Unit 6: Other activities of commercial banks

FIN203 — Commercial Banking 5 min read

I. Orientation: Beyond Deposit-Taking and Lending

Modern commercial banks earn well beyond the classical spread between deposit and loan rates (the "core" business). Fee income, agency services, technology-driven products and regulated non-fund activities now form a large share of revenue. This unit maps that widening perimeter, governed in India mainly by the Banking Regulation Act 1949 and RBI directions on para-banking and outsourcing.

Fund-based vs fee-based: Fund-based activity commits the bank's balance sheet (loans, overdrafts); fee-based activity earns commission without deploying funds (remittances, lockers, guarantees).
Core vs non-core: Core = accepting deposits and lending; non-core = support processes (IT, back office, cash logistics) that can be outsourced.
Regulatory boundary: A bank may undertake only business permitted under Section 6 of the BR Act; everything else needs explicit RBI approval.
Technology as substrate: Most new activities below ride on digital rails, so operational-risk and cyber-security controls apply throughout.

II. The Expanding Activity Set

A. Other basic banking activities

Services incidental to deposits and loans that generate steady fee income.

Remittances and collections: NEFT, RTGS, demand drafts; the bank moves value and charges per transaction.
Safe deposit lockers and safe custody: Rental of secured space; the bank is a bailee, liable only to the agreed extent.
Agency services: Collecting dividends, paying standing instructions, acting as executor or trustee.
Guarantees and letters of credit: Contingent liabilities—off-balance-sheet until invoked.

B. Para-banking activities

Permitted non-traditional businesses carried on departmentally or through subsidiaries, subject to RBI's Para-Banking Master Direction.

Equipment leasing, hire-purchase and factoring: Treated as banking-adjacent financing of assets and receivables.
Insurance and mutual-fund distribution: Banks act as corporate agents (bancassurance) earning distribution commission, with per-insurer caps on tie-ups.
Investment in and sponsorship of funds: Subject to prudential ceilings on capital markets exposure.
Pension-fund and depository participant services: Fee-based custodial roles.

C. Outsourcing of non-core activities

Delegating support functions while retaining accountability.

Principle: RBI's outsourcing guidelines hold that a bank cannot outsource its core functions—risk management, KYC decisioning, compliance and internal audit stay in-house.
Typical outsourced work: Call centres, cheque processing, cash-in-transit, IT infrastructure, document management.
Controls required: Board-approved policy, due diligence on vendors, right-to-audit clauses, data-confidentiality and business-continuity provisions.
Residual liability: The bank remains responsible to the customer and regulator for any lapse by the service provider.

III. New Entrants and Digital Models

A. Role of digital banks and fintech and neo bank

A spectrum of technology-first providers reshaping distribution.

Fintech: Technology firms delivering a narrow financial function—payments, lending, wealth—often partnering with licensed banks.
Digital bank: A licensed bank operating with little or no branch network, serving customers end-to-end online.
Neo bank: A customer-facing app with no banking licence of its own; it rides on a partner bank's licence and infrastructure for deposit-holding and settlement.
Impact: Lower cost-to-serve, faster onboarding, unbundling of products; banks respond by embedding fintech or buying stakes.

B. Digital wallets

Prepaid instruments storing value for quick payments.

Mechanics: Funds loaded into a wallet (e.g., via UPI or card) and spent at merchants; closed, semi-closed and open loop variants differ in where they can be redeemed.
Regulation: Issued as Prepaid Payment Instruments (PPIs) under RBI norms, with KYC-based loading limits.
Economics: Issuer earns on float, merchant discount and cross-sell; interoperability via UPI has compressed standalone wallet margins.

C. Peer to peer lending

Platforms matching individual lenders directly with borrowers.

Model: The platform does the credit scoring and servicing but does not lend from its own book; it is an intermediary, registered in India as an NBFC-P2P.
Risk sharing: Default risk sits with the lender, not the platform; RBI caps a single lender's aggregate exposure across all P2P platforms.
Attraction and limitation: Higher yields for lenders and quicker credit for thin-file borrowers, offset by illiquidity and no deposit insurance.

IV. Technology Infrastructure of Banking

A. Technology in banking

The digital stack that underlies every activity above.

Core banking system (CBS): Centralised ledger letting any branch or channel transact on a single customer record.
Channels: Internet banking, mobile apps, ATMs, UPI, IMPS.
Enablers: Cloud hosting, big-data analytics for credit and risk, and increasingly distributed ledgers for settlement.

B. Open banking APIs

Standardised interfaces exposing bank data and services to third parties with consent.

Mechanism: An Application Programming Interface lets an authorised third party fetch account data or initiate a payment via a secure call, only with the customer's explicit consent.
India's model: The Account Aggregator framework operationalises consent-driven data sharing between financial institutions.
Benefit vs risk: Enables account aggregation and embedded finance, but widens the attack surface—hence strong authentication and encrypted tokens.

C. Smart contracts

Self-executing agreements encoded on a blockchain.

Definition: Code that automatically enforces terms when predefined conditions are met, with no intermediary.
Illustration (pseudocode):

TEXT

on receive(payment) :
    if payment.amount >= invoice.due and date <= deadline:
        release(goods_title to buyer)
        send(payment to seller)
    else:
        refund(payment to buyer)

Banking uses: Trade-finance letters of credit, automated loan covenants, collateral release.
Limitations: Immutability makes bug correction hard; legal enforceability of code remains unsettled.

D. Two factor authentication

Layered identity verification for transaction security.

Principle: Confirms identity using two independent factors from—
- Knowledge: something you know (password, PIN).
- Possession: something you have (OTP to a registered phone, hardware token).
- Inherence: something you are (fingerprint, face).
Application: RBI mandates two-factor authentication for most card-not-present transactions in India (card details + OTP).
Weakness: SMS-OTP is vulnerable to SIM-swap and phishing, pushing adoption of app-based and biometric factors.

V. Artificial Intelligence in Banking

A. Fraud detection using AI

Machine learning that flags anomalous transactions in real time.

Approach: Models learn normal spending patterns, then score each transaction for deviation; both supervised (labelled fraud history) and unsupervised (outlier detection) methods are used.
Signals: Unusual location, velocity of transactions, device fingerprint, merchant category mismatch.
Payoff: Catches fraud faster than static rules and adapts to new patterns; the trade-off is false positives that inconvenience genuine customers.

B. Customer service personalization using AI

Tailoring products and interactions to individual behaviour.

Chatbots and virtual assistants: Natural-language models handle routine queries 24×7, escalating complex cases to humans.
Recommendation engines: Analyse transaction history to suggest relevant products (e.g., a loan top-up before a recurring large spend).
Governance: Requires data-privacy compliance and bias checks so personalisation does not become discriminatory.

VI. Cross Border Transactions

A. Cross border transactions

Movement of funds across national boundaries for trade and remittance.

Correspondent banking: Domestic banks hold nostro accounts (our money abroad) and vostro accounts (foreign bank's money with us) to settle across jurisdictions.
Messaging and settlement: SWIFT carries payment instructions; actual value settles through correspondent accounts or central-bank systems.
Trade instruments: Letters of credit and documentary collections reduce counterparty risk between exporter and importer.
Controls: FEMA regulations, AML/CFT screening and sanctions checks apply to every cross-border flow; emerging rails (CBDC corridors, stablecoins) aim to cut cost and settlement time.

VII. Loan Pricing

A. Marginal cost of funds based lending rate

RBI's internal benchmark linking lending rates to the current cost of fresh funds.

Purpose: Replaced the Base Rate so that policy-rate cuts transmit faster to borrowers.
Formula: