Concept 1 · free preview
What a bank is: legal definition, primary and secondary functions
Understand
A bank is a financial intermediary: it collects spare money from people who do not need it today (savers) and lends it to people who need it now (borrowers). The bank pays depositors a lower interest rate and charges borrowers a higher one; the gap (the spread) pays for its costs and profit. Indian law gives an exact definition. Section 5(b) of the Banking Regulation Act, 1949 says 'banking' means accepting, for the purpose of lending or investment, deposits of money from the public, repayable on demand or otherwise, and withdrawable by cheque, draft, order or otherwise. Three ideas are packed into this: deposits come from the public, they are taken in order to lend or invest, and they can be withdrawn. A trader who borrows from the public only to finance its own business is not doing 'banking' (Explanation to Section 5(c)). Banks also create money. When a bank gives a loan, it credits the borrower's account; that new deposit can be spent and re-deposited in another bank, which can lend a part of it again. Because banks keep only a fraction of deposits as reserves (CRR with RBI and SLR in safe assets), the banking system as a whole creates deposits several times its reserves. This is called credit creation.
Rule
Primary functions: (1) accepting deposits — savings, current, fixed and recurring; (2) lending — loans, cash credit, overdraft, bill discounting.
Secondary functions are of two kinds: agency functions (collecting cheques, paying bills and EMIs on standing instruction, buying/selling securities for customers) and general utility functions (lockers, letters of credit, bank guarantees, remittances, forex).
Section 6 of the BR Act lists the other businesses a banking company may do, such as dealing in bills, guarantees, letters of credit and acting as agent.
Section 7: only a banking company may use the words 'bank', 'banker' or 'banking' in its name, and a company doing banking in India must use at least one of these words.
Section 8 bars a banking company from trading in goods, except while realising a security or in connection with bills of exchange.
Credit creation: deposits create loans and loans create new deposits; the higher the reserve ratios, the smaller the money creation.
Example
Asha deposits ₹1,00,000 in a savings account. If banks keep about ₹20,000 as reserves (cash plus safe securities), ₹80,000 can be lent to Ramesh, a shopkeeper. Ramesh pays a supplier, who deposits ₹80,000 in another bank; that bank can again lend a part. Asha still sees ₹1,00,000 in her passbook, yet money in the economy has grown — that is credit creation.
Common mistake
Accepting deposits alone is not 'banking'; the deposits must be accepted for lending or investment and be withdrawable.
Issuing currency notes is not a function of commercial banks — only RBI issues bank notes (RBI Act, Section 22).
Lockers, LCs and guarantees are secondary (utility) functions, not primary functions.
A higher CRR or SLR reduces the credit-creation capacity of banks; it does not increase it.