How central bank controls commercial banks - SS2 Commerce Lesson Note

Central banks control commercial banks through various mechanisms, including regulatory oversight and the establishment of clearing systems.

·         Regulatory Oversight: Central banks have the authority to regulate and supervise commercial banks. They set rules and guidelines that commercial banks must follow to ensure the stability and soundness of the banking system. These regulations cover areas such as capital requirements, risk management, lending practices, and customer protection. By enforcing these regulations, central banks aim to maintain the safety of the banking sector and protect depositors' interests.

·         Licensing and Authorization: Central banks are responsible for granting licenses to new commercial banks and approving their operations. They carefully assess the financial health, management capabilities, and compliance with regulations before granting authorization. This process helps ensure that only qualified and trustworthy institutions are allowed to operate as commercial banks.

·         Reserve Requirements: Central banks establish reserve requirements, which mandate that commercial banks hold a certain percentage of their deposits as reserves. These reserves act as a safeguard against potential liquidity shortages and help maintain the stability of the banking system. By adjusting reserve requirements, central banks can influence the amount of money that commercial banks can lend and impact the overall money supply in the economy.

·         Discount Window and Lender of Last Resort: Central banks serve as the lender of last resort for commercial banks. They provide emergency funds through a facility called the discount window, allowing banks to borrow money to meet short-term liquidity needs. This function ensures that banks have access to funds, even during financial crises, and helps prevent bank runs and systemic failures.

·         Clearing Systems: Central banks establish and operate clearing systems that facilitate the smooth and efficient transfer of funds between commercial banks. These systems enable banks to settle transactions, such as checks, electronic transfers, and other payment instruments. By overseeing the clearing systems, central banks ensure the integrity and safety of these transactions, minimizing the risk of fraud and errors.