UNIT 9

Objectives The

BANK CREDIT - PRINCIPLES AND PRACTICES

objectives of this unit are to explain: The basic principles of sound lending The style of Credit their merits and demerits The types of security required and the modes of creating charge, and The methods of credit investigation

Structure 9.1 Introduction 9.2 Principles of Bank Lending 9.3 Style of Credit 9.4 Classification of Advances According to Security 9.5 Modes of Creating Charge Over Assets 9.6 Secured Advances 9.7 Purchase & Discounting of Bills 9.8 Non Fund Based Facilities 9.9 Credit Worthiness of Borrowers 9.10 Summary 9.11 Key Words 9.12 Self Assestment Questions 9.13 Further Readings Appendix : Observations of RBI on working capital cycles and Demand for bank credit

9.1

INTRODUCTION

Bank credit constitutes one of the major sources of Working Capital for trade and industry. With the growth of banking institutions and the phenomenal rise in their deposit resources, their importance as the suppliers of Working Capital has significantly increased. Of the total gross bank credit outstanding as at the end of August 22, 2003, of Rs.6,63,122 crore, Rs.2,78,408 crore is advanced to industry. This works out to around 41.98 percent. More particularly, there has been significant rise in the credit towards industry in the recent past. In this unit, first we shall examine the basic principles of bank credit, followed by a detailed account of the various types of credit facilities offered by banks and the securities required by them.

9.2

PRINCIPLES OF BANK LENDING

While granting loans and advances commercial banks follow the three cardinal principles of lending. These are the principles of safety, liquidity and profitability, which have been explained below: 1) Principle of Safety : The most important principle of lending is to ensure the safety of the funds lent. It means that the borrower repays the amount of the loan with interest as per the loan contract. The ability to repay the loan depends upon the borrowers capacity to pay as well as his willingness to repay. To ensure the former, the banker depends upon his tangible assets and the viability of his business to earn profits. Borrowers willingness depends upon his honesty and character. Banker, therefore, takes into account both the above mentioned

Financing Working Capital Needs

aspects to determine the credit - worthiness of the borrower and to ensure safety of the funds lent. 2) Principle of Liquidity : Banks mobilize funds through deposits which are repayable on demand or over short to medium periods. The banker therefore lends his funds for short period and for Working Capital purposes. These loans are largely repayable on demand and are granted on the basis of securities which are easily marketable so that he may realise his dues by selling the securities. 3) Principle of Profitability: Banks are profit earning institutions. They lend their funds to earn income out of which they pay interest to depositors, incur operational expenses and earn profit for distribution to owners. They charge different rates of interest according to the risk involved in lending funds to various borrowers. However, they do not have to sacrifice safety or liquidity for the sake of higher profitability. Following the above principles banks pursue the practice of diversifying risk by spreading advances over a reasonably wide area, distributed amongst a good number of customers belonging to different trades and industries. Loans are not granted for speculative and unproductive purposes

9.3

STYLE OF CREDIT

Commercial banks provide finance for working capital purposes through a variety of methods. The main systems or style of credit, prevalent in India are depicted in the following diagram. Bank Credit

Loans and advances

Discounting of bills

Overdrafts

Cash Credit

Loans

Short term Personal Loans loans

Medium & Long term loans

Bridge Composite loans loans

The terms and conditions, the rights and privileges of the borrower and the banker differ in each case. We shall discuss below these methods of granting bank credit.

9.3.1

Overdrafts

This facility is allowed to the current account holders for a short period. Under this facility, the current account holder is permitted by the banker to draw from his
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account more than what stands to his credit. The excess amount drawn by him is deemed as an advance taken from the bank. Interest on the exact amount overdrawn by the account-holder is charged for the period of actual utilisation. The banker may grant such an advance either on the basis of collateral security or on the personal security of the borrower. Overdraft facility is granted by a bank on an application made by the borrower. He is also required to sign a promissory note. Therefore, the customer is allowed the amount, upto the sanctioned limit of overdraft as and when he needs it. He is permitted to repay the loan as per his convenience and ability to do so.

9.3.2

Cash Credit System

Cash Credit System accounts for the major portion of bank credit in India. The salient features of this system are as follows: 1) Under this system, the banker prescribes a limit, called the Cash Credit limit, upto which the customer- borrower is permitted to borrow against the security of tangible assets or guarantees. 2) The banker fixes the Cash Credit limit after considering various aspects of the working of the borrowing concern i.e production, sales ,inventory levels, past utilisation of such limit, etc. 3) The borrower is permitted to withdraw from his Cash Credit account, amount as and when he needs them. Surplus funds with him are allowed to be deposited with the banker any time. The Cash Credit account is thus a running account, wherein withdrawals and deposits may be made frequently any number of times. 4) As the borrower withdraws from Cash Credit account he is required to provide security of tangible assets. A charge is created on the movable assets of the borrower in favour of the banker. 5) When the borrower repays the borrowed amount in full or in part, security is released to him in the same proportion in which the amount is refunded. 6) The banker charges interest on the actual amount utilised by him and for the actual period of utilisation. 7) Though the advance made under Cash Credit System is repayable on demand and there is no specific date of repayment, in practice the advance is rolled over a period of time i.e. the debit balance is hardly fully wiped out and the loan continues from one period to another. 8) Under this system, the banker keeps adequate cash balance to meet the demand of his customers as and when it arises, but interest is charged on the actual amount of loan availed of. Thus, to neutralize the loss caused to the banker, the latter imposes a commitment charge at a normal rate of 1% or so, on the unutilised portion of the cash credit limit. Merits of Cash Credit System The Cash Credit System has the following merits: 1) The borrower need not keep surplus funds idle with himself. He can deposit the surplus funds with the banker, reduce his debit balance, and thus minimise the interest burden. On the other hand he can withdraw funds at any time to meet his needs. 2) Banks maintain one account for all transactions of a customer. As documents are required only once in a year the costs of repetitive documentation is avoided.
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Financing Working Capital Needs

Demerits of Cash Credit System The Cash Credit System, on the other hand, suffers from the following demerits: 1) Cash Credit limits are prescribed only once in a year and hence they are fixed keeping in view the maximum amount that can be required within a year. Consequently, a portion remains unutilised for part of the year during which bank funds remain unemployed. 2) The banker remains unable to verify the end use of funds borrowed by the customer. Such funds may be diverted to unapproved purposes. 3) The banker remains unable to plan the utilisation of his funds as the level of advances depends upon the borrowers decision to borrow at any time. 4) As the volume of cash transactions increases significantly under the cash credit system as against the loan system, the cost of handling cash, honouring cheques, taking and giving delivery of securities increases the transactions cost of banks. 5) As there is only commitment charge of 1% or less, there will be a tendency on the part of companies to negotiate for a higher limit.

9.3.3 Loan System

Under the loan system, a definite amount is lent at a time for a specific period and a definite purpose. It is withdrawn by the borrower once and interest is payable for the entire period for which it is granted. It may be repayable in instalments or in lump sum. If the borrower needs funds again , or wants to renew an existing loan, a fresh proposal is placed before the banker. The banker will make a fresh decision depending upon the availability of cash resources. Even if the full loan amount is not utilised the borrower has to pay the full interest. Advantages of the Loan System The loan system has the following advantages over the Cash Credit System: 1) This system imposes greater financial discipline on the borrowers, as they are bound to repay the entire loan or its instalments on the due date/ dates fixed in advance. 2) At the time of granting a new loan or renewing an existing loan, the banker reviews the loan account. Thus unsatisfactory loan accounts may be discontinued at his discretion. 3) As the banker is entitled to charge interest on the entire amount of loan, his income from interest is higher and his profitability also increases because of lower transaction cost. Short Term Loans Short term loans are granted by banks to meet the Working Capital requirements of the borrowers. Such loans are usually granted for a period upto one year and are secured by the tangible movable assets of the borrowers like goods and commodities, shares, debentures etc. Such goods and securities are pledged or hypothecated with the banker. As we shall study in the next unit. Reserve Bank of India has exercised compulsion on banks since 1995 to grant 80% of the bank credit permissible to borrowers with credit of Rs 10 crore or more in the form of short term loans which may be for

various maturities. Reserve Bank has also permitted the banks to roll over such loans i.e. to renew the loan for another period at the expiry of the period of the first loan. Medium and Long Term Loans Such loans are generally called Term Loans and are granted by banks with All India Financial institutions like Industrial Development Bank of India, Industrial Finance Corporation of India, Industrial Credit and Investment Corporation of India Ltd. Term loans are granted for medium and long terms, generally above 3 years and are meant for purchase of capital assets for the establishment of new units and for expansion or diversification of an existing unit . At the time of setting up of a new industrial unit, term loans constitute a part of the project finance which the entrepreneurs are required to raise from different sources. These loans are usually secured by the tangible assets like land, building, plant and machinery etc. In October 1997 Reserve Bank of India permitted the banks to announce separate prime lending rate for term loans of 3 years and above. In April 1999 Reserve bank of India also permitted the banks to offer fixed rate loans for project financing. Reserve Bank of India has encouraged the banks to lend for project finance as well. In September, 1997 ceiling on the quantum of the term loans granted by banks individually or in consortia/syndicate for a single project was abolished. Banks now have the discretion to sanction term loans to all projects within the overall ceiling of the prudential exposure norms prescribed by Reserve bank. ( Fully discussed in the next unit). The period of term loans will also be decided by banks themselves. Though term loans are meant for meeting the project cost but as project cost includes margin for Working Capital , a part of term loans essentially goes to meet the needs of Working Capital. Bridge Loans Bridge loans are in fact short term loans which are granted to industrial undertakings to enable them to meet their urgent and essential needs. Such loans are granted under the following circumstances: 1) When a term loan has been sanctioned by banks and/ or financial institutions, but its actual disbursement will take time as necessary formalities are yet to be completed. 2) When the company is taking necessary steps to raise the funds from the Capital market by issue of equities/debt instruments. Bridge loans are provided by banks or by the financial institutions which have granted term loans. Such loans are automatically repaid out of the amount of term loan when it is disbursed or out of the funds raised from the Capital Market. Reserve Bank of India has allowed the banks to grant such loans within the ceiling of 5% of incremental deposits of the previous year prescribed for individual banks investment in Shares/ Convertible debentures. Bridge loans may be granted for a maximum period of one year. Composite Loans Composite loans are those loans which are granted for both, investment in capital assets as well as for working capital purposes. Such loans are usually granted to small borrowers, such as artisans, farmers, small industries etc. Under the composite loan scheme, both term loans and Working Capital are provided through a single window. The limit for composite loans has recently (in Feb., 2000) been increased from Rs. 5 lakhs to Rs.10 lakhs for small borrowers.

Financing Working Capital Needs

Personal Loans These loans are granted by banks to individuals specially the salary-earners and others with regular income, to purchase consumer durable goods like refrigerators, T.Vs., cars etc. Personal loans are also granted for purchase/construction of houses. Generally the amount of loans is fixed as a multiple of the borrowers income and a repayment schedule is prepared as per his capacity to save. Activity 9.1 1) What do you understand by Margin money for Working Capital? How is it financed? ...................................................................................................................... ...................................................................................................................... ...................................................................................................................... ...................................................................................................................... 2) Explain three important demerits of the Cash Credit System ...................................................................................................................... ...................................................................................................................... ...................................................................................................................... ...................................................................................................................... 3) What do you understand by Term Loans? For what purposes are they granted by banks? What is Reserve Banks directive to banks in this regard? ...................................................................................................................... ...................................................................................................................... ...................................................................................................................... ...................................................................................................................... 4) What is meant by Bridge Loan? What is the necessity for granting such loans. ...................................................................................................................... ...................................................................................................................... ...................................................................................................................... ...................................................................................................................... 5) Elucidate the principles of Bank lending. ...................................................................................................................... ...................................................................................................................... ...................................................................................................................... ......................................................................................................................

9.4

CLASSIFICATION OF ADVANCES ACCORDING TO SECURITY

Banks attach great importance to the safety of the funds, lent as loans and advances. For this purpose, they ask the borrowers to create a charge on their

tangible assets in their favour. In some cases, the banks secure their interest by asking for a guarantee given by a third party. Besides the tangible assets or a guarantee, banks rely upon the personal security of the borrower and grant loans which are called unsecured advances or clean loans. In the balance sheet, banks classify advances as follows: Advances

Secured by Tangible Assets Secured Advances

Covered by Bank /Govt. Guarantees

Unsecured

According to Banking Regulation Act 1949, a secured loan or advance means a loan or advance made on the security of assets, the market value of which is not at any time less than the amount of such loan or advances. An unsecured loan or advance means a loan or advance not so secured. The main features of a secured loan are: 1) The advance is made on the basis of security of tangible assets like goods and commodities, life insurance policies, corporate and government securities etc. 2) A charge is created on such security in favour of the banker. 3) The market value of such security is not less than the amount of loan. If the former is less than the latter, it becomes a partly secured loan. Unsecured Advances Unsecured advances are granted without asking the borrower to create a charge on his assets in favour of the banker. In such cases the security happens to be the personal obligation of the borrower regarding repayment of the loan. Such loans are granted to parties enjoying high reputation and sound financial position. The legal status of the banker in case of a secured advance is that of a secured creditor. He possesses absolute right to recover his dues from the borrower out of the sale proceeds of the assets over which a charge is created in his favour. In case of an unsecured advance, a banker remains an unsecured creditor and stand at par with other unsecured creditors of the borrower, if the latter defaults. Guaranteed Advances The banker often safeguards his interest by asking the borrower to provide a guarantee by a third party may be an individual, a bank or Government. According to the Indian Contract Act, 1872, a contract of guarantee is defined as a contract to perform the promise or discharge the liability of third person is case of his default. The person who undertakes this obligation to discharge the liability of another person is called the guarantor or the surety. Thus a guaranted advance is, in fact, also an unsecured advance i.e. without any specific charge being created on any asset, in favour of the banker. A guarantee carries a personal security of two persons i.e. the principal debtor and the surety to perform the promise of the principal debtor. If the latter fails to fulfill his promise, liability of the surety arises immediately and automatically. The surety therefore, must be a reliable person considered good for the amount for which he has stood as surety. The guarantee given by banks, financial institutions and the government are therefore considered

Financing Working Capital Needs

valuable.

9.5

MODES OF CREATING CHARGE OVER ASSETS

As we have noted above, in case of secured advance, a charge is created over an asset of the borrower in favour of the lender. By creation of charge it is meant that the banker gets certain rights in the tangible assets of the borrower. The borrower still remains the owner of the asset, but the banker gets the right of realizing his dues out of the sale proceeds of the asset. Thus bankers interest is safeguarded. There are several methods of creating charge over the borrowers assets as shown below: Modes of Creating charge

Pledge

Hypothecation

Mortgage

Lien

Assignment

9.5.1

Pledge

Pledge is the most popular method of creating charge over the movable assets. Indian Contract Act, 1872, defines pledge as bailment of goods as security of payment of a debt or performance of a promise. The person who offers the security is called the pledger and the person to whom the goods are entrusted is called the pledgee . Thus bailment of goods is the essence of a pledge. Indian Contract Act defines bailment as delivery of goods from one person to another for some purpose upon the contract that the goods be returned back when the purpose is accomplished or otherwise disposed of according to the instructions of the bailor. Thus when the borrower pledges his goods with the banker, he delivers the goods to the banker to be retained by him as security for the amount of the loan. Delivery of goods may be either (i) physical delivery or (ii) constructive or symbolic delivery. The latter does not involve physical delivery of the goods. The handing over of the keys of the godown storing the goods, or even handing over the documents of the title to goods like warehouse receipts, duly endorsed in favour of the banker amounts to constructive delivery. It is also essential that the banker must return the same goods to the borrower after he repays the amount of loan along with interest and other charges. The pledgee (banker) is entitled to certain rights, which are conferred upon him by the Indian Contract Act. The foremost right is that he can retain the goods pledged for the payment of debt and interest and other charges payable by the borrower. In case the pledger defaults, the pledgee has the right to sell the goods after giving pledger reasonable notice of sale or to file a suit for the amount due from him.

9.5.2

Hypothecation

Hypothecation is another method of creating charge over the movable assets of the borrower. It is preferred in circumstances in which transfer of possession over such assets is either inconvenient or is impracticable. For example, if the borrower wants to borrow on the security of raw materials or goods in process, which are to be converted into finished products, transfer of possession is not possible/practicable
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because his business will be impeded in case of such transfer. Similarly a transporter needs the vehicle for plying on the road and hence cannot give its possession to the banker for taking a loan. In such circumstances a charge is created by way of hypothecation. Under hypothecation, neither ownership nor possession over the asset is transferred to the creditor. Only an equitable charge is created in favour of the banker. The asset remains in the possession of the borrower who promises to give possession thereof to the banker, whenever the latter requires him to do so. The charge of hypothecation is thus converted into that of a pledge. The banker enjoys the rights and powers of a pledgee. The borrower uses the asset in any manner he likes, viz he may take out the stock, sell it and replenish it by a new one. Thus a charge is created on the movable asset of the borrower. The borrower is deemed to hold possession over the goods as an agent of the creditor. To enforce the security, the banker should take possession of the hypothecated asset on his own or through the court.

9.5.3

Mortgage

A charge on immovable property like land & building is created by means of a mortgage. Transfer of Property Act 1882 defines mortgage as the transfer of an interest in specific immovable property for the purpose of securing the payment of money, advanced or to be advanced by way of loan, an existing or future debt or the performance of an engagement which give rise to a pecuniary liability. The transferor is called the mortgagor and the transferee mortgagee. The owner transfers some of the rights of ownership to the mortgagee and retains the remaining with himself. The object of transfer of interest in the property must be to secure a loan or to ensure the performance of an engagement which results in monetary obligation. It is not necessary that actual possession of the property be passed on to the mortgagee. The mortgagee, however, gets the right to recover the amount of the loan out of the sale proceeds of the mortgaged property. The mortgagor gets back the interest in the mortgaged property on repayment of the amount of the loan along with interest and other charges. Kinds of Mortgages Though Transfer of Property Act specifies seven kinds of mortgages, but from the point of view of transfer of title to the mortgaged property, mortgages are divided intoa) Legal mortgages and b) Equitable mortgages In case of Legal Mortgage, the mortgagor transfers legal title to the property in favour of the mortgagee by executing the Mortgage deed. When the mortgage money is repaid, the legal title to the mortgaged property is re-transferred to the mortgagor. Thus in this type of mortgage expenses are incurred in the form of stamp duty and registration charges. In case of an equitable mortgage the mortgagor hands over the documents of title to the property to the mortgagee and thus creates an equitable interest of the mortgagee in the mortgaged property. The legal title to the property is not passed on to the mortgagee but the mortgagor undertakes through a Memorandum of Deposit to execute a legal mortgage in case he fails to pay the mortgaged money. In such situation the mortgagee is empowered to apply to the court to convert the equitable mortgage into legal mortgage. Equitable Mortgage has several advantages over Legal Mortgage. It is not
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necessary to register the Memorandum of Deposit or the covering letter sent along with the Documents of title. Actual handing over by a borrower to the lender of documents of title to immovable property with the intention to constitute them as security is sufficient. As registration is not mandatory, information regarding mortgage remains confidential and the mortgagors reputation is not affected. When the debt is repaid documents are returned back to the borrower, who may re-deposit the same for taking another loan against the same documents. But the banker should be very careful in retaining the documents in his possession, because if the equitable mortgagee is negligent or mis-represents to another person, who advances money on the security of the mortgaged property, the right of the latter will have first priority.

9.5.4

Assignment

The borrower may provide security to the banker by assigning any of his rights, properties or debts to the banker. The transferor is called the assignor and the transferee the assignee. The borrowers generally assign the actionable claims to the banker under section 130 of the Transfer of Property Act 1882. Actionable claim is defined as a claim to any debt, other than a debt secured by mortgage of immovable property or by hypothecation or pledge of movable property or to any beneficial interest in movable property not in the possession of the claimant. A borrower may assign to the banker(i)the book debts, (ii) money due from a government department or semi-government organisation and (iii)life insurance policies. Assignment may be either a legal assignment or an equitable assignment. In case of legal assignment, there is absolute transfer of actionable claim which must be in writing. The debtor of the assignor is informed about the assignment. In the absence of the above the assignment is called equitable assignment.

9.5.5

Lien

The Indian Contract Act confers upon the banker the right of general lien. The banker is empowered to retain all securities of the customer, in respect of the general balance due from him. The banker gets the right to retain the securities handed over to him in his capacity as a banker till his dues are paid by the borrower. It is deemed as implied pledge. Activity 9.2 1) Distinguish between a secured advance and a guaranteed advance. ....................................................................................................................... ....................................................................................................................... ....................................................................................................................... ....................................................................................................................... 2) Distinguish between pledge and hypothecation. Which provides better security to the banker and why? ....................................................................................................................... ....................................................................................................................... ....................................................................................................................... ....................................................................................................................... 3) What do you understand by Equitable Mortgage? What are its advantages vis-a-vis legal mortgage?
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.......................................................................................................................

....................................................................................................................... ....................................................................................................................... .......................................................................................................................

9.6

SECURED ADVANCES

Secured advances account for significant portion of total advances granted by banks. As we have seen, in case of secured advances, a charge is created on the assets of the borrowers in favour of the banker, which enables him to realise his dues out of the sale proceeds of the assets. Banks grant advances against a variety of assets as shown below: Securities for Advances

Goods & Commodities

Documents

Real Estates

Book Debts

Supply Bills

Documents of Stock Exchange Title to goods Securities

Life Insurance Policies

Fixed Deposit Receipts

Let us first study the general principle of secured advances: 1) Marketability of Securities: The banker grants advances on the basis of those securities which are easily marketable without loss of time and money, because in case of non-payment by the borrower, the banker shall have to dispose off the security to realise his dues. 2) Adequacy of Margin : Banker also maintains a difference between the value of the security and the amount lent. This is called margin. Suppose a banker grants a loan of Rs. 100 /- on the security valued at Rs. 200/- the difference between the two (i.e. Rs. 200 - Rs. 100 = Rs. 100) is called margin. Margin is necessary to safeguard the interest of the banker as the market value of the security may fall in future and /or interest and other charges become payable by the borrower , thus increasing the liability of the borrower towards the banker. Different margins are prescribed in case of different securities. 3) Documentation: Banker also requires the borrower to execute the necessary documents e.g. Agreement of pledge, Mortgage Deed, Promissory notes etc. to safeguard his interest. Goods and Commodities Bulk of the advances granted by banks are secured by goods and commodities, raw material and finished goods etc., which constitute the stock-in-trade of business houses. However, agricultural commodities are likely to deteriorate in quality over a period of time. Hence banks grant short term loans only against such commodities . The problem of valuation of stock pledged with the bank is not a difficult one, as daily quotations are easily available. Banker usually prefers those commodities which have steady demand and a wider market. Such goods are required to be insured against fire and other risks. Such goods either pledged or hypothecated to the banker are released to the borrower in proportion to the amount of loan repaid. Agro-based commodities such as foodgrains, sugar, pulses, oilseeds, cotton are
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sensitive to the market forces of demand and supply and prices. As our country has faced seasonal shortages in several of these commodities, the reserve bank of India under the authority vested in it by the Banking Regulation Act, issues directives known as Selective Credit Control (SCC) to scheduled commercial banks during the commencement of each busy season which is, in practical terms, the commencement of the Kharif or the Rabi season each year. In order to ensure that speculation in these sensitive commodities does not take place, the Reserve Bank of India in its busy season policy issues direction to control the credit for commodities by: i) Fixing an overall ceiling for credit to sensitive commodities for each bank as whole. For example, total credit against these commodities in a particular year may be restricted to 80% of the previous years level; Fixing margins and rates of interest that can be levied by banks in their credit against the selected commodities; and

ii)

iii) Banning the flow of bank credit towards financing one or more of these selected commodities. Each bank takes into consideration the RBIs policy on selective credit control while determining its own credit policy. The Head Offices of banks advise their branches on the terms and conditions applicable to SCC commodities. Documents of Title to Goods These documents represent actual goods in the possession of some other person. Hence they are proof of possession or control over the goods. For example, warehouse receipts, railway receipts, Bill of lading etc. are documents of title to goods. When the owner of goods represented by these documents wants to take a loan from the banker, he endorses such documents in favour of the banker and delivers them to him. The banker is thus entitled to receive the delivery of such goods, if the advance is not repaid. However, there remains the risk of forgery in such documents and dishonesty on the part of the borrower. Stock Exchange Securities Stock Exchange Securities comprise of the securities issued by the Central and State governments, semi-govt. orgaisations, like Port Trust & Improvement Trust, Shares and Debentures of companies and Units of the Mutual Funds listed on the Stock Exchanges. The Govt. securities are accepted by banks because of their easy liquidity, stability in prices, regular accrual of income and easy transferability. In case of corporate securities banks prefer debentures of companies vis--vis shares because the debenture holder generally happens to be secured creditor and there is a contractual obligation on the company to pay interest thereon regularly. Amongst the shares, banks prefer preference shares, because of the preferential rights enjoyed by the preference shareholders over equity shareholders. Banks accept equity shares of those companies which they approve after thorough screening and examination of all aspects of their working. A charge over such securities is created in favour of the banker. Reserve Bank of India has permitted the banks to grant advances against shares to individuals upto Rs. 20 lakhs w.e.f. April 29, 1998 if the advances are secured by dematerialized Securities. The minimum margin against such dematerialized shares was also reduced to 25%. Advances can also be granted to investment companies, shares & stock brokers, after making a careful assessment of their requirements. Life Insurance Policies A life insurance policy is considered a suitable security by a banker as repayment of loan is ensured to the banker either at the time policy matures or at the time of death

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of the insured. Moreover, the policy has a surrender value which is paid by the insurance company, if the policy is discontinued after a minimum period has lapsed. The policy can be legally assigned to the banker and the assignment may be registered in the books of the insurance company. Banks prefer endowment policies as compared to the whole life policies and insist that the premium is paid regularly by the insured. Fixed Deposit Receipts A Fixed Deposit Receipt issued by the same bank is the safest security for granting an advance because the receipt represent a debt due from the banker to the customer. At the time of taking a loan against fixed deposit receipt the depositor hands over the receipt to the banker duly discharged, along with a memorandum of pledge. The banker is thus authorised by the depositor to appropriate the amount of the FDR towards the repayment of loan taken from the banker. Real Estate Real Estate i.e. immovable property like land and building are generally not regarded suitable security for granting loans for working capital. It is difficult to ascertain that the legal title of the owner is free from any encumbrance. Moreover, their valuation is a difficult task and they are not readily realizable assets. Preparation of mortgage deed and its registration takes time and is expensive also. Real Estates are, therefore, taken as security for term loans only. Book Debts Sometimes the debts which the borrower has to realise from his debtors are assigned to the banker in order to secure a loan taken from the banker. Such debts have either become due or will accure due in the near future. The assignor must execute an instrument in writing for this purpose, clearly expressing his intention to pass on his interest in the debt to the assigner (banker). He may also pass an order to his debtor to pay the assigned debt to the banker. Supply Bills Banks also grant advance on the security of supply bills. These bills are offered as security by persons who supply goods, articles or materials to various Govt. departments, semi-govt. bodies and companies, and by the contractors who undertake govt. contract work. After the goods are supplied by the suppliers to the govt. department and he obtains an inspection note or Receipted Challan from the Deptt., he prepares a bill for the goods supplied and gives it to the bank for collection and seeks an advance against such supply bills. Such bills are paid by the purchaser at the expiry of the stipulated period. Security for bank credit could be in the form of a direct security or an indirect security. Direct security includes the stocks and receivables of the customers on which a charge is created by the bank through various security documents. If in the view of the bank, the primary or direct security is not considered adequate or is riskprone, that is, subject to heavy fluctuations in prices, quality etc., the bank may require additional security either from the customer or from a third party on behalf of the customer. The additional security so obtained is known as Indirect or Collateral Security. The term collateral means running parallel or together and collateral security is an additional and separate security for repayment of money borrowed. In case the customer is unable to provide additional security when required by the bank, he may be required to provide collateral security from a third party. The common form of the third party collateral security is a guarantee given by a person on behalf of the customer to the bank. The third party collateral security in turn may

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be unsecured or secured. For example, where the guarantor has executed a guarantee agreement only, The collateral security is unsecured. However, if he lodges along with the guarantee agreement, security such as title deeds to his property creating mortgage by deposit of title deeds with the bank, a secured collateral security is created.

9.7

PURCHASE AND DISCOUNTING OF BILLS

Purchase and discounting of bills of exchange is another way banks provide credit to business entities. Bills of exchange and promissory notes are negotiable instruments which arise out of commercial transactions both in inland trade and foreign trade and enable the debtors to discharge their obligations towards their creditors. On the basis of maturity period , bills are classified into (i) demand bills and (ii) usance bills. When a bill is payable at sight on demand or on presentment, it is called a demand bill. If it matures for payment after a certain period of time say 30,60,90 days , after date or sight, it is called a usance bill. No stamp duty is required in case of demand bills and on usance bills, if they (i) arise out of the bona fide commercial transactions , (ii) are payable not more than 3 months after date or sight and (iii) are drawn on or made by or in favour of a commercial or cooperative bank. When the drawer of a bill encloses with the bill documents of title to goods, such as the railway receipt or motor transport receipt, to be delivered to the drawee , such bills are called documentary bills. When no such documents are attached the bill is called a clean bill. In case of documentary bills, the documents may be delivered on accepting the bill or on making its payment. In the former case it is called Documents against Acceptance (D/A) basis, and in the latter case Documents against Payment (D/P) basis. In case of a clean bill, the relevant documents of title to goods are sent directly to the drawee. Procedure for Discounting of Bills When the seller of the goods draws a bill of exchange on the buyer (debtor), he has two options to deal with the bill. a) b) to send the bill to a bank for collection, or to sell it to, or discount it with, a bank

When the bill is sent to the bank for collection the banker acts as the agent of the drawer and makes its payment to him only on the realisation of the bill from the drawee. The banker sends it to its branch at the drawees place, which presents it before the drawee, collects the amount and remits it to the collecting banker, who credits the same to the drawers account. In case of collection of bills, the bank acts as an agent of the drawer of the bill and does not lend his funds by giving credit before actual realisation of the bill. The business of purchasing and discounting of bills differs from that of collection of bills. In case of purchase/discounting of bills, the bank credits the amount of the bill to the drawers account before its actual realisation from the drawee. The banker thus lends his own funds to the drawer of the bill. Bills purchased or discounted are therefore, shown under the head Loans and Advances in the Balance Sheet of a bank. The practice adopted in case of demand bills is known as purchase of bills. As demand bills are payable on demand, and there is no maturity, the banker is entitled to demand its payment immediately on its presentation before the drawee. Thus the money credited to the drawers account, after deducting charges/discount, is realised by the banker within a few days.

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In case of a usance bill maturing after a period of time generally 30,60,or 90 days, therefore, banker discounts the bill i.e. credits the amount of the bill, less the amount of discount, to the drawers account. Thereafter, the bill is sent to the banks branch at the drawees place which presents it to the drawee for acceptance. Documents of title to goods, if enclosed with the bills, are released to him on accepting the bill. The bill is thereafter retained by the banker till maturity, when it is presented to the acceptor of the bill for payment. Advantages of Discounting of Bills A banker derives the following advantages by discounting the bills of exchange: 1) Safety of funds lent

Though the banker does not get charge over any tangible asset of the borrower in case of discounting of bills, his interest is safeguarded by the fact that the bills of exchange contains signatures of two partiesthe drawer and the drawee (acceptor) who are responsible to make payment of the bill. If the acceptor fails to make payment of the bill the banker can claim the whole amount from his customer, the drawer of the bill. The banker can debit the customers account and recover the money on the due date. The banker is able to recover the amount as he discounts the bills drawn by parties of standing and good reputation. 2) Certainty of payment

Every usance bill matures on a certain date. Three days of grace are allowed to the acceptor to make payment. Thus, the amount lent to the customer by discounting the bills is definitely recovered by the banker on its due date. The banker knows the date of payment of the bills and hence can plan the utilisation of his funds well in advance and with profit. 3) Facility of re-discounting of bills

The banker can augment his funds, if need arises, by re-discounting the bills, already discounted by him, with the Reserve Bank of India, other banks and financial institutions and the Discount and Finance House of India Ltd. Reserve Bank of India can also grant loans to the banks on the basis of the bills held by them. 4) Stability in the value of bills

The value of the bills remains fixed and unchanged while the value of all other goods, commodities and securities fluctuate over period of time. 5) Profitability

In case of discounting of bills, the amount of interest (called discount) is deducted in advance from the amount of the bill. Hence the effective yield is higher than loans and advances where interest is payable quarterly/half yearly. Derivative Usance Promissory Notes As noted above, banks may re-discount the discounted bills of exchange with other banks and financial institutions. For this purpose, under the normal procedure, the bills are endorsed in favour of the re-discounting bank /institution and delivered to it. At the time of maturity reverse process is required. To simplify the procedure of re-discounting, Reserve Bank of India has dispensed with the necessity of physical lodgment of the discounted bills. Instead, banks are permitted, on the basis of such discounted bills, to prepare derivative usance

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Financing Working Capital Needs

promissory notes for suitable amounts like Rs. 5 lakh or Rs. 10 lakh and for suitable maturities like 60 days or 90 days. These derivative usance promissory notes are rediscounted with the re-discounting bank or institution. The essential condition is that the derivative promissory note should be backed by unencumbered bills of exchange of atleast equal value till the date of maturity. In the meanwhile, any maturing bill may be replaced by another bill for equal amount. No stamp duty is required on such derivative usuance promissory notes. Compulsion on the Use of Bills To encourage the use of bills of exchange by corporate borrowers, the Reserve Bank of India had directed the commercial banks to advice their corporate borrowers to finance their domestic credit purchases from small scale industrial units as well as from others at least to the extent of 25 percent by way of acceptance of bills drawn upon them by their suppliers. This was to be stipulated as a condition for sanctioning working capital credit limits. Banks were also authorized to charge an additional interest from those borrowers who did not comply with this requirements in any quarter. In October 1999 Reserve bank of India permitted the banks to charge interest rate on discounting of bills without reference to Prime Lending Rate. They are now free to offer competitive rate of interest on the bill discounting facility. The above-mentioned compulsion was also withdrawn. Revised Guidelines of RBI on Discounting of Bills

Banks may sanction working capital limits as also bills limits to borrowers after proper appraisal of their credit needs and in accordance with the loan policy as approved by their Board of Directors. Banks are required to open letters of credit (LCs) and purchase /discount/ negotiate bills under LCs only in respect of genuine commercial and trade transactions of their borrower constituents who have been sanctioned regular credit facilities by them. For the purpose of credit exposure, bills purchased discounted/negotiated under LCs or otherwise would be reckoned as exposure on the banks borrower constituent. Accordingly, the exposure should attract a risk-weight appropriate to the borrower constituent (viz.,100 per cent for firms, individuals, corporates) for capital adequacy purposes. Banks have been permitted to exercise their commercial judgment in discounting of bills of services sector. Banks would need to ensure that actual services are rendered and accommodation bills are not discounted. Services sector bills should not be eligible for rediscounting.

Bank Credit Through Debt Instruments During recent years, banks have resorted to granting large credit to the corporate sector and the public sector undertakings by investing in their debt instruments like bonds, debentures and commercial paper. Banks find excess liquidity with them in the midst of low off take of credit, by the corporate sector. Taking advantage of such a situation, companies prefer to raise funds by way of private placement of their bonds, debentures and commercial paper. During 1998-99 roughly Rs. 35, 000 crore was raised from debt instruments only through private placements. Most of this was subscribed by the banks. Their outstanding investment in debt paper was Rs. 41,458 crore as at the end March, 1999 as against Rs. 28,378 crore a year earlier. Investment in C.P.s stood at Rs. 4,033 crore at the end of March 1999. Thus corporates have been able to raise funds from the investors (including banks) at rates lower than the prime lending rates of banks. Moreover, investment in debt instruments is not reckoned as bank credit and hence
16

does not entail banks obligation to grant advances to priority sectors based thereon. Further, the relaxation granted by Reserve Bank of India in April 1997 to the banks to invest in the bonds and debentures of private corporate sector without any limit, has also contributed to the greater flow of bank credit through debt instruments.

9.8

NON FUND BASED FACILITIES

The credit facilities explained above are fund based facilities wherein funds are provided to the borrower for meeting their working capital needs. Banks also provide non-fund based facilities to the customers. Such facilities include ( i ) letters of credit and (ii) bank guarantees. Under these facilities, banks do not immediately provide credit to the customers, but take upon themselves the liability to make payment in case the borrower defaults in making payment or performing the promise undertaken by him. Letter of Credit A letter of Credit(L/C) is a written undertaking given by a bank on behalf of its customer, who is a buyer , to the seller of goods, promising to pay a certain sum of money provided the seller complies with the terms and conditions given in the L/C. A Letter of Credit is generally required when the seller of goods and services deals with unknown parties or otherwise feels the necessity to safeguard his interest. Under such circumstances, he asks the buyer to arrange a letter of credit from his banker. The banker issuing the L/C commits to make payment of the amount mentioned therein to the seller of the goods, provided the latter supplies the specified goods within the specified period and comply with other terms and conditions. Thus by issuing Letter of Credit on behalf of their customers, banks help them in buying goods on credit from sellers who are quite unknown to them. The banker issuing L/C undertakes an unconditional obligation upon himself, and charge a fee for the same. L/Cs may be revocable or irrevocable. In the latter case, the undertaking given by the banker cannot be revoked or withdrawn. Bank Guarantee Banks issue guarantees to third parties on behalf of their customers. These guarantees are classified into (i) Financial guarantee, and (ii) Performance guarantee. In case of the financial guarantees, the banker guarantees the repayment of money on default by the customer or the payment of money when the customer purchases the capital goods on deferred payment basis. A bank guarantee which guarantees the satisfactory performance of an act, say completion of a construction work undertaken by the customer, failing which the bank will make good the loss suffered by the beneficiary is known as a performance guarantee.

9.9

CREDIT WORTHINESS OF BORROWERS

The business of granting advances is a risky one. It is more risky specially in case of unsecured advances. The safety of the advance depends upon the honesty and integrity of the borrower, apart from the worth of his tangible assets. The banker has, therefore, to investigate into the borrowers ability to pay as well as his willingness to pay the debt taken. Such an exercise is called credit investigation. Its aim is to determine the amount for which a person is considered creditworthy. Credit worthiness is judged by a banker on the basis of borrowers ( i ) character, (ii) capacity and (iii) capital.
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Financing Working Capital Needs

1) Character includes a number of personal characteristics of a person e.g his honesty, integrity, promptness in fulfilling his promises and repaying the dues, sense of responsibility, reputation and goodwill enjoyed by him. A person having all these qualities, without any doubt in the minds of others , possesses, an excellent character and hence his creditworthiness is considered high. 2) Capacity If the borrower possesses necessary technical skill, managerial ability and experience to run a particular business or industry, success of such an enterprise is taken for granted except in some unforeseen circumstances, Such a person is considered creditworthy by the banker. 3) Capital The borrower is also expected to have financial stake in the business, because in case the business fails, the banker will be able to realise his money out of the capital put in by the borrower. It is a sound principle of finance that debt must be supported by sufficient equity. The relative importance of the above factors differs from banker to banker and from borrower to borrower. Banks are granting advances to technically qualified and experienced entrepreneurs but they are required to put in a small amount as their own capital. Reserve Bank of India has recently directed the banks to dispense with the collateral requirement for loans upto Rs. 1 lakh. This limit has recently been further increased to Rs. 5 lakh for the tiny sector. Determination of credit worthiness of a borrower has become now a more scientific exercise. Special institutions like rating companies such as CRISIL, ICRA, CARE, have come on to the field and each of them has developed a methodology of its own. This was discussed in earlier Block under Receivables Management in more detail. Activity 9.3 1) Why do banks prefer Govt. and semi-govt. securities vis--vis Corporate Securities for granting credit? Amongst the Corporate Securities why do they prefer debt instruments? ...................................................................................................................... ...................................................................................................................... ...................................................................................................................... ...................................................................................................................... 2) What are the advantages of discounting of bills to the banks? Is it compulsory for corporate borrowers to use bills of Exchange? ...................................................................................................................... ...................................................................................................................... ...................................................................................................................... ...................................................................................................................... 3) What do you understand by credit-worthiness of a borrower? What factors are taken into account by the banker to determine credit-worthiness? ...................................................................................................................... ...................................................................................................................... ...................................................................................................................... ......................................................................................................................

9.10
18

SUMMARY

In this unit we have discussed the basic concepts, principles and practices of bank credit as a source of working capital. Various forms in which bank credit is granted viz. Overdrafts, loans, cash credit and discounting of bills etc. are discussed with their merits and demerits. Different types of loans, and their classification on the basis of security and guarantee have been explained. After explaining the various modes of creating charge over the borrowers assets, we have discussed merits and demerits of different types of securities taken by banks. Purchase and discounting of bills as a method of granting credit has been duly explained. Concept of credit worthiness of the borrower has been clarified. In the end, the two important nonfund based facilities such as letter of credit and guarantee given by banks have been explained.

9.11 KEY WORDS

Overdrafts : This is a facility allowed to a current account holder for a short period. Under this facility, the account holder is allowed to draw from his account more than what stands to his credit, either on the personal security of the borrower or on the basis of collateral security. Cash Credit System: This is a method of granting credit by banks. Under this method the bank prescribes a limit, called the Cash Credit limit, upto which the customer is permitted to borrow against the security of tangible assets or guarantee. The borrower may withdraw from the account as and when he needs money. Surplus funds with him may be deposited with the banker any time. Thus, it is running a/c with the banker, wherein withdrawals and deposits may be made frequently in any number of times. Loan: Under the Loan System of granting credit a definite amount is lent for a specified period. Bridge Loan: Bridge Loan is a short term loan which is usually granted to industrial undertakings to enable them to meet their urgent needs. It is granted when a term loan has already been sanctioned by a bank/financial institution, but its disbursement takes some time or when the company is taking steps to raise funds for the capital market. It is a type of interim finance. Composite Loan: Those loans that are granted for both investment in capital assets and for working capital purposes, are called composite loans. Secured Loans: A secured loan is a loan made on the security of any tangible asset of the borrower. It means that a charge or right is created on the assets of the borrower in favour of the lender. The value of the security must be equal to the amount of the loan. If the former is less than the latter, it is called partly secured loan. An advance without such security is called unsecured advance. In case of secured loan the lender gets the right to realise his dues from the sale proceeds of the security, if the borrower defaults. Pledge: Pledge is a method of creating a charge over the movable assets of the borrower in favour of the lender. Under the pledge , the movable assets of the borrower are delivered to the banker as a security, which he will return back to the borrower, after he repays the amount due from him in respect of principal and interest. Hypothecation: It is another method of creating charge over the movable assets. Under hypothecation the possession over such assets is not transferred to the banker. Only an equitable charge is created in favour of banker. The assets remain in the possession of the borrower, who promises to give possession of the same to the
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Financing Working Capital Needs

banker , whenever he is requested to do so. Mortgage: It is a method of creating charge over the immovable property like land and building. Under Mortgage the borrower transfers some of the rights of ownership to the banker (or mortgagee) and retains the remaining rights with himself. The objective is to secure a loan taken from the banker. Actual possession over the property is not passed on to the mortgage in all cases. Equitable Mortgage: In this type of mortgage the mortgagor hands over the documents of title to the property to the mortgagee and thus an equitable interest of the mortgagee is created in the property. If the mortgagor fails to repay the amount of the loan, he may be asked to execute a legal mortgage in favour of the lender. Assignment: It is a method whereby the borrower provides security to the banker by assigning (transferring or parting with) any of his rights, properties or debts to the banker. Lien: Lien is the right of the banker to retain all securities of the customer, until the general balance due from him is not repaid. Documents of title to goods: These are the documents which represent the goods in the possession of some other person. For example a warehouse receipt or a railway receipt. By endorsing such documents in favour of the banker, the borrower entitles the banker to take delivery of the goods from the warehouse or railway, if he does not repay the advance. Credit worthiness: Creditworthiness indicates the quality of the borrower. It denotes the amount for which a borrower is considered worthy for borrowing from a bank. It depends upon his ability and willingness and is judged on the basis of character, capacity and capital of the borrower.

9.12
1. 2. 3.

SELF ASSESMENT QUESTIONS

Why does a bank as a general rule not lend on long term basis ? What are the common securities against which a bank may lend for working capital purposes ? Can a bank extend an unsecured loan or advance ? Does a bank need to be satisfied about the creditworthiness of a customer before extending non fund facilities to him ? If so why ? Would a bank guarantee issued in favour of Customs Authorities guaranteeing payment of customs duty be classified as a performance or financial one ? What are the different types of ventures that a bank can finance ? Does it include a handcart operator selling vegetables ? Discuss the different ways by which banks provide credit to business entities?

4. 5.

9.13
1. 2. 3. 4.

FURTHER READINGS

Tannans Banking Law and Practice (19th Edition) P. N. Varshney- Banking Law & Practice P. N. Varshney- Indian Financial System and Commercial Banking. S. Srinivasan 1999; Cash and Working Capital Management, Vikas Publishing house, New Delhi.

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Appendix Observation of RBI on Working Capital Cycles and Demand for Bank Credit Working capital is critical for daily management of cash flows to settle bills, wages and other variable costs. The working capital cycle is the period of time which elapses between the point at which cash begins to be expended on the production of a product and the collection of cash from sale of the product to its customers. Typically, the cycle begins with the injection of cash which is utillised for making payments to the suppliers of raw materials, workers, etc. Between each stage of this working capital cycle, there is a time lag. The amplitude of the working capital cycle depends on the type of activity. In general, careful management of working capital is vital for any firm, particularly where the gestation lag between the production process and realisation of the receivables is substantial in a situation when the firm has incurred all expenditure associated with production but has not realised the value of its product, it is imperative that the firm manages its cash flow carefully to stay liquid and operational. Working capital requirements can be financed from both internally generated resources (selling current assets) and externally acquired alternatives (borrowing or securing current assets). Mostly firms borrow on the strength of their current assets and the major sources of funds include trade credits, accruals, short-term bank loans, collateral papers, commercial papers and factoring accounts receivable. In a bankbased financial system, the loan from the bank by a corporate takes form of line of credit or overdraft. This is an arrangement between the bank and its customers with respect to the maximum amount of unsecured credit the bank will permit the borrower firm. Besides this arrangement, there are other forms of short-term financing by raising resources directly from the market through issue of commercial paper. In the Indian context, a major part of the working capital requirements are met by bank credit. Typically, periods of spurt in industrial activity are associated with surges in non-food bank credit, albeit, with some lag. These lags are more prolonged in a production based business rather than in service providing firms. Commercial paper (CP)has emerged as an important source of funding working capital needs; however it is restricted to a few large companies with triple-A corporate ratings and does not enjoy wider market acceptability. Thus, bank credit in the form of cash credit (CC) and working capital demand loan (WCDL)continues to remain the principal source of working capital requirements. An analysis of the data for large borrowers showed that working capital credit which constituted nearly 65 per cent of the total bank credit in mid-1990s, came down to nearly 55 per cent in 2002. The CC arrangement in India is a unique system, which is highly advantageous to the borrowers as the task of cash managment of the borrowers is passed on to the lending banks. Since the borrowers are free to draw from the cash credit account at any time depending on their cash requirements, it results in uncertainty in the utilisation of the cash credit limit. As such, banks are required to maintain large cash/liquid assets or resort to borrowal from the call money market to meet the sudden demand for withdrawal by the borrowers. In April 1995, under the 'Loan System' of delivery of bank credit, the CC component was restricted to a maximum of 75 percent of the Maximum Permissible Borrowerd Fund (MPBF) in respect of cases where the
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