Broadly speaking, the central hank ad:, ,1\ a banker’s bank in three capacitors. (I) A~ the custodian of thc cash re. curve of the commercial hanks; (ii) as the lender of I~ t resort and (iii) as a bank of central clearance, cattle mcnt and transfers. (i) Cu\I!Hliall (If the Cash Reserves (If <. ‘1lII1I11l’I’- cial lIank\, The practice of thc commercial banks of keeping their cash reserves with the central hank developed slowly and it has been closely associated with the functions of the central banks as thc bank of issue and as banker to the government, It was convenient to keep cash reserves with the central bank, because its notes commanded the greatest confidence, and also because government’s banking transactions took place through this institution. Originally, keeping of cash with the central bank was optional; later Oil, in most countries, it was made a statutory obligation. The practice has many advantages: First, it economists cash. The nation’s cash can be more effectively used when centralised than when scattered in the vaults of numerous banks. Secondly, it enabl commercial banks’to increase their reserves 111rei) b) di – counting bills with the central ban’ in time. of need instead of having to rely upon their own re ourc . Thirdly, it gives the central bank control over the credit policies of the member-banks as we shall presently sec. (ii} Lender of Last ReM, r t, The central bank is the lender of last resort to the commercial banks. When the commercial banks have exhausted their u n resources and have failed to supplement their fund fr m the usual outside resources, the central bank is called upon to function as the lender of last resort. It acts in this capacity mainly through its rediscount operations. In the narrow sense, rediscounting is applied only to first class trade and agricultural hills brought to the central bank by commercial banks and bill dealers or brokers, who arc temporarily in need of funds and want to convert some ‘)1 their short-term assets into cash. In the wider sense, as now current in most countries, rediscounting is defined as “the conversion directly or indirectly of commercial bank credit into additional central bank credit:” Rediscounting is thus applied also to treasury bills ami to short-term collateral loans to banks and other financial’institutions made by the central bank against bills or promissory notes and government securities.
Rediscounting facility enables cOli mercial banks to carry on their day-to-day business 5r1 smaller cash reserves, incc they can always rely upon the central bank in time of crisis. II gives increased elasticity and liquidity to the assets of the commercial banks. Rcdi counting, however, should not be abused. It hould be resorted to only in times of emergencies anti not in time of normal business activity. The central bank, in its turn, hould be ready to help in times uf distress, but should be Ie.. liberal in ordinary times. This is necessary to encourage elf-reliance among commercial banks and to conserve the strength of the central hank for emergencies. (iiil (‘h’arin~ and Sl’Ith’lIIl’lIl. The central clearing function is performed by all central banks. In some countries, it IS merely a matter of tradition or convenience, in others it is a duty imposed upon the central bank by law. This is a logical step” from the position of the bank as custodian of cash reserves of the commercial banks. Since banks kecp cash reserves with the central bank, settlements between them can be easily effected by means uf debits and credits in the books of the central bank. In some countries, separate clearing houses arc set up to settle mutual obligations between the banks, including the central bank. In such countries, the balances ultimately to be paid can be paid without cash transfers through mere book entries in the accounts of commercial banks with the central bank.
This method of settling accounts, apart from being convenient, is economical as regards the use of casl . It also strengthens the banking system by ICducing withdrawals of cash in times (If crisis. Moreover, it enables the central bank to be well informed about the state of liquidity being maintained by the commercial banks with regard to their assets. This information helps the central bank in its function of controlling the credit expansion in the country.