Central Bank

Principles of
Banking, Currency
& Finance
By. Prof Riaz Ahmed Mian
Central
Bank
By. Prof Riaz Ahmed Mian
Monetary Policy
Prof. Riaz Ahmed Mian, HCBF, University of the Punjab
Monetary Policy
Meanings:
Monetary Policy refers to all those steps
that the central bank of the country takes
to influence, manage and control the
supply of credit and to regulate the
volume of credit in the economy.
Monetary Policy contd
Explanation:
The basic rule is that too much of a
good thing is also bad. So credit,
investment and expenditure are no doubt
extremely essential for a healthy economy
but they must be put under some limits.
Excess of all these variable could produce
harmful effects over the economy.
Objectives of
Monetary Policy
Objectives of Monetary Policy

Underdeveloped Countries:
Meanings:
Under develop countries or LDCs
(Less Developed Countries) are those
countries which are either extremely
backward or which are in the process of
development.
4
1.
To Achieve Full Employment
2.
To Have High Efficiency
3.
To Have Large Scale Resource
Mobilisation
4.
To Increase Exports
5.
To Have High Investments
6.
To Provide Price and Exchange
Stability
7.
To Have Efficient Allocation and
Utilisation of Resources
8.
To Accelerate Economic Growth
(contd..)
9.
To Raise Living Standards
According to SBP Act, 1956,

The bank is required to regulate and
foster the growth of the monetary and credit
system to ensure monetary stability and to
secure full utilisation of countrys productive
resources.
Developed Countries
Meanings:
Developed countries include Japan,
USA. Germany etc. The economy of these
countries is characterise by high per
capita income, high rate of growth,
savings and capital formation, high living
standards, sound infrastructure and
institutions etc.
Developed Countries contd
1.
2.
3.
4.
5.
To Have High Aggregate Demand without

Inflation
Eradicating Inflationary and Deflationary
Gaps
High Research/Further Development
Providing Assistance to Other Countries
Gaining Monetary Control over Others
Tools of Monetary Policy
Tools of Monetary Policy

I.
II.
Quantitative Tools
Qualitative Tools
10
Tools of Monetary Policy contd
I.
Quantitative Tools:
These tools are of such nature that

they produce effects on whole of the
economy without any distinction.
11
I.
Open Market Operations (OMO)

Meanings:
Open Market Operations may be
defined as purchase and sale of
government securities in the open
market by the central bank. This is
basically done with the objective of
influencing the monetary assets of
commercial bank.
12
Open Market Operations (OMO) contd
Functions:
Buying Securities: State bank can buy
securities either from the commercial bank or
from public.
Selling Securities: Securities can be sold
either to banks or to public.
13
Open Market Operations (OMO) contd
Result:
When central bank buys securities from

commercial banks, it pays them in money. This
increases cash reserves of the commercial bank
and hence their lending power increases.
When it sells securities, it hands over

securities to commercial banks. Commercial
banks pay cash to central bank. This reduces the
commercial banks cash reserves and their
lending power is reduced.
14
Effects on Interest Rate
When securities are purchased by the

central bank then commercial banks end up
with excessive cash reserves. In order to
attract borrowers and investors they lower
their interest rates.
15
Effects on Interest Rate contd
When securities are sold, this results

in reduced cash reserves with commercial
banks. If there is high demand for loans
from borrowers and investors, the interest
rate and hence cost of borrowing rises.
16
Purpose of Open Market Operations

1.
To administer and maintain the prices of

government securities.
2.
To create suitable climate for the
floatation of new loans.
3.
To activate the money market.
4.
To manage gold inflows and outflows.
5.
To create climate in which other tools of
monetary policy i.e., bank rate could be
used effectively.
6.
To avoid sudden fluctuation in the
money market.
7.
To support government credit.
17
Limitations / Assumptions
1.
Undeveloped Market:
For effective Open Market Operations
the money and capital markets must be fully
developed.
18
Limitations / Assumptions contd
2.
Excessive Cash Reserves:

The basic rational of open market
operations is to decrease cash balances of
commercial banks so as to reduce their lending
power.
19
3.
Availability of Securities:
For Open Market Operations to be
effective, there must be ample and adequate
securities. The central bank purchases
securities at high prices in order to stimulate
economy and to push it out of depression or
slump. On the other hand, it sells securities in
order to check inflation however for all this
there must be adequate amount of securities
i.e., the total amount of securities must form
some considerable proportion of the total
excessive cash reserves.
20
4.
Economic Climate :
The economic climate of the country

also determines the effectiveness of Open
Market Operations.
21
5.
Willingness of Borrowers :
The investors and borrowers attitude
is an important factor that can disturb the
central bank plans based on open market
operations.
If
the
borrowers
are
discouraged and disappointed and they have
become pessimist about future then they will
not like to borrow or to make investment.
22
6.
Willingness of Bankers :
The bankers attitude also plays a role
in deciding the fate of open market
operations.
7.
Borrowings of Central Bank:

The borrowings of the central bank
neutralise the effects of open market
operations.
23
Open Market Operations with

Reference to Pakistan
In Pakistan the money and capital
markets are not fully developed. Open Market
Operations are not widely used as a chief
instrument of monetary policy. There have
been sales and purchases of government
securities by the central bank, but these were
basically done to provide timely assistance to
bank.
24
II. Bank Rate:

Bank rate is another quantitative tool
of monetary policy. Bank rate is the rate at
which central bank is willing to rediscount
first class bills of exchange of commercial
banks or is willing to advance loans against
approved securities. This rate is also called
discount rate.
25
Other Objectives:
1.
To reduce consumption expenditure and
to generate savings.
2.
To improve the countrys balance of
payment position. This is done by encouraging
the inflows of foreign funds and by restricting
outflows.
3.
To reduce inflationary trends in the
economy by reducing credit creating potential
of commercial banks.
26
Assumptions & Limitations :

1.
Development of Capital and Money
Markets
2.
Availability of Bills
3.
Economic Climate
4.
Borrowers Attitude:
If due to bright future prospects, the
borrowers and investors are determined to
borrow, whatever the cost, then increase in
bank rate is unlikely to contract the supply of
credit.
27
Assumptions & Limitations contd
5.
Lenders Attitude:
The lenders attitude can also help or
hinder central bank to produce desire results. If
following their own priorities, commercial
banks keep on advancing loans despite higher
bank rate then such a credit control policy will
be a failure.
28
6.
Absence of Excessive Cash Reserves:

In order that bank rate policy be
effective and fruitful, commercial banks must
not be maintaining excessive cash reserves
with themselves. In such a case, they will have
to rediscount bill of exchange whenever they
feel need of extra reserves. Then they will be
directly affected by the changes in the bank
rate.
29
7.
Relationship between Rates:

For bank rate policy to be affective,
there must be active relation between inter
bank rates and open market rates. If changes in
discount rates and other inter bank rates brings
any affect on open market rates then bank rate
policy cant be used as an effective weapon to
curtail credit creating powers of commercial
banks.
30
III. Cash Reserve Requirements :

It is a well known fact that every
commercial bank is required to hold certain
amount of cash reserves with the central
bank. This amount is expressed as a certain
percentage of banks time and demand
liabilities. This percentage is called cash
reserve ratio.
31
IV. Liquidity Ratio :
The cash reserve requirements which are

discussed above, is a part of the overall
liquidity ratio.
The liquidity ratio is defined as follows:
It means the percentage of total

demand and time liabilities which
commercial banks must keep in the form of
cash, gold or approved securities.
32
V. Special Deposits:
Meanings: Besides reserve requirements, the
central bank may call additional reserve from
commercial banks. Such deposits are called
special deposits and they are expressed as a
percentage of banks liabilities. These deposits
are other than operational deposits and some
interest is paid on these deposits.
33
Qualitative Tools:
Quantitative weapons which have
been just discussed are of such nature that
they cause affects the whole of banking
system. They affect the whole economy
without any distinction. Apart from these
controls, there are some other weapons
which can be used in such a way that only
certain required sectors of the economy are
affected. Such weapons are called selective
or qualitative credit control weapons.
34
Qualitative Tools contd
I.
Credit Rationing:
Central bank does so by rediscounting bills or by

providing loans and funds. Credit rationing can be
used to control credit supply. In this method, the
central bank specifies a maximum limit to which it
is prepared to accommodate commercial banks in
financial pressure. Under this method central bank
can adopt following ways.
1.
It can restrict the amount of loan that a
commercial bank can obtain from central bank.
2.
It may refuse to rediscount bills beyond
certain amount.
35
II.
Credit Ceiling:
Credit ceiling is another qualitative
credit control weapon. Under this central
bank specifies the maximum supply of
credit to the economy during a particular
period.
36
III.
Moral Persuasion:
A friendly and polite type of credit
control is called moral persuasion. Here
instead of specifying a particular limit and
imposing penalties, central bank requests
the commercial banks to follow the general
monetary policy and credit control
guidance.
37
IV.
Direct Action:
When the commercial banks continue to

avoid the instruction of central bank, the central
bank can take direct action against them.
Through direct actions the central bank
restricts commercial banks from expanding credit.
Direct action can be taken in any of the following
ways:
Central bank may refuse to rediscount bills of

exchange of the defaulting commercial banks.
Or it may not provide direct financial

assistance, advances and loans to such
commercial banks which do not follow the general
38
monetary policy.
V.
Advertisement:
From time to time for general as well
as for specific purposes, the central bank
publicises the objectives and goals of
monetary policy. This can also increase the
efficiency of the whole banking and
financial infrastructure.
39
Limitations of Monetary Policy

1.
Absence of Developed Banking System:

The monetary policy is effective only
when practised in a developed economy
where money and capital markets are
working efficiently.
40
Limitations of Monetary Policy contd
2.
Not Applicable for Foreign Banks:

Another limitation is that central
bank cant always exercise its extensive and
special powers against all banks especially
against foreign banks.
41
3.
Conflicting Objectives:
Sometimes the situation is such that
monetary policy is required to achieve two
conflicting objectives. For instance if an
underdeveloped country is experiencing
high rate of inflation then economic
development and price stability both are
needed at the same moment.
42
4.
Large-Scale Deficit Financing:

Monetary policy is also affected by the
size of the Public Sectors, Borrowing
Requirements (PSBR) or by Public Sector
Debt Repayment (PSDR). Where the
government is borrowing heavily and running
a budget deficit, monetary policy will find it
difficult to achieve the objective of controlling
credit in the economy.
43
5.
Position of Bank Reserve:

If commercial banks are holding
excessive amount of reserves with themselves
then monetary policy cant effectively work.
44
6.
Economic Situation:
Economic situation also determines the
success of monetary policy. If monetary
situation is stable and businessman is
optimistic about the future, he will continue to
borrow from banks despite the high cost of
borrowing.
45
Establishment, Management
& Functions of the State
Bank of Pakistan
46
Establishment, Management & Functions

of the State Bank of Pakistan
1.
The History:
The Reserve Bank of India was directed

to perform all functions of the Central Bank of
Pakistan until Sep. 1948.
The Reserve Bank of India to be the sole

currency note issuing authority for Pakistan
until Sep. 1948.
(contd)
47
The History contd
The Indian currency notes will be valid

and they will remain legal tender in Pakistan
until Sep. 30, 1948. The Pakistan government
will issue its own currency from Oct. 1, 1948.
The Indian coins will be valid and they

will remain legal tender in Pakistan for at least
one year from the date of issuances of
Pakistani coins. The Pakistan government will
issue its own coins from Oct. 1, 1948.
(contd)
48
The History contd
The Reserve Bank of India will transfer

the Pakistans share of 75 crore to Govt. of
Pakistan till Sep. 30, 1948.
49
Establishment of the State Bank of Pakistan
On Dec. 30, 1948 the British

Government's commission distributed the Bank
of India's reserves between Pakistan and India
as 30 percent for Pakistan and 70 percent for
India. The share of Pakistan was Rs. 75 crore.
Irrespective of the provisions of the Monetary
system and Reserve Bank Order 1947.
(contd)
50
Establishment of the State Bank of Pakistan contd
The Reserve Bank of India did not

perform its function with diligence and good
faith for Pakistan. Also this Bank refused to
transfer Rs.550 million which Pakistan was
entitled to receive as the proportionate share of
assets of undivided India. Further the losses
incurred in the transition to independence
which were amounting to Rs. 23 crore were
taken from Pakistan's share.
(contd)
51
Establishment of the State Bank of Pakistan contd
Governor General of Pakistan Quaid-eAzam Muhammad Ali Jinnah issued the order
of the establishment of SBP on 12May, 1948.
This order is known as the State Bank

of Pakistan Order, 1948 and under this order
the SBP started its operations on July 1, 1948.
52
Objectives (Under 1948 Order)
Regulating the issue of bank currency

notes and keeping the reserves with the view to
securing monetary stability in Pakistan and
generally to operate the currency and credit
system of the country to its advantage.
(contd)
53
Objectives (Under 1948 Order) contd
Regulate the monetary and credit

system of Pakistan and to foster its growth in
the best national interest with the view to
securing monetary stability and the fuller
utilisation of the countries productive
resources.
So the SBP has twofold objectives i.e.,

issuance of the currency notes and the
advanced objective of leading the country
towards development and prosperity.
54
The Laws Governing SBP
The powers, functions, operations and

administration of the SBP are governed and
directed by the SBP Act, 1956 and the Banking
Companies Ordinance 1962.
(contd)
55
The Laws Governing SBP contd
Functions / Role of the SBP

1.
Issue of Currency Notes

Currency Note Issue Offices:
The SBP has 3 offices of currency notes
issue situated at Karachi, Lahore and
Peshawar. Apart from this currency chests are
situated all over the country. The currency
chests remain in the custody of the National
Bank of Pakistan or the Treasury Officers.
56
Functions / Role of the SBP contd
2. Banker to the Government

3. Bankers Bank
57
4. SBP as Clearing House
By acting as a clearing house the SBP /

NIFT introduces flexibility in the banking
operations and also remains informed about
the liquidity position of various banks.
SBP / NIFT helps commercial banks to

settle inter-bank transactions with the
minimum use of cash.
(contd)
58
SBP as Clearing House contd
By acting as a clearing house, SBP /

NIFT also keeps a check on unwanted and
harmful competition among commercial
banks.
The clearing house function of the SBP

also helps the commercial banks, in times
of need and crisis. They can help one
another by deferring early payments.
59
5. Advisor to Government
6. Lender of Last Resort
7. SBP as Controller of Credit
1. Open Market Operations
2. Bank Rate Policy
3. Changes in Reserves Ratio
4. Changes in Margin Requirements
5. Change in Liquidity Ratio
6. Moral Persuasion
7. Publicity
Also in 1972, a National Credit Consultative
Council (NCCC) was setup for the purpose of
monitoring and controlling credit.
60
thank U
Best of
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Central Bank

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Principles of

By. Prof Riaz Ahmed Mian

By. Prof Riaz Ahmed Mian

Prof. Riaz Ahmed Mian, HCBF, University of the Punjab

Prof. Riaz Ahmed Mian, HCBF, University of the Punjab

Monetary Policy contd

Prof. Riaz Ahmed Mian, HCBF, University of the Punjab

Prof. Riaz Ahmed Mian, HCBF, University of the Punjab

Objectives of Monetary Policy

To Raise Living Standards

According to SBP Act, 1956,

Prof. Riaz Ahmed Mian, HCBF, University of the Punjab

Developed Countries contd

To Have High Aggregate Demand without

Prof. Riaz Ahmed Mian, HCBF, University of the Punjab

Tools of Monetary Policy

Prof. Riaz Ahmed Mian, HCBF, University of the Punjab

Tools of Monetary Policy

Prof. Riaz Ahmed Mian, HCBF, University of the Punjab

Tools of Monetary Policy contd

These tools are of such nature that

Prof. Riaz Ahmed Mian, HCBF, University of the Punjab

Open Market Operations (OMO)

Prof. Riaz Ahmed Mian, HCBF, University of the Punjab

Open Market Operations (OMO) contd

Prof. Riaz Ahmed Mian, HCBF, University of the Punjab

Open Market Operations (OMO) contd

When central bank buys securities from

When it sells securities, it hands over

Effects on Interest Rate

When securities are purchased by the

Prof. Riaz Ahmed Mian, HCBF, University of the Punjab

Effects on Interest Rate contd

When securities are sold, this results

Prof. Riaz Ahmed Mian, HCBF, University of the Punjab

Purpose of Open Market Operations

To administer and maintain the prices of

Prof. Riaz Ahmed Mian, HCBF, University of the Punjab

Limitations / Assumptions contd

Excessive Cash Reserves:

Prof. Riaz Ahmed Mian, HCBF, University of the Punjab

Limitations / Assumptions contd

Prof. Riaz Ahmed Mian, HCBF, University of the Punjab

Limitations / Assumptions contd

The economic climate of the country

Prof. Riaz Ahmed Mian, HCBF, University of the Punjab

Limitations / Assumptions contd

Prof. Riaz Ahmed Mian, HCBF, University of the Punjab

Limitations / Assumptions contd

Borrowings of Central Bank:

Open Market Operations with

II. Bank Rate:

Prof. Riaz Ahmed Mian, HCBF, University of the Punjab

Assumptions & Limitations :

Assumptions & Limitations contd

Prof. Riaz Ahmed Mian, HCBF, University of the Punjab

Assumptions & Limitations contd

Absence of Excessive Cash Reserves:

Prof. Riaz Ahmed Mian, HCBF, University of the Punjab

Assumptions & Limitations contd

Relationship between Rates:

Prof. Riaz Ahmed Mian, HCBF, University of the Punjab

III. Cash Reserve Requirements :