IGCSE Economics 0455: Central Bank vs Commercial Bank Roles

The government of Velmora has just established the Velmora Central Bank (VCB), the country's first central bank. Two long-established commercial banks, Portside Bank and Union Trust, continue to operate high-street branches across the country.

Portside Bank accepts savings deposits from local households and uses these funds to make loans to small businesses that are opening new shops.
The VCB has, for the first time, set Velmora's official rate of interest and is now the only institution permitted to issue Velmora's banknotes.
When Union Trust suffered a sudden loss of confidence from its depositors and could not find enough funds to meet a wave of withdrawals, it was the VCB, rather than Portside Bank, that lent Union Trust the money it needed to stay open.

(a) Identify two activities described above that are normally carried out by a commercial bank rather than a central bank. [2]

(b) Identify two activities described above that are normally carried out by a central bank rather than a commercial bank. [2]

(c) Explain why it was the VCB, rather than Portside Bank, that stepped in to lend money to Union Trust when it faced this loss of depositor confidence. [2]

Part (a): Commercial bank activities

Portside Bank’s two activities in the passage are both everyday commercial banking business: it accepts savings deposits from households, and it lends to small businesses opening new shops. Both involve dealing directly with ordinary customers and firms, which is the core role of a commercial bank rather than a central bank.

Part (b): Central bank activities

The VCB carries out three activities in the passage that are reserved for a central bank: it sets the official rate of interest for the whole country, it is the sole issuer of banknotes, and it lends to Union Trust when Union Trust cannot meet withdrawals. Any two of these count as central bank activities.

Part (c): Why the central bank, not a commercial bank, rescues a bank in trouble

Union Trust’s problem was not an ordinary business loan. It was a loss of depositor confidence that threatened the bank’s ability to operate at all. If Union Trust had been allowed to collapse, depositors at other banks might have panicked too, since a loss of confidence can spread quickly between banks that all rely on the public trusting them with their money.

The VCB, as the central bank, has a specific lender of last resort role: it is willing and able to lend to a struggling bank precisely to stop this kind of panic from spreading through the whole financial system, even when no ordinary commercial lender would take on that risk.

Portside Bank, in contrast, is itself a commercial bank competing with Union Trust for savers and borrowers. It has no special authority to create the scale of funds needed for a rescue, and rescuing a direct competitor is not part of what a commercial bank exists to do, that responsibility belongs to the central bank alone.

Final answers

(a) Accepting savings deposits from households; lending to small businesses.
(b) Any two of: setting the official rate of interest; issuing banknotes; lending to Union Trust as lender of last resort.
(c) The VCB is acting in its unique role as lender of last resort, protecting confidence in the whole banking system. A role no ordinary commercial bank, including a rival like Portside Bank, has the authority or responsibility to perform.