What Banks Do, and the Multifunctional Bank
Chapter Four
Syllabus topic 1, "Introduction"
Pages 17 to 20 of 453
In one line
A bank's functions divide into two: the primary functions, which are taking deposits and lending, and the secondary functions, which are agency and general utility services.
In the wording a student can write in an exam: the primary functions of a commercial bank are the acceptance of deposits and the granting of loans and advances, together with the creation of credit that follows from them; the secondary functions are agency functions, performed as agent for the customer, and general utility functions, performed for the public at large. A bank that carries on a wide range of the secondary functions alongside the primary ones is called a multifunctional bank, and section 6 of the Banking Regulation Act, 1949 is the provision that permits it.
Why the law lets a bank do more than banking
A bank that only took deposits and lent them would be a fragile institution. Its whole income would come from the spread between the two rates, and that spread narrows whenever competition increases or rates move against it.
The secondary functions solve that in two ways. They earn fee income, which does not depend on the spread and does not put the bank's own money at risk in the way a loan does. And they attach the customer to the bank: a customer whose salary, investments, locker and insurance all sit in one place does not move for a quarter of a per cent.
But the law had to draw a line, because a bank that could do anything would be risking depositors' money in ventures they never contemplated. That is why section 6 is a list rather than a general permission, and why section 8 forbids trading in goods altogether. Chapter 60 works both.
The primary functions
Accepting deposits. The bank takes money on current account, savings account, fixed deposit and recurring deposit, and each has different legal consequences, which chapter 360 works. This is the function that makes the institution a bank at all, because it is the one section 5(b) describes.
Lending and advancing. The bank lends by loan, overdraft, cash credit and by discounting bills. Module IV works the whole of it: chapter 490 the forms, chapter 500 the securities.
Creating credit, which is a consequence rather than a separate act. Because a bank must keep only a fraction of its deposits in cash, every loan it makes returns to the system as somebody's deposit and supports a further loan. The system as a whole therefore creates deposits several times the cash base, and that multiplier is precisely what the Reserve Bank controls through the cash reserve ratio in section 42 of the Reserve Bank of India Act, 1934. Chapter 260 works it.
What Banks Do, and the Multifunctional Bank
This is the point at which banking becomes a public concern rather than a private contract. A bank's lending decisions change the money supply, so the State has an interest in them that it does not have in an ordinary company's contracts.
The agency functions
Here the bank acts as the customer's agent, and the law of agency in the Indian Contract Act, 1872 supplies the duties. The bank collects cheques, bills and dividends for the customer; pays insurance premiums, rent and taxes on standing instructions; buys and sells securities on his instruction; acts as executor, administrator and trustee; and remits funds.
The legal consequence is not decorative. When the bank collects a cheque it is an agent for collection, and its protection against a claim by the true owner depends on that character, under section 131 of the Negotiable Instruments Act, 1881. Chapter 450 works it. When it acts as trustee, the money it holds is not part of its general assets, which chapter 310 works.
The general utility functions
These are performed for the public, not as anyone's agent. They include issuing letters of credit, travellers' cheques and bank drafts; giving guarantees; dealing in foreign exchange; providing safe deposit vaults and safe custody; underwriting issues of shares and debentures; and furnishing credit information.
Two of them carry disproportionate legal weight. The safe deposit locker produced a Supreme Court direction to the Reserve Bank to frame rules, worked in chapter 360. The bank guarantee is the most litigated non-lending business a bank does: in U.P. Cooperative Federation Ltd. v. Singh Consultants and Engineers (P) Ltd., (1988) 1 SCC 174, the Supreme Court held a guarantee to be an independent contract which a court will not interdict save on proved fraud or irretrievable injustice. Chapter 510 works it in full.
A worked example: one customer, six functions
Sunita Deshpande banks with a branch in Pune. Her salary is credited on the first of the month, which is a deposit. She has a car loan, which is lending. Her electricity bill is paid by standing instruction, an agency function.
She keeps her flat's title documents in a locker, a general utility function performed as bailee. Her firm imports machinery and the bank issues a letter of credit to the German seller, another general utility function. When she buys the machinery for the firm and the seller wants security for performance, the bank issues a bank guarantee.
Now see the exposure. The deposit is a debt the bank owes. The car loan is money at risk of the borrower's default. The locker is a bailment with a duty of care. But the guarantee is different in kind: the bank must pay the German seller on demand, whatever Sunita says about the machinery, unless fraud is proved. The bank's own money leaves before any dispute is decided, and its only recourse is against its customer afterwards.
What Banks Do, and the Multifunctional Bank
That is the objective behind the multifunctional bank and its price in one example. Six services from one relationship, each earning income and none of them requiring a fresh customer, but the risks are of quite different natures, and the guarantee's risk is the one a student most often misses.
Primary against secondary, in a table
| Primary functions | Secondary functions | |
|---|---|---|
| What they are | Accepting deposits, lending, and the credit creation that follows | Agency services and general utility services |
| Legal source | The definition itself, section 5(b) of the Banking Regulation Act | The permission in section 6 of that Act |
| Whose money is at risk | The bank's, through the borrower's default | Usually none, except in a guarantee or an underwriting |
| Income | The spread between deposit and lending rates | Fees and commission |
| Can a bank exist without them | No, they are what make it a bank | Yes, but it would be a weaker institution |
The objective behind the growth of multifunctional banking
Five reasons, and the question MU sets asks for them.
One, income that does not depend on the spread. Fee income is stable when interest margins are squeezed, and it consumes no capital, which matters under the capital adequacy norms.
Two, the customer relationship. Cross-selling to an existing customer costs a fraction of acquiring a new one, and every additional service makes the customer harder to lose.
Three, use of a network already paid for. The branch, the staff and the technology are fixed costs; putting more services through them lowers the cost of each.
Four, competition. Once the 1991 reforms let new private banks in, a bank offering only deposits and loans lost customers to one offering everything, and the movement became defensive as much as ambitious.
Five, the customer's own convenience, which is a real reason and not a slogan: a single relationship for payments, credit, investment and insurance is simply easier to use.
The case against, which a good answer gives
The risks are conglomerate risks. A loss in an underwriting or a guarantee falls on the same balance sheet that holds the deposits, and the depositor did not agree to underwrite anything. That is the argument for keeping banking narrow, and it is why section 8 exists and why section 19 limits what subsidiaries a bank may hold.
Mis-selling is the practical complaint, and it is what the Reserve Bank's conduct regulation now addresses: insurance and investment products sold at a bank counter carry the bank's authority even though the bank bears no risk on them.
What Banks Do, and the Multifunctional Bank
Supervision becomes harder. A bank doing many things is examined by one supervisor for banking and possibly by others for securities and insurance, which is why the regulatory perimeter and coordination between regulators is a live question.
Quick revision
Primary functions: accepting deposits; lending and advancing; the credit creation that follows.
Secondary functions: agency functions, done as the customer's agent, and general utility functions, done for the public.
Section 6 of the Banking Regulation Act is the permission for the secondary functions; section 8 forbids trading in goods; section 19 limits subsidiaries.
The objective behind multifunctional banking: fee income, customer retention, use of an existing network, competition after 1991, and customer convenience.
The price: conglomerate risk on the deposit-taking balance sheet, mis-selling, and harder supervision. The bank guarantee is the sharpest example, on Singh Consultants.
Test yourself
1. Distinguish a primary from a secondary function of a bank, and give one of each. A primary function makes the institution a bank and is described by the section 5(b) definition, for example accepting deposits. A secondary function is permitted by section 6 and is not part of the definition, for example collecting a cheque as the customer's agent.
2. What is credit creation and why does the law care? Because a bank keeps only a fraction of its deposits in cash, its lending returns to the system as further deposits and multiplies the money supply. The law cares because the multiplier is controlled through the cash reserve ratio under section 42 of the Reserve Bank of India Act, 1934.
3. Give three reasons for the growth of multifunctional banking. Fee income independent of the interest spread; retention of the customer through cross-selling; and better use of a branch network whose costs are fixed. Competition after 1991 and customer convenience are two more.
4. Which secondary function exposes the bank to the most immediate risk, and why? The bank guarantee. Under Singh Consultants the guarantee is an independent contract and the bank must pay on demand unless fraud or irretrievable injustice is proved, so its money leaves before the underlying dispute is decided.
5. Which two sections keep the multifunctional bank within limits? Section 6, which lists what a banking company may do, and section 8, which forbids it to deal in goods except in realising its security.
The rest of this subject
These notes are cut from the University's printed syllabus. Open the syllabus itself, or the past papers, for the same subject.