What is the Necessity of a Bank?
For a financial system to be well is functional in the modern economy, banks are the utmost. Banks perform important functions for society. These banks should be able to lend their money to the consumers and the business houses. In addition to this, the payments for goods and services are to be processed swiftly, safely, and at a lower cost.
Students studying commerce must know these banks and they also should have good knowledge about the difference between these two. In this section, we will priorly talk about the difference between Central Bank and Commercial Bank.
Central and Commercial Bank
Banks are mainly divided into – Commercial Banks and Central Banks. The Central and Commercial Bank plays an important role in the functioning of the economy. We need to clearly understand the meaning of these banks before we proceed to distinguish between the Central Bank and Commercial Bank.
What are Banks?
Banks are an integral part of the economy in a nation. They are the most important institutions which help to regulate the overall development of the economy.
Mobilisation of Money
Banks help in mobilizing the money in a nation. The banks act as a connecting pin between the government and the general population. The banks act as the facilitators of credit in the economy, they are an important component that drives growth in the stabilized economy.
The Two Types of Banks
There are two types of banks that are based on the system of authority, these are - central banks and commercial banks. The central bank can be called the apex banking system, they are responsible for formulating the monetary policy in an economy.
While, Commercial banks, on the other hand, are those banks that help in the flow of money in an economy by providing the facility of deposit and credit. Commercial banks provide financial services to individuals and businesses.
Definition of Central Bank
Central Bank is being the supreme financial institution that regulates the banking and the monetary system in the nation. This bank is formed for the purpose of monetary stability, issuing of notes, maintaining the value of a country’s currency in the international stock and commodity market. The Central Bank administers the currency and the credit system of the nation. The central bank which is RBI (Reserve Bank of India) plays the role of a centralized bank, which came into the existence, after passing the act in parliament in the year 1934. The bank is headquartered in Mumbai. These are the following functions which are fundamentally done by the Central Bank/RBI:
The RBI is authorized to issue the currency notes except for the coins and notes of a smaller magnitude amount.
RBI has the power to control, supervise and direct the commercial banks. RBI also helps these banks at the time of need or crisis.
The central bank employs various measures to control the credit operations of these commercial banks.
RBI is the banker and advisor to the government of India.
The RBI acts as the manager of the foreign exchange reserves.
RBI collects and publishes the information which relates to banking and the financial sector.
RBI oversees the credit and monetary policy of this nation.
Definition of Commercial Bank
The entities or the financial institutions that provide banking and financial services to a large number of people are known as the Commercial Banks. Commercial banks act as the mediator between the borrowers and the savers. The Commercial Banks receive the deposits from the general public and it lends it further to the general public or organizations of high interest. In this way, they facilitate the mobilization of savings that take place in the economy, thereby ensuring the economic cycle to go on smoothly.
Central Bank Vs Commercial Bank
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Difference Between RBI and Commercial Bank
FAQs on Difference Between Central Bank and Commercial Bank
1. What is the main difference between a central bank and a commercial bank?
The main difference lies in their core purpose. A central bank (like the RBI in India) is the apex financial institution focused on economic stability and public welfare. In contrast, a commercial bank (like SBI or HDFC) provides banking services to the public and businesses with the primary goal of earning profits.
2. What are the key functions of a central bank that commercial banks don't perform?
A central bank performs several unique functions that set it apart. These include:
- Issuing the nation's currency (banknotes).
- Acting as the banker and financial advisor to the government.
- Managing the country's foreign exchange reserves.
- Controlling credit and money supply to manage inflation.
- Serving as the lender of last resort for commercial banks.
3. What is the main objective of a commercial bank?
The primary objective of a commercial bank is to earn profit. It does this by accepting deposits from customers at a certain interest rate and lending that money out at a higher interest rate. The difference between these rates is the bank's main source of income.
4. Can a regular person like me open an account in the central bank?
No, the general public cannot open an account with a country's central bank. The central bank acts as a banker to the government and a banker to commercial banks. It does not provide direct banking services like savings accounts or loans to individuals.
5. Why is it necessary to have a separate central bank to supervise commercial banks?
A separate central bank is crucial to avoid a conflict of interest. Commercial banks are profit-driven, which could lead them to take excessive risks that might endanger the economy. The central bank, as a non-profit regulatory body, focuses on the long-term health and stability of the entire banking system, ensuring it operates in the public's best interest.
6. How does the central bank act as the 'lender of last resort' for commercial banks?
When a commercial bank faces a severe financial shortage and cannot borrow funds from other sources, the central bank provides emergency loans. This protective function is known as the 'lender of last resort'. It prevents bank failures, safeguards depositors' money, and maintains public trust in the financial system.
7. If commercial banks create credit, how does the central bank ensure they don't create too much?
The central bank uses several monetary policy tools to control the credit creation power of commercial banks. Key methods include adjusting the Cash Reserve Ratio (CRR), which is the portion of deposits banks must keep with the central bank, and changing the Repo Rate, which affects the cost of borrowing for commercial banks. These tools help manage the money supply in the economy.
