
- Custodian of the National Reserve – managing and safeguarding gold, foreign currencies, and IMF assets to ensure liquidity, stabilise the exchange rate, and strengthen the country’s economic stability.
- Banker to government and debt manager – Manages the accounts of the government, handles public debt, and helps finance the government through borrowing, acts as a fiscal agent, managing loans and interest payments.
What is Commercial Bank?
They are private sector banks with the aim of maximising profit. They provide a range of banking services to households and firms.
Functions of Commercial Bank
- Accepting deposits from individuals, businesses, and other institutions in the form of savings accounts, current accounts, and fixed deposits. This helps people safely store their money while earning interest in some cases.
- Providing loans to borrowers for personal, business, or commercial purposes. This includes personal loans, overdrafts, and business financing, which allows the bank to earn interest and support economic growth.
- Commercial banks offer agency services, such as paying bills, collecting cheques, and handling standing orders on behalf of customers.
Objectives of Commercial Banks
- Maintaining liquidity to ensure that they can meet their short-term obligations. Liquidity refers to the ability of turning an asset into cash without any loss. From an economic standpoint, maintaining adequate liquidity is essential to preserve public confidence and prevent bank runs, which can destabilize the entire financial system. Banks manage liquidity by holding a portion of deposits as cash reserves and investing in short-term, liquid assets. By doing so, they strike a balance between keeping enough funds readily available for customers and using the rest to generate income through loans and investments. Adequate liquidity not only protects the bank from insolvency risks but also supports the smooth functioning of the payment system, which is vital for overall economic stability.
- Increase profitability to sustain their operations and provide returns to shareholders. Profitability is achieved primarily through the interest earned on loans and investments, which must exceed the cost of attracting deposits and other funds. Economists emphasize that banks must manage this objective carefully by balancing risk and return. By efficiently allocating resources to creditworthy borrowers, banks can maximize their interest income while minimizing default risks. Additionally, commercial banks seek to diversify their income sources by offering various fee-based financial services such as wealth management, foreign exchange, and payment processing. A profitable banking sector is crucial for economic growth because it ensures the continued availability of credit to businesses and consumers, enabling investment, consumption, and overall economic development.