Advantages and Disadvantages of Central Bank in Modern Economy

Alt: = "Central Bank of Switzerland Building"
Central Bank of Switzerland


What is Central Bank?

A Central Bank is a government-owned bank which helps to control and supervise the entire monetary and financial system of a country. In some territories, Central Bank is also referred to as Federal Reserved Bank. Being a financial organ of the government, of carries out the major financial operations of the government. It regulates, directs, assists and coordinates the operations of other financial institutions so as to make them comply with the monetary and economic policies of the government.

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 of Central Bank in Modern Economy

Issuing of Currency: one of the advantages of having a central bank is  that it is the sole authority empowered by law to issue banknotes and coins within the economy. If more currency is to be put in to circulation, the central bank  does so. It also arranges the withdrawal of sold currency and replace with new currency whenever the need arises. In this modern economy where the use of digital currencies are being accepted as means exchange, the central bank issues Central Bank Digital Currency (CBDC) which has legal backing and is issued by a sovereign state unlike the cryptocurrency.

Central Bank promotes economic growth. It achieves this in many ways. These include the development of the money and capital markets to finance the various development projects. It helps in promoting price stability and also makes money available to entrepreneurs at very cheaper rate for product purposes.

Maintenance of monetary stability. Central bank controls, supervises, assists and co-ordinates the activities of commercial banks and other financial institutions so that they fulfill the requirements of government monetary policies. Central bank uses monetary policy as measure to control inflation in an economy.

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. With the proliferation of financial technologies, central bank regulates the activities fintechs to minimize the incident of fraud.

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 submit reports on their reserves, transactions and risks assessment to central bank which creates confidence in the financial sector of any economy.

Read also: Similarities and Difference Between Central Bank and Commercial Banks

Disadvantages of Central Bank in Modern Economy

Many argue that central bank has no disadvantages. As right as their arguments may sound, that doesn’t take away the maxim: “anything that has advantages has disadvantages.”  We are going to look at areas where central bank has disadvantages especially in modern economy.

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.

Independence: Central banks are usually independent of political interference and as good as that is , however, a lack of political oversight is undemocratic and monetary policy should complement fiscal policy. Fiscal and monetary policies should work together; when each is controlled separately they might work in opposite directions; and there may be evidence that monetary policy needs political intervention to work in tandem with program of government and ensure it helps all members of society, not just a few. Monetary policy has failed several times, most notably during the Great Depression of the 1930s, and political intervention might have prevented more recent failures. More recently, it took political intervention to cushion the effects of COVID-19 and the economy, and avert economic recession.

Also read Advantages and Disadvantages of Central Bank Controlling Commercial Banks and other Financial Institutions

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