Section I Modes of Credit Delivery
Section II Legal Aspects of Lending
Annexures I, II, III, IV (Case Study)
We have seen the basic principles and processes of the lending function in the previous chapter. The con cepts discussed in the chapter have universal applicability. We will learn in this chapter how these concepts are applied by Indian banks.
Typical credit delivery modes used by Indian banks are summarized in Table 6.1.
The features of each of these credit delivery modes are designed to help the borrower carry on operations without interruption, simultaneously facilitating recovery of the debt for the lending bank. The terms and conditions, the rights and privileges of the bank and borrower differ in each case, as described below.
Annexure I provides an overview of the methods of lending prevalently used by Indian banks for various purpose-oriented loans.
The cash credit system used to be the dominant mode of lending and the most preferred by borrowers. However, this mode of credit delivery is gradually being replaced by the short-term loan for reasons that will be discussed below.
Under the cash credit system, the bank specifies a credit limit for the borrower. The credit limit is backed by prime securities in the nature of inventories or book debts or receivables, and collaterals and guarantees, if the bank so insists.
The cash credit account is almost a mirror image of the ‘current deposit account’, and is operated in quite the same manner, except that the balances in the cash credit account are predominantly debit balances. The customer withdraws funds from the account for operating expenses, and deposits the cash inflows, primarily by way of sales. The bank generally stipulates that the account should be ‘brought to credit’ periodically, the periodicity of such credit depending on the cash-to-cash cycle. Hence, the sum of the credits in the account should practically reflect the ‘sales’ achievement of the firm for the period. This can be verified by the bank by periodically calling for the borrower’s sales revenue data. The bank can also question the borrower when there is a substantial difference between the actual sales achievement of the borrower and the sum of ‘credits’ into the cash credit account. Such a discrepancy should be taken seriously by the lending bank since it could imply that the borrower is diverting bank funds either to long-term uses or for purposes other than those for which such funds were intended. Such practices could ultimately jeopardize the bank’s chances of recovering the amount lent.
The bank also levies a ‘commitment charge’ on the unutilized portion of the cash credit limit. The magnitude of the commitment charge reflects the bank’s opportunity cost of earmarking a portion of its liabilities for the loan assets created for the borrower.1
While the cash credit system provides great flexibility and operational convenience to borrowers, it leads to higher transaction costs for the bank, in the form of monitoring and opportunity costs. In the present competitive and profit-focused environment, the banks may find the system cumbersome and costly to operate.
Hence, to usher in discipline in the funds utilization of large borrowers and in still efficient funds management in banks, the loan system for delivery of bank credit was introduced in the mid 1990s. Though the new system is mandatory for borrowers enjoying working capital limits of over ₹10 crore from the banking system, the central bank encourages all borrowers to adopt the system. The system stipulates that the assessed working capital requirements of the borrower will be delivered as two components—a loan component, called the WCDL, constituting not less than 80 per cent of the assessed credit limit, with the ubiquitous cash credit component forming the remaining 20 per cent.
RBI Guidelines—Loan component and cash credit component2
Banks may change the composition of working capital finance by increasing the cash credit component beyond 20 per cent or increasing the loan component beyond 80 per cent, where warranted.
The repayment of these loans will be periodical, within the assessed period for which the credit limit has been granted. For example, the bank may want the WCDL repaid every quarter, with a replenishment of the limit for the next quarter, within the overall credit limit. The periodicity of the WCDL being ‘brought to credit’, like the cash credit, will be closely linked to the working capital cycle of the borrower.
Therefore, the WCDL is a more disciplined version of the cash credit system, with more advantages for the lending bank.
Overdrafts are like cash credits because they are permitted as withdrawals over and above the borrower’s credit balance in his current account. But overdrafts are unlike cash credits in that they are not purpose-oriented. The bank may grant an overdraft to satisfy urgent credit requirements of a borrower against a collateral security or personal guarantee.
The contract of an overdraft can be express or implied. In the case of an express contract for an overdraft, the customer approaches the bank with a request, which is appraised by the bank, the primary requisite being the track record of the borrower and his integrity. In some cases, when the overdraft is requested as a continuing facility, suitable collateral security is taken. The bank can also stipulate the number of times the account should be ‘brought to credit’ or minimum repayments into the account, during the period for which the overdraft is granted.
Since the credit is not purpose-oriented, and the securities may or may not be tangible, the risks are greater. Therefore, the interest rate on the overdraft account is normally fixed higher than that for other loan accounts.
An implied overdraft is created when the customer overdraws on the balance in his account, and the bank does not dishonour the payment. Can the bank charge interest on such overdrawn balances? Is the customer liable to repay, since there is no express contract between the bank and the customer? The Bombay High Court has decreed that an implied contract of overdraft arises when the customer overdraws on his account, and he is liable to compensate for the bank’s outlay of funds with interest, as well as repay the amount overdrawn.4
Can an implied contract of overdraft be terminated by the bank without giving the customer reasonable notice? The Gujarat High Court has ruled that the bank cannot unilaterally terminate the contract, even if it is called a ‘temporary overdraft’.5
This is one of the very important modes of credit delivery. Typically ‘bill financing’ occurs when bills of exchange (BOE) (as defined in Annexure I) drawn by the borrower or by counter parties on the borrower, are discounted by the bank. On the basis of payment obligations on the part of the bank, the methods of bills finance can be classified into the following:
In all these cases, the banker takes on an obligation, with the only difference that the first two are fund-based facilities and the remaining two are non-fund based.
The fund-based facilities—purchase of bills and discounting of bills arising out of sale of goods or services— score over cash credit and other types of working capital finance on the following counts:
Bills purchased and discounted by banks fall under one of the following categories:
Clean Bills This is a bill of exchange not supported by any documents of title to goods,6 since the seller has already delivered the goods and the documents to the buyer. Clean bills are also drawn to effect discharge of a debt or claim. Clean bills are treated like unsecured advances by banks, since their realization depends on the honesty and creditworthiness of the counter parties.
Documentary Bills A bill of exchange accompanied by documents of title to goods is a documentary bill. The goods have been despatched by the seller but the transfer of documents of title to goods has not yet taken place. Examples of documents of title to goods are lorry receipts, railway receipts, airway bills and bills of lading. Documentary bills are considered safer than other types of bills since they are backed by the security of documents of title to the goods, and they are either made in favour of the bank or endorsed in favour of the bank thus enabling the bank to liquidate the goods and realize its debt, in case the bill is not paid.
There are two types of documentary bills—documentary demand bills or documents against payment (D/P) and documentary usance bills or documents against acceptance (D/A).
D/P bills are similar to cash sales in that the buyer has to pay the bank before collecting the documents and taking delivery of the goods. In this type of transaction, the seller draws the bill on the buyer and sends the bill to his bank along with the documents of title to goods, instructing the bank to hand over the bill and documents only when the buyer pays for the goods.
D/A bills are similar to credit sales with a specified credit period or usance period. The usance bill is supported by documents of goods and bears the instruction to the bank that the documents can be delivered to the buyer if he ‘accepts’ the bill in writing. The bank finances the seller against the ‘accepted’ bill and holds the accepted bill till it is paid on the specified date. On the due date, the bill is presented for payment and the credit is adjusted.
It is easy to see why banks consider D/P bills safer than D/A bills. A usance bill turns into a ‘clean’ bill, since once the buyer accepts the bill, the documents are delivered and the buyer takes possession of the goods. Thereafter, the bank will have to depend solely on the ‘acceptance’ of the buyer, till the bill is paid. Hence banks should be cautious while purchasing or discounting bills on D/A basis.
Supply Bills These bills do not fall in the ambit of the Negotiable Instruments Act. They are in the nature of ‘debts’ and can be assigned in favour of the bank.
Supply bills are raised when the buyer is the government or a large corporation. In this case, the seller or supplier delivers the goods against a specified ‘work order’, and produces documents evidencing despatch of goods, such as a railway receipt or a bill of lading. These goods have to be inspected by the buyer, and once he is satisfied, an invoice is raised on the buyer. The supplier submits the invoice along with the buyer’s certification of acceptance of the goods to the bank for financing, till the invoice is processed by the buyer and payment is received.
Banks take care to lend against supply bills only to borrowers who have a proven track record of supplies to the government or large corporations. The charge is only an ‘assignment’ (see the next section for definition of assignment) and, therefore, advances against supply bills are ‘clean’ advances—the bank may not realize the full amount of the bill due to a counterclaim or set off by the government.
The salient features of RBI’s guidelines to banks while purchasing/discounting/negotiating/rediscounting of genuine commercial/trade bills are summarized below.
The bank advances against bills that are in the process of collection, after retaining a suitable margin. In all the above cases—purchase, discount and advances against collection of bills—the bank becomes ‘holder in due course’8 for the bills.
Drawee Bills In the earlier cases, the drawer of the bill, who is the seller, is financed by the bank. When the bank finances the buyer, the drawee, the buyer’s bank itself discounts the bills and sends the amount to the seller. This has the effect of financing the purchases of the buyer. The buyer’s bank grants an ‘acceptance credit’ to the buyer and accepts bills up to this limit. In short, drawee bills finance purchase of inputs and raw materials, while drawer bills (in the cases discussed above) finance receivables.
Annexure II outlines the broad guidelines to banks in India for reclassifying financial statement items for the purpose of credit appraisal.
Banks in India are given the freedom to price loans with the objective of sustaining their profitability. However, for certain classes of borrowers, the interest rates will have to conform to the periodic RBI directives, the latest directive having been issued on March 29, 2016.
The previous chapter has described a generic model of loan pricing that is comparable to pricing any product taking into account variable costs, fixed costs, and profit margin, as well as a premium that is unique to the financial instruments, that of risk.
The internal benchmark interest rates are unique to each bank in India and are calculated following a similar procedure. Please note that the external financial benchmarks described in the previous chapter are published by external benchmark administrators for the industry as a whole, while the internal benchmarks are more bank specific.
In 2010, the concept of “Base rate” was introduced as the internal benchmark rate. It was calculated as follows:9
Base rate = Cost of deposits/ funds + Negative carry on CRR/ SLR + Unallocated overhead costs+ Average return on net worth
Thus, the base rate served as the minimum lending rate to borrowers. To reflect the borrower or instrument specific risk, a risk premium would be added to the base rate, that would be quoted as the interest rate to the borrower.
The base rate used predominantly the “average cost of funds”. We have seen in the previous chapter that using the average costs of funds as the variable cost to determine the loan price could understate the interest rate. This means that the bank would make lower profit if the average cost of funds did not reflect the real cost of funds used to create the loan.
The above concern has been addressed in the move towards “Marginal cost of funds based lending rate” (MCLR).
All rupee loans sanctioned and credit limits renewed from. April 1, 2016 are to be priced with reference to the MCLR, that will now serve as the internal benchmark for banks.10
Each component is explained below
This comprises of the marginal cost of deposits and borrowings, and a return on net worth. The process of arriving at the marginal cost of deposits and borrowings is set out in the Annexure to the RBI Directions quoted above, as well as RBI guidelines on Asset Liability Management (ALM) – amendments, dated October 24, 2007. The marginal cost is calculated as the product of the rates offered on each head of deposits/ borrowings on the date of review, (or the actual rates at which the funds were raised,) and the balance outstanding in the deposit / borrowing head taken as a percentage of total funds (other than equity).
Since return on net worth is also part of cost of funds for a bank, its marginal cost of funds will be calculated as follows:
Return on net worth is reckoned as the cost of equity. Under Basel III requirements (Please refer to the relevant chapter), the common equity tier 1 (CET1) capital is required to be 8% of Risk Weighted Assets. Hence, the weightage given for this component is 8%. The return on net worth or cost of equity is the minimum desired rate of return on equity over the risk free rate. Banks can compute cost of equity using any pricing model such as the Capital Asset Pricing model (CAPM) to arrive at the cost of equity capital. (For more details on various pricing models for calculating cost of capital, please refer to a standard text book on Corporate Finance).
“Negative carry” denotes a loss of income or profit that could arise when funds are sourced at a higher cost than the return on investment of these funds. Investment in CRR does not earn for a bank, since no interest is paid by RBI on CRR balances. However, the bank has to pay interest to depositors and others for sourcing the funds from which the CRR is maintained.
The marginal cost of funds arrived at in (a) above is used in calculating the negative carry.
All operating costs associated with the loan (see the example on Customer Profitability in the previous chapter) will be included under this head. However explicit service charges that are charged separately, such as upfront processing fees, will not be added in this component.
The tenor premium is not borrower or loan class specific. For a given tenor of loan (residual maturity), the tenor premium would be the same. Calculation of the tenor premium is shown in the Annexure to the 2016 instructions of RBI. More clarifications can be found under the head FAQs on the subject on the RBI website.
Since MCLR is a tenor linked benchmark, internal benchmarks will have to be published by banks for various maturities such as overnight MCLR, one month MCLR, three month MCLR, six month MCLR, one year MCLR, and MCLR for longer maturities as well.
In addition to the MCLR as an internal benchmark, banks can determine interest rate on loans to specific borrowers based on market determined external benchmarks (described in the previous chapter).
The components of ‘spread’ linked to the loan price would be decided by each Bank’s Board. The policy would have to include principles governing quantum of each component of spread, the range for a borrower category or loan type, and the powers delegated for loan pricing.
Under the MCLR, two components of ‘spread’ are to be adopted –Business Strategy and Credit Risk premium.
The component related to “Business Strategy” would include considerations such as business strategy, market competition, embedded options in the loan (eg- prepayment etc), market liquidity of the loan and similar aspects.
The component related to ‘credit risk premium’ would reflect the default risk based on an appropriate credit risk rating or scoring model, that would also include factors such as customer relationship, expected losses, and collaterals. (More on Credit Risk models can be found in later chapters).
The spread charged to an existing borrower cannot be increased unless there is a deterioration in the credit risk profile of the customer, and the increase should be supported by full fledged risk profile review of the customer.
Reset dates for loans are to be specified by individual banks, and can be linked to the date of sanction of credit limits or date of review of MCLR. The MCLR prevailing on the date of disbursement will be applicable till the next reset date. Periodicity of reset will be one year or lower, and is to be specified in the loan contract.
Bank’s policy on interest rates would be approved by the Board. These interest rates would be determined with reference to an external benchmark (as described in the previous chapter).
The types of loans that would be exempted from the provisions of the MCLR, and not linked to the MCLR, include the following:
We have seen in the earlier chapter on ‘Banks’ Financial Statements’ that loans and advances can be classified by security arrangements into ‘secured’, ‘covered by bank/government guarantees’ and ‘unsecured’ loans.
If a loan is not backed by any tangible security, except the personal guarantee of the borrower himself or a third party, the loan is classified as ‘unsecured’. In the event of borrower default, the bank will be ranked an unsecured creditor and gets no seniority in claiming against any property of the borrower. Hence, banks generally do not create unsecured loans unless the borrower is well established, has a track record of integrity and prompt repayments, and the bank has confidence in the borrower’s future solvency, otherwise called ‘creditworthiness’.
A notable exception is those loans covered by guarantees of the government or other banks. Balances under advances within India and granted abroad, covered by guarantees of Indian or foreign governments, or by agencies such as ECGC, are categorized under ‘advances covered by bank/government guarantees’ and are not considered unsecured.
A major portion of bank loans and advances fall under this category. Though a bank lends only to creditworthy borrowers, tangible securities are sought for the credit extended, over and above the assessed ‘creditworthiness’ of the borrower. This is to safeguard the bank’s interest in the worst case scenario.
Secured loans are backed by tangible assets in the form of ‘floating’ or ‘fixed’ assets. Examples of floating assets are current assets, where the composition of the assets keeps changing over a specified period of time, the amount secured being constant. Examples of fixed assets are plant and machinery or land and buildings, whose composition cannot be altered in the short term without substantial investment. In some categories of advances, documents and commodities also form part of tangible securities.
As discussed earlier in this chapter, the securities can be ‘prime’ or ‘collateral’ in nature.
Securities and Their Features Can the banker accept any asset offered by the borrower as security for the advances made? Some basic safeguards observed while accepting assets as securities would help the bank recover most of its dues in the event of default.
Safeguard 1—Ensure adequate ‘margin’: For a bank, ‘margin’ signifies the difference between the market value of the security and the amount of advance granted against it. For example, if the bank has sanctioned ₹75 lakh as advance against a security worth ₹1 crore, the bank has a margin of ₹25 lakh (100 – 75 = ₹25 lakh). The rationale for adequate margin stems from the following factors:
Safeguard 2—Easy marketability: In case of default, the security should have wide and ready marketability, to enable the bank sell off the security and realize its dues. For example, gold or jewels held as security are more liquid since they have wider marketability than, say, real estate.
Safeguard 3—Documentation: The bank’s security interest is evidenced by legally valid documents that are executed by the borrower. These documents have to be periodically reviewed, especially in the case of securities for long-term loans or revolving credits, to ensure that the documents are kept enforceable and the legal limitation period for such agreements does not render the agreements invalid.
Some commonly accepted securities and their relative merits are discussed in Annexure III.
Though commonly used by bankers, ‘security’ is not defined in any act. The Provincial Insolvency Act defines a ‘secured creditor’ as one who holds a mortgage, lien or charge on the property of a debtor, as security for a debt due from the debtor. In banking parlance, securities accepted by banks fall into the following categories:
When the bank accepts different securities in respect of loans granted, the bank is said to have a ‘charge’ over the assets which constitute these securities.
We will now elaborate upon the various types of securities and their features.
Pledge: Section 172 of the Indian Contracts Act, 1872, defines ‘pledge’ as ‘bailment of goods as security for payment of a debt or performance of a promise’. The bank (pledgee) enters into an explicit contract of pledge with the borrower (pledgor), under which the securities are delivered to the bank. Such delivery of possession can be actual or constructive. Thus, a pledge implies (a) bailment11 of goods, and (b) that the objective of bailment is to hold goods as security for the payment of a debt or performance of a promise.
The primary advantage of pledge is that the goods are in the ‘possession’ of the bank thus preventing security dilution by the borrower. However, the bank would find holding goods of various borrowers under pledge a cumbersome exercise, since the bank, as the pledgee, has to take reasonable care of the goods and any loss has to be compensated to the borrower. This entails higher monitoring and inspection costs for the bank.
The disadvantages cited above, along with the risks associated with the nature of the goods under pledge,12 have rendered this type of security unpopular.
Hypothecation: This is one of the most popular methods of creating security interest for banks, and is characteristic of the banking industry. Interestingly, ‘hypothecation’ is not governed by any identifiable Act in law. Simply defined, hypothecation is a legal transaction involving movable assets, amounting to an ‘equitable charge’ on the assets. The difficulties of holding the security in the bank’s custody are removed in hypothecation, as the security interest is created without transferring the possession of assets to the bank. In hypothecation, the security remains in the possession of the borrower, and is charged in favour of the bank through documents executed by the borrower. The documents contain a clause that obligates the borrower to give possession of the goods to the bank on demand. Once possession over the goods is relinquished by the borrower, hypothecation becomes similar to pledge.13
How does hypothecation differ from ‘pledge’ and ‘mortgage’? Box 6.3 explains in brief.
Though the cumbersome procedures under pledge are eliminated by the process of hypothecation, the latter is more risky for the bank. Since the securities are in the borrower’s possession, the borrower can fail to give possession to the bank on demand, or sell the securities without the bank’s knowledge, or borrow from another bank on the strength of the same securities. In this respect, advances under hypothecation are as risky as unsecured or clean advances.
The bank will therefore have to take the following precautions:
If a vehicle hypothecated to a bank under vehicle loan is involved in an accident, and the passengers are injured, will the bank be liable for compensation to the victims?
An interesting point in this connection is the position of the ‘guarantor’ to the loan given by a bank to its borrower, who sells goods hypothecated to the bank without the bank’s knowledge and does not repay the debt owed to the bank.
Under the above circumstances, the question is whether the guarantor is discharged from his liability since the goods were sold without the guarantor’s consent (section 141 of the Contracts Act). Since the rights and obligations of a hypothecator and the hypothecatee are not defined precisely under a specific Act, courts have so far taken different and sometimes, opposing stances regarding the rights and obligations of various parties under hypothecation.18
Assignment: Borrowers ‘assign’ actionable claims to the bank. Section 130 of the Transfer of Property Act, 1882, permits an assignment to anyone except a judge, legal practitioner or an officer of the court of justice. Section 3 of the act defines actionable claim 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, either actual or constructive, of the claimant, which the civil courts recognize as affording ground for relief, whether such debt or beneficial interest be existing, accruing, conditional or contingent’.
What are the actionable claims a borrower can assign to a bank?
Assignment takes two forms—(1) legal assignment; and (2) equitable assignment. A legal assignment, which is in writing by the assignor, constitutes an absolute transfer of the actionable claim. The assignor also informs his debtors of the assignee’s interest, which is followed up by the assignee seeking confirmation from the debtors of the balances assigned. In the case of equitable assignment, the above conditions are absent.
The bank gets absolute right over the funds assigned to it. Once the borrower assigns his claims to the bank, other creditors of the borrower cannot get priority over the bank in the realization of their dues from the assigned debts.
Bankers’ Lien: This is one of the most important rights of the lending bank. ‘Lien’ is the right of the bank to retain the securities given by the borrower until the debt due is fully repaid.
Lien is of two kinds—general lien and particular lien. Section 171 of the Indian Contracts Act, 1972, confers the right of general lien on the bank, stated as ‘Bankers…may, in the absence of a contract to the contrary, retain as a security for a general balance of account, any goods bailed to them.’ In the case of a particular lien, specific securities are earmarked for a specific debt. Once the debt is satisfied, the lien ceases to have effect. Example of a particular lien is that marked on a fixed deposit against which a loan has been taken. Once the loan is repaid, the fixed deposit becomes unencumbered.
The distinguishing features of the bankers’ right of general lien are the following:
The following are the exceptions to the right of general lien:
What is ‘Right of Set Off’? The bank’s right of set off enables it to adjust the credit balance (or deposit) in one account of a customer with the debit balance (or loan) in another account of the same customer. For example, if a customer has a term deposit of ₹2 lakh, and he owes ₹3 lakh to the bank, the bank can combine both the accounts, set off the deposit amount against the loan amount, and claim the remaining ₹1 lakh from the customer. The right of set off can be exercised under the following conditions:
The bank has another right—the right of appropriation of payments received from the borrower, where the latter has taken more than one loan from the bank, or has more than one account with the same bank. This right is governed by Sections 59 to 61 of the Indian Contract Act, 1872, by which the bank can appropriate payments received to debts that have already fallen due for payment. Payments should first be appropriated towards interest and then towards principal repayments, unless there is a contract to the contrary. The rule derived from the famous Clayton’s case20 is of substantial practical application to banks. According to this landmark ruling, credits to loan accounts would adjust or set off debits in the chronological order. Further, in case of death, retirement or insolvency of a partner of a firm, the then existing debt of the firm is set off by subsequent credit inflows to the account. The bank thus loses its right to claim the debt from the assets of the outgoing partner, and may have to suffer a loss if the remaining debt cannot be recovered from other partners. Hence, to prevent the operation of the rule in Clayton’s case, the bank closes the existing account of the firm, and reopens in the name of the reconstituted firm.
In Vijay Kumar vs M/s Jullundur Body Builders, Delhi and others [AIR 1981, Delhi 126], Syndicate Bank issued a bank guarantee on behalf of its customer. As security for the bank guarantee, the customer deposited two fixed deposit receipts, duly discharged, with a covering letter stating that the deposits can remain with the bank as long as any amount was due to it from the customer. However, the bank officer made an entry on the reverse of the deposit receipts, implying that the deposits served as security only during the validity period of the bank guarantee. When the bank guarantee was discharged, the bank claimed its right of general lien on the deposits. However, the Delhi High Court ruled that the bank had only particular lien since the officer’s comments on the reverse of the deposit receipts were explicit and specific, while the covering letter from the customer was on a printed format.
However, the Supreme Court had a different view in the same case. In AIR 1992, SC 1066, the Supreme Court upheld the right of bankers’ lien and right of set-off, holding that these are of mercantile custom and are judiciously recognized. It was held that ‘The bank has general lien over all forms of securities or negotiable instruments deposited by or on behalf of the customer in the ordinary course of banking business and that the general lien is valuable right of the banker judicially recognized and in the absence of an agreement to the contrary, a Banker has a general lien over such securities or bills received from a customer in the ordinary course of banking business and has a right to use the proceeds in respect of any balance that may be due from the customer by way of a reduction of customer’s debit balance. In case the bank gave a guarantee on the basis of the two FDRs it cannot be said that a banker had only a limited particular lien and not a general lien on the two FDRs. It was hence held that what is attached is the money in deposit amount. The banker as a garnishee, when an attachment notice is served has to go before the court and obtain suitable directions for safeguarding its interest’
In Brahmayya vs. K P Thangavelu Nadar [AIR 1956, Madras 570], the Madras High Court has explained the rationale thus: ‘When goods are deposited with or securities are placed in the custody of a bank, it would be correct to speak of rights of the bank over the securities or goods as lien, because the ownership of the goods or securities would continue to remain in the customer. But when moneys are deposited in a bank as fixed deposit, the ownership of the moneys passes to the bank and the right of the bank over the money lodged with it would not be really a lien at all. It would be more correct to speak of it as a right of set off or adjustment’
The court can interfere in the exercise of the Bank’s Lien. In Purewal and Associates and another vs. Punjab National Bank and others (AIR 1993, SC 954) the debtor failed to pay dues to the bank which resulted in denial of bank’s services to him. The Supreme Court of India ordered that the bank shall allow the operation of one current account which will be free from the incidence of the Banker’s lien claimed by the bank so as to enable the debtor to carry on its day to day business transactions etc. and the liberty was given to bank to institute other proceedings for the recovery of its dues.
In City Union Bank Ltd.vs.Thangarajan (2003)46 SCL 237 (Mad), certain principles with respect to Banker’s lien were reiterated. The bank gets a general lien in respect of all securities of the customer including negotiable instruments and FDR s, but only to the extent to which the customer is liable. If the bank fails to return the balance, and the customer suffers a loss thereby, the bank will be liable to pay damages to the customer. In the quoted case the Court based its decision on the principle that in order to invoke a lien by the bank, there should exist mutuality between the bank and the customer i.e., when they mutually exist between the same parties and between them in the same capacity. Retaining the customer’s properties beyond his liability is unauthorized and would attract liability to the bank for damages.
Banker’s Lien is not available against Term Deposit Receipt in Joint Names when the debt is due only from one of the depositors In State Bank of India vs. Javed Akhtar Hussain and others, AIR 1993, Bom.87, the bank obtained a decree against applicant and non-applicant who stood as a surety to the non-applicant No.1. After a decree was passed, the nonapplicant No. 2 deposited a sum of `32,793 in TDR No. 856671 with the appellants in joint names of himself and his wife in another branch of the same bank. They were also having RD account. The applicant bank retained lien on both these accounts without exhausting any remedy against non-applicant No.1. The Court held that the action of keeping lien was a sort of suomuto act exercised by the Bank even without giving notice to the non-applicant No. 2 and his wife. The applicant could have moved the court for passing orders in respect of the amounts invested in TDR and RD accounts. However, it was ruled that the action of the bank in keeping lien over both these accounts was unilateral and high-handed.
A banker’s right of set off cannot be exercised after the money in his hands has been validly assigned or in any case after he has been notified of the fact of an assignment.(Official Liquidator, Hanuman Bank Ltd. vs. K.P.T. Nadar and Others 26 Comp.Cas. 81)
In Punjab National Bank vs. Arunamal Durgadas, AIR 1960 Punj.632 State Bank of India vs. Javed Akhtar Hussain, AIR 1993 Bombay, 87, certain essentials to exercising the right of set off were indicated. It was established that: (1) Mutuality is essential to the validity of a right of exercising set-off (2) It must be between the same periods.
Mortgage: Section 58 of the Transfer of Property Act, 1882, defines a mortgage as ‘the transfer of interest in specific immovable property for the purpose of securing the payment of money advanced or to be advanced by way of loan, on existing or future debt or the performance of an engagement, which may give rise to a pecuniary liability’.
The transferor of the property is the ‘mortgagor’. The entity to whom the transfer takes place is the ‘mortgagee’. The document through which mortgage takes effect is the ‘mortgage deed’.
From the definition, it follows that there are two important ingredients to a mortgage—(a) the transfer of interest in the mortgaged asset, and (b) the transfer is to create a security for the amount paid or to be paid by the bank as loan.
The following points about mortgage are to be noted:
The Transfer of Property Act recognizes six types of mortgages. They are as follows:
Box 6.5 summarizes some Supreme Court decisions in respect of equitable mortgages.
There are three important requirements for an equitable mortgage: (a) debt, (b) deposit of title deeds of the property and (c) the intention that the title deeds will be the security for the debt.
In K J Nathan vs. S V Maruthi Rao (ATR 1965, SC 430), it was opined that, ‘Whether there is an intention that the deeds shall be security for the debt is a question of fact in each case… there is no presumption of law that the mere depositing title deeds constitutes a mortgage, for no such presumption has been laid down, either in the Evidence Act or in the Transfer of Property Act’…
In United Bank of India vs. Lekheram sonaram and comp.(AIR 1965, SC 1591), it was stated that ‘But if the parties choose to reduce the contract to writing (with all terms and conditions) such document requires registration under Section 17 of Indian Registration Act 1908. If a document of this character is not registered it cannot be used in evidence at all and the transaction itself cannot be proved by oral evidence either’.
Further, in Deb Dutt Seal vs. Raman Lal Phumsa (AIR 1970, SC 659), the Supreme court ruled… When the debtor deposits with the creditor, title deeds of his property with interest to create a security, the law implies a contract between the parties to create a mortgage and no registered instrument is required under Section 59 as in other classes of mortgage.
Charge: This is a word that can commonly be used to describe any form of security for debt, whether the borrower is an individual, partnership firm, private or public limited company or the government.
More specifically, charges registered, under the Companies Act, 1956 include rigorous provisions, and can generally be classified into a ‘fixed charge’ and a ‘floating charge’.
A ‘fixed charge’ (not to be confused with ‘fixed assets’) is a specific charge over designated properties of the company. It gives the bank the right to sell the assets and appropriate the sale value to the debt due from the company.
A ‘floating charge’ (a) ‘floats’ over the present and future property of the company (including those under fixed charge) and is not attached to any specific asset or assets; (b) does not restrict the company from selling the assets under charge or assigning them as security for loans from other parties; and (c) could crystallize into a fixed charge upon the happening of an event or contingency, such as liquidation of the company. It is important to note that when the floating charge becomes fixed, it constitutes a charge on all properties and assets belonging to the company, and gains seniority over all subsequent fixed charges, unsecured creditors and money advanced to the liquidator.
It is, therefore, evident that, in order for the bank to be the senior creditor, it will have to ensure seniority in claims over the bank’s assets as well. This purpose is achieved by registering the bank’s charge with the Registrar of Companies under Section 125 of the Companies Act, 1956. Such registration of charge will have to be done within 30 days of execution of the loan agreement, and can be extended up to 60 days with a penal provision.
What are the consequences of non-registration of charge by the bank? In the event of the company going into liquidation, the bank’s debt, otherwise ranked senior to all other creditors’ claims, will now be treated as unsecured, and will rank low as an unsecured creditor at the time of settlement of claims. It is to be noted that in spite of non-registration of charge, the bank’s debt is recoverable and the securities are enforceable, as long as the company is a going concern. The bank gets ranked as an unsecured creditor only in case of company liquidation. A more serious consequence would be when a junior creditor moves up to senior position at the time of enforcement of securities, merely by virtue of having filed its charge with the registrar of companies before the senior creditor did. This is in accordance with the provisions contained in Section 126, which clarifies that notice of charge registered by the bank under Section 125 will be reckoned from the date of registration and not from the date of creation of the charge. It is also mandatory that every time there is a change in the loan agreement, a modification charge is filed with the registrar of companies within 30 days of such modification taking effect.
The bank should also verify prior fixed and floating charges on the assets charged to it by the borrowing company before specifying the security backing in its loan agreement. For example, if the borrowing company had made a debenture issue, secured by floating charge on all the company’s assets, with a specific clause prohibiting creation of any charge senior to ranking on par with debenture holders, then the bank cannot gain a senior creditor position in spite of registering its charge on time. If the bank still finds lending to this company profitable, it should stipulate suitable covenants that would compensate for a likely shortfall in security backing for its advances to the company.
Box 6.6 presents an illustrative checklist of the precautions bankers should take while lending to a company.
A detailed description of the provisions of law relating to registration of charges can be found in Sections 124 to 145 of the Companies Act, 1956.
Answer ‘True’ or ‘False”
Check your score in Rapid fire questions
The company requires current assets of ₹620 lakh during this period, the split up for which is as follows:
Inventory: | ₹300 lakh |
Receivables: | ₹180 lakh |
Cash and others: | ₹140 lakh |
Fill in the following table to assess the structure of working capital finance, if current liabilities amount to ₹70 lakh and the bill finance required is ₹40 lakh. Assume the bank wants a margin of 25 per cent for all the modes of financing it extends to the borrower.
Margin on capital expenditure will be @ 25 per cent on long-term assets.
Typically, there are six types of borrowers to whom banks can lend. They are as follows:
In this section, we will look at the methodologies adopted by Indian banks to assess the various types of credit requirements of borrowers. Recognizing the need for banks to be competitive, both in the domestic and international markets, the RBI has now given banks the autonomy to evolve their own internal methods for appraisal and assessment of credit requirements. While credit appraisal closely follows the framework presented in the previous chapter, the methods of lending have been customized for various categories of borrowers, depending on the purpose, their contribution to the economy and their developmental needs.
Banks in India have traditionally been lenders for working capital needs of borrowers, with the financial institutions having been slated for the role of term lenders. The composition of liabilities and assets of banks and financial institutions, as two different categories of financial intermediaries, also varied to suit the purpose for which they were formed. The financial sector reforms and progressive privatization, consolidation and globalization of the banking sector have now led to the blurring of the distinction between banks and financial institutions. In the present context, Indian banks have almost taken over the functions of the financial institutions, and have also made a foray into financial services in a big way.
Banks are now are expected to lay down, through their Boards, transparent policies and guidelines for credit dispensation, in respect of each broad category of economic activity, keeping in view the credit exposure norms and various other guidelines issued by the RBI from time to time. Some of the currently applicable guidelines and practices are detailed in the following paragraphs.
Banks generally use one of the following methods to assess the working capital financing requirements of borrowers.
Projected Turnover Method This method is generally used for assessing working capital finance requirements in case of borrowers whose fund-based working capital requirements are less than ₹2 crore. According to this method, the working capital requirement would be assessed at 25 per cent of the projected turnover to be shared between the borrower and the bank, i.e., borrower contributing 5 per cent of the turnover as net working capital (NWC) and bank providing finance at a minimum of 20 per cent of the turnover. Alternatively, the banks may use the traditional method of assessment, using the working capital or cash-to-cash cycle to determine credit requirements. If the credit requirement based on traditional processing cycle is higher than that assessed on projected turnover, the bank may, at its discretion, sanction the former as the credit limit, as the borrower can be financed up to a minimum of 20 per cent of the projected annual turnover of the firm.
The simplicity of the procedure is intended to speed up credit sanctions for small and needy borrowers and does not amount to dilution of the assessment of the borrower’s creditworthiness. Credit appraisal has to be carried out on the lines discussed in the previous chapter. It is also important to verify how reasonable the borrower’s projections are. Hence, the bank should call for annual statements of accounts and other documents, such as returns filed with sales-tax/revenue authorities, and ensure that the estimated growth during the year is realistic.
Illustration 6.1 will clarify the computation.
Borrower: ABC Limited | (₹ in Lakh) |
1. Projected turnover for the coming year | 60.00 |
2. Gross working capital [assessed at 25 per cent of (1)] less | 15.00 |
3. Borrower’s margin (a minimum of 5 per cent of (1) or projected NWC, whichever is higher) (Assume 5 per cent) | 3.00 |
4. PBF (2) 2 (3) | 12.00 |
Case 1
In case the borrower has projected an NWC (current assets less current liabilities) of say, 7 lakh, the PBF will reduce to ₹8 lakh.
Case 2
In case the borrower’s operating cycle is such that the actual working capital requirement would be ₹20 lakh, and the bank is convinced that this is an accurate reflection of the borrower’s operations, the PBF can be increased, after deducting the requisite margin.
The borrower can be permitted to draw against the credit limits after instituting the usual safeguards to ensure that the bank finance will be used for the purpose intended. Banks will have to ensure regular and timely submission of monthly statements of stocks, receivables, etc., by the borrowers and also periodical verification by credit officers of these statements with physical stocks.
The Permissible Bank Finance Method This method is generally applied by banks to working capital limits of over ₹2 crore.
The earlier prescription regarding maximum permissible bank finance (MPBF), based on a minimum current ratio of 1.33:1, recommended by the Tandon Working Group has been withdrawn. Banks are now free to decide on the minimum current ratio and determine the working capital requirements according to their perception of the borrowers and their credit needs. Banks may adopt any of the following methods:
The basic framework for arriving at the PBF will be on the lines shown below (Table 6.2).
Some ratios generally calculated to assess the reasonableness of the projections and the borrowers’ capacity to repay.
Cash Budget Method This method is prevalently applied to borrowers with fund-based limits of over ₹10 crore from the banking system. Optional to all borrowers in industry, trade and service sectors, this method is preferred by borrowers in the construction industry and other seasonal industries.
Under this method, the amount of working capital finance is determined from the projected monthly cash flows, and not from the projected levels of assets and liabilities. The permissible bank finance will be restricted to the peak level gap between cash inflows and outflows in the cash flow projections. This method is preferred in cases where cash flows would fluctuate within a short time frame, and an ‘averaging’ of production and sales parameters (as in the case of PBF method) may lead to anomalies in the requirements and utilization of bank finance.
TABLE 6.2 THE BASIC FRAMEWORK FOR ARRIVING AT THE PERMISSIBLE BANK FINANCE
The cash flow budgets, after scrutiny by the credit officer, may be presented in the following manner to arrive at the funding gap as shown in Table 6.3.
The maximum bank finance for working capital requirements would be the peak ‘gap’ of the four quarters. Funds may be drawn by the borrower in accordance with the monthly or quarterly cash deficit in the projected cash flow statement, after reporting the actual cash flows during the preceding period. In case of a likely significant change in cash flows, the borrower will have to submit a revised cash flow budget for that period. However, borrowings will be capped by the assessed ‘gap’, though flexibility within this ceiling is permitted.
Once the quantum of eligible bank finance is determined by any of the above methods, the bank will have to fix the amount of credit that it will extend to the borrower. How does the bank arrive at the credit limit appropriate to specific portions of the working capital cycle? Some illustrative situations are presented as following.
Situation 1: The borrower seeks working capital finance against raw material inventory, which needs to be stocked for 2 months. The value of this inventory is assumed at ₹1 crore. The borrower gets market credit for the inventory, creditors for which at any point in time show a balance of ₹25 lakh. The limit is structured as a percentage of the fully paid inventory that the borrower holds in one working capital cycle at any point of time.
The eligible bank finance against raw material inventory can, therefore, be only ₹75 lakh (to avoid double financing). Of this amount, the borrower is expected to bring in a margin of 20 per cent, or ₹15 lakh. Hence, assuming that the projected NWC of the borrower is not higher than ₹15 lakh, the bank will finance up to a credit limit of ₹60 lakh.
Situation 2: The borrower seeks working capital finance against inventory and receivables in the form of book debts. Let us assume that the borrower in Situation 1 has work in progress (WIP) and finished goods inventories of ₹2 crore and book debts amounting to ₹50 lakh outstanding at any point of time. After ascertaining that these inventories and book debts are current, marketable and realizable, the bank fixes appropriate margins of, say, 25 per cent for inventories and 50 per cent for book debts. Accordingly, against inventories of ₹3 crore (inclusive of raw material), the bank would fix a credit limit of 75 per cent amounting to ₹2.25 crore, and against book debts of ₹50 lakh the borrower would be eligible for ₹25 lakh as credit limit. Thus the bank would finance up to ₹2.75 crore of working capital.
Receivables can be in the form of book debts or ‘bills’. Book debts are generally included as part of the assessed overall credit limits. However, bills are considered ‘self liquidating’ instruments and are financed separately.
BOE are ‘negotiable instruments’,25 which arise out of commercial transactions both in inland and foreign trade. They are instruments in writing, containing an unconditional order signed by the maker (seller) directing a person (buyer) to pay certain amount only to certain person (bank).
When the creditor or seller of the goods draws a Bill on the debtor or the buyer, he has two options to realize the revenue from the sale—(a) he could send the bill for collection through the seller’s bank, or (b) he could sell it or discount it with the bank, which has sanctioned him credit limits against such transactions. The bank can, therefore, easily assess the credit requirements of the borrower against goods or services sold by him against such BOE. The bank may sometimes agree to purchase or discount bills drawn on specified counter parties alone.
Except working capital, all other requirements are met by banks through installment credit, i.e., the loan is repaid by the borrower in periodic installments over a pre-specified period. Such loans are also called ‘term loans’, and are generally used to finance projects or asset purchases. Banks in India follow similar steps outlined in the previous chapter while appraising requests for term loans. DCF26 valuation methodologies are applied to assess the financial viability of most projects in the medium-and long-term. The debt service coverage ratio is an important criterion for the decision to lend.
In India, there are currently many online P2P lending platforms and the sector has been growing at a rapid pace. The Reserve Bank released a consultation paper on P2P lending in April 2016. The paper deliberated the advantages and disadvantages of regulating P2P platforms and underscored the need to develop a balanced regulatory approach that would protect lenders and borrowers without curbing the underlying innovations. Accordingly, P2P platforms are proposed to be regulated as a separate category of NBFCs.
Peer-to-peer (P2P) lending is an innovative form of crowdfunding with financial returns. It involves the use of an online platform to bring lenders and borrowers together and help in mobilising unsecured finance. The borrower can either be an individual or a business requiring a loan. The platform enables a preliminary assessment of the borrower’s creditworthiness and collection of loan repayments. Accordingly, a fee is paid to the platform by both borrowers and lenders. Interest rates range from a flat interest rate fixed by the platform to dynamic interest rates as agreed upon by borrowers and lenders using a cost-plus model (operational costs plus margin for the platform and returns for lenders).
One of the main advantages of P2P lending for borrowers is that the rates are lower than those offered by money lenders/unorganised sector, while the lenders benefit from higher returns than those obtained from a savings account or from any other investment.
Although there has been significant growth in online lending platforms globally, there is no uniformity in the regulatory stance with regard to this sector across countries.
It is argued that regulation may stifle the growth of this nascent sector. On the other hand, proponents of regulation argue that the unregulated growth of this sector may breed unhealthy practices by market players and may, in the long run, have systemic concerns given the susceptibility of this sector to attract high risk borrowers and also weaken the monetary policy transmission mechanism.
While P2P lending platforms are banned in Japan and Israel, they are regulated as banks in France, Germany and Italy, and are exempt from any regulation in China and South Korea.
Companies Act | RBI Guidelines | Rationale | |
---|---|---|---|
Liabilities | |||
Share Capital | All kinds of share capital like equity, redeemable and irredeemable preference shares. | Excludes preference shares. | The repayment obligation in redeemable preference shares is certain and time bound. Hence, it is preferable to treat these as debt rather than equity. |
Merits
Demerits
Merits
Demerits
Examples of documents of title to goods: bill of lading, railway/lorry/airway receipts, warehouse certificates and delivery orders.
Merits
Demerits
Merits
Demerits
These are debt instruments issued by companies, mostly bearing fixed interest payments at regular intervals. They are generally secured by the assets of the company issuing the instruments.
Merits
Demerits
Banks usually permit depositors to borrow against their own term deposits. This is one of the most secured advances for the bank, since the security needs no valuation or verification of title.
However, the security is enforceable only if the loan is granted in accordance with the norms. To illustrate: (a) the advance can be granted only to the person(s) in whose name(s) the term deposit stands; (b) no loan should be granted against fixed deposits of other banks;28 (c) the bank should immediately mark its ‘lien’ over the deposit to avoid payment of the deposit amount before the loan is adjusted fully and (d) no loan should be granted against fixed deposits in the name of a minor.
Murali Krishna, proprietor of Krishna Steels, was in deep thought. He was convinced that there would be substantial increase in sales of his firm over the next couple of years. However, he had to look for borrowed funds, since he seemed to be perpetually short of cash, in spite of good profits. At the end of the first quarter of 2016, his outstanding borrowings from Smaller Bank stood at Rs 4 crore, which meant that he had fully utilized the credit limit granted for working capital by his bank, Smaller Bank. He was doubtful if the bank would agree to a significant increase in the present credit limit of Rs 4 crore. Krishna was just managing to stay within the credit limit granted by the bank by relying heavily on credit from his suppliers.
Krishna had discussed his problem with Mr Jai, who headed the city branch of Larger Bank. Jai had tentatively agreed to raise the credit limit to a maximum of Rs 7 crore. Krishna thought that a credit limit of this size would improve his firm’s cash position and profitability. However, Jai made it clear that the sanction of credit limit by his bank would be based on investigation and appraisal by his team of credit officers, and that Murali would sever his relationship with Smaller Bank in case his loan was sanctioned by Larger Bank.
The following points are excerpts from the credit officers’ report to Jai:
The financial statements for Krishna Steels are given in Tables 6.4 and 6.5
The credit officer also commented on the key aspects of the firm’s financial performance, particularly the growth in sales, current assets and current liabilities, and paid atten-tion to key financial ratios that seemed to be impact Krishna’s cash generation and profitability.
TABLE 6.4 KRISHNA STEELS BALANCE SHEET 2014-2016