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Financing Working
Capital Needsaspects 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 tovarious 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 Medium & Bridge Composite
Personal
Loans Long term loans loans
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 overa 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 NeedsDemerits 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 ofthe 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
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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 usuallysecured 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 costincludes 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.
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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 Covered by Unsecured
Tangible Assets Bank /Govt. Guarantees
Secured Advances
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 caseof
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
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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, thebanker 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 thepoint of view of transfer of title to the mortgaged property, mortgages are divided
into-
a) 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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Financing Working
Capital Needsnecessary 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 inwriting. 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.
.......................................................................................................................
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.......................................................................................................................
2) Distinguish between pledge and hypothecation. Which provides better security
to the banker and why?
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.......................................................................................................................
3) What do you understand by Equitable Mortgage? What are its advantages
vis-a-vis legal mortgage?
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.......................................................................................................................
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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 & Documents Real Estates Book Supply
Commodities Debts Bills
Documents of Stock Exchange Life Insurance Fixed Deposit
Title to goods Securities Policies 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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Financing Working
Capital Needssensitive 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;
ii) Fixing margins and rates of interest that can be levied by banks in their credit
against the selected commodities; and
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 togoods. 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 easyliquidity, 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 toindividuals 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 assignedto 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 risk-
prone, 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 orCollateral 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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Financing Working
Capital Needsbe unsecured or secured. For example, where the guarantor has executed a guaran-
tee 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) to send the bill to a bank for collection, or
b) 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 aretherefore, 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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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 ofunsecured 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 Needs1) 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) CapacityIf 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) CapitalThe 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 thatdebt 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?
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2) What are the advantages of discounting of bills to the banks? Is it compulsory
for corporate borrowers to use bills of Exchange?
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3) What do you understand by credit-worthiness of a borrower? What factors are
taken into account by the banker to determine credit-worthiness?
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9.10 SUMMARY
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