(a) What is a commercial bank? [4 marks] (b) Describe any four ways by which the Central Bank controls the amount of credit given by the commercial bank [16...

Answer Details

(a) Commercial bank. A commercial bank is a financial institution that accepts deposits from the public, keeps them safe, and lends or invests them, giving loans and advances and creating credit, while operating with the aim of making profit. It also provides services such as the transfer of money and the operation of current, savings and fixed-deposit accounts.

(b) Four ways the Central Bank controls credit given by commercial banks.

• Open market operations (OMO). The Central Bank buys or sells government securities in the money market. Selling securities takes cash out of the banks and reduces their ability to lend (credit contracts); buying securities puts cash into the banks and increases lending (credit expands).
• Bank (discount) rate policy. This is the rate at which the Central Bank lends to commercial banks. Raising the rate makes borrowing dearer, so banks raise their own lending rates and lending falls; lowering it encourages more lending.
• Cash (reserve) ratio requirement. The Central Bank fixes the minimum fraction of deposits banks must keep as reserves. Raising the required ratio leaves banks with less to lend, contracting credit; lowering it frees funds for more lending.
• Special directives and moral suasion. The Central Bank may issue directives or special deposit calls, or appeal to the banks (moral suasion) to restrain or expand lending in particular sectors.

Examination takeaway: for each instrument state the tool and then the direction, how a tightening move (sell securities, raise the bank rate, raise the reserve ratio) reduces the banks' capacity to create credit.