Question

How is a central bank different from a typical commercial bank?

Short answer

A central bank is a government-controlled institution responsible for overseeing the monetary policy, regulating the banking sector, managing foreign exchange and gold reserves, issuing currency, and acting as a lender of last resort. In contrast, a commercial bank is a privately-owned entity that provides banking services to individuals, businesses, and organizations, such as accepting deposits, granting loans, and facilitating trade and business transactions. The main differences between the two include their purpose, control, functions, lending activities, authority over currency issuance, and customer base.

Step-by-step solution

1. Functions of a Central Bank

A central bank, often referred to as a monetary authority, is a financial institution that is responsible for overseeing the monetary policy of a country or a group of countries. They manage the supply of money and interest rates to ensure price stability and control inflation. Central banks have several specific functions: (i) Formulation and implementation of monetary policy: The central bank sets the country's monetary policy to control inflation, stabilize exchange rates, and achieve full employment. (ii) Regulating and overseeing the banking system: Central banks act as the regulator and supervisor of the banking sector in the country, ensuring that banks follow prudent practices and maintain stability in the financial markets. (iii) Managing the country's foreign exchange reserves and gold reserves: Central banks hold and manage the foreign exchange reserves and gold reserves in order to maintain stability in the exchange rates and protect the national currency. (iv) Issuing currency: Central banks issue the national currency and are responsible for its circulation. (v) Acting as a lender of last resort: In a financial crisis, the central bank provides emergency funding to financial institutions to prevent them from failing.

2. Functions of a Commercial Bank

A commercial bank is a financial institution that provides banking services to individuals, businesses, and organizations. They are involved in multiple operations and their main functions include: (i) Accepting deposits: Commercial banks accept deposits from customers, including savings deposits, current deposits, and fixed deposits. (ii) Granting loans and advances: Commercial banks provide loans, credit facilities, and advances to their customers (both individuals and businesses) based on their creditworthiness. (iii) Facilitating trade and business transactions: Commercial banks provide various services to facilitate trade and business transactions, including foreign exchange services, letters of credit, bill discounting, etc. (iv) Providing various additional financial services: Insurance, wealth management, merchant banking, and other financial products are offered by commercial banks.

3. Differences between a Central Bank and a Commercial Bank

Based on the functions and roles of central and commercial banks, we can list the main differences between them: (i) Purpose: The central bank's primary objective is to maintain stability in the country's financial system, while commercial banks aim to earn profits by providing banking services to their customers. (ii) Control: Central banks are government-controlled institutions, while commercial banks are privately-owned entities. (iii) Functions: Central banks are mainly responsible for setting monetary policy and regulating the banking sector, while commercial banks focus on providing banking services, such as accepting deposits and granting loans. (iv) Lending: Central banks act as a lender of last resort during a financial crisis, whereas commercial banks provide loans and advances to customers based on their creditworthiness. (v) Issuing currency: Central banks have the sole authority to issue and regulate the national currency, while commercial banks circulate the currency issued by the central bank. (vi) Customers: Central banks mostly deal with the government and commercial banks, while commercial banks serve individuals, businesses, and organizations.