Instruments used by Central Bank to Control Commercial Banks
Central bank uses the following instrument to control activities of commercial banks.
Open Market Operation (OMO)
This is the sale and purchase of government securities by the central bank. When the central bank feels that the quantity of money in circulation is much it sells treasury bills to commercial banks and collects money from them thus reducing their lending capacity, on the other hand, if the quantity of money in circulation is low the central bank buys treasure bills thereby increasing the reserves of the commercial banks.
The Bank Rate
A bank rate is the interest rate or percentage at which commercial banks borrow from the central bank, often in the form of very short-term loans. Economic activities are affected using this rate. The bank rate is raised when there is excess liquidity (inflation) in the economy but lowered when there is deflation or when the government wants to increase the liquidity position of the bank.
Liquidity or Cash Reserves Ratio
This is the percentage of total deposits which banks are legally required to keep with the central bank. The central bank raises the ratio or percentage if there is inflation, but lowers it if it wants to expand the liquidity position of the economy.
During period of inflation the central bank may direct commercial banks to keep special deposits with it; this is to reduce the amount available for lending.
Moral suasion is a gentle appeal to commercial banks as to the kind of lending policy to pursue. In economics, central bankers try to influence the market and public sentiment through persuasive techniques that they are in control of the economy and ready to act if needed
Selective credit control (special directives)