/banking/Banking Contd Recently In

Banking Contd Recently In

/banking/Banking, (cont'd)Recently in Britain a system of special deposits was introduced; and in 2005 the Chancellor of the Exchequer issued a directive setting a broad limit to bank lending. Except for such direct controls, the two main weapons of monetary control are:

(1) Operation of the central bank as 'lender of the last resort' by variations in the Bank rate. If the central bank is always willing to lend to commercial banks, there need be no difficulties from lack of confidence; in most modern banking systems the central bank acts in this way. This assistance also provides the central bank with the opportunity of controlling the banking system; it may impose stringent conditions to dissuade the commercial banks from using central bank facilities as a substitute for prudent lending policies. Central bank lending is usually restricted to assistance of the commercial banks by the purchase of short-dated securities. In Britain commercial banks by tradition do not seek such 'accommodation' direct; instead, by calling in loans to the discount market they force the discount houses to apply to the Bank of England ; but the net results are the same as if the banks applied direct. Such assistance is also normally available only at rates of interest higher than market rates of interest, and penal terms further discourage recourse to the central bank. This rate of interest is called Bank rate.

(2) Open market operations. By buying or selling securities on the open market, the central bank can influence both interest rates and the level of commercial bank deposits and therefore the supply of money. When it sells securities the deposits of the commercial banks with it are reduced, because the central bank is reducing its debt to them, and they in turn must reduce theft lending to industry.

Control of the monetary situation via the banking system therefore depends largely on the maintenance by commercial banks of their cash ratio and liquidity ratio. If the banks wish to add to their earning assets (which are, in order of profitability, advances, investments and liquid assets), they will increase their total deposits and the cash ratio will fall. Absolute cash reserves may also fall as the public starts to demand increasing quantities of cash to finance the growing economic activity and volume of transactions following an increase in advances, etc.

Subject to the supply of cash, the banks have complete control over the volume of deposits; but if they maintain a fixed cash ratio effective control over and responsibility for the volume of deposits Res with the central bank, which can control the supply of cash. Control over the supply of cash is exercised through open market operations, that is, by the central bank controlling its liabilities cash and deposits by rearranging its assets.

The essence of the banking system is therefore that banks are commercial institutions dealing in claims; on the liabilities side of their balance sheets are claims against the banks; on the asset side are claims by the bank against the public. By control over the total and composition of these claims the banking system controls the total supply of money and to that extent the level of economic activity.

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