Central Bank and Commercial Bank: The Two Compared

A central bank issues the settlement asset that commercial banks hold and pay each other in, and it is nobody's customer. A commercial bank issues deposits that households and firms hold and pay each other with, and it is the central bank's account holder. The claim runs one way: a commercial bank holds a claim on the central bank, and never the reverse.

Both institutions have the word bank in the name. Both hold money that belongs to somebody else. Both publish a balance sheet with two sides that add to the same total. From a distance the two look like the same animal at two sizes. Almost everything a reader gets wrong about a central bank starts there, in the assumption that a central bank is a commercial bank scaled up.

One difference separates them, and it is not size. Every institution that takes money from somebody issues a promise back to them, and that promise is a liability to the institution and an asset to whoever holds it. The question worth asking is not how big the institution is, but whose promise everybody else settles up in. A deposit is money to a household because the household can pay with it, and a balance at the central bank is money to a commercial bank for exactly the same reason, one level further in. That stacking is the whole of the relationship, and once the stack is visible any arrangement at all can be placed on it.

Suvarna Commercial Bank Limited, an invented commercial bank, carries every rupee figure below, and every ratio is divided out of two figures printed in the same sentence. Almost every central bank number that exists anywhere is a maintained series that has moved by the time it is read. The central bank therefore carries no figure at all here, and is set out entirely by what it does and by which way the claim runs.

What is a commercial bank, and whose liabilities does it issue?

A commercial bank does three things, and all three are worth naming before anything is compared. The bank takes deposits that are repayable on demand at parRepayable whenever the holder asks for the money, and rupee for rupee. A hundred rupees put in comes back as a hundred rupees, not as whatever a hundred rupees turns out to be worth that morning.. The bank lends money out. And the bank settles payments between the accounts it holds. Money moving from one of its account holders to another is a pair of entries on its own books, and nothing leaves the building.

Every one of those three creates a liability. The deposit is the obvious one: the household put money in and the bank owes it back. A commercial bank's account holders are households and firms, its liabilities are their assets, and it is run by shareholders who expect a return on what they put in. Everything about it is a business, including the part that looks like a public service. The bank chooses which customers to take, prices what it lends, reports a profit and can make a loss.

A shop at the end of a street takes cash from the cooperative next door and keeps it in a safe overnight for a small fee. The shopkeeper owes that money back on demand. If the shopkeeper spends it and the cooperative asks for it at nine the next morning, that is the shopkeeper's problem and nobody else's. Scaled up by a very large number and given a lending book, the shape has not changed at all.

What is a central bank, and whose liabilities does it issue?

A central bank has to be defined without reference to a commercial bank, or the definition inherits the mistake. So set the commercial bank aside completely.

A central bank issues two things: the currency people carry around, and the balances commercial banks hold in accounts with it. The balances in those accounts are what one bank pays another bank with. When money moves from an account at one bank to an account at a different bank, something has to move between the two banks themselves, and what moves is a balance at the central bank. A central bank's account holders are banks and the government rather than households, its liabilities are their assets, and nobody runs it for a return.

The clause about nobody running it for a return does more work than it looks. Read it again. There are no shareholders sitting behind a central bank waiting to be paid for the use of their money. There is no board asking why the return was thin this year. A central bank is not a large bank, not the biggest bank in the country, and not the bank that other banks would use if they had a better option. Calling it a big bank feels harmless and it produces every single misunderstanding that follows on this subject.

Which way does the claim run between the two?

The answer falls out from the bottom up. Start at the bottom and work back.

A household's deposit is a liability of the commercial bank and an asset of the household. Two parties, one entry, opposite signs, and it nets to nothing when both sides are set down together. One level in, the balance the commercial bank holds at the central bank is a liability of the central bank and an asset of the commercial bank. Same shape, same pair of signs, one storey higher.

The direction never reverses: the central bank does not hold a deposit at a commercial bank, and there is no arrangement anywhere in which it would. This is not a convention that happens to hold at the moment, and it is not a rule somebody could relax. The direction falls out of what the two institutions are. A commercial bank needs a claim on the thing it settles in; the institution that issues that thing has no reason to hold a claim on anybody who does not issue it.

What does each one hold for the other?

The direction has a consequence worth drawing out slowly. The consequence looks lopsided until the reason for it becomes clear.

The commercial bank holds a reserve balanceA commercial bank's own account at the central bank, and the money sitting in it. A bank's day-to-day use of that balance is a subject of its own. at the central bank, and it sits on the asset side of its balance sheet alongside its advances and its investments. The reserve balance is the asset the bank uses to pay other banks. The central bank, meanwhile, holds nothing at the commercial bank. The central bank carries instead the other side of that very same entry, a liability to the commercial bank.

One entry, two sides, two institutions, and only one of them is holding. The everyday version is a shopkeeper who holds a bank balance. The bank does not hold a shop account in return, and nobody finds that strange or unfair. The shopkeeper needs a claim on the bank in order to pay suppliers; the bank has no need of a claim on the shop. The lopsidedness is the arrangement working, not the arrangement being unequal.

How is each one measured, and why does one measure not travel?

A commercial bank is measured on what it earns per rupee it holds and per rupee its shareholders put in. Take Suvarna Commercial Bank Limited's stated year. Its profit after taxWhat is left of a year's income once every expense, every provision and the tax bill have come off. A shareholder's return gets worked out from that figure. was Rs 2,250 crore. Divided by total assets of Rs 2,40,000 crore, the profit gives 0.9375 per cent for the year, reported as 0.94 per cent. The same Rs 2,250 crore divided by net worthWhat is left of an institution once everything it owes has been taken off everything it holds. Net worth is the shareholders' claim, and it is the last claim in the queue to be paid. of Rs 24,000 crore gives 9.375 per cent for the year, reported as 9.38 per cent.

The two returns are not rival answers. The second is the first multiplied by leverageHow many rupees of assets an institution carries for each rupee of its own money. Divide total assets by net worth., and the leverage here is Rs 2,40,000 crore over Rs 24,000 crore, which is 10.0 times exactly. A reader handed only the 9.38 per cent cannot tell whether it came from earning a lot per rupee held or from holding a great many rupees per rupee of shareholders' money, and those are completely different businesses. So print both limbs in the same place every time.

One caution about the arithmetic, and it catches careful readers more often than careless ones. Multiply the two reported figures together and 0.94 times 10.0 comes to 9.40 per cent, not the 9.38 per cent that is reported. Nothing is wrong. The rounding happens after the multiplication rather than before it, so the honest chain runs 0.9375 times 10.0 equals 9.375, and only then does 9.375 get reported as 9.38. Rounded numbers multiplied together carry the error with them.

The same question, asked of a central bank, falls apart. No shareholders run a central bank for a return, and no institution that issues the settlement asset can be short of it. The equity return question is therefore not merely uninteresting when applied to a central bank. It is structurally meaningless. This is not a hard question with a low answer. The equity return question has no place to attach itself. A missing answer and an inapplicable question are different kinds of nothing, and the second is why the comparison cannot be made on a scoreboard.

What can a central bank do that a commercial bank cannot?

One thing, and every other difference is downstream of it. A central bank can create the asset that everybody else settles in, so a claim on it denominated in that asset can always be met. A commercial bank can never do that. The commercial bank can only obtain more of the asset from somebody who already holds it, whether that is another bank, a depositor putting money in, or the central bank itself. Obtaining is not the same as issuing, and the distance between those two verbs is the distance between the two institutions.

Everyday version. A household cannot print a rupee, so a debt of eight thousand rupees falling due on Friday has to be met with eight thousand rupees obtained from somebody by Friday. Whether that happens depends on other people. An institution that issues the thing itself is never in that position, and can therefore stand behind arrangements nothing else can stand behind.

Four things a reader now wants to know are settled by rule rather than by mechanism. The borrowing corridor, the facilities the central bank operates inside it, how much of a deposit base cannot be lent out under the cash reserve requirementA rule saying that some fixed part of what a bank has taken in must be kept rather than lent out. How large that part is gets set by an authority and moves., who may hold an account at the central bank at all, and whether a balance there earns anything: every one is set by an authority, and every one of them moves. Each appears below as a named row with the place to confirm it printed inside.

What does a commercial bank do that a central bank does not?

The mirror of the last part, and it is just as absolute. A commercial bank decides who gets credit, name by name, and a central bank chooses no borrower at all. A central bank sets the conditions under which credit is made across the whole system. A commercial bank sits with one file, reads one set of accounts, forms a view about one particular applicant, and says yes or no to that person. Nobody at a central bank has an opinion about whether the second shop on a particular street should get its stock loan.

The difference decides who carries the consequence, and it matters more than it sounds. Suvarna Commercial Bank Limited reports gross non-performing advances of Rs 6,480 crore against gross advances of Rs 1,44,000 crore. The division gives 4.50 per cent of gross advances. Every rupee in that Rs 6,480 crore came from a decision somebody at the bank made about a named borrower. Choosing the borrower means carrying that cost when the choice goes wrong, and no other institution shares it.

Where do the two institutions meet on one balance sheet?

All of the above shows up as one line inside Suvarna Commercial Bank Limited's own asset side, and locating that line beats holding the idea in the abstract.

The total is Rs 2,40,000 crore. Two lines inside it charge interest: the Rs 1,44,000 crore the bank has lent out, and the Rs 60,000 crore it has invested. Together those come to Rs 2,04,000 crore of earning assetsThe part of what an institution holds that actually charges interest. On a bank that is its advances and its investments, and nothing else.. Take that off the total and Rs 36,000 crore is left over. The balance the bank holds at the central bank is somewhere in that leftover block, it earns the bank little or nothing, and it is therefore part of exactly the slice that separates a margin struck on earning assets from one struck on total assets.

The leftover block is never cut any finer in the record, and what share of it the central bank balance takes stays unstated. A split made up for the sake of an answer would look exactly like a reported one, and no reader could tell the two apart.

What does the direction look like on three lines already visible?

Run the check on Suvarna Commercial Bank Limited's own reported lines, one at a time, and the abstraction disappears.

Every row in that table is a pair, and every pair nets to nothing when both sides are set down together. Rs 1,92,000 crore is a plus for the depositors and a minus of exactly the same size for the bank. The balance at the central bank is a plus for the bank and a minus of exactly the same size for the central bank. The pair stays matched whatever size it turns out to be, and the shape can therefore be taught without knowing the amount. The last row is the one worth remembering. No line exists at which the central bank holds a claim on the commercial bank, and the row is struck through rather than left blank.

The record underneath all of this is thin: one bank, one year, and a short list of reported lines. Everything a reader instinctively reaches for next is absent from it, and the table below names what is missing.

Two things about these figures pull in opposite directions, and both are true. Hold them at the same time. The arithmetic above is exact to the rupee and it reaches almost nowhere. Every division above can be redone on paper and will come out where it says. A single bank drawn up for teaching cannot be typical of a population it was never drawn from. None of the arithmetic turns into a rate for any other period, none of it says whether one way of running a bank works better than another, and none of it describes a typical institution. Precision and reach are different properties, and the first never delivers the second.

Who actually uses this distinction, and what do they do with it?

Four people use it constantly, and none of them would describe it this way.

A household choosing where to keep money it will need next month is holding a claim on a commercial bank, not on the institution behind it. The honest version of the question is which failure they can see coming, not which promise sounds firmest, and the cover a deposit has if a bank fails is set by an authority.

There is no such question as what a central bank earned, and an analyst reading a lender never asks it. The analyst reads the two limbs together instead: what the lender made per rupee it held, and how many rupees it held per rupee of its own money. Handed one limb without the other, an analyst is being shown an answer with its working hidden, and the working is where the whole difference between two lenders lives.

Settling up with another bank means moving that balance one level in, and no other asset the bank holds will do the job. A treasury officer inside a bank thinks about that several times a day. And anybody reading a policy announcement needs to know that a change in the conditions under which credit is made is not the same event as a decision to lend to somebody. Confusing the two is how a general instrument gets read as a particular favour.