Central Bank is a Banker to Commercial Banks

Broadly speaking, the central bank acts as the banker’s bank in three different capacities:

(a) It acts as the custodian of the cash reserves of the commercial banks

(b) It acts as the lender of the last resort

(c) It is the bank of central clearance, settlement and transfer.

We shall now discuss these three functions one by one.

(a) It acts as the custodian of the cash reserves of commercial banks: Commercial banks keep part of their cash balances as deposits with the central bank of a country known as centralization of cash reserves. Part of these balances are meant for clearing purposes, that is, payment by one bank to another will be simple book entry adjustment in the books of the central bank. There are many advantages when all banks keep part of their cash reserves with the central bank of the country. In the first place, with the same amount of cash reserves, a large amount of credit creation is possible. Secondly, centralized cash reserves will enable commercial banks to meet crises and emergencies. Thirdly, it enables the central bank to provide additional funds to those banking institutions which are in temporary difficulties. Lastly, it enables the central bank to influence and control the credit creation of commercial banks by making the cash reserves of the latter more or less.

(b) Lender of the last resort: As the banker’s bank, the central bank can never refuse to accommodate commercial banks. Any commercial bank wanting accommodation from the central bank can do so by re discounting (selling) eligible securities with the central bank or can borrow from the central bank against eligible securities.

By lender of the last resort, it is implied that the latter assumes the responsibility of meeting directly or indirectly all reasonable demands for accommodation by commercial banks in times of difficulties and crisis.

(c) Clearing agent: As the central bank becomes the custodian of cash reserves of commercial banks, it is but logical for it to act as a settlement bank or a clearing house for other banks. As all banks have their accounts with the central bank, the claims of banks against each other are settled by simple transfers from and to their accounts. This method of settling accounts through the central bank, apart from being convenient, is economical as regards the use of cash. Since claims are adjusted through accounts, there is usually no need for cash. It also strengthens the banking system by reducing withdrawals of cash in times of crisis.

Furthermore, it keeps the central bank of informed about the state of liquidity of commercial banks in regard to their assets.