Central bank

Also called: Monetary authority · Topic: Banking, Credit Creation and Monetary Policy · NCERT: Class 7, Ch 8 "Banks and the Magic of Finance"; Class 12, Ch 3 "Money and Banking"

Meaning

A central bank (also called the monetary authority) is a country's top (apex) money institution. It alone issues banknotes and controls the money supply (currency held by people plus their bank deposits). It acts as banker to the government and to banks, lends to banks as the lender of last resort, and holds the country's foreign exchange (forex) reserves.

It is not run to make a profit, unlike a commercial bank. Its main goals are stable prices, a stable financial system and support for growth. India's central bank is the Reserve Bank of India (RBI).

Explanation

What a central bank does: its core functions

• Monopoly of note issue: only the central bank may issue banknotes.
• These notes are fiat money, which has value because the government says so, not because gold or silver backs it.
• They are legal tender (money that nobody in the country can refuse as payment of a debt).

• Every note is a liability of the central bank, meaning something it owes.

• Banker to the government:

• It gives short-term loans when government spending runs ahead of receipts.

• It manages public debt. It sells government securities (G-secs), which are bonds through which the government borrows. It also pays interest on them and repays them when they fall due.

• Banker to banks:

• Banks keep accounts and reserves with it. One example is the Cash Reserve Ratio (CRR), the share of deposits that banks must keep with the RBI.
• It settles interbank payments by moving money between banks' accounts with it.

• It lends to banks, for example through the repo window (short-term loans to banks against government bonds).

• Custodian of forex reserves: it holds the country's foreign currency assets and gold. It uses them to keep the exchange rate steady and to pay for imports in a crisis.

• Regulator and developer: it supervises banks, oversees payment systems and brings poor and rural people into formal banking (financial inclusion).

Lender of last resort: why a central bank is needed

• The problem: a bank run
• Depositors fear that a bank may fail, so they all rush to withdraw their money.
• Even a healthy bank cannot pay everyone at once, because it has lent most deposits out.

• Panic can then spread to other banks.

• The central bank's answer

• It lends to a sound bank facing a liquidity crisis (a sudden shortage of cash) when no one else will lend to it.
• Depositors are paid, so the panic stops and does not spread.

The balance sheet: how a central bank earns

• Liabilities (what it owes): currency in circulation, deposits of banks and governments, and reserves such as the Contingent Risk Buffer (CRB).
• Assets (what it owns): foreign currency assets and gold, G-secs, and loans to banks and governments.
• Sources of income:
• interest on forex assets and G-secs;
• income from liquidity operations (lending to banks through repo and similar windows);

• seigniorage, the profit from issuing currency.

• Seigniorage worked example (illustrative):

• The RBI issues ₹100 crore of new notes, which cost very little to print.
• It uses them to buy ₹100 crore of G-secs that pay 7%.
• It earns about ₹7 crore a year, minus the small printing cost. That gain is seigniorage.

How much surplus goes to the government: the ECF

• The Economic Capital Framework (ECF) is the RBI's method for deciding how much risk capital (money kept aside to absorb losses) it must hold before it transfers its surplus.
• The Contingent Risk Buffer (CRB) is a reserve for sudden shocks, such as losses on forex or bonds. It is set as a % of the balance sheet.
• Formula (simplified):
• Required CRB = CRB % × size of the RBI balance sheet

• Surplus transferred = net income − (top-up needed to reach the required CRB)

• Cause and effect:

• Higher CRB → the RBI keeps more of its income → smaller surplus for the government.

• Lower CRB → the RBI keeps less → bigger surplus for the government.

• Worked example (illustrative numbers):

• The balance sheet is ₹70 lakh crore and the board picks a CRB of 6.5%.
• Required CRB = 0.065 × 70 = ₹4.55 lakh crore.
• The existing CRB is ₹4.0 lakh crore, so the top-up needed is ₹0.55 lakh crore.
• Net income is ₹3.4 lakh crore, so the surplus = 3.4 − 0.55 = ₹2.85 lakh crore.

In India

• Institution: the Reserve Bank of India is India's central bank.
• Origin:
• The Hilton Young Commission (1926), also called the Royal Commission on Indian Currency, recommended a central bank to be called the "Reserve Bank of India" [2].

• The Indian Central Banking Enquiry Committee (1931) took up the idea again [2].

• Law: the RBI Act, 1934 (Act II of 1934) was passed on 5 March 1934. It is the RBI's statutory basis, meaning the RBI exists because this law created it [2].

• Start: the RBI began work on 1 April 1935 as a shareholders' bank, owned by private shareholders. Sir Osborne Smith was its first Governor [3].
• Its head office was first in Calcutta. It moved permanently to Bombay in 1937.

• From 1937 it also worked as banker and currency manager for Burma [3].

• Nationalisation: on 1 January 1949, under the RBI (Transfer to Public Ownership) Act, 1948 [4]. Sir Benegal Rama Rau became Governor on 1 July 1949 [3].

• Currency split: the RBI issues banknotes. The Government of India issues coins and ₹1 notes, and the RBI puts these into circulation too.
• Legal tender: under Section 26 of the RBI Act, 1934, RBI banknotes, including the digital e₹, are legal tender anywhere in India and are a liability of the RBI [5].
• Banker to government:
• For the Centre, this is a duty under the RBI Act. For states, it is done by agreement with each state.

• Ways and Means Advances (WMA) are short-term, overdraft-like loans that cover timing gaps only.

• Payment systems: the RBI runs or oversees:

• RTGS, which settles large payments one by one, instantly;
• NEFT, which settles payments in batches;

• UPI, which is run by NPCI under RBI oversight.

• Digital rupee (e₹): this is a Central Bank Digital Currency (CBDC), which is legal tender in digital form and a direct liability of the RBI.

• The Finance Act 2022 changed the RBI Act so that "bank note" includes a digital form.
• The RBI released its Concept Note in October 2022 [6].
• The wholesale pilot (e₹-W) started on 1 Nov 2022 and the retail pilot (e₹-R) on 1 Dec 2022.

• Retail e₹ is a digital token that represents legal tender [7]. 19 banks offer e₹ wallets, and e₹ pays no interest [5].

• Surplus transfers:

• Bimal Jalan Committee (2019): set a CRB range of 5.5–6.5%. A record ₹1.76 lakh crore was transferred in 2019.
• 2025 ECF review: widened the CRB band to 4.5–7.5%. ₹2.69 lakh crore was transferred for 2024-25 (latest confirmed figure).

Don't confuse with

• Commercial bank: it takes deposits from the public and lends to earn a profit. A central bank does not work for profit and does not deal with the general public. It is the bank for banks and for the government.
• Government of India as currency issuer: the Government issues coins and ₹1 notes. All other banknotes are issued by the RBI, which holds the monopoly of note issue.
• Nationalisation (1949) vs start of central banking (1935): NCERT Class 7 says the RBI has been "banker of banks" since 1949. In fact it did central-banking work from 1935. The year 1949 changed only who owned it.
• UPI vs e₹: UPI moves bank-deposit money, which is a liability of a commercial bank. e₹ is central-bank money, a direct liability of the RBI.

Prelims Hooks

• The RBI was recommended by the Hilton Young Commission (1926). The RBI Act was passed on 5 March 1934 [2]. The RBI began work on 1 April 1935 as a shareholders' bank under Governor Sir Osborne Smith [3].
• It was nationalised on 1 January 1949 under the RBI (Transfer to Public Ownership) Act, 1948 [4]. Trap: central-banking work started in 1935, not 1949.
• Notes → RBI. Coins and the ₹1 note → Government of India. Under Section 26 of the RBI Act, RBI notes, including e₹, are legal tender and an RBI liability [5].
• Ways and Means Advances are short-term overdrafts, not long-term loans. The RBI is banker to the Centre by law and to states by agreement.
• ECF CRB bands: Jalan Committee (2019) = 5.5–6.5%. The 2025 review = 4.5–7.5%. A higher CRB means a smaller surplus for the government.
• Seigniorage is the profit from issuing currency. e₹ pays no interest, so that people do not pull deposits out of banks [5].

Mains Points

• Central bank surplus and fiscal policy (GS-III):
• Large transfers (₹1.76 lakh crore in 2019; ₹2.69 lakh crore for 2024-25) help the government meet its fiscal deficit target (the gap between what it spends and what it earns) without borrowing more.
• But a lower CRB leaves the RBI with a thinner cushion for future shocks.

• This sets central-bank independence against the government's need for revenue. The rule-based ECF tries to settle this debate.

• Lender of last resort vs moral hazard (GS-III):

• RBI support stops bank runs and prevents panic from spreading.
• But if banks expect to be rescued, they may take bigger risks. This is called moral hazard.

• So the support must come with strong supervision: checking cash balances and making banks report how much they lend, to whom and at what interest rate.

• From shareholders' bank to multi-role regulator (GS-II/III):

• The RBI moved from private ownership (1935) to public ownership (1949).
• Today it regulates banking, payments (RTGS/NEFT/UPI) and digital currency (e₹), and it promotes financial inclusion.
• The e₹ design, with no interest and wallets run by banks, keeps banks as the middlemen, so their lending and credit creation are not weakened. It still raises privacy concerns.

Related concepts

• Currency issue monopoly
• Banker to banks
• Lender of last resort
• Bank supervision
• Economic Capital Framework
• Central Bank Digital Currency
• Retail CBDC
• Wholesale CBDC

Read more

• The Reserve Bank of India: origin, functions and balance sheet