Edited By Amara Onuh
Lesson Objectives
By the end of the lesson, students should be able to:
- Describe how the central bank controls commercial banks.
- State the differences between a Central Bank and Commercial Banks.
Table of Contents
How The Central Bank Controls The Commercial Banks
Commercial banks are governed by the Central bank through the following ways:
1. Bank Rate Policy
The central bank can influence how commercial banks lend money by changing the bank rate, that is, the interest it charges when lending to commercial banks.
When the central bank increases the bank rate, borrowing becomes more expensive for commercial banks, so they also increase the interest they charge their customers. This reduces the amount of money in circulation.
When the bank rate is reduced, commercial banks borrow more cheaply and are able to lend more to the public. This increases the amount of money in the economy. In this way, the central bank uses the bank rate to control lending and maintain stability.
2. Open Market Operations
Open market operations involve the central bank buying or selling government securities, such as treasury bills and bonds. When the central bank sells securities, money moves from commercial banks to the central bank, thus reducing the amount of money commercial banks can lend.
By buying securities, commercial banks are paid. This increase their reserves and allows them to lend more. This method helps the central bank increase or reduce money in the economy to control inflation, interest rates, and overall economic activity.
3. Cash Reserve Ratio
The cash reserve ratio is the percentage of customer deposits that commercial banks must keep with the central bank. By increasing this ratio, the central bank forces commercial banks to keep more money in reserve, leaving them with less to lend to customers.
This reduces the money supply in the economy. When the central bank lowers the ratio, banks release more money for lending because they now hold less in reserve. This method helps the central bank regulate how much money flows through the banking system.
4. Directives
The central bank can issue instructions or guidelines to commercial banks on how they should operate. These directives may relate to interest rates, lending to particular sectors, credit limits, or handling customer deposits. Commercial banks must follow these rules to remain in good standing.
By giving such instructions, the central bank ensures that banks behave responsibly, protect customer funds, and support national economic goals. These directives help maintain order and discipline within the financial system
5. Licensing and Supervision
The central bank is responsible for granting licenses to commercial banks before they are allowed to operate. It also supervises their activities through regular inspections and audits. This helps the central bank ensure that banks follow financial laws, maintain proper records, and protect customers’ money.
If a bank is not performing well or is breaking rules, the central bank can give warnings, impose penalties, or even withdraw its licence. Through supervision, the central bank maintains stability and prevents banking failures.
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Differences Between Central Bank And Commercial Banks
A. Purpose and Role:
A central bank exists to manage a country’s financial system and ensure stability in the economy. Its duty is to regulate money supply, control inflation, guide the banking sector, and support government economic policies.
A commercial bank, however, focuses on providing financial services to individuals, businesses, and organisations. It aims to attract deposits, give loans, and offer payment services. The central bank serves the whole nation, while the commercial bank serves the general public for profit.
B. Issuing of Currency:
The central bank has the exclusive authority to print and issue the country’s currency. This means all bank notes and coins in circulation come from the central bank.
Commercial banks cannot create legal tender. They only distribute money given to them by depositors or received from the central bank. While commercial banks help people access money, only the central bank has the power to produce and regulate the supply of currency.
C. Ownership and Profit Motive:
A central bank is usually owned and controlled by the government. It does not operate to make profit. Its main goal is to maintain economic stability and support national development. In contrast, commercial banks are owned by private individuals, shareholders, or sometimes the government, but they operate mainly to make profit. Their income comes from loans, fees, and other banking services.
The central bank works for public welfare, while commercial banks work to earn returns on investment.
D. Customers Served:
The central bank serves the government and commercial banks. It keeps the government’s accounts, manages public debt, and supports other banks when they face financial problems. Commercial banks serve the public, including individuals, companies, and organisations. They receive deposits, offer loans, and help customers make payments.
The central bank does not offer everyday banking services like savings accounts or personal loans to the public.
E. Lender of Last Resort:
When commercial banks face financial difficulties or cannot meet customers’ withdrawal demands, the central bank steps in to lend them money. This is why the central bank is called the lender of last resort. Its support prevents bank failures and protects the financial system.
Commercial banks cannot play this role because they rely on customer deposits for lending. They do not have the authority or financial capacity to rescue other banks.
G. Control of Money Supply:
The central bank controls the amount of money circulating in the economy through policies such as interest rates, open market operations, and reserve requirements. By doing this, it helps prevent inflation or recession. Commercial banks cannot control the money supply. Their role is to operate within the guidelines set by the central bank. They lend money and accept deposits, but they must follow the central bank’s rules to ensure the system remains safe and stable.
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Lesson Summary
- How the central bank control commercial banks: bank rate policy, cash reserve ratio, open market operations, licensing and supervision, directives.
- Difference between central bank and commercial banks: central bank regulates and controls, issues currency, serves government; commercial banks serve the public, aim for profit, cannot issue currency.
Tags
Central bank, Commercial bank, Bank rate, Open market operations, Cash reserve ratio, Licensing, supervision, Lender of last resort, Money supply control, Government banker, Profit-orientated bank, Currency issuance
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