Management Notes

Reference Notes for Management

In what way the Central Bank serves as a Banker’s Bank?

In what way the Central Bank serves as a Banker’s Bank?

    1. By maintaining gold reserve
    2. By controlling currency
    3. By acting as a lender of the last resort
    4. By reducing the interest rates

Correct Answer: By acting as a lender of the last resort

 Answer Explanation

The correct answer is (c) By acting as a lender of last resort. The Central Bank serves as a Banker’s Bank by acting as a lender of last resort to the commercial banks.

When financial crises or liquidity shortages threaten commercial banks’ ability to meet their financial obligations. And the ability to  maintain sufficient reserves to meet withdrawal requests from customers, this function is crucial. To meet their liquidity needs and borrow funds, commercial banks can turn to the Central Bank as the lender of last resort.

As a result of the lender of last resort function, bank runs and systemic collapses are prevented. By providing emergency funds to commercial banks, the Central Bank helps maintain the overall stability of the financial system and ensures that the banking sector can continue its essential role in facilitating economic transactions and credit allocation.

Why the other options are not correct

a. By maintaining gold reserve:

The gold standard system was historically used to back central bank currencies, but it is no longer prevalent in modern economies. As a result, most countries today use fiat money, which is not backed by gold as a physical commodity.

The value of fiat money is rather determined by the government issuing it and by how well it manages the economy. As part of their foreign exchange reserves, central banks may hold some gold reserves, but this alone does not define their role as a banker’s bank.

b. By controlling currency

A central bank has the authority to regulate the money supply in an economy by using monetary policy tools.

However, being a controller of currency alone does not qualify them as a banker’s bank. Inflation, interest rates, and economic stability are all dependent on the central bank’s control of currency. Its primary role is to serve and support commercial banks, which is more than controlling the currency.

d.  By reducing the interest rates:

Central Banks can influence interest rates through monetary policy tools like the bank rate or open market operations. To boost economic activity, the central bank reduces interest rates to stimulate borrowing and spending. This function, however, is not the sole definition of the central bank’s role as a banker’s bank, but is part of its broader role in managing the economy.

Conclusion

By acting as a lender of last resort, the Central Bank serves primarily as a Banker’s Bank. As a result of this critical function, the banking system is stable and financial crises are prevented by providing emergency liquidity to commercial banks when needed.

As well as maintaining gold reserves, controlling currency, and reducing interest rates, the other options do not exclusively define the central bank’s role as a banker’s bank. It is the lender of last resort function, however, that distinguishes the central bank as a crucial institution that supports and safeguards both the banking sector and the overall economy as a whole.

Which of the following is a qualitative or selective method of credit control by the central bank?

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