Table of content
- Introduction
- How central bank controls commercial banks and other financial institutions
- Advantages
- Disadvantages
The advantages and what seem to be disadvantages of central bank are seen in the functions of the central bank. The disadvantages of central bank controlling other financial institutions mainly disadvantage the financial institutions.
The central bank has the statutory powers to regulate other financial institutions on behalf of the government authority. These control powers have both advantages and disadvantages in an economy. Many argue that central bank control over lending banks and other financial institutions does not have any intrinsic disadvantage. In this article we are going to examine the roles of central bank in controlling other financial institutions to see the advantages and disadvantages alike.
How Central Bank Controls Commercial Banks, Other Financial Institutions
1. Issuing of operational licenses
Before any commercial bank or financial institution would commence operations in an economy, it must get operational license from the central bank. Existing financial institutions that intend to make changes in their system of operation also need approval by the central bank.
2. Maintenance of monetary stability
The Central Bank controls, supervises, assists, and coordinates the activities of commercial banks and other financial institutions so that they fulfill the requirements of government monetary policy. The central bank does this by using various instruments of monetary policy such as the bank rate, open market operations, directives, the cash-deposit ratio etc.
Use of Bank Rate: The bank rate is the rate at which the Central Bank discounts or rediscounts bills for commercial banks and other financial institutions, or the rate at which it lends money to them. The bank rate influences the other interest rates in the economy. A higher bank rate leads to higher interest rates. If there is inflation, the central bank will increase the bank rate. This will force the commercial banks to increase their own interest rates. People and organizations will be discouraged from borrowing money from the commercial banks. Their lending ability is therefore reduced , leading to reduction in volume of money in circulation and a consequential control of inflation. On the other hand, if the volume of money in the system is too small, and the Central Bank wants to increase it, it will reduce the bank rate. This will encourage commercial banks to reduce their interest rates. Borrowing will therefore be encouraged, and the amount of money in circulation will be increased.
Use of Open Market Operations: Open market operations refer to the buying and selling of the government securities, such as treasury bills and bonds, from and to the public and business organizations. If the amount of money in circulation is too high, and the Central Bank wants to reduce it, it will sell securities to the public and financial institutions. When they buy ,they pay cheques to the Central Bank. When the cheques are cleared, the amount of money left with commercial banks and other financial institutions will fall. Their lending capacity is thereby reduced and this helps to reduce the amount of money in circulation. However, if the amount of money in circulation is too small, and the Central Bank wants to raise it, it will buy back securities from the public and financial institutions. This will increase the amount of money in circulation and increase the lending ability of financial institutions.
Cash-deposit Ratio: This refers to the minimum legal cash reserve requirements of the commercial banks. It relates to the ratio of cash reserves to their total deposits. If the amount of money in circulation is too large, and has to be reduced, the central bank will increase the cash-deposit ratio; and when the amount of money in circulation is too small, the central bank will as well reduce the cash-deposit ratio. This is to control the level of money in circulation per time.
Use of Directives and Moral Suasion: A directive is an instruction from the central bank to the commercial banks and other financial institutions regarding the size of loans to give and the areas of the economy to which the commercial banks and other lending institutions are to channel their lending.
Use of Special Deposits: They are additional deposits other than the one required by law, which the central bank may require the commercial banks to keep with it. This is used when the use of cash-deposit ratio is not sufficient to keep down the rate of inflation.
Funding: This refers to the conversion of government’s short-term securities to long-term securities such as bonds.
3. Issuing Guidelines
Central Bank issues guidelines from time to time on banking, money market and other financial instruments to ensure liquidity in the financial sector and indeed the economy, to protect the depositors, investors from any sharp practices of the deposit money banks, others.
Advantages and Disadvantages of Central Bank Controlling Other Financial Institutions
Having discussed the various ways the central bank controls other financial institutions, lets look at the advantages and disadvantages of some of these measures.
Advantages
• Central Bank controlling and directing the activities of commercial banks and other financial institutions make them conform with government economic policies and help in maintaining monetary stability and speed up much needed economic development.
• Central Bank issues guidelines from time to time on banking, money market and other financial instruments to ensure liquidity in the financial sector and indeed the economy, to protect the depositors, investors from any sharp practices of the deposit money banks, others. It protects the bank customers from unwholesome, fraudulent and unethical practices of the financial institutions. It checkmates the excesses of financial institutions.
• The commercial banks submitting reports on their reserves, transactions and risks assessment is of importance in creating confidence in the financial sector of any economy.
• Bank rate: the use of bank rate by the central bank to control commercial banks and other financial institutions, is a veritable tool in controlling inflation, as it reduces the amount of money in circulation.
• Interbank settlement: As the custodian of the cash reserves of the commercial banks, the central bank acts as the clearing house/ agent for these banks, and can easily settle their claims and counterclaims against one another. Without the central bank, commercial banks and other financial institutions would find it very difficult to settle the millions of transactions carried out each day by account holders. The seamless use of Fintech in financial transactions in this cashless era is made possible by interbank settlements handled by central bank. It therefore reduces the use of cash in settling banks claims and counterclaims, and reduces cash withdrawals, thereby allowing the banks to create large cash reserves.
• Central bank monitors the liquidity of deposit money banks to hedge against their collapse. Central banks usually set a minimum capital base for the commercial banks and other financial institutions, a measure to guard against easy collapse of commercial banks and to protect the depositors fund.
• The regulatory power of the central bank in issuance of licenses and in setting operational standards ensures that the financial institutions are qualified to run such business, and ensure that financial services do not become all comers business. It ensures that commercial banks and other financial institutions maintain banking and financial services ethics. The fear of being sanctioned, makes the financial institutions to operate within the confide of the regulatory laws and guidelines. Without the central bank the financial sector of an economy will become an all comers business.
• Maintenance of monetary stability: Central bank uses monetary policy as measure to control inflation in an economy.
Read also: Advantages and Disadvantages of Central Bank in Modern Economy
Disadvantages
• Bank rate: The bank rate influences the other interest rates in an economy. A high bank rate leads to higher interest rates. When the central bank increases banks rate, it will force other financial institutions to increase their own interest rates. This will make costs of borrowing so high on businesses, and will impact negatively on their profits. It will discourage people and businesses from borrowing, thereby reducing the transactions and revenue of the lending financial institutions.
• Use of directives and moral suasion: the directive of the central bank to commercial banks and other lending financial institutions to increase, reduce or restrict lending to some certain areas of the economy are not usually to the business interest of the financial institutions, rather to the interest of the government economic policies. The areas to reduce or restrict lending may be the areas with more bankable values, less risks. Businesses operating in such sectors will be starved of credit facilities.
• Cash-deposit ratio: If the commercial banks keep a higher percentage of their total deposits as reserves in compliance with increase in cash-deposit ratio order by the central bank, their lending ability will be reduced, thereby reducing their profits, and businesses in the real sectors of the economy, which may require funding may not be able to source funds through financial institutions.
• Use of Open market operations: Most times, the securities the government sell to the public and financial institutions are not for government’s developmental projects, but just to reduce the amount of money in circulation and to reduce the lending capacities of financial institutions. The costs of selling these securities that will lie idle are paid with taxpayers money. Like the Cash-deposit ratio, use of open market operations starves the real sectors of the capital funding by financial institutions.
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