1.0. INTRODUCTION
The Central Bank is one of the most important institutions in the
financial system of a
country. In this note, you shall learn about what a central bank
is and its functions in an
economy. You shall equally learn about Credit Control in an
economy by the central
bank, objectives of credit control and methods of credit control
by the central bank. This
note will also help you to actually understand the major
differences between central bank
and commercial bank.
2.0. OBJECTIVES
At the end of this note, you should be able to;
· Explain what a central bank is
· Enumerate and explain the functions of a central
bank
· State and explain the objectives of credit
control in an economy
· List and discuss methods of credit control
· Explain the major differences between commercial
banks and central banks
3.0. CENTRAL BANKING
3.1. The concept of Central Bank
Central Bank is a government owned bank and each country owns only
one Central
Bank. A Central Bank is therefore government’s representative in
the banking system and acts
mainly as a banker to the government. It is the apex bank in a
country which controls its
monetary and banking structures. It is usually owned by the
government of the country and
operates in national interest.
It regulates and issues currency, performs banking and agency
services for the country,
keeps cash reserves of commercial banks, keeps and manages
international currency, acts as the
lender of the last resort to commercial banks in the country, acts
as clearing house, and controls
of credit.
Therefore, a Central Bank can be briefly and functionally defined
as “ a national (financial)
institution that traditionally possess the monopoly of issuance of
legal tender money in a country,
is entrusted with the custody of the cash reserves of the banking
system (that is function as a
banker to banks), and acts as lender of last resort”. It usually
acts as banker and financial adviser
to government, and the custodian and manager of the nation’s
foreign exchange reserves.
A Central bank is very different in both its organization and
functions compared to other
types of banking institutions. Since it is said to be at the apex
of any banking system, the law or
charter that establishes a central bank is normally very different
from those other laws or
legislations establishing other types of banks. The Central Bank
of Nigeria (CBN) was
established on March 17th, 1958 by the Central Bank
Ordinance of 1958. The bank effectively
came into existence and fully operational on 1st July, 1959.
3.2. Functions of Central Bank
Issuance of legal tender currency: The CBN is the sole authority vested with the
power to issue
legal tender currency in the country. Because of the primary
importance of legal tender currency
(Notes and Coins) in the smooth functioning and development of the
economy, the issuance of
legal tender money is the foremost responsibility of all central
banks the world over. Also, it is
the central banks’ responsibility to safeguard the internal and
international values of that
currency. So, to service the economy with legal tender currency,
the central bank organizes not
only its production, but also its distribution and the periodic
replacement of old or damaged ones.
It is also the sole responsibility of the central bank to withdraw
notes. By this function, it is able
to maintain the financial stability of the economy.
Banker to the government: The central bank serves as banker and financial
adviser to the
Federal Government and other state Governments. In its capacity as
Banker to Government, the
bank receives deposits and makes payments on behalf of the Federal
Government. It also
provides banking services to State Government – owned
institutions.
Bankers’ Bank: The Central Bank acts as banker to commercial,
merchant, development banks
and other financial institutions in that they keep part of their
deposit with the Central Bank of
Nigeria. Every bank in Nigeria is therefore required by law to
keep an account with the Central
Bank of Nigeria, not only as a statutory requirement, but rather
also as a necessity in order to
meet interbank transactions best handled through the CBN; for
example, through the clearing
system. To this end, the CBN established a number of clearing
houses in the country to facilitate
the clearing of cheques among commercial banks and further improve
the payment system in the
economy.
Banks control and supervision: The Central Bank controls, supervises and
assists the activities
of commercial, merchant banks and other financial institutions in
the economy. The CBN
exercise surveillance over the operations of the banks with a view
to ensuring sound banking
practices. For instance, the CBN prescribes periodically the
proportion of deposit liabilities
which banks must hold in the form of liquid assets so as to foster
public confidence in their
ability to meet their customers’ cash demand.
Lender of last resort: Commercial banks in financial difficulties have
the central bank as the last
place to run to, to borrow or to discount bill of exchange. This
function helps to prevent a
banking crisis which may have been disastrous. By granting
accommodation in the form of rediscounts
and collateral advances to commercial banks and other financial
institutions, the CBN
acts as a lender of last resort. The CBN lends to such
institutions in order to help them in times
of financial stress so as to save the financial structure of the
country from collapse.
Formulation and implementation of
monetary policy: A major responsibility of a
modern
Central Bank is the formulation and implementation of monetary
policy in the economy. By this
function, the CBN seeks to promote monetary stability with a view
to ensuring a stable internal
and external value of the national currency. It is important that
the supply of credit and money
are adequate to support desirable and sustainable growth without
generating inflationary
pressures and undue instability in the naira exchange rate. Thus,
monetary policy is applied to
influence the availability and cost of credit in order to regulate
money supply.
Maintenance of External Reserve: To safe-guard the internal value of our legal
tender
currency, the CBN maintains the management of the country’s debt
and its foreign exchange. It
manages the national debts, controls the foreign exchange as well
as deals with the central banks
of other nations. In managing the nation’s external reserves as
required, the central bank seeks to
maintain an adequate volume of external reserves to preserve the
international value of its
domestic (the naira). To achieve this aim, the CBN therefore has
the responsibility of managing
the country’s foreign exchange reserves. The bank not only manages
external reserves but also
manages the exchange rate.
In Nigeria, the major objectives of exchange rate policy in
support of stable economic
growth and development including deriving an appropriate exchange
rate for the naira and
ensuring stability of naira exchange rate. A viable and realistic
exchange rate ensures efficient
use of resources, widens the scope of legitimate foreign exchange
transactions and facilitates the
achievement of internal and external balance. Also, stability of
the exchange rate ensures that
economic agents can plan ahead without fear of escalating costs.
Foreign Exchange Management: The foreign exchange management activities of
the central
bank involve the acquisition and development of foreign exchange
resources in order to reduce
the destabilizing effects of short term Capital inflows. The CBN
monitors the use of scarce
foreign exchange resources to ensure that foreign exchange
disbursement and utilization are in
line with economic priorities and within the annual foreign
exchange budget and thereby ensure
a viable balance of payments position as well as the stability of
the naira. The CBN also conducts
routine examinations into the foreign exchange operations of the
authorized dealers. The
activities of some “Bureau De change” are also investigated to
ensure compliance with foreign
exchange market (FEM) regulations.
3.3. Credit Control by the Central Bank
Credit control is the means to control the leading policy of
commercial banks by the
central bank.
3.3.1. Objectives of Credit Control
The Central Bank controls credit to achieve the following:
i. Maintenance of relative stability in domestic prices: One of
the major objectives
of controlling credit in the economy is to stabilize the price
level in the country.
Frequent changes in prices adversely affect the economy. This is
because excessive
increases or decreases in prices make it difficult for economic
planning and decision
making as a result of the uncertainty in the economy. Inflationary
or deflationary
trends can be prevented by judicious credit control policy in the
economy.
ii. To stabilize the rate of foreign exchange: with the change in
the internal price
level, exports and imports of the country are affected when prices
fall, export increase
and decrease. Consequently, the demand for domestic currency
increase in the foreign
market and its exchange rate rises. On the contrary, a rise in
domestic currency,
increases in the foreign market and its exchange rate rises. On
the contrary, a rise in
domestic prices leads to a decline in export and an increase in
imports. As a result, the
demand for foreign currency increases and that of domestic
currency increases and
that of domestic currency falls, thereby lowering the exchange
rate of the domestic
currency. Since it is the volume of credit money that affects
prices, the central bank
can stabilize the value of foreign exchange by controlling bank
credit.
iii. To protect the outflow of Gold: The Central Bank holds the
gold reserves of the
country in its values. Expansion of bank credit leads to rise in
prices which reduce
exports and increase imports, thereby creating an unfavorable
balance of payments.
This necessitates the export of gold to other countries. Central
bank has to control
credit in order to prevent such outflows of gold to other
countries.
iv. To control business cycles: Business cycles is a common phenomenon
of market
economies which lead to periodic fluctuations in production, employment,
and prices.
They are characterized by alternating periods of prosperity and
depression. During
prosperity, there is large expansion in the volume of credit, and
production,
employment and prices rise. During depression, credit contracts,
and production,
employment and prices fall. The central bank can counteract such
cyclical
fluctuations through contraction of bank credit during boom
periods, and expansion
of bank credit during depression.
v. To achieve growth with stability: In recent years, the
principal objective of credit
control is to achieve growth with stability. The other objectives,
such as price
stability, foreign exchange stability, etc, are regarded as
secondary. The aim of credit
control is to help in achieving full employment and accelerated
growth with stability
in the economy without inflationary pressures and balance of
payments deficit.
3.3.2. Methods of Credit Control
The Central Bank of Nigeria adopts two methods of credit control.
They are the quantitative and
qualitative methods. Quantitative aim at controlling the cost and
quantity of credit by adopting
such techniques as variations in the bank rate, open market
operations (OMO) and variation in
the reserve ratios of commercial banks.
On the other hand, qualitative methods control the use and
direction of credit. These involve
selective credit controls and direct action. The methods of credit
control by the Central Bank of
Nigeria (CBN) are discussed as below:
Bank Rate or Discount Rate Policy: The bank rate or discount rate is the rate fixed
by the
Central Bank at which it rediscounts first class bills of exchange
and government securities held
by the commercial banks. The bank rate is interest charged by the
Central Bank of which it
provides rediscount to banks through the discount widow. The
Central Bank controls credit by
making variations in the bank rate. If the need of the economy is
to expand credit, the Central
Bank lowers the bank rate. By this, borrowing from the Central
Bank becomes cheap and easy.
So the Commercial Banks will borrow more from the CBN. The
Commercial Banks in turn, will
loan to customers at a lower rate. The market rate of interest
will then be reduced. This therefore
encourages business activities, and expansion of credit follows
which encourages the rise in
price.
The opposite happens when credit is to be contracted in the
economy. The Central Bank raises
the bank rate which makes borrowing costly from it. So the banks
borrow less. They in turn raise
their lending rate to customers. The market rate of interest also
rises because of the tight money
market. This discourages fresh loans. This also discourages
business activities. There will also be
a contraction of credit which depresses the rise in price. Thus
lowering the bank rate offsets
deflationary tendency and raises the bank rate which controls
inflation.
Open Market Operations (OMO): Open Market Operations (OMO) is another method
of
quantitative credit control used by the Central Bank of Nigeria
(CBN). This method refers to the
sale and purchase of securities, bills and bonds of government as
well as private financial
institutions by the Central Bank. There are two principal motives
of Open Market Operations.
One, to influence the reserves of commercial banks in order to
control their power of credit
creation. Two, to affect the market rates of interest as so to
control the commercial bank credit.
The effect is that when the central bank sells securities to the
market, the commercial bank’s
reserves is reduced. In this way, open market operations reduce or
enhance, respectively the
banking system’s ability to create credit and hence money supply.
The required reserve ratio: Every commercial bank is required by law to
maintain a minimum
percentage of its deposits with the central bank. The minimum
amount of reserve with central
bank may be either a percentage of its time and demand deposits
separately or of total deposit.
Whatever the amount of money remains with the commercial bank over
and above these
minimum reserves is known as excess reserves. It is on the basis
of this excess reserves that the
commercial bank is able o create credit. The larger the size of
the excess reserves, the greater is
the power of a bank to create credit, and vice versa. When the
central bank raises the reserve
ratio of commercial banks, it means that the latter are required
to keep more money with the
former. Consequently, the excess reserves with the commercial
banks are reduced and they can
lend less than before. On the contrary, if the central bank wants
to expand credit, it lowers the
reserve ratio so as to increase the credit creation power of
commercial banks. Thus, by varying
the reserve ratio of commercial banks, the CBN influences their
power of credit creation and
thereby controls credit in the economy.
Selective credit control: Selective or qualitative methods of credit
control are meant to regulate
and control the supply of credit among its possible suppliers and
uses. They are different from
quantitative or general methods which aim at controlling the cost
and quantity of credit. Unlike
the general instruments, selective instruments do not affect the
total amount of credit but the
amount that is put to use in a particular sector of the economy.
This confers on the CBN the power to regulate the terms on which
credit is granted in specific
sectors. These powers or controls seek typically to regulate the
demand for credit for specific
uses and the period of time over which the loan is to be paid.
This involves official interference
with the volume and directions of credit into those sectors of the
economy which planners
believe are of crucial importance to economic development. These
tools include Moral suasion
and selective credit controls or guidelines.
Moral suasion: This involves the employment of persuasions or
friendly persuasive statements,
public pronouncements or outright appeal on the part of the CBN to
the banks requesting them to
operate in a particular direction for the realization of specified
government objectives. For
examples, the CBN may appeal to the banks to exercise restraint on
credit expansion by
explaining to them how excess expansion of credit might involve
serious consequences for both
banking system and the economy as a whole.
Selective credit controls or guidelines: Selective credit controls or guidelines
involves
administrative orders whereby the CBN uses guidelines, instructs
banks on the cost of and
volume of credit to specified sectors depending on the degree of
priority of each sector.
3.4. Difference between Central Bank and Commercial
Bank
A Central bank is basically different from a commercial bank in
the following ways:
i. The Central Bank is owned by government, whereas the commercial
bank is
owned by shareholders.
ii. The Central Bank is the apex financial institution and banking
structure of the
country. The commercial bank is one of the organs of the money
market.
iii. The Central Bank is a non-profit institution which implements
the economic
policies of the government. But the commercial bank is a
profit-making
institution.
iv. The Central Bank is a banker to the government and does not
engaged itself in
ordinary banking activities. The commercial bank is a banker to
the general
public.
v. The Central Bank has the monopoly of issuing notes, while the
commercial banks
can issue only cheques. The notes are legal tender but cheques are
in the nature of
near money.
vi. The Central Bank is the bankers’ bank. As such, it grants
accommodations to
commercial banks in the form of rediscount families, keeps their
cash reserves,
and clears their balances. On the other hand, the commercial bank
advances loans
to and accepts deposits from the public.
vii. The Central Bank is the custodian of foreign currency
reserves of the country
while the commercial bank is the dealer of foreign exchange.
4.0. CONCLUSION
The above analyses show that a Central bank is very important in
the live wire of the
financial sector of an economy. Therefore, government need to
accord the Central Bank
of Nigeria (CBN) the necessary support and backing to be able to
take active in
discharging its functions adequately and efficiently in an
economy.
5.0. SUMMARY
In this note, we have learned about;
i. The concept of Central Bank,
ii. The functions of the Central bank,
iii. Credit control by Central bank,
iv. Objectives of credit control,
v. Methods of credit control, and
vi. The difference between central bank and Commercial Bank
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