CENTRAL BANKING

What is Central Banking System?

Before the World War First, there were
only a few countries which had their own
central banks. After the War, the number
of central banks has increased and now
there is not a single country in the world
which does not have its own central
bank.
There were many considerations
underlying the establishment of a
central bank. After the First War, there
was complete confusion in currency &
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of money from banks. The bank reserves

fell below the needed levels. There was
no institutions which could supervise the
working of banks and also serve as a
fiscal agent. In addition to the above
difficulties, there was rigidity or lack of
elasticity in the supply of currency.
In order to solve the monetary
problems of the countries and set them
on healthy footings, a Conference was
held at Brussels in 1920. it was decided
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maintain stable business conditions,

each country must establish its own
central bank.
Evolution & Growth:
The Riksbank of Sweden was set up in
1656 and declared as central bank in
1668 and is considered to be the oldest
of the central banks. The Bank of
England was established in 1694. it
is also called the Mother of central
banks. The Bank of France was set up in
1800. The National Bank of Denmark
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1876. In U.S.A Federal Reserve System

was set up in 1914. The Reserve Bank
of India was formed in 1935.
The Central Bank of Pakistan
named as State Bank of Pakistan
(SBP) was established in July 1,
1948. It is the main monetary
authority in our country. According
to the State Bank of Pakistan Act
1956, the SBP is charged with
regulating the monetary and credit
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Definitions:
R.P. Kent: An institution, which is
charged with the responsibility of
managing the expansion and contraction
of the volume of money in the interest of
the general public welfare.
Comprehensively: The Bank in any
country authorized by the Government
to control the amount of credit and to
supervise
the
operations
of
the
commercial banks. It carries out the
business of the Government and
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countrys reserves and takes steps to

preserve the value of the countrys
currency and the foreign exchange.
State Bank of Pakistan:
The State Bank of Pakistan as
envisaged in the State Bank Order is not
guided by profit motive in its operation.
It is to regulate the monetary and credit
system of Pakistan and to foster its
gowth in the best national interest with a
view to securing monetary stability and
fuller utilization of the countrys
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Organization Structure:
The
general
supervision
and
direction of the affairs of the Bank vests
in a Central Board of Directors which
consists of one Governor, one Deputy
Governor, and eight Directors. There
is also an Executive Committee which
is empowered to transact business on
behalf of Central Board of Directors.
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Major Responsibility to Regulate

Banking System:
In order to regulate and monitor the
banking system, SBP issues laws and
regulation from time to time. These
regulations
provide
guidelines
for
opening of accounts, limit against
advances, setting up internal audit
system,
requirement
for
minimum
capital and reserves for banking
company, maintaince of liquid assests
for every banking company etc.
In short State Bank of Pakistan is an
apex institution in the country. Its
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as a banker to the central Govt. it is fully

charged with the responsibility for
maintaining the internal and external
stability of the country.
However in
developing countries the central bank is
also responsible for directly contributing
in the promotion of planned economic
development of the economy.

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Principles/Objectives of
Central Bank

1. Economic Stability:
Central bank basically works for the
fulfillment of the financial needs,
economic stability and for the growth
of banking system. If any sector of
economy faces problems, special
treatment is given by the central bank
to consolidate its financial position.
2. National Interest:
The basic object of central bank is not
to earn the profit rather to work in the
best interest of the nation. Central
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interest to all other things. Beside it,

central bank also pursues the other
member banks to work earnestly in the
best interest of the nation.
3.Effective Policy:
Central bank implements effective
policies to control the undue expansion
or contraction of credit in the country.
The central bank uses its powers to
subdue the commercial banks in order to
enforce the devised policies.
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4. Special Authorities:
Central bank has special authorities to
perform its functions effectively
including issuance of currency notes,
control of credit and different other
functions being a Govt Bank etc. The
central bank uses its authorities to
strengthen the economy of the
country with a great responsibility.
5. Constitutional Limitations:
Central bank works according to the
framed rules and regulations of the
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Central bank not only observes the

constitutional limits but also instruct the
other banks and financial institutions to
observe the said limits.
6.Free From Political Pressure:
Central bank does not accept any
kind of pressure of any poltical party or
group while rendering its duties for the
better
interest
of
the
country.
Unfortunately, if the central bank
becomes
an
instrument
of
any
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7. Custodian of Banking System:

Central bank is responsible for the
protection and growth of banking
system. So the central bank not only
keeps a watchful eye on the economic
affairs of the country but also plays a
vital role to strengthen and secure the
present banking system.
8. Custodian of Credit System:
Central bank is also responsible for
the protection and stability of credit
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Functions of a Central
Bank

Central banks of a country look after the

national interest rather than the profit. It
is the banker of government and
bankers bank. It does not deal with the
public deposits or loans and advances to
the public. The functions of central bank,
as mentioned by banking experts, are
performed almost by all the central
banks of the several countries of the
world although there may be variations
in degree of functions.
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1. Sole
Right
of
Issuance
the
Currency Notes:
Central bank has the monopoly to
issue currency notes. The main
reasons for delegating the authority of
note issue to the central bank in a
country are as follows;
i. It brings uniformity in the system of
note issue.
ii. The central bank can exercise better
control over the money supply in
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iii. It increases the public confidence

in the monetary system of the
country.
iv. It enables central bank to control
the lending operations of the
commercial banks.
2. Bankers, Agent and Adviser to
the Government:
i. The central bank acts as banker to
the government, it receives deposits,
cheques and drafts deposited in the
government account.
ii. It makes short term advances to
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for the purchase of foreign goods,

repaying external debts etc.
iv. As financial agent, it collects taxes
and other payments on behalf of the
government and makes investments
in Long-term Government securities.
v.
As adviser to the government, it
gives advice on all monetary &
economic matters such as controlling
inflation or deflation, devaluation or
revaluation
of
currency,
foreign
exchange policy etc.
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3. Banker to Commercial Banks:

As banker to commercial banks,
the
central bank performs the
following functions;
i. It keeps the cash reserves and
deposits of the commercial banks.
ii. It rediscounts the bills of exchange of
their member banks in the time of
need.
iii. It influence the creation of credit by
the commercial banks in the best
interest of the country.
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v. A new bank or a branch of an existing

bank cannot be established or start
its operations without the prior
permission/license of central bank.
vi. It is the duty of central bank to
promote the growth of the over all
banking system on sound footing.

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4. Clearing Agent:
As the custodian of the cash reserves
of commercial banks, the central bank
acts as a clearing house for
commercial banks. As all schedule
banks have their accounts with the
central bank, the central bank can
easily settle the claims of various
banks against each other with least
use of cash. The clearing house
functionof the central bank has the
following advantages;
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ii. It strengthens the banking system by

reducing withdrawals of cash in times
of need.
iii. It keeps the central bank fully
informed about the liquidity position
of the commercial banks.
5. Lender of The Last Resort:
The central bank is the supreme bank
of the country. If the commercials
banks are at any time in need of
money and are not able to meet their
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bank as lender of last resort provides

financial help to the commercial bank by
rediscounting their bills of exchange. The
central bank functioning as lender to last
resort increase the elasticity and
liquidity of the whole credit structure of
the economy.
6.Controller of Credit:
Another
important
function
of
central bank is to control the
availability and cost of credit in the
country. Central bank makes policies
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of credit and to stable the credit or

money supply in the country. The steps
taken or methods adopted by central
bank in this regard are called monetary
policy.
7.Controller of Foreign Exchange:
The central bank is responsible for
the management of foreign exchange
and maintenance of the value of home
currency. Moreover, foreign exchange
reserves are also kept with the central
bank. It prepares the balance of
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Government to keep the balance

favourable.
8.Representative of Foreign Trade:
Central
bank
acts
as
the
representative
of
Government
in
international trade & business. Due to
such involvement on the part of central
bank in these trades makes the country
enable to prosper.
9.Exchange Rate Stability:
The central bank fixes the exchange
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limits in keeping with its obligations as a

member of the International Monetary
Fund and
tries to bring stability in
foreign exchange rates.
10. Development Role:
In developing countries of the world,
the central bank besides perforimg the
traditional functions, also performs
developmental
and
promotional
functions. The central bank undertakes
the responsibility of economic growth
with stability in the economy. It ensures
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such as agricultures, exports, small scale

industry etc.
11. Miscellaneous Functions:
i.Central bank not only provides the
modern training to the staff working
in various banking institutions but also
establishes training institutes in this
regard.
e.g:
Institute
of
Bankers
Pakistan. Etc
ii.It
maintain
relations
with
international agencies such as IMF,
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methods to promote the habit of

saving among
the people of country.
iv. It conducts seminars, surveys and
publishes annual reports giving
real economic picture of the economy.

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Central Banks Monopoly

of Note Issue

Central bank has the monopoly of note

issue in the every country of the world
now, the concentration of note issue
in a central bank has the following
advantages;
1) Uniformity in note circulation: it
brings uniformity in the circulation of
currency.
2) Control over money supply: The
central bank is in a better position to
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3) Control over commercial banks:

The sole power to issue notes enables
the central bank to control the lending
operations of the commercial banks.
4) Public Confidence: The right to note
issue is regulated by law. Therefore it
increases public confidence in the
monetary system of the country.

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Principles of Note Issue

There are two principles of note issue,
one is called the Currency Principle
and the other is named as Banking
Principle. Both of these principles are
contradictory to each other. One school
of thought says that there should be
full convertibility of notes into
gold bullion. The second gives
importance to the elasticity of
supply. Now we discuss the two
principles one by one.
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1. Currency Principles:
According to the currency principle,
the central bank of the country should
keep 100% gold for every note
issued. In other words, their should be
full convertibility for the amount of
legal tender currency. It assumes full
convertibility of notes because every
note issued is covered by gold
reserve.
Advantages
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ii. No Danger of Inflation:

There is no danger of over-issue of
the currency, which is an effective
check to the possibilities of inflation.
iii.Public Confidence:
The currency principle provides
greater confidence to the public,
because it provides assurance in case
of convertibility of notes.
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Disadvantages
i. Inelastic:
it makes the supply of money highly
inelastic, because the issuance of
notes is only possible on the
availability
of
gold.
So,
the
government cannot issue note in
case of emergency.
ii. Dependent:
According to this principle, paper
cuurency can only be printed and
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availability of gold rather than the

trade & industry need.
iii.Lock up of Gold:
There is unnecessary lock up of
gold for the currency, which may be
used for some other purposes.

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2. Banking Principle:
According to this principle, there is no
need to keep 100% gold or silver
against notes issued. The notes issued
should
have
a
guarantee
of
convertibility into gold. It is sufficient
to keep only a certain percentage of
total paper currency in the form of gold
and silver reserves. The notes issued in
the country should be according to the
needs of trade & industry.
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Advantages
i. Elastic System:
The banking principle is elastic because
it does not require 100% metallic
backing against the note issue,
however the gurantee of convertibility
also acts as a regulator of note issue.
ii. Government Needs:
This system is best fit for meeting the
government
needs
in
case
of
emergencies.
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Disadvantages
i. Over-Issue:
In order to meet the demands of the
money, there may be a further issue of
notes beyond to a certain limit which may
leads to the possibility of inconvertibility
of excess notes and undue inflation.
ii. Public Confidence:
Under this system there is chance to lose
the public confidence in the currency and
monetary instability.
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Methods of Note Issue

There are different methods of note issue
adopted by different countries of the world at
different time. The most important of them
are as under:
1.Fixed Fiduciary System:
Under fixed fiduciary system, the government
fixes a fixed amount of notes without keeping
any metallic reserve. But this portion of
currency must be backed by government
securities, which is called fiduciary limit. The
notes issued other than fiduciary limit must
be fully backed by gold or silver reserves.
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This system was introduced by England in

1844. Norway and Japan was also adopted
this method. This system provides security
for the convertibility of notes but at the same
time it lacked elasticity and was not capable
of satisfying the needs of trade and industry.
This system was abandoned in 1913 in
favour of propotional reserve system.
2.Propotional Reserve System:
Under this system, the central bank is
required to keep certain percentage of note
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issued in form of gold and the remainder is to

be covered by sound government securities.
The reserve proportion is usually from 30% to
40%. It means a central bank can issue Rs.
1000 note after keeping the gold value of
Rs.300 or 400.
This system remained prevalent in USA,
Britain and over a large part of the world. It
was first adopted by Germany in 1876. The
proportional reserve system was also adopted
by State Bank of Pakistan (SBP) and it
remained enforced till December 1965. This
system was
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abandoned in 1965 as it was rigid and lacked

elasticity. The State Bank of Pakistan could not
give guarantee for full convertibility of notes.
The SBP has now adopted a new system of note
issue named as Minimum Reserve System.
3.Minimum Reserve System:
The proportional reserve system of note issue
has been replaced by minimum reserve system
in Pakistan in 1965. According to this system,
the central bank is required to keep only a
minimum amount of reserve in the form
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of gold and foreign exchange securities.

The central bank can expand note issue in
accordance with the volume of business
activities without backing of gold. The
merit of this system is that it ensure an
adequate supply of currency to meet the
business demands of the country. In other
words, the method of the note issue is
sufficiently elastic. The demerit is that
paper currency issued is practically
inconvertible in this system.
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Clearing House/Clearing
Process
A clearing house is an association of
commercial banks set up in a given
locality for the purpose of interchange
and settlement of credit claims. The
function of a clearing house is performed
by the central bank of a country by
tradition or by law. In Pakistan the
clearing system was operated by the
State Bank of Pakistan. But now it is
performed by the National Institutional
Facilitation Technologies (Pvt.). Ltd. (NIFT)
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About NIFT:
NIFT - National Institutional Facilitation
Technologies (Pvt.). Ltd. was incorporated
in September 1995 as joint venture
between association of six banks and
entrepreneurs from the private sector. All
commercial banks and all of their branches
in major cities avail NIFT's services. As of
January 2014, 38 commercial banks and
their 8382 branches in 273 major
cities, and towns utilize NIFT's services
through 28 Data Centers.
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After the World War II, there has taken place

a rapid growth in the banking institutions.
The use of cheques in making payments has
also widely increased. The collection and
settlement of mutual obligations in the form
of cheques is now a big task for all the
commercial banks. The mechanism, whereby
cheques are exchanged in bulk and the cross
obligations of the banks are offset, is
explained in brief.
Cheques as we know, is an effective method
of making payments. When cheques are
drawn on one bank
and the holder (payee)
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deposits the same in his account at the bank

of drawer, the mutual obligations are settled
by the bank Internal Transfer and there
arises no inter bank debits from the use of
cheques.
In practice, the person receiving the cheque
is rarely a depositor of the cheque at the
same bank as the drawer. He deposits the
cheque with his bank(other than of the
payer) for the collection of the amount. Now
the bank in which the cheque has been
deposited becomes a creditor of the
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the debtor bank will pay his amount of the

cheque by transfering it from cash reserves if
there is no offsetting transactions. In the
course of everyday life, there are large
number of cheques drawn on bank but
deposited in other banks. The bank on which
the cheques are drawn become in debt to the
banks in which the cheques are deposited.
At the same time, the creditor banks receives
large amounts of cheques drawn on other
banks giving claims of payments by them, it
will become uneconomical and confusing if
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banks had to transfer cash for meeting

each other liability. The easiest,
safe and the most efficient way is
to offset the reciprocal claims
against one another and receives
only the net amount owned by
them. This facility of net inter
bank payments is provided by the
clearing house.

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Lets deeply understand the working of

clearing house with the help of an example:
Suppose Mr. Ali gives the cheque of his
personal account maintain at Bank Alfalah
for Rs.100,000 to Mr.Imran to pay off his
obligations. Mr.Imran having the personal
bank account in Meezan Bank and he
deposited the cheque in his bank (which is
drawn on Bank Alfalah) from the collection
of funds.
At the same time Mr. Zeeshan issues the
cheque of Meezan Bank for Rs.80,000 to
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Mr. Salman(Supplier) against his business

payment. And Mr. Salman depositedthe
same cheque for collection of funds in his
account maintained at Bank Alfalah.
In the above situation, Bank Alfalah has to
transfer the funds of worth Rs.100,000 to
Meezan Bank and Meezan Bank has to pay
the funds of Rs.80,000 to Bank Alfalah. So
the net differences between both the bank
balance will be settled by transfer
Rs.20,000 by Bank Alfalah to Meezan Bank.
Such inter bank net claims are
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only possible to settled with the

presence of Automated Clearing
System which is known as Real Time
Gross Settlements (RTGS).

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