Central Bank: Definition, Features, Functions & Examples

Definition of Central Bank

A Central Bank is a National Government owned apex financial institution which controls and supervises the entire monetary system of a country. It assists, directs and regulates the activities of other financial institutions to make them comply with government monetary and economic policies.

Features of Central Bank

• The method of establishing central bank is through an act of parliament.
• The central bank has the feature of being only one in the country though with branches in all parts of the country.
• Profit making is not the main aim of establishing the central bank in a country.
• The central bank is owned by the federal government not by the state government or organisations or individual(s).
• The central bank is the highest financial institution in a country.
• It does not transact business with private individuals.
• The central bank is the only authority authorised by law to issue currencies in a country.

Functions of the Central Bank

A Central Bank performs certain roles in an economy. These include:

• Serves as government’s bank and financial adviser: The Central Bank collects all revenues accruing to the government from taxation and other sources. It makes payments on the government’s behalf and advises the government on monetary matters.
• Banker to other banks: The commercial banks and other financial institutions keep a percentage of their deposits with the Central Bank as legal reserves or special deposits. It also offers clearing house facilities for settling interbank indebtedness.
• A lender of last resort: It makes loans to commercial banks and other financial institutions to enable them meet unusual cash demands by customers. This helps to prevent monetary crisis.
• Issuing of currency: The Central Bank is the sole authority permitted by law to issue currency (coins and bank notes) which is then put into circulation through the commercial banks.
• Implementation of government monetary policy: It assists the government in executing its monetary policies by the use of various instruments such as open Market Operations, Bank rates, directives, and Cash deposit ratio etc. These help to regulate the money supply and stabilize prices.
• Servicing of the national debt: It helps to manage the national debt. Apart from helping the government to secure loans (both from within and outside the country) it helps to service the loans.
• Promotion of economic development: It does this either directly or indirectly. It finances projects directly on behalf of the government. By encouraging the growth of financial institutions, by judicious application of monetary policy, and undertaking economic research etc. it indirectly encourages economic development.

Instruments of Credit Control used by the Central Bank

The Central Bank exercises control over the commercial banks through the use of the instruments of monetary policy. These instruments help to control their credit policies. Such instruments include:

• The bank rate: This is the rate at which the Central Bank rediscounts first class bills. If the Bank Rate is high, commercial banks would increase interest rates and this would discourage borrowing by the public. A reduction of the bank rate would encourage borrowing.
• Liquidity ratio (i.e. cash-deposit ratio): This refers to the legal reserve requirements or the ratio of commercial bank cash reserves to total deposits. If it is decreased, the lending power of commercial banks would increase. But if it is increased, they would have less money to lend.
• Open market operation (OMO): This involves the buying and selling of securities such as treasury bills from or to the public. Buying from the public would increase the cash available with banks thereby increasing their lending power. But if they are sold to the public the amount of cash left with commercial banks would decrease. If cheques drawn by people on those banks are cleared, this reduces their lending power.
• Special deposits: These are additional deposits which the Central Bank may ask commercial banks to keep. This is used when the use of cash ratio is not sufficient to regulate the money supply as desired.
• Directives: These refer to directives given by Central Bank to commercial banks regarding lending. It could be to either increase or decrease lending generally, or to increase lending to priority sectors.
• Moral persuasion: This refers to a gentle appeal to commercial banks to pursue certain credit policies.
• Funding: This refers to the conversion of shortterm securities (e.g. treasury bills) to long-term securities (e.g. bonds). If the conditions of the economy are not yet improved for the refund of the loans obtained through the sale of treasury bills, they may be converted to bonds. This controls the amount of money that is in commercial banks.