Commercial Banks: What They Do That No One Else Does

A commercial bank does three things together that nothing else in finance is permitted to do together. It takes deposits repayable on demand at their face value, it lends that money out for longer than the deposits are committed for, and it settles payments so a balance can travel to somebody else. The deposit is the part that needs a licence.

Most people, asked what a bank does, name one of the three functions, usually lending. Lending is the visible function, and it is also the one with the least to do with why banks are treated as a category of their own, kept under a licence, and worried about by people who never worry about a shop or a factory. Plenty of institutions lend. A moneylender lends. A supplier who ships goods in March and asks for payment in June has lent. Almost nothing else takes a depositor's money this morning on a promise to hand the identical number back this afternoon, uses it in the meantime to fund something that will not come back for seven years, and lets that depositor pay an electricity bill out of the same balance while all of that is going on.

One sentence carries the whole argument. A bank is not a lender with a bigger sign outside. A bank is the one arrangement that funds long lending with money it has promised to repay on demand at face value, and settles other people's payments out of the same balances.

What are the three functions, and why do they have to travel together?

The set is the definition, and no single member of it is. Write all three out before opening any one. A commercial bank accepts deposits repayable on demand at par. The bank makes advances out of that money. And it settles payments between accounts. A balance sitting with the bank can be moved to somebody who holds a balance somewhere else.

Plenty of institutions do one of these, and some do two. Doing all three together is what the word bank means, and it is what requires a licence. A lender that raises its money from the market and hands it on does the second. An arrangement that only moves money between accounts does the third. Neither of them may do the first, and the first is what makes the other two behave the way they do inside a bank.

The licence repays a closer look. A banking licence is not a licence to lend. Anybody with money is free to lend it. The licence is a licence to accept money from the public on a promise of one particular kind, and the conditions attached to it are the Reserve Bank of India's to set. Each of those conditions is named below, with the address of the body that sets it in place of a value.

What do the words at par and on demand actually promise?

Two words, two separate promises, and it is worth pulling them apart because removing either one turns a deposit into something else entirely.

At par means a rupee put in is a rupee coming out. The number does not move. The number does not move for any of the usual reasons: a market fell, rates rose, the bank had a poor year, or somebody else wanted to sell the same thing on the same afternoon. A salary of Rs 60,000/- credited on the first is Rs 60,000/- on the first, and it is still Rs 60,000/- on the fourth, whatever happened anywhere that week. A traded claim has a price, and a price is the whole point of trading it. Every traded claim in finance breaks that promise as a matter of course.

On demand means today, without notice, without a market and without a buyer. That last part is the one people skip. When a holder sells a traded claim, somebody has to be on the other side of it: the money arrives because a buyer appeared and agreed a price. When a depositor withdraws, nobody appears. There is no counterparty, no price, no queue for a matching order. The bank simply pays, out of what it holds, at the number printed.

The two together make a promise with no equivalent anywhere else in finance: a fixed number, available immediately, with no market standing between the holder and it. The combination is why the balance is convenient, why the bank pays so little for it, and why the whole arrangement has to be licensed.

A claim always has two ends. Now write the same deposit down from both. Deposits at Suvarna Commercial Bank Limited, an invented bank, come to Rs 1,92,000 crore, four fifths of everything the institution holds. The deposit total sits on the bank's books as a liability. The identical Rs 1,92,000 crore sits on the depositors' side as an asset. The two added together come to Rs 0/-, and that is not a curiosity: it is the test of whether one claim is in view or two. Nothing was created by writing it down twice. One promise exists, and it has been recorded from each end.

What does a lender that takes no deposits do differently?

The clean way to price the deposit is to look at a lender that does not have one. Rukmini Finance Limited, an invented lender, is a finance companyA lender that raises its money in the market and takes no deposits. What such a lender is like as a business in its own right is worked through separately.. It lends. Rukmini Finance Limited is not permitted to accept a deposit, so not one rupee of what it lends arrives as one. The money is raised from other lenders instead: Rs 14,400 crore of borrowings sit behind Rs 18,000 crore of assets under management, with Rs 3,600 crore of net worth underneath. Borrowings and net worth together come to exactly the Rs 18,000 crore it holds. The two lines are the whole of its funding side.

The two are not the same arrangement bought at two different prices. The deposit and the market borrowing are different arrangements, and three things separate them.

The first is how the money leaves. A deposit base runs away in a queue: everybody may ask on the same morning, and nobody has to give notice. Market borrowing does not do that. Market borrowing sits until its date and then simply fails to be renewed. The failure is slower, more visible, and lands on a calendar somebody can read in advance. Both are dangerous, in different shapes.

The second is who sets the price. A household accepts a low rate on a balance because the balance is convenient, reachable and usable. A market lender to a finance company gets no convenience out of the arrangement, and accepts nothing of the kind. The market lender is getting a rate, and sets that rate against what else it could do with the money. So one lender's funding cost is decided by what a household will accept for convenience and the other's is decided by whoever is lending to it that quarter.

The third is the one nobody expects, and it is the sharpest. Nobody pays anybody with a liability of a finance company. A lender's borrowing cannot be handed to a shopkeeper. But a balance at Suvarna Commercial Bank can be handed to somebody else, and when it is, the bank moves it and the shopkeeper accepts it as money. The ability to hand a balance on is why one of these two settles payments and the other settles nothing, and why the third function could never have belonged to a finance company.

What does the deposit actually buy, in rupees?

Now put a number on it, and be careful about the base. The base is exactly where a comparison goes wrong.

Suvarna Commercial Bank Limited paid interest expended of Rs 11,160 crore in the stated year. Divide the entire bill by the deposit base of Rs 1,92,000 crore and the answer is 5.8125 per cent across the year, printed at two places as 5.81 per cent. 5.8125 per cent is an upper limit on what deposits cost, and calling it the cost would be wrong. Sitting above the deposit base and the net worth is a further Rs 24,000 crore the bank owes, on terms this record never states. Some slice of the interest bill was paid to whoever holds it. Loading all of it onto the deposit base can only make the deposit look dearer than it is, never cheaper. The answer is therefore an upper bound, and the bound is useful anyway.

Rukmini Finance Limited has no deposits to strike a rate on. The lender reports a cost of borrowingsWhat a market funded lender pays for a year on the money it has borrowed, struck on the borrowed amount rather than on everything it holds. of 8.50 per cent a year on its borrowings of Rs 14,400 crore. Interest for the year comes to Rs 1,224 crore.

Set the two down with both bases named. At most 5.8125 per cent on the deposit base against 8.50 per cent on the borrowed base. The gap is at least 2.6875 percentage points, printed as 2.69. One side of the gap is a ceiling, so the gap is a floor rather than a point estimate. The true gap can only be wider. The gap is what the deposit buys, and it buys it not because the bank negotiated well but because a household will accept a low rate on money it can reach this afternoon and pay a bill with.

The everyday version is a street vendor and a wholesale supplier. The customer is buying a snack rather than lending, so the vendor takes cash across the counter all day at no cost at all. Sixty days' credit is a loan and both sides know it, so the supplier who ships stock on those terms charges for the sixty days one way or another. Convenience on one side is a discount on the other. Convenience bought at a discount is the whole mechanism, and the bank runs it at Rs 1,92,000 crore.

What does the deposit cost, once everything is counted?

A comparison that stops at the funding gap has told half the story, and the flattering half. The deposit is not free money with a discount attached. The deposit brings three things with it that a market funded lender never carries, and all three are the reason the licence exists.

The first is that not all of it may be lent. A part of a deposit base has to be kept rather than deployed, and a set of liquidity conditions attaches to the rest. Which part, and which conditions, are the Reserve Bank of India's to set, and they move.

The second is the cover that sits beneath a depositor if the institution fails. The cover exists precisely because the promise is at par and on demand and made to the public. The cover, what it applies to and what it does not, belongs to the Deposit Insurance and Credit Guarantee Corporation.

The third needs no regulator at all: the deposit can leave tomorrow. Market funding contracted to a date cannot. Leaving is not a rule imposed on the bank but the promise the bank made in order to get the money cheaply in the first place, and it is inseparable from the discount.

Wherever a requirement decides an answer, the row is drawn and named, and then left empty with the address of the party that sets it printed inside. A requirement typed out from memory does the reader harm rather than good. Set down in print it is indistinguishable from a figure somebody verified, it goes stale without any outward sign, and whoever believes it ends up worse placed than whoever received an empty box and a place to look. Hence the form.

Retail Bank vs Corporate Bank: what does each side actually run?

Start with what is missing from the record. The honest version of this part starts there. Suvarna Commercial Bank Limited reports one year of consolidated figures and no split of its advances or its deposits by customer type. There is no retail column and no corporate column anywhere in it. So the two sides below are described by their shape, with no rupee figure attached to either. A split that was made up would read exactly like a counted one.

The retail side

Deposit relationships in enormous numbers, each of them modest, and advancesThe bank's word for money it has handed over and expects back. Judging a borrower, and pricing what they are charged, are worked through separately. in the same shape. Standardised products. A product designed once and sold a million times is the only way the arithmetic works at that unit size. And a cost of distribution and servicing that scales with the number of customers rather than with the number of rupees. Opening an account, answering a query and chasing a missed instalment cost about the same whether the amount is Rs 5,000/- or Rs 5,00,000/-.

The economics are one fact seen twice: the funding is cheapest on this side and the operating cost is highest on this side. They are the same fact because they have the same cause. A small depositor is buying convenience rather than a rate, and that is what makes the money cheap. The same small depositor generates a full account's worth of servicing on a small balance, and that is what makes the cost high. The first cannot be taken without the second.

The corporate side

Few large deposit relationships and few large advances. Terms negotiated one at a time rather than printed on a form. A single relationship is worth the negotiation. And a cost of coverage that scales with the number of relationships rather than with the number of rupees. One team covering one large customer costs roughly what it costs regardless of how many rupees that customer moves.

The mirror holds exactly: the funding is dearer here because a large depositor negotiates, and the operating cost per rupee is lower here because one relationship carries a great many rupees. A treasurer with a large balance knows what it is worth, compares it against what else could be done with it, and asks for a rate. A household with a salary account does not, and is not being foolish: the household is buying something the treasurer is not buying.

Are they different businesses, or the same business at different sizes?

Most treatments duck this, so here it is plainly. Retail and corporate are the same three functions performed at different unit sizes, and the difference shows up in the cost lines rather than in the functions themselves. A retail deposit and a corporate deposit are both money repayable on demand at par. A retail advance and a corporate advance are both money lent and expected back. A retail payment and a corporate payment both move a balance from one account to another.

The point matters more than it looks. A reader who expects two different mechanisms will go looking for the second one and will not find it. There is no separate machinery on the corporate side. The size of one relationship changes, and everything else follows from that: the cost of acquiring it, the cost of servicing it, the rate that has to be paid for it and the rate that can be charged on it. Change the unit size and every cost line moves. Nothing else does.

An everyday version, and it is exact rather than loose. A tea stall and a canteen supplying one office building both buy, prepare and sell. Neither is doing something the other is not. The stall serves four hundred customers at Rs 15/- and the canteen serves one contract at a time. The stall's cost of serving a customer is enormous relative to the sale and its cash comes in with no negotiation at all. The canteen negotiates every term and serves far fewer relationships for the same money. Same three activities. Completely different cost sheets.

What do the two lenders look like side by side, in rupees?

The two arrangements separate on the funding side, so work both funding sides first.

Take the bank first. Rs 2,40,000 crore of assets are funded three ways. Deposits account for Rs 1,92,000 crore, four fifths of the whole. Net worthThe shareholders' share of a balance sheet: whatever remains once every claim against the institution has been met. accounts for Rs 24,000 crore. With both subtracted from the asset total, Rs 24,000 crore is still unaccounted for, so the bank owes that much to somebody on terms this record never states. The Rs 24,000 crore owed elsewhere is arrived at rather than reported, and it stands as an absence rather than as something plausible.

Rukmini Finance Limited holds assets under management of Rs 18,000 crore. Against them sit borrowings of Rs 14,400 crore, again 80.0 per cent of the total, and net worth of Rs 3,600 crore. The two add to Rs 18,000 crore with nothing left over.

So both institutions are funded four fifths by somebody else's money, and that shared number is exactly why the comparison is worth making. The share is identical. The arrangement behind the share is not, and no ratio on the funding side will ever show it.

The next question is what each lender does with the gap it has bought, with every base named along the way.

Rukmini Finance Limited lends at a yield on advances of 14.50 per cent a year. On Rs 18,000 crore that is Rs 2,610 crore of interest earned. The company pays 8.50 per cent a year on Rs 14,400 crore of borrowings, or Rs 1,224 crore. Its net interest incomeInterest earned for a period less interest paid over the same period. How the line is built and what it is properly divided by are worked through separately. is therefore Rs 1,386 crore, or exactly 7.70 per cent of its assets under management.

Note that this is wider than the 6.00 percentage point spreadThe gap between the rate a lender earns and the rate it pays, with the base each of the two rates is struck on named alongside. between the two rates, and the reason is a base difference rather than anything clever. The lender earns on Rs 18,000 crore and pays on only Rs 14,400 crore, so the Rs 3,600 crore funded by its own net worth earns without paying. At 8.50 per cent that is Rs 306 crore, exactly the difference between the Rs 1,386 crore it reports and the Rs 1,080 crore that 6.00 per cent of Rs 18,000 crore would give. How that arithmetic generalises is worked through separately.

For the bank, interest earned came to Rs 18,600 crore for the year and interest expended to Rs 11,160 crore, leaving net interest income of Rs 7,440 crore. Advances of Rs 1,44,000 crore added to investments of Rs 60,000 crore give earning assetsThe slice of a lender's holdings that actually earns interest. The measures struck on that base are worked through separately. of Rs 2,04,000 crore, and the Rs 7,440 crore against that base reads 3.65 per cent across the year. Name the base on every outing. The very same Rs 7,440 crore measured against the full Rs 2,40,000 crore of assets comes out at 3.10 per cent instead. Nothing the bank did moved between those two readings. Only the number underneath the line moved.

Here is the finding, and it is not the one most readers expect: the lender without deposits runs the far wider margin and is not the more profitable business per rupee of equity. Hold that thought for two paragraphs.

Why can the same return on equity mean two different businesses?

Two lenders can land on the same return on equity and still be nothing alike.

Suvarna Commercial Bank Limited earned profit after tax of Rs 2,250 crore in the stated year. Over total assets of Rs 2,40,000 crore that is a return on assetsProfit after tax for the year divided by the assets held, so it says how much is earned per rupee of holdings. of 0.9375 per cent, printed as 0.94 per cent. Over net worth of Rs 24,000 crore the same Rs 2,250 crore is a return on equity of 9.375 per cent, printed as 9.38 per cent. Take that 0.9375 per cent, apply leverageAssets held for each rupee of net worth. Here it is Rs 2,40,000 crore divided by Rs 24,000 crore. of 10.0 times, and the equity figure follows.

Rukmini Finance Limited earned profit after tax of Rs 337.50 crore. Over assets under management of Rs 18,000 crore that is 1.875 per cent, printed as 1.88 per cent. Over net worth of Rs 3,600 crore it is 9.375 per cent, printed as 9.38 per cent. Same second figure. The first is twice the bank's and the leverage is half.

The two equity figures match for a reason, and an identical number left unexplained looks like somebody copied a row wrong. One institution earns half as much on each rupee it holds and carries twice as many rupees per rupee of net worth, and the two effects cancel to the last decimal. Rank the pair on the equity figure by itself and they are indistinguishable. Almost nothing about how they operate is alike.

One arithmetic warning, and it catches careful people. Multiplying the printed limbs gives the wrong answer. 0.94 multiplied by 10.0 is 9.40, and 1.88 multiplied by 5.0 is 9.40, and neither of those is 9.38. Nothing is wrong with the figures. Rounding a limb to two places before multiplying it by ten moves the product by more than the rounding itself. The exact limbs are 0.9375 and 1.8750, and the decomposition has to be done on those and printed alongside the reported ones.

What was never there to work with?

Everything above sits inside a single period for two made up institutions, and the honest close to a worked instance is the list of things that were absent from it. Somebody who wants to push this arithmetic one step further needs to know which step is the last one.

Two things hold together here, and both belong in the account rather than only the flattering one: the arithmetic closes to the rupee, and it reaches almost nowhere. Precision and reach are separate properties, and a worked instance earns trust by admitting the second while demonstrating the first. Nothing above turns into a rate for a different stretch of time. Nothing above is evidence about what any way of running a lender delivers. Two made up institutions cannot be typical of anything, so nothing above is typical.